Anyone Have Experience with Fraudulant Companies?

[randomep]

 

hi, I am in the process of going more and more into smallcaps. But with smallcaps the big issue is fear of the unknown. The logic goes that big companies have more people scrutanizing them but small caps are less so. So small caps are more "risky".

 

However as with many things in investing the theory or instinct doesn't jive with reality. And this may be one of those cases. So I wonder if anyone has experienced or know of small caps where the stock tanked because the world found out about company/accounting fraud. For example, let's say a company's netnet is based largely on its inventory but the inventory is exaggerated.

 

The key mechanism to prevent fraud is the audit. But what if the auditor is not a nationally known firm. What if it is a 1-man shop. What then? How can I check up on the integrity of the accountant?

 

[yadayada]

common sense and cash flow statements seems like the only way here imo. Look how they turned inventory in the past? If you see one or two red flags, just avoid. Are they dealing in something that is likely to be overvalued or depreciate fast in time?

And finally, avoid the really small auditors. Seems to me that half decent audit firms aren't very motivated to play along with some small company's fraud, because they dont make that much in auditing costs. So there isn't much incentive to let them get away with it. If they have a history of churning through auditors, avoid. Really just avoid if something is shady, or if you see a red flag. Best thing you can do with investing is say next imo.

 

 

[claphands22]

Hi randomep,

 

Check out Quality of Earning by O'Glove the book does a great job of showing potential signs of fraud in the balance sheet. The Art of Short Selling is great as well, but I would suggest Quality of Earnings first.

 

Just because you have a Big 4 auditor doesn't mean the company will be fraud free. If it is a smaller accounting firm, research them -- often times they are fine but if they have worked with other fraudulent firms it is generally best to stay away.

 

I would heavily discount inventory of a small cap (or large company for that matter) if you are taking a balance sheet approach to valuing a company.

 

I don't know if I have answered your question. Reviewing financial fidelity can be tricky, it takes three measures of skepticism for each measure of optimism.

[DoddDisciple]

The Beneish M Score should work with smaller companies, right?

[bz1516]

There are lots of different things you can do to detect fraud, or more accurately suspect fraud with a high enough probability to either avoid the stock or short it if it meets your shorting criteria.

 

Looking at accountants is a good way to develop suspicion.  Just in the last two weeks i saw this little nanocap with a story and numbers that made it look like a 10 bagger.  i soon found out it was a reverse merger, nothing to do with the Chinese, but a yellow caution flag nonetheless.  In further reading that daY I saw that the CEO was fired for a run in with the SEC for something that took place "years ago".  So now being undecided about what to do I decided to look into the accountant, because the company's numbers were so compelling and I really wanted to take a position.  If the accountant were acceptable I would invest.  if not then no.

 

So I went on the internet and was able to identify the two name partners, and not any other accountants, though I couldn't say they didn't exist.  A phone call to the company produced a nothing more than a voicemail menu and I left a message.  So it was not looking good, but if I were going to give up this 10 bagger, I wanted a smoking gun.

 

So i searched EDGAR by the accountant's name and hit pay dirt.  A dozen companies showed up that they audited.  All were penny stock pump and dumps.  Guilt by association worked for me.  The company was OPRX.

 

I would still be making money had I bought IT.  My subjective evaluation is there is at least a 40% chance of fraud.  Not all companies that use such accountants are frauds.  NOG comes to mind as one that is likely not a fraud, though they fired the suspect accounting firm.

[ItsAValueTrap]

For example, let's say a company's netnet is based largely on its inventory but the inventory is exaggerated.

 

Look at the number of inventory turns and compare that to a real business in the same industry.  If they are reporting fake inventory, the inventory turns will likely get worse and worse.

 

The key mechanism to prevent fraud is the audit.

No....

 

Historically, auditors have rarely caught fraud.  (To be fair sometimes they do.  But it's rare.)  Let me be clear: their job is NOT to catch fraud.  Their duty to catch fraud is limited.

 

YOU should take responsibility for what you invest in.  If you don't understand it (and I don't understand a lot of the stuff out there), then I would stay away.  If you don't trust management's integrity, I would definitely stay away.  Outside of the stock market, it wouldn't make sense to invest with shady people... so why do it when it comes to the stock market?

 

Auditors aren't going to protect you.

Regulators aren't going to protect you.

I'd recommend you do your own due diligence.

[yadayada]

financial shenenigans is also a good book on this.

[twacowfca]

Most frauds in the English speaking developed countries where the rule of law is well established and  in other developed countries begin when the results appear to be likely to disappoint.  Then, a company may start to play accounting games to make the results seem better than they really are.  Next, things get worse, and not following the spirit of the accounting profession to accurately reflect reality can slip insidiously into fraud. 

 

Digging into financial statements and especially reading all the footnotes in recent years to see if there are changes that indicate management is glossing over adverse developments is quite helpful in spotting accounting games that put management on the slippery slope to fraud.

 

The most blatant frauds involve the problem of agency.  The Chinese reverse mergers are merely the most glaring example of this problem.  The officers of these companies have not been the agents of the noncontrolling shareholders, but are the agents of self dealing skimmers and criminal gangs often abetted by corrupt officials.

 

It is entirely possible for a bad agent to transfer assets of a company legally to the detriment of shareholders, especially when the transfer is from one country to another with government  oversight that is less strict.  This can happen even in developed countries where it may be difficult to extradite someone who is very likely guilty of fraud back to the country where the fraud took place.

 

When the numbers and ratios for companies that appear at the top of the list when a screen is run are outliers, it is wise to think that something is not right.  In 2001, Friedman's Jewelers and USG had the best P/E ratios of small cap to large cap publically traded companies.  Five minutes of research revealed the reason USG was trading as a bargain: major asbestos liability. However, what was wrong at Friedman's was not obvious. 

 

I stayed away from Friedman's because I didn't understand why they were so very profitable. They were a downscale jeweler that extended credit to many of their customers.  The price of their stock tripled within two years after they appeared as the best bargain on the P/E screen.  Then, they went bankrupt when their management was no longer able to juggle the inadequate allowance for bad accounts.  I didn't dig deeply into Friedman's because Their results seemed strange in relation to the low quality of their business without a good edge in a competitive market.

 

One company I did lose money on was Trident Microsystems that I bought as a flyer because they were a US company with real assets and lots of cash that showed up on the Magic Formula screen as a dramatic net net.  Their tech edge was deteriorating and an activist fund manager made a move on them to try to get them to return cash to shareholders.  Their managers nipped that in the bud by taking a big chunk of their cash and using that to buy questionable R&D from a related Taiwan company.  I saw the writing on the wall and sold my shares at a sizeable loss.  Fortunately, it was only one or two percent of the portfolio.

 

A few years later, the management cut a deal with a Taiwan company that apparently transferred all the substantial good assets of the company to Taiwan in exchange for something of questionable value, leaving Trident with a big hole that soon led to bankruptcy.  for all I know, this may have been perfectly legal because two different legal systems governed the transactions.

[ItsAValueTrap]

There's a good amount of fraud in developed countries... frauds where insiders had an intent to deceive from day one.  For example, there are still a lot of pump and dump penny stocks going on in the US.

 

[GregS]

Do NOT rely on the auditors to detect fraud.

 

I worked as an audit defense attorney. ItsAValueTrap nails it:

 

Historically, auditors have rarely caught fraud.  (To be fair sometimes they do.  But it's rare.)  Let me be clear: their job is NOT to catch fraud.  Their duty to catch fraud is limited

 

I've worked on cases with Big 4 firms (umm, used to be Big 5), small and midsize firms.  Cases involving small companies, big front page stuff, and one of the first Chinese RTOs to blow up. In no case have I seen anything that would suggest the auditor was in on it or ignored it. When the company blew up, the auditors were as surprised as everyone else.  Auditors must rely on management representations in order to conduct their audit, and management bent on committing fraud will work as hard to fool the auditors as the investors.

 

I would say that sometimes there have been questionable accounting decisions where they let the company get too aggressive.  Read the footnotes and try to understand how the accounting impacts earnings.  Understand the industry to know what's normal. Be careful with complex businesses. The books suggested above have techniques to identify problems.

 

Watch out for auditor resignations, especially if questions have been raised about the company. Auditors will never say fraud has been committed because they can't. The closest thing they say is don't rely on our reports.

 

And as far as an auditor's history, I would say that technique is better for identifying short candidates than longs.

[yadayada]

What happens with an audit anyway? They verify the cash streams in the bank right? And check the money really went were it was suposed to go. And check if the cash is really there. I heard with some of these chinese frauds they actually bribed local  bank managers.

[twacowfca]

There's a good amount of fraud in developed countries... frauds where insiders had an intent to deceive from day one.  For example, there are still a lot of pump and dump penny stocks going on in the US.

 

Yes, the problem of bad agency is much more likely with small companies that don't have established records. being in a country with a strong tradition of the rule of law is no guarantee against bad agents, especially when there are lots of perfectly legal ways to shaft minority sharehders.  A certain big liar comes to mind. 8)

[twacowfca]

Do NOT rely on the auditors to detect fraud.

 

I worked as an audit defense attorney. ItsAValueTrap nails it:

 

Historically, auditors have rarely caught fraud.  (To be fair sometimes they do.  But it's rare.)  Let me be clear: their job is NOT to catch fraud.  Their duty to catch fraud is limited

 

I've worked on cases with Big 4 firms (umm, used to be Big 5), small and midsize firms.  Cases involving small companies, big front page stuff, and one of the first Chinese RTOs to blow up. In no case have I seen anything that would suggest the auditor was in on it or ignored it. When the company blew up, the auditors were as surprised as everyone else.  Auditors must rely on management representations in order to conduct their audit, and management bent on committing fraud will work as hard to fool the auditors as the investors.

 

I would say that sometimes there have been questionable accounting decisions where they let the company get too aggressive.  Read the footnotes and try to understand how the accounting impacts earnings.  Understand the industry to know what's normal. Be careful with complex businesses. The books suggested above have techniques to identify problems.

 

Watch out for auditor resignations, especially if questions have been raised about the company. Auditors will never say fraud has been committed because they can't. The closest thing they say is don't rely on our reports.

 

And as far as an auditor's history, I would say that technique is better for identifying short candidates than longs.

Thank you, Greg, for giving us your insider's view of the limitations of auditors to catch fraud.

[muscleman]

 

hi, I am in the process of going more and more into smallcaps. But with smallcaps the big issue is fear of the unknown. The logic goes that big companies have more people scrutanizing them but small caps are less so. So small caps are more "risky".

 

However as with many things in investing the theory or instinct doesn't jive with reality. And this may be one of those cases. So I wonder if anyone has experienced or know of small caps where the stock tanked because the world found out about company/accounting fraud. For example, let's say a company's netnet is based largely on its inventory but the inventory is exaggerated.

 

The key mechanism to prevent fraud is the audit. But what if the auditor is not a nationally known firm. What if it is a 1-man shop. What then? How can I check up on the integrity of the accountant?

 

I lost a lot of money in CCME. It was audited by Deloitte, and Star International was its biggest shareholders, so I thought it would be fine, but turned out to be a fraud.

Small cap does have this risk. I think you have to do your own research and try to know the CEO well in order to understand his incentive.

[SharperDingaan]

Auditors do not give absolute assurance, & are not there to catch fraud.

And they are not saying there are no miss-statements ... only that the net miss-statement is within a defined acceptable limit.

 

SD

[writser]

Maybe this is too obvious, but I think there are a lot of things you could look at as heuristics to minimize the risk of buying into a fraud:

 

- Google everything. Look for their HQ with Google Maps, google the CEO, google their products, google the auditor etc.

- Try to order their services / products.

- Do insiders own a significant amount of equity?

- In the past, has the company been paying dividend or raising capital? Do they have a history of profitability and positive cashflow?

- Is management compensation reasonable? Are they diluting existing shareholders? Is management very promotional?

- Are there dubious footnotes in their filings? I.e. a change in inventory valuation method, pension liability assumptions, etc.

- Does the company story sound too good to be true? Is it a 'hot' sector stock (fracking, social media, 3d printing, solar power)?

- Do other investors have their doubts about the company being a fraud or not?

 

And probably a lot more. The real question is; what risk are you willing to take if the company scores badly at some of these points. Personally, I pass most of the time. Enough other opportunities out there. You can practically apply half of WEB's quotes here: "bla .. bla .. honest management .. bla bla .. wait for the pitch .. bla bla .. willing to trade away a big payoff for a certain payoff .. bla bla .. rule 1 never lose money .. bla bla". No disrespect :)

 

I also agree with other posters suggesting Financial Shenanigans and Quality of Earnings as great reads.

[matjone]

I ran across this a few months ago

 

http://www.beyondproxy.com/detecting-accounting-fraud-asia/

 

if you understand it maybe you can explain it to me.

[dpetrescu]

I recommend reading Sam Antar's blog . He was the CFO for Crazy Eddy in I think the 90s. The way he manipulated the books was by recording non existing inventories as assets and borrowing against them. It also helped they had an insider in their auditor. The company would drive around inventories to different facilities as they were being audited and use empty boxes.

 

Sam has said that loss reserves and inventories are the easiest adjustments to manipulate. Also, other non cash adjustments such as depreciation period or change in useful life in fixed assets. if there's any doubt, focus should be on cash flow.

 

I've noticed a few on here are long Overstock. Sam has uncovered that the company increased the useful life of software and hardware thus minimizing amortization thus increasing earnings. They did this without disclosing it in their SEC filings. Also almost half of their earnings increase one quarter was a decrease in loss contingency even while litigation costs increased (eg...they were just charged and fined with fraudulently listing competing prices)

 

So stick with cash not earnings

[dpetrescu]

I've made a lot of errors when I first started investing ear trading. The most telling of fraud is a complex ownership structure or complex ownership of investments. Take two examples.

 

1. Typical book value fraud with investments, especially with miners. when main company invests in non public side company (they are related owners) it can then arrange for a third company to purchase a very very small stake in side company at an inflated price. This will increase the value of side company and main company records twice as much in value of investments.

 

2. An alternate method, Enron invested in a company that in turn was a customer and turned the invested assets magically into revenue as well.

 

I think it's very valuable to read research reports by short analysts to see typical methods of fraud

[GregS]

What happens with an audit anyway? They verify the cash streams in the bank right? And check the money really went were it was suposed to go. And check if the cash is really there. I heard with some of these chinese frauds they actually bribed local  bank managers.

 

I read this article on problems auditing cash balances in China awhile ago and it gives some insight into the basic audit process and what can go wrong.  Definitely worth a read.

 

http://www.chinaaccountingblog.com/weblog/auditing-cash-in-china.html

 

Basically, it goes like this: Auditing a bank statement should be the easiest thing in the world (it's also critical).  The auditors get third party confirmation from regarding balances from the bank and it matches the company accounts, and the overwhelming majority of the time they match and that's it.  But auditors get complacent and lazy like people sometimes do, and the article describes a case where PwC let the CFO fax the confirmation to the bank himself (I'm sure the CFO was very helpful and insistent) and he faxes it to another machine and forges it and faxes back.  Totally stupid and wrong for the auditors to do that, but it happens and all the investors have left is a civil claim.  Note that the threat of liability and professional discipline wasn't enough to keep the auditors on task.

 

But other auditors do what they are supposed to do and correctly do the third-party confirmation.  And it comes back clean, except the CFO who faked the accounts know they will do this and bribe the low level official at the local bank branch, or find some other way to muck up the confirmation process.  The auditors fulfill their duties and investors get screwed, because a company hell bent on fraud will find a way to cover it up. 

 

So now you end up in the situation of the China MediaExpress Case.  Deloitte gets wind of possible fraud (I don't recall how) and decides they are going to contact the bank's head office instead of the branch.  The company refuses and Deloitte resigns.  Investors get crushed.

 

Note what Deloitte was doing here was beyond what is normally required of auditors, unless there is strong reasons to suspect fraud.  I'd argue that account confirmations for every company in China at this point need to be done this way, but that's not going to be the case in the US (in fact, my advice to any accounting firm wanting to audit a Chinese company is "don't").  The broader point is this: bank confirmations are simple, but even then the auditors can be deceived.  Now imaging trying to do the same process for inventories, shipments, sales contracts, etc.  The company can easily move product around and fabricate documents.  In many cases, third party confirmation may not be required (if I recall correctly, it depends on the auditor's assessment of fraud risk).  There's a lot of ways an auditor can be fooled or miss things.  It especially doesn't help that if the CFO and controller are in on it, they are probably former auditors who know exactly what their auditors will look at.

[yadayada]

THey did found out by going to the bank's headquarters tho. They cannot bribe their way out there. But they usually only do that if they spot other red flags. ALlthough almost all these chinese companies with relaly nice margins and earnings look suspicious to me anyway.

[ItsAValueTrap]

What happens with an audit anyway? They verify the cash streams in the bank right? And check the money really went were it was suposed to go. And check if the cash is really there. I heard with some of these chinese frauds they actually bribed local  bank managers.

 

As I understand it:

A- They have to test the company's internal controls.

B- They have to do some basic stuff like checking if the cash is there, sampling some of the paper trail and verifying it, etc.  (I believe that they don't have to verify everything, because that would get a little ridiculous.)

C- They have to check if accounting rules and GAAP are being applied appropriately.  Some of these rules are subjective... an auditor might let the company get away with stuff depending on the relationship.

 

Sometimes they will screw up one or more of the items above.

 

On top of that, some auditors will provide other services to the company such as consulting services and tax services.  This can lead to potential conflicts of interest.

 

---

GregS:  Nice posts!  ChinaAccountingBlog.com is a very good blog that explains a lot of accounting issues.  (Personally I find accounting boring.)

 

I've noticed a few on here are long Overstock. Sam has uncovered that the company increased the useful life of software and hardware thus minimizing amortization thus increasing earnings. They did this without disclosing it in their SEC filings. Also almost half of their earnings increase one quarter was a decrease in loss contingency even while litigation costs increased (eg...they were just charged and fined with fraudulently listing competing prices)

 

I found that particular argument to be incredibly weak.  Increasing the useful life slightly makes their accounting *slightly* more aggressive.  But the useful life is still very reasonable.

 

A lot of companies out there are far more aggressive in depreciating their software and hardware over a longer period of time.  Take CLR for example:

 

http://glennchan.files.wordpress.com/2013/12/clr-aggressive-accounting1.png

 

Software that has a useful life of 25 years... imagine that.

[dpetrescu]

The useful life was just one example. (Before I go on I should say I don't know about overstock aside from what I've read on Sam's blog. I just like to learn about how something is done wrong to look out for it. I have no opinion on the value of overstock equity) Sam noticed that Overstock in the mid/late 2000s was misrepresenting reported EBITDA values. Instead of starting out with net earnings and adding back ITDA, it 1) started with operating income and 2) added back stock based compensation as well as ITDA. This meant that values were misrepresented higher because 1) non operational expenses like 1 time losses were not included and 2) SBCs also not included. For one quarter EBITDA value was 50% overstated compared to proper GAAP. For another GAAP EBITDA was supposed to be negative but SEC filed EBITDA was positive. Eventually in their SEC filing end of 2008, the company added the word "adjusted" before "EBITDA".

 

I guess that's why it's theoretically best to use Excel and calculate your own ratios.

 

I agree about CRM, maybe they are using software that is perfect and will not need updating for a quarter century?...Off topic but...I think in their case they actually bring in high cash flow so cash is there but a lot of expenses are with high stock based compensation so if stock becomes out of favor that cash might not be sustainable if they have to actually pay expenses with real cash. And then they won't be able to buy revenues through acquisitions every week causing a self reinforcing downtrend.

 

I've noticed a few on here are long Overstock. Sam has uncovered that the company increased the useful life of software and hardware thus minimizing amortization thus increasing earnings. They did this without disclosing it in their SEC filings. Also almost half of their earnings increase one quarter was a decrease in loss contingency even while litigation costs increased (eg...they were just charged and fined with fraudulently listing competing prices)

 

I found that particular argument to be incredibly weak.  Increasing the useful life slightly makes their accounting *slightly* more aggressive.  But the useful life is still very reasonable.

 

A lot of companies out there are far more aggressive in depreciating their software and hardware over a longer period of time.  Take CLR for example:

 

http://glennchan.files.wordpress.com/2013/12/clr-aggressive-accounting1.png

 

Software that has a useful life of 25 years... imagine that.

[dpetrescu]

Just wanted to add one more note about the increase in lifetime of software. In Q3 2013 when overstock reported 28% increased earnings, they had also increased lifetime from 2-3 years to 2-4 years in q2 2013. This is completely reasonable, especially in light of CRMs 25 years (good find BTW, I'd  be interested in knowing more about how they justify it) What's even more amazing is that although minor, that 1 year adjustment accounted for half of overstock's increase in earnings. Overstock could probably increase it 1 more year and not be too unreasonable. It just shows the possibility for earnings to be manipulated. Theoretically, a company could increase lifetime of fixed assets every year and manufacture growing earnings.

[ItsAValueTrap]

I think you're confusing CLR with CRM.

 

Here are CRM's numbers:

 

Computer, equipment and software

  3 to 7 years

 

Furniture and fixtures

  5 years

 

Leasehold improvements

  Shorter of the lease term or 10 years

 

Building improvements

  Amortized over the estimated useful lives of the respective assets when they are ready for their intended use.