Bonding 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 can 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 unavoidable. It is considered a valuable “management quality report card.”
There are three levels of financial reporting by Certified Public Accounts (CPA):
- Compilation: a properly organized report where the numbers have not been verified or evaluated by the CPA
- Review – Includes some key item “Review” checks
- Audit: This is the highest level and includes the CPA’s statement that they have checked 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
plus what that? Does the reader sometimes wait
too?
Let’s consider what the FS actually says and what it doesn’t say…
the balance sheet
This shows assets and liabilities. Describe the dollars in the business (assets) and who owns them (liabilities and stockholders’ equity). You know many of the normal entries: Cash, Accounts Receivable, Accounts Payable, Inventory, Bank Debt, the Equity/Stockholders Equity section, etc.
The balance 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 found by subtracting current liabilities from current assets. When the bond underwriter has the NQ number, they can be incorporated into the decision making.
What size bonds will be approved for this applicant? How much total capacity can be assigned to them? The NQ figure becomes a reference point that is used for the reminder of the year.
For many analysts, this number has a big effect over the next 12 to 15 months.
Fast-forward one day, to 1/1/2018. “Happy New Year!” and we will check the bank account. Some money has come in! Accounts receivable and cash have changed. Other changes have also occurred and so if we calculate the NQ based on the 1/1 balance sheet, the NQ will probably be different from the 12/31. Again, that’s because the balance sheet shows the status of these accounts 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 reference points 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 others. It’s the self-delusion we commit by relying too much on these “one-day numbers.” To do so is to miss the big picture!
Insurers love to see a big cash account on that top line (of the balance sheet). But that’s a one day number. Isn’t it even more important to determine the average funds on deposit for the previous six months or year? 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. Past A/R and A/P schedules are easy to obtain and provide more than a day’s perspective. These documents are not automatically included in the FS and may not be requested by subscribers.
conclusion
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 one-day snapshot. It should be examined 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.