For this installment of Investing 101, we’ll take a look at how to spot accounting fraud. It can be found almost anywhere. In some cases, even well-known companies that are publicly traded have deceived investors using calculated dishonesty for financial gain.
In 2008, Bernard Madoff, founder of a Wall Street investment firm, admitted that his business was an elaborate Ponzi scheme.
Enron is another example of a huge, prominent fraud that took a multi-billion dollar company to bankruptcy in under a year.
Identifying fraud requires being able to spot red flags, something Carson Block, founder of Muddy Waters Research, specialized in.
Block has lately turned his attention to Chinese publicly traded companies like, NQ Mobile, criticizing delays in collecting payments from customers. He says investors can usually find warning signs in a company’s financial statements. "We might see things such as the accounts receivable just seem to be very high," Block says.
Another one of Block's red flags is a company that is overly acquisitive. "One thing that a lot of frauds tend to do," he says, "is rather than faking the cash in the cash balance, they’ll go out and claim to have acquired a company or an asset for a lot more money than they really actually paid for it. So they might spend $100,000 to acquire a company, but they’ll claim that they spent $2 million, and that way they’re able to burn off $1.9 million in fake cash."
There are risks involved in exposing business’s deceptive accounting practices. Most people would rather not deal with the overwhelming amount of litigation that may follow accusations. So it’s up to you to do the research and make your own decision.
"Try to weigh, for yourself, the quality of the analysis that’s put forth on the bear side versus that on the bull side," Block offers. "And do not give weighting to the quantity of comments and the quantity of analysis because the bull side always wins even in the biggest of frauds in terms of the quantity."