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Superior Returns By Avoiding Fraud

Unfortunately, fraud permeates certain sectors of the financial community and can destroy even the best researched valuation. So what is a poor investor to do when they are not privy to process that produces the information they seek? While research is sparse, Accounting sheds some light on the issue through a framework known as the fraud triangle. Our current understanding requires opportunity, rationalization, and pressure (or motivation) to simultaneously exist for fraud to be able to happen.

Thus, companies with increased pressure through a short term performance focus, compensation geared more towards commissions than salaries, and companies with poorer internal controls may enable the conditions for fraud to exist more than those who do not. While these standards are not true in all circumstances (commissions can produce superior customer service in certain circumstances and sectors, for example), the general principles on which they are based are time tested and used by both practitioners and academicians today. While we do not have access to the mindset of the fraudster, the tone at the top can provide an easy mechanism to provide the rationalization that "I was doing what the boss wanted."

The point is this: using existing models financial models and ratios is excellent practice. I employ these methods in my own company as well as the materials I teach as a professor. However, taking time to learn about the views of the CEO, the organizational culture, incentive compensation, and internal control process can be equally, if not even more valuable. Individual investors who take the time to learn about such nonstandard measures find themselves in a much stronger position to avoid a blowup than those that do not. By taking time to learn more about the company in which you invest, superior returns should follow. Happy investing!