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Can Financial Statements Be Fraudulent?

Reading the financial statement of a company that you want to invest in what the usual value investors will do. This may be no different from what Warren Buffett and his team will do as well.

But why understanding a company’s financial statement is so important? This is because it will give you various indicators to know if a company’s financial health is able to sustain its continual operations and thereby bring values to us in terms of dividend profits and capital appreciation over the long run.

Public Listed Companies are under the scrutiny of public’s eyes and the government. And can such companies fail you by reporting fraudulent financial statements? Yes, certainly.

Case Study of Fraudulent Financial Statement of Enron Corporation

Enron Corporation was once the fifth largest company in US quoted by Fortune Magazine in 2002. But Enron had filed for the largest bankruptcy in the history in 2001 due to a massive loss amounted to a total of $74 billions.

The reason for its collapse is largely due to the mis-management where the top executives earned millions of dollars due to offline partnerships. On the other hand, the top management falsely reported their financial statements by inflating its earning profits to the shareholders.

The deregulation of energy traders led to overconfidence in investments that Enron made. These traders thought they were in control and ended up in an over bought situation. When the market acted against them, it caused the collapse of Enron.

The collapse of Enron further led to the collapse of its auditor, i.e. one of the big four accounting firms, Arthur Andersen LLP . The saddest part of this story was to know that the key insiders had sold their stocks shortly before Enron announced the gaps to the public. Shareholders were also mis-led to buy Enron shares thinking that Enron was still making good money.

Case Study of Fraudulent Financial Statement of China Aviation Oil Singapore

Assessment of management is also important. In local contexts, we also had similar cases like China Aviation Oil of Singapore (CAO). CAO lost over $550 million in derivatives due to its CEO’s disastrous trading strategies.

Before its collapse, CAO was responsible for filling virtually all of China’s jet fuel requirements. China Aviation switched its trading strategy from trading oil-related derivatives to hedge its jet-fuel purchases against fluctuations in the price of oil, but moved to using the derivatives to bet on market trends.

Their traders did not follow the rules and exceeded the trading limits. CEO tried to conceal the huge losses but eventually could not hold the truth anymore.

Conclusion

The case study of Enron and China Aviation Oil has served a good lesson to all of us. We should be careful in reading the financial statements and assessing the management’s credibility. Corporate governance of a company becomes an important aspect of our due diligence check in value investing.

So, the next question is whether due diligence check becomes more complicated and tedious for value investors? This is a myth.

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Good luck in your value investing!

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