How to Detect Business Fraud

For those who are interested in the accounting side, I highly recommend Financial Shenanigans by Howard Schilit [1]. If you don't have an accounting background, all you need to get value out of this book is a basic understanding of the double entry accounting method, and understand the four financial statements: balance sheets, income statements, cash flow statements, and statements of shareholders equity.

After reading this book, I found myself digging through earnings reports to look for signs of shenanigans, and have found cases that raise my armchair-accountant eyebrows.

[1] https://www.amazon.com/Financial-Shenanigans-Fourth-Accounti...

> Each stock fraud is fraudulent in its own way. But there are common elements. One is a breach between earnings as defined by Generally Accepted Accounting Principles (GAAP) and non-GAAP measures. Another is an increase in “days payable outstanding”, a yardstick of how long it takes a company to settle bills with suppliers. Delay boosts cashflow, at least for a while. So does gathering more quickly payments you are owed. Firms with dressed-up earnings also tend to pile on debt because they lack strong underlying cashflow. And there are grounds to suspect the worst of companies that engage in a lot of acquisitions. Aligning the accounts of acquirer and acquired gives ample scope for fiddling.

> Transcripts of conference calls with stock analysts can also be revealing. If the company keeps moving the goalposts, then be on alert.

The China Hustle[1] is a great documentary about the systemic securities fraud committed by Chinese companies selling into the American markets in a way that allows them to avoid much of the disclosure and due diligence typically required. It follows investors from the Muddy Waters firm mentioned in the this article and was made by the same group who did documentary version of The Smartest Guys in the Room.

I believe the film is currently streaming on Hulu.

[1] https://en.wikipedia.org/wiki/The_China_Hustle

I think one of the most interesting methods of business fraud detection is Benford's law. It has been found that natural transactions do abide by this law.

https://en.wikipedia.org/wiki/Benford%27s_law

Inflating sales is a classic move:

> In indictments involving the case, prosecutors said HBOC sold software or services to more than a dozen hospitals with conditional "side letters" that allowed the hospitals to back out of the deals. The side letters were then hidden from auditors and the transactions were reported as sales.[0]

McKesson (and perhaps other pharma wholesalers) also played games by timing invoice payments and chargebacks to increase quarterly growth.

0) https://www.nytimes.com/2005/01/13/business/mckesson-agrees-...

Edit: Another tactic is hiding rebate and chargeback transactions in numerous ~unauditable spreadsheets, stored on individual employee machines. Or even only as hard copy.

They exposed Luckin Coffee $LK and called it a fraud in January to no reaction in the market. The stock collapsed 80+% before being suspended in April. They had this exchange of tweets with Citron Research which might be my favorite case of "I told you so":

https://twitter.com/muddywatersre/status/1245704324342108161

Highly recommend "lying for money" by Dan Davies, a very readable account of a wide range of business frauds.

Self plug: If you are interested in short selling and activist funds, I run an online community where people post original research and discuss other short theses: https://activist.cafe/

it would be interesting to codify the known heuristics of forensic accounting into a software package (maybe even AI all the things!), then create a company out of it in partnership with prosecutors and regulators to root out fraud like this through both technological and legal means. i'm sure there have been some efforts to that end, though not commonly known.

it would help rebalance the legal system toward the service of people over corporations.

Can you detect any shenanigans going on at Tesla?

If so, then this would be a very good stock to short.

Aside from this article (paywalled), I liked learning from some story that certain financial / bank employees are required by the Fed or SEC to go on vacation and not have access to their email or phone for a certain number of contiguous days every year. Is this correct -- was it something to do with the Madoff scandal?

As I understood it, the idea was that to perpetuate a financial fraud, a criminal relies on being present and able to intercept / continue feeding fraudulent information to others and not be discovered. Or maintaining some fraudulent trading position.

The tactic I liked about this was the thinking about what's required to perpetrate a fraud, and make the conditions difficult or impossible for someone to go undetected.

Rather than retroactively finding the fraud and just trying to detect it better when it has already happened.

The first story is about finding out a company is junk, shorting their stock, then releasing the information. Is that not a form of stock fraud, or at least manipulation, as well?

Good investigative reporting into shady business practices good for this world.

However short selling companies before dropping your investigation is a massive conflict of interest. Muddy waters is incentivized to produce a scandalous hit piece, rather than necessarily do fair or accurate reporting. They will make money regardless. The damage their reporting does may make a self-fulfilling prophecy, ensuring they don't get a reputation hit for inaccurate scoops.

I'm surprised the economist didn't even include a nod to the potential manipulation going on here.