Can Audited Financial Statements Truly Be Trusted?
Although you may never think about it, every investment that you make relies on the accuracy of the figures that a company reports in its financial statements. The fact that an audit firm has certified these is very reassuring.
In fact, the process of maintaining a company’s accounts is highly regulated. The accountant has to follow a strict set of rules and must abide by well-established norms that specify how a company’s revenues and profits are to be calculated.
After a company’s accounts are prepared, the auditors study them in great detail. They also perform checks that could involve obtaining confirmations from the parties that the company deals with. This practice could include contacting the company’s bankers and debtors directly.
All these procedures have one common goal. They seek to ensure that the accounts reflect an accurate picture of the company’s financial position.
How effective are auditors?
But are audited financial statements infallible? Do they always contain information that is correct? Unfortunately, accounting frauds are all too common. At times, the company’s auditors are willing partners in cooking the company’s books.
Consider the fact that KPMG, one of the Big Four, has been General Electric’s auditor for the last 109 years. In 2009, the U.S Securities and Exchange Commission (SEC) accused the US$120 billion giant of accounting fraud. The company paid US$50 million to settle the charges.
In November last year, the SEC began a new investigation into GE’s accounting practices. Now, shareholders are asking for KPMG’s removal. They are questioning the auditor’s role in GE’s dodgy accounting practices.
Sadly, KPMG’s record is not too good. They are also the auditors for Wells Fargo, a leading American bank that has been accused of opening 3.5 million fake accounts.
Here are a few examples of accounting frauds and the manner in which they were committed:
NEL Group – auditor highlights round tripping
The company, which had interests in the distribution of high tech products and the oil and gas sector, was listed on the Singapore Exchange in May 2000. Towards the end of 2008, KPMG, who happened to be the auditors of a company named Advance Modules, submitted a confidential report to the finance minister of Singapore pointing out that Advance Modules and NEL had entered into a fraudulent round tripping transaction.
Round tripping involves two or more companies buying and selling goods from each other with the purpose of inflating sales and profits. It is not a regular business transaction.
Interestingly, KPMG happened to be the auditor of NEL too. Subsequently, NEL removed KPMG as its auditor, and under the direction of the Singapore Exchange, appointed a new special auditor to look into its accounts.
What effect did these shenanigans have on NEL’s share price? The company’s stock fell to four cents on November 27, 2008. After that date, trading was suspended.
Enron – how the fraud played out
At one point, Enron was a stock market darling. In August 2000, the company’s shares were trading at US$90.56. Barely 15 months later, Enron declared bankruptcy, and investors saw prices crash to US$0.26.
What went wrong at the company that had made an enormous success of trading in natural gas commodities? In a short period, Enron had managed to become the largest natural gas merchant in the U.S. and the U.K.
In November 2001, Enron declared that it had overstated profits by US$600 million over the prior four-year period. The company’s auditor, Arthur Andersen, had failed to point this out. In fact, the accounting firm later admitted that it had destroyed documents related to the company’s audit. Arthur Andersen was convicted for obstruction of justice, and the 28,000-employee company had to close down finally.
The fallout of the Enron scandal was not restricted to the auditors. J.P. Morgan Chase and Citigroup, two of the company’s bankers, also suffered large financial losses. They paid a total of US$255 million into a fund for fraud victims to settle charges.
WorldCom – market cap of US$175 billion to zero
WorldCom was a telecom giant headed by Bernard “Bernie” Ebbers, a flamboyant Canadian famous for his cowboy boots and a ten-gallon hat. Under his charge, the company overstated profits by billions of dollars by recording expenses as capital assets. The total value of the fraud was US$11 billion.
When the fraud was discovered, Bernie Ebbers who was a former milkman with no accounting knowledge said that the company’s CFO had masterminded it. WorldCom’s auditor was the hapless Arthur Andersen, the accounting firm that had recently been convicted for shredding Enron’s documents.
WorldCom’s shareholders lost a massive US$175 billion. Bankers Citigroup, Bank of America, and J.P. Morgan settled lawsuits with creditors by paying out US$6 billion.
Bernie Ebbers was sentenced to a jail term of 25 years and Scott Sullivan, the CFO of the company, who testified against Ebbers, received five years.
You are never safe
A corrupt CEO, a compliant CFO, and an auditor who is willing to turn a blind eye to the company’s fraudulent practices can be a disastrous combination for investors. It’s likely that history will repeat itself and new frauds will continue to surface, wiping out large sums of investors’ money.
How can you avoid investing in a company that has cooked its books of accounts? That’s extremely difficult. If the fraud has got past the regulators and the experts in the asset management companies, what chance do you have of spotting it?
But there is one precaution that you can take. If the financial performance of a company seems too good to be true, it probably is. Bernie Madoff, the Wall Street financial adviser and stockbroker, provided consistent returns of between 12% and 13% year after year to investors, regardless of the performance of the stock market.
By the time the Ponzi scheme that he ran was discovered, thousands of investors had been cheated. The total losses added up to about US$50 billion.