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Business | Cooking the books

A sleuth's guide to the coming wave of corporate fraud

Mischief is cyclical--it is bred in good times and uncovered in bad
times

[20221112_W]
Nov 7th 2022
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The bad news just keeps coming. Ten months after America's
stockmarket peaked, its big technology companies have suffered
another rout. Hopes that the Federal Reserve might change course have
been dashed; interest rates are set to rise by more than previously
thought. The bond market is screaming recession. Could things get any
worse? The answer is yes. Stockmarket booms of the sort that crested
in January tend to engender fraud. Bad times like those that lie
ahead reveal it.

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"There is an inverse relationship between interest rates and
dishonesty," says Carson Block, a short-seller. Quite so. A decade of
ultra-low borrowing costs has encouraged companies to load up on
cheap debt. And debt can hide a lot of misdeeds. They are uncovered
when credit dries up. The global financial crisis of 2007-09 exposed
fraud and negligence in mortgage lending. The stockmarket bust of the
early 2000s unmasked the deceptions of the dotcom bonanza and the
book-cooking at Enron, WorldCom and Global Crossing. Those with
longer memories in Britain will recall the Polly Peck and Maxwell
scandals at the end of the go-go 1980s.

The next downturn seems likely to uncover a similar wave of corporate
fraud. Fraud-busters concede that exactly where is hard to know in
advance. Everyone has a favourite hunch. The rush to comply with the
demands of environmental, social and governance (ESG) investing seems
ripe for more imbroglios; in May German police raided the offices of 
dws, an asset manager, over claims of greenwashing. The various
government schemes to shore up businesses in the pandemic are another
candidate. They were designed to be tapped quickly, so checks were by
necessity lax. Evidence of fraud is already emerging.

The archetypal sin revealed by recession is accounting fraud. The big
scandals play out like tragic dramas: when the plot twist arrives, it
seems both surprising and inevitable. No simple formula exists to
sort the number-fiddlers from the rest. But the field can be narrowed
by searching within the "fraud triangle" of financial pressure,
opportunity and rationalisation.

Start with pressure. This can be self-imposed. If you make the cover
of Business Genius Monthly, in Mr Block's words, "the guy on the
cover becomes your identity, the ceo of a high-flying firm." Fessing
up that it isn't flying high becomes unthinkable. Often it is the
result of external expectations, says Andi McNeal of the Association
of Certified Fraud Examiners, a 90,000-strong professional body based
in Texas.

The expectations to be met, or gamed, can be regulatory: think of how
bankers pulled the wool over the eyes of their watchdogs before the
financial crisis; or how Volkswagen deceived environmental agencies
about the pollution from its cars in the "diesel-gate" scandal. For
bosses of listed firms, the external eyes to please are often those
of portfolio managers, analysts and traders--and the thing doing the
pleasing is accounting earnings. The stockmarket uses profits as a
rough guide to how well a firm is doing and at what price its shares
should change hands. Earnings "misses" can be punished brutally. The
shares of Meta, owner of Facebook, lost 25% of their value after
disappointing quarterly earnings last month. A lot of ceo pay is tied
to share prices, creating the incentive to meet earnings forecasts.

[20221112_W]

That bosses feel pressure to deliver predictable profits is well
documented. Almost all the 400 managers surveyed in the mid-2000s by
John Graham, Campbell Harvey and Shiva Rajgopal, a trio of academics,
confessed to a strong preference for smooth earnings. Most admitted
they would delay big spending line items to meet a quarterly earnings
target. More than a third said they would book revenues this quarter
rather than the next, or incentivise customers to buy more earlier.
The rewards for smoothing earnings have since grown. Investors attach
rich valuations to the shares of dependable earners. Such "quality
stocks" have sagged already (see chart). Some bosses will resort to
fraud to avoid plummeting further.

Motive is not enough. The circumstances have to be right, too (or
rather, wrong). Opportunity varies by jurisdiction. Where the rule of
law is weak, scope to falsify accounts with impunity is wider. You
should expect to find more book-cooking in emerging markets than in
rich ones. Some short-sellers, such as Mr Block, examine Chinese
firms listed abroad, whose accounts are hard for foreigners to
verify. They landed a big target in 2020, when Luckin Coffee agreed
to pay $180m to settle accounting-fraud charges in America. India is
another font of scandal.

In rich countries, opportunity beckons in the latitude of accounting
practices. Earnings are a slippery concept. In a simple business,
like a lemonade stand, profit is the difference between the cash
coming in from sales and cash going out to buy lemons. Bigger
businesses must account for non-cash items, or "accruals", such as
sales that have been booked but not yet paid for. Accruals also
include costs that will eventually be a drain on cash, but aren't
yet: wear and tear (depreciation) of assets, pension payments, bad
debts and so on. Accruals rely on a forecast or best guess of how
things will turn out. "Accountancy is full of such estimates," says
Steve Cooper, former board member of the International Accounting
Standards Board, who now writes the Footnotes Analyst, a blog.

Accruals estimates can change for defensible reasons. Amazon Web
Services, the e-emporium's cloud-computing division, said in February
that it would extend the working life of its servers by a year, thus
lowering its depreciation costs. This is perfectly legitimate. No one
knows for sure the useful life of fixed assets, such as servers (or
aircraft or office buildings). Some less scrupulous firms, however,
can time accruals changes to give earnings a bump, by bringing
forward revenue to the present or deferring costs to the future.

Eventually, earnings must tally with cashflow. Firms that do not
generate a lot of cash tend to pile on debt to disguise the fact.
Corporate sleuths know this, which is one reason fraudsters go to
great lengths to conceal their true debt burden. Another reason,
powerful during recessions, is to avoid a downgrade from rating
agencies, which would raise borrowing costs.

The side that completes the fraud triangle is rationalisation. Though
some fraudsters are, as Mr Block points out, sociopaths who don't
feel the need to justify themselves to anyone, fraud is likelier to
occur if ceos feel they can justify it to themselves. "Everybody does
it" is something you might hear from the earnings-smoothers at the
white-lie end of the accounts-fiddling spectrum. Some fraudsters tell
themselves they are altruists, doing it to save jobs or investors.
"This is just temporary" is another common rationalisation, says Ms
McNeal.

Chef executives

Book-cooking can feel acceptable in a slump, in cases where the boss
sincerely believes the business has good long-term prospects. This is
what happened at one company. It was a classic story, says the
executive who was brought in to clean up the mess. Business was good.
The management believed they had found a recipe for success. They
repeated this formula until long after it had stopped working. The
pressure rose after recession struck. Costs were slashed in an effort
to sustain profits. The cuts served only to hurt the business.
Somehow reality had to be kept at bay. So the company began to fiddle
its accounts.

How many such cases are thrown up by the next recession depends on
its severity. It is easier to keep a fraudulent show on the road in a
short downturn. In a prolonged one, a few sorts of corporate sinners
are likely to be unmasked. The least guilty type are firms that were
run with a view to meeting accounting goals, but to the long-term
detriment of the business. This group includes firms so obsessed with
managing earnings that they skimped on investment in capacity, new
products or brands, and firms that were so intent on managing costs
that they destroyed valuable relationships with suppliers or
employees.

A firm that pays too much attention to accounting measures of success
is not committing fraud. But such a focus may be a gateway to dodgier
practices. Some high-flyers that suddenly lose altitude may decide to
fiddle the numbers in the hope that the good times return. A loss of
revenue is the likeliest trigger for fraud of this kind. The peculiar
circumstances of the post-pandemic economy have now given rise to
others, such as excess inventories or problems with suppliers going
bust. The share prices of Walmart and Target fell sharply in May,
after the two retailers revealed they had misjudged demand for some
goods. Less honest firms may cover up mistakes of this kind rather
than own up.

Then there are firms with no real business or not much of one.
Wirecard, a much-feted German "fintech" firm that imploded in 2020,
fits this category. So does Nikola, a startup with plans to make
battery-powered lorries, whose founder, Trevor Milton, was found
guilty last month by a federal court in New York of defrauding
investors. By the cold light of recession, similar such examples will
come to light. A lot of venture capital (vc), much of it
undiscerning, has poured into untested enterprises in recent years.
The valuations they were assigned in the boom years already look like
fantasy; many of their business models will prove similarly fanciful.

Their vc backers may try to conceal such souring bets. Their fees are
based on the value of their portfolio firms, whose equity is not
frequently traded. That gives the vc fund managers wide discretion
over the value (or "marks") they place on them. The same is true of
private equity. Both vc firms and private-equity firms, which focus
on mature businesses, are notoriously slow in writing down these
values in bad times. When a fund matures, its sponsor must usually
sell companies, at which point the market value ought to be clear.
But these days a lot of private-asset "exits" are sales to other
private funds, including some run by the same asset manager. Clubby
arrangements of this kind invite abuse.

The slow-growth, low-rate 2010s were a favourable climate for fraud
to breed. Financial pressure, opportunity and rationalisation no
doubt became aligned in at least a few instances. Everybody does it?
Maybe. But even the "smoothing" that seems acceptable in a boom will
be judged harshly in a bust. #

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This article appeared in the Business section of the print edition
under the headline "A sleuth's guide to corporate fraud"

Business November 12th 2022

  * A sleuth's guide to the coming wave of corporate fraud
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  * As tech lay-offs spread, Meta sacks 11,000 workers
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  * The UN takes on corporate greenwashing
  * Elon Musk's challenge to management thinking
  * Even with political gridlock, America Inc should still fear the
    bossy state

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