Hey gents, is there a source where I can turn to in order to find out whether a company is involved in fraud or is being investigated other than the OSC site? Additionally, and perhaps more importantly, are their specific balance sheet items I should look for when investing that act as red flags that a company might be engaged in fraud? I’m totally having a mental blank here. Willy
there are a zillion kinds of fraud? I guess start with the auditors certification and work from there? take a class on forensic auditing? ask where they keep their cash and call the bank to verify. If you don’t understand it then don’t own it. Good luck.
Fraud is a pretty big word (it’s criminal deception). Are you sure that’s what you are looking for?
I recognize that I am asking a fairly broad question, which is partially why I had such a mental blank. Perhaps the question is two part: what in the financials 10K or 10Q foreshadows fraud and what websites operate as a centralized data base for companies being investigated by the SEC? Willy
The classic answer is when the auditor doesn’t give them a clean stamp of approval (a letter at the end of 10k). Really, just read the CFA stuff on “Shenanigans” as a starting point. If you want to get deeper then read up on forensic accounting. Otherwise, post what is causing you to have suspicion.
the footnotes and/or management discussion section in annual report might mention investigations and lawsuit details
What was that Shenanigans book saying then? I never read that one. I passed L2 before they introduced that [apparently] valuable text book. Willy
Ok, I’ll sum it all up for you in 1 sentence. It said management engages in shenanigans to boost profitability so they can take home bigger bonuses. You can skip this section entirely for level 3 now that I’ve summed it up.
I think the Shenannigans book talked more about taking “aggresive” interpretations of GAAP, or manipulating the timing of actions based on their financial statement impact, rather than outright fraud. Tne thing about fraud is that it can happen at any level in an organization from top management (Enron), to a grunt with a couple of passwords (SocGen). The latter reinforced the fact that even relatively low level people can engage in huge frauds.
Not sure what kind of fraud you’re talking about, but I think reports to the Better Business Bureau might also help for US companies (though I wouldn’t consider it my only source, since accounting fraud might not show up in customer complaints). For accounting, I think you need to look at the auditors statement at the end of the 10K and also look to see if the company has been switching auditors much (switching often is a bad sign).
If you’re trying to “screen” for potential shorts due to fraud, Forget about it. It’s very difficult. In this current competitive environment, You just have to know the industry and the company very well in order to find “fraudulent” companies. There are screens like weak cash flow but growing net income, DSOs y/y higher than sales y/y, etc. Those screens are better at detecting terrible companies than fraudulent companies.
Willy, if I remember correctly, you help manage a fund of funds? If so, isn’t being able to detect fraud a major part of your position? Why would you be asking advice on a public message board? Maybe you should call up Jeff at RBC
I would guess that to detect fraud you have to first of all understand the business you’re evaluating and understand it really well. Most likely, experience in that industry is necessary. Then see how they generate revenues to see if that is done too aggressively or inappropriately relative to how the practice is normally handled. The same goes for the cost side. Truth be told, if you’re looking for Enron type fraud, you won’t have much luck since the auditors HAVE to be involved in accounting irregularities and you simply won’t have the tools to catch them. The statements are there to deceive you so you have to look somewhere else. the people that were skeptical of Enron were not simply looking at the Balance sheets or doing FSA, but questioned the structure of the business which led them to question how such numbers were appearing on the B.S. the question that was asked was, “how did they really generate revenues”. Understand the business or lack thereof.
Well, people commiting fraud generally try not to raise any suspicion so that complicates things for you a bit, Willy. Still, there is a centralized database of companies in the process of commiting a fraud (i.e., fraud not detected by law enforcement companies yet) accessible at www.willyr-is-a-clown.com. Hope that helps. If not, have the quants ‘reporting into you’ google for it, maybe they’ll find something.
OK - it’s kind-of a dumb question and we abused him appropriately but it is maybe an interesting thing to talk about. Fraud usually shows up when vol picks up (harder to cover your tracks), economic growth slows (can’t earn your way out of trouble), and the stock market drops (everyone looks for the villain). I don’t know this, but a climate of fraud in govt may make fraud more likely in business (sounds good and I really hate W). Anyone got any likely candiadates that we can acuse of fraud? You know, get sued for slander or libel or defamation or whatever you get sued for when you falsely accuse of a felony on a public internet site?
honestly, if you’re managing a fund, you really have very little time to look for specific things like fraud. Its best you just go after good companies and diversify away the idiosyncratic risk. I doubt even research analyst are able to pick out fraudulent companies. Forensic accountants can pick them out only if the information they’re given is not already tainted, but most companies i believe have to be audited to be listed right? I have noticed however that some companies have their stock halted from trading when they’re unable to meet SEC regulations. Many times this is due to the fact they can’t comply with submitting their statements. So i would think that might be a red flag. but these are usually penny stocks anyways.
Fraud may vary by industry. Industries that do a lot of government contracting have higher rates of fraud, I suspect. They certainly do in emerging markets. So defense, infrastructure, some utilities, and things like that are candidates. Of course, the government also tends to be the place to go to remedy fraud, so there might be less likelihood of things blowing up because of that, but that doesn’t mean the company is going to earn more because of it.
Great point BCW. Willy