Which of the following is a red flag in financial statements that may signal financial trouble?

• A. Unexplained significant increases in revenue without corresponding cash flows
• B. Transparent disclosure of accounting policies
• C. Consistent and reasonable expense recognition
• D. Stable and predictable inventory turnover ratios

Answer: (A)

Verified step by step guidance

1. Understand the concept of 'red flags' in financial statements: These are indicators that may suggest potential financial trouble or irregularities in a company's financial health.
2. Analyze the options provided in the question. A red flag typically involves inconsistencies or anomalies in financial data that cannot be easily explained.
3. Option 1: 'Unexplained significant increases in revenue without corresponding cash flows' is a potential red flag because revenue growth should generally align with cash inflows. If revenue increases significantly but cash flows do not, it may indicate issues such as aggressive revenue recognition or fictitious sales.
4. Option 2: 'Transparent disclosure of accounting policies' is not a red flag. In fact, it is a positive sign of good corporate governance and financial reporting practices.
5. Option 3 and Option 4: 'Consistent and reasonable expense recognition' and 'Stable and predictable inventory turnover ratios' are also positive indicators of financial stability and are not considered red flags.