While investing in any stock investor should always be aware of possibility of fraud company might doing . And shall make rational analysis to avoid falling in such traps.
Because when any fraud comes to surface shares loose all premium and over that, fear cause stocks price to dive down deeply and remain there for very long period of time. Thus investors are ones who loose most.
Employees will get another job, creditors and banks will get their money either form bailout or liquidation, fraudsters will get bail from court with minimal penalty but money that investor loss will never be recovered.
Frauds can be classified in two types first where there is mismanagement of assets and second is where there is accounting misstatement .
In this article we are going to cover some common elements and lessons financial frauds.
Stay away from what you don’t know
One of the biggest accounting manipulation happened in history was in Enron.
They created many special purpose entities to hide loans from their balance sheet. Also they entered into number of derivative contracts and booked revenue before virtual certainty of these revenue happening. What was most surprising thing was all wall street professionals were making future estimates of profits.
But one of the world’s most famous short seller investor Jim Chanos when read annual report of Enron didn’t understand how exactly they are earning profits.
And shorted stock.
How can wall street predict what best investor can’t even understand ? Answer is simple they were relying on whatever statements managements are making .
Bottom line of Enron’s story is investors loose lot of money because they invested based on others recommendation rather than their own understanding.
Don’t Trust On Credit Rating Agencies
Whether it is great financial crisis of 2008 (credit risk that investment banks were exposed to), Enron’s bankruptcy or even company default on payment of loan installments or repayment of debenture by any other company, credit rating agencies were very late to react .
I still haven’t read or found any of major fraud, bankruptcy or default where credit rating agencies were the ones who exposed it.
Usually what seen is they downgrade their rating only after misappropriation or other major issue brought to the surface by others.(at point where all world knows what shit is happening inside company.)
This may happen because of bureaucracy in large such large companies . So credit ratings are no useful for investors (and I will say to lenders also to much extent).
Promoter Behavior Changes When They Think Things Are Now Out Of Control
Most common management of promoters behavior when there is mismanagement in company:
- Resignation of CEO and CFO stating personal reason for doing so.
- Making statement of everything is rock solid when bad things about company starts to appear.
- Selling of state and stock options by most of management of company.
- Selling of shares by promoters
- Pledging of shares when stake is very large.
- Resignation of auditors.
- Frequent changes in auditors .
Siphoning Off Fund To Related Entities
When company raises loan or issues share then company have to use proceedings for same purpose as stated in agreement .
But in last decade in India many frauds have surfaced where loans given by banks were used for personal gains by owners of company. What they do they transferred some to some non existential company or subsidiary joint venture special purpose entity.
These internal transactions are very hard to detect and so most of them prefer to use this.
Sadly we have no way to detect this but we can reduce risk of happening something like this by investing in company with high management integrity. Also related party transactions and other interests of management should be properly analyzed.
One figure in financial statement which can be very easily manipulated and can have large impact on profits of the company is revenue figure.
Different industries record revenue at different stage of sale process. Say some book revenue when goods are sent from warehouse some book when order is received and others books when goods are accepted by purchaser.
At any stage it can be done provided there is virtual certainty fund flow.
Revenue recognition process is decided by management. So it is based on management perception which is in professional language called as management assumptions. Many managements take advantage of this and record revenue at point of deal where it shall not be recorded because of virtual certainty factors which we have discussed above
This artificially inflate revenue for a certain period say quarter. And management in this way very smoothly achieve their quarterly targets .
How we can tackle this ?
In annual report there is information about the revenue recognition process of company. Generally given after financial statements.
There are two ways to increase profit of company either increase revenue of decrease expenses .
Artificial increment of revenue we discussed above now decreasing expenses
In late 1990 many technology companies give free products in order to increase their customer base. They did not treat this as expense but treat this as an investment made to increase future customer base and thus recorded it as assets (goodwill). And amortized it over the period.
Again management assumptions played its role here.
Not only looking at profits of company is analysis investor must link profit and loss statement of company to balance sheet and both to cash flow statement of company.
Detailed analysis of assets side of balance sheet is key to know this type of fraudulent accountant practices.
More Emphasis On cash Flow Statement Than Profit And Loss
Profit and Loss can be manipulated very easily through.
- Improper revenue reorganization
- Capitalizing expenses
- Change in accounting policies
- Change in accounting estimates
- Extraordinary items
- Onetime expenses
- Non-recurring gains
Because of this many investors rely on cash flow statement than on profit and loss statement along with less manipulation scope there are other advantages of using cash flow statement.
- Adverse changes in working capital which tells that terms of trade are not in favor of business.
- Capex tells how much capital investment company need to continue growing at present CAGR.
Earning Estimates Of Brokerage House
If you see any channel any broker site or any newspaper you will see very few ‘sell recommendation’ in comparison with ‘buy recommendation’.
Brokers have to maintain good relationships with companies .
There is symbiotic relations with brokers and managers, managers provide much needed information to brokerage companies in turn brokers praise companies results, make favorable statements about management and recommends their stock on their platform.
Earning expectation– Stock Price -Media–Accounting Or Financial Frauds
Good Earnings >> Good Results >>More praise by media and brokers >> More buying >> Large leap in stock price >> Increased management urge to fulfill Wall Street’s expectations(mostly by manipulation) >> Blind optimism of Brokers and Media >> More Recommendation >> More Buying >> Self fulfilling Prophecy >> Vast gap between Real and Reported Earning dues to manipulation over the years. >> Management cannot hide all anymore >> Management accept of wrong doing.
Stay Away From What Looks Illogical
After some time management try to cover their mismanagement so they take illogical decisions like buying a company with completely different business, selling of part of company to get some real funds.
Their main motive to do this is to cover fictitious assets accumulated in balance sheet with real assets. Also to more deeply hide fraudulent transactions by passing complex accounting entries during mergers acquisitions.