
How to Detect Business Fraud - known
https://www.economist.com/finance-and-economics/2020/04/30/how-to-detect-business-fraud
======
mierle
For those who are interested in the accounting side, I highly recommend
Financial Shenanigans by Howard Schilit [1]. If you don't have an accounting
background, all you need to get value out of this book is a basic
understanding of the double entry accounting method, and understand the four
financial statements: balance sheets, income statements, cash flow statements,
and statements of shareholders equity.

After reading this book, I found myself digging through earnings reports to
look for signs of shenanigans, and have found cases that raise my armchair-
accountant eyebrows.

[1] [https://www.amazon.com/Financial-Shenanigans-Fourth-
Accounti...](https://www.amazon.com/Financial-Shenanigans-Fourth-Accounting-
Gimmicks/dp/126011726X/)

~~~
refurb
I took a class specifically on this - how company manipulate their financial
statements to make things look better.

It's really fascinating. If you're willing to dig into the financial
statements (and ones from the past), you can learn a ton about how a company
defines "performance" and whether or not it's reasonable.

Despite GAAP accounting rules, there is enough gray area for companies to hide
a lot of bad information.

~~~
realtalk_sp
Any book you'd recommend to get a quick general grasp of accounting? Aside
from the one referenced in the parent, which I'm probably going to buy.

~~~
gpav
The Accounting Game: Basic Accounting Fresh from the Lemonade Stand, by
Darrell Mullis and Judith Orloff

------
wrkronmiller
> Each stock fraud is fraudulent in its own way. But there are common
> elements. One is a breach between earnings as defined by Generally Accepted
> Accounting Principles (GAAP) and non-GAAP measures. Another is an increase
> in “days payable outstanding”, a yardstick of how long it takes a company to
> settle bills with suppliers. Delay boosts cashflow, at least for a while. So
> does gathering more quickly payments you are owed. Firms with dressed-up
> earnings also tend to pile on debt because they lack strong underlying
> cashflow. And there are grounds to suspect the worst of companies that
> engage in a lot of acquisitions. Aligning the accounts of acquirer and
> acquired gives ample scope for fiddling.

> Transcripts of conference calls with stock analysts can also be revealing.
> If the company keeps moving the goalposts, then be on alert.

~~~
Deleriumm
Thanks, I couldn't read the article.

~~~
known
[https://archive.vn/yDhDb](https://archive.vn/yDhDb)

~~~
jolmg
> 403 Forbidden -- Cloudflare

~~~
gruez
I don't think they actually use cloudflare. Neither their nameservers nor
their server IPs are cloudflare. They only copied their interstitials.

~~~
jolmg
> nor their server IPs are cloudflare

They are for me, apparently because I'm using cloudflare's DNS service, and
cloudflare is returning its own IP when I query for archive.vn's.

    
    
      $ dig +short @8.8.8.8 archive.vn 
      5.196.68.232
      $ dig +short @1.1.1.1 archive.vn       
      1.0.0.1
      1.1.1.1
    

They don't return themselves for all hosts,

    
    
      $ dig +short @1.1.1.1 google.com
      172.217.9.14
    

I wonder by what criteria they intercept, and if this by archive.vn's or
cloudflare's initiative.

~~~
function_seven
This link should answer your questions and give the backstory.

[https://news.ycombinator.com/item?id=19828317](https://news.ycombinator.com/item?id=19828317)

------
elliekelly
The China Hustle[1] is a great documentary about the systemic securities fraud
committed by Chinese companies selling into the American markets in a way that
allows them to avoid much of the disclosure and due diligence typically
required. It follows investors from the Muddy Waters firm mentioned in the
this article and was made by the same group who did documentary version of The
Smartest Guys in the Room.

I believe the film is currently streaming on Hulu.

[1]
[https://en.wikipedia.org/wiki/The_China_Hustle](https://en.wikipedia.org/wiki/The_China_Hustle)

~~~
csomar
Except, the problem, is that the China Hustle displayed AliBaba in a bad shape
and I doubt the guys were short the NYSE:BABA stock. The film was slightly
hinting that you should be shorting or offloading your BABA stock.

But what happened since? The film was released in 2017 (BABA around ~90) and
now the stock is trading around ~195.

So if you offloaded your stock, you'll have lost on some nice gains. It's
worse if you have shorted: It'd have been a real hustle and it's not clear
when the stock will correct.

~~~
hippich
IMHO, exposing issues at the company does not guarantee its stock will go
down. After all, investors (broadly defined, as in individual ones, 401k,
mutual funds, pensions, etc) can keep momentum up. Something about the market
can stay irrational longer than an individual investor's account positive.

So it is risky no matter what, just perhaps risk/reward ration increases
maybe?

------
RandomWorker
I think one of the most interesting methods of business fraud detection is
Benford's law. It has been found that natural transactions do abide by this
law.

[https://en.wikipedia.org/wiki/Benford%27s_law](https://en.wikipedia.org/wiki/Benford%27s_law)

~~~
jerzyt
In real financial data you'll often see departures from the Benford's law. For
example, if a company has $50 expense limit for dinner, you'll find a lot of
invoices for $49.99. Same goes with approval limits at different management
level. Not as useful in practice as in theory.

~~~
craydandy
I've found the same. It sounds great and applicable but could not find any
practical application with real data.

Even when applied to large number of real companies' journal entries, the
amount of false positives is overwhelming.

------
mirimir
Inflating sales is a classic move:

> In indictments involving the case, prosecutors said HBOC sold software or
> services to more than a dozen hospitals with conditional "side letters" that
> allowed the hospitals to back out of the deals. The side letters were then
> hidden from auditors and the transactions were reported as sales.[0]

McKesson (and perhaps other pharma wholesalers) also played games by timing
invoice payments and chargebacks to increase quarterly growth.

0) [https://www.nytimes.com/2005/01/13/business/mckesson-
agrees-...](https://www.nytimes.com/2005/01/13/business/mckesson-agrees-to-
pay-960-million-in-fraud-suit.html)

Edit: Another tactic is hiding rebate and chargeback transactions in numerous
~unauditable spreadsheets, stored on individual employee machines. Or even
only as hard copy.

~~~
jgalt212
I don't know how such tactics as side letters are legal. In finance, there's
numerous hoops and rules to jump through to actually prove that you sold and
asset and did not merely engaged in a dressed up repo transaction.

a few links

[https://en.wikipedia.org/wiki/Repo_105](https://en.wikipedia.org/wiki/Repo_105)

[https://www.deallawwire.com/2017/05/18/true-sales-a-
refreshe...](https://www.deallawwire.com/2017/05/18/true-sales-a-refresher/)

~~~
nmfisher
Side letters are legal. Lying to an auditor is not.

Ideally, auditors would verify the legitimacy of a transaction with the
counterparty. As in, physically visit their office and speak to the person
whose signature is on the contract.

Unfortunately, this is impractical when there are hundreds or thousands of
such contracts every year. There aren’t enough auditors and there’s not enough
time. So mostly, auditors rely on the assumption that they’re not being
provided with falsified documents, and they’re not being lied to.

Unfortunately, that’s sometimes (often?) just not true. Even though it’s
illegal, it’s still highly vulnerable to exploitation.

------
ucha
They exposed Luckin Coffee $LK and called it a fraud in January to no reaction
in the market. The stock collapsed 80+% before being suspended in April. They
had this exchange of tweets with Citron Research which might be my favorite
case of "I told you so":

[https://twitter.com/muddywatersre/status/1245704324342108161](https://twitter.com/muddywatersre/status/1245704324342108161)

------
ikeboy
Highly recommend "lying for money" by Dan Davies, a very readable account of a
wide range of business frauds.

~~~
camjohnson26
Other great reads:

The Match King

The Smartest Guys in the Room

Bad Blood

Billion Dollar Whale

Also, famed short seller Jim Chanos teaches a class on frauds and recently
posted this short list of recommendations:
[https://twitter.com/WallStCynic/status/1256962642499035137?s...](https://twitter.com/WallStCynic/status/1256962642499035137?s=20)

~~~
kratom_sandwich
"The Smartest Guys in the Room" was great, indeed. Also, the book from the guy
who reported Madoff to the SEC sounds interesting:
[https://en.wikipedia.org/wiki/No_One_Would_Listen](https://en.wikipedia.org/wiki/No_One_Would_Listen)

------
nakedshorts
Self plug: If you are interested in short selling and activist funds, I run an
online community where people post original research and discuss other short
theses: [https://activist.cafe/](https://activist.cafe/)

------
clairity
it would be interesting to codify the known heuristics of forensic accounting
into a software package (maybe even AI all the things!), then create a company
out of it in partnership with prosecutors and regulators to root out fraud
like this through both technological and legal means. i'm sure there have been
some efforts to that end, though not commonly known.

it would help rebalance the legal system toward the service of people over
corporations.

~~~
Kalium
If you can reliably determine what companies and securities are fraudulent
more accurately than the rest of the market and faster than government
entities, then you can use this to make rather a lot of money as a short-
seller.

~~~
mjcohen
You may have problems when the fraudsters run the government.

~~~
Kalium
You're absolutely right. This particular approach has limitations and
potential shortcomings. Of course, the same might be said about any approach.

Do you have something else in mind? A discussion here could be very
interesting!

------
deerIRL
[https://outline.com/gdqBaR](https://outline.com/gdqBaR)

~~~
laegooose
Doesn't work.

"Something went wrong We're sorry. This page failed to Outline."

~~~
ErikAugust
[https://beta.trimread.com/articles/13934](https://beta.trimread.com/articles/13934)

------
blackrock
Can you detect any shenanigans going on at Tesla?

If so, then this would be a very good stock to short.

------
supernova87a
Aside from this article (paywalled), I liked learning from some story that
certain financial / bank employees are required by the Fed or SEC to go on
vacation and not have access to their email or phone for a certain number of
contiguous days every year. Is this correct -- was it something to do with the
Madoff scandal?

As I understood it, the idea was that to perpetuate a financial fraud, a
criminal relies on being present and able to intercept / continue feeding
fraudulent information to others and not be discovered. Or maintaining some
fraudulent trading position.

The tactic I liked about this was the thinking about what's required to
perpetrate a fraud, and make the conditions difficult or impossible for
someone to go undetected.

Rather than retroactively finding the fraud and just trying to detect it
better when it has already happened.

~~~
mennis16
This was definitely a thing pre-Madoff even, my dad had to do this for two
weeks every year as a foreign exchange trader.

------
codazoda
The first story is about finding out a company is junk, shorting their stock,
then releasing the information. Is that not a form of stock fraud, or at least
manipulation, as well?

~~~
ip26
Isn't it just price discovery?

Nobody would be upset if you bought a company you thought was undervalued and
told other people they should buy it too.

------
advisedwang
Good investigative reporting into shady business practices good for this
world.

However short selling companies before dropping your investigation is a
massive conflict of interest. Muddy waters is incentivized to produce a
scandalous hit piece, rather than necessarily do fair or accurate reporting.
They will make money regardless. The damage their reporting does may make a
self-fulfilling prophecy, ensuring they don't get a reputation hit for
inaccurate scoops.

I'm surprised the economist didn't even include a nod to the potential
manipulation going on here.

~~~
nodesocket
Absolutely. Just look at Pershing Square‘s Bill Ackman. He goes on CNBC
essential calling for the end of the world, turns out he had credit protection
on bonds and tuned a huge profit[1].

[1] [https://markets.businessinsider.com/news/stocks/bill-
ackman-...](https://markets.businessinsider.com/news/stocks/bill-ackman-hedge-
profits-billions-coronavirus-tanks-stock-market-economy-2020-3-1029035562)

~~~
camjohnson26
And a thousand other hedge fund managers talk about how bright the future is
after investing in stocks. Maybe we shouldn’t rely on hedge fund managers for
our opinion of the economy.

~~~
WalterBright
I believe them about as much as I believe the promoters of "Get Rich Through
Real Estate" seminars. If their methods worked, they'd be getting much richer
doing real estate than pushing seminars.

I recorded one once on TV, and carefully went through the spiel. It was fairly
complex, and I was suspicious it was hiding something. Turns out, it relied on
tricking the other party into accepting a bond with a maturation value of
$10,000 instead of $10,000 now. The money was made on the difference.

~~~
pdonis
_> If their methods worked, they'd be getting much richer doing real estate
than pushing seminars._

More generally, one should be suspicious of anyone whose business model is not
"get rich doing X" but rather "get rich by selling the secret of how to get
rich doing X".

