How to detect potential fraud in companies before investing in their stocks?

There are many “conflicts of interest” possible in any investing situation. These conflicts often emanate from promoters and management. Social media and mainstream media are also incessantly bombarded with marketing and motivated messaging by influencers and operators. These are weapons of mass destruction of wealth.?

Hence, the investor must be armed with defences and weapons of mass protection. Not taking leverage, and avoiding intra-day trades and derivatives are basic precautionary principles for long-term investors. These investors do not have the time, energy, or emotional forbearance to navigate the choppy markets. As a SEBI Registered Investment Advisors, we suggest a proven investing framework, such as ROOTS & WINGS which reduces the chances of committing mistakes, and over time build a portfolio that helps one build and preserve wealth. There are some techniques that can help too, and this helps detect potential fraud, mainly in the first category discussed in the previous chapter (‘Conflict of interest in investee company management’).?

Forensic accounting checks are a set of such techniques that conduct a detailed study of the annual reports and quarterly results of various companies. These techniques rely on accounting, auditing, and investigative skills to examine the finances of the company. The profit & loss and balance sheet numbers are correlated, and any contradictions identified are further investigated. Forensic accountants usually look beyond the statistics and financial numbers to check the realities of the business.?

There are many uses for a forensic accounting approach. Many firms use these for tracing funds, identifying assets, initiating asset recovery, establishing damages from insurance claims, and also performing due diligence on companies. In fact, the analysis generated is suitable for use in judicial proceedings involving financial crimes such as fraud, insider trading, and embezzlement. Most retail investors may not be able to deploy these methods, but an understanding of them definitely gives an edge and provides insights on what to look for in a company before investing. Some of the potential danger signs that one can look for while evaluating companies are listed in the following paragraphs.

Topline or Revenue Mis-statements

1. Low cash flows

If the company is showing low cash flows relative to its earnings, then it is a sign of aggressively "recognizing" revenue and hence showing artificial growth. We have seen this with one large edu-tech player in September 2022, they took nearly a year and a half to close the previous year’s financials, which involved allegations of recognizing revenue ahead of the subscription period.

1. High non-operating income

Unusually high ‘other income’ compared to its operating income. Some companies may resort to such other income gimmicks by selling off assets, or marking up investments, to cover up for poor operational performance.

1. High ‘fee’ income

In the case of banks or other non-banking lending companies, the ‘other income’ check can involve computing the fee income as a % of total interest income or treasury income as a % of net interest income.

Bottomline or Profit Manipulation

1. Fluctuating NPAs

In the case of banks or other non-banking lending companies, the provisioning policy could be tweaked to delay the recognition of ‘non-performing assets. Any NPA immediately reflects as a loss in the P&L statement, which the company may wish to avoid. Lending is a tough business and while aggressive growth can be seen in the initial years, the subsequent impact of poor credit decisions becomes all too apparent in the form of NPAs, leading to high incidences of write-offs.

1. Fluctuating Reserves

Frequent changes in reserves and adjustments to profit after taxes. When the PAT fluctuates too much, due to reasons not related to operations, then it could be a cause for concern.

1. Volatile Depreciation

The company manipulates depreciation rates and thereby expenses to its convenience and hence shows higher profitability. They may increase the lifespan of assets, revalue them to a higher number, or reclassify them to reduce the depreciation expense. They may also keep defunct assets alive on the balance sheet instead of writing them off. Any unusual changes in the related assumptions are something that warrants attention.

Sometimes the depreciation method itself might be changed to boost profits. In the Jet Airway case study we covered earlier, the company when under tremendous stress, resorted to changing its calculation method from Written Down Value to Straight Line Method which added back Rs 920 crores to its profits.

1. Extraordinarily high margins (flash in the pan)

unusually higher operating margins compared to peers, especially if the industry is a commodity industry with little scope for product differentiation. Sometimes, we may come across something that seems too good to be true. A company may be showing extraordinary profits but in fact, the talent of the company might be in cooking the books. They may collude with suppliers to receive inflated bills for goods supplied, or even when goods were never supplied to support payment receipts.

1. Sporadic Cash Flows

If the company’s Cash Flows are lumpy or sporadic across the years, then it indicates that the business does not have regular activities or is at the mercy of dominant suppliers or customers (who may be Government entities or large corporations. An investor may want to stay away from such companies because of the unreliable earning stream.

1. High Miscellaneous Expenses

If a company shows a very high percentage of ‘miscellaneous’ expenses as a ratio of the total expenses, then this could point to accounting irregularities. This is analogous to non-operating income being very high and leads to a situation where it is difficult to anticipate the earning stream of the company.?One can look for a variance of the percentage from previous periods and also from the industry peers.

Balance Sheet Manipulations

While Profit & Loss statements tell us about the flow of cash and earnings, the Balance sheets tell the story of how the tangible and intangible stock assets of the company grow or shrink over time.

1. Low Asset Base

In the manufacturing industry, a growing company typically reflects growing assets under the plant & machinery category.?This may be true of the services industry too, where some real estate infrastructure may be required to run operations. An investor ought to be worried if a company’s stock price is shining but the ‘block of assets is not growing.

Another trend to look for is if the depreciation is very low. To retain a higher ‘gross block’ the company may use a very low depreciation rate.

1. Unusually High Working Capital?

Working capital norms vary by industry. While adequate working capital is a good thing, extremely high working capital may occasionally be a sign that a business isn't investing its extra cash as effectively as it could be possible. The company may also be ignoring growth opportunities in favour of maximising liquidity. This is not shareholder friendly and could be a precursor to potential misallocation of capital. It could also be a sign of excessive inventory investment or a sluggish debt collection process, both of which could point to declining revenues and/or inefficiencies in operations.

1. Low Cash Yield

When a company keeps idle cash on its balance sheet, it reflects poorly on its treasury operations. The company is not using cash in its best interest. In some cases, the balance sheet could also be misstated.?

1. Under Reporting of Non-Performing Assets

The provisioning policy of a lender has a material impact on their reported earnings. With large lenders, the scale of operations becomes so complex that controlling the ‘bad assets’ is itself a huge effort. One type of fraud is when management underreports assets going bad, i.e., when recovery of a loan is difficult because the borrower is unable (or unwilling) to repay. The lending company clearly wants to boost earnings. Borrowers (who may collude with lenders) may play a few tricks, such as:

• Borrowers may use fraudulent financial statements to obtain credit facilities beyond the actual borrowing capacity. They may inflate the net worth by infusing fake equity (round trip bank funds into the borrowed entity as promoter equity). They may inflate revenues through false bills and avail credit from the lender. They may also inflate receivables similarly.
• They may overstate the collateral pledged against the loan by inflating the price and/or quantity of stock/inventory, or worse showing someone else’s ‘maal’ as theirs. They may also fraudulently remove pledged stocks or dispose of hypothecated stocks without the lender’s knowledge. They could also pledge the same assets with different lenders.
• The borrower may inflate the cost of the project to avail of a higher loan. Sometimes the inflated cost is so high that the promoters need not contribute any net equity to the project, thereby funding the entire investment through borrowings. The borrowed funds could then be diverted to related parties as unsecured advances for execution.

1. Debtor Write-Offs

The company may lend or sell its goods to related parties with a vested interest. Once bad debts are collected, the company may suddenly write them off. This results in a loss to the shareholder.

1. High Capital Work in Progress / Delay in Commissioning

If the company shows very high capital work in progress relative to its gross block, then it might indicate delayed commissioning of plant and machinery (or IT projects). The reason for such delays could be to reduce costs by delaying the associated depreciation. This approach could be because revenues take time to materialise whereas costs are immediate.

Auditor Firm Shenanigans

1. Frequent Auditor Changes

This is a potential red flag and suggests that auditors are not comfortable working with the company management. The company may dismiss the auditor themselves or the auditor may resign on their own.

1. Unknown Auditors

It is expected that a company with sizable revenues and operations engages an auditor of repute. Not doing so might indicate that they are exerting undue influence on the auditor. When coupled with a company with a highly complex organizational structure with multiple subsidiaries and cross holdings, this is a cause for concern.

1. Auditor Compensation Spikes

When the auditor firm’s compensation grows very rapidly relative to the growth in the consolidated revenues of the company, it could hint at collusion between them. The number to check here will be the 3-year CAGR in audit’s compensation with the corresponding company numbers or auditor firm compensation as a ratio to the company revenues. An exception would be if the auditor started with a very small fee structure, which would be the case with some startups.

Account checks with a forensic lens do help identify potential frauds. Experts use these in court testimonies, criminal investigations, and litigations where quantification of damages is required. For most retail investors, a basic understanding of these tools helps them invest with awareness. It is entirely possible that companies not scoring well on some of the above 18 parameters may still see excellent growth in their stock prices. But catching them will be a matter of chance. Companies that meet most of the above parameters along with the fundamentals of ROOTS & WINGS are likely to do much better.