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Can We Trust An Auditor’s Report?

Accounting scandals have been in the spotlight in recent months. Companies such as Wirecard (ETR: WDI) and Luckin Coffee are two of the more recent high profile cases that have cost investors billions of dollars.

Worryingly, both companies were given a pass from reputable auditors before their respective cases blew up. As investors, we rely on external auditors to give us a sense of the company’s financial well being. But with the latest scandals, can we truly trust an auditor’s stamp of approval?

Nothing new

There have been many high profile accounting scandals over the past few decades.

One major example that comes to mind is the accounting scandal of Waste Management Inc. In 1998, the company was revealed to have faked over US$1.7 billion in earnings from 1992 to 1997. Then CEO, A. Maurice Meyers was eventually found guilty along with other top executives and the SEC (Securities & Exchange Commission) fined Arthur Anderson, the company’s auditor, over US$7 million.

But the case that truly shocked the world came a few years later in 2001- Enron. Enron was a US energy, commodities, and services company. In that year, it was discovered that the company had been using accounting loopholes to hide billions of dollars of bad debt, while inflating earnings. Within a year, Enron lost US$74 billion in market capitalisation. Its auditor was again Arthur Anderson, which by then had lost so much of its reputation that it was forced to dissolve.

Recent scandals 

You would have thought that the demise of Arthur Anderson would have brought a swift change to the industry. And yet, more than two decades later, we still hear of major scandals rocking the financial world.

Earlier this year, the China-based but US-listed coffee chain, Luckin Coffee, admitted that at least US$310 million of its sales over the previous three quarters were fabricated.

Today, Luckin Coffee’s shares have been delisted from the NASDAQ exchange where they were previously listed, and the company’s survival is in serious doubt. One of the company’s major shareholders is none other than GIC, one of the Singapore government’s investment arms, owned 5.37% of the Chinese company as recently as March 2020.

The other big-name scandal this year was Wirecard, a high flying payment solutions company that is headquartered and listed in Germany. It was considered one of Germany’s tech success stories and was briefly included in the country’s main stock market bellwether, the DAX index.

However, on 25 June this year, Wirecard filed for insolvency after revealing that €1.9 billion in cash was missing from its coffers. One of the company’s largest investors is Softbank, which injected €900  million cash in 2019. Softbank has since joined efforts with Wirecard’s other investors to pursue legal action against the company’s auditor, EY.

Worrying for investors

Although the vast majority of companies are free from accounting fraud and investors can fully trust whatever they see on the financial statements, these recent accounting scandals cast a shadow of doubt for investors.

Both Wirecard and Luckin Coffee were audited by reputable auditors and yet both managed to distort their financial statements. Even professional investors such as GIC and Softbank were badly burnt.

Most worryingly, Wirecard reportedly managed to hide the missing cash from auditors for years. As investors, we often look at the cash statement as the most reliable piece of information because cash is traditionally the hardest to manipulate. And yet, Wirecard was able to mislead investors that they had more than US$2 billion in cash, which they didn’t.

What other steps can we take

As investors, we usually look to the auditor’s report as the source of truth. They are supposed to be our neutral insiders. Yet, the past few scandals have shown that sometimes an auditor’s stamp of approval is simply not enough.

So what more can we as investors do?

I think as investors, it is difficult to sniff out whether a company’s financial statements are legitimate. Even big-name investors may end up betting on the wrong horse. The best we can do is to look at trends and market data. For instance, investors should look at the past track record of the company, the background of the managers, and where the company is audited and listed.

If anything seems amiss or too good to be true, our danger-radar should be up.

Portfolio sizing is also important to try to reduce the risk of accounting scandals. Having a sufficiently diversified portfolio and sizing down a position that you think has a greater risk of fraud ensures that if you are unfortunate enough to bet on a fraudulent company, your portfolio as a whole will still not be severely impacted.

A call for change

Based on recent scandals, we can see the clear conflicts of interest for auditors. Auditing firms are paid by the company that they are auditing, and these contracts may be worth millions of dollars.

To protect their nest egg, auditors could be under pressure to turn a blind eye on accounting malpractice, as was the case in the Enron scandal.

Changes, therefore, need to be made in the way companies are audited. The conflicts of interest create an unnecessary incentive and can be the reason why accounting fraud may take such a long time to be detected.

Regulatory bodies need to find a way to reduce these conflicts of interest to prevent accounting scandals that not only hurt investors but the integrity of the financial markets as a whole.

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Note: An earlier version of this article was published at The Good Investorsa personal blog run by our friends.

Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.