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