The Economist April 18th 2020 pp47-48. Corporate Fraud “Who’s lost their trunks?” “The crisis will expose a decade’s worth of swindling and aggressive accounting”
High tide raises all boats including swindlers and make-up artists putting “lipstick on a pig”. Like other financial crises, in the past namely the dot.com bust of the 1990s and the mortgage meltdown of 2007, the COVID-19 financial fallout will expose familiar and even new schemes for defrauding investors. “When economic survival is threatened, the line separating what is acceptable and unacceptable…can be blurred”.
Examples so far are Luckin Coffee “the Nasdaq-listed Chinese chain announced an ongoing internal probe [about overstating sales by $280M]” and GSX, a Chinese online-tutoring firm listed in New York, of inflating last year’s sales. These examples highlight the difficulty non-Chinese investors have in evaluating financials from Chinese firms.
Fraud-hunters like Citron, Muddy Waters and Blue Orca Capital will be searching for “firms with discrepancies between the amount of capital they need to raise and the cash their accounts say they are generating”. “Others are focusing on industries hit hardest by the pandemic, such as travel, entertainment and property”.
Most of the “bull market” wrongdoing amounts to “gray area” accounting and financial reporting rather than explicit fraud. A popular recent example is WeWork’s use of something called community-based EBITDA whereby they subtract out "corporate" costs of operating in highly-priced real-estate and staff markets and in doing so “trimmed a hefty loss for 2018…into a profit”. The use of Non-GAAP adjustments to financials is a recurring theme likely to play out much in the months to come. It’s hard, especially for an individual investor, to get a true sense of corporate financial wellbeing when so many adjustments are included in company filings. These Non-GAAP adjustments for S&P500 firms has increased from “2.5-7.5 in the past 20 years”. When examining credit-agreements the “definition of EBITDA ranges from 75 words to 2,200.” As a matter of record, GAAP profits are 15% lower than Non-GAAP profits.
The economic upheaval of COVID-19 creates the potential for more shady maneuvers “from iffy accounting to stimulus-linked scams as thousands of firms-including bogus applicants-hustle for help”. Companies supported by “deep-pocketed” private equity may be particularly tempted as many will not qualify for government assistance.