Some Tips To Investors To Spot Red Flags

Foreword from ShareInvestor

This article “Some Tips To Investors To Spot Red Flags” by Teh Hooi Ling was first published in The Business Times Weekend on 06-07 Feb 2010 and is reproduced in this blog in its entirety.

Apart from the warning signs in financial statements, look at a firm’s reputation and its country of operation

IN the current market environment, macro factors dictate which direction prices go. Few would be interested to read about accounting red flags.

But for value investors, the time to invest is anytime, as long as a stock is trading below its fundamental value with enough margin of safety built in. And by that definition, it is a time of general market weakness that value investors would find most opportunities in.

CFA Singapore conducted an informative lunch time forum with three speakers early this week on How to Spot Red Flags.

Before we go into what was discussed during the forum, here are some interesting facts. A study done by Deloitte Forensic Centre found that financial executives such as chief financial officers and accounting officers accounted for 44 per cent of the individuals alleged to have committed financial statement fraud. Chief executive officers made up 24 per cent of the total.

Deloitte analysed 430 accounting and auditing enforcement releases related to 392 companies and issued by the US Securities and Exchange Commission (SEC) between January 2000 and December 2008. The study was limited to releases that concerned financial statement fraud, which includes improper disclosures and manipulation of assets and expenses.

Revenue Recognition

Of the cases, revenue recognition fraud was the most common form of financial statement fraud, accounting for 38 per cent of all such schemes, the study found. But since 2003, instances of revenue recognition fraud have fallen in all but one year.

Improper disclosures made up 18 per cent of the schemes and manipulation of expenses represented 16 per cent, according to the study.

Technology, media and telecommunications companies made up 30 per cent of financial statement fraud schemes alleged by the SEC, while consumer businesses made up 29 per cent, financial services 18 per cent, and life sciences and health care 12 per cent.

The SEC has found that more than half of all enforcement actions for financial reporting and disclosure violations filed by the SEC during a five-year period involved improper revenue recognition. In most enforcement cases, senior management was held accountable.

An earlier study done between mid-1997 through mid-2002 found the bulk of the violations to be improper revenue recognition and improper expense recognition.

In the CFA lunch time forum, Thomas Robinson, managing director of the Education Division of CFA Institute, noted that common ways in which revenue was improperly recognised include: recognising revenue in advance, bill and hold, fictitious revenue, and improper valuation of revenue. Improper expense recognition includes improper capitalisation of expenses, overstating inventory, understating bad debts/loan losses, and failure to record impairments.

Frauds, said Dr Robinson, typically starts small. “Companies start by dressing up the little things for the quarter, in the hope that things will get better in the next quarter. But things don’t improve, and the dress-ups get bigger and bigger until they unravel.”

Many a time, company executives also rationalise that what they are doing is for the benefit of all shareholders. For example, if they doctored the numbers so they don’t breach certain debt covenants, and as a result, they are able to sustain the business longer, or borrow more, then all shareholders will benefit.

There are usually three conditions that need to exist for fraud to happen – the so-called the fraud triangle. First is pressure or incentive to commit fraud. Second is rationalisation on the part of the fraudster, be it that they are doing it for the good of all shareholders or that they deserve what they are taking. And finally, opportunities need to be there for fraud to be committed.

Dr Robinson highlighted that the most common assets inflated by dishonest companies are Accounts Receivables and Inventories.

Corporate scandals of course are not recent phenomena. In fact, if we had studied history, we would have found similarities between scandals of recent years and those of a few decades ago. As George Santayana put it: “Those who ignore history are doomed to repeat it.”

For example, Charles Ponzi discovered an arbitrage opportunity in the form of international reply coupons (IRCs) in the 1920s. One could buy IRCs cheaply in one country and exchange them for stamps to a larger value in another country. He sold this scheme to the public, and raised money with the expressed intention to profit from such arbitrage. In effect, what he was doing was to use the capital investments of subsequent batches of investors to pay off the early investors. At the peak of its popularity, Ponzi would have to buy some 150 million IRCs to be able to make money for his investors. But there were only about 30,000 IRCs in circulation then

Similarly for Bernie Madoff, said Dr Robinson. “The options market was not as big as the number of options he would have to buy in order to make the kind of profit he purported.”

Dr Robinson reminded participants of the numerous warning signs to look out for. They include growth in revenues which are out of sync with the economy, industry or peer companies and with growth in receivables. “Particular attention should be paid when receivables are growing faster than revenues or days receivables are increasing over time. This could indicate non-existent sales,” he said.

Other warning signs include operating cash flow which is out of line with reported earnings, deferral of expenses, classification of expenses or losses as extraordinary or non-recurring, excessive use of operating leases, gross or operating margins which are out of line with peer companies and long useful lives for depreciation and amortisation.

Investors should also look at footnotes on accounting policies, examine disclosures on off-balance sheet items, and watch for related party transactions and unconsolidated entities. “Ask questions. If no satisfactory answers are forthcoming, walk away,” said Dr Robinson.

Rodney Hay, executive director with Deloitte Forensic in Singapore and South-east Asia, said financial statements are not the only factor that contribute to value when trying to identify undervalued companies. Another bigger factor is the reputation of the company, its directors and the country it operates in. “Investors should carry out integrity due diligence as well, look at the soft indicators and not just the hard financial numbers.”

Code Of Conduct

He cited studies which show that when we surround ourselves with people of less ethical integrity than us, we open ourselves to their negative influences. Another study suggested that when people are constantly reminded of a code of conduct that is expected of them, the propensity to commit fraud is much reduced in an organisation. So companies should come up with a code of conduct for all employees, and regularly remind them of it.

From that perspective, companies which are trying to increase their value can start by improving their reputation – particularly those operating in a country with a high risk of fraud, he said.

The final speaker was Vineet Vohra, general manager for wealth management, Asia Pacific, at ANZ. He spoke on identifying red flags in structured products. We all like good news, and tend to look at the positive side of things rather than the negative, he noted. In evaluating a structured product, investors should remind themselves that if something looks too good to be true, it probably is. Secondly, they should examine closely the packaging of the product. And third, do due diligence on their financial advisers. And finally, always look what the outcome is in the worst case scenario.

These are sound advice to bear in mind no matter what phase of the market we are in.