Accounting Fraud: The Signs

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Accounting Fraud: The Signs

The difference between “aggressive accounting” and “fraud” can be unclear; most cases of “aggressive accounting” are simply that. Here are some signs that can help tell the difference.

One of the greatest challenges for investors is uncovering fraud. Frauds are so rare that investors generally consider almost every other explanation, and we don’t want to believe that massive fraud at large companies can exist. We want to believe that processes are in place to prevent frauds, from internal corporate oversight to external auditors. In hindsight, the signs of fraud are often very visible, but before that period, the difference between “aggressive accounting” and “fraud” may not be clear, and most cases of “aggressive accounting” are simply that, as opposed to fraud.

Let’s look at several corporate examples to show the difficulty.

Worldcom

Looking back at WorldCom, which ended with fraud charges for executives, the company had at least two major areas of accounting issues. First, ordinary expenses were being booked as capital expenditures, inflating profits. Importantly, this one was—or should have been!—visible to investors looking at the cash flow statement, as free cash flow fell far short of earnings. Any time that happens, investors’ antennae should be raised. Second, WorldCom was understating reserves; this would be almost impossible for external parties to catch as management is allowed to use a wide range of judgment in determining reserves, collections, bad debt expense, and the like.

Enron

Another major fraud—Enron—had some of the most complicated accounting you’ll ever see, with wide use of special purpose vehicles that resulted in obscuring debt. Additionally, the company was showing impressive revenue growth, with reported sales rising from $13bn in 1996 to $100bn in 2000. The revenue growth came from trading, with the gross value of trades booked instead of the spread, resulting in trading figures far above any Wall Street bank. This was entirely legal, and in the interest of brevity, we’re shortening the story. Still, one sign for investors again would have been that free cash flow trailed earnings dramatically; another would have been that the hyper-growth for what was essentially a utility company did not make sense.

Lehman

For our last example, we’ll use Lehman, which used a “repo 105” program at quarter-ends to move debt off its balance sheet and hide its true condition. This aggressive accounting would have been hard to pick up given that Lehman only moved assets off its balance sheet for a few days, and so the auditors would have been the only line of defense. However, we have seen cases where the interest expense line indicates more debt intra-quarter than is evident at quarter-end as companies use “window dressings” to make their balance sheets look better at the time of regulatory filings. General Electric was recently flagged for this practice.

For investors, whether they are in equity, fixed income, private equity, or venture capital, studying the accounting and looking for disparities between the cash flow and income statements may offer some protection. Aggressive accounting is not a crime, but it may be a red flag for either the valuation or for a company to be watched more closely. Here, too, we should note that presenting the results in the most favorable light is not necessarily a problem – we all do this—and couching results favorably usually isn’t even something we’d consider aggressive.

But true frauds often have a few additional warning signals.

  • First, management teams often avoid the tough questions on the accounting or are dismissive of them with a “you don’t understand,” “we’re different,” or “because we are changing the industry, you should expect some noise, but it’s nothing to worry about.” Analysts and journalists may be denied access to management by asking tough questions, making the fraud harder to uncover, and those investors with the ability to walk away may simply move on, leaving the risk with others.
  • Second, management teams often aggressively attack the naysayers, whether they may be skeptical analysts, investigative journalists, or short sellers. Dick Fuld at Lehman, Jeff Skilling at Enron, and other “celebrity” CEOs have blamed short sellers for problems with their stock price performance. In reality, the problems were with the financial situations at their companies. In contrast, CEOs with nothing to hide don’t generally have to worry about short-sellers and some—in recent years, Netflix’s Reed Hastings response to Whitney Tilson is the most famous example—have directly engaged with short sellers. Short sellers make an efficient market and do not destroy value by their mere existence.
  • Third, fraudulent companies often have poor disclosures that don’t answer all of the relevant questions. This can be in the financials, but it can also be failing to disclose SEC probes. Services like Probes Reporter use Freedom of Information Act requests to uncover data. While this is not an endorsement, it is just a note that these kinds of services exist.
  • Fourth, sometimes there’s just outright evidence that a product or process doesn’t work as advertised. Theranos is a major recent example of this, but companies regardless of whether they are funded by Kickstarter campaigns and or are large-cap public companies, have hyped products that show impressive growth but can’t seem to be manufactured for a profit. Additionally, demand estimates and backlog figures may not be all they seem; these kinds of companies almost inevitably end up in a restructuring.
  • Fifth—and the last we’ll list in this piece but certainly not the last to consider—is that often those involved with a fraud build up a celebrity aura such that people feel they can’t ask the hard questions because “they’re so successful, they must be right”. These CEOs wrap themselves in a bubble so that what they deem as boring, boneheaded questions get dismissed.

What are the defenses?

Whether it’s a fraud, aggressive accounting, or simply an overvalued security, often the best defense seems to be answering the question “Does this make sense?” The problems with this question alone are twofold: it ignores that sometimes revolutionary technologies come along, and more importantly, it ignores that humans are very susceptible to believe an attractive story. We give people the benefit of the doubt and assume they are telling the truth. Instead, a better question might be: “What happens if the story I’m being told isn’t as positive as it sounds?” In value investing, we might call this, “What’s my margin of safety?” There is a large universe of potential investments in the world; if the margin of safety is not great enough, there are always opportunities that may carry less reward but also much less risk.

 

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