Discerning the red flags of financial fraud in Asia

Published June 13, 2014

First published in Business Times, June 11, 2014

By Mak Yuen Teen


Copyright of illustration belongs to Mak Yuen Teen and Chris Bennett. Not to be reproduced without permission.

FOR many years, I taught accounting to non-financial managers in an executive programme at the NUS Business School. One of the topics was “Creative Accounting”, in which we looked at the myriad ways that companies “manage” their profits, cash flows and financial position, using methods which range from those within the boundaries of Generally Accepted Accounting Principles (GAAP), those which are grey, and those that are outright violations of GAAP (and which may be illegal). This topic always received the most favourable comments and had the most attentive participants. Although there were a number of books in the market on corporate financial shenanigans, none focused on Asian companies. I had to develop my own Singapore and Asian cases from various news sources for my course.

Therefore, when Tan Chin Hwee told me about the new book that he and co-author Thomas Robinson had written on detecting financial irregularities in Asian companies and asked if I would review it, I had no hesitation in saying yes. I felt there was a need for a book on this topic using Asian companies as examples.

The book, titled Asian Financial Statement Analysis: Detecting Financial Irregularities (Wiley, 2014), provides a comprehensive discussion, with lots of excellent examples, of how Asian companies engage in financial irregularities and how analysts and investors can detect these irregularities. The authors are eminently qualified to write the book. Both are CFAs and CPAs, who together have many years of experience in investments, financial services, education, and assisting in investigations of fraud cases.

The book starts with the basic building blocks of financial statements and relationships among these statements and financial statement items, all done in a non-technical manner. Chapters on how to detect overstated earnings, financial position, earnings management, and operating cash flows, then follow.

In assessing the risks of, and detecting, financial irregularities, it is very important to consider the presence of factors that may increase the risk of such irregularities. Unfortunately, directors and executives of dodgy companies do not (usually) come with dark sunglasses and dragon tattoos with prisoner numbers on their foreheads. In fact, they are often highly charismatic, and their companies often proclaim allegiance to “best practices in corporate governance”. Indeed, the founder-chairman of Satyam – an example used in the book – won an Entrepreneur of the Year Award and the company won a Best Corporate Governance Award shortly before the massive fraud was uncovered.

The book covers these corporate governance risk factors in a chapter on evaluating corporate governance and related-party issues. The issues covered in this chapter include board governance and independent directors, shareowner rights, interlocking ownership or directorships, related party transactions, excessive compensation, personal use or expropriation of assets, lack of transparency and auditor issues. Although these factors are not unique to Asian companies, some are particularly serious in these companies, such as interlocking ownership and related-party transactions.

The authors use excerpts from Asian cases throughout the chapters to illustrate their points, and comprehensive cases at the end of each chapter, with summaries of what happened, the warning signs and key lessons. They also provide checklists of warning signs and analysis techniques relating to each of the topics at the end of each chapter.

In the final chapter, the authors pull it all together and provide a very useful master checklist of warning signs and analysis techniques. This checklist is particularly useful for investors, and also for directors, especially those who serve on audit committees, as a guide to possible red flags and questions to ask.

The examples used by the authors are all companies that have either been publicly alleged to have engaged in financial irregularities or have been proven to have done so. Although the true extent of the financial irregularities involved was often unknown until it was too late, these companies often had red flags well before they imploded, such as financial numbers that did not quite add up, weak corporate governance practices, unusual business practices and corporate structures, and extensive related party transactions.

However, they were able to seduce investors with their growth stories. Most of these companies have reputable investment bankers, lawyers and accountants backing their growth stories. When we see investors lapping up some of the recent initial public offerings with very similar red flags to the companies covered in this book, we are reminded once again that history tends to repeat itself.

The authors have done an admirable job with their book. I would just like to add two further thoughts.

Questionable practices

Even supposedly “bluechip” companies may engage in questionable accounting practices. For example, Olympus and Satyam, both covered in the book, were well-respected companies.

In the US, Microsoft Corporation had faced scrutiny from the Securities and Exchange Commission (SEC) for alleged “earnings management” because its quarterly earnings trend over many years was smoother than the curve of its mouse. It was alleged that this was achieved primarily by the way Microsoft defers some of the revenues from the sales of its software packages on the basis that part of the revenues had not been earned.

In my course, I also showed how reputable companies, including some of our government-linked companies, appeared to take actions to make their financial numbers look better, such as by timing the disposals of assets, changing the classification of items in financial statements, issuing debt-like securities which can be classified as equity on the balance sheet, and using asset securitisations which shifted assets and liabilities off their balance sheets even though the companies still bore the risks and rewards.

Of course, what these companies were doing were generally well within the accounting rules then. They were also not so egregious as those discussed in the book. Further, as accounting rules caught up with “innovative” business and accounting practices, many loopholes have been closed and certain creative accounting practices are now clearly disallowed. However, as the book shows, creative accounting and financial irregularities are alive and well today – even if their guises may change over time or may differ in different markets. Therefore, investors and directors need to continue to be vigilant and exercise scepticism when reviewing the financial statements of companies, even those that are supposedly bluechip companies.

My second thought which the authors touched on is how as we moved from the traditional historical-based model of accounting to today’s model of accounting which is highly reliant on fair values, we have created new loopholes for companies to exploit. While financial reporting standards (FRSes) have become more prescriptive, as we can see from the voluminous FRSes today, and fair value accounting can result in more relevant accounting numbers, accounting numbers today are often also less reliable. The scope for “massaging” financial numbers when accounting for things like goodwill, biological assets, intangible assets, complex financial instruments, and applying “fair value” accounting methods like estimating value-in-use or impairment testing, is quite considerable. Of course, it is unfair to just blame fair value accounting as financial “innovations” have introduced complexity that make financial statements susceptible to manipulation.

To conclude, the book by Tan and Robinson is a highly informative and welcome addition to the very sparse professional literature on financial irregularities and corporate governance in Asia.

The writer is an associate professor of accounting at the NUS Business School, where he teaches corporate governance and ethics



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