Given Super Micro Computer's accounting challenges, investors should never forget this investing lesson

The resignation of Ernst & Young (EY) as Great microphone computer'S (SMCI -31.97%) The accounting firm caused its shares to wobble. Not only did the stock price collapse, but investors now have to contend with one of the more promising tech growth stories being doomed by alleged accounting irregularities.

Faced with this challenge, Supermicro has instead become a painful lesson in investing. Unfortunately, there is only one way for investors to mitigate the potential consequences of such problems.

What happened?

EY's resignation is forcing even Supermicro bulls to take a negative view of the stock. In July, EY raised concerns about its internal controls over financial reporting, questioning whether the company had sufficient controls, governance and transparency. After receiving “additional information,” she has now decided to resign.

In his resignation letter, EY said:

We are withdrawing due to information that has recently become known to us that has resulted in our inability to rely on the representations of management and the Audit Committee and our unwillingness to be associated with the financial statements prepared by management .

Supermicro immediately expressed its disagreement with EY's decision to resign. Still, the company still hasn't released its delayed annual report, and the resignation is a major setback for the company's efforts to win investor confidence.

In fact, the extent of Supermicro's accounting challenges remains unknown. However, the high level of uncertainty makes it almost impossible to view Supermicro shares as an investment under such conditions. Therefore, shareholders who bought this AI stock for anything other than speculative purposes should get out now. If you hold on to your shares, make sure you can absorb any losses.

The lesson on investing

Unfortunately, the incident painfully reminded investors of an important lesson in investing: diversification is the only tool available to investors to protect themselves from a company's accounting problems.

Ultimately, you can only rely on company reports and records to understand a company's financials. You also need to have confidence that regulations and accounting audits protect the integrity of reports.

Again, it was difficult for investors to predict this challenge. Most signs point to Supermicro's growth story being plausible, and I'm one of the shareholders who believed it. The growth of NvidiaSupermicro's AI chip business seemed to confirm Supermicro's explosive growth as it is one of its key partners. Although the AI ​​growth opportunities could still be true, it remains questionable to what extent the company has actually taken advantage of them and how this is reflected in its financial reports.

The only significant evidence investors could find to cast doubt on the story was another accounting investigation of Supermicro's books between 2014 and 2017. The company subsequently corrected its May 2019 annual report and paid a civil penalty of $17.5 million.

However, Supermicro wasn't a very popular stock at the time. Therefore, it is likely that most of the company's newer investors were unaware of this earlier investigation.

Furthermore, even if you knew about it, you could assume that the company had learned its lesson. Accounting irregularities can result in large fines and notices that affect a stock's performance. In more extreme cases, it can also lead to executives being sent to prison. Such consequences tend to prevent most serious accounting irregularities from occurring.

However, EY's resignation shows that strict regulations and penalties cannot always prevent such problems and investors need to take preventative measures in case they are surprised by such incidents.

We continue with the lessons from Supermicro

Ultimately, diversification is the only way to protect against irregularities in a company's accounting.

Most individual equity investors are already diversified and well-positioned for a recovery. In other cases, this incident may discourage some investors from investing in individual stocks.

Fortunately, investors can turn to mutual funds or exchange-traded funds (ETFs) that can do the heavy lifting of stock selection. Some of these funds can even meet or exceed the market average.

What investors should not What I can do is stop investing altogether. The S&P 500 (^GSPC -0.02%) has offered an average annual total return of approximately 10% for almost 100 years. This average takes into account corporate bankruptcies and all types of economic downturns and protects the individual investor.

In the end, individual companies can let us down. Nonetheless, shareholders can best sustain themselves by remaining invested in well-run companies and taking protective measures such as diversification to guard against unexpected problems.