Secrets of Bonding 163: Financial Statement Fraud
You know the old adage, “Financial statements don’t kill people, people kill people.”
While it’s true there can be misrepresentation and deception in a financial statement (FS), the document is not inherently bad, it is the poor intentions of the preparer or company that is to blame.
As credit analysts, we always review and rely on FSs when underwriting surety bonds. We know there may be attempts to mislead our judgement or already downright deception. But the need to estimate the financial report is unavoidable. It is considered a valuable “report card on the quality of management.”
There are three levels of financial presentation by Certified Public Accounts (CPAs):
- Compilation – a properly organized report where the numbers have not been verified or evaluated by the CPA
- Review – includes some checking “Review” of meaningful elements
- Audit – is the highest level and includes the CPAs statement that they have checked and believe the numbers are correct
The reader of the FS is entitled to certain expectations: A candid and complete presentation that informs the reader. Are they entitled to more than that? Does the reader sometimes expect too much?
Let’s consider what the FS truly says, and what it doesn’t…
The Balance Sheet
This shows assets and limitations. It describes the dollars in the company (assets) and who owns them (limitations and stockholder’s equity). You know many of the normal entries: Cash, accounts receivable, accounts payable, inventory, bank debt, the net worth / stockholder’s equity section, etc.
The balance sheet always has a date, such as 12/31/2017. It shows the position of these accounts on the one day. Credit analysts calculate the Working Capital aka Net Quick (NQ) which is considered a measure of short term financial strength. You find the NQ by subtracting current limitations from current assets. When the bond underwriter has the NQ number, it can then be incorporated in the decision making.
What size bonds will be approved for this applicant? How much total capacity can they be allocated? The NQ figure becomes a benchmark that is used for the reminder of the year.
For many analysts, this one number has a huge effect for the following 12-15 months.
Let’s move forward in time one day, to 1/1/2018. “Happy New Year!” and let’s check the bank account. Some money has come in! The accounts receivable and cash have changed. Other changes have also occurred and so, if we calculate the NQ based on the 1/1 balance sheet, the NQ will probably be different from 12/31. Again, that’s because the balance sheet shows the state of these accounts on ONE DAY. It is always changing!
The reality is that the working capital number is only correct for one day, then it is unprotected to change. This is not to say the number is not important or applicable. And certainly decision-makers must have benchmarks and a method for their determinations. It is very important, but so are other elements.
Financial Statement Fraud
The most shared FS fraud is not committed against us by others. It is the self-deception we commit by over relying on these “one-day numbers.” To do so is to miss the big picture!
Underwriters love to see a big cash account sitting on that top line (of the balance sheet). But that’s a one-day number. Isn’t it already more important to determine the average funds on place for the prior six months or year? Many analysts fail to ask for this info.
Accounts Receivable and Payable – here is another meaningful area where the “one-day number” can easily be given a historical perspective. Aged schedules of A/R and A/P are easy to acquire and they give a perspective over more time than one day. These documents are not automatically included in FSs, and underwriters may fail to ask for them.
As readers of these documents and analysts, let’s not cheat ourselves by over relying on the balance sheet or thinking it is more than a one-day snapshot. It should be scrutinized and viewed in harmony with other meaningful underwriting factors such as mid-year financial reports and supporting documents.
In this manner underwriters can make realistic, well-informed decisions.