Can Corporate Deception Be Spotted Early?

Can Corporate Deception Be Spotted Early?

In the 1990s investors worried about missing the next Enron or WorldCom. Today they worry that they’ll find them. Unfortunately, say scholars at Emory University and its Goizueta Business School, there’s no easy way to spot a company that’s out to mislead investors.

“It’s hard to pin down any underlying patterns in these things,” says Andrew Ward, professor of organization and management at Emory University’s Goizueta Business School. “If they’re good enough to work, the people are competent enough to pull this fraud over people for quite a while. It doesn’t necessarily tend to follow a pattern.”

Emory scholars say that not only is it difficult to see such a case ahead of time, but even sector bubbles are not always easy to identify until after the fact.

In companies, obscurity tends to be one danger signal, Ward says. ‘If you can’t figure out what’s going on by what the company’s putting out, then you have to be wary of what’s actually going on inside the company. There’s no reason why in their [financial statements] they can’t be made clear as to what they’re doing and why they’re structuring these things in such a way,” he adds.

If the numbers don’t make sense, don’t look to the company’s board of directors for assurance, Ward advises. No matter how distinguished the panel, the board is reliant on numbers supplied by the company.

One key may be to avoid companies for whom things seem to be going too well, too consistently, says Edward Chancellor, a London-based journalist and author of Devil Take The Hindmost, a history of financial speculation. It’s difficult to sustain 15% growth in an economy that’s growing at 5%, he says.

Robert S. Chirinko, a professor of economics at Emory’s Department of Economics, says that it may not pay to rely too heavily on earnings numbers. Instead, he suggests that price to cash flow is a stronger indicator. "Income or earnings are accounting concepts, and hence more susceptible to manipulation than cash flow."

But numbers don’t tell the whole story. One New York investor relations advisor, L.J. Rittenhouse, claims that the CEO’s annual letter to shareholders can be an important tool in evaluating a company’s leaders. Rittenhouse grades shareholder letters using a model that rates each letter by the amount of “clichés, technical jargon, generic throw-away phrases, obvious spinning” that she finds.

“For the most part, these shareholder letters are discounted, ignored, or thrown out in the garbage without being read,” she says. Around two-thirds probably deserve this fate, according to Rittenhouse, but those that are models of clarity tend to be among the strongest companies in their own sector. “Companies that are top of their industry in the Fortune 500 will score high in their language,” she says. In the past three years she has been making these ratings, she notes, the top 15 of the Fortune 100 companies whose letters she analyzes generally outperform the market.

“What’s interesting about the letter is that it is a statement of personal accountability. It is signed by that CEO,” she says. A good letter leaves you feeling that you’ve met with the CEO in person. “You feel you’ve been given a balanced view of the business,” she explains. “You’ve been told in specific ways what worked during the year, what was successful. You will also be told what didn’t work.”

This year, Rittenhouse’s candidates for remedial corporate communications class include WorldCom and AOL TimeWarner. Bernard Ebbers, WorldCom’s former CEO, earned poor marks for clarity and directness. “There was no balance in that letter. Everything was hype, hyperbole, ‘everything’s going to be great, we’re forging ahead.’” On June 25 WorldCom announced $3.8 billion in fraudulent capital expenses in its financial statement, which sent the stock plummeting and resulted in the immediate layoff of 17,000 employees.

As for AOL TimeWarner, one of Rittenhouse’s chief concerns is that a letter by former CEO Gerald M. Levin failed to discuss a $54 billion charge the company took following its merger. “It didn’t even mention it,” she says.

Al Hartgraves, a professor of accounting at Goizueta, says that taking a good look at the financial statements can go a long way toward identifying most possible problems. “I think good old fashioned basic financial statement analysis is what people need to do, instead of investing on some hot tip or whatever happens to be the hot stock at the moment. Momentum investing has proven itself to be very, very risky,” he says.

A few classic red flags, according to Hartgraves:

Inconsistencies between the amount of cash that operations are generating and the amount of profits operations are generating. “If profits are going up, and operating cash flows are going down, it’s a very clear signal that there are problems,” he says.

Declining gross profit margins. If accounts receivable are growing faster than sales, watch out, Hartgraves advises. Accounts receivable are payments owed the company by its customers; if they’re piling up faster than sales, it could be a sign that the company is either in trouble or heading for it.

Regular and frequent “big bath” write-offs. “There’s a real correlation between the frequency with which a company has these so-called one-time write-offs and the riskiness of a company, from an investor’s standpoint,” Hartgraves says.

Even before a company gets its IPO, venture capitalists look for indications of character, according to Andrea Hershatter, a lecturer in organization and management who specializes in entrepreneurship. Most venture capitalists want founders to have a kind of “missionary zeal” about their company – and try to avoid people who just want to create something they can turn around and sell. “They seek to find people who are truly committed to whatever the need or the niche is that the company is being built to serve,” observes Hershatter, who is also assistant dean and director of the BBA program at Goizueta.

Ultimately, the only way to be absolutely safe may be to be particularly watchful in a market when it is bubbling. As English financial thinker Walter Bagehot noted nearly 150 years ago, good times “almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity.”

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