Checklist to Detect misreported Assets and Liabilities
by Chetan Parikh
  
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In a wonderful book The Financial Numbers Game, the authors, Charles W. Mulford and Eugene E. Comiskey, have developed a checklist to detect misreported assets and liabilities.

Detecting Overvalued Assets

 A. Accounts receivable

    1. Compare the percentage rate of change in accounts receivable with the percentage rate of change in revenue for each of the last four to six quarters.

       a. What are the implications of differences in the rates of change?

    2. Is the allowance for doubtful accounts sufficient to cover future collection problems?

       a. Compute AIR days for each of the last four to six quarters

          i. Is the trend steady, improving, or worsening?

         ii. Is the overall level high when compared with competitors or other firms in the industry?

   3. Have economic conditions for the company's customers worsened recently?

       a.   Are company sales declining?

       b.   Are there other general economic reasons to expect that customers are, or may be, having difficulties?

   4.   Are sales growing rapidly?

       a. Has the company changed its credit policy?

          i. Is credit being granted to less creditworthy customers?

       b. Have payment terms been extended?

B.       Inventory

    1.  Are inventories overstated due to inclusion of nonexistent inventories or by the reporting of true quantities on hand at amounts that exceed replacement cost?

       a. Compute gross margin and inventory days for the last four to six quarters

         i. Is the trend steady, worsening, or improving?

         ii. How do the statistics compare with competitors and other firms in the industry?

   1. Before making comparisons with competitors, make sure that the same inventory methods (LIFO, FIFO, etc.) are being used

         b. Do ongoing company events and fortunes suggest problems with slackening demand for the company's products?

             i. Are sales declining?

            ii. Have raw materials inventories declined markedly as a percentage of total inventory?

      c. Are prices falling, suggesting general industry weakness and an increased chance that inventory cost may not be recoverable?

      d. Is the company in an industry that is experiencing rapid technological change, increasing the risk of inventory obsolescence?

      e. Has the company shown evidence in the past of inventory overvaluation?

          i. Is there an example of a prior year write-down of inventory that became value impaired?

    2. Does the company use the FIFO method?

       a. Companies that use FIFO run a greater risk that inventory costs may exceed replacement costs 

   3.  Does the company employ the LIFO inventory method for at least a portion of its inventory?

        a. Are LIFO adjustments being made for interim periods?

            i. Has the LIFO reserve account remained unchanged during interim periods?

            ii. If the LIFO reserve account has been adjusted during interim periods, does the estimate of inflation used appear reasonable?

          iii. How does gross margin for interim periods compare with prior years' annual results?

        b.   Was there a decline in LIFO inventory?

           i. Have the effects of  LIFO liquidation been disclosed?

          ii. What were the effects on gross profit and net income?    

 4.   What is the nature of the company's environment with respect to inventory controls?

      a. Do controls to guard against theft seem adequate?

      b. When a physical inventory is taken, how does the amount compare with the books?

          i. Do the books consistently exceed the physical count by a significant amount?

         ii. Are the books adjusted or are differences dismissed as errors in taking the physical inventory?

 c.       Investments

    1.   For debt securities held until maturity and nonmarketable equity securities:

        a. Is there evidence of a nontemporary decline in fair value?

    2.   For debt securities and marketable equity securities that are available for sale:

        a. Are investment losses included in stockholders' equity that might be taken to income in the future?

          i. Might the designation of these losses be changed to other-than-temporary?

          ii. Is sale of one or more investments imminent?

        b. Has stockholders' equity been buoyed by substantial write-ups to market value that may disappear in a market decline?

   3. For investments accounted for under the equity method:

        a. Is there evidence of a non temporary decline in fair value?

Detecting Undervalued Liabilities

A.    Accrued expenses payable

    1.   What is the trend in accrued expenses payable?

    2.   Compare the percentage rate of change in accrued expenses payable with the percentage rate of change in revenue for each of the last four to six quarters.

          a. What are the implications of differences in the rates of change?

    3.  Does an improvement in selling, general, and administrative expense as a percentage of revenue reflect true operating efficiencies?

B.   Accounts payable

   1.   Compute A/P days for each of the last four to six quarters

          a. Is the trend steady, worsening, or improving?

          b. How does the statistic compare with competitors' and other firms in the industry?

  2.    Was there an unexpected improvement in gross profit margin?      

  3.    How does the percent change in accounts payable compare with the percent change in inventory?

C.    Tax-Related Obligations

  1. What is the effective tax rate and how does it compare to the statutory tax rate?

        a. Review the reconciliation of the statutory to the effective tax rate or statutory to actual tax expense and identify nonrecurring items.

  2. What is the valuation allowance, if any, for deferred tax assets?

        a. Does it seem reasonable after carefully considering the prospects for future taxable income?

D.   Contingent Liabilities

  1.   What unrecognized contingencies are noted in a careful reading of the footnotes?  

  2.   Given an understanding of the company's business dealings, is there reason to believe that an unrecognized contingent liability exists?