There are many \u201cconflicts of interest\u201d possible in any investing situation. These conflicts often emanate from promoters and management. Social media and mainstream media are also incessantly bombarded with marketing and motivated messaging by influencers and operators. Detect Potential fraud in companies is the weapon of mass wealth destruction. <\/p>\n\n\n\n
Hence, the investor must be armed with defenses and weapons of mass protection. Not taking leverage, and avoiding intra-day trades and derivatives are basic precautionary principles for long-term investors. These investors do not have the time, energy, or emotional forbearance to navigate the choppy markets. As SEBI Registered Investment Advisors, we suggest a proven investing framework, such as ROOTS & WINGS<\/a> which reduces the chances of committing mistakes, and over time build a portfolio that helps one build and preserve wealth. There are some techniques that can help too, and this helps detect potential fraud in companies, mainly in the first category discussed in the previous chapter (\u2018Conflict of interest in investee company management\u2019).\u00a0<\/p>\n\n\n\n Forensic accounting checks are a set of such techniques that conduct a detailed study of the annual reports and quarterly results of various companies. These techniques rely on accounting, auditing, and investigative skills to examine the finances of the company. The profit & loss and balance sheet numbers are correlated, and any contradictions identified are further investigated. Forensic accountants usually look beyond the statistics and financial numbers to check the realities of the business. <\/p>\n\n\n\n There are many uses for a forensic accounting approach to detect potential fraud in companies. Many firms use these for tracing funds, identifying assets, initiating asset recovery, establishing damages from insurance claims, and also performing due diligence on companies. In fact, the analysis generated is suitable for use in judicial proceedings involving financial crimes such as fraud, insider trading, and embezzlement. Most retail investors may not be able to deploy these methods, but an understanding of them definitely gives an edge and provides insights on what to look for in a company before investing. Some of the potential danger signs that one can look for while evaluating companies are listed in the following paragraphs.<\/p>\n\n\n\n If the company is showing low cash flows relative to its earnings, then it is a sign of aggressively “recognizing” revenue and hence showing artificial growth. We have seen this with one large edu-tech player in September 2022, they took nearly a year and a half to close the previous year\u2019s financials, which involved allegations of recognizing revenue ahead of the subscription period. Unusually high \u2018other income\u2019 compared to its operating income. Some companies may resort to other income gimmicks by selling off assets or marking up investments, to cover up for poor operational performance. In the case of banks or other non-banking lending companies, the \u2018other income\u2019 check can involve computing the fee income as a % of total interest income or treasury income as a % of net interest income. In the case of banks or other non-banking lending companies, the provisioning policy could be tweaked to delay the recognition of \u2018non-performing assets. Any NPA immediately reflects as a loss in the P&L statement, which the company may wish to avoid. Lending is a tough business and while aggressive growth can be seen in the initial years, the subsequent impact of poor credit decisions becomes all too apparent in the form of NPAs, leading to high incidences of write-offs. Frequent changes in reserves and adjustments to profit after taxes. When the PAT fluctuates too much, due to reasons not related to operations, then it could be a cause for concern. The company manipulates depreciation rates and thereby expenses to its convenience and hence shows higher profitability. They may increase the lifespan of assets, revalue them to a higher number, or reclassify them to reduce the depreciation expense. They may also keep defunct assets alive on the balance sheet instead of writing them off. Any unusual changes in the related assumptions are something that warrants attention. unusually higher operating margins compared to peers, especially if the industry is a commodity industry with little scope for product differentiation. Sometimes, we may come across something that seems too good to be true. A company may be showing extraordinary profits but in fact, the talent of the company might be in cooking the books. They may collude with suppliers to receive inflated bills for goods supplied, or even when goods were never supplied to support payment receipts. If the company\u2019s Cash Flows are lumpy or sporadic across the years, then it indicates that the business does not have regular activities or is at the mercy of dominant suppliers or customers (who may be Government entities or large corporations. An investor may want to stay away from such companies because of the unreliable earning stream. If a company shows a very high percentage of \u2018miscellaneous\u2019 expenses as a ratio of the total expenses, then this could point to accounting irregularities. This is analogous to non-operating income being very high and leads to a situation where it is difficult to anticipate the earning stream of the company. One can look for a variance of the percentage from previous periods and also from the industry peers.<\/p>\n\n\n\n While Profit & Loss statements tell us about the flow of cash and earnings, the Balance sheets tell the story of how the tangible and intangible stock assets of the company grow or shrink over time.<\/p>\n\n\n\n In the manufacturing industry, a growing company typically reflects growing assets under the plant & machinery category. This may be true of the services industry too, where some real estate infrastructure may be required to run operations. An investor ought to be worried if a company\u2019s stock price is shining but the \u2018block of assets is not growing. Working capital norms vary by industry. While adequate working capital is a good thing, extremely high working capital may occasionally be a sign that a business isn’t investing its extra cash as effectively as it could be possible. The company may also be ignoring growth opportunities in favor of maximising liquidity. This is not shareholder friendly and could be a precursor to potential misallocation of capital. It could also be a sign of excessive inventory investment or a sluggish debt collection process, both of which could point to declining revenues and\/or inefficiencies in operations.<\/p>\n\n\n\n When a company keeps idle cash on its balance sheet, it reflects poorly on its treasury operations. The company is not using cash in its best interest. In some cases, the balance sheet could also be misstated. <\/p>\n\n\n\n The provisioning policy of a lender has a material impact on their reported earnings. With large lenders, the scale of operations becomes so complex that controlling the \u2018bad assets\u2019 is itself a huge effort. One type of fraud is when management underreports assets going bad, i.e., when recovery of a loan is difficult because the borrower is unable (or unwilling) to repay. The lending company clearly wants to boost earnings. Borrowers (who may collude with lenders) may play a few tricks, such as:<\/p>\n\n\n\n The company may lend or sell its goods to related parties with a vested interest. Once bad debts are collected, the company may suddenly write them off. This results in a loss to the shareholder. If the company shows very high capital work in progress relative to its gross block, then it might indicate delayed commissioning of plant and machinery (or IT projects). The reason for such delays could be to reduce costs by delaying the associated depreciation. This approach could be because revenues take time to materialize whereas costs are immediate. This is a potential red flag and suggests that auditors are not comfortable working with the company management. The company may dismiss the auditor themselves or the auditor may resign on their own.<\/p>\n\n\n\n It is expected that a company with sizable revenues and operations engages an auditor of repute. Not doing so might indicate that they are exerting undue influence on the auditor. When coupled with a company with a highly complex organizational structure with multiple subsidiaries and cross holdings, this is a cause for concern.<\/p>\n\n\n\n When the auditor firm\u2019s compensation grows very rapidly relative to the growth in the consolidated revenues of the company, it could hint at collusion between them. The number to check here will be the 3-year CAGR in audit\u2019s compensation with the corresponding company numbers or auditor firm compensation as a ratio to the company revenues. An exception would be if the auditor started with a very small fee structure, which would be the case with some startups.<\/p>\n\n\n\n Account checks with a forensic lens do help identify potential frauds. Experts use these in court testimonies, criminal investigations, and litigations where quantification of damages is required. For most retail investors, a basic understanding of these tools helps them invest with awareness. It is entirely possible that companies not scoring well on some of the above 18 parameters may still see excellent growth in their stock prices. But catching them will be a matter of chance. Companies that meet most of the above parameters along with the fundamentals of ROOTS & WINGS are likely to do much better.<\/p>\n\n\n\n <\/p>\n\n\n\n Maxiom Wealth \u2014 Free Tool<\/p>\n A 7% FD rate drops to ~4.9% after 30% tax for high earners \u2014 barely above inflation. See how FD compares to goal-based investments over your horizon.<\/p>\n FD Returns Calculator \u2192<\/a>\n Talk to a Financial Advisor<\/a>\n<\/div>\n\n","protected":false},"excerpt":{"rendered":" There are many \u201cconflicts of interest\u201d possible in any investing situation. These conflicts often emanate from promoters and management. Social media and mainstream media are also incessantly bombarded with marketing and motivated messaging by influencers and operators. Detect Potential fraud in companies is the weapon of mass wealth destruction. Hence, the investor must be armed… Read More »How To Detect Potential Fraud In Companies Before Investing In Their Stocks?<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":5567,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[8],"tags":[78,310,478,591,648,687,693,801,809,826],"class_list":["post-2487","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-wealth-creation-portfolio-management-pms-investment-advisory","tag-build-your-portfolio","tag-how-to-detect-frauds-in-investing","tag-long-term-investing","tag-portfolio-tracking","tag-roots-and-wings-investment-strategy","tag-smart-investing-tips","tag-start-up-investing","tag-value-investment-strategies","tag-ways-to-manage-your-portfolio-risk","tag-wealth-managers-india"],"_links":{"self":[{"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/posts\/2487","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/comments?post=2487"}],"version-history":[{"count":6,"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/posts\/2487\/revisions"}],"predecessor-version":[{"id":6611,"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/posts\/2487\/revisions\/6611"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/media\/5567"}],"wp:attachment":[{"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/media?parent=2487"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/categories?post=2487"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/maxiomwealth.com\/blog\/wp-json\/wp\/v2\/tags?post=2487"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}Topline or Revenue Mis-statements<\/h4>\n\n\n\n
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<\/p>\n\n\n\nBottomline or Profit Manipulation<\/h4>\n\n\n\n
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Sometimes the depreciation method itself might be changed to boost profits. In the Jet Airway case study we covered earlier, the company when under tremendous stress, resorted to changing its calculation method from Written Down Value to Straight Line Method which added back Rs 920 crores to its profits.
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<\/p>\n\n\n\nBalance Sheet Manipulations<\/h4>\n\n\n\n
Another trend to look for is if the depreciation is very low. To retain a higher \u2018gross block\u2019 the company may use a very low depreciation rate.
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<\/em><\/p>\n\n\n\nAuditor Firm Shenanigans<\/h4>\n\n\n\n
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Are FD Returns Beating Inflation After Tax?<\/h3>\n