This article, although dated, is an extremely interesting read. I was looking for readings on how companies usually cook their books/commit accounting fraud and this article covers most of it.
Key summary points are:
The five metrics that we used to run our check:
Booking Revenues In Advance: Are a company’s Cash Flows from Operations (CFO) growing as fast as its Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA)? The formula: Calculate the percentage rise in CFO and EBITDA from one financial year (FY) to next. Compare the two to see by how much percentage is EBIDTA outgrowing CFO. The higher this result the more the chance of the company booking revenues without corresponding cash flows.
Shoring Up Operating Revenues: This metric asks, “Is a company’s ‘other income’ growing more or less in line with its investment assets?” The formula to apply is: Calculate the proportion of Other Income (OI) to Cash Investments (CI) for a FY. Do the same for previous FY. Compare the two to see whether the former has fallen drastically compared to the latter. The higher the fall the more the chance of a possible diversion of ‘non-core’ revenues to topline revenues.
Disbursement Of Loans To Related Parties: This metric directly looks at the quantum of a company’s loans disbursed to related parties. As a general thumb rule, if more than 1 per cent of loans or advances given out are to such related parties then there is a case to ask the question “Is cash being pulled out of the firm by the promoter?” The formula: look at Loans and Advances figure in the balance sheet. Get the loans to related parties figure from the notes to accounts in the annual report. Find the proportion of the latter to the former.
Shifting Expenses Away From The Current Period: This metric asks “Has a company’s ratio of depreciation to Gross Block of Assets changed significantly in a given FY from the previous one? If so, is the company using depreciation to ‘manage’ earnings?” Calculate the depreciation rate of a FY by dividing the Gross Block of Asset with the Depreciation Charged. Do the same for previous FY. Subtract the former with the latter. If the difference is negative and significant it raises a red flag to dig deeper.
Mis-match Between Quarterly Un-audited Figures and Annual Audited Figures: Do the audited annual FY Sales and Profit After Tax (PAT) reported to the stock exchanges tally with the quarterly sales and PAT reported earlier at the end of each quarter? Except for minor variations or variations due to demergers or other major corporate restructuring they should. Add Q1, Q2, Q3 and Q4 Sales and PAT figures for a given FY. Get the final audited figures for Sales and PAT. Compare the two.
Also, usually in such cases, one thing leads to another and I spent more than an hour reading the links below. Extremely interesting reads. The Equity Desk actually has some company names mentioned.