Fraud doesn’t take a holiday

On top of everything else investors have had to deal with this year, frauds and volatile financial reporting are a risk as companies struggle to survive the pandemic.

Luckin Coffee is a China-based chain frequently cited as a major competitor to Starbucks in Asia. The company was listed in the U.S. in May 2019 at $17 per share (all prices are in USD). Luckin posted impressive results during the year and the stock reached over $50 in January, shortly after the company sold a new swath of shares for $42.

As the month closed, due diligence firm Muddy Waters Research said it had received an anonymous report alleging widespread financial misrepresentation at the company. Muddy Waters is best known in Canada for unearthing the fraud at Sino-Forest Corp.

Based on a review of thousands of hours of video scrutinizing traffic numbers and tens of thousands of customer receipts, the anonymous report claimed that the number of items sold by Luckin was inflated by 69% in the third quarter of 2019 and by 88% in the fourth.

As with any information void, there were competing views. Citron Research, best known in Canada for publicizing the troubles at Valeant Pharmaceuticals before its steep decline, defended Luckin.

In April, Luckin stock collapsed by 76% the day the company confirmed that its chief operating officer and several subordinates had been suspended for allegedly fabricating transactions and inflating 2019 sales by roughly $439 million during the last nine months of the year.

By comparison, the company reported total sales of $578 million during the first nine months of the year. The company withdrew its financial statements for the affected period and set up a special committee of independent directors to investigate.

In hindsight, Luckin was growing at an incredible rate. After just two years in operation, the company had more outlets in China than Starbucks, which had even altered some of its store formats to compete.

For the second and third quarters of 2019 (the final periods for which results were published), Luckin reported quarter-over-quarter increases in the number of items sold of 60% and 70%, respectively. This was after showing a decline in the first quarter of 2019, which the company said pre-dates the manipulation.

Really, something else to worry about?

Why further raise anxiety now by reminding advisors that financial frauds never take a holiday? Because fraud increases under economic and market pressures. That’s especially true if management sees a downturn as temporary, with a V-shaped rebound.

The accounting rules provide more than enough leeway to allow for short-term manipulations. Executives can borrow a bit from the fourth quarter of 2020 to make the second and third quarters look better. Executives might do this if liquidity is an issue and there is a need to raise funds mid-year. The auditors won’t come around until after year-end and, even then, there’s no guarantee they’ll catch accounting chicanery.

Some executives might feel emboldened and pressured to do what they can. This can also include doing the complete opposite and making short-term results (first and second quarters) look as bad as possible to boost second-half returns. This way, quarter-over-quarter comparisons look better, the growth trend looks steeper, and the pump is primed if previous negative assumptions and losses need to be reversed in the latter half of the year.

While this type of accounting manipulation is no better than inflating earnings, the market tends to give it more of a pass. If we had to give odds, this is what advisors should be on the watch for in 2020 financial statements.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp. www.accountabilityresearch.com