Sunday, 4 October 2015

How are you living your Trading Life?


6 Types of Financial Fraud and Manipulation

History has taught us one thing: as long as companies are managed by human beings, fraud and manipulation will occur. However, as corporations become larger, so does the financial and social impact of such avarice. 

The boom years of the 1990s raised the need to exceed analysts' expectations and boost shareholder value to unprecedented levels. 

As a result, corporate managers went to great lengths to deceive Wall Street, investors, and the government. Through elaborate schemes involving sales skimming, misappropriation of funds, improper revenue recognition, overstatement of assets, and understatement of liabilities, corporation managers created paper wealth of untold proportions. 

And as the web of deception unraveled, a costly price was paid by the stock market and the overall economy. If any good came of this, it was the painful reminder that each and every one of us should understand the basics of financial analysis and, more important, know the ways to detect corporate fraud.

Types of Fraud

Most types of fraud can be assigned to one of the six areas detailed below.

Money Laundering

Money laundering is essentially taking money from illegal sources and passing it through another business to make the money appear legitimate. For example, an organized crime syndicate involved in the drug trade might create a chain of dry cleaners to pass through money from drug sales in an effort to “wash” those funds. Generally speaking, money laundering tends to be a relatively low priority for the IRS. Could it be that they are more likely to collect taxes when the funds are washed and declared? For the FBI, in contrast, it is a different story.

Sales Skimming

Sales skimming involves the deliberate omission of revenue to lower taxable income. This could very well be the case with small businesses that only accept cash, as it would be difficult to track their sales receipts. It becomes a much larger issue when we are talking about Fortune 500 companies that use creative methods to defer revenue or simply hide revenue, as was the case in many of the recent corporate fraud scandals.
Overstating Expenses

This type of fraud often takes the form of running personal expenses through a business to lower taxable income. This is something that might occur in small private companies, and generally it goes unnoticed when done on a small scale. It becomes a larger concern in publicly traded companies, in which a CEO might decide to expense his private art collection to the company.
Bribes and Payoffs

Often committed by large businesses seeking to fix prices or land contracts, this is the type of thing that occurs when a large company is seeking to capture a portion of an international market to secure a large account. Usually some type of bribe or payoff is offered to local government officials or business leaders to gain their approval. In my naive younger days, while I was working as a financial advisor in Latin America, I found it a strange coincidence that when a lucrative privatization contract was awarded to a foreign bank, it seemed to coincide with the minister of commerce’s purchase of a brand-new Hummer.

Shifting Sales and Expenses between Businesses and Operating Subsidiaries

Often large corporations will shift expenses from a less profitable unit to a more profitable unit. This allows for a smoother distribution of profits, and in some cases it can reduce the overall tax burden. For example, the more profitable unit may be facing an excessive tax bill. When expenses are added to its income statement, that burden may ease.

Phony Off-Balance-Sheet Financing Schemes

Overall, off-balance-sheet entities are not considered to be inherently deceptive. However, a combination of creative accounting and lax observance of ownership rules has created an opportunity to hide liabilities in them. A special-purpose entity is created to take on the debt of a parent company, and in the process, the liability essentially is hidden. The perception is that the holding company has a much stronger balance sheet, something that analysts and investors prefer.


Quote for the day

“Moral virtues come from habits. They are not in us neither by nature, nor in despite of nature, but we are furnished by nature with a capacity for receiving them, and we develop them through habit. These virtues we acquire first by exercising them, as in the case of other arts. Whatever we learn to do, we learn by actually doing it: men come to be builders, for instance, by building, and harp players by playing the harp. In the same way by doing just acts we come to be just; by doing self-controlled acts, we come to be self-controlled; and by doing brave acts, we come to be brave.” - Aristotle