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Financial shenanigans, financial statement fraud
In early 2001, Joe Nacchio, the chief executive officer of Qwest Communications, stood onstage at a company-wide meeting and delivered a rousing speech intended to energize his team and focus it on his priorities for the company
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n early 2001, Joe Nacchio, the chief executive officer of Qwest Communications, stood onstage at a company-wide meeting and delivered a rousing speech intended to energize his team and focus it on his priorities for the company. “The most important thing we do is meet our numbers,” Nacchio declared. “It’s more important than any individual product; it’s more important than any philosophy; it’s more important than any cultural change we’re making. We stop everything else when we don’t make the numbers.”
Through his words and deeds, Joe Nacchio created a culture that resulted in US$2.5 billion of phantom earnings, landing himself in federal prison and devasting investors who saw the stock price tumble by 97 percent in the 18 months following his speech. Actually, there are still many other cases related to financial statement fraud, such as Waste Management Inc., WorldCom’s, Enron’s cases and so on.
In June 2019, the Indonesia Financial Services Authority (OJK) announced that Garuda Indonesia’s financial report was faulty and ordered the airline to pay Rp 100 million ($7,140) in fines. Each of the airline’s seven directors and five commissioners also has to pay the same amount in fines.
The Finance Ministry, in its capacity as the supervisor of public accounting practices, also slapped a one-year ban on the public accounting firm that audited Garuda’s financial report.
The financial statements are designed to provide economic information and measurement of the resources and performance of a company as a basis for decision making. Good and qualified
financial reporting will provide a clear picture of the company’s performance and future prospects to the investors.
Asymmetry information arises when there is an imbalance of information acquisition between the management as a provider of information and the shareholders and stakeholders as general users of information.
Financial shenanigans are actions taken by management that mislead investors about a company’s financial performance or economic health. As a result, investors are tricked into believing that the company’s earnings are stronger, its cash flow more robust and its balance sheet position more secure than they really are.
Some shenanigans can be detected in the numbers presented by carefully reading a company’s balance sheet (formally called the statement of financial position), income statement (statement of operations) and statement of cash flows.
Signs of other shenanigans might not be as easily detected in the numbers and instead require scrutiny of the narratives contained in footnotes, quarterly earning releases and other representations by management.
Financial statement fraud is just what it sounds like — falsifying balance sheets, income statements and cash flow statements to fool those who read them. The fraudster may be out for personal gain, or be trying to keep the business afloat.
False financial statements are among the many varieties of accounting fraud. They can involve multiple crimes, including securities fraud and prejury.
Unsurprisingly, many people commit financial statement fraud for personal gain. If their bonus depends on how much revenue their department brings in, it’s in their self-interest to inflate revenue on the income statement.
If company performance was poor, the company’s management may keep the owners happy by writing false financial statements to say otherwise.
Management fraud schemes aren’t necessarily about enriching the scemers. The business owners or top management may manipulate the accounts to make the company look healthier to investors or lenders. They can do this by either inflating income and asset values, or underplaying the company’s debts and liabilities.
One of common tricks in committing fraud is to falsify the value of an asset. If, say, a stock investment loses value, the company is supposed to reflect that on the balance sheet. Not doing that makes the company’s assets look more valuable than they are.
People who engage in fraud do not use a single trick; they often use multiple tricks. They may perpetrate other kinds of fraud, as well.
Legendary investor Warren Buffett generously uses his annual letter to shareholders as a vehicle to educate all interested parties about the art of investing. Buffett uses the story of X-rays to warn investors about companies that try to hide the truth about their deteriorating business’ economic health by touching up the financial statements.
No doubt, a company’s use of financial shenanigans to paper over its poor economic health would be no more effective than a doctor touching up X-rays to improve a patient’s physical health. Such gimmicks are pointless, as the truth of the company’s deterioration will remain unchanged and will ultimately come to light one day.
Companies with structural weaknesses or inadequacies provide a fertile breeding ground for financial shenanigans.
Investors should probe a company’s governance and oversight by asking these questions: (1) Do appropriate checks and balances exist among senior executives to snuff out corporate misdeeds? (2) Do outside members of the board play a meaningful role in protecting investors from greedy, misguided, or incompetent management? (3) Do the auditors possess the independence, knowledge and determination to protect investors when managers act inappropriately? (4) Has the company improperly taken circuitous steps to avoid regulatory scrutiny?
The independent auditor plays a crucial role in protecting investors from dishonest management and an indifferent and ineffective board of directors. The auditor, however, can be either friend or foe to investors: a friend if the auditor is competent, independent and fastidious in sniffing out problems; a foe if the auditor is incompetent, lazy, or a “rubber stamp” for management.
Sometimes the very high fees and close personal relationships built up over years lead to botched audits and big losses for investors. Here are the key factors to consider when evaluating into which camp the auditor falls — friend or foe:
OJK Regulation No. 1/2017 and and OJK Circular No. 36/2017 state that the appointment of a public accountant and/or public accountant firm to will carry out a general audit of the financial statements of a financial services institution must be proposed by the board of commissioners, which shall consider the recommendations of the audit committee.
The audit committee is essentially an oversight committee for its managers, who are responsible for the internal controls and the financial statements.
The committee however, has to satisfy itself, on behalf of the board and ultimately the shareholders, that key controls are operating, that ethical practices are being reinforced, that key accounting estimates and judgements are being properly made and that internal and external audits are effective.
On the other hand, besides audit committees carrying out their duties and responsibilities properly and public accountants who conduct general audits being independent, supervisors should more quickly sniff out the existence of financial statement fraud in public companies and financial institutions.
Finally, investors and stakeholders must be able to comprehend and analyze a company’s financial statements comprehensively to minimize financial losses that might occur and encourage implementation of good corporate governance.
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Audit Committee member of state-owned PT Bank Rakyat Indonesia (Persero), Tbk. The opinions expressed are his own.
