Corporate governance and accounting warning signs Indian investors can spot without forensic training — related party loans, auditor changes, pledging and cash flow gaps.

Accounting problems in listed companies are rarely invented from nothing. They are usually visible for several years in the disclosures before the price collapses — in the notes, the cash flow statement and the shareholding pattern rather than in the headline numbers.

You do not need forensic accounting training to spot most of them. You need to know where to look and what pattern to be suspicious of.

Category 1: The Cash Flow Gap

Profit that never becomes cash

The check: sum five years of reported net profit. Sum five years of cash flow from operations. Compare.

Reported profit is an accounting judgement about when revenue was earned. Operating cash flow is a record of money that moved. A company can defer costs, recognise revenue early and capitalise expenses to shape profit. Sustaining a cash flow illusion for five years is much harder.

If cumulative CFO is well below cumulative PAT, the profit is sitting somewhere on the balance sheet. Find out where: receivables, inventory or capital work in progress.

Rising receivables outpacing revenue

Compute days sales outstanding each year: (Receivables ÷ Revenue) × 365. If revenue grows 20% and receivables grow 45%, the company is either selling to weaker customers, extending credit to win business, or recognising sales that may not convert to cash.

Inventory building ahead of sales

Days inventory rising steadily is a common precursor to write-downs, particularly in manufacturing, pharma and consumer durables.

Category 2: Where the Money Goes

Related party transactions

The most informative section in an Indian annual report. Look for:

• Loans and advances to promoter-linked entities, especially unsecured, interest-free, or repeatedly rolled over
• Sales to or purchases from group companies at prices you cannot verify against market rates
• Corporate guarantees given for group entities — a liability that becomes real if the guaranteed entity fails
• Rent, royalty or brand fees paid to promoter entities, particularly where they scale with revenue

None of these is illegal. Collectively and repeatedly, they describe a structure where value moves out of the listed entity to entities minority shareholders do not own.

Note that SEBI’s tightened SME IPO norms require disclosure of transactions with promoter group entities exceeding 5% of revenues or assets in any of the preceding three years, along with the board’s assessment of whether they were at arm’s length — a useful indication of what the regulator considers material.

Capital work in progress that never completes

CWIP does not attract depreciation. Projects that remain in CWIP across multiple years, particularly where stated commissioning dates keep moving, warrant scrutiny — both as a possible profit flattering device and as a sign of capital being spent with little return.

Frequent acquisitions with growing goodwill

Serial acquirers can be excellent businesses. But when goodwill grows steadily while consolidated earnings do not, an impairment is being deferred.

Category 3: The People and the Paperwork

Auditor resignation or change

The single strongest signal on this list. An auditor resigning mid-term, or a large firm being replaced by a much smaller one without a clear commercial reason, is a serious matter. Read the resignation letter — listed companies must disclose the reasons.

Qualifications, emphasis of matter and key audit matters

Auditors rarely say things bluntly. Read the exact language. “Emphasis of matter” regarding recoverability of receivables or going concern is the professional register for a significant problem.

High promoter pledging

Not in the annual report — in the quarterly shareholding pattern filed with the exchanges. Pledged promoter shares mean the promoter has borrowed against ownership. If the price falls, lenders may invoke the pledge and sell into an already weak market, accelerating the decline. Rising pledging alongside a falling price is a dangerous combination.

Promoter stake reduction without explanation

Steady selling by promoters over several quarters, especially through the open market rather than a disclosed strategic transaction.

Board and CFO churn

Independent directors resigning, particularly citing “personal reasons” shortly before results, and repeated CFO changes. Read resignation letters — SEBI’s disclosure norms require them to be filed.

Category 4: The Story Not Matching the Statements

Growth that is too smooth

Real businesses have uneven quarters. Revenue and margins that rise in an almost straight line through a full economic cycle deserve extra scrutiny of the cash flow statement, not less.

Other income doing heavy lifting

If a meaningful share of profit comes from treasury income, forex gains or asset sales, the operating business is smaller than the reported profit suggests. Recompute margins excluding other income.

Contingent liabilities exceeding net worth

Disclosed in the notes. Tax disputes, litigation and guarantees. Large contingent liabilities do not always crystallise, but they define the downside.

Presentation and reality diverging

Compare the investor presentation’s adjusted, normalised metrics against the audited statements. Persistent large gaps between “adjusted EBITDA” and reported operating profit indicate what management would prefer you to look at.

Category 5: Market Structure Signals

Surveillance listings

Exchanges publish ASM (Additional Surveillance Measure), GSM (Graded Surveillance Measure) and ESM lists daily. GSM in particular targets companies with weak fundamentals experiencing abnormal price rises — low net worth, weak earnings, high P/E. SEBI’s consolidated surveillance framework also requires exchanges to show cautionary pop-ups on trading terminals when clients attempt to trade these securities.

A stock’s presence on these lists is not proof of wrongdoing. It is a public statement that the exchange considers the trading pattern abnormal.

Sudden volume without news

Sharp volume spikes with no corresponding disclosure, particularly in low-float small caps, are worth noting.

A Practical 30-Minute Screen

• Five-year CFO versus five-year PAT.
• DSO and inventory days trend.
• Related party transaction note — read it in full.
• Auditor’s report — opinion, qualifications, key audit matters.
• Contingent liabilities versus net worth.
• Shareholding pattern — pledging percentage and trend.
• Corporate announcements over 24 months — resignations, auditor changes.
• Exchange surveillance lists — is it on ASM, GSM or ESM?

Any two of these firing together justifies either much deeper work or simply moving on. There is no shortage of companies.

Frequently Asked Questions

Does one red flag mean I should sell?

No. Individually, most have benign explanations. Clusters are what matter — a cash flow gap plus rising related party loans plus an auditor change is a pattern.

Are these signals only relevant for small caps?

They are more common in small and micro caps, where governance and analyst coverage are thinner. But large-cap accounting failures have occurred in India and elsewhere, and the same checks apply.

Where do I find shareholding patterns and pledging data?

NSE and BSE websites publish quarterly shareholding patterns, including pledged share details, for every listed company.

Can I rely on credit rating agencies to flag these?

Ratings are useful inputs but they lag. They typically move after a deterioration is visible, not before.

Sources and Further Reading

• NSE and BSE corporate filings, shareholding patterns and surveillance lists
• SEBI Master Circular on Surveillance of the Securities Market
• SEBI ICDR amendments relating to related party disclosure for SME issuers
• Ministry of Corporate Affairs portal — mca.gov.in