Thursday, April 02, 2009

Leveraging Fraud

I've been reading a few sites about white collar fraud.

In the YouTube Clip below, the former CPA and convicted fraudster Barry Minkow talks about the ways that white collar criminals use complex financial schemes with multiple entities leveraging against each other to commit fraud.

An interesting theme is that the most common fraud of small private firms is tax evasion. Companies would make profits look lower than they were to evade taxes.

When they are trying to take a leveraged position, fraudulent firms inflate profits to inflate their leveraging power. Both the tax evasion fraud and leveraged fraud are evil and wrong. The problem with leverage is that a highly leveraged fraud does much more damage than a small private non-leveraged fraud.

It appears that Minkow is wanting an improved auditing system.

My thoughts go in a different direction. My beef is with the financial tools that allow companies to take hugely leveraged positions. These tools effectively magnify the impact of a fraud.

Auditing plays an important role in leveraging. Financial institutions give leverage to a firm based on the audited numbers.

The audited numbers, of course, come from the CPAs and auditing firms. A CPA willing to commit fraud need simply become adept at showing auditors want they want to see. They then leverage off the goodwill given by the auditors.

Truly honest firms are unable to show auditors what that auditors what the auditors want to see.

The system of hyper-leveraging that exists in the market allows dishonest firms to leverage ficticious audited numbers and bowl over the honest competition.

Dishonesty is a big problem. The financial system designed to give investors massive massive leveraging poweer in the market has created a world where the bad guys are able to massively leverage their dishonesty and magnify the hurt created by their efforts.

As the dishonest player will always be adept at lying to auditors, the solution to the problem is to deleverage and to break the tools that allow hugely leveraged positions.

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