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Accounting Fraud: A 'How-To' Guide

Stocks in this article: CCMELFT

Another major category of accounting fraud: acquisitions. Indeed, any company that can be described as a "roll up" -- a business built almost entirely through a series of acquisitions -- should automatically draw the skepticism of investors, fraud experts say.

That's because the opportunity for theft is so ripe. Essentially, a company managed by fraudsters overpays for an acquisition, then pockets the difference or cycles it through the income statement in order to falsely boost earnings.

It should perhaps not be surprising that many Chinese companies listed in the U.S. are complicated roll-ups. One short-seller who focuses on Chinese stocks says that dubious acquisition-accounting "appears to be the modus operandi of the most common fraud in China."

Any executive engaged in acquisition-related fraud will attempt to cover his tracks through misdirection. But there are ways to smell the smoke coming from this type of fire. "You gotta watch the goodwill," says Antar. One way for an executive to overpay for an acquisition is to inflate goodwill -- the excess of the purchase price over the fair market value of a target's assets and liabilities. Once again, the skeptical investor must go to the filings. If it turns out that goodwill makes up a majority of a company's assets -- watch out.

Fraud strategies are, of course, inherently unsustainable. Built on air, they all must collapse eventually, whether law enforcement pursues them or not. Still, depending on the skill of the perpetrator, fraudulent companies can last for years, even decades. This raises a dangerous point.

Crazy Eddie, for example, lasted three years as a public company following its IPO in 1984. "Before we imploded, the stock kept on rising no matter what the skeptics said," Antar recalls. "So here's the problem: Were the longs right? Or were the longs wrong -- and they traded right? In many cases, even though they're being probed by the SEC, even though there are a lot of legitimate questions being raised about these companies, their stock prices still go up. With Wall Street, it's all about the trade. So if you're gonna be a short seller, not only do you have to be right, you have to be right on time."

-- Written by Scott Eden in New York

>To contact the writer of this article, click here: Scott Eden.

>To follow the writer on Twitter, go to http://twitter.com/ScottEden.

>To submit a news tip, send an email to: tips@thestreet.com.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.
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