How to tell if a company is cooking its books

It's immensely difficult for an investor spot a company that's not on the level. But there are a handful of quick and easy tests that can tip you off if something is wrong. Cris Sholto Heaton explains.

Until January, Indian IT firm Satyam was an investor favourite, thanks to its rapid growth, healthy margins and a cash pile of $1.1bn. One high-profile British manager had almost 10% of their India fund invested in the stock. Then chairman Ramalinga Raju made a shocking confession: it was all a sham. He'd been fiddling the accounts for years. Profit margins were just 3% and cash on hand was around $80m. The stock collapsed, the company has now been bought at a fraction of its old value and Raju is now stewing in a Hyderabad prison.

Should investors have been able to spot the fraud in advance? Unfortunately, there's no single test that will tell you if a company is cooking its books. Most of due diligence on investments boils down to forming an overall impression: for example, is the company structure oddly complicated, with lots of deals with related parties? This takes a lot of work; many investors don't have enough time, and put their trust in the fact that a major auditor PricewaterhouseCoopers in this case has signed off on the accounts. But there are a handful of quick and easy tests that can tip you off if something is wrong.

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Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.