Book review: Business Fairy Tales by Cecil W. Jackson.
This book provides a better analysis of financial accounting problems than you can find in the news media. But it’s not thoughtful enough for me to recommend it. The author sounds like an academic who has little experience as an investor.
The book provides little perspective on which mistakes did the most harm. I can’t tell whether the author sees any difference in seriousness of Enron’s inconsistent reports to the SEC about when it adopted mark-to-market accounting and the absence of market prices to guide its so-called mark-to-market accounting (it seems obvious to me that the former is trivial and the latter is outrageous, but I wouldn’t have learned that from reading this book).
I’m also disappointed that the book never takes the perspective of the villains to ask why they thought they could get away with bad accounting. Were they all confident that perpetually rising stock prices would ensure that investors would never complain? Could they have have thought they would make enough money before getting caught to profit even if they were punished? In some cases I can guess why the answer might have been yes to one of these, but in most cases I’m as puzzled as I was before reading the book.
The book suggests a number of signals that investors might look for to detect fraud. But none of them are valuable enough to change the way I read financial reports. A few, such as sales growth not meeting expectations or rising inventory / sales ratios, are valuable signs of an overrated company even though they rarely indicate accounting problems. Most of the signals the book recommends involve things like increases in receivables where there’s no obvious way to distinguish routine fluctuations from changes that indicate problems, so I suspect the number of false alarms would make these signals useless.
I suspect that avoiding the stock market during bubbles is a more practical and effective way of avoiding harm from accounting fraud than trying to follow this book’s advice. I’d guess that 10% of investors will learn to avoid bubbles if they try, but I doubt more than 1% will succeed at identifying fraud. If you do try to identify fraud, pay more attention to people such as Jim Chanos who have found ongoing frauds than to books such as this that only do post-mortem analysis.
The book claims that a benefit of Sarbanes-Oxley is that it restored investor confidence in corporate financial statements. This seems misguided. The stock market decline that prompted Sarbanes-Oxley was largely due to mistaken extrapolations of real trends in internet-related profits. Many investors prefer to exaggerate the role played by fraud because it distracts attention from the mistakes they made at the peak of the bubble. It’s unclear whether increased investor confidence is desirable. Accounting fraud is most common at peaks of bubbles because investor confidence makes it temporarily easier to avoid questions about suspicious accounting practices. Stock markets appear to function best with moderate amounts of suspicion among investors to help keep corporate reports honest.