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Apr 18th 2020 edition

Who’s lost their trunks?

The economic crisis will expose a decade’s

worth of corporate fraud
Downturns are accounting crooks’ worst enemy

Apr 18th 2020

Editor’s note: The Economist is making some of its most important coverage
of the covid-19 pandemic freely available to readers of The Economist Today,
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W hen bernie madoff owned up to a $65bn Ponzi scheme in

December 2008, it was not out of guilt. He knew the game was up.
Three months earlier Lehman Brothers had imploded. The market
meltdown sent clients clamouring to withdraw from his funds, leaving
them depleted with many investors still unpaid. American regulators had
not spotted the fraud, despite a tip-o! years earlier. It was not them that
did for Mr Mado!, but recession.

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Booms help fraudsters paper over cracks in their accounts, from "ctitious
investment returns to exaggerated sales. Slowdowns rip the covering o!.
As Baruch Lev, an accounting professor at New York University, puts it,
“In good times everyone looks good, and the market punishes you harshly
for not keeping up.” Many big book-cooking scandals of the past 20 years
emerged in downturns. A decade before the crisis of 2007-09 the dotcom
crash exposed accounting sins at Enron and WorldCom perpetrated in the
go-go late 1990s. Both "rms went bust soon after. As Warren Bu!ett, a
revered investor, once put it: “You only "nd out who is swimming naked
revered investor, once put it: “You only "nd out who is swimming naked
when the tide goes out.” This time, thanks to a pandemic, the water has
whooshed away at record speed.

Hell and low water

Much of the swimwear was already threadbare: a borrowing binge has
strained many corporate balance-sheets. Some dirty secrets are beginning
to come out. Take Luckin Co!ee, which had expanded to take on
Starbucks in China, attracting big-name investors like Blackrock and
Singapore’s sovereign-wealth fund. On April 2nd the Nasdaq-listed
Chinese chain announced an ongoing internal probe amid allegations
that its chief operating o#cer and other employees may have fabricated
over 2bn yuan ($280m) in sales. On April 14th Citron Research, a short-
seller, accused gsx, a Chinese online-tutoring "rm listed in New York, of
in$ating last year’s sales. In a statement gsx denied the allegations and

said Citron’s report was misleading and “full of subjective maliciousness”.

These revelations have revived fears over the $aky corporate governance
of Chinese "rms listed on foreign exchanges, whose audits, conducted at
home, China’s government makes it hard for outsiders to inspect. A
gaggle of fraud-hunters like Citron and Muddy Waters, which outed
Luckin, claimed numerous scalps after the "rst wave of such listings a
decade ago. This time they are looking beyond China.

Blue Orca Capital, an Asia-focused fund targeting corporate “zeros”,

expects opportunities to pop up in other emerging markets, Europe and
America. “My entire career has been in a bull market,” says its founder,
Soren Aandahl. “This is exciting.” Mr Aandahl is eyeing any "rms with
discrepancies between the amount of capital they need to raise and the
cash their accounts say they are generating. Others are focusing on
industries hit hardest by the pandemic, such as travel, entertainment and
property.
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Only a small minority of "rms resort to outright fraud. Far more prettify
pro"t-and-loss statements with accounting wheezes that fall in a grey
area. This accounts for much of what John Kenneth Galbraith, an
economist, called “the bezzle” and “psychic wealth”: gains that appear
real but prove illusory.

In the bull market startups became masters of conjuring up novel metrics

that $atter performance. WeWork’s “community-adjusted” earnings
before interest, taxes, depreciation and amortisation (ebitda)
transformed a hefty loss for 2018 under Generally Accepted Accounting
Principles (gaap) into a pro"t. Illegal? No. A red $ag? Absolutely. Many
investors turned a blind eye because they bought into what Mr Aandahl
calls “the myth in the shareholder list”: all would be well if other high-
pro"le backers were on board (as with Luckin).

Non-gaap adjustments have spread like wild"re through corporate

accounts, making it harder to discern what numbers re$ect a "rm’s true
accounts, making it harder to discern what numbers re$ect a "rm’s true
"nancial position. The average number of non-gaap measures used in
"lings by companies in the s&p 500 index has increased from 2.5 to 7.5 in
the past 20 years, according to pwc, a consultancy. In credit agreements
analysed by Zion Research Group, the de"nition of ebitda ranges from 75
words to over 2,200. gaap is far from perfect, but some of the divergence
from it has clearly been designed to pull wool over investors’ eyes. One
study found that non-gaap pro"ts were, on average, 15% higher than
gaap pro"ts.

Playing around with earnings and revenue-recognition metrics is this

generation’s equivalent of dotcoms using bots and other tricks to boost
“eyeballs” 20 years ago, says Jules Kroll of k2 Intelligence, the doyen of
corporate sleuths. “When an area is hot to the point of overheated, there
is a growing temptation to juice the numbers.” In an ominous sign,
SoftBank, a Japanese technology conglomerate which bet big on WeWork
and dozens of other startups, said this week that it expects an operating

loss of ¥1.4trn ($12.5bn) in its last "scal year.

Besides exposing old schemes, the pandemic is likely to give rise to new
ones. When economic survival is threatened, the line separating what is
acceptable and unacceptable when booking revenues or making market
disclosures can be blurred. Mr Kroll reckons that “amid such massive
dislocation, some will inevitably cheat.”

Bruce Dorris, head of the Association of Certi"ed Fraud Examiners, the

world’s largest anti-fraud out"t, says the e!ects of covid-19 look like “a
perfect storm for fraud”. It may engender everything from i!y accounting
to stimulus-linked scams as thousands of "rms—including bogus
applicants—hustle for help. One fraud investigator points to private-
equity-owned "rms as potential targets. “There are lots of them, they are
highly leveraged and they may not qualify for bail-outs because they have
deep-pocketed sponsors,” he says. That increases the temptation to resort
to unseemly practices. The ebbing tide is likely to reveal plenty of
to unseemly practices. The ebbing tide is likely to reveal plenty of
corporate nudity. That will not stop some businesses from taking up
naturism.7

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This article appeared in the Business section of the print edition under the headline "Who’s lost
their trunks?"

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