madura - what every investor needs to know about accounting fraud (2004)

[...]... be able to cover even a small amount of interest payments on its debt C H 3 A P T E R BACKGROUND ON DECEPTIVE ACCOUNTING HE NEXT SEVERAL chapters explain how accounting methods can T distort the financial measures that investors use to value stocks When the financial measures are distorted, the valuations of stocks may be distorted as well Investors who recognize these distortions can attempt to limit... guidelines allow much flexibility However, this form of accounting can be misleading to investors HOW ACCOUNTING CAN BE USED TO INFLATE REVENUE 25 Investors can review the footnotes of financial statements to catch a creative accounting method that exaggerates a firm’s revenue However, many investors will not have the resources to detect the accounting methods used by some firms The analysis of financial... ZERO-TOLERANCE INVESTING The publicity about unethical behavior in financial markets is giving birth to a new attitude of zero tolerance Investors realize that even with more stringent rules, there will still be criminal activity in financial markets that could destroy the value of their investments They need to take matters into their own hands by adopting a zero-tolerance attitude Some investors... rules of zero-tolerance investing Part I explains the different ways in which misleading accounting practices can distort stock valuations Part II explains why accounting controls cannot be trusted Part III explains how boards of directors can prevent deceptive accounting Part IV suggests how governance may prevent deceptive accounting Part V describes how investors can cope with deceptive accounting. .. investigated due to faulty accounting • Bristol-Myers announced that it would need to restate its earnings because of numerous accounting violations that overstated earnings • Tyco acknowledged some accounting errors that required an accounting adjustment of more than $1 billion for the second quarter of 2003 This occurred after Tyco hired accountants and attorneys to clean up its books following its accounting. .. 2001–2002, and securities were revalued once investors were better informed about the firms that issued securities However, one major difference between the financial scandals of 2001–2002 and the junk bond crash is THE ACCOUNTING MESS 3 that more investors were exposed to the stock market in 2001–2002 than had been exposed to junk bonds Consequently, more investors took a hit in the 2001–2002 period than... auditors do not necessarily ensure that a firm’s financial statements are valid 1 2 3 4 1 Copyright © 2004 by The McGraw-Hill Companies, Inc Click Here for Terms of Use 2 HOW ACCOUNTING CAN DISTORT STOCK VALUATIONS INVESTOR CYNICISM These financial scandals have created a new cynicism in the financial community The most basic ground rules of corporate responsibility to investors have been violated If investors... intentionally left blank P I A R T How Accounting Can Distort Stock Valuations 7 Copyright © 2004 by The McGraw-Hill Companies, Inc Click Here for Terms of Use C H 2 A P T E R THE LINK BETWEEN ACCOUNTING AND STOCK VALUATION ECISIONS CONCERNING stock investments are based on valuations Investors purchase stocks when their valuation is higher than the prevailing stock price, and they sell some of their... valuation process Cash Flow Method While investors have different opinions as to how a stock should be valued, all investors agree that the expected future cash flows are relevant Some investors attempt to forecast a firm’s future cash flows and then determine the present value of those future cash flows If, for example, this method THE LINK BETWEEN ACCOUNTING AND STOCK VALUATION 11 results in an estimate... new phenomenon However, investors are less likely to detect or complain about such behavior when stock market conditions are as favorable as they were in the late 1990s Had investors been more cynical in the late 1990s, they would not have had as much confidence in some stocks as they did Consequently, they would not have driven stock prices up so high In the past, even when investors incurred losses . INVESTOR NEEDS TO KNOW ABOUT ACCOUNTING FRAUD FM _Madura_ 1422765 10/22/03 12:24 PM Page i WHAT EVERY This page intentionally left blank. WHAT EVERY INVESTOR NEEDS TO KNOW ABOUT ACCOUNTING FRAUD Jeff. 152 Index 157 About the Author 165 vi CONTENTS FM _Madura_ 1422765 10/22/03 12:24 PM Page vi WHAT EVERY INVESTOR NEEDS TO KNOW ABOUT ACCOUNTING FRAUD FM _Madura_ 1422765 10/22/03 12:24 PM Page vii This. VALUATIONS Ch01 _Madura_ 1422765 10/19/03 5:37 PM Page 2 that more investors were exposed to the stock market in 2001–2002 than had been exposed to junk bonds. Consequently, more investors took a hit