Investors need to keep an eye out for several red flags. Last year, an article in Barrons came up with some words in company disclosures that basically served as warning signs for investors. These words should make investors' hair stand up on end. They include "related party", "bill and hold", "percentage of completion accounting", "unbilled receivables", "change in revenue recognition". "materially and adversely affected" and "substantial doubt."
So how much are these words worth? How much of an impact do they actually have?
It's worth looking at this study Barron's Red Flags: Do They Actually Work?
which identified some really bad ones to watch out for.
According to the researchers, phrases like "related party transaction" or "consulting relationship" would likely see shareholders accusing the firm of material omissions. That makes a lot of sense because when directors do consulting for their firms, there is less incentive to monitor some of the deals of managers.
Similarly, aggressive (but legal) accounting practices of unbilled receivables or changing the estimated useful life or change in revenue recognition are practices that are more likely to see management later on accused of inflating the stock prices through material omissions.
Phrases like sale and leaseback, substantial doubt, and materially and adversely affected are linked with filing period returns, subsequent volatility, and analyst forecast dispersion.
Not all the phrases are that important and none are statistically significant. Still, the phrases serve as a warning for investors. When they pop up, investors should start digging deeper.
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