How to detect accounting fraud

Ignacio de la Torre. Professor. IE Business School

4 September 2014

Auditors nobody has heard of, commissions run by yes-men, overvalued assets and growth in sales that in no way match the company’s cash flow are all clues that something strange is going on in a company’s accounts. 

I have been using a listed Spanish company’s 2001 annual report in class for ten years now. It was audited by a big four firm.  I always ask my students about the accounts of said firm. Is there any truth in them? The reply in this case is that the only figure that is correct in this particular case is the year (2001).

Recent scandals have once again left many flabbergasted, given that we are not yet used to the fact that accounting scandals tend to recur over time. The best way to prevent them from happening is training people in the good years to identify possible areas of risk. This little article is going to take a look at a series of recommendations.  

First: Creative accounting can be legal or illegal. In most cases it is legal, given that accounting depends on interpretations. Hence, Spanish savings banks managed to keep up the fiction that their loans to developers awarded up until 2007 were still worth the original amount, in spite of the developers’ increasingly obvious incapacity to pay the loans back.  This way, the 2008 – 2011 balance sheets of many savings banks and the odd investment bank were false.  Legal, but false. The greatest risk posed by illegal accounting lies in the audited false figures, like the murky and close-to-home case we have recently seen in the press. Possible ways of reducing the risk would be: a) first, although every auditor has a license to work (in Spain that license comes from the ICAC, which operates under the aegis of the Ministry of Finance), in my opinion the issuing of bonds in stock markets requires a special register of auditing firms with the size and capacity to audit companies that issue bonds or shares.   The investor shouldn’t have to validate the accounts per se, but should rather have to discriminate and enquire if the auditor has the sufficient size and capacity to audit accounts of the size of the share market issuer in question.  Moreover, the issuer should always have an auditing committee made up mainly of independent members. These independents have to be “scholars” of financial accounting. The best recipe for an inept commission is to appoint financial illiterates as members of the auditing commission (the accusation of ex politicians that made up savings banks, and which now, to their shame, say in their defense that they do not know what an asset or a liability is, is a toe-curling example). The commission should also have the legal authority to appoint an external auditor, to review the accounts, and to head the internal audit, which should never be reported to the financial director, thereby avoiding that the fox is left guarding the henhouse. It is better not to invest in a company that does not meet these requirements.

Second, if accounting is legal, its interpretation may be so contrived that it gives rise to false, albeit legal, accounting. In order to identify accounting time bombs it is a good idea to divide said bombs into four areas: a) recognition of income: How does the company recognize its sales?  A sale is only a sale if the product or service has been satisfied and the risk has been transferred to the client. It is worth questioning the way each firm recognizes sales and ensure that every recognized sale that appears as income satisfies the above requisite; b) capitalization of expenses. Many companies disguise expenses as investments. Thus they manage to ensure that the money going out of the company does not reduce profits in the short term because money going out is disguised as an “investment” and, little by little, it trickles into the results sheet as amortizations in such a way that that the underdeveloped EBITDA (profit before amortizations) is inflated and does not reflect the amount of cash-flow generated; c) overvaluation of assets. An asset is only an asset if the present value of cash flow that said asset can generate in the future is equivalent to its accounting value. Thus, a potato field bought in 2006 on Spain’s Costa Blanca to build semi-detached houses was not worth the same in 2006 as in 2010, and yet according to the company’s books it does; d) hiding debt using financial engineering to concentrate the debt in unconsolidated  subsidiaries (“integrated” using the equity method of accounting) so that the debt doesn’t appear on the balance sheet even though it is guaranteed by the parent company (this “sin” is often revealed in the footnotes).

Third, what are the simple rules for identifying the possible risks described in the previous paragraph? First, check to see if the increases in sales coincide with the increases in operational cash flows. Thus the sales of a bar could be constantly rising if it lets its customers pay for their beers in six months’ time, but the cash flow will no rise as fast as the number of beers sold… Second, find a balance between the EBITDA and free cash flow from operations - all EBITDA that is not supported by recurring cash flow is nothing more than a mirage. Third, work out if the assets that the company has on its balance sheet are worth what it says they are worth (said assets are often listed on the stock exchange and their real value is well below what the balance sheet states…). Fourth, identify the debt outside the balance sheet. The simplest trick here consists of capitalizing the financial costs (divide interest paid by the financial cost and the resulting quotient will shed light on the real level of debt, and not the camouflaged debt of December 31).

Warren Buffet says that when the tide goes out you can see who is swimming naked.  In accounting terms this could not be more true.   Use a few of the tips in this article wisely and you will see quite a few embarrassing underwater secrets of many a smug swimmer.   

 

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