In 2019, Muddy Waters shook up AIM by attacking the junior market’s then-biggest business, Burford Capital (LON:BUR). The investment firm, founded by famed short-seller Carson Block, had already enjoyed great success with its short reports on many Chinese companies listed in the US, but this was the first time it had gone after a British firm. In a scathing note, Muddy Waters said that “for years, it [Burford Capital] was the ultimate ‘trust me’ stock” and claimed that it had been “egregiously misrepresenting its profit figures”.
At the time, many private investors cried foul. Burford Capital had been a darling of AIM and here was a big, bad hedge fund from the US stomping in to ruin the run. But the points Muddy Waters made were prescient. Burford Capital’s share price fell 56% in the summer of 2019 and has never really recovered.
The difficulty is that, despite tight regulation, corporate accounting is open to interpretation and has numerous grey areas. While staying within generally accepted accounting rules, company directors can report their earnings in flattering ways - making investors believe that things are going better for the company than they actually are (Burford Capital never committed fraud, but misled its investors by using some generous reporting).
Creative accounting and earnings misrepresentation is a pervasive problem in the capital markets. According to a recent academic paper, 41% of companies misrepresent their financial statements, while 10% of all large public corporations commit securities fraud, most of which goes undetected.
This article will help you identify signs of earnings mis-representation and help you understand when dubious-looking numbers might be worth a closer look.
Warning Sign 1: Booking revenue before the cash comes in
Companies make money in many different ways and collect the cash from the sale of their products or services at different times. For example, a furniture retailer might sell a sofa to an individual who can pay for it with either cash or credit. A software company could offer a subscription which is paid for on a rolling monthly or annual basis. Companies account for this difference in timing by marking the balance of money due for goods or services which has been delivered but not yet paid for as accounts receivable.
Companies record accounts receivable as assets on their balance sheets because there is a legal…
