What is Forensic Accounting?
Forensic accounting is a detailed method of examining and analyzing publicly available financial statements. This approach often searches for the “red flags” of aggressive accounting and revenue recognition practices that some companies have been found to employ.
What are some of the red flags forensic accounting attempts to identify?
Red flags that forensic accounting attempts to identify include fictitious revenue, accelerated revenue recognition, inventory issues, unsustainable margin expansion and financial ratio adjustments.
What do these “red flags” mean?
Red flags may indicate underlying business problems that negatively impact the value of a company’s stock.
How might an unexamined financial statement mislead investors?
There are numerous ways that company management may overstate revenues to make things look better in the present, even though the revenues may not be sustained or may eventually suffer.
For example, company management may offer an existing customer an incentive to sign a contract today, allowing the company to immediately book the revenue. Without that incentive, the customer might have signed the contract next quarter and the revenue would be booked then.
This practice isn’t illegal or even unethical, but it distorts the real performance of the company’s underlying business. It does this by stealing revenue from the future and pulling it into the present. In this example, if demand to sign contracts with the company was strong, management would have never engaged in this practice in the first place.
So how can forensic accounting and investing be used together?
Forensic accounting pulls back the curtain on financial statements and assesses the quality of revenues, sustainability of margins, sources of earnings growth, and consistency of cash flow. This may help investors identify and avoid stocks that are on course to potentially lose value due to the poor underlying business results being currently masked.
Besides simply avoiding companies with “red flags,” forensic accounting identifies financial statements that are attractive because of their avoidance of aggressive accounting tactics. These companies are dubbed to have “high quality earnings” and may be favorable to investors over the long term.
How can I access the benefits of forensic accounting?
Instead of hiring a forensic accountant, a more convenient and cost efficient way to access forensic accounting analysis is to consider the Forensic Accounting Long-Short ETF™ (FLAG). FLAG seeks to track The Forensic Accounting Long-Short Index™. The index combines the science of accounting with the art of investing through a rules based stock selection process.