Accounting quality is a key aspect of Marcellus’ investment philosophy and hence detecting accounting fraud is beyond just a skill for the Marcellus analyst. This article is dated 7th November, the day before FTX unravelled. The Economist’s prescience is less to do with the specifics of Samuel Bankman-Fried or crypto in general than the remarkably repetitive pattern of corporate frauds with economic cycles – created during booms and unravelling with the busts. Indeed, recession is here and the era of low interest rates has ended.
“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.”
But the article goes one step ahead in giving us a framework to understand the origins of fraud and with that, hopefully anticipate and stay away from them. It calls it the ‘fraud triangle’ – financial pressure, opportunity and rationalisation.
Pressure comes from various sources – regulators, shareholders (or market expectations) or even 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.
…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
…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.”
Opportunity comes from weak rule of law such as in emerging markets or the latitude that accounting rules give such as in the rich world.
“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.
…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.”
Rationalisation is the third part of the fraud triangle:
““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…
…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.”
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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
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