Avoiding our Dark Wood of Errors: Risk of Accounting Irregularities & Tunnelling Fraud

Avoiding our Dark Wood of Errors: Risk of Accounting Irregularities & Tunnelling Fraud

Once you have found your North Star, keeping it in view is a fine way to stay on course, as long as the sky remains clear.

But what about the cloudy nights and the dark wood of errors?

In situations when you feel utterly befogged by the risk of accounting irregularities, we need some help figuring out where our North Star lies. It is helpful to have inner compasses wired into our brain and body to guide us in the search for our true path.

As shared earlier, we are honoured and grateful to have had the opportunity to share our thoughts with the top management team of the Monetary Authority of Singapore (MAS) on 23 September 2015 about implementing a world’s first fact-based forward-looking fraud detection framework to benefit the capital markets in Singapore and the public and investment community.

We strongly believe this potential fintech platform that combines accounting data, especially footnotes, with a wide array of contextual information will provide fresh insights and actionable, dynamic, inter-connected analytical information, as opposed to merely descriptive static data or a loose bag of disparate red flags, on Singapore and Asian companies, for the regulator and the public. This include:

– Unusual related-party transactions,

– Money-go-round off balance-sheet activities,

– Governance, group structure and ownership analysis,

– Textual and linguistic analysis,

– Analysis of event-based “catalysts” (information-based manipulation),

– Sensitive market announcements (action-based manipulation in prices and volume)

Close Encounter #1

We were quite close to investing an initial investigative stake in a listed software application company claiming to have global market leadership when our accounting fraud detection system alerted us to uncover from the footnotes. It was discovered that the listed entity provided a loan guarantee for $10 million to an undisclosed entity that is an off-balance sheet contingent liability. We believe this item should be recognised as a liability, which would also mean the company has to reduce its equity.

Guarantees of $0.68m was also given to banks and customers in relation to contract warranty and performance as an off-balance-sheet item, which provided “financial support to subsidiaries in a net liability position”. We felt this amount should be included as a liability (provision for warranty) in the balance sheet.

Close Encounter #2

We also avoided a listed pharmaceutical company with business prospects that looked promising on the capex ramp-up. However, our accounting fraud detection system alerted us to the inconsistency in a larger divergence between addition of Gross PPE (Plant, Property, and Equipment) reported in the balance sheet and the capex figure reported in the cash-flow statement.

During FY13-15, the pharma firm added $41m in gross PPE but reported $89.6m in cash outflow from capex addition. Between FY12-15, new additional sales created were $78.7m, which eerily matches the following cash outflow: total cash outflow in capex; related party loans ($15m); other payables ($4.4m); intangibles ($17.8m). 

Based on tunnelling analysis, the cash outflows from related-party loans or related-party investments/capex could be re-routed back to the listed company to artificially inflate sales. This corresponding match of increase in sales verses cash outflow in unusual items should not happen since revenue is recorded when there is a sale of products, not when money is lent to one another or when a new plant or production line is set up.

Furthermore, it made a corporate guarantee to related parties that was perhaps improperly reported as an off-balance contingent liability under that country’s GAAP instead of reporting it as financial liabilities under FRS 39. As a result, this entity’s net worth would have to be reduced downwards from $7.3m by $24.5m to become negative.

We all know the risk implications when loan guarantees turn sour, with the prominent case of banks seeking out repayment of loans taken out by colourful Kingfisher beer tycoon Vijay Mallya, chairman of United Breweries. Mallya allegedly personally guaranteed US$900m in loans to Kingfisher Airlines, which stopped operating in 2012.