Wirecard - Why Income Statement Manipulation Results in Balance Sheet Manipulation

R^2 -Not Affiliated with Wirecard or Hin Leong

As you will recall, Financial Times articles reporting that Wirecard’s (WC) revenues and thus net income had been deliberately overstated triggered the unraveling of the company. Here is an article from early 2019.

If these allegations are true, then it should be no surprise that a significant amount of WC’s assets (most likely cash) does not exist.

And like AA’s “missing” Maybach S 850 Luxury Edition never did.

What that means is that Wirecard’s “billions” have not be misappropriated.

Nor have they been misplaced. Not left, perhaps, in the German equivalent of the Victoria Station Brighton Line cloakroom in a handbag or handbags.

Furthermore, we should have expected to learn that assets were inflated when we first read that income had been.

Since it seems that there is some confusion on this matter, (example here) I’m writing this post to explain why income statement manipulation necessarily requires manipulation of the statement of condition (balance sheet) by the same amount.

Similarly if there is misstatement of a company’s balance sheet, then it’s a very good “bet” that company’s income statement has been misstated as well as discussed further below. 

Why is this?

The answer comes the fundamental accounting identity: Equity = Assets – Liabilities.

If net income is overstated, then equity must be similarly overstated because the results of operations – net income or net loss – are added to equity.

As the balance sheet identity above demonstrates, if equity is overstated, then so must A-L.

Inflating net income then requires that one:

1. overstate assets or 
2. understate liabilities. 
3. Or some combination of 1 and 2.

But there’s more.

There is a very close relationship between the income statement and balance sheet.

In general every entry on the income statement is mirrored in an equal but opposite entry or entries on the balance sheet.

If one reports USD 100 in revenues (a credit), then a debit or debits for the same amount must appear on the balance sheet, e.g., in cash and/or accounts receivable.

If one reports USD 100 in expenses (a debit), then an equal amount credit or credits appears in the balance sheet, e.g., in cash and/or in accounts payable (a liability).

Non-cash revenues (e.g., revaluation of assets, reversal of provisions) must be accompanied by debits to the assets concerned or to existing provisions (contra accounts or liabilities).

Non-cash charges (e.g. depreciation, amortization, provisions) must be accompanied by credits most often to contra accounts to assets or in some cases creation of liabilities, e.g., reserve for litigation.

There’s no escaping this – if one’s balance sheet is to balance.

A dollar’s worth of “fiddling” the income statement, requires a dollar’s worth of “fiddling” the balance sheet.

As noted above, when one hears that a company's assets have been manipulated - usually to make them larger, then one should know that so has income.

By way of example is the case of Hin Leong Trading Singapore.

At this time, reports are preliminary not final.

Details remain “sketchy”--in both senses of the word.

Based on these three articles, CNBC, The Independent (Singapore), and AsiaOne, it appears that HLT hid some USD800 million in derivatives losses (oil futures), and fabricated some USD 2.2 billion of accounts receivable.

As well, the company's inventory is "short" USD800 million.

What that means in layman speak is that HLT’s inventory is overvalued. In this case the value of the actual (physical) inventory is USD800 million less than the value shown on HLT’s balance sheet.

HLT seems to have had two goals with the manipulation of its financials.

Creating fictitious income to cover losses.

Because the amount of the “inflated” receivables is much greater than the USD800 million derivatives losses it’s clear that HLT has been unprofitable for some time as well as cashflow negative.

HLT’s unrecorded sale of USD800 million in pledged inventory to obtain cash for its general operations not only supports the latter conclusion (negative cashflow) but shows just how serious it was.

Maintaining/expanding its “borrowing base”

Most banks lend to commodity traders on a secured basis, with the maximum loan expressed as a percentage (borrowing base) of receivables and inventory.

The “base” is always less than 100% to provide a margin of additional protection because typically one doesn't realize the face value of collateral.

When the outstanding loan is equal to the allowed borrowing under the “base”, the bank will make no further loans.

If outstandings are greater than the amount allowed under the "base", the bank will demand a repayment in the outstanding loan to bring it within the base.

Account Receivables

Banks generally tier the lending percentage according to the days outstanding of receivables, the credit standing of the obligor, etc. The quicker a receivable is collected the better credit quality it is. The longer a receivable is outstanding the lower the quality and therefore the "base".

The nature of the goods being sold is also a factor.

HLT fabricated multiple transactions to replace “aging” bogus receivables with new ones to maintain the borrowing base.

And critically as well to create additional amounts of receivables to expand its “base” and fund its cash “burn”.

Banks also monitor the turnover (inflows and outflows) in borrowers’ balance sheet accounts as well as the borrower's cash account with the bank, particularly those borrowers involved in trading.

If a borrower’s account is “stagnant”, it is a sign of distress in its business. If receivables are turning over (being collected) at a glacial pace, another red flag.

HLT round tripped cash through its accounts to give the appearance of robust cash flow, e.g. collection of receivables.

Inventory

Banks perform a similar borrowing base calculation with inventory, factoring in price volatility, nature of the commodity/goods, costs of sale, etc. 

For example, in general crude oil inventory would be considered “better” than specialty manufactured goods that could be used by only a limited set of potential buyers.

HLT needed cash and didn’t want to reduce its borrowing base which would prompt a demand for reduction in its loans. So it sold pledged inventory without recording it in the income statement or its balance sheet.