Spotting the Signs Part 3: Practical Red Flags & The "Smell Test" ("實戰篇")

TL;DR: This final part focuses on practical, operational red flags that often accompany financial manipulation. Beyond analyzing financial statements (cash flow, AR/AP, etc.), look for things that just seem "off" operationally ("反常即為妖" – abnormality signifies trouble). Key signs include: large cash transactions, unusual cash flow directions (e.g., paying customers), sudden drastic changes in business scope, unexplained dominance by new partners, paying upfront but never receiving goods, excessively old inventory, project costs staying capitalized after completion, suppliers being unpaid for suspiciously long periods without consequence, and sharp, unnatural revenue spikes right at quarter/year-end. Always question anomalies.

(Final Disclaimer Reminder: This series is purely for educational awareness to help you identify potential red flags. It is not a guide for committing fraud, nor a substitute for professional forensic accounting when serious concerns arise.)

Hi everyone, James here for the final part of our series on spotting signs of "cooked books."

In the previous posts, we covered foundational checks and more advanced techniques involving revenue manipulation and balance sheet distortions. Analyzing cash flows, sales contracts, receivables, payables, and applying those initial "7 tricks" can reveal many issues directly visible in the financial statements.

However, some manipulations are subtler, embedded within the company's day-to-day operations. Spotting these requires going beyond the numbers and applying a critical "smell test." There’s wisdom in the ancient Chinese text, the Zuo Zhuan (左傳), which states: "反常即為妖" (fǎn cháng jí wéi yāo) – Abnormality signifies trouble (or literally, a demon). When things deviate significantly from normal business practices without logical explanation, it's time to dig deeper.

Beyond the Ledger: Operational Anomalies to Watch For

Here are nine practical, operational red flags that should raise questions:

1. Excessive Large Cash Transactions: In today's digital economy, legitimate businesses rarely conduct frequent, large transactions using physical cash. High volumes of cash changing hands can be a sign of off-book dealings or money laundering.
2. Reversed Cash Flow Directions: Normally, cash flows in from customers and out to suppliers. If you see significant cash flowing out to customers (beyond normal refunds) or large sums flowing in from suppliers (unrelated to financing), it’s highly irregular and needs explanation.
3. Sudden, Unexplained Change in Business Scope: A company fundamentally changing its core business overnight (e.g., a restaurant suddenly becoming an art trading house) without a clear strategic rationale or transition plan is suspicious. Is it a genuine pivot, or an attempt to obscure past performance or inject unrelated/fabricated revenue streams?
4. Sudden Dominance by New/Unknown Partners: If a previously unknown supplier or customer suddenly accounts for a massive percentage of the company's purchases or sales, probe further. Is it a legitimate major deal, or a related party/shell company created specifically for fraudulent transactions?
5. Prepayments Without Goods Received: Paying suppliers in advance (prepayments) can be normal. However, if the company makes significant prepayments but the corresponding goods or services are never received after a reasonable time, it could indicate fake purchases designed to siphon cash out of the company.
6. Excessively Old Inventory: Holding inventory ("坐貨") is part of business. But inventory that sits unsold for extremely long periods (the example given was over six months, but it depends on the industry) without being written down or off suggests it might be obsolete, overvalued, or perhaps doesn't even exist (phantom inventory).
7. Lingering Capitalized Project Costs: For large projects (e.g., construction, software development), capitalizing certain costs as assets during the project is standard accounting. However, these costs should be appropriately expensed or reclassified once the project is complete or abandoned. If significant project-related assets linger on the balance sheet long after the project's conclusion, it might be a way to hide expenses.
8. Suppliers Tolerating Extreme Payment Delays: While stretching supplier payments ("拖數") happens, if a company consistently delays payments to key suppliers for exceptionally long periods (e.g., six months or more) without facing lawsuits, stopped shipments, or other serious consequences, it could suggest the supplier relationship isn't at arm's length (perhaps a related party) or the liability itself isn't entirely legitimate.
9. Unusual Quarter/Year-End Revenue Spikes: Some businesses have natural seasonality. But consistently massive, unexplained surges in revenue booked right at the very end of a reporting period (quarter or year-end) can be a red flag for channel stuffing (forcing excess inventory onto distributors) or, worse, booking fictitious sales simply to meet financial targets.

The Power of Simple Questions

Often, uncovering issues comes down to asking simple, common-sense questions about these abnormalities, especially during due diligence for acquisitions or mergers. I recall one instance asking about a single customer who surprisingly accounted for half the target company's business. The seemingly innocent, yet revealing, answer? "係親戚嚟嘅" ("It's a relative...") – delivered as if it were the most normal thing in the world (like they'd eaten an "Honest Bean Paste Bun" - 誠實豆沙包 - from Doraemon!). Sometimes, the most straightforward questions about odd situations yield the most important answers.

好孩子不要學系列：「如何識穿做數：實戰篇」

//本系列會說明一些常見的「做數」方法，但目的並非叫你學會「做數」，呢啲事留番俾受過訓練的專業人士就好。相反，這系列是為了讓你更有能力去發現舞弊的「蛛絲馬跡」。//

「左傳：反常即為妖」

睇一間公司嘅財務狀況，睇資金帳流、銷售合同、應收帳款、應付款費用等，再用入門篇嘅7招，大部份財務報表上問題都會睇到。但係有好多細節及營運問題就要了解「反常點」嘞。

1. 「大額現金交易」
2. 「公司同客收錢，俾錢供應商係正常；倒轉呢？」
3. 「業務經營範圍」做緊餐廳生意，突然轉做Art Trading.
4. 「突然有新嘅供應商或新客戶佔咗大比例生意」
5. 「買嘢預付款係正常，但係預付款收唔到貨就唔正常。」
6. 「坐貨係正常，坐超過半年就唔正常。」
7. 「做大型項目將開支變流動資產（例：建築項目保證金）就正常；項目完咗冇轉翻嚟就唔正常。」
8. 「拖供應商數正常，但係拖咗半年唔使還就唔正常。」
9. 「收入有季節性就正常，但係每次季尾年尾突然間暴增就唔正常。」

通常去到被收購、合併公司都會有好多好搞笑嘅嘢。例如我會問「你哋其中一個客其實鍾意你哋啲乜，佔你哋一半生意喎。」「係親戚嚟嘅」…… 真係食咗誠實豆沙包。

This concludes our brief series on spotting potential financial manipulation. Remember, robust financial analysis combined with a healthy dose of skepticism and critical thinking about operational realities is crucial for effective leadership, prudent investing, and safeguarding business integrity. Always look for the story behind the numbers, and never hesitate to investigate when things just don't seem right. Stay diligent.