 |
| 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:
- overstate assets or
- understate liabilities.
- 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.
Posts
