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CFA Level I Exam · Financial Reporting Quality

Warning Signs and Non-GAAP Measures in Financial Reporting

Updated 7 October 2026 · Fact-checked

Warning signs are patterns in reports that suggest low-quality or manipulated earnings. Non-GAAP measures, key performance indicators and off-balance-sheet items can portray results more favourably than reported statements. To answer questions, compare the adjusted figure with the reported one, find what was excluded, and judge whether the exclusion is recurring or flattering.

Understand Warning Signs and Non-GAAP Measures

Financial reporting quality asks two things: are the reports decision-useful, and are the results sustainable? Managers have incentives to look good. Pay, debt covenants and share price all depend on reported numbers. So analysts look for signals that a company is stretching the rules or steering attention away from the audited statements.

Non-GAAP measures (also called non-IFRS or alternative performance measures) are figures not defined by the accounting standards, such as adjusted EBITDA, adjusted earnings or free cash flow. They can help, because they strip out truly one-off items. They also create risk. A company chooses what to exclude, so costs that recur (restructuring, share-based compensation, impairments) can be removed year after year. Definitions may change between periods, and the measure may be shown more prominently than the reported one. In the US, the SEC requires a reconciliation to the nearest GAAP measure and bars giving non-GAAP figures more prominence. Treat that as a US GAAP point.

Key performance indicators (KPIs), such as subscribers, same-store sales or backlog, are operating metrics outside the financial statements. They are usually unaudited. Risks: the definition may be unclear or may change, the KPI may not be linked to cash flow, and management may report only the flattering ones.

Off-balance-sheet items keep assets and liabilities out of the statements. Examples are special purpose entities, unconsolidated affiliates, sale of receivables with recourse, and guarantees. They make leverage look lower and returns look higher. Under IFRS, lessee leases now mostly sit on the balance sheet, but other arrangements can still hide obligations.

Common warning signs include: revenue growing much faster than cash flow from operations; rising receivables or inventory relative to sales; a falling allowance for doubtful accounts; aggressive capitalization of costs; frequent changes in accounting policies, estimates or auditors; qualified opinions; related-party transactions; a gap between net income and operating cash flow; fourth-quarter revenue spikes; and a complex structure that is hard to understand. A warning sign is not proof. It tells you where to look harder.

Key formulas to remember

Non-GAAP reconciliation
Adjusted earnings = Reported earnings + Excluded expenses − Excluded gains (after tax if stated)
Always check what was added back and whether it recurs.
Accrual ratio (cash flow method)
Accruals = Net income − CFO − CFI; ratio = Accruals ÷ Average net operating assets
A high positive ratio suggests lower earnings quality. This is the cash flow method, which subtracts both CFO and CFI from net income. The alternative balance sheet method measures accruals as the change in net operating assets over the period. Both methods divide by average net operating assets, and they can give different values. If a question gives its own definition, use that.
Cash-to-income comparison
CFO ÷ Net income
A persistent ratio well below 1 can signal aggressive accruals. It can also reflect genuine growth in working capital.
Receivables test
Receivables growth vs revenue growth
Receivables growing faster than revenue suggests aggressive revenue recognition or weak collections.
Free cash flow (simple)
FCF = CFO − Capital expenditure
A common non-GAAP measure. Check whether capex or leases were left out.

How to solve Warning Signs and Non-GAAP Measures questions

Use this routine for any question on red flags, non-GAAP measures, KPIs or off-balance-sheet items.

  1. 1Identify what the question shows: an adjusted figure, a KPI, a disclosure or a ratio trend.
  2. 2Find the nearest reported (IFRS or GAAP) measure and compare it with the adjusted one.
  3. 3List what was excluded or hidden and ask: does it recur, and is it a real cost?
  4. 4Check the link to cash: compare income with CFO, and revenue with receivables and inventory.
  5. 5Look for changes: definitions, policies, estimates, auditor, or presentation.
  6. 6Decide which concern best fits the facts: aggressive recognition, cost shifting, hidden leverage, or a misleading metric.
  7. 7Eliminate the two options that do not match the evidence. Pick the one that is supported, not merely possible.

Quickest way: Compare, find the exclusion, test the cash

When to use it: For short three-option questions in about 90 seconds.

  1. Read the last line first to see whether the question asks for a concern, a risk or a best response.
  2. Spot the gap: adjusted vs reported, income vs cash, revenue vs receivables.
  3. Pick the option that names the specific gap. Reject options that call any non-GAAP measure always misleading or always acceptable.
  4. If two options remain, choose the one that the facts directly support.

Common mistakes in Warning Signs and Non-GAAP Measures

  • Treating every non-GAAP measure as manipulation.

    Students memorize the risks and forget the benefits.

    Fix: Non-GAAP measures can clarify true one-off items. The concern is recurring or inconsistent exclusions.

  • Assuming a red flag proves fraud.

    Warning signs sound conclusive.

    Fix: A red flag only prompts deeper analysis. There may be a legitimate business reason.

  • Ignoring cash flow when judging earnings.

    Focus stays on the income statement.

    Fix: Always compare net income with CFO. Persistent divergence is a key signal.

  • Thinking KPIs are audited.

    They appear in annual reports beside audited figures.

    Fix: KPIs are generally outside the audited statements and can be defined or changed by management.

  • Missing off-balance-sheet leverage.

    Analysts use reported debt only.

    Fix: Adjust for guarantees, unconsolidated entities and receivable sales with recourse when judging solvency.

  • Applying SEC rules to IFRS questions.

    Non-GAAP is a US term.

    Fix: Say US GAAP or SEC only when the question does. Otherwise think of alternative performance measures under IFRS.

Worked examples

Example 1

A company reports net income of €40 million and adjusted net income of €58 million. The adjustment is a restructuring charge of €18 million, which the company reported in the current year and in each of the past four years. Which conclusion is best? A. Adjusted income is the better estimate of sustainable earnings. B. The exclusion is questionable because the charge recurs. C. The adjustment is acceptable because restructuring charges are infrequent by nature.

Show the solution
  1. Adjusted minus reported = 58 − 40 = €18 million, which equals the restructuring charge.
  2. The charge appears in the current year and in each of the past four years, which is five consecutive years. It is not a one-off.
  3. A recurring cost excluded from adjusted income overstates sustainable earnings.
  4. Option A ignores recurrence. Option C assumes restructuring charges are infrequent by nature, but a charge that appears five years in a row is not infrequent. It is a normal cost of running this business, so excluding it is questionable.

Answer: B

Example 2

Over one year, a firm's revenue rose 6%, receivables rose 28%, and net income of $120 million compared with CFO of $45 million. Which is the most likely concern? A. Conservative revenue recognition. B. Possible aggressive revenue recognition. C. Improved collection efficiency.

Show the solution
  1. Receivables grew far faster than revenue (28% vs 6%), suggesting sales not turned into cash.
  2. CFO is well below net income: 45 ÷ 120 = 0.375, a low cash-to-income ratio.
  3. Both signals point to aggressive recognition or weaker credit quality.
  4. Conservative recognition would not inflate receivables, and better collection would lower them.

Answer: B

Exam tips

  • Expect three-option questions asking which red flag or risk best fits a short scenario. Match the specific facts.
  • Reject extreme wording such as always or never when judging non-GAAP measures.
  • Remember that reconciliation to the reported measure is the key safeguard in the US setting; say so only for US GAAP.
  • Use the cash-versus-income and receivables-versus-revenue checks first. They resolve many items.
  • Link this topic to earnings quality and earnings management, since the same signals recur.

Practice questions from Financial Reporting Quality

Warning Signs and Non-GAAP Measures in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Warning Signs and Non-GAAP Measures: frequently asked questions

What are non-GAAP measures in the CFA curriculum?

They are performance figures not defined by accounting standards, such as adjusted EBITDA or adjusted earnings. They can aid analysis but can also hide recurring costs. Compare them with the reported figures.

Which red flags are most commonly tested?

The most common are income growing faster than operating cash flow, receivables or inventory outpacing sales, and frequent changes in policies or auditors. Aggressive capitalization of costs and complex related-party structures also appear.

Are key performance indicators audited?

Generally no. KPIs sit outside the audited financial statements, so definitions can vary or change. Check how they are defined and whether they connect to cash flow.

Do off-balance-sheet items always mean misreporting?

No. Some are legitimate and disclosed. The risk is that liabilities and leverage are understated, so analysts adjust for them when assessing solvency.