Accounting Fraud Can Generate Fake Revenue on the Books, but Dividends Checks Require Real Cash in the Bank
7 Reasons to Invest for Income -- Reason #4
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In 2002, thanks to Enron, WorldCom, Tyco and other such companies, we learned that many corporations have been using crooked methods to hide expenses and artificially enhance revenues. Incredibly, such formerly reputable accounting firms as Arthur Anderson continued to certify the books of these companies after their audits.
When I was an accounting major many years ago, there was an on-going controversy about whether or not companies should be allowed to expense or capitalize research and development expenditures. In those days, accountants were concerned about setting standards that reflected reality and were fair to both companies and investors.
Accounting Fraud Can Bushwhack Your Investments
Now, corporate accountants use many outrageous tricks to manipulate earnings. They play bookkeeping games with pension funds, off the books derivatives, offshore funds, subsidiaries and so on. What I've read about accounting practices at Enron, just for example, made no sense in terms of what I was taught. I'm sure that my teachers would have been shocked to hear of such shenanigans.
And there's no reason to believe that questionable practices are confined to the few companies that have been caught and put out of business.
There are analysts who pore through a company's books and follow the streams of cash, in an attempt to detect irregularities. I can't advise anyone without the technical knowledge to try that at home. You'd need to know how to read balance sheets and income statements.
But beyond that, you'd have to comprehend the debits and credits of double entry bookkeeping, and then know how to follow standard corporate accounting entries. You'd not only have to know accounts payable from accounts receivable, but know what was normal and standard financial accounting practices for that particular industry.
What kind of depreciation does the law allow? What kind of depreciation is normally taken? Straight line? Double declining balance?
How is inventory generally valued? First In, First Out (FIFO)? Last In, Last Out (LIFO)? Or something else?
You can't know what signals fraud without knowing what is normal and accepted, as well as Generally Accepted Accounting Principles -- GAAP.
Corporate Accounting Gets Complicated, and the Details are Automated
Debit and credit entries are made automatically by computer programs, of course. The average order clerk or sales person doesn't need to know the details of what's going on behind the scenes.
Of course, every company's books must be audited by an independent accounting firm. That is something investors greatly rely on. And it's how some major accounting companies let them down in the 1990s.
Turns out they weren't as independent as everyone thought. That's because they'd discovered that selling consulting services to companies was more profitable than auditing those same companies, so auditors were pressured not to upset the companies, lest they give their consulting business to another accounting partnership.
If a company passes an audit, how can somehow outside the company -- without access to its books -- detect fraud or deception?
It's difficult. Plus, in the case of Enron anyway, much of the fraud and deception took place "off the books." What can the ordinary investor do about that? Only a few Enron employees at the very top of the company knew what was going on. Everybody else there thought the company was in great shape.
So how do you protect yourself? You can't detect fraud yourself. Even if you know how to read the balance sheets and income statements published in annual reports (and most investors can't), you can't know the true story behind those numbers without closely examining the books. And if they're hiding something off the books, you can't find that from examining the books!
Receiving Cash is Your Best Protection Against Poor, Illegal or Deceptive Accounting Practices
You can, however, insist on cash income from your investments. Cash is cash, no matter what the accountants call it. Whether it's from dividends or bonds, you can spend it.
The company may be manipulating its earnings, but it must make certain that its checking account contains enough real money so that your interest or dividend check clears.
Next: Reason #5 -- 1/2 of Historical Total Stock Returns
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