Better investing through fraud awareness

There’s much to gain from studying financial statement frauds. Accounting schemes are often recycled because of weak accounting rules and lax auditing. Since frauds are rarely unique in any significant way, there’s an opportunity to recognize the signs and steer your clients clear of trouble.

Roadrunner Transportation Systems is a U.S.-based trucking company whose share price has fallen by 97% over the past few years for various reasons, not the least being a multi-year accounting fraud as alleged in a recent SEC complaint.

The April 2019 filing details allegations against three former executives involving accounting manipulation from 2013 to 2017.

The SEC said the executives’ motive was fairly ordinary: manipulate earnings to meet analyst expectations and prod the share price to cash out stock options. The accounting scheme included several other elements that we commonly encounter in financial statement frauds.

Roadrunner grew in size by purchasing smaller shipping companies: 20 of them over a span of seven years. Growth by acquisition is a red flag in investing, since it’s easier to cover up accounting manipulations in a fast-growing company where the picture is constantly changing. Frauds can be carried on for years without detection by increasing the size of the cover-up with each passing quarter, especially if auditors are less than attentive. Investors need clear insight into underlying organic growth versus acquired growth—or they risk mispricing shares.

The acquisitions did not go well for Roadrunner and the company was at risk of missing consensus earnings expectations. The SEC alleges the executives decided to defer the recognition of expenses to future quarters and ignore the impairment of various assets (including accounts receivable) to artificially inflate earnings. Delaying expenses can be achieved in multiple ways and Roadrunner used at least two familiar gambits that avoid auditor detection: not entering payables into the accounting system, and lowballing expenses related to road accidents (something found more in transportation and insurance companies).

Whenever Roadrunner acquired a smaller firm, part of the consideration was in the form of an earn-out based on the acquisition’s future performance. Since these earn-outs are a contingent liability for Roadrunner, they are recorded on the balance sheet at their estimated fair value every quarter. When an acquisition underperforms, the value of the contingent liability should be lowered to reflect the smaller expected future payout. However, analysts are generally attuned to this warning sign, so the executives at Roadrunner allegedly kept the liabilities inflated to maintain the appearance that everything was performing as expected.

The executives also used multiple adjustments to achieve the desired result in the financial statements, another common attribute of fraud. When expenses are pushed into a future quarter, an even greater amount needs to be pushed in the following quarter to show earnings growth—unless another technique can be employed to manipulate results. The executives chose to also use the earn-outs as a “cookie jar” liability, decreasing the liability slightly when needed to provide a small income boost (when enough expenses could not be stripped out to meet earnings expectations).

As the alleged fraud progressed, and larger cover-ups were needed, the executives used four more common schemes to inflate earnings: not recording customer claims for damaged shipments, under-amortizing prepaid fees, delaying writing off bad debts and not recording bonus accruals.

Other motives to inflate earnings also developed over time, including the need to stay within EBITDA-based borrowing covenants. In one quarter, the SEC said that Roadrunner overstated operating income by 50% and earnings per share by 65%.

As in this case, such frauds usually collapse under their own weight, sometimes helped by an internal whistleblower or astute investor pushing the board to question the books.

Many of the accounting items that were allegedly manipulated at Roadrunner fall into the category of management judgment, which requires executives to estimate amounts on a quarterly basis, and which can be stretched more easily and pushed past weak auditors.

There were many red flags: growth by acquisition, large earn-out provisions, increasing leverage, unusual shifts in expense categories and major customer defections that did not hinder results.

It’s always better to avoid the hallmarks of cooked books when investing because there’s almost no chance of recovering funds lost to executive fraud or auditor negligence. Recognizing some of the more common recycled tricks can help your clients avoid trouble before it happens.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.