Financial Statement Manipulation and Fraud: A Dirty Dozen Warning Signs

Controversy again erupted on the stock market recently with first Sino-Forest Corp (TSX: TRE) being accused of illegal deceptive financial reporting and then Silvercorp (TSX: SVM) too being accused of falsifying data. Though the verdict on the accusations is not in for these two companies, it reminds us that financial misrepresentation does happen, ranging from dubious but often legal earnings management through to outright falsification and fraud.

Whether dishonest perpetrators eventually get caught or not, in the meantime investors can lose a lot of money since the inevitable result of the malfeasance is big losses in stock value and often total loss. It's better to detect problems in the first place and either avoid the stock altogether, or for those brave enough, such as those first raising the stink about Sino-Forest and Silvercorp, short-sell the stock.

To that end, we offer a list of warning signs that something may be amiss in a company. Most of these signs are culled from two books: Financial Statement Analysis (4th edition) by Martin Fridson and Fernando Alvarez and; Swindlers by Al Rosen and Mark Rosen (reviewed by CanadianFinancialDIY, by Jonathan Chevreau in the Financial Post and by CorporateKnights)

1. Unexpected turnover of senior management - e.g. the sudden resignation of the Chief Financial Officer or the CEO
2. Late financial statements - companies must publish results within a certain time after quarter and year-end dates; e.g. the Ontario Securities Commission sets out deadlines here
3. Incomplete quarterly statements - e.g. missing the Balance Sheet or Cash Flow Statement
4. Professional financial analysts state they cannot understand the company's financial statements - Fridson and Alvarez note that such was often said about Enron before it went up in smoke. They cite Warren Buffett's trenchant comment - "... if you cannot understand the footnotes [in financial statements], it is because management does not want you to."
5. Board members not sufficiently independent of management or not very experienced or with little ownership stake or simply a Board that is too small - this forms part of overall corporate governance, which we reviewed in our post Stocks and Corporate Governance: Do the Good Guys Finish First or Last?
6. Infrequent meetings of the Board audit committee - on the other hand, it is a good sign when the independent (i.e. not family or business relations of senior managers) committee members meet more than twice a year (see study in next bullet)
7. Members of the audit committee had short term stock options - see Corporate Governance and Earnings Management (download here from SSRN) by researchers Sonda Marrakchi Chtourou, Jean Bédard and Lucie Courteau
8. Management untrustworthy on other grounds - Fridson and Alvarez give the example of insider trading by Richard Scrushy at HealthSouth before it imploded
9. Related party non-arm's length transactions and private companies set up by executives to do business with the public company - these situations present opportunities for the executives to enrich themselves at the expense of the public company and its shareholders
10. Corporate restructurings - where there is the danger that excessive costs are written off, creating a cookie jar account reserve that management can use later to boost earnings as the high costs do not come to pass.
11. Industries that are more susceptible include non-manufacturing, non-retail sectors like finance, credit unions, banks, insurance, real estate and not surprisingly, resources
12. Weasel words in earnings conference calls - we can listen carefully to those post-earnings conference calls where management explains results to professional analysts (which the Internet now makes possible for individual investors to listen in on - get links from the company investor relations website area or a news website like CNW's webcast listing). According to David Larcker and Anastasia Zakolyukina's paper Detecting Deceptive Discussions in Conference Calls, the question and answer time at the end is where "... the answers of deceptive executives have more references to general knowledge, fewer non-extreme positive emotions, and fewer references to shareholder value. In addition, deceptive CEOs use significantly more extreme positive emotion and fewer anxiety words."

None of these warning signs is necessarily sufficient to conclude that hanky-panky is going on. Combinations of factors along with actual digging through the accounting statements is required to arrive at a determination. Nor is it 100% sure that even with the utmost expert due diligence - that was the depressing take-away from the Enron situation where pretty well everyone was oblivious to the fraud - will it be possible to detect every fraud. Nevertheless, paying attention to warnings signs and checking out the situation can help avoid investing grief.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.