"And yet our distress comes from no failure of substance. We are stricken by no plague of locusts. Compared with the perils which our forefathers conquered, because they believed and were not afraid, we have still much to be thankful for. Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply.
Primarily, this is because the rulers of the exchange of mankind's goods have failed, through their own stubbornness and their own incompetence...
Faced by failure of credit, they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They only know the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish...
Recognition of that falsity of material wealth as the standard of success goes hand in hand with the abandonment of the false belief that public office and high political position are to be valued only by the standards of pride of place and personal profit; and there must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, and on unselfish performance; without them it cannot live...."
Franklin D. Roosevelt, First Inaugural Address, 4 March 1933
Bear in mind that the data from this university study is the result of a
survey of 169 CFO's and not a forensic examination of the books.
I am a little surprised that the fraud number came in that high in a survey. I do not know many CFOs that would readily self-identify their work as fraudulent in nature. So therefore I also think that in actuality the number is rather low, given what I have seen for myself and the vagaries of human nature. When cheating becomes accepted and profitable almost everyone does it.
It should not surprise that so many of the CFO's chafe under the rules from FASB, which is the accounting industry self-regulator. They complain of too many restrictive rules, and yet they also admit fraud is pervasive. And it is their own organization that sets the standards.
Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting that govern the preparation of financial reports by nongovernmental entities.
I cannot speak for the current period, but during the build up to the tech bubble the manipulation of earnings was almost par for the course, as certain industry leaders set standards of consistent returns that were obviously based on questionable accounting practices.
From what I have seen, the same is true for the financial sector which had its own bubble and collapse. As a rule of thumb, any genuine bubble conceals a cesspit of fraud and criminal activity amongst insiders.
Here are the red flags that the study derived:
The three most common flags are persistent deviations between earnings and the underlying cash flows, deviations from industry and other peer experience, and large and unexplained accruals and changes in accruals.
There are also a number of red flags that relate to the role of the manager’s character and the firm’s culture, which allow and perhaps even encourage earnings management.
That last sentence is a polite way of saying that some companies become almost indistinguishable from criminal enterprises in their values and methods.
Probably the most easily identifiable red flag is an improbable consistency, the 'beat by a penny' quarter after quarter syndrome. If something looks too good to be 'real' then it is probably based on a fraud, in either the accounting or the market activity, and often both. It may not be illegal, but it certainly may be a material misrepresentation of the health of the business that will bite down the road.
From my own experience and stated as a non-professional accountant the key areas I would look for are in writedowns of inventory that can then be used to supplement profits later, holding back the realization of revenues in an arbitrary manner, shifting of tax and depreciation numbers, transfer pricing from foreign subsidiaries, and the manner in which one accounts for acquisitions.
The key point is that in the US for the past twenty years the numbers are often phony and the game is rigged, because greed in the financial and managerial elite has overcome any fear of prosecution. When the rewards are great and the risks incidental, dishonesty thrives.
The consequence is that the financial sector has become a largely extractive, outsized activity that thrives on the fraudulent manipulation of risk and value, distorting the real economy, and transferring wealth from the productive to the clever and unscrupulous.
This may serve during a period of endless financial expansion, but when the hard times come the frauds collapse quickly.
Regulators and politicians turn a blind eye to this, when the good times are rolling. And when the hard times come, even more wealth is extracted from the public to cover their bets and maintain their grand illusion. And then comes the deluge.
Earnings Quality: Evidence from the Field
By Dichev (Emory), Graham (Duke), Harvey (Duke), and Rajgopal (Emory)
Abstract
We provide new insights into earnings quality from a survey of 169 CFOs of public companies and indepth interviews of 12 CFOs and two standard setters. Our key findings include:
(i) high-quality earnings are sustainable and are backed by actual cash flows; they also reflect consistent reporting choices over time and avoid long-term estimates;
(ii) about 50% of earnings quality is driven by innate factors;
(iii) about 20% of firms manage earnings to misrepresent economic performance, and for such firms 10% of EPS is typically managed;
(iv) CFOs believe that earnings manipulation is hard to unravel from the
outside but suggest a number of red flags to identify managed earnings; and
(v) CFOs disagree with the direction the FASB is headed on a number of issues including the sheer number of promulgated rules, the top-down approach to rule making, the curtailed reporting discretion, the de-emphasis of the matching principle, and the over-emphasis on fair value accounting.
The complete paper can be downloaded
here.
Thanks to Matt Taibbi for letting me know of this paper.
