The WSJ on July 9th outlined a new task force formed by the SEC to identify fraud. According to the article “There still is financial-reporting fraud going on out there,” said Andrew Ceresney, the new co-director of the Securities and Exchange Commission’s Division of Enforcement”. If so, the SEC may have delivered a wake-up call. “We think there’s a need to focus our attention to identify accounting fraud,” said Mr. Ceresney, the new co-head of the task force… “ With the recovery gaining, companies have to worry about rising interest rates as investors brace for a reduction in bond buying by the Federal Reserve. Some businesses that have benefited from historically low interest rates could be in for a shock. ‘Frauds come to light when the economy tightens up and money is restricted,’ Mr. Ratley said.
Many of us deal with nonpublic enterprises. These enterprises have less access to working capital and less oversight, increasing opportunities for fraud during stressful periods. The economy is still growing slowly and many of our customers / clients strive to keep up and support their lifestyle putting more pressure on cash flow.
Experience has taught us that even “nice” clients use creative maneuvers to generate cash.
• One client had issues with following our recommendation of improving inventory controls and convinced a Mezzanine group, they knew personally, to fund the company. No new inventory controls were installed and the mezzanine group lost millions and regrets not getting CRL involved in the process.
• In another case three pillars of a local community are in jail.
• In the first fraud case I uncovered a former Army General who was the CEO who thought cooking the books is what you do. So no matter your personal relationship dig deep and communicate with in house auditors or engage a true professional to take a look.
The sources of fraud will vary by constituency. The SEC is focusing on revenue recognition, valuation; capitalize versus noncapitalized expenses, reserves, acquisition accounting and other areas that do not follow standard accounting principles.
Let’s take a look at what we have uncovered over the years in the “cash is king” world:
Receivables and Revenue:
• Prebilling – We all have seen pre billing and it usually flushes out.
• Failure to book credits timely will create real issues. In one case major retailers returned late arriving goods and the company was trying to flush through the credits months later. $3 million was written off!
• Fraudulent invoices need to be removed or the AR is going to grow exponentially. Days outstanding will increase and the gross profit on the financials will differ from the detailed testing.
We all know the long stories of water in oil tanks, fictitious goods and frozen fish instead of lobster. One of the best was goods bought at liquidation auctions recorded as new clean goods. Best part was the merchandise bought at auctions was unsalable.
The best I found was a high tech laser booked in capital assets, inventory, and deferred assets. Yup three times.
We have always found this as an area to dump expenses from Advertising to Samples.
The failure to record liabilities does not create availability or cash but does improve profits and ratios.
• In a recent case our client sourced and sold for the same multinational enterprise. It appears they failed to book our clients invoices in the millions. The company’s board contacted us during their investigation creating further pressure on a struggling international company.
• The best was a CEO who said, …. them we are not going to pay the bills. We resigned.
We know of no simple fix all solution to avoiding fraud. A client that commits fraud usually results in a CEO opportunity for someone, carrier ending opportunity for sure. Banks use their own internal audit staff to visit clients on an ongoing basis. What you do with the reports and how loan officers communicate with the audit staff is critical in my eyes. It cannot be stressed enough to sit down with your auditors, have a cup of coffee and review each client. No, do not review the report but have general conversation regarding what the auditor saw and his impressions of the operations. It is this conversation that can save you from a CEO opportunity.
In summary, keep an eye on rates and as interest expense increases try and understand the economics creating the continued net profit and cash flow. In the end it is all about the cash.</p>