Advisors and managers retooling to combat fraud

by Cynthia Harrington

Once solid blue chippers, the names Enron, World Com, Tyco and AOL Time Warner now strike fear in the hearts of investors. Losses in the double and triple digits are more than most investors can bear. And what makes the staggering losses from these companies even harder to accept is that many of them dispensed inaccurate financials.

Although you could compile a laundry list of procedures to help prevent fraud, a thorough system of internal controls probably would occupy a high place on that roster.

Carol A. Cashman, CPA, manages the financial lives of multi-generations of families at Dallas-based Wealth Management Associates Inc. She and her colleagues select and monitor outside money managers for clients’ assets. "Investment managers need to get comfortable with the need for a company to create internal controls to prevent fraud," she said.

"Their analysts and portfolio managers need to learn to look through the numbers to make sure they don’t get caught up in the greed of the day and end up buying companies that aren’t honest," said Cashman.

Accountants are in a unique position to understand the process. "I’m an old auditor," continued Cashman. "I grew up in the business at Price Waterhouse. I know that things go on, but I also know it’s a tough sell for the CFO to do something like capitalize expenses instead of expensing them."

She explained, "I also understand that there are gray areas in generally accepted accounting principles. Sometimes the rules change. Take the incentives to procure oil leases that were legal and pervasive in the 1970s. Three years later, the gift of a Rolex watch was a bribe."

Cashman concluded, "I’ve been in lots of meetings with money managers recently where they’re saying they have to find new ways to evaluate stocks. I expect that a whole lot of people will be coming up with a whole lot of new answers to how to do that."

The Association of Certified Fraud Examiners believes that it has one of those new solutions. The Austin, Texas-based organization has developed a series of questions for audit committees on boards of directors to assess the company’s likelihood of preventing fraud. The fraud prevention checkup is available at www.cfenet.com. Toby J.F. Bishop, president and chief executive, drove the development of the new test. "The idea of checkup is to make it free of charge, to see whether companies have appropriate processes in place and whether they’ve been tested for effectiveness," said Bishop, CFE, FCA, CPA.

"It can be done in a few hours or an afternoon. Some questionnaires out there are too time consuming for the first step, and they frighten people away from initiating an evaluation."

Bishop suggested that the same series of questions are useful to investors, as well as to audit committees. "All investors should ask these questions of management before buying that company’s stock. I would expect they will hear ‘no, no, no, yes,’ but haven’t tested the procedure," said Bishop. "If companies begin to see that shareholders demand better controls, then they will respond."

Advisors are responding to lessons learned the hard way. "I can tell you I’ve got a different viewpoint on this," said Cashman. "For instance in the private equity deals I’ve evaluated recently, I’m looking far beyond the numbers. I’m asking myself if I trust this person. I have to look past the numbers to see if this is a good deal or a good sales pitch."

Money manager Jay Taparia, CFA, incorporates fraud detection into his analytical process. Taparia is the managing director of Sanskar Investments Inc., in Chicago and a professor of finance at the University of Illinois.

Before investing, Taparia looks at whether management’s growth expectations make sense for their industry, and evaluates a series of other ratios like inventory turnover and all short-term cash flow ratios. "Investors minimize the accounting risk premium in owning public companies by deeply analyzing the company’s financial statements," he said.

Taparia also conducts seminars on detecting fraud for non-investment professionals. "I’m not a CPA but I scour the GAAP books before analyzing stocks. Only companies that conform end up in the Sanskar stock portfolio and earn our clients’ assets," he said.

Cashman’s prediction of new tools for investment analysis has come true in one case already. Messod Daniel Beneish, Ph.D., CA, of the Kelley School of Business, at Indiana University, in Bloomington, Ind., tested a series of ratios and found eight that revealed a high probability of earnings manipulation. His results were published in the Financial Analysts Journal, in September 1999. "The model is easy to use," said Beneish. "With two years of public financial data, anyone can plug in the numbers and see potential problem areas."

Beneish’s model highlights companies whose future might be deteriorating. Problems with revenue recognition, competitive pressure on costs and the likelihood that firm is treating as assets what should be treated as expenses show up in the results. "A major red flag is above average sales growth," said Beneish. "Fast growers are usually young companies with centralized control and lower corporate governance controls. They also have an incentive to fool with the numbers because fast growers are likely to go into distress."

As yet, no companies have stepped up to provide time-saving fraud ratings. "I’d love to see S&P or Moody’s investigate the processes [that are now] in place at public companies, and how effective those processes might be," said Bishop. "Then they could publish a rating to allow investors to see how risky investments really are."

New tools and exhaustive research go a long way toward keeping investors out of stocks with hidden accounting problem time bombs. Cashman also focuses on evaluating the integrity of the company culture and the management team. "I watch for situations in which conditions are right for fraud. When a small number of people have too much authority and control, and there’s a need to massage the numbers, that’s a huge red flag," said Cashman. "An advisor has to consider the qualitative factors of the company. They have to look at whether there’s a culture of a bunch of cowboys out there doing bigger and bigger deeds, with lots of ego and testosterone driving the actions, or whether there’s an integrity basis in the company," she reasoned.

She then added, "If I could come up with a way to quantify integrity, I think this problem would be solved."