Soft areas in accounting refer to areas where company management have the greatest ability to manipulate the way that they report a company's performance. And historically, these are also the areas where we've actually seen companies conceal poor underlying performance. Now, these soft areas of accounting fall into three categories, non-GAAP numbers, estimated numbers, and classification of cash flows. If we find evidence of bias in any of these three areas, this suggests that the company is choosing to report numbers in a way that conceals poor performance. And this is therefore a major red flag for analysts. So what are these three areas? Well, non-GAAP numbers refer to the use of adjusted earnings metrics, and these are used by companies to exclude non-recurring or non-core revenues and costs.

But companies sometimes try to cherry pick the adjustments that they're making so that adjusted earnings are simply inflated earnings.

Estimated numbers refer to numbers in the financial statements, which rely on company management rather than actual transactions. For example, when a company includes accrued expenses in its selling general and admin costs, this relies on management estimating how much of an accrual is needed. Management concern with meeting quarterly profit targets could be tempted to underestimate the accrued expenses for the quarter, thereby boosting their reported profits. Classifying cash flows refers to the choices that companies make in how to classify transactions in a cashflow statement. Although cash flows are often assumed to be more factual than earnings, there is still some degree of discretion here. For example, if a company decides to capitalize software development costs rather than expensing them, the related cash outflows are treated as investing cash flows rather than as an operating cash flow. And so this would enhance reported operating cash flows.