"Investor Protection-Rules, Risk Knowledge" 31.

-- Lend you a pair of eyes, see through financial fraud.

In the previous series of articles, we introduced that investors can interpret the financial statement data of listed companies to obtain important information to judge the "quality" of listed companies. However, once the interpreted financial data is "whitewashed" by fraud, it may bring huge losses to investors. Starting from this article, we will take financial fraud as the theme, from the theoretical analysis and practical case two dimensions to take investors to understand several types of common financial fraud. In this article, we start with a look at the general motivations for financial fraud, common ways to identify and prevent strategies.

Motives for 1. Financial Fraud

Nothing can be done without the word "motive", and financial fraud is the same. To identify financial fraud, we must first understand the motivation of financial fraud in listed companies. There are two common motives for financial fraud:

(I) raising share prices is generally caused by shareholder arbitrage or pressure from market demand for financing. Usually this motivation brings fraud, will deliberately create a beautiful performance of the enterprise, create a star enterprise halo, in order to attract investors.

(II) to meet financial indicators, I .e., fraud to meet the requirements of various stakeholders for specific financial indicators. The stakeholders here mainly include major shareholders, controlling shareholders, actual controllers or company directors and supervisors. For example, some financial indicators of some companies are lower than the regulatory requirements. In order to avoid the risk of delisting, stakeholders may whitewash the data through financial fraud. Another example is that when some companies obtain loans from financial institutions, they generally have to meet additional restrictions such as financial indicators. Once the company faces cash flow pressure, stakeholders may meet the financial index requirements of creditors through financial fraud, avoid financial institutions to stop lending or take other restrictive measures.

Common ways to 2. financial fraud

If the financial statements are compared to the "face" of a listed company, its plain appearance corresponds to the true financial situation and performance of the listed company. Driven by the motivation of fraud, if the management takes the risk of "improving the value" of the financial statements, it will usually achieve the goal through local "cosmetic surgery" or even the overall "face change.

(I) "cosmetic" type of financial fraud

"Plastic" financial fraud is usually manifested as accounting errors, such as early recognition of income, delayed recognition of expenses, misuse of asset impairment related accounting estimates to avoid impairment losses (e. g. accounts receivable bad debts, goodwill impairment, etc.). These local "cosmetic surgery" are often based on real transactions, usually do not need to involve different departments of listed companies, the concealment is relatively high.

(II) face-changing financial fraud

"Face-changing" financial fraud is a kind of "out of nothing" fraud that falsifies economic business activities, such as fictitious transactions that do not exist, exaggerating the scale of transactions, etc. "Face-changing" is usually a systematic fraud, which requires the mobilization of more resources within the listed company and involves the participation of different departments of the enterprise to cover up the clues of fraud.

Identification and Prevention Strategy of 3. Financial Fraud

In the face of a variety of fraud routines, as an ordinary investor, how to determine whether there is a listed company fraud motive, and then identify signs of fraud? We may wish to start from the following aspects:

Identification of (I) Fraud Motives

With regard to the fraudulent motive to raise the share price, we can focus on the shareholdings of shareholders of listed companies, especially significant shareholders, and identify whether they have a need for short-term realization. For example, you can focus on whether the lock-up period for major shareholders is nearing its expiration date, whether significant shareholders have capital chain pressure or cash-out needs (e. g., they are borrowing against equity pledges, implementing major acquisitions, and large debt maturities).

The motivation to meet financial indicators is relatively more hidden, but it can also be analyzed and identified by reading quarterly, semi-annual and annual reports of listed companies, information related to external debt in financial statements and notes, and the correlation between changes in remuneration of key managers and changes in performance.

Identification of signs of (II) fraud

1. For "face-changing" financial fraud, as a bad and short-term difficult to detect financial fraud, such financial statements often show:

(1) "otherworldly". The changes in financial performance in recent years have greatly exceeded the performance of companies in the same industry, and a large number of "excellent" performance can be found when correlating financial statements with business data. For example, the analysis of output and the number of workers found that per capita output greatly exceeded the level of peers, divided by income sales, found that the unit price greatly exceeded the normal level;

(2) "critical state". Each year's performance rises at a stable rate, or periodically "performance picks up", or "turns losses into profits" every three years, etc;

(3) "Extraordinary". In a number of negative external environments (e. g., policy changes, technology iterations, etc.), corporate performance rises rather than falls, so when investors see these seemingly "excellent" financial statements, they should beware of the risk of fictitious fraud.

2, for the "cosmetic" type of financial fraud, because this kind of fraud target for specific financial indicators, so it is usually manifested in the performance of the face quickly, the cycle is relatively short, belongs to the "one shot for another place". To identify this pattern, investors may wish to consider whether there is a habitual misuse of accounting treatment by observing the performance of the company in previous years, including management, governance, changes in external auditors, and other factors. Understanding the motives, methods, and identification of prevention strategies for financial fraud is the first step in identifying financial fraud. Subsequently, we will explain several common types of financial fraud to investors, including false sales transactions, false capital flows, fictitious long-term assets, etc., and use the content of this article to help investors "polish their eyes" and "dismantle the trap".