hi I'm Jimmy in this video we're gonna walk through eight different tips and
tricks that we can use to identify the early red flags for a possible fraud in
the making so in a recent video I did where we looked at the fraud accusations
on General Electric well it hit me that it might make sense to go through some
of the different ways that we could try to notice strange things that a
company's management team might do that could eventually lead to a full-blown
fraud okay let's kick it off so let's imagine
we had a scale that looks something like this
all the way at the top is the highest quality companies out there and then all
the way down here at the bottom you have companies that are straight up
committing fraud now generally companies don't start as frauds usually what
happens is they start somewhere up in the green area and then something goes
wrong and they gradually adjust things slowly compromising the business until
they eventually end up in the situation where a full where they are a full-blown
fraud so first we're gonna look quickly at this scale and then we're gonna touch
on some ways that we can identify where a company is on the scale and which
direction they're heading are they getting better are they getting worse so
there are a couple factors that help us determine where on the scale a company
might stand first do they follow the rules of either IFRS or US GAAP that's
the accounting standards both in the US and international then in their
financial reporting section in their financial reports do they give us the
information that we need to make good decisions are they unbiased in their
accounting choices are they are they fully disclosing everything are they
transparent things like that then we have earnings quality now earnings
quality refers to profits that are the profits of real are they sustainable and
can they keep the company growing and will they provide enough additional
capital to return to us investors okay simple enough now if we go ahead and
fill in this whole table we can see what this looks like so the key to
understanding how fraud could happen and also how this scale works is for us to
realize that a cup is funny within the company's financial
statements and within the rules of accounting they're usually choice these
choices are usually necessary since there are so many different types of
businesses and in theory the company should make the choice that is most
appropriate for their business but sometimes companies can make choices
that make their financial statements look better than they really are
ultimately that's what we're trying to identify it's also how this scale works
so the ideal company well this is the highest quality company well of course
they follow the accounting rules and they also give us all the information we
need to make good investment decisions they're very transparent about what they
do they also have high quality earnings but as we slide down to the next level
well maybe the next level is still a very solid company but they're just not
quite as transparent and because they lack a little bit of transparency well
in theory their earnings quality is just a little bit lower because there's some
things we don't know then down here well here the company is starting to get a
little bit tricky maybe some of their choices are still within the rules of
accounting but perhaps they are just a little bit biased in some situations yes
they're still following the rules but we want to recognize that maybe their
numbers are a bit biased then if we move down to the next level well now they're
really starting to get a now management they're still following the rules but
things are not looking that great because now they're really starting to
manage earnings or manage revenue or whatever it might be but they're still
following the rules well then we drop into the fraud zone and here we have
groups that are no longer following the accounting rules this is where Enron
would land then the bottom level well that's just straight up fraud in Enron
situation what they did was they had a business they were actually doing things
but they lied they just didn't follow the rules of accounting and Bernie
Madoff skates well it was just straight-up frauds just made-up numbers
okay so now on to our eighth item checklist for identifying fraud red
flags first we'll start with revenue and although revenue might seem to be fairly
straightforward there's actually a lot that a company can do that could be
considered biased or even suspicious so we start our research we're going to
soon companies all the way up here we're
gonna listen there a high quality company but as we go through our
analysis well we may come across a company that is smoothing earnings or
actively managing revenue so this is actually the first item on the checklist
and that is look for a company that makes changes to their revenue
recognition policy generally the company will if they do change their the method
that their accounting for revenue well they're going to talk about that usually
fairly extensively in either the earnings call the earnings at least a
10k the ten cubes something like that and oftentimes it's perfectly fine
but sometimes we're going to notice that there's not a lot of disclosure as to
why they did it or how things are impacted and to me that's the real red
flag if they change things and they don't really explain it they just
quickly gloss over yeah we made a change and then they move on because we're
required by rule to say that they made a change but how much they explained it
could be all the difference in the world okay next on the checklist is a
receivables turnover number that continues to fall so to calculate
receivables turnover what we take revenue and we divide that by the
average number of receivables so this is how much the company expects to collect
from its customers and to get the average receivables basically we take
the receivables from the end of the period and the beginning of the period
we add them up divide by to take the average number so what does receivables
turnover tell us well receivables are how much the customer owes the company
and if receivables got larger well then receivables turnover would get smaller
so if receivables turnover is consistently getting smaller what looks
possible that the company is getting more lenient with their credit policy
with their customers so if we were to see let's pretend we see sales rising
and receivables turnover getting smaller well maybe sales are only rising because
the company is offering better financing terms so back on our scale here well if
that's what they're doing that would lead to a falling earnings quality which
would move them down our scale okay next on our checklist is inventory turnover
which is actually very similar to receivables turnover except this time we
take cost of goods sold and divide it by average
to inventory so if we're consistently seeing falling inventory turnover well
this could be a sign that management is doing a poor job of managing the
inventory and this is another good example of falling earnings quality
which is a good thing for us to recognize the next thing that we could
watch for that could be an indication of management playing with numbers a bit is
something called LIFO liquidation so LIFO stands for last in first out and
it's a way for a company to account for their inventories now this is only
allowed in the US under US GAAP so this wouldn't apply to companies that follow
IFRS but let's imagine that we're analyzing a lumber company and they come
down they cut down the lumber they throw in a pile and that lumber cost them $10
each well they go ahead and they sell that for $15 okay they don't quite sell
all of it so they only sell out of 100 units that they produce they only sell
let's say 90 of them next year they do it again produce 100 some 90 of them
except this time they produced it for $11 they sell it for $16 then 12 and
they saw the 17 in the following year well in the fourth year the company
realizes that they now have 40 units on hand at a cheaper cost basis so this
year what the company does is they produce only let's say 50 units they
sell all 90 units again but the first ten are at $10 the second 10 are at $11
the third 10 are at $12 and what you end up with is much better-looking margins
because you're selling them all for $18 per item
that's called a LIFO liquidation and if a management if management doesn't go
out of their way to explain what they did and why their margins got better
that could be a real problem that would be a good indication of a lack of
disclosure and that would make them slide down our scale now it's not
necessarily a negative thing companies do this they have that inventory they're
gonna have to get rid of it the key to the whole thing is disclosures do they
properly explain what it is up front and center and why in theory their margins
got better but if they try to hide it at all well clearly it's untrue that their
margins just got better due to some improved business method and that could
be a problem for the company forward okay next we have operating cash
flow - net income consistently being less than one so if we think about
operating cash flow well this is how much cash a company brings in so if we
take in that cash and we divided by the net income then what we end up with is
operating cash flow in that income now both numbers are the same the ratio
would end up being one but let's imagine that one time a company extended credit
to a customer and that customer is yet to pay so you have net income that
company brought in that revenue they account for it but cash flow doesn't go
up in theory you would expect for the next period to include that cash that
the customer would have since paid then and the two numbers should about average
out to be somewhere near one but if the company doesn't pain the number stays
consistently below one this could be an indication that the company is somehow
manipulating earnings without bringing in cash which cash often is fairly
verifiable by auditors so they might be a bit more hesitant to mess with the
cash before they're willing to mess with profits okay now we're into the final
couple pieces and here we compare our company to its competitors there are
three different pieces seasonality capitalizing costs and depreciation
methods so seasonality is important to recognize in an industry for example
maybe an industry may be in the toy industry their fourth quarter is very
strong well one company has a pretty decent
fourth quarter but not a great one like all the other area companies are having
that are in the same industry but then their first quarter is far and away
better than everybody else's that might make us question is management doing
something to somehow kick revenue from the fourth quarter over the first
quarter and this would be a good example of smoothing earnings and messing with
the revenue recognition numbers then we have capitalizing costs and depreciation
methods so every company has a choice of how they're going to account for the
assets that they have if they expense them it just goes in the income
statement reduces profits profits end up smaller if you capitalize in an expense
well what would happen was that go on the balance sheet as an asset and
then you gradually expense that through depreciation so in theory it make this
periods profit look bigger now if everybody need the street isn't doing
that in our company is that could end up being a problem along those same lines
is depreciation if everybody's if every company in a particular industry is
buying trucks and when they buy those trucks are all buying the same truck and
they're all depreciating it over five years but for some reason the company
we're analyzing it is depreciating it they're going to depreciate it over ten
years well if they're doing that the depreciation expense would be spread
out more so it'd be smaller each year in theory it would look like they have
bigger profits because they would be taking a smaller expense so it's
important to compare depreciation methods and capital of what they
capitalize on what they don't to other competitors to see if that's normally
the way the industry does it because every industry is a little bit different
so those are the top eight things that we can use to identify red flags in
accounting that could eventually lead to fraud when we're jumping over to our
scale here well we don't want to see a company sliding down slowly getting less
transparent of what they're doing a lower quality of earnings we want to
avoid that and it might make sense for us to only limit ourselves to companies
that stay in the top let's say the top two but there are many different ways
outside of the eight that I've named here are there any that you would have
included on this list that I didn't include please let me know what you
think in the comments below if you haven't done so yet hit the thumbs up
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video and I'll see in the next video thanks