The last few years have been marked by unprecedented high levels of liquidity in the U.S. economy. Despite the recent tightening of credit markets in the wake of the sub-prime crisis, many capital sources seeking to deploy capital still remain.
It has been my experience that in times of high liquidity and easy money, especially in the credit markets, that management fraud in terms of financial reporting is more likely to occur. The reasons are simple. First, the capital sources are focusing heavily on expanding portfolio size at the expense of preserving asset quality. Second, management feels everyone seems to be making so much money that they may convince themselves that their big pay day is just around the corner and they can buy a little time to also get the big payday by fudging the numbers.
It is my belief that there are a significant number of frauds brewing in many private middle-market companies in this high-liquidity market right now. This article represents a consultant’s view of seven examples of fraudulent financial reporting that I have seen in the last few years.
Borrowing Base Calculations for an Asset Based Loan (ABL) are Complicated
An ABL is collateralized, almost exclusively, by accounts receivable and Inventory. If a company’s accounting records for these two staples of financial information are difficult to verify and can’t be explained quickly and in a straightforward manner, then there is a significant risk these account balances are either wrong or can be manipulated or both. High quality collateral is rarely that hard to understand and verify.
Processing of accounts receivable Credits has Slowed
Credits always lag invoicing and hence there is an accounts receivable dilution risk in all accounts receivable collateral. However, when the average days to process credits starts to increase, accounts receivable balances becomes overstated and dilution understated. This increase in processing days always occurs when the volume of credits accelerates, sometimes intentionally and sometimes not. Increasing levels of credits typically indicate quality problems, product returns or accounting errors. All of which are issues that management may want to cover up.
Raw Materials and Components are being Supplied by Customers
When customers are also suppliers, that customer’s accounts receivable is impaired by the amount of accounts payable (usually called a Contra) owed to that customer. When customers start to provide more and more raw materials and components, the historical trends go out the window and the fact that accounts receivable transactions (i.e., invoices) occur real time on the company’s book but accounts payable transactions lag by days or even weeks make the overall magnitude of a Contra “sea change” very hard to quantify until several months after it happens. Note that many companies in financial distress start to procure raw materials and supplies from their customers in a desperate attempt to keep making products for those customers.
Accounts Receivable with Major Customers are Short Paid
Companies change prices and sometimes new prices are disputed. Many times, management informs a customer of price increases and then just invoices the new price. Unfortunately, most large companies have a formal process to control and approve price increases. Therefore, a price increase that has not been formally agreed to is simply an over-billing awaiting credit and correction. If there are pricing credits imbedded in accounts receivable over 90 days, there are also pricing credits in the accounts receivable under 90 days.
Checks Paying “Customer” Contras are not Clearing Timely
Accounts payable balances go away when a check is cut “unless” checks in float are manually added back to accounts payable. It is very easy to hold a significant value of accounts payable contra checks right before a borrowing base measurement is taken, especially if done monthly, to manipulate the amount of Contras recorded as impairing accounts receivable. This is a harder game to play with a weekly borrowing base than a monthly one.
Inventory Valuation has Changed
One of the many odd things about cost accounting is that management is rewarded for taking product cost increases by getting to write-up inventory and record income on the write-up. Of course, this paper exercise also miraculously increases collateral values. Given this incredibly foolish result, management has the ability to re-cost and re-value its inventory fairly easily if a little more borrowing capacity would be helpful in their mind to generate cash. It is very easy to re-value inventory as a means to increase borrowing capacity. Distressed companies sometimes start to re-value inventory quarterly.
Financial Statements are Not Consolidated using Accounting Software
Companies that consolidate financials using Excel spreadsheets can easily manipulate financial reporting. The key line items on financial reports must tie back to underlying general ledgers even if they aren’t integrated in one system, yet this basic cross-check can easily be missed in verifying reported financial information. In essence, financial results can be whatever management decides to project using the wonders of Excel.
The above seven techniques to perpetuate fraudulent financial reporting are real techniques that I have seen used to defraud lenders and investors. I have seen more fraud in the last two years than I have in the previous 10 years. I predict we will be seeing many frauds on the heels of the last 3 years of high liquidity. Hopefully, being aware of these techniques will provide you with “An Ounce of Prevention.”