Accounting, Fraud, and Margin of Safety

Note: This article is for readers at Level 4 or 5 of our Investor Hierarchy. To know more, read this

A big challenge in investing is that you are an outsider to the company. major decisions, their reasons, success or failure is often obscured by management, and you have no way to be absolutely sure on many of these things. 

You may think ok, I can at least be sure of what is in the financial statements, since they have to follow a certain standard and are audited. You are mistaken. There is so much leeway for management within the accounting guidelines to provide you with numbers that can be different from what we called “real picture of business”.

Take revenue. It should give us a picture of what the company has sold in given period. But, revenue can be counted in many ways. Future sales (based on a long term agreement) can be included in current ones. In cases of obvious fraud, money received from a vendor or creditor can be counted as sales. There are endless ways.

Same for costs and profits. Costs can be split between operating costs (counted this year) vs capital costs (spread out over future years). Profits are a result of revenue and costs, and can accordingly be changed.

Even if you rely on the statement of cash flow, management can move around cash between operating , financial or investing activities. 

There are endless examples and entire books written on this topic.

For now, I leave you with a warning to pay close attention to the financials and especially how they change from one period to another.

To be really safe, always have a decent “margin of safety” - a concept introduced by Benjamin Graham almost a century ago, that is still the foundation of a good investment decision.