Detecting Financial Irregularities
This is important for forensic accounting and detecting accounting anomalies. Learn to detect tricks played by other companies. Due Diligence is important for non-arm length transactions. Some of the fraud cases include Satyam, Sino-Forest, Olympus etc. I approached Tom Robinson to collaborate on the manuscript.
Satyam was founded in 1987 and was an IT consultancy firm in India. 90% of their profits were cooked and the chairman stepped down in Jan 2008. Later on, it was acquired by Tech Mahindra Limited. Benjamin Graham was known as the father of investing. Satyam was overpriced by the market because of inflated earnings etc. Fictitious transactions and bogus customer receipts were used. How does one detect such fraudulent practices? Parmalat in Europe was another example of a horrible accounting scandal as well. Corporate governance has been a big issue recently. Many businesses are controlled by the founder or his family. There is a need to weed out corrupt practices and improve the situation. This book starts off with a framework for analysing financial statements. It will teach you how to identify red flags (like overstated earnings, overstated financial position, multiyear earnings manipulation, overstated operating cash flows, related party transactions and poor corporate governance). Later on, case studies will be presented as well.
A Framework for Evaluating Financial Irregularities. The P/L is linked to the balance sheet and overstating one will affect the other. Inflating operating cash flow will result in a decrease of investing and financing cash flow. Look for unusual increases in assets or intangibles in the balance sheet that are not explained in the footnotes to the FS. A = L + OE must always balance. Revenues should always be presented on a gross basis. Revenues must be classified into operating and non-operating appropriately. Note that the financial statements are all closely tied with each other and it is important to understand this. If you want to overstate revenue, you need to adjust your balance sheet as well. That is through overstating assets or understating liability. Usually, companies will overstate accounts receivable. Elevated AR might be a sign of inflated revenues. Sino-Forest used other companies to engage in fraudulent purchase and sales of timbre with it. This resulted in the AR and AP increasing. Learn to understand the accrual basis of accounting and the matching principle of recognizing expenses with revenue. If a company collects cash first before service is provided, then a liability called unearned revenue must be provided. Learn to understand accrued expenses as well. Sometimes, the cash flow can occur later or before the earnings. You need to read the whole financial statements as a whole to evaluate and not just evaluate the income statement on its own. For overstatement of revenue, the most likely overstatement will be AR. Sometimes, revenue can be reported even before it is earned. Be alarmed if revenue is growing too quickly. 90% of their cash and bank deposits did not exist. Companies can understate expenses by failing to recognize the COGS or defer recognition of expenses by creating deferred assets. An example of an asset which should be expensed is deferred acquisition costs. One way to remove liabilities is to reduce assets as well and transfer everything to an SPE to avoid consolidation. Olympus once kept liabilities off its books in this way. They later purchased the SPEs and overpaid for them, resulting in excess goodwill in their books when consolidation was required. One way to smooth earnings is to overstate bad debt expenses. Sometimes, companies can classify operating expenditure as a capital expenditure. This will lead to an overstatement in operating cash flow and an understated investing cash flow
Those companies that want to artificially make themselves look better cannot manipulate one financial statement without impacting either another financial statement or an offsetting item on the same financial statement. – ChinHwee Tan & Thomas R. Robinson
There are two kinds, both premature revenue recognition and reporting non-existent revenues. There are motivations to make the earnings better than what they currently are. Fraudulent reporting of revenue is quite common. Sometimes, their revenue recognition principle might still be acceptable by the accounting standards. Revenue and gains might be distinguished properly. It might not be correct to record revenue at the point of contract signing, for instance. Look at the days sales in receivables ratios etc. Overstatement of cash is more difficult as auditors might be able to detect it. Satyam used ‘Investment in Bank Deposits’ which was fictitious and non-existent. The conclusion to make is that overstatement in revenue should result in an overstatement of assets (cash, inventory, investments etc). Longtop set up a new company, but did not consolidate it. Some of the expenses were parked in the new company. One simply way is to avoid recording liabilities on the company’s books. Gains can be shifted to revenue. Look out for share ownership and any related transfers. Look out for increasing share buyback programmes. Look at profitability margins as compared with their peers. Be wary of ‘extreme’ outsourcing as that could be a significant red flag. Sometimes, do not rely on management’s earnings forecasts. Be careful of non-arms length transactions. If a company fails to name their major suppliers or customers, it could be a potential red flags. ‘Authorized Intermediaries’. Listing through reverse takeovers often avoids the typical IPO due diligence. Limited management ownership and capital raisings without returns to shareholders can be alarming. Strategic investors should have a board seat in the governance of the company. Look out for alignment between management and their shareholders.
Detecting Overstated Financial Position. There are incentives for management to present a strong balance sheet. Investors often look at the balance sheet of the company. One way to accomplish this is to use off-balance sheet financing. Exclusion of A and L is possible through unconsolidated entities/joint ventures. For instance, via operating leases. Understating assets improves the ROA. Companies are not required to recognize an asset/liability on BS if an operating lease is used. Leasing means borrowing the asset. Please consider the impact of leasing and get the PV of future lease payments. Adjust earnings by adding back after tax lease payments and subtract estimate after-tax interest and depreciation expenses. One way of off-balance sheet financing is the selling of receivables, but still bearing some credit risk of collections. An analyst needs to read news in order to detect off-balance sheet activities. Look out for key words like ‘SPEs’, ‘joint ventures’, ‘associated companies’, ‘non-consolidated entities’, ‘guarantees’, ‘commitments’. For example, a company can guarantee a debt of others but fail to recognize the liability on its balance sheet. Overstatement of assets is actually quite popular. Sometimes, over-statement of valuation of assets on the balance sheet is possible. Fair value measurement is possible. PPE is measured at cost model or revaluation model. The book showcases the different types of recognition criteria. Financial assets should be measured at fair value or at amortized cost (depending on classification). Sometimes gains through revaluation can only be measured in other comprehensive income and not in the income statement. Biological assets valuation can be subjective as it involves a measure of the stage of growth and a value for that stage of growth. It can be difficult when there is no intermediate market. Compare it to other assets in similar assets. Off-balance items like underground reserves of oil can be overstated. Independent estimates for proved reserves need to be obtained. How are the companies accounting for their affiliates? Using the equity method of accounting?
Detecting Earnings Management. Some companies use cookie jar accounting. Management might be incentivised if they generate year-on-year profit. Management can change estimates or even use their judgement. Bad debts must be accrued as an allowance of bad debts. Examine the bad debt presented on the balance sheet and also use professional scepticism when auditing that number. For companies who collect in advance, use the deferred revenue account. See whether accrued or prepaid expenses are sensible even a company’s business model. Look out for DTA and DTLs on the balance sheet and know how to account for them. A company can also set up a cookie jar reserve. Will the deferred tax be used in future years?
Detecting Over-stated Operating Cash Flows. Cash flow can be used as a gauge for the quality of earnings. In addition, the discounted cash flow model is used by analysts. A strong earnings figure, coupled with negative cash flows, is concerning. One way is to misclassify cash flow. An analyst needs to understand the relationship between the cash flow statement and the income statement. The cash flow statement is divided into operating, investing and financing sections. Debt and equity transactions form the firm’s financing activities. You must be clear how a firm generates its cash. GAAP and IFRS are vary slightly on where to place interest/dividends on the cash flow statement. Investing usually consists of PPE or intangible assets. The financing section shows the long term inflow or outflow of capital to the firm in the form of cash from investors. In a healthy company, the operating income should be able to support the company on its own. The company’s operations must be healthy. Understand what are the main items that should enter the 3 categories. Most firms use the indirect method of presentation. The net income can be reconciled to the cash flow statement. You can use ‘cash flow from operating activities/sales revenue’. ‘Cash flow from operating activities/net income’. The free cash flow to the firm can be computed as Cash Flow from operating activities – capital expenditures. Purchase of PPE on credit must be declared. Worldcom misclassified normal operating expenses as capital expenditures.
This is accomplished by removing the effects of items that appear on the income statement but do not affect cash such as depreciation and amortization expense, items where the timing between accrual and cash is different (eg., changes in accounts receivable, accounts payable, prepaid), as well as items that appear on the income statement but are not categorized as operating activities for cash flow purposes. (eg. Gain/loss on PPE) – ChinHwee Tan & Thomas R. Robinson
Evaluating Corporate Governance and Related Party Issues. When the investor and manager are the same, there is an alignment of interest. However, in big companies, this is not possible. Corporate governance is the system of internal controls and procedures by which individual companies are managed. Good corporate governance is essential. The board must largely consists of independent members. An independent board reduces the possibility of inappropriate related-party transactions. It is recommended that at least 50% of the board be independent non-executive directors. The minority rights should be protected. Related-party transactions are quite common. Examine the structure to see if there are interlocking directorship or ownership situations. Learn to scrutinize related party transactions closely. It is unusual for compensation of executives to be paid through another company as consulting fees. It is worse when they are accrued but not paid. Look out for poorly designed compensation plans and excessive compensation. Be wary of embezzlement of funds from the company. Major transactions must be explained clearly. Strong internal auditors are important to ensure that strong internal controls are in place. It is important to make independent assessment over revenue projections.
Summary and Guidance. There have been many global scandals along the way. Be diligent in evaluating accounting games. The games cannot continue forever and will be revealed eventually. Understanding the business is the key. Gather and read through all of the financial statements and footnotes for the last several years. Prepare a common-sized analysis of the balance sheet and income statement.