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The 5 Ways Companies Cook Their Books
Education | 17 September 2014
By: Shane Goh
Articles (99) Profile

In the early 2000s, Enron and WorldCom grabbed the headlines with the largest corporate financial scandals in US history at that time.

Closer to home, the unravelling of Eratat Lifestyle’s finances in recent months paint a grim picture for investors holding onto the company’s shares.

However, when news of a firm’s fraudulent acts is being reported and the shares subsequently suspended, it will be too late for investors.

What if there are signs to look out for that might raise some red flags on a company’s financial health?

Fraud Detecting Framework

In a recent seminar organised by CFA Singapore, the speaker, Tan Chin Hwee, Partner at Apollo Global Management, touched on a framework to help identify fraudulent behaviour.

Tan highlighted five aspects that companies may touch on to massage their books:

Source: Tan Chin Hwee, SharesInv

1. Overstating earnings
Most investors tend to focus on a company’s income statement when assessing its attractiveness, thus, a company may choose to massage its figures to artificially make its latest financial results appear better than it actually is.

This includes aggressive revenue recognition as well as wrong classification of one-off income items as turnover and operating expenses as one-off items.

2. Overstating financial position
As leverage and cash at hand are things investors look out for, a company is incentivised to hold their debt in separate firms, known as off balance sheet financing, or inflate the cash by transferring large wads of money into the bank accounts prior to printing out the statement.

3. Overstating operating cash flow
Similar to the income statement, investors like to see a company that  is raking in cash through their operations. The ways in which a firm can artificially increase its operating cash flow, include classifying its operating expenses as capital expenditures or booking its borrowings as income. Not only would it seem like the company is rolling in more dough, its margins will improve as well.

4. Corporate governance / related party / auditor issues
The key here is an alignment of interests between the management and its shareholders. Having a sufficient number of independent representatives on a firm’s board may help to mitigate any fraudulent behaviour.

Other concerns include overpriced related party transactions or excessive compensation or perks usage by the management as well as a frequent change of auditors or different auditors used for different parts of a firm’s capital structure.

5. Use of reserves / provisions impacting multiple financial statements and years

Case Studies: Early Signs

To improve our understanding, it is always good to look at past cases of erroneous accounting.

FibreChem Technologies was a fraudulent case exposed in 2009. The company was a specialty textile producer. The material was used in making shirts.

A closer look at its financial statements would uncover superior and stable operating margins (double of its competitors). However, specialty textile is a cyclical business and one producer is largely similar to the next, how could the firm boasts such figures?

Other red flags for FibreChem included the refusal from Deloitte to sign off on its accounts and limited disclosure on its cash reserves.

The second case study is Eratat Lifestyle, a footwear and apparel company.

In August, China Banking Regulatory Commission (CBRC) found a forged bank confirmation linked to Eratat’s main subsidiary, HMW.

CBRC also confirmed that HMW only had Rmb73,000 in cash, compared to an earlier claim by the subsidiary that it had cash reserves amounting to Rmb577 million.

One red flag is the issuance of Rmb100.5 million worth of bonds in July 2013 with an effective interest rate of 16.7 percent despite the firm holding Rmb545 million in cash. Why would a firm pay such a high interest rate to raise about 20 percent more cash when it had not deployed its existing cash at hand?

Another red flag, albeit more subtle, is the interest income. In FY12, Eratat earned an interest income of Rmb1.4 million on a cash of about Rmb270 million. This suggests an interest rate of 0.5 percent, which is far lower than the 3 percent obtainable at Rmb-denominated deposit rates at that time.

SI Research Takeaway

Accounting fraud is not exclusive to small-cap firms as seen by the collapse of Enron and WorldCom. As investors, we need to be cautious with our investments and look out for potential pitfalls.

One simple question to ask is: How does a company make money?

By answering that, we can use simple logic to deduce if the numbers make sense to us before sinking our money into any investment.

Tan Chin Hwee is the founding partner in Asia for Apollo Global Management, a leading global alternative investor. Tan is a board member of Singapore Press Holding and Keppel REIT. In April 2014, Tan co-authored a book – Asian Financial Statement Analysis: Detecting Financial Irregularities.
Currently pursuing his Chartered Financial Analyst qualification, Shane provides coverage on the property, consumer and environmental sectors at Shares Investment.

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