Everything Might Be Accounting Fraud

Here’s an accounting trick. You start a company. You sell 20% of the stock to investors and keep 80% for yourself. The company makes widgets; it gets $1 million of revenue from selling the widgets. The company needs raw materials to make the widgets. The raw materials cost $500,000. The company also has various other expenses — salaries and rent and so forth — which total $600,000. In total the company has $1 million of revenue and $1.1 million of expenses, for a negative net income. The economics aren’t great, and the stock won’t be worth very much.

So the trick is, you buy the raw materials, with your own money, and you give them to the company for free. Now the company has $1 million of revenue, $600,000 of expenses, $400,000 of net income and a 40% profit margin. “Our margins were high this quarter because we negotiated favorable pricing with suppliers of raw materials,” you say on the earnings call. (You are also the chief executive officer.) The stock soars; the company trades at 30 times earnings, or $12 million. You own 80% of the stock. You sell it for $9.6 million. You are out the $500,000 for raw materials, but the $9.6 million more than covers that. Next year, you stop paying for the materials, the company starts losing money, and the stock collapses, but that’s not your problem.