Financial Basics – Fundamentals of Investing in Firm Investments
This paper explores the tellativeness of short selling on detecting firm investment fraud, how short selling investors adjust their positions prior to the release of an accounting statement, and how fraudulent investors use their own information to take advantage of company inefficiencies. The paper finds that companies can minimize their losses through taking advantage of inefficiencies by taking advantage of management’s inability to properly communicate with their stakeholders. By following a series of well-defined strategies, short selling investors can take advantage of any inherent inefficiencies and file fraudulent claims based on that inefficacy. Finally, the paper discusses where firms that are using short selling as a strategy should draw the line, where and why it is appropriate to rely on short selling to meet specific business requirements, and finally, how a firm should use the recent Accounting Standards revisions to justify its use of short selling in its investment portfolio. We conclude that the majority of firms that are relying on short selling are doing so because they do not want to incur additional financial risk. Finally, we argue that the majority of accounting measures addressing firm investment and liquidity problems will likely continue to include provisions for addressing inefficiencies that stem from short selling, such as the need to minimize or eliminate losses due to fraudulent transactions and the need to rely on accounting statements to provide accurate, relevant, and reliable information to decision makers.
Fraudulent short selling has been considered an optimal risk management strategy by many firms. In a recently published paper, “The Truth About Company Losses Due to Firm Investment Misvaluations,” we argue that misvaluation-induced errors can occur in a variety of settings, and that the widespread use of misvaluation may be undermining investors’ confidence in the markets. Specifically, we suggest several reasons why misvaluation may occur in the financial services, technology, food, and energy markets. Although we acknowledge the importance of addressing all potential sources of fraud, we focus on two specific areas in which we believe the current regulatory measures and industry norms are inadequate to guard against misvaluation-induced risks. Specifically, we suggest that:
A firm’s financial books typically contain information about internal controls that are not tested against the hypotheses that are actually being used in the investment decision-making process. As a consequence, if a firm invests in a risky project with a high probability of turning a loss into a profit, the misvaluation-induced risks will not be included in the firm investments’ accounting records. As a consequence, a public firm’s bookkeeping records may not accurately reflect the frequency and size of these misvaluations, which could result in significant understated compensation costs and other errors.
An alternative approach to identifying the cause of misvaluation is to examine the assets’ capital structure. We argue that there are two important categories of fixed assets: tangible and intangible. If the purpose of the investment is to build long-term assets, the assets should be included in the equity and retained earnings categories. On the other hand, if the purpose of the investment is to mitigate risk, then the assets should be classified into three categories: fixed income instruments, short-term assets, and long-term assets.
The tangible categories typically include goodwill and other intangibles, long-term leases, plant and equipment, and property. Other types of fixed assets may also be included in the firm’s portfolio but are not considered as fixed assets. For example, a firm could build a fleet of trucks instead of purchasing them, although this might have an impact on the firm’s ability to service its existing fleet of trucks. As a result, it might incur miscellaneous items such as interest, rent, and depreciation, which would then be recorded as an expense in the firm’s statement of income. Because this type of miscellaneous item usually represents a depreciating asset, it would be viewed as a non-vesting equity instrument in the firm’s balance sheet.
Finally, in considering investment-related risks, the definition of risk differs from that of asset classifications. A firm’s risk of loss occurs when it incurs a loss (the total value of the total assets when all of the liabilities are taken into account). This definition excludes the effects of default, bankruptcy, and other economic factors that could reduce the value of a firm’s stock. Because these risks cannot be determined with certainty, they are placed into different categories based on their extent and frequency of occurrence. These categories, based on their frequency and magnitude, are also used to assess the overall risk of an investment. Allocation of investment-related risks between these three categories will help ensure that a firm maximizes its potential for returns.