For retail investors, detecting accounting fraud is usually very difficult if you do not have in-depth knowledge of accounting or a professional qualification. Companies who are engaging in such practices usually implement a number of 'creative' accounting methods to mask their fraudulent behaviour. The average investor might have no idea what is going on, only to one day find that he has been duped out of his hard-earned funds.
There are several key indicators which serve as warning signs of potential fraud. These include:
- Overstating the net worth of a firm's assets. This may include, for example, utilising improper depreciation and/or amortisation methods which overvalue the actual worth of a firm's property or equipment. In the case of firms who sell natural resources, improper depletion methods may be utilised and their 'reserves' may be overstated, significantly affecting the real worth of a firm.
- A lack of transparency & structured finance deals: While a lack of proper disclosure does not mean that accounting fraud is taking place, it may be a tip-off sign that some 'fishy' behaviour is taking place. For example, companies such as Enron utilised a holding structure, to effectively double-count earnings. Net income was reported both at the subsidiary level and then at the parent firm level. They also engaged in a complex web of transactions whereby subsidiaries bought and sold from one another, however, no real profit was actually created.
- Hidden liabilities: Firms who have engaged in accounting fraud have, for example not declared that properties they own may be due for large increases in rentals. They may also hide legal costs which they are facing to give the impression of lower expenses.
- A Breach of their legal agreements: A firm may be close to breaching its debt covenants. A firm may, therefore, begin to manipulate its debt ratios to ensure that they are not in technical breach, although their financial situation is clearly worsening. Companies who are unable to meet their loan payments in the long-term may focus on their ability to meet short-term debt, while their business model lacks sustainability and the ability to service debt over the long-term.
- The 'Sniff' test: Something just feels 'off' about a particular company. In the case of Enron it was journalists, rather than accountants who conducted due diligence and discovered the firm's accounting fraud.
Takeaways for Investors
Detecting accounting fraud is not easy. With the stock market currently booming along, it seems like nothing can go wrong. However, investors should be aware that manipulation is always happening- it's just that you might not be aware of it.
A combination of extensive accounting analysis and gaining a feel 'insight' into the company can be very useful to picking up any signs of potential fraud and protecting your hard earned savings.
