Updated: May 14
Welcome to the last part of our series on "Ratio Analysis 101". For this article, we will be concluding the series by concentrating on the quality of financial data. We cannot emphasize enough the importance of the accounting data quality as the output of your analysis is very much dependent on it. Investment and managerial decisions made on the premise of poor quality data might yield unfavourable results and damage shareholders' value.
Keep an open mind and a sceptical mind. Capital is the much-needed lifeblood that keeps a business running and enables it to grow. In this market dominated by fierce competition for investors' capital, there are unscrupulous managers out there who paint misleading pictures of the company's finances to investors, enticing them to invest. We will examine what motivates them, some common tools and more importantly, how to detect and correct them. Without further ado, let's get started!
TABLE OF CONTENT
The Benford's Law
Understanding Cash Flow
Degree of Leverage
To understand accounting shenanigans, we need to first understand who are the users of the financial statement. There are internal users such as the board of directors, managers, and employees, who use financial data for the operation of the company, strategic budgeting, determining compensations, corporate finance activities, etc. Being corporate insiders, they enjoy a degree of access to information that is normally unavailable to external investors such as investors, creditors and regulators.
However, the insiders hired to run the money are not owners (as in major shareholders) of the company and they might not necessarily act to the full benefit of the shareholders. In addition, they possess an information advantage do not lose the capital invested when the company goes south, so managers are often compensated for results but seldom sanctioned for poor performances
The above graph illustrates how corporate finance work.s We have a little challenge for all my readers here. Look at the links between the providers of capital, the board of directors and senior management and try to identify if there is any potential for a breakdown at any point?
Accounting shenanigans can range from loose interpretations of the accounting standard to outright frauds. Self-interested managers who have information asymmetry may misrepresent the company's finances in an attempt to mislead external stakeholders for various reasons.
Agency conflict is the conflict of interests between the owners of a company who would ideally have the value of their shareholding maximized and the agents whom they hired to run the company to generate returns. The agents, whom we term as managers, might harbour other ideas of enriching themselves at the expense of the owners. For example, the compensation for managers are up-for-voting in the AGM and to justify their paycheck, managers have to generate returns in terms of dividend and capital gain. Good financial performances generally increase the share price and the reward of managers. So when performance is suboptimal, some managers might be tempted to overstate profit to continue enjoying the benefit.
For public-listed firms, the voting power of shareholders is further diluted by a large shareholder base. Combine that with managers who have absolute information asymmetry, it creates an environment that encourages moral hazard (benefits from upside but costs nothing if it fails), and opens the pandora box for frauds and malfeasance if there are insufficient countermeasures.
To address that, a board of directors comprising of largely "non-executive, independent" directors is required to be appointed in many jurisdictions for listed firms. This system is also used by larger private firms where agency conflicts exist.
The board's role is to appoint and oversee the managers, conduct self-regulation and oversee the firm's executive nomination and compensation, risk-management, compliance and external audit processes. Agency conflict does not occur in a sole proprietorship where the owner and manager is the same person.
THE FRAUD DIAMOND
This framework is a comprehensive model that explains why and how frauds are enabled and committed.
The defence mechanism to tackle the opportunity to commit fraud is an effective internal control system. Its effectiveness can be inferred from the auditor's opinion about the internal control system. A quick scan of the business news may also help users uncover significant internal control failures covered by the press.
The system to protect against justification to commit fraud is a code of ethics. It should be implemented on the ground and translated into corporate actions through training programs, leadership by example, effective supervision program. To help reduce the motivation to commit fraud, the organization's design should be built around the philosophy of sustainable growth. The compensation structure, corporate strategy should then be built around the philosophy.
Lastly, managers with the intent to mislead are becoming more sophisticated and aware of the various fraud detection tools in the marketplace. Thus, they are more capable of misreporting without triggering detection mechanism. The corporate governance board, which should ideally be staffed by competent people of diverse skill sets, including financial professionals, and their team of internal auditors are the first line-of-defense.
HOW CAN MANAGERS MISREPRESENT FINANCIAL RESULTS?
The table below summarizes some of the ways that managers can misrepresent financial performances. Possible solutions were discussed in our previous articles.
THE BENFORD'S LAW
This is also known as the first-digit law and is an observation on the frequency of natural occurrence for leading numbers (or the first digit of a number (Eg. 1 for 100 and 8 for 8,888) in a data set. It has many applications and one of them is to help detect accounting misreporting. The probability of picking 1 to 9 in a sufficiently large data set is 11.11% (100%÷9). However, under the first-digit law, 1 has the highest probability of occurring as the leading number, followed by 2 and so on. The frequency distribution is as illustrated.
If the accounting data's leading number frequency distribution differs significantly from the Benford's Law frequency, an investigation.is warranted.
UNDERSTANDING CASH FLOW
Accruals are the non-cash component of earnings. For example, a trade receivable is recognized when a sale occurs, which is then followed by the receipt of cash proceeds later. The receivable also carries a risk of non-payment. Therefore, the quality of earnings can be compromised if it is padded up by a substantial level of accrual, which may cause the "on-paper" earnings to substantially deviate from actual cash income.
Maureen is a financial executive of Sloane Engineering Inc., a maker of precision equipment. She examines the cash flow statement of a customer, who wrote a request to increase the credit limit by 50% and increase the credit term to 45 days.
To better understand the cash flow statement, it is important for Maureen to understand the 3 sources of cash inflows and outflows for an organization, namely cash flow from every day recurring operating activities (CFO), cash flow from investing activities (CFI), and cash flow from financing activities (CFF). The illustration below illustrates the movement of cash between external investors and within the business entity.
For a healthy organization like the company Maureen is analyzing, it should be generating cash from its every day recurring operating activities, reflected by a positive CFO. The positive CFO is used to reinvest in the firm (in form of new PP&E), reflected by the negative CFI and repaid to investors in the form of principal repayment and dividend, again shown by the negative CFF. Hence, it is critical for a healthy business to have positive CFO, and \normal to have negative CFF and CFI, as long as the proceeds are used to fund the sustainable level of dividends and invested in productive assets at a competitive price.
For the purpose of cash flow analysis, CFI and CFF inflows are excluded as a business cannot be perpetually funded by cash proceeds from liquidating assets and capital injections. The calculation of CFO can be separated into 2 components, namely fund from operations (FFO), which is adjusted for non-cash gains and expenses like depreciation and amortization and gain/loss from an asset sale, and the change in working capital, reflected by comparing past and present current asset and liabilities level.
The process of computing CFO eliminates the effects of accruals and non-cash items. However, it is too superficial to take CFO at face value. To answer the questions of quality, stability, and level of CFO, Maureen conducts trend analysis of the breakdown. For example, she did a trend analysis and suspects that the fast increase in net profit could be due to the unsustainable increase in account receivables.
In addition, current liabilities level has also been rising faster than normal, raising the possibility that her customer has been making late payments. She suspects that a liquidity crisis could be looming and she proceeds to confirm if this is the norm for the industry at this particular stage of the business cycle by comparing the breakdown against the CFOs from her other customers.
CASH FLOW ACCRUAL RATIO
Maureen may also use the Cash Flow Accrual Ratio (CAR) to assess the quality of cash flow, A high ratio implies that the net income could possibly be fluffed-up with accruals such as receivables which affect the quality and persistence of earnings. A high-quality ratio will be the one that is close to zero as it signifies that cash is a high percentage of earnings.
Sometimes, in order to boost the company's current performance, a company might put off investments in return-generating assets to boost current earnings at the expense of the future. If assets are not replaced over time, fixed assets will wear down and intangibles will expire sooner or later, impairing the company's future ability to generate returns.
The CAPEX is the fund spent to purchase and improve PP&E and intangible assets. For a normal and growing company, the ratio should be at least 1.0 as it signifies the company is at least replacing its assets. Maureen calculates the ratio and finds out that it consistently falls below 1.0, indicating that her company is not spending enough to replace its ageing assets.
Maureen then proceeds to calculate the average lifespan, remaining life, and age of the assets. As the average lifespan and age of her customer's assets have shown a persistent increasing trend, it confirms the firm's under-investments in return-generating assets.
In addition to the 4 ratios, Maurice should also examine the quality of assets. As there is little way for a corporate outsider like her to access internal data, she has to rely on the following methods to infer assets' quality. The impairment is the practice of writing-down inventory and fixed assets to mark the carrying value to the asset's fair value. If the firm has a track record of frequent and huge impairments, it suggests that the firm's assets and D&A estimates might not be of the highest quality.
Restructuring and impairment are common tools to conduct "big-bath" accounting in which huge one-time expenses are declared, often to smooth profitability. For example, when times are bad, the accountant under-declare expenses to inflate profits and only recognize them when the sales level recovers. The result is more consistent profits, blissfully-unaware investors and a fat compensation package for managers.
One has to examine if restructuring and impairment are really one-time in nature or held periodically. The audit report, where the auditor conducts sample field tests to validate the reasonableness of assets' valuation is another way to help external users infer the quality of assets.
The model uses financial ratios to check if there is a high probability of earning manipulation and misreporting. A score of greater than -2.22 reckons that the firm is likely to be manipulating its earnings and its reported finances are unreliable.
We shall explain the components in the order of significance
+4.679 TATA measures the current level of accrual. Remember that profitability does not necessarily equal to cash flow due to the timing difference in the recognition of sales and expense, and collection and disbursement of cash.
+0.920 DSRI measures the extent of growth in receivables as a percentage of sales. The higher it is, the more likely the business is boosting sales by making it easier to buy on credit.
+0.892 SGI measures sales growth. If there is an exceptional growth that is out-of-line with historical trends, it is possible that the business is artificially boosting sales.
+0.528 GMI measures the decline in profit after deducting production costs from sales, If there is a decline in the gross margin, the managers are under pressure to turnaround, which may compel some to resort to dishonest means.
+0.404 AQI measures the growth in low-quality assets which are illiquid that takes considerable time and cost to liquidate, and have values that are subjective and possibly differs from fair value. One significant low-quality asset is goodwill, which basically represents the excess payment made by the acquirer during the M&A transaction.
+0.172 SGAI measures the growth in selling, general and administrative overheads, which are fixed costs that are incurred regardless of the level of sales. A high ratio signifies that a change in sales is going to have an amplified effect of profits. So when sales dip, it may pressure some managers to manipulate earnings.
+0.115 DEPI measures the decline in depreciation and amortization expenses. A falling ratio suggests that a company is under-investing, has revised the assets' lifespan and salvage value estimate to D&A expense to artificially boost current earnings.
-0.327 LEVI measures the increase in debt leverage. An increase in debt gives impetus for managers to artificially lower the debt level by off-balance-sheet financing to gives a false impression of higher debt capacity and/or avoid violating loan covenants.
After the ratios for each variable are calculated, they are entered into the linear formula to calculate an M-score. Please note that the M-Score CANNOT BE used to measure the probability of misreporting for financial firms as their revenue and cost structure are very unique. The formulas for each variable are listed in the table.
DISADVANTAGES OF THE BENISH-M MODEL
Like all statistical models, it does not predict misreporting with 100% certainty. Combined with the fact that many managers today are manipulating earnings with higher sophistication, one should not just rely on the M-score alone. Instead, it should be used 1) as one of many tools to determine earnings quality, and 2) to understand the contribution of each factor to misreporting.
External users conduct a financial analysis to make an opinion on the company's current finances in order to project its expected performances. The computation of the long-term sustainability and viability of the corporation is thereby, imperative. The Z-score model measures the likelihood that a publicly-traded, non-financial company might go into insolvency in the future.
A score of 1.8 and lower suggests that a company might soon be bankrupt while a score of 3.0 and above suggests that the firm's finances are in a sound position. Why so? We shall explain each component in the order of significance
+3.3 EBIT/Total Asset measures the current ability of the company to generate sales and optimize its operating expenses to generate operating profit (EBIT).
+1.4 Retained Earnings/Total Asset measures the level of the undistributed portion of earnings which can then be utilized to tide the firm over during hard times.
+1.2 Working Capital/Total Assets measures the level of working capital (current assets less current liabilities), as the shortage might cause a liquidity crisis.
+1.0 Revenue/Total Asset measures the ability of the company to manage its assets to generate sales, also known as the Asset Turnover Ratio.
+0.6 Market Value of Equity/Total Liabilities measures the market's sentiments. If the market anticipates a crisis, one can expect the firm's share price to plummet.
The Z-score model can also be modified to measure the likelihood of a private, non-financial company becoming insolvent by substituting the market value with the book value of equity. The book value of equity represents the actual ownership of the business after all liabilities are deducted from assets.
A score of 1.23 and below is indicative that the likelihood of financial embarrassment is high while a score of 2.9 and above imply that the private firm's finances are in good standing based on reported data. But again, managers have become more sophisticated at gaming the system so users have to assess the company's viability in relation with other analysis.
An auditor is employed by the company's audit committee to independently and systematically examine the company's books, accounts and documents to express on opinion on the company's financial statements after assessing if they are true and fairly presented. For public companies, their role also includes the assessment of the company's internal control mechanism.
For the purpose of this article, we are covering external auditors, who are different from internal auditors and are externally engaged from a CPA firm, The auditor report is a certification that accompanies the financial statements and is based on an audit on the procedures and records used to produce the financial statement.
Typically, the audit report is separated into 3 sections. The first part covers the responsibility of the management and the audit firm, while the second covers the scope which financial statement an opinion are given (generally consists of the P&L, balance sheet, cash flow, statement on change of equity, and footnotes as MD&A and quarterly disclosures are not audited). The third section then contains the auditor's opinion on the covered financial statements, along with additional information that supports it.
There are 4 kinds of auditor opinions.
Unqualified Opinion The auditor expresses an unqualified opinion if the financial statements are presumed to be free from material misstatements and if the internal controls are effective after field works have been performed to justify its effectiveness.
Qualified Opinion A qualified opinion is issued when a company has not adhered to the generally accepted accounting practices (GAAP) in all financial transactions but does not cause the company's finances to be materially misstated. The auditor typically supplements the report with additional information to elaborate on the deviations from GAAP.
Disclaimer of Opinion Issued in the event that the audit was not able to be completed due to reasons beyond the auditor. Could be due to the absence of accounting records, lack of cooperation, etc, which causes the auditor to issue a disclaimer of opinion. This is indicative of accounting and internal control shortfalls that have to be addressed.
Adverse Opinion The auditor believes that the accounting records are not prepared in accordance with GAAP and the presented performance materially deviates from the company's true financial position and could possibly indicate a fraud. The company's presented financial data are thereby unreliable, and should not be used for financial analysis.
HOW THE AUDIT MECHANISM WORKS?
The Audit Risk Model depends on 3 factors and both inherent and control risks are uncontrollable from the perspective of the auditor, The inherent risk measures the likelihood of an error or omission due to lack of training, poor judgement of accounting transactions, etc, while the control risk, which is the possibility of misreporting stemming from weak internal controls. such as poor bookkeeping infrastructure, frauds, etc.
The last factor, detection risk, is the sole risk that is controllable by the auditor. When the audit risk is higher due to high inherent and control risks, an auditor lowers the detection and audit risk down by conducting more field works. Therefore, the audit report is merely an opinion based on evidence collected and sampling done, It is NOT a guarantee against fraud and misreporting! In addition, as they function as the 2nd line of defence against misreporting and it is critical that they remain independent from the management's undue influence.