Fraud, Fraudsters, and False Financials

Fraud, Fraudsters, and False Financials

Can we see financial fraud before it hits us?


Photo: Dave Meier. Source: Picography

Not always. But published financials can give us some clues as to when managers might be cooking the books.

Published financial statements are supposed to reflect reality on the ground. They’re supposed to give an accurate picture about how the business is doing in its day-to-day operations. But we live in a world where investors often fixate on one number—earnings per share (EPS). That number is supposed to the single best indicator of company profitability.

The problem is, since investors focus so much on EPS, company management is often paid based on how well EPS does—through incentive pay based on the stock price. And because management prepares the financial statements, we really do have a situation where the fox is guarding the chicken coop.

There are lots of ways to manipulate earnings. Some of the most common include inflating sales, understating amortization, delaying bad account write-offs, and using off-balance sheet derivatives in inappropriate ways.

Fortunately, we can see unusual changes in these accounting elements. The items that go into making earnings look good can themselves look out of whack. For example, when accruals go up but sales don’t, the average time to collect a receivable—receivable days—spikes. The balance sheet becomes bloated. Stocks with bloated balance sheets find it difficult to maintain their earnings.

Not all accrual increases are fraudulent, of course. But by using a weighted average of commonly manipulated items, we can sometimes sniff out fishy accounting before it starts to stink. Such an approach isn’t perfect, but it does reduce the likelihood that we’re investing in a swindle—like Enron, Adelphia, HealthSouth, Parmalat, or a host of other financial scams.

John Kenneth Galbraith once noted that at any given time the accumulated “bezzle” in an economy—the inventory of undiscovered embezzlement—amounts to many millions of dollars. Of course, that’s not real wealth, it’s fictional. By paying attention to what goes into earnings, investors can reduce the chances that they’ll be victims.

Douglas R. Tengdin, CFA

Chief Investment Officer

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