Wednesday, 3 August 2011

How to Spot Dubious Accounting?

In general poor quality earnings, typified by

  • Increasing earnings
  • But no increase or even decrease in cash (in China this might be manipulated)
  • Rise in Inventory (inventory might be worth less than valued)
  • Rise in Receivables (might include fake receivables or difficult to collect)
  • Rise in Debt (often short term)
There are other things to look for, for instance:

  • Rights Issues that make no sense: companies that claim to be highly profitable, but need lots of cash in the form of Rights Issues
  • No dividends or very low dividends
  • High Margins: normally that is what we want as investors, but in competitive industries margins that are much higher than competitors are a potential red flag
  • High Sales compared to low Property, Plant & Equipment, if the last one is too low, than the Sales are possibly bogus
  • Interest Received versus Interest Expenses, if the company claims to have a lot of cash versus debt, but the Interest paid is much higher than Interest received, than something is likely wrong
  • Basic Numbers checking: for instance Bernie Madoff claimed to turnover a larger amount of options than the total amount that was traded.
  • Related Party Transactions: always a source of potential problems
  • Dubious brokers and accountants (note that Top Tier accountant companies have been involved with huge frauds, they are not a guarantee that all is well)
A selection of interesting articles from Bronte Capital, all China related, how to "kick the tires" of a Balance Sheet and Profit & Loss statement:

And the danger of short selling:

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