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Seven signs of fraud

Investors need to be aware of likely possible accounting tricks which, while perfectly legal, are still highly misleading, according to visiting expert Howard Schilit.

Tuesday, July 13th 2004, 1:31AM

by Rob Hosking

Speaking to a Wellington meeting of the Society of Investment Professionals, Professor Schilit – the US-based author of Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reporting says there are only seven ways firms can pull the wool over investors’ eyes.

Danger periods include just after a merger or just after a new chief executive takes over.

Mergers allow firms to get up to all sorts of quite legal tricks in the process of aligned the two firms’ reporting dates, he says. One example form the US was when 3Com took over US Robotics in 1997 – there was a two month “stub period” when the two companies’ reporting dates were aligned

“No one was going to care about that, right?” says Schilit. The two firms boosted reported expenses in that two-month period, and cut back reported revenue. The first batch of figures for the newly merged firm looked very good, he says.

Schilit says one big warning sign is sudden changes in a trend.

Enron is classic example of this, he says – from 1985 to 1995 the firm recorded mediocre growth.

“The profits barely budged – the rest of the sharemarket performed very well over that period, and they missed a lot of action.”

Suddenly in 1996 there was a disproportionate surge in profits, driven by a lot of “one off” items.

“Their growth wasn’t coming from their core businesses but form one-time activity. That’s another warning sign: you need to look at what is happening to their core business.”

Another warning sign is changes to amortisation policies. A few years ago Volkswagen changes its amortisation period form 15 years to 25 years.

“The question you need to be asking as investors, is what is going on in that company which makes that kind of move necessary?”

The issues are less ones of accountancy than the age old human failings: greed and fear, he says. Companies want to make their profits look good and are afraid of looking bad.

And overall, he says, investors cannot rely on auditors.

“The auditors are failing. They understand accounting: they don’t understand capital markets and they don’t understand psychology.”

Rob Hosking is a Wellington-based freelance writer specialising in political, economic and IT related issues.

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