Let's turn up the heat before books are cooked

IDENTIFYING and profiting from irregularities or straight out fraud has become quite an industry for short-sellers looking at Chinese stocks listed abroad.

IDENTIFYING and profiting from irregularities or straight out fraud has become quite an industry for short-sellers looking at Chinese stocks listed abroad.

It's not something one could easily profit from when focusing on Australian companies, but accounting irregularities, earnings manipulation and even fraud perpetrated by employees have been exposed often enough that one must accept it as an ongoing risk of investing in equities. The "accounting irregularities" revealed at Hastie Group are by no means a one-off for the market.

Perhaps the most high-profile Australian company to have been caught manipulating earnings in recent times was ABC Learning. But we've also had waste management leader Transpacific restate its accounts for the 2008 financial year because of $48 million of "irregular items" included in operating earnings that were actually profits on the sale of land and a reversal of remediation provisions.

Then there was the highly publicised fallout from real estate investment vehicle Centro Properties' misclassification of a number of current borrowings as non-current in its 2007 accounts. And in the case of collapsed retailer Clive Peeters, management was taken for a ride by the employee who misappropriated $19.4 million via falsified entries in its payroll account to purchase 41 properties from 2008-10 financial years.

We can dig further back to HIH and the case of retailer Harris Scarfe, which as a listed entity collapsed in 2001 (the brand has since been revived) with ASIC prosecuting its CFO for false entries over five years, entries which ASIC alleged had allowed the retailer to lift the apparent level of profits.

Analysts and investors can "eyeball" executives and directors or take heart that an auditor has run a critical eye over the numbers. But if the prospect of an annual audit does not act as a deterrent, which it hasn't for many past cases, anything that is usually discovered by auditors is discovered well after the fact. And rarely has a management interview revealed accounting irregularities, although the lack of a clear explanation for certain elements of reported earnings may provide a flag, such as a mismatch between operating cash flow and earnings.

Even those brought inside the tent after the fact may not find evidence of irregularities. Just ask Bob Wild, the former Leighton Holdings executive brought in to turn Hastie around just over six months ago. Wild has stated that for his due diligence he relied on the prospectus and the audited annual accounts.

In the case of Hastie, specifics around the $20 million of irregularities have not been publicised, other than confirmation that they appeared to be the results of deliberate action by an employee and that some management may have "participated".

Scrutinising the interplay between changes in the balance sheet and differences between reported earnings and cash flow is necessary for the vigilant investor seeking to minimise risk.

One tool that may have caused an investor to probe Hastie more closely is a composite of financial metrics created by US academic Messod Beneish, who in 1999 took a sample of 74 growth companies that had been found to have manipulated their earnings.

Beneish found that manipulators typically overstated earnings by recording fictitious, unearned, or uncertain revenue, recording fictitious inventory, or improperly capitalising costs.

So Beneish sought out "smoking guns" among various financial metrics and came up with a formula that indicated potential earnings manipulation, based on statistical analysis of the 74 manipulators and similar non-manipulating businesses matched against them. Based on this formula, Beneish's M Score, Hastie's accounts for the 2009 financial year would have raised a flag, with the company's score being within the range deemed to be indicative of manipulation.

Essentially there were four smoking guns: strong sales growth may have meant Hastie was under pressure to meet high expectations (and was therefore more likely to consider manipulation) strong growth in receivables as a percentage of sales could have indicated that reported sales were boosted artificially (say by bringing to account sales that really related to a future period) a reduction in the gross margin could also be indicative of a company under pressure to meet expectations and an increase in the proportion of non-current assets that are not PP&E may have indicated efforts to defer costs.

The waters are muddied by the fact that Hastie was an active acquirer, making comparisons of the company's financials between different periods more problematic. This could be an argument for leniency in assessing changes in financials, but acquisitions can also be an opportunity to "paper over" other problems.

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