What are the main characteristics of companies that engage in fraud? What are the tell-tale signs?

A new study reveals that price-earnings ratios and market-to-book ratios are unusually high prior to the fiddling of the books. Also, firms that engage in this sort of activity have had unusually strong stock price performance in the years prior to the misdeeds. So you don't really see it coming.

According to the study, Predicting Material Accounting Manipulations, another telltale sign was the amount of new financing as the company scrambled to get more cash. Indeed, cash from financing more than doubles in the manipulating years. Also, accounting rates of return are declining, earnings growth rates are negative and cash margins are tightening around the time they embark on their shenanigans.

The researchers behind the study, Patricia M Deschow from the Haas School of Business, Weili Ge from University of Washington Business School, Chad R Larson from University of Michigan's Stephen Ross School of Business and Richard G Sloan from Barclays Global Investors, also found that larger firms were relatively more likely to misstate earnings. They found that 15.3 per cent of the manipulations occurred in the largest 10 per cent of firms. Why is that? For a start, they are under more scrutiny from the media and analysts, which means problems are more likely to get attention. Second, they are more complex, consisting of many separate reporting units. As a result, managers can manipulate the numbers more easily, with less likelihood of audit detection. And finally, the Securities and Exchange Commission has limited resources and so may see better cost benefits focusing its limited enforcement budget on relatively large firms.

The study, which identified 680 unique firms misstating at least one of their quarterly or annual financial statements, found that the biggest trick was to play tricks with how much they booked in as revenue. That occurred in 55 per cent of cases. Manipulations of reserves occurred in 10 per cent of the samples, and manipulations of inventory and costs of goods sold occurred in 25 per cent of cases.

And which industries had the biggest offenders? Watch out for Computer and computer services, retail and general services such as healthcare and telecommunications.

This study won't stop fraud. But at the very least, it gives us some idea of what to look out for.