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Financial shenanigans: A warning to investors

Financial shenanigans maybe defined as actions intended to misrepresent the real financial performance or financial condition of an entity.

Nesbert Ruwo

The actions range from minor deceptions to more egregious misapplications of accounting principles. The basic strategy underlying accounting shenanigans is either inflating or deflating current reported income.

Inflating current performance makes a company look better than it is while deflating income is normally used to smoothen the company’s earnings over a period of time.

Warren Buffet in his 2014 letter to shareholders was not forgiving to the accounting shenanigans.

He writes that “the Street’s denizens are always ready to suspend disbelief when dubious manoeuvres are used to manufacture rising per-share earnings” and he castigated auditors who “willingly sprinkled their holy water on the conglomerates’ accounting and sometimes even made suggestions as to how to further juice the numbers”.

According to Buffet, companies that used accounting shenanigans viewed having an “accounting wizard” as security for ensuring that reported earnings would never disappoint. This philosophy is captured when CEOs focus on nothing else but “meeting the numbers” to keep the markets happy.

A 2012 US survey of 169 Chief Financial Officers (CFOs) of public companies and in-depth interviews of 12 CFOs on earnings quality shows that 20% of firms “manage” earnings to misrepresent their economic performance.

For such firms that manage earnings, 10% of the typical earnings per share (EPS) are misrepresented.

The research also shows that about 60% of earnings management is about inflating income, while 40% relates to income-decreasing activities.

Corporate history is rich with cases of companies that manipulated their numbers to give a rosy picture about their financial performance and prospects.

The end result — investors lost billions of dollars of value. It is therefore important that investors be extra vigilant when assessing company financial results.

Sometimes the numbers in the glossy annual reports are not what the reality on the ground is.

The latest case of accounting gimmickry is that of the London Stock Exchange-listed, UK-based supermarket group, Tesco Plc.

The UK’s Financial Reporting Council announced in December 2014 that it was investigating the parties involved in the preparation, approval and audit of Tesco’s financial statements for the years 2012, 2013 and 2014, as well as their conduct in relation to accounting practices that led to a £263 million overstatement of the company’s 2014/5 first-half profit forecast. The company’s share price has fallen 23% (£5,8 billion in shareholder market value) over the past 12 months.

In other high-profile cases of financial manipulation, Enron Energy’s bankruptcy in 2001 after allegations of massive accounting fraud wiped out over $75 billion in stock market value and led to the collapse of Arthur Andersen (auditing firm), the passage of the Sarbanes-Oxley Act of 2002 (SOX) and a class action settlement of $7,2 billion.

Enron used aggressive accounting practices while the outside world viewed Enron as a successful company.

With the WorldCom (2002), the company inflated assets by as much as $11 billion by capitalising rather than expensing and inflating revenues with fake accounting entries leading to $180 billion in losses for investors.

In the case of American International Group (2005), accounting fraud to the tune of $3,9 billion was alleged in which loans were booked as revenue, along with bid-rigging and stock price manipulation.

This is almost similar to what the Lehman Brothers (2008) did — it hid over $50 billion in bad loans through a structure that disguised the loans as sales.

With Bernie Madoff (2008), investors were duped off $65 billion through a massive Ponzi scheme.  An Indian information technology firm Satyam (2009), falsified its revenue by $1,5 billion and exaggerated the size of its business and profitability, while its key men siphoned off millions of dollars.

In all cases, what should stun investors is that the books of the culprit companies were audited and signed off by directors and independent audit firms. These and many other scandals have shaken the accounting and auditing industry, regulatory authorities and investors alike.

This has seen the reworking of the industry with increased regulatory oversight through regulations such as SOX, more stringent governance, accounting and analytical frameworks.

Prior to the accounting scandals of the 2000s, the accounting industry was mostly self-regulated.

While the reforms in the regulatory framework have improved accounting reporting oversight, the risk of manipulated numbers has not been mitigated completely. The recent case of Tesco shows that the risk is still there.

Given all this, what should a typical investor do? The 2012 earnings quality survey advocate paying close attention to the key managers running the firm, understand the correlation between the company’s earnings and cash flows, and significant deviations between firm and peer experience.

In simple terms, investors should focus on understanding what the company does and how it makes money. If you cannot understand these basic tenets, chances are high that you are probably investing in something you do not know.

Focus on what matters — the cash.  After all, as an investor you are buying into the capability of a company to generate future cash flows.

It’s all about the quality of earnings.

Nesbert Ruwo (CFA) is an investment professional based in South Africa. He can be contacted on nesr@opportunvest.co.za

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