Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (7 page)

As the investigation into the auditors’ role in the Enron collapse proceeded, Arthur Andersen fired its lead audit partner for Enron, David Duncan, after learning that he had destroyed documents from the audit file. Subsequently, a federal jury convicted Arthur Andersen of destroying Enron-related materials to impede an investigation by securities regulators. It vowed to appeal, but before the appeal and its subsequent exoneration, Arthur Andersen ceased auditing public companies and disbanded.

Too Long and Close a Relationship Prevents a Fresh Look at the Picture

The fraud and collapse of Parmalat, the Italian dairy behemoth, has been referred to as the “European Enron.” While the businesses and accounting issues differ, both Enron and Parmalat had one obvious similarity: independent auditors missed the fraud.

One intriguing fact in this case concerns Parmalat’s change in primary auditors from Grant Thornton to Deloitte & Touche. Indeed, Parmalat’s chicanery might have continued longer had it not been for an Italian law that requires companies to switch audit firms every nine years. Deloitte & Touche replaced auditor Grant Thornton in 1999 and may have been the first to scrutinize certain nonexistent offshore accounts (many of which were still audited by Grant Thornton, as they were not subject to Italian law). As a result, fraudulent offshore entities were exposed, including Bonlat, a Cayman Islands subsidiary of Parmalat and one of the primary vehicles used to hide fake assets.

INVESTORS SHOULD DEMAND AUDITOR ROTATION EVERY FEW YEARS

The fact that Italian regulations concerning auditor change precipitated the discovery of the Parmalat fraud lends strength to the argument that
this type of policy should be more broadly implemented
. Auditor term limits were nearly included in the Sarbanes-Oxley legislation, but they were ultimately excluded in favor of rotating audit partners within the same accounting firm. In light of Parmalat’s crimes, risk managers might wonder if Sarbanes-Oxley is missing a very important component, given that auditor complacency or collusion may contribute to inappropriate financial reporting.

Opponents of auditor limits point to the benefits of having a long-term relationship with an auditor who knows the company’s business, but Parmalat has shown that such a relationship can breed complacency and that an auditor may overlook or encourage behavior (either by design or by accident) that can prove fatal to the business.

Like Parmalat, the biggest recent accounting fraud to hit Japan went undetected for far too long because the auditor had too long and cushy a relationship with company management. Kanebo, a cosmetic and textile company, had been audited by an affiliate of PricewaterhouseCoopers for
at least 30 years
. When one of the company’s consolidated subsidiaries hit a very bad stretch, the auditors allegedly advised management to reduce its shareholding in the subsidiary and deconsolidate it. The auditors also allegedly turned a blind eye to the booking of fictitious sales to pad the revenue numbers during slack periods. Kanebo reported about $2 billion in nonexistent profits from 1996 to 2004. The regulators were so incensed with the treacherous behavior of the auditors that they immediately brought legal action against these auditors and imposed a two-month business suspension.

Incompetent Auditors Can Serve as Shills for Management

As you have no doubt seen from these vignettes, financial shenanigans and audit failures are not just an American affliction. The United States gave the world Enron and WorldCom and the meager effort by the auditor of both companies, Arthur Andersen; Italy’s contribution was Parmalat and its auditors Grant Thornton and Deloitte & Touche; and Japan’s gift to investors was Kanebo and the compliant work of auditor PricewaterhouseCoopers. And the most recent entrant to the “Hall of Shame,” India’s contribution, Satyam, provides another wonderful effort by PricewaterhouseCoopers.

Satyam
ironically means “truth” in Sanskrit. But with CEO Ramalinga Raju’s admission of the company’s bald-faced lies to investors for years, maybe he was a bit confused when he selected the company name. Perhaps he really had planned to use the more apt Sanskrit name
Asatyam
, meaning “untruth.”

PricewaterhouseCoopers, which had been Satyam’s auditor since 1991, failed to detect
inflated cash and bank balances on the order of over $1 billion
, according to Raju’s own confession. Current allegations claim collusion between Satyam and its auditor. According to a member who joined Satyam’s board after the scandal broke out, the documents were “obvious forgeries” and would have been visible as such to anyone.

Management Schemes to Avoid Regulatory Scrutiny

As we pointed out, shenanigans tend to breed freely in environments in which no checks and balances exist among senior management, when the outside board of directors lacks the skills and the desire to protect investors, and when the auditors fail to detect signs of problems. One other substantial line of defense for investors exists in the form of regulators. In the United States, the SEC oversees setting reporting requirements and reviews their content. If the reports don’t pass muster, the SEC can prevent the securities from being issued or suspend any future stock trades.

While the SEC has mostly served investors well over the years, it has occasionally failed to catch serious reporting infractions. For this it deserves some criticism. Moreover, some companies truly go out of their way to avoid SEC reviews and scrutiny. The following section shows just how this is done and when investors should be especially cautious.

Lack of Usual Regulatory Scrutiny before Going Public

If management really wants to avoid serious scrutiny from SEC reviewers, it will first sidestep the normal registration process for an initial public offering (IPO) by merging into an already-public company. This is a backdoor approach to becoming a public company and avoiding the typical detailed review that is part of the normal IPO process. Thus, investors should be particularly wary of companies that avoid SEC review by merging into a “shell company” using either a reverse merger or a “special-purpose acquisition company” partner and immediately becoming a public company.

Techniques to Detect Investment Manager Shenanigans

Clients of Bernie Madoff’s investment firm were shocked and saddened to learn in early December 2008 that they had been the victims of a Ponzi scheme and that their investment account balances were completely wiped out. Madoff had a sterling reputation as a money manager for delivering consistently strong returns, and for years investors had poured tens of billions of dollars into his coffers, only to learn later that the funds were used to support a Ponzi scheme in which early investors were paid back with later investors’ funds. In June 2009, Madoff was sentenced to a 150-year prison term after acknowledging the fraud and asserting that he had acted alone.

While this book mainly addresses the analysis of financial reports of public companies (rather than detecting crooked money managers), it teaches investors how to analyze companies, including a privately held investment firm like Bernard L. Madoff Investment Securities. In evaluating any company, a stakeholder should

(1) 
understand the nature of the business and assess whether the numbers make sense,

(2) 
assess the competence and ethics of management, and

(3) 
evaluate the adequacy of checks and balances

Understand the Business to Assess whether the Numbers Make Sense

Two glaring warning signs would emerge in evaluating the key numbers related to Madoff’s business, investment returns and fees charged to investors. First,
monthly
investment returns seemed unusually consistent over many years. Despite volatile bull and bear markets over these years, Madoff rarely reported a monthly loss— an illogical and impossible feat. Legitimate investment managers generate uneven returns, with certain periods of outperformance and others of underperformance.

Second, the fees typically charged to investors like Madoff’s include a management fee (1 to 2 percent of assets managed) and, for hedge funds, an incentive payment based on positive returns (as much as 20 percent). Curiously, Madoff charged investors neither fee. Instead, he apparently was happy to receive only the puny brokerage commission of a few cents per share trading securities in the customers’ accounts. On the face of it, investors should know that there is “no free lunch.” Madoff lured investors to come in droves and keep funds with him by reporting consistently strong returns and charging customers virtually nothing. Remember the adage about something that seems “too good to be true”? Investors should know that they should never give an investment manager their money when the manager’s performance looks too good to be true. Madoff’s investors should have understood that an equity investment with no volatility in performance and no management or other fees made absolutely no sense.

Assess the Competence and Ethics of Management

As discussed earlier in the chapter, structural weaknesses or inadequate oversight provide a fertile breeding ground for shenanigans. Like Adelphia’s family business, Bernard Madoff’s investment firm included many family members in the executive office. Specifically, Madoff’s brother, two sons, and a niece held key management roles at the firm. Such an environment clearly represents a potential breeding ground for bad behavior and should be looked at with a skeptical eye by any potential investor.

Moreover, whenever someone boasts about being highly ethical, investors should be put off and do further investigation. Ethical people rarely brag about such virtues, as it is unbecoming and inappropriate; others should reserve judgment on who acts honorably. Consider the following boastful passage found on the Madoff Web site.

Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair dealing and high ethical standards that has always been the firm’s hallmark.

Evaluate the Adequacy of Checks and Balances

Investors should also expect their money managers to have other checks and balances in place, such as competent independent auditors and third-party bank or brokerage custodians to safeguard their assets. For Madoff investors, it seems that neither of these safeguards existed. For one thing, Madoff’s independent auditor, Friehling & Horowitz, was a tiny unknown shop, which certainly should have seemed odd given the size of Madoff’s investment funds. The SEC charged this auditor with helping to enable Madoff’s fraud by, among other things, pretending to conduct an audit on Madoff’s investment firm and signing off on Madoff’s financial statements as if it had done so. Another obvious warning sign for Madoff investors was the absence of a third-party custodian to safeguard cash and securities for the investors to prevent theft. Without such an intermediary, investors have no independent assurance that the assets actually exist. A word of caution to any investor who outsources money to an investment manager— always require a third-party custodian to handle your money.

Looking Back

Warning Signs: Breeding Ground for Shenanigans

• Absence of checks and balances among senior management

• An extended streak of meeting or beating Wall Street expectations

• A single family dominating management, ownership, or the board of directors

• Presence of related-party transactions

• An inappropriate compensation structure that encourages aggressive financial reporting

• Inappropriate members placed on the board of directors

• Inappropriate business relationships between the company and board members

• An unqualified auditing firm

• An auditor lacking objectivity and the appearance of independence

• Attempts by management to avoid regulatory or legal scrutiny

Looking Ahead

Now you are ready to jump in and learn about the three categories of Financial Shenanigans: Earnings Manipulation (Part 2), Cash Flow (Part 3), and Key Metrics (Part 4).

Earnings Manipulation (EM) Shenanigans highlight tricks used by management to inflate or smooth out earnings and portray a healthy company with predictable profits. Each of the seven EM Shenanigans we have identified is discussed in the next part, so please turn the page to begin the lesson.

PART TWO:

Earnings Manipulation Shenanigans

Investors rely on the information that they receive from corporate executives to make informed and rational securities selection decisions. This information is assumed to be accurate, whether the news is good or bad. While most corporate executives respect investors and their needs, some dishonest ones hurt investors by misrepresenting the actual company performance and manipulating the company’s declared earnings. Part 2 fleshes out the seven most common Earnings Manipulation (EM) Shenanigans and suggests how skeptical investors can ferret out these tricks to avoid losses.