Overview – Financial Dishonesty is Never Justifiable
You’ve probably heard it said before that “honesty is the best policy”. One would hope that the people or organizations we interact with are truthful, but as experience has taught us all, this isn’t always the case.
People and organizations choose to be dishonest for all sorts of reasons, and a couple of them include the desire to hide less-than-stellar performance or to overstate subpar performance.
We’re quick to share our accomplishments, no matter how big or small they may be, but we’re also just as fast to conceal our poor performances or failures. After all, nobody goes around proudly telling everyone about the setbacks, disappointments, and other hardships they’ve faced.
Publicly traded companies are always seeking more investment capital while also working to retain their current investors, so they constantly flaunt their financial and business prowess to try and accomplish those things.
While there’s nothing wrong with companies showcasing their strength and accomplishments, it’s important for investors to remember that all companies experience ups and downs. While most companies have no problem being honest about problems and disappointments they’ve experienced, others refuse to do so.
These companies that refuse to talk about their areas of weakness may simply choose to bury this unpleasant information as a footnote somewhere, or in some cases, go as far as directly manipulating their financial data to make it appear better than it seems.
Choosing to falsify financial data may provide some extremely short-term benefits, but the costs of cooking the books almost always cancel out any benefits, short or long-term, that may have been gained.
How Financial Dishonesty Affects Investors
Say you’ve recently come across a publicly traded company that, at a glance, seems like a potentially good investment, so you decide to investigate it further. What you don’t know, however, is that this company’s financial data has been manipulated to such an extent that it will significantly influence your decisions.
When a company decides to manipulate their financial data, this represents a major source of investment risk, especially if this falsification has been going on for quite some time. This investment risk is two-fold.
First, when an investor works with manipulated data, the analysis they perform and the decisions they subsequently make will be inherently flawed. Because of this, they may choose to park their capital with a company they believe is a solid investment, but in reality, is a dud.
If this manipulation persists, the investor may continue to be under the impression that they have a solid company in their portfolio and may choose to increase their stake (i.e., buy more shares). Unbeknownst to them, what they’re actually doing is inadvertently building a larger house of cards, atop which they stand. The higher this house of cards becomes, the harder the fall will be when it collapses.
Unless this company happens to be world-class at consistently falsifying its financial data, it’s only a matter of time before someone notices that something is amiss – this leads us to our next point.
When a company’s data manipulation comes to light, they will soon find themselves drowning in all sorts of lawsuits, fines, and penalties they must deal with. Amidst this mess, investors will find themselves caught in the crossfire. The fallout from such a revelation can vary significantly, ranging from hefty legal fines at best all the way to shutting down operations entirely at the absolute worst.
In such a chaotic scenario, investors stand to lose quite a bit, whether it’s experiencing a precipitous drop in stock price, a dramatic slash or full suspension of the dividend, some combination of both, or even the stock being delisted entirely. The larger an investor’s stake in this company is, the steeper their potential losses are.
While all of this may sound fanciful, there are two high-profile examples that show this is something that can definitely happen: the Enron and WorldCom scandals. The details won’t be explained here, but essentially, both Enron and WorldCom engaged in major accounting fraud, the fraud was eventually discovered, and both companies took very heavy blows because of it.
Given that several years have passed since these scandals occurred and the dramatic changes in technology that have happened since then, it’s easy to think that such scandals are a thing of the past. However, that isn’t the case at all.
In 2021, the Kraft Heinz company was fined $62 million for engaging in a years-long accounting scheme, and in 2022 an infrastructure company named Granite Construction was fined $12 million for manipulating earnings figures from 2017 through 2019.
Financial dishonesty has some very serious, far-reaching consequences, and investors who unknowingly involve themselves with companies that engage in this nefarious act stand to lose so much through no fault of their own.
Are Major Cases of Financial Dishonesty Still a Problem in Today’s Investing World?
Following the Enron and WorldCom scandals, the financial and business worlds underwent a major upheaval to ensure such high-profile events never happen again, or at least minimize the chances. In 2002, as a direct response to these scandals, the U.S. passed a new law known as the Sarbanes-Oxley Act, which mandated certain financial record-keeping and reporting practices for corporations.
Given the rapid development of technology, and the fact that more people than ever now have internet access, investment information is readily available and can be viewed by virtually anyone. With so many people now having relatively easy access to a company’s financial data, it becomes much harder to perform accounting fraud and hope to get away with it when hundreds of thousands, if not millions, of people can now scrutinize the data as much as they want and discuss their findings with countless others.
Ever since Enron and WorldCom, there haven’t really been any cases of financial dishonesty similar in scale and impact. As we quickly went over previously, companies still perform financial sleight of hand, but they certainly aren’t multi-billion dollar behemoths, and such cases are usually handled without much fanfare.
So, does this mean financial dishonesty is a relatively small problem that investors don’t really need to care much about?
Although major cases of fraud are few and far in between, financial dishonesty is still a problem investors face, and those who get involved in companies that perform accounting tricks are unknowingly putting their capital on the line.
There are so many external, uncontrollable factors that can affect an investor’s portfolio, and whether or not a company decides to take part in this nefarious practice happens to be one of them. Although investors can’t control what companies decide to do with their financials, they can equip themselves with the skills and know-how needed to detect if the financial data is amiss.
Detecting Financial Dishonesty
Going over every single detail on how to detect financial dishonesty is a very exhaustive discussion, something that is far beyond the scope of this article. A great resource that goes over this topic in-depth is Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard Mark Schilit. Be warned: this is a very comprehensive book that covers a lot of ground.
Companies that are complicit in some form of accounting fraud won’t go out of their way to tell others about it, and there’s no equation or software package that investors can use to determine if a company is cooking their books or not. Because of this, picking up on financial dishonesty is very difficult for an untrained investor because it’s something that can be done in plain sight.
Now, you don’t need to memorize Financial Shenanigans from cover to cover in order to detect shady financial reporting (although, the more you remember from the book, the better), nor do you even have to read it. That’s because detecting financial dishonesty is all about knowing how to look past the information that’s presented to you and instead take the time to dig deeper.
Therefore, an effective way of picking up on financial dishonesty is to take a question-based approach. There’s no rule that states how many questions an investor should ask, but rather the focus is on asking high-quality questions that will cause an investor to dig as deep as they possibly can.
Below are some sample questions that investors may want to ask which also have the potential to lead to even deeper inquiries.
How Does This Company Earn its Revenue?
This may seem like a ridiculous question, but it’s an important one that should be asked right away. That’s because if this question can’t be sufficiently answered or it takes a lot of time and effort before arriving at an answer, then investors have a valid reason to believe that something is up.
Companies should have no real reason to conceal or convolute what their revenue streams are unless they’re trying to hide a failing area of their business or they’re bringing in revenue through illicit means. A company that’s truly operating on legitimate business practices and wants to attract capital should have no issues disclosing something as simple as its revenue streams to potential and current investors.
Now, just because a company has more than one source of revenue doesn’t mean investors immediately need to be suspicious – it’s not uncommon for companies to have multiple sources of revenue, especially ones with extensive and/or global operations. Rather, the point of understanding what those different streams are is to pick up on any potential anomalies.
For example, insurance companies have two major sources of revenue: premiums and investment income. Typically, these figures are reported separately before being tallied up for a total revenue figure, but an insurance company you’re looking at has decided not to do this.
You noticed that, over the past 5 years, their revenue has been relatively unchanged, but their customer base has also been dwindling during this time. Fewer customers mean fewer premiums being paid, which should also mean lower revenue, but how is this insurance company still humming along? The logical explanation must be that their investment income has steadily been increasing.
This leads to two follow-up questions: what sort of investments is this insurance company making such that it can maintain its revenue while also dealing with a shrinking customer base, and how long can this approach be sustained?
These questions have the potential to open a can of worms, and it all started by understanding where revenue comes from.
Is an Increase in Revenue/Profit Justifiable?
Investors love seeing growth, whether it’s something as simple as a dividend payment being increased, or seeing the total number of holdings they have in their portfolio gradually increase over time. When looking at prospective companies to invest in, something that immediately catches most investors’ attention is growth in revenue/profit.
While there’s nothing inherently wrong with increased revenue/profit, it would be wise for investors to take a step back and ask if this increase can be reasonably justified. In some cases, meteoric growth may make sense, while in others it may be a sign of potential financial dishonesty.
For example, a software company that’s experienced major success in its home country decides to capitalize on this momentum and expand to other markets. Over the coming years, they gradually set up operations in other countries and continue to experience the same level of success as they did back home.
Because of this, their earnings figures grow very rapidly year after year, but this is within expectations given the circumstances, so there’s no need to be suspicious.
On the flip side, utility companies aren’t exactly known for rapid earnings growth; rather, they’re known for their ability to maintain very stable earnings figures despite the rough patches they may come across. Because of this, utilities are typically viewed as “defensive” investments.
Now, utility companies still have the ability to grow their earnings, just not as quickly or drastically as other businesses. This growth can be achieved either by increasing their customer base, which is easier said than done, or charging their current customers more, which usually can’t happen right away because many utilities are regulated (i.e., utility rates are set by some sort of government agency).
With this knowledge in mind, if an investor were to come across a utility company that’s experienced impressive earnings growth in recent history, then they have reason to believe that something isn’t right, and should warrant a deeper search.
Is the Company Always Meeting or Exceeding Earnings Expectations?
Almost every publicly traded company is assigned expected earnings figures, usually by analysts. Whether it’s quarterly earnings per share or year-end net income, all sorts of expected results are thrust upon publicly traded companies. The more prominent a given company is, the more closely they’re followed to see whether or not they exceed their expectations.
One of the most visible ways for a company to demonstrate its financial strength is to meet, or better yet, surpass earnings expectations. The ability to consistently deliver results well beyond what’s expected of them is an easy way to attract and retain investment capital.
While it’s great to see companies posting results that exceed the predictions thrust upon them, it’d be naive to think that earnings expectations will always be met or exceeded. A company’s performance is subject to all sorts of factors, some of which they can control and others that they can’t. Sometimes, all it takes is an unexpected, detrimental change in circumstances for a company to perform weaker than usual.
Most investors understand that these ups and downs come with the territory, but when a company always meets or exceeds its predicted earnings no matter what, especially when all of its competitors have failed to achieve a similar feat, then investors should take the time to figure out what’s going on.
Companies obsessed with meeting earnings targets at all costs may resort to some “creative” accounting measures in order to do so. What appears to be consistent financial strength may in fact just be a facade meant to keep up appearances, when in reality the true financial situation may be enough to turn away even the most optimistic investors.
Asking your Own Questions
The questions presented above present a potential starting point for deeper analysis, but of course, investors are free to decide what questions to ask based on the specific circumstances they’re dealing with, as well as what exactly they’re trying to uncover.
Ultimately, the specific type of questions being asked isn’t the most important part, what matters is that the questions being asked have a high probability of leading to subsequent questions, until finally, you uncover the financial dishonesty that’s happening. The 5 Whys Analysis is an example of a series of questions being asked until the root cause of a problem is uncovered.
Of course, coming up with excellent questions is much easier said than done, but coming up with a handful of high-quality questions may mean the difference between performing an analysis deep enough that financial dishonesty is successfully uncovered, or an analysis that fails to even scratch the surface.
No Guarantee That Financial Dishonesty Can Be Successfully Uncovered
Now, just because you ask a bunch of questions doesn’t automatically mean that you’ll successfully uncover a financial dishonesty scheme. Asking the right questions improves your chances of discovering shady accounting practices, but by no means does it guarantee that you will.
Companies have all sorts of tricks they can pull off to hide their nefarious acts, and assuming they’re willing to spend the time and energy, can do so very effectively.
Does this mean that the question-based approach that was discussed earlier is useless? Not at all. Rather, the point here is that it’s important for investors to manage their expectations of what they can realistically hope to achieve from this approach.
By asking the right questions, the goal is to minimize the likelihood of anything slipping through the cracks. Assuming an investor takes the time to perform this work properly and earnestly, then the likelihood of any major fraud going unnoticed is extremely small, but this possibility is still non-zero.
Wrapping Up
In an attempt to cover up poor financial performance, artificially keep stock prices high, or simply save face, some companies may resort to financial dishonesty as a way to accomplish those nefarious goals.
Enron and WorldCom are two infamous cases of financial dishonesty that had disastrous consequences. Although such high-profile cases are rare in today’s business world, there are still companies that manipulate their financial data.
Naturally, companies that are complicit in cooking their books won’t explicitly say so, and will usually make sure that these criminal acts remain hidden. This presents a major problem to investors, since, at a glance, they can’t determine whether a company has modified its financial data or not.
That being said, that doesn’t mean investors are completely powerless: by taking the time to ask some well-thought-out questions, they have a fighting chance at discovering cases of financial dishonesty. Of course, this method is by no means perfect, but doing so greatly reduces the chances that an investor will fall victim to the consequences of financial dishonesty.
