Financial Shenanigan - must read for any investor to detect fraud

Financial Shenanigans â How to detect accounting gimmicks & fraud in financial reports by Howard M. Schilit

I have made note of some key points from the above book. I thought it can act both as review of the book and also helps to take the discussion on fraud forward. Highlighted in blue are the instances, where I could co-relate the points mentioned in the book with some of the Indian companies.

Why must read: I think itâs a must read by any investor, both beginner and mature professional as 1) it shows the various ways fraud has happened in the past in the developed world 2) Suggest additional analysis which can be performed to detect fraud early 3) Not to rely on cash flow blindly, as even cash flow can be manipulated. Though other than Satyam, this book does not contain any examples from Indian companies, even then I believe that it will be helpful even to Indian investors.

********Some key points highlighted in the book *********

  • Companies with structural weaknesses or inadequate oversight provide a fertile breeding ground for shenanigans. Investors should probe a companyâs governance and oversight by asking these basic questions:
    • Do appropriate checks and balances exist among senior executives to snuff out corporate misdeeds? Do outside members of the board play a meaningful role in protecting investors from greedy, misguided, or incompetent management? ( to my knowledge majority of the companies in India fall under this category with notable exceptions like Infosys, L&T , ICICI bank etc)
    • Do the auditors possess the independence, knowledge, and determination to protect investors when management acts inappropriately? (Always give preference to companies with reputed auditors, preferably big 4). See Sanghvi movers FY12 results. Its not a co-incidence that in the year in which it appointed one of the big four, its provision for doubtful debts and bad debts is highest in the recent past)
    • Has the company improperly taken circuitous steps to avoid regulatory scrutiny? (I do not have an indian example but I remember a HK based company (China Grand Foresty ticker 910 HK) where the company got listed by way of reverse merger with a listed company, allegedly to avoid scruity and disclosure required for a new listing. After experiencing a dream run on HK exchange, ultimately it was discovered that company was a total fraud)
    • Be wary of companies where single management dominates management and board?
    • Be Skeptical of Boastful or Promotional Management. Investors should be particularly careful when a management publicly boasts about its long consecutive streak of meeting or exceeding Wall Streetâs expectations?
    • Boards lacking competence or independence ( Appointment of film actor Shah Rukh khan & Yash Raj Chopra to board of directors of Jet Airways and even after he opt not to renew the term director Yash Raj Chopra was appointed in his place . Regarding explanation on expertise in relevant field, this is what company said in the resolution Mr. Shah Rukh Khan is a well-known Actor from the Indian Film Industry. He is the recipient of Thirteen Filmfare Awards, three National Honours including Best Indian Citizen Award in 1997, Rajiv Gandhi Award for Excellence in 2002. In 2005, Mr. Khan was conferred the Padma Shri, one of the prestigious civilian honours conferred annually by the Government of India. He is also recognized as a cultural ambassador of India to the rest of the world. I fail to understand in what way Mr. Khan expertise would have been useful to company)
    • Failure to challenge management on inappropriate compensation plans ( There is no dearth of examples for this in Indian scenario)
    • Astronomical fees lead to conflicted independent auditor.
    • Failure to challenge management on related party transaction (On 16 Dec 2008 Satyam passed a resolution to acquire Maytas which is into totally unrelated field and got it board of directors to approve the transaction. Shareholders still had 15 days before the share price collapsed completely.)
  • Red flags
    • Sharp jump in receivables, especially long term and unbilled.
    • Cash flow from operations, materially lags behind net income.
    • Be wary of companies using percentage of completion method, as there are more chances of using aggressive assumptions.
    • Watch out if non-recurring expenses/extra-ordinary expenses has been recurring one.
    • Do not get excited by the results of a company for few quarters after it has written of certain assets, as it is possible that it is the result of writing down good inventory or assets. Eg. Company indicating that it will not scrap all of the written down inventory.
    • Watch out for companies which try to include non-core income to boost operating margins in times of stress or economic slowdown.
    • Increase in capex, without corresponding increase in sales, indicate that company might be capitalizing normal operating expenses.
    • Rapidly growing fixed asset accounts or âsoftâ asset accounts (e.g., âother assetsâ) may be a sign of aggressive capitalization. Create a quarterly common-size Balance Sheet (i.e., calculate all assets and liabilities as a percentage of total assets) to help you quickly identify assets that are growing faster than the rest of the Balance Sheet.
    • Inflating revenue right after closing on an acquisition is a pretty simple trick: once the merger is announced, instruct the target company to hold back revenue until after the merger closes. As a result, the revenue reported by the newly merged company improperly includes revenue that was earned by the target before the merger.
    • Look out in the notes to account for disclosure regarding securitisation or factoring of receivables. It is possible that a company facing stress in collection of receivables will simply sell its receivables on recourse basis (meaning if debtor fails to repay, company needs to pay to the bank) and record it under operating cash flow. Eg. In case of Sanghvi movers (annual report FY12), there is no information whether sale of receivables is on recourse or without recourse basis.
    • BE wary of serial acquirers, as its difficult to understand operating cash flow. Eg When the acquired company collects receivables or liquidate inventory, it is recorded under operating cash flows, while the company had made purchase of inventory or sales prior to acquisition and so these transactions were never recorded as operating cash flow (OCF)
    • Boosting OCF, by making slower payments to vendors. Watch out for increase in payables.
    • Watch out if the company stop disclosing any key metric and argues that it does not indicate the company performance accurately.
    • Auditors rarely disagree with management, so if they do disagree with management on transaction of significant magnitude, in all possibility it gives indication of some wrong doing.