Companies with multiple subsidiaries are at risk of hiding negative financial results in the books of the subsidiaries
Scandals to learn from: Enron, GE, Crazy Eddie
They say that those who fail to learn from history are doomed to repeat it.
Let’s learn from the world’s worst financial scandals so that we may avoid repeating them.
Enron is by far the most interesting modern day scandal to look at. Why? Because Enron’s bankruptcy on December 2, 2001, led to the destruction of Arthur Andersen, one of the big five audit firms that also included KPMG, PwC, Ernst & Young, and Deloitte. More frightening, it is credited with triggering the 2002 Sarbanes-Oxley (SOX) Act of US Congress. SOX sought, quite forcefully, to improve transparency and protect investors.
There were, in my opinion, three main issues that led to Enron’s bankruptcy. The first was the use of special purpose entities, think of them as companies, to hide debt. This is related to the issue of having multiple related companies or, worse, deconsolidating subsidiaries so that their books do not show up on the parent’s books, allowing the parent to hide liabilities in the subsidiary that are not transparent in Enron’s books. The second issue was revenue recognition. There were multiple problems but the main one was Enron generating revenue by entering into artificial transactions with its subsidiaries. The final issue is basically “wasta,” Enron successfully lobbied for its energy trading arm to be exempt from financial regulation.
General Electric (GE) has always been viewed as a blue chip global conglomerate. However, in 2009 the Securities and Exchange Commission, America’s main market regulator, fined GE US$50 million for fraud. GE was accused of manipulating its earnings in multiple ways. One was the recognition of revenue from the sale of locomotive and aircraft spare parts before the actual sale was effected. Another was an interesting accounting irregularity in managing the volatility of GE’s interest rate swaps: GE would classify an interest rate swap as a hedge or not, only after it became clear what would have the least impact on earnings. This is illegal. The astounding thing about the GE scandal was that it took four years and cost them an estimated US$200m in lawyer’s fees. The impact of reversing these false profits was also about $200m. If GE, that blue chip of blue chips, can stumble in this way then what company is immune?
If you were in the US in the 1980’s or early 1990’s then you have probably heard of Crazy Eddie, a consumer electronics chain. His jingle was “Crazy Eddie, his prices are insane!” The initial fraud perpetuated by Eddie Antar, the titular Eddie in Crazy Eddie, was basic; mostly the skimming of cash. But that was a fraud on the tax collectors. The fraud on the public, however, is what is instructive for the GCC. Eddie decided to IPO his stores and to get a higher price he did two things. First he slowly decreased his skimming so that the profit margin for the company looked like it was going through the roof. But the true criminal innovation was that Eddie used the money he had skimmed to generate fake sales, boosting both revenue and profit. This boosted the IPO price.
So what have we learnt so far?
From Enron we learnt that subsidiaries can be used to both hide debt and losses as well as increase profit via artificial transactions with those same subsidiaries. From GE we learnt that timing of revenue recognition as well as classification of revenue can easily be tampered with. From Crazy Eddie we learnt how self-dealing can easily inflate revenue and profit.
What does that mean for investors?
Companies with multiple subsidiaries are at risk of hiding negative financial results in the books of the subsidiaries. At the same time, fake or low quality profits can be generated by trading with those subsidiaries. Investors in such companies should demand from the board clear and separate reporting of all relevant financials as well as clearly highlighting inter-company transactions and the basis for the pricing in such transactions.
The second conclusion is that companies must provide a clear explanation of their revenue classification and recognition policies for every line item. Investors need to learn to review all the notes of the financial statements of a company.
The third conclusion is to be on the lookout for sudden inflation of financial performance. Crazy Eddie did this by decreasing the amount he was skimming as well as using previously skimmed funds to pump up revenues. But it does not have to be so convoluted. You can improve a share price not only by inflating revenue and profit but by also manipulating the market. This can include, but is not limited to, starting rumours, buying and selling between related parties to create the appearance of investor interest, or ramping up prices by buying a small amount of shares in an illiquid stock.
One indicator of potential fraud that I have found useful is the difference between the income statement and cash flow statement. There will always be a difference in timing of revenue and expense recognition, but if profit is consistently increasing whilst cash flow is consistently decreasing and/or negative, then you might want to dig a little deeper.