Investing For Beginners

Investing For Beginners is a series of articles, resources, and other information about basic investments, value investing, quantitative research and other ideas.

Accounting Fraud: How to Recognize The Signs

Accounting fraud is a deliberate and improper manipulation of the recording of sales revenue and/or expenses in order to make a company's profit performance appear better than it actually is. Accounting fraud may also involve misappropriation of funds for the benefit of the owner or friends and relatives.

What Constitutes Fraud?

Some things that companies do that can constitute fraud are:

  • Not listing prepaid expenses or other incidental assets
  • Not showing certain classifications of current assets and/or liabilities
  • Collapsing short- and long-term debt into one amount.
  • Misappropriating funds

Over-recording sales revenue is the most common technique of accounting fraud. A business may ship products to customers that they haven't ordered, knowing that those customers will return the products after the end of the year. Until the returns are made, the business records the shipments as if they were actual sales.

Or a business may engage in channel stuffing. It delivers products to dealers or final customers that they really don't want, but business makes deals on the side that provide incentives and special privileges if the dealers or customers don't object to taking premature delivery of the products. A business may also delay recording products that have been returned by customers to avoid recognizing these offsets against sales revenue in the current year

Picture of magnifying glass over the words 'crime' and 'fraud'

The other way a business commits accounting fraud is by under-recording expenses, such as not recording depreciation expense.  Or a business may choose not to record all of its cost of goods sold expense fore the sales made during a period. This would make the gross margin higher, but the business's inventory asset would include products that actually are not in inventory because they've been delivered to customers. 

A business might also choose not to record asset losses that should be recognized, such as accounts receivable that are in in default, or it might not write down inventory under the lower of cost or market rule. A business might also not record the full amount of the liability for an expense, making that liability understated in the company's balance sheet. Its profit, therefore, would be overstated.

How to Recognize Accounting Fraud

It is very common for foreign companies such as those in China and India to inflate sales, inventory, and inventory turnover in order to meet funding requirements. While such accounting can be considered "standard practice" in an emerging economy, they are not legal in the United States. Fraudulent accounting activity can also be found in some U.S. Over-The-Counter (OTC) stocks or "pink sheets" that do not have the same reporting requirements as exchange listed stocks.

Before making a final decision to invest in a company, one should look for the following red flags:

  1. Recent change of auditor
  2. Delays in filing audited financials to the SEC
  3. Recent change or frequent turnover of Chief Financial Officer (CFO)
  4. Frequent management/staff turnover
  5. Inadequate disclosure of customers, suppliers, their independence, and their size/volume of business
  6. How contracts are won

The investor should do his or her own independent research into the top 10 - 20 customers and suppliers, who they are, whether they are independent, whether the size of businesses are consistent with product/service volume, etc.  The investor should also scrutinize any agreements / trades / transfer of funds to the company owner and make sure that such activities exist at all, that they are done at fair market value.

This article is educational and should not be interpreted as financial advice.

AUTHOR:  Steve Auger

DISCLOSURE: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it . I have no business relationship with any company whose stock is mentioned in this article.