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 several 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 that 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, usually anything 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.
Frequently Asked Questions about this Article…
What are accounting irregularities and why should everyday investors worry about earnings manipulation?
Accounting irregularities and earnings manipulation involve misstating revenue, profits or balance-sheet items to make a company look healthier than it really is. The article highlights this as an ongoing risk for equity investors, citing Australian examples such as Hastie Group, ABC Learning, Transpacific, Centro Properties and Clive Peeters. These cases show that irregularities can lead to restatements, management fallout and large investor losses, so vigilance is important.
Which red flags in financial statements can signal possible earnings manipulation?
Key red flags include a mismatch between operating cash flow and reported earnings, unusually strong sales growth combined with big increases in receivables as a percentage of sales, falling gross margins, unexplained increases in non-current assets that aren’t property, plant & equipment, and unexpected restatements or large ‘irregular items’ in accounts. The article points out these signals as things investors should probe.
What is the Beneish M‑Score and how can it help investors detect accounting fraud?
The Beneish M‑Score is a composite formula developed by Messod Beneish (1999) that combines several financial ratios to flag firms likely to have manipulated earnings. The article notes that the M‑Score would have flagged Hastie’s 2009 accounts as suspect and highlights the typical “smoking guns” the M‑Score picks up, such as rapid receivables growth, margin changes and unusual asset composition.
Can investors rely on auditors and annual audits to catch fraud before it hurts shareholders?
No — the article warns that audits often uncover problems after the fact and don’t always act as a deterrent. It notes that audits and management interviews rarely reveal irregularities in time for investors to avoid losses, so investors shouldn’t rely solely on an auditor’s sign-off.
What did the Hastie Group situation reveal about the limits of due diligence?
Hastie disclosed around $20 million of irregularities that appeared to result from deliberate employee action and possible management participation. The article explains that incoming management who relied on the prospectus and audited accounts — such as the executive Bob Wild brought in to help turn the company around — still missed those issues, showing limits to standard due diligence.
How do restatements and misclassifications affect investor confidence and risk?
Restatements and misclassifications (for example, Transpacific’s $48 million of ‘irregular items’ and Centro’s borrowing misclassification) are warning signs that past accounts were unreliable. They typically increase investor risk by revealing prior misreporting, prompting closer scrutiny and often affecting share prices and trust in management.
How should everyday investors use financial-statement analysis to minimise the risk of being misled by cooked books?
The article recommends scrutinising the interplay between balance-sheet changes and differences between reported earnings and operating cash flow, checking receivables relative to sales, watching margin trends, and being wary of unexplained non‑PPE non‑current assets. Using screening tools like the Beneish M‑Score and digging into unusual ‘irregular items’ or restatements can help investors spot problems earlier.
Do acquisitions make it harder to spot earnings manipulation, and what should investors do about it?
Yes — the article explains that active acquirers like Hastie can muddy year‑to‑year comparisons, making it harder to interpret changes in financial metrics. That doesn’t mean investors must avoid acquisitive companies, but they should be extra vigilant: adjust for acquisitions when comparing periods, examine integration accounting, and watch for acquisitions being used to ‘paper over’ other problems.
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