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Accounting Fraud: A 'How-To' Guide

Stocks in this article: CCME LFT

It's true that some types of fraud have fallen out of favor. For instance, the off-balance-sheet, special-purpose entities famously used by the boys at Enron to falsify earnings, says Straney, "isn't as big of a problem now as then. That's been tightened up."

But other categories have remained durable. And although fraud, when executed at a high level, is extremely difficult to detect, there are ways for investors to identify signals that may point to potential abuse.

First things first: Investors need to adopt a stance of extreme skepticism, what Sam E. Antar likes to call "professional paranoia." He should know. As the CFO of the infamous electronics retail chain Crazy Eddie's in the 1980s, he helped "mastermind" an A-level fraud that eventually cost investors hundreds of millions of dollars.

"I pretty much did everything that everybody else is doing now," Antar likes to say. "Maybe on a smaller scale, but I did it all. That's why the Crazy Eddie case is taught at colleges and universities, even today, 20 years later. It became like the all-in-one textbook case."

To avoid being duped, Antar says, amateur investors need to recalibrate how they understand financial reports. For Antar, they're little more than "marketing brochures. They exist to sell a product, and that product is stock. OK? Forget about internal auditors, external auditors, compliance people, whatever. Financial reports are there to present the company in the best light possible."

Accounting fraud at publicly traded companies has an obvious motive. By falsely inflating their earnings as represented on financial filings and reports, C-suite crooks aim to raise money by selling shares to an unsuspecting public. Or, once the company is public, they want to drive their companies' share prices higher, an effort to increase their own personal wealth or preserve their jobs. Or they want to disguise the fact that they're skimming off the top.

One well-known method for falsifying earnings involves inventory accounting, sometimes known as "cookie jar reserves." It's the easiest form of fraud to perpetrate, says Antar, who now blogs about fraud and advises the likes of the FBI and the Securities and Exchange Commission.

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