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FTX is a signal to refresh your red flags

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It’s only when the tide goes out that you find out who swam naked, as Warren Buffett so aptly put it. After more than a decade or so of near-zero interest rates and the mother of all stock market parties, the tide of free money is most certainly receding. The bankruptcy of Sam Bankman-Fried’s FTX empire is a taste of what could come. As the crypto world dances to an obscure beat that is perhaps only tangentially tied to the realm of conventional finance, it is emblematic of tougher times than a company valued at $32 billion there. only a few months had found no one to put in the extra funds that would allow it to continue.

If history is any guide, the expected upward trend in business failures due to rising costs of capital will likely be accompanied by an increase in the incidence of fraud. The Enron Corp scandals. and WorldCom Inc. both boomed in the years following the bursting of the dot.com bubble, another period of near-free money, at least for companies that might tinge themselves with a New Economy aura. Bernie Madoff’s investment firm finally collapsed at the height of the global financial crisis in 2008, exposing the world’s biggest Ponzi scheme. In the UK, Polly Peck International Plc grew rapidly during the 1980s before sinking into the recession of 1991. Its CEO was subsequently imprisoned for theft. The Asian crisis of 1997-1998 exposed abuses in some Chinese international trust and investment companies. The list continues.

“You’re going to have a lot more fraud,” Christopher Leahy, chief executive of Singapore-based research and advisory firm Blackpeak Group, told the Asian Corporate Governance Association conference in London. With a recession coming, “we need to be prepared,” he said. “Everywhere you look there are potential landmines.”

It may be time for investors to revisit the forgotten skills of sifting through balance sheets, profit and loss accounts, and cash flow statements for red flags. It would not be surprising if these fundamentals of value investing atrophied after the crisis. The practice of finding and buying companies that are trading below their intrinsic value has not worked very well for much of the post-crisis era. No wonder: who needs the downside protection of conservative finances and the safety margin when corporations can shake the magic money tree for whatever they need? These easy conditions fade in the rearview mirror, however. Here are some key principles that can give you a chance to spot the next public company fraud scandal before it blows up:

• Read accounts, duh. More importantly, read the back. The front is where the pretty images, colorful graphics, and company spin go. The notes at the back, usually voluminous pages of densely typed text and numbers, are where all the nasty things are buried.

• Don’t ignore the obvious. The Madoff fraud was still hiding in plain sight. Former security industry executive Harry Markopolos has repeatedly provided the Securities and Exchange Commission with a list of red flags, such as his suspicious and consistent returns. His plan had ballooned to $65 billion before collapsing. An old investment adage holds: if something is too good to be true, it probably is. Everyone who has invested with Madoff has ignored this caution.

• There are no stupid questions. Accounting can be fiendishly complicated. However, it is guided by a basic logic. The balance sheets must balance. And if the accounts are so convoluted that they can’t be understood even by a reader familiar with the financial statements, then perhaps the company doesn’t want you to understand them – raising the question, why?

• Watch for anomalies. Pay close attention to anything that seems unusual or doesn’t make sense. Leahy spoke of an Indonesian company his company had been hired to review on behalf of a potential investor, who suspected something was wrong. Eventually, he found a disclosure in the notes of a $60 million cash outflow, with an explanation that contradicted what the company had said elsewhere. “There’s a reason people trade,” he said. “If there’s a transaction that doesn’t make sense, then you need to figure out why.”

• Listen to whistleblowers. Most whistleblowers are insiders who know what’s going on within their company and are upset about it, according to Leahy. They played a role in the downfall of Enron and WorldCom. There are many potential downsides to being a whistleblower, and very few upsides. That means they deserve to be taken seriously — although by the time a whistleblower’s report becomes public, you’re probably already too late to avoid a loss.

No country has a monopoly on fraud. Accounting scandals cover markets around the world, from Wirecard AG in Germany, to Parmalat SpA in Italy, to Olympus Corp. in Japan. And the variety of potential red flags is too numerous to list: overstating income; underestimating liabilities; excessively high inventories; discrepancies between the income statement and the cash flow statement; unexplained loans; an excessive number of related party transactions, to name a few. Whole books have been written on the subject, including Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard Schilit. It might be time to give him another scan. Good reading.

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This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Matthew Brooker is a Bloomberg Opinion columnist covering Asian finance and politics. A former editor and bureau chief of Bloomberg News and associate business editor of the South China Morning Post, he is a CFA charterholder.

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