Sarbanes-Oxley Act (SOX) in July 2002 to protect sharehold- ers and the general public from account errors and fraudulen
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Joseph McNamara, CCE, CICP
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As a 25-year veteran of credit management, I have always believed the two most critical areas for a credit practitioner are the customer relationship and the strength of the credit team. From company to company, variances exist. However, the core fundamentals virtually always remain the same, starting with a solid analytical team in its respective credit departments. I have found meeting with customers an invaluable experience, as it allows you to better understand their needs and wants and helps build important long-term business-partner relationships. If a credit professional meets with them at their facility, it is also possible to pick up visual clues that can help with credit assessments. On such visits, credit professionals should ask themselves many questions: • Was the facility clean, dilapidated or updated? • Were employees busy or meandering around? • Is a lot of office space open or unused? If an office tour includes the warehouse, which I’d highly suggest, how does their inventory look—are they stocked to the rafters or at a bare minimum? • Is there seemingly too much concentration from one manufacturer or is there a good assortment of product across diverse product categories?
Corporate collapses and scandals that affect credit managers and their employers can have a catastrophic effect, especially if they lead to insolvency or bankruptcy. As for the strength of the credit team, at the core of all successful departments is strong credit analysts. Skill sets, levels of expertise and the information available may vary among analysts, but it is invaluable to have a team that can come together to collate, decipher, trend and ultimately put together information into an easily readable format. Despite comfort in the strength of relationships and the credit teams in my professional experience, one concern that always sat in the back of my mind focused on the
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accuracy of information: What if the financial statements were wrong and, if there was a misrepresentation in the numbers, was it committed unknowingly or on purpose? Corporate collapses and scandals that affect credit managers and their employers can have a catastrophic effect, especially if they lead to insolvency or bankruptcy. “Many of the companies that commit financial statement fraud are dealing with adverse performance issues and committing fraud to cover those up,” said Toby Bishop, director of the Deloitte Forensic Center. “A significant proportion of them, at least 20%, will end up filing for Chapter 11.” Fraud-linked bankruptcies like Enron, WorldCom and Adelphia kept U.S. courts busy for years. Notably, companies admonished for financial-statement fraud were twice as likely to file for bankruptcy as those that were not cited, sources like AccountingWEB and others have noted. More than half of U.S. organizations that experienced fraud in the past three years reported an increase in the number of occurrences, according to a report by PricewaterhouseCoopers (PwC) data. It also found a rise in accounting fraud, bribery and corruption, with cybercrime moving to the forefront of U.S. companies’ concerns. PwC U.S. found a continuing upward trend in the frequency and detection of economic crime, according to its Global Economic Crime Survey 2014. About 45% of organizations in the United States reported being victimized in some type of fraud scheme in the past two years, more than the global average of 37%, according to a February 2014 Accounting Today article by Michael Cohn.
april 2015
Fraud, Accounting Scandals and the Effect on Trade Credit: Part I
Although accounting fraud has happened throughout the years, a wave of scandals erupted in the U.S. in the early 2000s, with some notable ones that ended in bankruptcy: • E nron was a global gas and oil product manufacturer once believed to be highly profitable, in part because the company’s energy commodities were so heavily traded. In 2001, the U.S. Securities and Exchange Commission (SEC) noticed irregularities in Enron’s financial statements. It was found that Enron was booking round-trip trades with prearranged buying and selling agreements where Enron would sell and buy back the commodities at the same price, and no actual profit was recognized. But trading was very heavy, enticing investors to buy the company’s stock. It also had substantial bank borrowings that were channeled through other Enron made-up companies and were made to look like the borrowed funds came from substantial trading deals. Investors withdrew their investments, and in December 2001, Enron filed for bankruptcy protection. • W orldCom was one of the largest global telecommunications companies that met with failures in its long-distance telephone ventures due to technological advancements in communications. Causing falling share prices and a failed share-buyback scheme, courts found that directors used fraudulent accounting methods to inflate the stock price. Its internal audit team found irregular accounting entries that ultimately spurred an SEC investigation. There was $11 billion in fictitious accounts receivable entries. This caused stockholders to pull out their investments and WorldCom filed for bankruptcy in July 2002. • G lobal Crossing, was another telecommunications company that found itself overextended, with substantial borrowings and failed business projects. It used fraudulent accounting transactions to cover this up. Investors were led to believe that transactions with other telecom companies were exchange swaps, and not round-trip trades. Borrowings were also made to appear as money coming from trade negotiations. In January 2002, it filed for bankruptcy protection. • P armalat was a multinational Italian dairy and food corporation that entered into the world’s financial markets after it made several international acquisitions, financed with debt. However, many of its divisions were producing losses. It started to use the derivative market with the intention of hiding losses and debt, with plans to raise 300 million euro through new bond issuance. The bond issuance was dropped, but public concerns over transactions with a Cayman Island-based mutual fund sank shares. Unable to acquire the cash needed to pay debts and bond payments, Parmalat filed for bankruptcy protection in December 2003.
These incidents were all caused by accounting fraud or by misstatement of account records at the buyer level. Similarly, account fraud caused three of the four largest claims at Equinox Global, a trade credit insurance provider. Notably, the claims Equinox handled occurred in the U.K., Germany and Denmark—these are countries believed to be associated with very low fraud levels. As the number of high-profile public cases with financial scandals and fraud in the U.S. mounted in the early 2000s, including the above mentioned U.S. firms and others like Tyco and Adelphia Communications, investors lost faith in the audited reports. The U.S. Congress stepped in and passed the Sarbanes-Oxley Act (SOX) in July 2002 to protect shareholders and the general public from account errors and fraudulent practices, as well as to improve the accuracy of corporate disclosures. The SEC administers the act, which sets deadlines for compliance and publishes rules on requirements.
As organizations rely more on technology, they increasingly do business in a “borderless economy” where they are more susceptible to threats from all sides. SOX not only affects the financial side of corporations, but also the IT departments charged with storing a corporation’s electronics records. It is not a set of business practice mandates and does not specify how a business should store records, It does, however, clarify which records need to be maintained and for how long. Fraud incidents have not stopped with the uncovering of these or the advent of SOX. PwC noted that as organizations rely more on technology, they increasingly do business in a “borderless economy” where they are more susceptible to threats from all sides. Fraud at U.S. organizations initially detected by external measures or by accident in 2014 more than doubled from 2011 levels (up to 32% from 15%). In 2011, incidents initially detected through external tip-offs occurred more often than any other method, according to Accounting Today. Joseph McNamara, CCE, CICP is vice president of credit and political risk at Equinox Global, a Lloyd’s of London coverholder specializing in trade credit insurance. He previously worked for well-known companies including Panasonic, Castrol NA (a BP Amaco Company), Kemper Casualty and Samsung Electronics. Look for part two of this story in the May edition of Business Credit. *This is reprinted from Business Credit magazine, a publication of the National Association of Credit Management. This article may not be forwarded electronically or reproduced in any way without written permission from the Editor of Business Credit magazine.
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