Question

What are the “red flags” that may indicate that a firm has crossed over from earnings smoothing or earnings management to fraudulent reporting?

Answer 1

Summing up, the dominant red flags are lack of correspondence between earnings and cash flows, and deviations from peer and industry norms. But there is much additional texture in the responses, with the interviews especially emphasizing the role of corporate governance and tone at the top. Specific red flags include the areas of acquisition accounting, provisions for taxes and pensions, and use of subsidiaries and off-balance sheet entities. These red flags can potentially counter the difficulty that analysts and investors experience in identifying earnings misrepresentation from the outside.