The Phantom of the Audit

 

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You have probably never heard of Livent Inc. or if you have your memory of what transpired within the company may have faded over the past 15 years.  Yes, one of Canada’s most disgraceful accounting scandals is “celebrating” its 15th anniversary this year.  Livent has also recently been in the news since the Ontario Securities Commission, the stock exchange regulator for Livent, has finally decided to actually regulate.  I don’t want to be too harsh on the OSC, but really – it takes 15 years for you to decide that the perpetrators should be banned from being involved with publicly traded companies?  

Let’s rewind to 1998 when the *&^% hit the fan. Livent had been on a roll; it was producing great theatre performances in Toronto including the Phantom of the Opera and had been reporting fantastic financial results.  Ex-Disney executive Michael Ovitz purchased Livent in 1998 and then realized that it was a financial house of cards.  Note: all the following documents are publicly available through SEDAR.com

First, let’s take a look at the original December 31, 1997 balance sheet:

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Things to note:

  • A small negative deficit ($27M)
  • Accounts payable and accruals ($29 M) that are less than the cash available ($10M) and the accounts receivable ($32M)
  • A preproduction cost asset, representing money already paid to develop future performances, $67M

Now, here is the restated balance sheet after examining some dodgy accounting practices:

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Look at the December 31, 1997 column and compare that to the original figures:

  • The deficit is longer small, it is $124M, approximately $100M larger than originally reported.  Total equity now represents just 1% of the total assets.  That means that 99% of the assets really belong to debt holders
  • Accounts receivable have gone down by $13M and accounts payable has gone up by almost $20M
  • Preproduction cost assets have decreased by $8M

With virtually all frauds, one key culprit is revenue recognition.  Revenue would seem to be an easy thing to account for, but it can get complex pretty easily; primarily timing and amounts.  A simple example of this was Livent’s treatment of certain sponsorship revenue.  Like many arts organizations, Livent earned a portion of its revenue through sponsorship dollars – companies paying for the right to have their logo and signage in the lobby, on the stage, or on the playbill.  This is very similar to the corporate logos you see at the hockey rinks.  Assume that a business paid Livent $500,000 for the right to have their logo on the playbill of the Phantom.  The company probably paid months in advance to secure its sponsorship right.  When should Livent record that payment as revenue?  (a) When they received the cash?  (b) When the show started its 3 year run? (c) Or spread evenly over the three year run?  If you answered (a) you want to review revenue recognition criteria ASAP, before you meet Livent executives in jail (IAS 18).  If you answered (c), congratulations you’re well on your way to becoming an excellent accountant.  Or it was just common sense.  Its interesting how accounting, when done right, involves a lot of common sense.

Another frequent area of accounting fraud is to record expenses as an asset.  How does this work?  Well there is a fine line between assets and expenses.  To keep it relatively simple, assets are expenses that have a benefit in the future.  That’s why we capitalize property and buildings – they will provide a benefit for years to come.  Conversely expenses do not have any future benefit, their benefit has all been used up in the current period.  Well a fairly simple (and fraudulent) technique is to increase your net income by recording expenses as an asset.  Did you notice that decrease in Livent’s preproduction costs?  Yep, that’s what was going on.  They were capitalizing (recording as an asset) production costs that were never going to generate any future value.

A third area where Livent got caught with their hand in the cookie jar was less common (I’ll explain why in a minute) – not even recording the expense.  What was happening was as Livent got a bill in near year end, they were not paying the bill yet (that’s fine, that’s good cash flow management).  A proper accounting system would set that bill up as an expense and as an account payable before year end.  By ignoring that, Livent was artificially increasing their net income (since they didn’t record the expense) and artificially decreasing their liabilities (since they didn’t record the accounts payable).  Wrong on both accounts.  Now why is this not a common area of fraud?  Because its pretty damn easy to find.  All an auditor has to do is look through a stack of unpaid bills and subsequent bill payments and note the date on the bill.  Prior to yearend?  It should be recorded.  Just after yearend?  Let’s do a little more investigation.  So Livent was a case of really sloppy auditing.  No surprise that the three key auditors have all got their knuckles rapped pretty hard.

In conclusion, I know this case is REALLY old but its worth revisiting since it highlights very basic accounting principles that all accounting students should be able to understand.  One final thought – if you’re involved as an accountant with a business avoid this kind of crap at all costs, its not worth it to your reputation.

Here is the official description of the accounting restatements that I discussed above (November 18, 1998 letter):

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 Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

Can’t See the Trees in the (Sino-)Forest?

Sino-Forest has been the centre of a major accounting scandal in Canada since June 2011, when the first word of missing trees came out. The gist of the scandal is that Sino-Forest, a Chinese tree farm/lumber company listed as a publicly-traded company on the Toronto Stock Exchange, claimed to own hundreds of thousands of acres of forest in China. It turned out that those forests were as fictional as Treebeard and the rest of his clan in The Lord of the Rings.

How does one lose a forest? You might have thought that the auditors (Ernst & Young) would have checked for their existence, and they probably did. But auditing forests is not an easy job. Auditors might ask management to take them to the forests to see them first hand, but would have no way to know if the trees they were looking at actually belonged to Sino-Forest. I also suspect you could almost blindfold any auditor, spin them around three times, clap your hands, and the forest would look different enough that you could claim they were looking at a different package of land.

Things were also complicated by the fact that many of the documents were in Chinese, and most of the audit staff didn’t read Chinese.Its difficult to consider a purchase/sale document for a hunk of land as solid audit evidence when very few people could actually read the document. So, we have a “potential” case of audit failure. Again. (Sigh.)  Ernst & Young (Canada) has settled all civil litigation related to this failure for $117 million—the largest such settlement in Canadian history. I should point out that the settlement clearly states that there is NO admission of guilt.

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The Sino-Forest scandal and Ernst & Young’s settlement comes right on the heels of all the Big 4 accounting firms getting their knuckles rapped for violating some US SEC audit rules about disclosure of audits of foreign (primarily Chinese) companies. But if an audit firm does disclose the necessary information to keep the SEC happy, it breaks a Chinese rule about privacy and non-disclosure—a can’t-win situation. Nonetheless, the SEC has kicked over 40 Chinese companies off American stock exchanges in the past few years for various violations.

What’s going on here? I suspect that Chinese companies that are growing and need access to capital look to North America (NYSE, TSE, etc.) with eyes wide with anticipation. These companies are greeted by North Americans who have been told time and time again that they should invest in the red-hot Chinese economy (Sino-Forest shares were recommended as recently as May 2011, less than a month before things unraveled). In order to be listed in North America, a Chinese company must enlist the help of one of the Big 4 North American accounting firms. The Big 4 are all too happy to help since they want to hold on to market share and grow their billings. Combine uninformed investors with compliant auditors and a massive language barrier and you get the obvious result: Sino-Forest.

From an accounting perspective, what went on at Sino-Forest? To keep it simple, money was flowing out of the company supposedly for the purchase of massive tracts of forest. In reality, the money disappeared into the hands of a select few executives. So Sino-Forest had no cash, massive debt, no forests, and hence no future revenue. Its stock plummeted and the firm went bankrupt.

Stories like this make investing in Walmart or Apple substantially more appealing, don’t they? I can drive down the street and see a Walmart store with my own eyes; I can see and hear the massive crowds in the store buying merchandise. I can sit at my local coffee shop and observe that more than half the people there are using iPhones. But I can’t easily see, hear, or smell the forests “owned” by Sino-Forest. They were supposedly halfway around the world in some remote area of China, and since one forest looks pretty much like any other forest out there, I couldn’t have told them apart even if I had seen them. What’s the lesson here? KISS (keep it simple stupid), I think. Invest where you can see, hear, feel, or smell the business. At least then you’ll have some assurance that Treebeard won’t sweep in and steal the business out from under your eyes/ears/nose.

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)