The Enron scandal has become the face of financial fraud in the world, surpassing all of history’s accounting fraud cases in terms of corporate malfeasance and auditing failures. Enron’s malice, together with the failure of auditing firm Arthur Andersen, swindled many retail investors of their hard-earned savings.
It is important for investors to know how to protect ourselves, especially when our supposed accounts guardians (i.e. auditors) go rogue. In this article, we shall point out some accounting red flags investors should look out for, through some interesting case studies of past stock frauds.
HealthSouth was one of the largest healthcare providers in the United States that committed an infamous accounting scandal which was perpetrated from 1996 through 2002.
HealthSouth CEO Richard Scrushy instructed the company’s senior officers and accountants to falsely inflate earnings by US$1.4 billion. This was done to meet investor expectations and chalk up ‘buy’ ratings from analysts.
HealthSouth’s co-founder and ex-CFO Aaron Beam recounted in hindsight that it was greed that drove his and Srushy’s fraudulent behaviour. Beam recalled how ‘it was so much fun being rich, buying those ties and flying all over the world in our private jets.’
In 1996 when HealthSouth badly missed its earnings target, Scrushy began to tremble and shouted at HealthSouth’s financiers with: ‘You know how to fix these numbers. Now go back to your offices and do it!’
Scrushy, the main perpetrator of the fraud, was surprisingly acquitted on all 36 accounting fraud counts against him after a jury trial in June 2005. However, just a year later, Scrushy was convicted on new charges before a federal grand jury.
How they got caught
In August 2002, Scrushy sold a huge stake of his HealthSouth shares days before the company posted a large loss. HealthSouth’s stock price plunged, and this triggered the SEC’s attention.
What investors can learn
Although HealthSouth’s accounting tricks eluded even their auditors, an analysis of some of HealthSouth’s financial ratios would have raised some suspicions about the management.
The percentage of HealthSouth’s intangibles as part of its total assets was a whopping 41% in 1997, 65 times that of Tenet Healthcare, its largest competitor of that time. This would have hinted at HealthSouth inflating its asset values, which they later used to shore up earnings when needed.
|HealthSouth (31 Dec 1997)||Tenet Healthcare (31 May 1997)|
|Intangible Assets as Percentage of Total Assets||41.5%||0.63%|
Source: SEC filings
For a modern comparison, an asset-light company like Alphabet (Google’s parent company) only has 8.6% of its total assets as intangibles and goodwill.
Intangibles are assets that are not physical in nature and can be hard to value. Intangibles include brand recognition, trademarks, and intellectual property, amongst others. Intangibles are obscure and are often overstated on the balance sheet for fraud.
Fun fact: Despite the apparent fraudulent practices, Scrushy maintains his innocence till this day. In a 2017 documentary, Scrushy said, ‘I went for five years and I was an innocent man. I never should have gone, I didn’t do anything wrong.’
Parmalat was founded by Calisto Tanzi when he had just dropped out of college as a 23-year-old. His break came with a procedure called UHT — ultra-high temperature — to produce long-conservation milk that doesn’t need to be refrigerated. This milk became an instant hit in Europe and NATO even ordered it in bulk for its troops.
Parmalat soon became a global leader in dairy and food production. The company was Italy’s pride and the Tanzi family was like the first family of Parma, Tanzi’s hometown. Tanzi projected an image of anything but a fraudster — he would go to Saturday evening mass on foot with his family, was always accessible to regular folks, and was described to have strong moral values.
Little did people know that Parmalat’s booming success was a farce. As Parmalat’s performance began to slip in 1990, Tanzi decided to disguise them through fraudulent practices like these:
- Inflating revenues by creating fake transactions via a double-billing scheme
- Receivables from fake sales were used as collateral
- Took up legitimate debt but hid it from investors
- When Parmalat issued bonds, they disguised it as equity on the balance sheet with the help of investment bankers
How they got caught
On December 2003, despite having reported €4 billion in cash and current assets, Parmalat defaulted on a €150 million eurobond payment. Parmalat claimed a customer had not paid its bills. It was later revealed that the ‘customer’ was owned by Parmalat.
What investors can learn
A firm’s balance sheet must fit with the financial actions the firm has taken. For example, Parmalat had considerable cash on the balance sheet but was very reliant on funding from the debt markets.
A company’s business must also tie in with its financials. This is when it’s important to recall one of Warren Buffett’s core investment principles — that is to invest only in companies you understand.
An understanding of the dairy business would guide our suspicions towards Parmalat’s profit margins, which was twice the industry’s average. Parmalat neither had lower cost processes, better tasting milk nor superior distribution that gave it reason to enjoy superior economics. Thus, it’s important to understand the industry in which a company operates to sniff out red flags like these.
Fun fact: Tanzi’s status was elevated to a demi-god among football-crazy Italians when he bought Parma Football Club and led it to tremendous success. Also, whenever Tanzi’s private jet would fly over Parma, its residents would refer to it as the ‘airplane of God’.
3. Waste Management
One of the largest waste management and environmental services companies in the United States, Waste Management Inc. manipulated depreciation expenses on its income statement from 1992 to 1997. This was an attempt to meet predetermined earnings targets that were tied to the compensation of Waste’s chief officers.
To boost earnings, Waste’s accounts were manipulated by its chief officers in the following ways:
- Reduced depreciation expenses by inflating salvage values and extending the useful lives of the company’s garbage trucks
- Refrained from recording expenses for any decreases in the value of the landfills
- Refused to record necessary expenses to write off unsuccessful landfill development projects
- Improperly capitalised a variety of expenses which would defer expenses paid on Waste’s books
Waste bribed its auditors, Arthur Andersen, to turn a blind eye to their accounting improprieties. This was possible due to the cosy relationship between Waste’s top executives and the auditing firm — some of Waste’s important chief officers previously came from Arthur Andersen.
Waste’s CFO was trained at Arthur Andersen as an auditor, while Waste’s Chief Accounting Officer was also a partner at Arthur Andersen for quite some time. This close relationship between the key stakeholders at Waste and Arthur Andersen allowed Waste to get away with their fraudulent practices.
How they got caught
In July 1997, Waste’s new CEO ordered a review of the company’s accounting practices and publicly revealed the accounting malpractices of the previous management. In 1998, Waste restated its 1992-1997 earnings by US$1.7 billion, the largest restatement in history.
What investors can learn
As depreciation expenses have an impact on the company’s profitability, firms — especially capital-intensive ones — have an incentive to reduce depreciation expenses.
They can do so with the following ways:
- Increasing the lifespan of an asset, spreading depreciation expenses over a longer period of time. The firm is essentially pushing costs into the future and inflating current earnings.
- Changing the method of depreciation from the straight line method to the written-down value method. This reduces expenses incurred in the later years of the asset’s useful lives.
Investors should look out for any sudden changes in depreciation methods and if reasons given for the changes are reasonable or not.
Fun fact: Despite his misdemeanours, ex-Waste CEO Dean Buntrock is a 2007 inductee into the National Solid Wastes Management Association Hall of Fame.
The fifth perspective
The above examples show us the extent of deceit some companies and their management have pursued as they cook the books at the expense of shareholders like you and me.
While these red flags in itself are not a confirmation that a fraud is indeed taking place, a combination of factors and unusual/aggressive accounting practices could very well raise your suspicions or, at least, signal you to tread carefully before you invest any of your heard-earned money.