The pandemic and beyond — the increasing importance of forensic analysts
Published on March 10, 2021 by Fawas Ahamed
If 2020 were a normal year, accounting scandals at Wirecard, NMC Health and Nikola would have demanded more headlines. The problems at these companies and the eventual fallouts are well documented. The purpose of this blog is to reflect upon the benefits of employing a sceptical view of the popular narrative and the increasing importance of forensic analysis as a key tool to investors, drawing from the lessons from these scandals and highlighting possible catalysts for more scandals waiting to be uncovered.
In auditors we trust. Or do we?
NMC Health and Wirecard were audited by Ernst and Young (EY). Nikola was audited by RSM US LLP. EY has a global presence and is a mammoth in the accounting industry. RSM US LLP was ranked fifth in the list of US accounting firms by revenue in 2019 1. Both firms are well respected. Both missed the most basic signs of fraud!
These episodes yet again remind us of the need to treat auditor assurances with the proverbial grain of salt. The debate on watchdogs and bloodhounds rages on. The inherent conflict in the “issuer pays” model — how auditors are paid and who pays them — along with the dependence on audit clients for lucrative non-audit-related services, continues to be a key chink in auditors’ armour. Revenue from non-audit-related fees was almost double that from audit fees at the Big Four audit firms in 2020 2. Auditors continue to hide behind legalese, caveats and disclaimers even as the world tries to dislodge them from their fortress of limited accountability, foisting upon them the responsibility to detect, at least the very basic forms of fraud (the kind that can be spotted by adhering to basic audit procedures, such as seeking an independent confirmation of cash and bank balances in the case of Wirecard).
Over the past three decades, this vacuum, created by the audit industry’s unwillingness to accept responsibility for detecting fraud, has been surreptitiously filled in — by hedge funds, asset managers and the like — by employing the services of forensic analysts. One common indicator of an attractive short-selling opportunity is questionable accounting practices, typically identified by forensic analysts who are willing to spend hours digging through filings and public disclosures to spot signs of accounting indiscretion.
When the tide goes out
“Only when the tide goes out do you discover who’s been swimming naked.” — Warren Buffett
The US stock market has been on an extended bull run since April 2020. Low interest rates, generous fiscal stimulus packages and the availability of only limited investment (and entertainment) options to retail investors have been cited as reasons for the meteoric rise in share prices (in some cases, totally detached from fundamentals). We have even seen instances of what would have conventionally been bad news about a stock leading to an increase in share prices. Among the more bizarre stories are those of Hertz and JC Penny, the share prices of which rose just days after they filed for bankruptcy!
In March 2020, lockdowns suppressed economic activity and rendered, at least temporarily, the business models of many industries redundant. This pushed some companies — with unsustainable levels of leverage, shaky earnings and declining operating cash flow — dangerously close to bankruptcy. Proactive measures by central banks around the world helped prevent a financial crisis similar to that in 2008–09 (helped in no small measure by banks having much better capital cushions compared with 2008–09). However, financial markets awash with cheap capital also meant that companies that were in not-so-good financial health before the pandemic received a lifeline of cheap debt and equity financing, helping them prolong their (inevitable) correction in share prices (or bankruptcy). According to UNCTAD 3, global non-financial corporate bond issuance stood at a record USD2tn in 1H20, a 49% increase vs 1H19 and ‘there are growing concerns that much of this debt is substandard’. Thus, the tide of cheap capital has helped cover those that were “swimming naked”, and it is only a matter of time before it goes out.
When will all this unwind? With US policymakers unable to agree on a new round of stimulus, countries navigating towards a painful end to the second wave of infections and the vaccine rollouts tempting central banks around the world to rethink the extension of stimulus packages, we are perhaps beginning to see the first signs of a return to normal, at least from the perspective of financial markets.
What happens when the pandemic-related concessions are pulled back?
Many companies have benefitted from pandemic-related concessions in the form of, for instance, debt moratoriums, extensions and deferrals. Debt covenants have been relaxed or suspended during the pandemic. Even accounting standards have been amended to provide pandemic-related lease concessions that sometimes result in a gain on the income statement (through negative variable lease payment adjustments). Thus, much of the pain has been postponed. Once vaccination campaigns reach the coveted point of herd immunity and we enter the recovery phase, though, these concessions will likely be lifted, causing the added burden of payments related to deferred debt servicing. It is reasonable to expect some companies with high leverage plus accounting red flags related to cash flow generation and earnings to likely be up for a painful correction in valuation, or worse.
It is in this context that forensic analysis and an extra layer of scrutiny of elements such as earnings and cash flow sustainability, use of capital and leverage gain paramount importance.
Forensic analysis is today a well-established niche tool in an investor’s toolkit. The role of forensic analysis differs based on whether an investor is bullish or looking to sell short. For shorts, it often forms a key pillar of the investment thesis — indeed, accounting-related anomalies are a stronger, more credible reason for taking a short position on a stock. For investors bullish on a stock, forensic analysis provides an important layer of investment validation, i.e., gauging whether historical results are sustainable or if these results are tainted by questionable accounting or other strategic/financial choices not reflective of the operational and capital management needs of the entity or industry.
We at Acuity Knowledge Partners have a team of forensic analysts with more than 10 years of experience in catering to this niche market. Our clients include asset managers, hedge funds and investment banks.
Originally published at https://www.acuitykp.com.
About the Author
Fawas, Assistant Director, ACA, ACMA (UK), ACCA (UK), has been a part of the Acuity Forensic Analysis team for 8 years, and has 13 years of total work experience. He is knowledgeable in forensic analysis, investment research (with focus on quality of earnings), and auditing, and is well versed on corporate governance best practices and the UK combined code. Currently at Acuity he works as Senior Forensic Analyst engaged in preparing and supervising accounting diagnostic reports and their updates, supervising forensic-lite reviews, and providing forensic accounting support for clients looking to short stocks. Fawas started his career at Ernst and Young, where he was Executive in charge of statutory audits at the time of leaving. He is an Associate member of CA Sri Lanka, an Associate member of ACCA (UK), an Associate member of CIMA (UK) and has completed level II of the CFA examination.