The World Is Facing a Wave of Corporate Fraud. How to Spot Cheaters
It is during recessions that companies that falsify documents and deceive investors are most actively detected in the market. The Economist explains this addiction and tells you where to look for potential scammers this time.
Ten months after the U.S. stock market hit its latest all-time high, big tech stocks have suffered yet another decline. Hopes that the US Federal Reserve would change course did not come true: the increase in interest rates would be more serious than previously thought. The bond market is signaling the onset of a recession. Could it be worse? Of course yes. Boosting periods in the stock market, such as the one that peaked in January, are usually accompanied by an increase in fraud. And the obvious deception becomes when there is a recession.
“There is an inverse relationship between interest rates and the level of swindle,” argues American investor Carson Block, who expects the market to fall further. A decade of extremely low borrowing rates has allowed companies to build up substantially cheap debt. The history of these debts is often not the most transparent and hides a number of frauds. They come to the surface when it’s time to repay loans. The global financial crisis of 2007-2009 exposed fraud and disorder in the mortgage lending industry. The stock market crash of the early 2000s exposed the deceptive dot-com prosperity and falsified accounting records at Enron, WorldCom, and Global Crossing. And someone may remember the corporate scandals of the 1980s, resulting in the bankruptcy of the textile company Polly Peck and the media holding Maxwell. It is likely that during the next economic downturn we will learn about new cases of corporate fraud.
Where exactly it will declare itself, while experts can not say for sure. Everyone puts forward their own version. It is likely that some scandals may arise on the basis of investing in ESG companies (that is, those that comply with the principles of sustainable development in terms of environmental friendliness, social responsibility and corporate governance quality.). In May, the German police raided the office of the DWS management company in connection with suspicions of greenwashing (speculation on the topic of ecology.). It may also become known about companies that illegally exercised the right to state support during the pandemic. The fact is that in order to provide assistance as quickly as possible, the necessary checks were not strict. Some cases of forgery have already come to the surface.
The eternal problem of falsification of financial statements also declares itself. Fraud plots develop predictably, but each time there are nuances. Finding a scammer is not easy. However, there is a diagram that will at least help narrow the search. This is the so-called triangle of fraud, which includes elements such as pressure, opportunity, and justification.
Pressure is what encourages fraud, and not necessarily from outside. When your face is on the cover of the next issue of Business Genius magazine, “you begin to completely identify with this guy. After all, you are the CEO of a unique company,” says Carson Block. So the very thought that things are not so rosy can be daunting. The public often has unreasonable expectations of leadership, says Andy McNeill of the Texas-headquartered Association of Certified Theft Investigators (more than 90,000 members).
Therefore, companies are ready to go to great lengths to justify the hopes placed on them. So, on the eve of the financial crisis, bankers deceived the supervisory authorities. Volkswagen misled officials from the US Environmental Protection Agency (EPA) about the emissions of its vehicles. The scandal that erupted in 2015 was called dieselgate. CEOs of publicly traded companies usually try to appease portfolio managers, analysts and traders, and do so by manipulating accounting profits. Stock market participants look to earnings as an indication of how well a company is doing and what a fair price for its papers is. The loss of part of the income can lead to serious punishment. Meta shares (recognized as an extremist organization in Russia and banned) the owner of Facebook, lost 25% in October after the release of quarterly profit data that disappointed investors. In addition, a significant portion of the CEO’s salary is linked to the share price, so they do everything possible to achieve their planned profits.
Some research shows that CEOs feel bound by the need to achieve projected profits. Nearly 400 executives surveyed in the mid-2000s by academics John Graham, Campbell Harvey, and Shivaram Rajgopal said they prioritized income stability. Most of them admitted that they were willing to put aside large expenses in order to reach their quarterly earnings goal. More than a third said they would report revenue this month rather than next month and encourage customers not to delay purchases. In any case, stable profits are now highly valued by the market. Investors give a premium for securities of reliable issuers, or the so-called blue chips. Those companies that do not live up to expectations will face difficulties. Some leaders go for falsification
To go down the path of fraud, it is not enough just to have reasons for it. The conditions must be suitable. In many ways, the set of opportunities depends on the jurisdiction in which the company is registered. Where the rule of law is not respected, there are more opportunities for falsification. This is typical for countries with developing economies. Some bear market participants (the so-called bears) are now looking at Chinese firms listed on foreign exchanges. It is extremely difficult for investors to obtain comprehensive information about their financial condition. One of the finds for the “bears” in 2020 was the Chinese coffee company Luckin Coffee. In the US, the company had to pay a $180 million fine for defrauding investors. Similar problems may arise for Indian companies:
In wealthy countries, a condition that favors fraud is the diversity of accounting practices. Profit is a relative concept. In the case of a simple business, like a lemonade stand, profit is the difference between the money that is made from selling lemonade and the money that goes into buying lemons. When it comes to a more complex business, it becomes necessary to take into account non-cash items or accruals, that is, amounts that should be received under the terms of transactions, but have not actually been received yet. They also include those expenses that will reduce profits, but also have not yet been taken into account in the current period: depreciation and amortization, contributions to pension funds, written off debts, and so on. “There are a lot of such articles in accounting,” notes Steve Cooper,
Companies can freely change the amount of accruals. Amazon Web Services, the cloud services division of the well-known online retailer, said it would extend the life of its servers by a year. This in turn will lead to lower depreciation charges. And it’s completely legal. No one really knows the useful life of fixed assets such as servers (airplanes, office buildings, and so on). Therefore, in some companies, the accrual of expenses may be delayed, and income that has not yet been received, on the contrary, be taken into account in the current period.
After all, profit margins must be consistent with the cash flows that the company generates. However, firms that don’t earn much tend to borrow money to hide this fact. Experts are well aware of this, and this is one of the reasons scammers go to great lengths to disguise their true debt burden. Another reason they do this is to avoid a credit downgrade, which would increase the cost of borrowing for them.
And finally, the third risk factor is justifications for fraud. According to Carson Block, some adventurers are real sociopaths who do not feel the need to justify themselves to anyone. However, the likelihood of fraud increases if company leaders find an excuse for themselves. “Everyone does it” is something you often hear from people who aren’t doing anything illegal. Some of those who resort to fraud cover themselves with altruism, telling themselves they are doing it to save jobs or investor confidence. “It’s only done temporarily” is another common explanation, McNeil says.
Manipulating financial statements may seem like something acceptable to company management if they sincerely believe that the business has good prospects in the long run. According to a crisis manager who was invited to work in one such company, this is a classic story. Business worked well. The leadership believed that they had found the key to success. But then problems set in, which were exacerbated by the recession. I had to cut costs to keep profits at the same level. However, cutting costs only harmed the business. I had to escape reality somehow. Then the company began to manipulate the reporting.
How many such cases will arise during the next recession will depend on its strength. Deception is easier to hide during a short recession. If the recession is prolonged, there will be many revelations. The least will go to companies whose management did not go beyond the law, but negatively affected their development prospects. This group includes companies whose directors are so eager to control the level of income that they save on investments in the development of production facilities and the development of new products or brands. Also, these are firms where they are so preoccupied with cutting costs that they have ruined relationships with suppliers and employees.
Companies that pay too much attention to accounting indicators are not breaking the law. However, such an obsession may eventually end up in manipulation of reporting. The management of some firms that have skyrocketed but are now on a losing streak may decide to play with the numbers in the hope that good times will soon come again. Most often, such companies resort to fraud in the event of a drop in income. In a post-pandemic economy, other triggers could be triggers, such as overstocking or supplier failures. Share prices for Walmart and Target fell sharply in May after retailers said they misjudged demand for certain product categories and were left with large stocks of unsold items. It is easy to imagine that there will be less open firms
In addition, there are companies that actually produce almost nothing. This category includes, for example, the well-known German fintech Wirecard, which went bankrupt in 2020. So did the startup Nikola, which was going to make trucks powered by batteries. Its founder, Trevor Milton, was found guilty in a New York federal court in October of defrauding investors. In light of the recession, there will be more such examples. In recent years, a lot of venture capital has been indiscriminately invested in rather dubious ventures. The valuations they received during the booming markets already look fantastic. As, however, and the business models of many of them.
The venture capitalists who back them may try to smooth this over. Their commissions depend on the value of these companies, and the shares of the latter are rarely traded. This gives VC fund managers the ability to manipulate their value. The same applies to the area of private wealth management. Both venture capitalists and private equity firms that specialize in established businesses are notorious for how slow they are to reprice their investments in difficult times. When it comes time for a fund manager to sell an asset, the market value of the asset should be clear. But these days, “exiting” private equity often involves reselling assets to other funds run by the same management company. Such castling is often associated with abuse.
The 2010s, a time of slow economic growth and low rates, was a favorable period for the emergence of various kinds of scammers. Undoubtedly, there are those companies where all three risk factors have worked. Does everyone do that? Maybe. But during a recession, even legitimate accounting manipulation, acceptable when the economy is booming, will be judged much more severely.