How to Spot Accounting Fraud

Thanks to Tracy Coenen for pointing this out.

Joseph Wells has a good article on how you can use time series of financial ratios to spot accounting fraud. He uses ZZZZ Best (Barry Minkow’s fraudulent company) as an example of how this works. When there is fraud, there will usually be excessive accruals, or non-cash items, relative to the actual cash flow of the business. This is because such accruals can be faked, whereas actual cash flows cannot easily be faked. If a company has $10 million in cash in the bank is easy for the auditor to verify. It is much harder to verify sales that have been billed but not yet paid. Any two-bit criminal can falsify a sales record and added big number to the Accounts Receivable line.

Accruals have already been shown to lead to poor stock performance, so this is just one more reason to avoid companies with high accruals.

See the article.

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