The economic crisis will expose a decade’s worth of corporate fraud

Every single day in Marcellus we tell our clients that at least 80% of Indian companies have suspect accounts. Further, as we have explained in this blog – https://marcellus.in/blogs/accounting-fraud-and-liquidity-crunches-are-bedfellows/ – in a crisis may of these companies find that their time is up. In the article, the Economist makes a similar point for the world at large: “Booms help fraudsters paper over cracks in their accounts, from fictitious investment returns to exaggerated sales. Slowdowns rip the covering o!. As Baruch Lev, an accounting professor at New York University, puts it, “In good times everyone looks good, and the market punishes you harshly for not keeping up.” Many big book-cooking scandals of the past 20 years emerged in downturns. A decade before the crisis of 2007-09 the dotcom crash exposed accounting sins at Enron and WorldCom perpetrated in the go-go late 1990s. Both firms went bust soon after. As Warren Buffett, a revered investor, once put it: “You only find out who is swimming naked when the tide goes out.””
In this context, it looks highly likely that the Corona driven liquidity crunch around the world will lead to more accounting frauds coming to light: “Some dirty secrets are beginning to come out. Take Luckin Co!ee, which had expanded to take on Starbucks in China, attracting big-name investors like Blackrock and Singapore’s sovereign wealth fund. On April 2nd the Nasdaq listed Chinese chain announced an ongoing internal probe amid allegations that its chief operating officer and other employees may have fabricated over 2bn yuan ($280m) in sales. On April 14^th Citron Research, a short-seller, accused GSX, a Chinese online-tutoring firm listed in New York, of inflating last year’s sales. In a statement GSX denied the allegations and said Citron’s report was misleading and “full of subjective maliciousness”.”
In fact there is good reason to believe that accounting blow-ups in the wake of Covid could be amongst the most spectacular ever: “Non-GAAP adjustments have spread like wildfire through corporate accounts, making it harder to discern what numbers reflect a firm’s true financial position. The average number of non-GAAP measures used in filings by companies in the S&P 500 index has increased from 2.5 to 7.5 in the past 20 years, according to PwC, a consultancy. In credit agreements analysed by Zion Research Group, the definition of EBITDA ranges from 75 words to over 2,200.”

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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. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.