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X-Ray Vision: The M-Score Test to Detect Fraud

In a prior post I discussed using the Altman Z-Score to predict business bankruptcy. Today, I highlight another analytical tool but this time we review one whose purpose is to help detect earnings manipulation.

The Beneish M-Score

The Beneish M-Score was developed in 1990s by Messod Beneish, then an Associate Professor at Indiana University. Interestingly, the Beneish model was one of the tools used by a group of six Cornell students who accurately concluded that Enron might be manipulating its earnings before its collapse.

Mathematically, the M-Score consists of eight ratios to capture financial statement distortions and uses two years worth of data for comparison. These ratios focus on financial statement distortions that can result from manipulating earnings and consist of the following indices:

1. Days sales outstanding in receivables (DSRI)
2. Gross margin (GMI)
3. Asset quality, as measured by non-current non-PP&E assets divided by total assets (AQI)
4. Sales growth (SGI)
5. Rate of depreciation, as measured by depreciation expense divided by depreciation plus net PP&E (DEPI)
6. The ratio of SG&A expense to revenues (SGAI)
7. The ratio of accruals to total assets, as measured by working capital excluding cash less depreciation divided by total assets (TATA)
8. Lastly, total leverage, or debt divided by assets (LVGI)

The M-Score formula that Professor Beneish developed based on his sample study of 50 known earnings manipulators and 1,708 non-manipulators with individual probability weightings for each index is:

M= 4.84+0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327LVGI.

An M-Score greater than -2.22 indicates that there is a high likelihood of earnings manipulation. In backwards testing, Beneish found that his formula accurately predicted earnings manipulation 76% of the time, while showing false positives 17.5% of the time.

Although the formula and its eight indices consist of a myriad of numbers, the gist of the formula’s predictive power is that changes in gross margins, and relative sales growth, depreciation expense, SG&A expenses, accruals, and non-current non-PP&E assets, can point to financial statement shenanigans.

A cautionary note: although the Beneish M-Score is a powerful predictive tool, it should not be used in a vacuum. Instead, it should be combined with other analytic techniques such as ratio analysis and correlation of net income with cash flows to corroborate the possibility of financial mis-statement.

So there you have it: an eight step test that will provide the X-ray vision needed to see through the reported  numbers to help determine if a company’s financials reflect manipulated results.

The Tide Comes In: Reshoring in America

In the summer of 2000 U.S. factories employed 17.3 million workers. Now, a little more than a decade later, over 5 million more manufacturing jobs have been lost, a disappearance that has devastated cities, towns and families across America.

I was born in a GM town and had uncles and family friends that worked at the car plant. Since most of them were recent immigrants from Holland, these jobs allowed them to start raising families, buy houses, and secure the American dream. For immigrants and young people today, such opportunities have evaporated as outsourcing and the rise of China have taken hold.

Earlier this year, Boston Consulting Group released a study that said that the U.S. should experience a "manufacturing renaissance" in the next 5 years as the wage gap with China shrinks. They cite factors such as annual wage increases in China that have averaged 15% to 20% per year and a rising yuan contrasted with flexible work rules and state government incentives here in the U.S.

Reshoring is the term that is now being used to describe bringing manufacturing jobs back home. Proponents of reshoring point to the need to use a total cost of ownership model when making decisions about where to build products and locate factories. They cite such advantages as improved quality, reducing inventory pipeline, clustering manufacturing near R&D centers, reducing IP risk, and strengthening a companies ability to respond to customer demands. The business case for bringing these jobs back to America is improving. The hollowed-out economy we suffer from today which has helped to create a shrinking middle class can be filled in to revitalize not only our manufacturing sector, but the broader economy as well.

With the upcoming  Presidential election, there has been renewed discussion on jobs and manufacturing. Rick Santorum has been notable with his plan to cut the income tax on manufacturing companies from a maximum of 35% to 0%.  Momentum is gaining on both political and economic fronts that could pave the way for an eventual  resurgence in America's manufacturing base. The tide of jobs, factories and the products they produce is starting to trickle back towards American shores where hope and opportunity await.

ACCOUNTING TRANSFORMATION: LEAN ACCOUNTING

Cost accounting has undergone evolutionary change in the last few decades. As globalization washed to American shores, increased competition and decreasing profit margins initially impacted the manufacturing industry. Forced to now search for sources of competitive advantage, manufacturers placed new emphasis on product costing to provide better information for pricing and build versus buy decisions.

The cost accounting that emerged from the mass production environment of the early 1900s was based on cost structures that consisted of 60% direct labor. But now, a century later, the percentage of direct labor to total cost has shrunk to an average range of 5% to 15%. Under a traditional cost accounting system, overhead is allocated to products based on direct labor. With an inverted labor cost pyramid, this approach no longer makes sense.

In the late 1980s “Activity Based Costing” came to the forefront in an effort to more accurately track the true costs of multiple products. So-called cost drivers were identified and used to better assign overhead cost to products. However, ABC costing could be difficult to implement and costly to maintain.

In recent years “Lean Accounting” has emerged as a by-product of the lean manufacturing method developed by Toyota. According to Wikipedia, Lean Accounting has two main thrusts: 1) the application of lean methods to the accounting process in order to eliminate waste, speed up the process and reduce errors and 2) to fundamentally change the accounting process to motivate lean change and improvement to provide a better understanding of customer value. The result is that Lean throws out variance accounting, standards costing and activities based costing. Instead, it organizes costs by value streams rather than departments and focuses on direct costs rather than the sometimes arbitrary allocation of overhead costs. Because lean manufacturing is demand driven, inventories are negligible and may even be immaterial to the external financial statements.

Since 2003 the accounting world has been consumed with Sarbanes Oxley and external reporting requirements. Currently, efforts to merge accounting standards with IFRS are at the forefront as standards setters are proposing far-reaching measurement and reporting changes. Yet, businesses will miss out if they focus only on financial reporting compliance and rules changes rather than on the Lean Accounting practices that foster continuous improvement, waste reduction and quality improvement. Although Lean Accounting has emerged from the transaction-heavy world of manufacturing, it is being considered and adopted in other industries that are seeking the benefits of simplification and transparency.

You may want to look into Lean Accounting to consider how your business can make this transformation rather than be driven solely by the constantly changing demands of external financial reporting. Don't let the vision for the possibilities of your accounting system and processes be hollowed out by the ever-evolving landscape of reporting compliance.

Why Cash is King in 2010

The old adage that “cash is king” and you should “take money while you can” has been drilled into me for most of my career. This refrain served me well in raising public equity money in the 1980's, convertible debt in the 1990's, and VC and angel money in the years since. Given the crossroads our economy seems to be in as of mid-2010, I thought it would be useful to survey the macro picture for corporate financing to examine whether this continues to be sound advice.

On the bank lending front, although the Federal Reserve has doubled the monetary base since late 2007, U.S. banks have generally used this money to pile up excess reserves rather than to lend. In the realm of private companies, the latest survey update (June 2010) from the Pepperdine Capital Markets Project reports that over the last six months respondent banks declined over 70% of cash-flow based lending applications and 90% of real estate loan applications. Over 90% of the banks surveyed also believe they will see an increase in loan applications in the next year with a similar percentage indicating they expect interest rates to rise. As if this isn't enough, Basel III, the latest proposed banking rules, would require banks to hold and raise more capital thereby having a dampening effect on lending and economic growth worldwide.

Turning to the equity market, a recent report by Grant-Thornton (www.GrantThornton.com/IPO) indicates that the number of IPO's in 2009 was 61, up from 38 in 2008 but down significantly compared to over 500 per year in the decade of the 1990s. The report also indicates that the average deal size in 2009 was $140 million, a significant increase from deals commonly done 20 years ago. The authors point out that the deterioration in the IPO market has hurt small businesses by reducing access to capital and then propose an innovative solution through structural improvements to the equity market.

Meanwhile, in the corporate world companies are flush with cash. As of June 30, 2010, S & P 500 companies are now sitting on a cash hoard of over $800 billion, a record high amount. Google alone has stockpiled $30 billion with no announced plans for a stock buyback or shareholder dividends, to the chagrin of the writers at the Motley Fool.

So there we have it: a corporate world of the haves and the have-nots. While large public companies and banks are piling up cash, small businesses face tighter bank scrutiny and an anemic IPO market. In general, it would seem that for the majority of businesses, the cost of capital is going to increase as more companies crowd the market seeking new or rollover financing, as regulations increase, and as the expectation for an eventual increase in interest rates takes hold. Faced with low growth and continued uncertainty, cash remains supreme for businesses that look to thrive in this difficult economic environment.

Technology Cup Man of the Match

With World Cup fever gaining strength, I started thinking about the world’s largest companies and their leaders. If there was a World Cup of technology companies and we were in the final game of the tournament, who would be man of the match (soccer's version of MVP)?

The top two market cap technology companies these days are Microsoft and Apple. At today’s closing prices (June 14) their market caps are $223B and $231B with Apple now in the lead. If we compare these two “teams,” who is the player with the greatest influence? Regrettably, even though I live in Microsoft’s backyard, I don’t think there are any finalists for this honor at the Redmond software complex. Microsoft’s stock price has been virtually flat for the last ten years. Apple’s stock has gone up nearly ten-fold over that same period.

According to a recent article (June 7, 2010) in Network World, over the last decade, Microsoft has spent $71 billion on R&D and made over 100 acquisitions. Apple, on the other hand, has invested only $8 billion in R&D and acquired 11 companies. In other words, Microsoft has outspent Apple over nine times on new or future products and services, and yet the market has rewarded Apple far more prodigiously than Microsoft.

The key difference according to the article is innovation. Apple has focused on the user while Microsoft has been bogged down adding features. Innovation will trump evolution every time.

Even though I grew up in Silicon Valley, Apple's home turf, I live in Redmond and very much want my giant corporate neighbor and many of my friends to succeed. Unfortunately, the Apple team has the momentum and their fans are screaming and blowing loudly on their vuvuzelas. Their team is putting on quite a show and their players are passionately expressing their talents out on the field. In contrast, the Microsoft side of the stadium is rather quiet as our team plays a methodical and predictable style of soccer. The scoreboard is showing ten-zip.

Oh, I almost forgot. The man of the match has to be Steve Jobs. He’s the guy who has remained laser-focused on the importance of design and functional elegance. The result has been products that have an almost cult-like following.

Fortunately, in the real world, the tournament is not over. I want my home team to score goals, win games, get the fans fired up, and re-learn how to be a winner.

Private Company Cost of Capital

Cost of capital is an important factor in determining the value of a business. The market rewards a business that can raise money more cost effectively than its peers. Such a company is deemed to have a competitive advantage and hence a higher fair market value.

But cost of capital is more than the ability to raise money on the cheap. It also represents the expected rate of return that investor’s require based on the risk of the underlying business. In other words, cost of capital is a market driven rate balancing risk and reward.

For private companies, business valuators have long used the so-called build-up method to develop a company’s cost of capital. This method takes a risk-free rate and then adds various risk premiums – an equity risk premium, small company size premium and specific company risk premium – to determine the cost of capital. Two out of three of these premiums - the equity risk premium, which represents the premium that investors demand to invest in stock rather than a government bond, and the size premium- are determined by reference to public company data.

This approach to determining cost of capital has been argued to be inadequate for private companies since the markets for public versus private capital are much different. And yet, without the ability to access comparable private company data, there has been no alternative but to use the available public company data.

In the summer of 2009 the Pepperdine University School of Business completed a survey of the cost of capital for private companies. This survey captured the rate of return expectations for each of the private capital market segments (VC firms, private equity groups, mezzanine funds, asset-based lenders and senior lenders). The survey is being updated semiannually with the latest report dated February 2010.  

The availability of private company return data has enabled development of a new model to value private cost of capital. For business valuators and owners alike, this is an exciting development that will provide more meaningful appraisals of private companies and thereby guide owners to making more intelligent decisions regarding their use of funds.

As a private company business owner, board member, or CFO, it’s important that you get a handle on your company’s cost of capital. In so doing you will have gained new insight into how the market views your risk/reward equation. This not only allows you to better set valuation expectations, it allows you the means to determine how to change your company’s profile to tip the scales in your favor.

Impacting Business Value: Cash Flows

Like the waterfalls that cascade into Yosemite Valley, cash flows are the life source for a business. This becomes especially apparent when a business runs low on cash and is forced to prune people, product lines and expenses just to survive.

The key to having cash flows that optimize the value of a business are predictable, sustainable and growing. Predictable cash flows are valuable because they provide certainty and facilitate planning. Sustainable cash flows are valuable because they are recurring and long-lived. Growing cash flows are valuable because growth is vital to any business in order to gain market share and to offset cost inflation.

Net cash flows consist of both inputs and outputs – costs and revenues. Both need to be managed in order to maximize value. The need for a disciplined approach to costs and expenses has been highlighted these last few years in response to the recession. A similar discipline should apply to an evaluation of a Company’s revenue streams in evaluating which are profitable, predictable and the most likely to be sustainable and to grow. In a typical software company, maintenance renewals may be the predictable and sustainable revenue stream, new licenses may be the growth stream, and professional services may be an adjunct profitable stream. Because of the symbiotic relationship of these streams, management may find that decisions that impact one revenue stream will impact the others. The guts of the business can be complex and messy. The management team that best understands its business and that is proactive rather than passive will be in the best position to create value.

Profitability is related to but not the same as net cash flows. In accounting terms, net cash flows are net income after tax plus noncash charges such as depreciation expense and stock option expense, less incremental working capital needs, less capital expenditure needs. What might cause net income to be high and yet net cash flows to be low or even negative? Often times the culprit is working capital. If receivables grow faster than payables working capital needs are higher and cash flows are lower. This may occur because of rapid growth of a new product, or it may occur because the company is offering liberal payment terms. It might also occur because the company has staffed up its accounting department and bills are being processed faster. The point is that, just as with costs and with revenues, working capital needs to be managed in order to optimize cash flows and the value of a business.

The common denominator with valuable and healthy cash flows is capable management. Just as grapevine pruning is needed to maintain size, shape and productivity, business management is needed to actively manage a business so that it can reach its potential.

Understanding Business Value

Wikipedia makes the rather startling assertion that business value is an informal concept for which there is no consensus on its role in effective decision-making. I say startling, because surveys consistently show that there is a tidal wave of businesses that will change hands in the next few years. If I’m a business owner who plans to retire in, say, 5 years and the sale of the business is hoped to be my nest egg, I would want to have a laser-like focus on business value. I would bet that the business owner who is attuned to value will, over the long run, make better decisions than one who is not.

It is often said that beauty is in the eye of the beholder and so too with value. Business value can be subjective and business valuation is both an art and a science. For example, when valuing a business there are different standards that can be used depending on the purpose of the valuation: fair market value, investment value and intrinsic value, to name a few. There are also a variety of valuation approaches that can be used: the income, market or cost approach. And yet, despite the variety of standards and approaches that can be used, there are some known constants that directly impact the value of most businesses.

So what factors almost always influence business value? There are at least three: net cash flows, growth, and cost of capital. You accountants out there will have recognized that these are the inputs into our good buddy the discounted cash flow model. Thats because the value of any business is the total of the expected future benefits that result from ownership.

We’ll continue this discussion by looking at these important value determinants in subsequent posts . . .

The Business Bankruptcy Crystal Ball

Not surprisingly, 2009 was a record year for bankruptcy filings in the U.S. According to the American Bankruptcy Institute, the number of businesses filing for bankruptcy here in Washington state increased from 477 in 2007 to 714 in 2008 and then to 1,158 in 2009.

The Z-Score

Fortunately, there is a time-tested tool that has proven itself useful in predicting bankruptcy called the “Z-Score”. Developed by Edward Altman way back in 1968, the original formula was based on a sample of 66 publicly traded manufacturing firms with assets greater than $1 million. In 2002 Altman updated his research for private companies and made adjustments for non-manufacturing companies. I should point out that in this era of proprietary research and down loadable fee-based calculators, the nice thing about this model is that it is both free and reliable.

Z Math

The Z-Score model requires knowing only five factors about a company: working capital (WC), total assets (TA), net worth (NW), total debt (TD), and operating income (OI). Once these are determined the following formula is used to determine the Z-Score for private non-manufacturing companies:  6.56*(WC/TA) +1.05*(NW/TD) + 3.26*(NW/TA) + 6.72*(OI/TA). To interpret the result, the lower the resulting score, the higher the probability of bankruptcy. A score below 1.81 indicates insolvency while a score of 2.65 or lower indicates the possibility of bankruptcy.

Benchmarking

Given the continued economic uncertainty, this tool can be useful to provide a benchmark for the financial viability of a company and can be monitored over time to determine if the company is increasing or decreasing its risk of failure. No matter what your role – be it shareholder, manager, board member, or potential investor - the Z-Score is a useful tool that can quickly provide a measure of a company’s risk of insolvency.

Fool me . . . Not: Avoiding financial statement fraud

As the old adage goes, fool me once shame on you, fool me twice shame on me. Today we explore how to avoid being fooled by fictitious financial statements so, according to the lyrics of  The Who, we don't get fooled again.

In the 2008 Report to the Nation fraud survey by the Association of Certified Fraud Examiners (ACFE), the top three detection methods for all types of occupational fraud were (in descending order): tips, by accident, and internal controls.

Tips

The hot tip in catching fraudsters is to have a tip hot-line. Public companies have long had fraud hot-lines in response to Sarbanes-Oxley so that employees and others can report suspected fraud. Private companies can emulate this approach.

Internal Controls

Internal controls are more than simply adequate segregation of duties, documented policies and procedures, and flowcharts. They are a proactive mechanism that is the responsibility of everyone in an organization to help fraud from occurring in the first place. Rather than pay lip service, management needs to lead by example and not circumvent or minimize their companies policies and procedures by creating two sets of rules.

Financial Statement Fraud

Financial statement fraud presents a particular challenge to organizations because the very people who are responsible for producing or reviewing the financials are the ones perpetrating the fraud. In fact, according to the 2008 ACFE report cited earlier, almost 60% of the cases of financial statement schemes were perpetrated by the owner, and 40% by managers.  Unfortunately, for financial statement fraud, internal controls may not be of much help due to management override of the controls in place.

To help thwart financial statement fraud, companies can take at least two actions. They can perform background checks on anyone who has access to the financial records or who is a custodian of significant assets of the company. In addition, they should review all compensation and bonus plan structures on a regular basis to ensure that they are in the best long-term interests of the organization and all of its stakeholders. Focusing on people and incentives is key to warding off financial statement fraud.

The readers of financials need to do more than simply being skeptical. Analytics can be useful to make sure the story portrayed by the financials is reasonable. Ratio analysis can be used to examine trends over time and relative to industry norms. For example, an increase in day's sales outstanding can esult from recording fictitious sales. Disclosures should be reviewed with an eye towards what is missing and compared to the prior year and other known information such as press releases.

In the end, readers of financials should keep in mind that fraudsters are like drug addicts: they are believable liars. Knowing who you are doing business with is paramount. Simply calling mutual contacts or doing basic internet research might prevent a decision to extend credit, invest money, enter into a partnership, or join a company that could otherwise have long-term repercussions.