In the last five years we’ve seen several instances of illegal creative accounting — Enron, WorldCom, Tyco, Fannie Mae, Global Crossing, Adelphia, and the list goes on. I was fortunate to have either passed on or sold stock in Enron and Tyco before their implosion. I was not, however, so lucky with Fannie Mae. The signs of trouble brewing were there, but I and many others chose to ignore them. There are, however, some simple things investors can look for that might indicate financial shenanigans.

The first alert is a decoupling of cash flow from operations and net income. Charting cash flow from operations (found on the statement of cash flows) and net income (found on the income statement) over several periods can help identify the relationship between the two values. If the two track nicely for several periods but then cash flow from operations starts a downward trend while net income grows at a healthy rate, it might be a sign to head for the exit. This might happen because of operational deterioration — receivables are being paid more slowly or inventory is being sold at reduced prices. Another possibility is that a company is recording expenses as assets (e.g. advertising costs to build a brand.)

The second sign is excessive or out-of-the-ordinary related-party transactions. There is a section in the proxy statement (or footnotes to annual statements) where companies list these transactions. If there are a number of transactions with executives and/or their families, it might indicate some serious conflicts of interest or even ways to conceal profits or losses. In a research paper on these transactions, Mark Kohlbeck and Brian Mayhew of UW-Madison found that [Related-party] transactions provide a more liquid source of compensation. and may make it easier for the CEO and directors to engage in transactions that favor themselves individually rather than benefiting the firm. Sarbanes-Oxley has banned the use of some more egregious transactions, but a RateFinancials study indicates that related-party transactions are still common.

The third sign is declines in balance-sheet ratios including total-asset turnover. inventory turnover. and accounts receivable turnover. If a company tinkers with the income statement, they often add things to the balance sheet to hide them. If these numbers are decreasing (i.e. fewer turns per year), it may be a sign that the books are being cooked.

The fourth sign — heavy insider selling — has less to do with accounting and more to do with greed. While insiders may have legitimate reasons to sell unrelated to the performance of the company (think buying that villa in Tuscany ), it could be a sign of rough seas ahead. Insider selling alone may not be a reason pull the trigger, but it should prompt an investor to dig deeper to see if there’s other troubling information. You can find insider sale information from the stock quotes on Yahoo! .

Any one of the four signs above may happen for a number of legitimate reasons, but they could be an indicator that the company is the next Enron. Therefore, if a company exhibits one or more of these signs it may be time to dig deeper before investing in the company.

Additional Resources:

• Dr. Howard Schilit wrote Financial Shenanigans. a book about how to spot creative accounting.
• Michelle Leder maintains Footnoted. a blog about out-of-the-ordinary items in the footnotes of SEC filings.
• Investopedia provides a guide to fundamental analysis for stocks.