Lies and the Lying Liars with Fake Financials

Can we find financial fraud in advance?

Enron Logo. Source: Wikipedia

Not always. But published financials can give us clues when managers might be cooking their books.

Published financial statements are supposed to reflect reality: they’re supposed to give let us know how the business is doing in its day-to-day operations. But we live in a world where investors – and computer trading systems – often fixate on just one number: earnings per share (EPS). That number is supposed to the single best indicator of company profitability.

The problem is, since investors just look at EPS, company management is often paid based on how well EPS does, through incentive pay structures, stock options, and restricted stock. And because management prepares the financial statements, we have a situation where the fox is guarding the chicken coop.

Photo: Peter Trimming. Source: Wikipedia

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 sales go up but cashflow doesn’t, the average time to collect a receivable spikes. The balance sheet becomes inflated. 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, investors may be able to sniff out fishy accounting before it becomes widely known. 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” – the inventory of undiscovered embezzlement – can grow to become a significant percentage of the economy. Of course, that’s not real wealth, it’s fraudulent. By paying attention to what goes into earnings, investors can reduce the chances that they’ll be victims.

Douglas R. Tengdin, CFA

By |2017-07-17T12:21:28-04:00March 9th, 2017|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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