Investing Series Part 3: Accounting Frauds: Lessons for investors

What is accounting fraud?

Accounting fraud is committed when a company makes adjustments to its financials to hide negative financial developments. Commonly known as "cooking the books", accounting frauds are actually more common than the famously known Enron or Worldcom.  Finding them takes a bit more work than just reading the financial statements or digging through the footnotes. Investors are better off by just avoiding what looks like an attractive investment. The investment may be attractive but if you don't understand how does the company makes money, you are better off investing in other boring stocks.  To quote Ben Franklin, "An ounce of prevention is worth a pound of pure."

As an introduction, Worldcom was one the largest telecommunication in the world at the height of the 2000 dot com bubble. It expanded through various acquisition in the 1990s and become the second largest phone company in U.S. (after AT&T). Enron started as a energy pipeline company but ended up more like a financial services company by focusing more on energy trading rather than energy transportation.

Why Commit fraud? Cooking the book is not as fun as cooking a meal

Both companies got a tailwind from the raising bull market of the 1990s. Managers, like the ones at Enron and Worldcom, were playing a special game called `"earnings management". In Layman`s terms, the earnings management is merely a game where the  management wants to at least match what the average earnings expectation numbers estimated by Wall Street analysts every quarter (every 3 month). Usually quarterly profit numbers that are better than expected is rewarded with a higher share price while those companies that report profit numbers that are worse than expected is punished with a lower share price. By the end of 1990s, analysts increased earnings expectations by a rate of 2X while the companies can only grow at a rate of X. Pressured at meeting those high expectations and maintaining a high share price, companies like Worldcom and Enron decided to do cheat the system a little bit. What turned out to be a little cheating snowballed into a lot of cheating.

One of the main reason for keeping a higher share  price  is due to the vast amount of stock options held by corporate managers and officers. Managers were increasingly being paid in options, not cash. Option is a right but not an obligation to buy the company`s share at a pre-determined price in the future. To put that in plain English, it is a lottery ticket on the stock price but essentially given to the officers of the company for free. (Note: Prior to 2006`s implement of the FAS123R rule, companies did not have to expense stock options whereas cash compensation would have reduced earnings). Companies argued it aligns manager's interest with shareholder by focusing on shareholder wealth; the argument is totally false: shareholders suffer the full downside of the stock if the price drops below strike price X while holders (managers) of these options have no downside at all.  For the managers, its head I win, tails I don't lose at all.

After being rewarded those lottery tickets, it doesn't take a high IQ person to realize that the managers will do whatever they can to maximize their own interest, especially since they have the ability to affect the value of these options through the reported financials. Hence the vicious cycle continued until the two companies got pulled back to earth by financial gravity.

Accounting 101 example: Worldcom`s fun with the accounting equation

Worldcom's fraud is actually simple.  It only takes elementary accounting 101 to explained what they did. Let's just review the fundamental accounting equation of Assets = Liability + Shareholders equity. It is an entity because anything increase on the left hand side will increase on the right hand side. Now expand the equation into Assets = Liabilities + Beginning equity + Revenues - Expenses (ignore share issuances and dividends for simplicity). Now, in order to increase profit (Revenue - Expenses), the company has to either increase revenues or decrease expenses.

One infamous method that Worldcom used to decrease expenses is to capitalized them. In accounting, companies  may capitalize expenses (put on the balance sheet) as long as they provide future economic benefit for more than one reporting period. A big capital expenditure like buying a machinery will significantly impact net income if expensed immediately. To solve this problem, accountants allowed these expenses on the balance sheet and charge an expense called depreciation that allocates the cost of assets over their useful life on the income statement. By capitalizing an expense (increasing the left side of the accounting equation), expenses on the right side of the accounting equation shrink, making net income higher and achieving the goal of artificially boosting profits. Also, operating cash flow is increased as well by the additional depreciation expense (killing two birds with one stone!). Worldcom accomplished this by capitalizing their excessive leased line costs (think of it as a rent expense on its leased networks).

Investors should be wary of companies that have suspicious or unexplained increases to capital expenditures accompanied with slowing receivable turnover numbers. These are signs the firm may be capitalizing normal operating expenses. If these changes cannot be explained to investors, just don't invest in those companies. 

Worldcom also booked small artificial revenues that wouldn't have met the standard revenue recognition tests. These were small in amount compared to the capitalizing of line costs. 

Enron: The more complex case

Enron's case was far more complex involving moving assets off the balance sheets to Special Purpose Vehicles (SPV) or Special Purpose Entities (SPE) and using mark-to-model accounting which allowed the company to book artificial profit numbers.

Rather than learning complicated structured finance, investors should stick to their basic investing knitting. A quick look at the financials will make you think you should look for another company

Table 1: Enron Financials in Millions   (2000 annual report released in early 2001) 

Item	2000	1998	% Change
Revenue	$100,789	$31,260	224%
Operating Expense	$98,836	$29,882	230.8%
Operating Profit	$1,953	$1,378	41.7%
Net Income	$896	$686	30.6%

It does not take a genius to figure out there is something fishy when you compare the revenue growth number (from 1998 to 2000) to the expense growth in table 1.Revenues grew 224% over the two years but expense grew much faster at rate of 231%.  Investors can merely stop here as there are plenty of better businesses that have revenues growth higher than expenses (this is called positive operating leverage). If investors want more warning signs, look at the growth rate of revenue to operating profit or growth rate of revenue to net income. Revenue grew 231% while operating profit grew 42% while net income grew only 31%. Normally firms with positive operating leverage is preferred. If investors need a final simple tests, look at the profit margins. In 1998, the profit margin is 2.2% while in 2000 it is a mere 0.9%.

Another reason to avoid Enron was the wording in its annual report, particularly to its footnotes. Management spend a lot more time on discussing the rise in the share price than actual business operations. (a company should not be a cheerleader of its own stock!). Also in 2000, there was a footnote that stated "Enron entered into transaction with limited partnerships whose general partner's managing member is a senior director of Enron". There is clearly a conflict of interest since the managing partner of the partnership would maximize his own interest which meant ripping off the shareholders of Enron. Clearly, it's better to look for another company than to investigate Enron further, which had all these complicated footnotes that are in another foreign language. In Buffett's famous quote: "I don't look for 7 foot bars to jump over, I look for 1 foot bars that I can step over".

Common cautionary signs

One lesson learned from the Worldcom's case is be wary of growth by acquisitions. It is easy for companies to capitalize inappropriate items or not capitalize appropriate items. For example, in the early 2000s, the pooling of interest method of accounting for acquisition  (no long allowed by IFRS or U.S. GAAP) allowed the acquirer to record the assets of the target at book value Thus, the assets are understated, which reduce amortization expense and overstate earnings. Acquisitions is preferred over organic growth because  goodwill write-down would be eliminated (no goodwill is recorded). Growth by acquisitions can be a good strategy but be wary when companies keep announcing "restructuring charges";  you don't want to be the shareholder that pays the corporate managers' tuition fees. 

One lesson learned from the Enron case is understanding the footnotes. If the footnotes are difficult to understand, the managers are probably hiding something or they don't want you to fully understand certain financial transactions. 

How to invest intelligently and avoid being a lemming

After reading all the negatives on accounting scandals in the past, investors must be extremely cautiously in the trusting company's reported financials and information. Investors should not completely take the financial data at their face value but they do provide valuable information when analyzed carefully. If anything looks fishy, it may be best to move on and find another company to look at. There are thousands of companies in North America investors won't have trouble finding a couple of good ones.

One final word, it very be easy to be a lemming that follows the latest fad in the market. To avoid this, always conduct considerable research on an investment before committing capital and stick with what you can understand. Aesop once said "a bird in the hand is worth two in a bushes" or Buffett's equivalent translation "a girl in a convertible is worth five in a phonebook". It's better to look for businesses (stocks) you can understand rather than invest in a company because you think another fool will come along to pay a higher price than you. The latter is pure speculation. Remember the following two quotes from Ben Graham and you'll be successful in your investing journey: "An investment is an operation where upon thoroughly analysis, promises safety of principal and an adequate return" and "in the short run, the market is a voting machine. In the long run, the market is weighing machine."