INVESTORS, BEWARE OF COCKROACHES


Published September 17, 2017

By Mak Yuen Teen

According to Warren Buffett: “In the world of business, bad news often surfaces serially: you see a cockroach in the kitchen; as the days go by, you meet his relatives.”

Mr. Buffett was speaking to The Guardian following the accounting scandal at Tesco in the UK in September 2014, where Berkshire Hathaway reportedly lost US$444 million from its investment. The scandal had to do with how Tesco recognised “commercial income”, which are promotional fees, discounts and rebates from suppliers. Buffett candidly admitted that he was too slow to react to the escalating problems and was guilty of ‘thumb-sucking’ –  a term coined by his long-time business partner Charlie Munger to describe the delay in acting when things are going wrong.

Prior to the scandal, Tesco had disclosed that it had complied with all provisions of the UK Corporate Governance Code, except for one non-executive director missing the AGM and the company not having yet adopted re-tendering of the external audit every 10 years. It had a non-executive chairman who met independence guidelines at the time of his appointment as recommended by the UK Code, 8 out of the total board of 12 directors being independent directors, and relatively healthy gender diversity with 3 female independent directors.

Unfortunately, the risk of erroneously concluding that a company has good corporate governance based on claimed adoption of “best practices” can be quite high. Companies may score well in corporate governance ratings because they make the disclosures or adopt the practices incorporated into these ratings, but have other failings not reflected in them.  Companies (and individuals) sometimes win corporate governance-related awards more because of recent business performance or profiles, not because of outstanding corporate governance. It is therefore important for investors to look out for red flags, even if companies win corporate governance-related awards or are ranked highly on corporate governance ratings.

Accounting and corporate governance scandals are often preceded by the presence of certain red flags. In Tesco’s case, none of the non-executive directors had prior experience in retail. There were repeated profit warnings. The remuneration policy for management was very heavily weighted towards financial performance. The group CEO and CFO had maximum potential upside of 525% and 425% of their respective annual salaries through the annual bonus and long-term performance share awards, with a slightly higher weighting towards long-term incentives. For the annual bonus, about 75% was based on underlying profit performance and 25% on non-financial strategic objectives, while the vesting of the performance share awards was based entirely on growth in return on capital employed and earnings per share. In the two financial years preceding the scandal, neither individual received any annual bonus or performance share award.

A challenging business environment, coupled with tremendous financial pressure to deliver financial results, increases the risk of aggressive accounting.

PricewaterhouseCoopers (PwC), Tesco’s auditor for 30 years, had in its 2014 report identified the judgment required and risk of manipulation in recognising commercial income as an area of particular audit focus. However, the audit committee said in its report that it considered that management operated an appropriate control environment which minimised risks in this area and therefore it did not consider it to be a significant issue for disclosure in its own report.

Here in Singapore, Yamada Green Resources (Yamada), a Chinese company listed on the Singapore Exchange (SGX), announced on September 4 that it had requested for a second extension of time to release its FY2017 annual results and hold its FY2017 AGM. It said that fire involving a vehicle transporting certain finance documents and IT/computer hardware had resulted in the destruction of some of these documents and hardware. Management would therefore require time to reconstruct the documents and the audit will be delayed.

The following day, it announced that the further extension “is also intended to provide more time for the Company’s external auditors, BDO LLP, to perform additional audit works in relation to certain inconsistencies in the Group’s financial records and other audit queries which were raised by the external auditors to the Audit Committee in the course of their audit for the Group’s financial statements for FY2017.”

When Yamada sought the first extension on August 25, it cited high staff turnover in the finance team (another common reason given by companies applying for extensions) and the auditors requiring more time to complete the audit as the group expected a material loss due to unfavourable conditions in its cultivation business, including bad weather conditions such as typhoons and higher than average temperatures, rising labour costs and slowdown in the Chinese economy.

This followed an earlier profit warning on August 11 signalling expected losses for the fourth quarter and the full financial year.

 Yamada is just the latest S-chip to lose its accounting records to fire or other mishaps just as they were facing questions about their financials. In April 2011, Sino Techfibre claimed that a fire had broken out at its office premises in China, destroying all the company’s accounting records, including original journal vouchers and supporting documents, for the period from January 2008 to February 2011. In December 2012, China Paper announced that a fire in its office premises had destroyed its financial records for FY2011, partially damaged its financial records for the first eight months of 2012, and severely damaged those for September to November 2012.

A mishap of a different kind happened at China Sun Bio-chem in 2009. After KPMG was called in to review the company’s accounts following concerns about its cash balance raised by its then auditors PricewaterhouseCoopers, the company announced that the truck transporting the company’s accounting records had been stolen while the driver was having his dinner – preventing KPMG from doing its review. Another Chinese company, China Animal Healthcare, which delisted from SGX in August 2013 and listed in Hong Kong, lost five years of its financial records in the middle of an investigation ordered by Hong Kong regulators. The records were apparently stolen from a truck transporting them while the driver was having his lunch.

Perhaps the next S-chip scandal will involve a vehicle on fire crashing into the office premises causing all financial records to catch fire. Certainly, the accounting records would be too much for the CFO’s dog to have eaten them all.

Using the companies included in the annual corporate governance case studies collection published by CPA Australia which I edit (including volume 6 due out in October this year), I have been working on a project to identify early warning signs and red flags present in Singapore, Asia Pacific and global companies engulfed in recent corporate governance and accounting scandals.

I am planning to publish a report on this in the first half of 2018. Hopefully, this will help investors spot cockroaches before they find out that the whole place is infested.

________________________________

The writer is associate professor of accounting at the NUS Business School where he teaches corporate governance. He has been involved in developing several corporate governance ratings and has chaired or served on several selection committees for corporate governance-related awards.

Comments are closed.