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Overview
Everything investors who skipped accounting class need to know to spot--and steer clear of--companies whose numbers don't add up
Individual investors today are painfully aware that accounting fraud is more widespread than ever, yet often they aren't sure what this fraud looks like or even where to look. What Every Investor Needs to Know About Accounting Fraud explains common accounting maneuvers, distortions, and outright deceptions that savvy investors must be able to recognize and steer clear of, all in a concise, easy-to-understand format. Professor Jeff Madura has created a book that is both accessible and informative, and doesn't talk down to the reader. Concise yet complete, it provides investors with:
- Methods for uncovering scams that distort revenues, hide expenses, and more
- Studies of infamous accounting frauds and how they could have been avoided
- A zero-tolerance investing code, useful for protecting portfolios
Product Details
| ISBN-13: | 9780071442923 |
|---|---|
| Publisher: | McGraw Hill LLC |
| Publication date: | 12/23/2003 |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 160 |
| File size: | 5 MB |
About the Author
Jeff Madura, Ph.D. (Fort Lauderdale, FL) is the SunTrust Bank Professor of Finance at Florida Atlantic University, where he also heads the doctoral program. Professor Madura is the author of a number of leading college textbooks as well as numerous articles for academic publications.
Read an Excerpt
WHAT EVERY INVESTOR NEEDS TO KNOW ABOUT ACCOUNTING FRAUD
By Jeff Madura
The McGraw-Hill Companies, Inc.
Copyright © 2004The McGraw-Hill Companies, Inc.All rights reserved.
ISBN: 978-0-07-144292-3
Excerpt
CHAPTER 1THE ACCOUNTING MESS
THE FINANCIAL SCANDALS involving firms such as Enron, WorldCom, and Global Crossing have provided several lessons for investors:
1. A firm's executives do not necessarily make decisions that are in the best interests of the investors who own the firm's stock.
2. A firm's board of directors does not necessarily ensure that the firm's managers serve shareholders' interests.
3. A firm's financial statements do not necessarily reflect its financial condition.
4. Independent auditors do not necessarily ensure that a firm's financial statements are valid.
INVESTOR CYNICISM
These financial scandals have created a new cynicism in the financial community. The most basic ground rules of corporate responsibility to investors have been violated.
If investors cannot rely on executives, board members, or auditors for valid information about a firm, investing in a stock is essentially a form of uninformed gambling. However, there is a difference between gambling with a small amount of funds as a source of entertainment and investing for retirement or other future needs. There are many true stories of investors who struck it rich by investing in a stock that was unknown at the time. However, there are many more cases in which investors lost most or all of their investment as a result of buying stocks on the basis of inaccurate information.
One of the most common reasons why investors incur large losses is that they have too much faith in the information provided to them by neighbors, friends, brokers, analysts, and the firm's executives. Unethical behavior on the part of some executives is not a new phenomenon. However, investors are less likely to detect or complain about such behavior when stock market conditions are as favorable as they were in the late 1990s. Had investors been more cynical in the late 1990s, they would not have had as much confidence in some stocks as they did. Consequently, they would not have driven stock prices up so high.
In the past, even when investors incurred losses on investments, they tolerated unethical behavior. Many investors prefer to keep their investment losses confidential. Others realize that their losses may be attributed to their own poor decision making and not to unethical behavior on the part of accountants or financial market participants. Moreover, unethical behavior by a firm's accountants, executives, directors, or independent auditors may be difficult to prove.
The events in the 2001–2002 period are reminiscent of those of the late 1980s, when the market for high-risk (junk) bonds fell apart. At that time, junk bonds were highly valued because investors relied too heavily on the brokers who sold junk bonds for advice and recommendations. Investors learned about the risk of junk bonds when economic conditions deteriorated and some issuers of these bonds began to default on their obligations. In a similar manner, investors were taken by surprise by the accounting scandals of 2001–2002, and securities were revalued once investors were better informed about the firms that issued securities. However, one major difference between the financial scandals of 2001–2002 and the junk bond crash is that more investors were exposed to the stock market in 2001–2002 than had been exposed to junk bonds. Consequently, more investors took a hit in the 2001–2002 period than during the junk bond crash in the late 1980s.
The savings and loan crisis also occurred in the late 1980s. Many savings institutions that investors perceived to be safe took excessive risks (including investments in junk bonds) and ultimately failed. In the 1990s, the media referred to the 1980s as the decade of greed because of the junk bond crisis and the savings institution crisis. Yet new scandals emerged in the 1990s. The treasurer of Orange County, California, used county funds to make inappropriate risky investments and caused massive losses for the county. Long-Term Capital Management (a mutual fund of a special type) experienced major losses on its investments as a result of poor portfolio management, and was bailed out by the government. Consequently, it can be argued that the 1990s differed from the 1980s only in the form of greed that was applied in the financial markets.
In the early 2000s, the major scandals were related to financial reporting, ratings assigned by analysts, and insider trading. The unethical behavior of the late 1980s was not eliminated in the 1990s or in the early twenty-first century, it simply took on a new form.
The regulators of the accounting industry and the financial markets were publicly embarrassed by the financial scandals. They took initiatives to regain their credibility. The regulators imposed rules that were intended to make executives accountable for their actions. Independent accounting firms were put on notice to properly do the auditing for which they are compensated. Directors, who oversee a firm's operations, were put on notice to perform the monitoring tasks for which they are compensated.
Even with all the publicity about corporate government reforms that are supposed to prevent faulty accounting, consider the following events that occurred in 2003:
• The Securities and Exchange Commission (SEC) reviewed drafts of annual reports of all Fortune 500 firms. It sent written comments of concerns to 350 of these firms. In particular, it had concerns about the limited financial data provided in the drafts, a lack of clarity (transparency), and methods of estimating numbers. Specifically, some firms are not fully disclosing the material year-to- year changes and other information that indicates their cash flow situation. They are not explaining the accounting policies properly or the assumptions they used within the accounting function. They are not explaining how they derived the numbers for key items such as intangible assets.
• AOL and the Securities and Exchange Commission were arguing about the degree to which AOL overstated its revenue. AOL estimated that it overstated revenue by $190 million, but the SEC believed that the overstatement should be higher.
• The federal mortgage agency called Freddie Mac was investigated due to faulty accounting.
• Bristol-Myers announced that it would need to restate its earnings because of numerous accounting violations that overstated earnings.
• Tyco acknowledged some accounting errors that required an accounting adjustment of more than $1 billion for the second quarter of 2003. This occurred after Tyco hired accountants and attorneys to clean up its books following its accounting scandal in 2002. That effort, which led to 55,000 hours of audit work and cost Tyco $55 million, apparently was not sufficient to detect the faulty accounting.
• Beyond the more blatant accounting errors, investors are still subjected to a general lack of transparency. Important financial information about expenses and revenue is still commonly buried in a footnote. Many annual reports continue to serve as a public relations campaign rather than full disclosure of the firm's financial condition.
EVOLUTION OF ZERO-TOLERANCE INVESTING
The publicity about unethical behavior in financial markets is giving birth to a new attitude of zero tolerance. Investors realize that even with more stringent rules, there will still be criminal activity in financial markets that could destroy the value of their investments. They need to take matters into their own hands by adopting a zero-tolerance attitude. Some investors may take the extreme approach of completely
(Continues...)
Excerpted from WHAT EVERY INVESTOR NEEDS TO KNOW ABOUT ACCOUNTING FRAUD by Jeff Madura. Copyright © 2004 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
Contents
Chapter 1 The Accounting Mess
Part I How Accounting Can Distort Stock Values
Chapter 2 The Link Between Accounting and Stock Valuation
Chapter 3 Background on Deceptive Accounting
Chapter 4 How Accounting Can Be Used to Inflate Revenue
Chapter 5 How Accounting Can Deflate Expenses
Chapter 6 How Accounting Can Inflate Growth
Chapter 7 How Accounting Can Reduce Perceived Risk
Chapter 8 How Accounting Can Contaminate Your Investment Strategies
Part II Accounting Controls: Out of Control
Chapter 9 Why Auditing May Not Prevent Deceptive Accounting
Chapter 10 Why Credit Rating Agencies May Not Prevent Deceptive
Accounting
Chapter 11 Why Analysts May Not Prevent Deceptive Accounting
Part III How Boards of Directors May Prevent Deceptive Accounting
Chapter 12 Board Culture to Serve Shareholders
Chapter 13 Board Mandate to Revise Executive Compensation Structure
Chapter 14 Board Mandate to Report Stock Option Expenses
Chapter 15 Board Efforts to Tame Corporate Executives
Part IV How Governance May Prevent Deceptive Accounting
Chapter 16 Governance by the Financial Accounting Standards Board
Chapter 17 Governance by the SEC
Chapter 18 Governance Enforced by the Sarbanes-Oxley Act
Chapter 19 Governance by Stock Exchanges
Part V How Investors Can Cope with Deceptive Accounting
Chapter 20 Look beyond Earnings
Chapter 21 Use a Long-Term Perspective
Chapter 22 Don't Trust Anyone
Chapter 23 Invest in Mutual Funds
Chapter 24 Invest in Exchange-Traded Funds
Chapter 25 Invest in Other Securities
Appendix A Investing in Individual Stocks
Appendix B The Danger of Initial Public Offerings
Index
About the Author