economic crisis will expose a decade’s worth of corporate fraud
are accounting crooks’ worst enemy
When bernie madoff owned up to a $65bn
Ponzi scheme in December 2008, it was not out of guilt. He knew the game was
up. Three months earlier Lehman Brothers had imploded. The market meltdown sent
clients clamouring to withdraw from his funds, leaving them depleted with many
investors still unpaid. American regulators had not spotted the fraud, despite
a tip-off years earlier. It was not them that did for Mr Madoff, but recession.
Booms help fraudsters paper over cracks in
their accounts, from fictitious investment returns to exaggerated sales.
Slowdowns rip the covering off. 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.” This time, thanks to a pandemic, the water has whooshed away at
Hell and low water
Much of the swimwear was already
threadbare: a borrowing binge has strained many corporate balance-sheets. Some
dirty secrets are beginning to come out. Take Luckin Coffee, 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 14th 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”.
These revelations have revived fears over
the flaky corporate governance of Chinese firms listed on foreign exchanges,
whose audits, conducted at home, China’s government makes it hard for outsiders
to inspect. A gaggle of fraud-hunters like Citron and Muddy Waters, which outed
Luckin, claimed numerous scalps after the first wave of such listings a decade
ago. This time they are looking beyond China.
Blue Orca Capital, an Asia-focused fund
targeting corporate “zeros”, expects opportunities to pop up in other emerging
markets, Europe and America. “My entire career has been in a bull market,” says
its founder, Soren Aandahl. “This is exciting.” Mr Aandahl is eyeing any firms
with discrepancies between the amount of capital they need to raise and the cash
their accounts say they are generating. Others are focusing on industries hit
hardest by the pandemic, such as travel, entertainment and property.
Only a small minority of firms resort to
outright fraud. Far more prettify profit-and-loss statements with accounting
wheezes that fall in a grey area. This accounts for much of what John Kenneth
Galbraith, an economist, called “the bezzle” and “psychic wealth”: gains that
appear real but prove illusory.
In the bull market startups became masters
of conjuring up novel metrics that flatter performance. WeWork’s
“community-adjusted” earnings before interest, taxes, depreciation and
amortisation (ebitda) transformed a hefty loss for 2018 under Generally
Accepted Accounting Principles (gaap) into a profit. Illegal? No. A red flag?
Absolutely. Many investors turned a blind eye because they bought into what Mr
Aandahl calls “the myth in the shareholder list”: all would be well if other
high-profile backers were on board (as with Luckin).
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. gaap is far from perfect, but some of
the divergence from it has clearly been designed to pull wool over investors’
eyes. One study found that non-gaap profits were, on average, 15% higher
than gaap profits.
Playing around with earnings and
revenue-recognition metrics is this generation’s equivalent of dotcoms using
bots and other tricks to boost “eyeballs” 20 years ago, says Jules Kroll
of k2 Intelligence, the doyen of corporate sleuths. “When an area is hot
to the point of overheated, there is a growing temptation to juice the
numbers.” In an ominous sign, SoftBank, a Japanese technology conglomerate
which bet big on WeWork and dozens of other startups, said this week that it
expects an operating loss of ¥1.4trn ($12.5bn) in its last fiscal year.
Besides exposing old schemes, the pandemic
is likely to give rise to new ones. When economic survival is threatened, the
line separating what is acceptable and unacceptable when booking revenues or
making market disclosures can be blurred. Mr Kroll reckons that “amid such
massive dislocation, some will inevitably cheat.”
Bruce Dorris, head of the Association of
Certified Fraud Examiners, the world’s largest anti-fraud outfit, says the
effects of covid-19 look like “a perfect storm for fraud”. It may engender
everything from iffy accounting to stimulus-linked scams as thousands of
firms—including bogus applicants—hustle for help. One fraud investigator points
to private-equity-owned firms as potential targets. “There are lots of them,
they are highly leveraged and they may not qualify for bail-outs because they
have deep-pocketed sponsors,” he says. That increases the temptation to resort
to unseemly practices. The ebbing tide is likely to reveal plenty of corporate
nudity. That will not stop some businesses from taking up naturism.?
This article appeared in the Business section
of the print edition under the headline “Who’s lost their trunks?”