The essence of stock investing lies in accurate financial statement analysis. However, if the values in the financial statements are incorrect, no matter how well one analyzes, accurate results cannot be obtained. For instance, even if parents memorize their child’s report card perfectly, it is of no use if the child forged the report card. Similarly, financial fraud can be a critical issue for investors.
The Reality of Financial Fraud
Corporate Financial Statement Management
Just as fund managers use window dressing to manage returns, corporate executives often manipulate financial statements to make them look better. For example, if there is too much profit, some of it is hidden to use it later when profits are lower, making it seem like the company is consistently generating stable earnings. These polished financial statements lead shareholders to believe the company is robustly managed, and investors are willing to provide funds.
The Prevalence of Financial Fraud
New investors often think financial fraud is a rare occurrence by malicious companies. However, the reality is different. Even South Korea’s largest company, Samsung Electronics, is known for its legal financial manipulation. They adjusted their accounting methods to increase or decrease profits as needed. Similarly, Microsoft in the United States is also notorious for financial fraud. If such world-renowned companies engage in financial fraud, what about other companies?
The Role and Limitations of Accounting Firms
Auditing by Accounting Firms
Monitoring financial fraud is the role of accounting firms. However, auditing by accounting firms has inherent limitations. Since regulatory authorities do not assign accounting firms to each company but rather companies choose their auditors, it’s like the police receiving a salary from the suspect they are investigating. If executives aim to achieve certain goals by adjusting financial statements and a rigid accounting firm interferes, the company will not continue to employ that accounting firm for audits.
Expertise Limitations of Accounting Firms
In cases like oil exploration companies, it is impossible for accounting firms to calculate the oil reserves underground. No matter how competent an accounting firm is, they cannot fully understand all industries, and their understanding of recent technological developments in IT companies is limited. Therefore, if a company intends to deceive the accounting firm, it is not difficult.
The Role of Investors and Detecting Financial Fraud
Loss of Trust in Audits
Investors who have experienced financial fraud despite audits by accounting firms lose trust in these audits. Stock experts who lose confidence in analyzing financial statements start to teach the conditions of companies likely to commit financial fraud. However, why are investors doing the work that should be done by financial statement analysis experts? How effective is it for investors to find simple matters that accountants would already know?
Trust in Financial Statements
To investors striving to detect financial fraud in financial statements, I ask: “Even if the company hasn’t committed financial fraud, if you cannot trust the accounting firm, how can you trust the numbers in the approved financial statements? And if you trust the accounting firm, why are you trying to detect financial fraud in the approved financial statements?”
Conclusion
Investors need to detect financial fraud due to fundamental doubts about the reliability of financial statements. However, this responsibility lies with the accounting firms and corporate executives, not the investors. Investors should demand transparency from accounting firms and corporate executives to ensure the reliability of financial statements.