Relationship Secrets 163: Financial Statement Fraud

You know the old adage: “Financial statements don’t kill people, people kill people.”

While it is true that there may be misrepresentation and deception in a financial statement (FS), the document is not inherently wrong, it is the bad intentions of the preparer or the company that are to blame.

As credit analysts, we always review and depend on FS when signing bonds. We know that there may be attempts to mislead our judgment or even outright deception. But the need to evaluate the financial report is inescapable. It is considered a valuable “management quality report card”.

There are three levels of financial presentation by Certified Public Accounts (CPA):

  1. Compilation: a properly organized report where the numbers have not been verified or evaluated by the CPA.
  2. Review: Includes a verification “review” of the key elements.
  3. Audit – This is the highest level and includes the CPA’s statement that they have verified and believe the numbers are correct.

The reader of the FS is entitled to certain expectations: A sincere and complete presentation that informs the reader. They have the right to
more What that? Does the reader sometimes expect
too?

Let’s consider what the FS actually says and what it doesn’t …

The balance sheet

This shows assets and liabilities. Describe the company’s dollars (assets) and who owns them (liabilities and equity). You know a lot of the normal inputs: cash, accounts receivable, accounts payable, inventory, bank debt, the equity / shareholders’ equity section, etc.

The balance sheet always has a date, such as 12/31/2017. Shows the status of these accounts in one day. Credit analysts calculate working capital, also known as Net Quick (NQ), which is considered a measure of short-term financial strength. The NQ is obtained by subtracting current liabilities from current assets. When the bond subscriber has the NQ number, he can be incorporated into the decision-making.

What size bond will be approved for this applicant? How much total capacity can they be allocated? The NQ figure becomes a benchmark that is used to remember the year.

For many analysts, this number has a big effect over the next 12-15 months.

Let’s fast-forward one day to 1/1/2018. “Happy New Year!” and let’s check the bank account. Some money has come in! Accounts receivable and cash have changed. There have also been other changes, and therefore if we calculate the NQ based on the 1/1 balance, the NQ will probably be different from 12/31. Again, that’s because the balance sheet shows the status of these accounts in ONE DAY. It is always changing!

The reality is that the working capital number is only correct for one day, then it is subject to change. This is not to say that the number is not important or relevant. And certainly decision makers must have benchmarks and a method for their determinations. It is very important, but so are other elements.

Financial statement fraud

The most common FS fraud is not committed against us by third parties. It’s the self-deception we commit by relying too much on these “one-day numbers.” To do so is to lose the big picture!

Subscribers love to see a big cash account on that top (balance sheet) line. But that’s a one-day number. Isn’t it even more important to determine the average amount of funds deposited over the previous six months or years? Many analysts do not ask for this information.

Accounts Receivable and Payable – Here’s another key area where the “one-day number” can easily be given historical perspective. Aged A / R and A / P schedules are easy to obtain and give a more than one day perspective. These documents are not automatically included in the FS and may not be required by insurers.

Conclution

As readers of these papers and analysts, let’s not fool ourselves by relying too heavily on the balance sheet or thinking that it is more than a snapshot of a day. It should be analyzed and viewed in harmony with other key underwriting factors such as mid-year financial reports and supporting documents.

In this way, subscribers can make realistic and well-informed decisions.

Leave a Reply

Your email address will not be published. Required fields are marked *