Cooking the financials: 5 cases to watch out when analyzing the group reporting

In the previous article I analyzed the 7 potential ways to cook the intangible assets. Today we will discuss several cases with consolidated or group reporting.

Let’s first dig into the recent history and review one of the recent quite straightforward cases with fraudulent reporting involving group reporting.

Introduction – Accelera case

Accelera Innovations, Inc., a Delaware corporation doing business in Frankfort, Illinois, was incorporated in April 2008 as a shell company in the business of acquiring and managing other companies, primarily in the healthcare and information technology service industries.

On November 11, 2013, Accelera signed a stock purchase agreement with Behavioral Health Care Associates, Ltd., a health care provider in Illinois, specializing in psychiatry and substance abuse treatment. The agreement provided for Accelera to acquire Behavioral’s stock once it paid $1 million as consideration 90 days after closing, with the rest of the $4.55 million purchase price to be paid in installments over time.

Despite never making any of the payments due under the agreement, Accelera consolidated Behavioral’s revenues, assets, and liabilities with those of its own in its filings to the SEC from 2013 through 2015. Consolidation did not comply with the US GAAP (or IFRS), which required the acquirer to have obtained control of the acquired company and for consideration to change hands. By consolidating Behavioral’s finances with its own, Accelera’s revenues were overstated by 90% in 2013 and 2014.

This is one of many cases where companies have used creative accounting to vastly inflate its financial position and results by treating another company’s revenues, assets, and liabilities as its own.?

Available guidance in IFRS

Current IFRS guidance provides for accounting of investments into other companies based on the level of control and is very high-level, which is quite understandable. The way business and shareholder agreements are structured can be quite complex and instead of guiding each particular case IFRS and US GAAP provide overall guidance.

The current rules are as following:

Definition of control is very complex and requires significant judgment to prove the availability of 3?major components: power over the investee (ability to direct the relevant activities), exposure to variable returns (e.g. to receive the dividends) and the ability to use the power to gain the returns. As a result, the investor can guarantee control over the company with shareholding much less than 50%, and on the other hand shareholding of more than 50% in the company does not guarantee control.

Our firm has done a lot of work on analyzing various shareholding agreements to confirm whether there is a control over the companies.

Let’s look at several examples of the accounting areas to analyze in the consolidated reporting:

1) Consolidation of the subsidiaries without actual control.

Like the case with Accelera/Behavioral shows, the control should provide the ability to direct the relevant activities of the company in a way to get profits.??

The further investigation performed by the SEC revealed that Accelera never made any management decisions for Behavioral or entered into contracts on its behalf; never paid its expenses or controlled its bank accounts; never supervised the CEO of the company or decided on his salary; never directed or made employment decisions about Behavioral’s employees; never directed Behavioral’s day-to-day operations; and never received any of Behavioral’s revenues.

These are quite obvious proofs that Accelera did not ever have control over Behavioral and could not consolidate it in its financial statements.

However, there can be much more complex cases when availability of control over investment is subject to much greater assumptions.

2) Non-consolidation of the loss-making entities.

On the other hand, the company may structure the shareholding documents of a loss-making or debt bearing investment in a way which makes it possible not to include in its consolidated financial statements. This results in a fact that the losses and/or debt are off the consolidated books.? This can be a case with so-called structured entities.?

The case of Enron was the most famous case with non-consolidation of the loss-making or debt bearing investments, when thousands of SPEs were used. Enron used the SPEs to attract financing, which was not presented in its books, sold assets to those SPEs and recorded additional profits in its books, parked troubled assets, that were falling in value and even used the SPEs for payment of additional remuneration to the top management, which was not approved by the board or shareholders.???

If the control is not proved, the company may also need to either account for the investment using equity method or at fair value. In any case all these methods mostly do not require to show liability or losses in the group’s financial statements.

3) Application of the proportionate consolidation.

In many industries the cooperation is usually structured through setting up a joint venture, when both (or even more) investors agree on unanimous decision-making over the most important (or relevant) activities of the company’s operations.?

The standards (in this case IFRS 11) usually require application of the equity method of accounting when a joint venture is structured as a separate legal entity.?

However, in certain cases when for example the joint venturers are bound to purchase the whole output of the joint venture, it can be a case for example in mining industry, the investment can be proportionally consolidated into the books of the venturers and as a result provide for much higher total assets and revenues on a group level.

We had a case when there was a joint venture, structured as a separate legal entity, found and owned by two venturers. Both venturers accounted for the investment using equity method thus effectively only showing their share in the joint ventures net assets. If all output of the joint venture is bought by only the venturers and the venturers were also bound to provide the financing to the joint venture in case of lack of liquidity. As a result, we advised that the joint venture should be accounted for using the proportionate consolidation method in the joint venture's financial statements.

4) Purchase accounting: Estimation of the fair value of consideration.?

A further interesting way to inflate a group’s assets would be estimation of the fair value of consideration. According to IFRS 3 when a group acquires a business it should access the fair value of the business acquired. It can be very easy to do once you pay cash on acquisition. While it can be quite a complex issue when the payment’s form is, for example, the acquirer’s own equity.

An example could be the case with CannaVEST Corp. and its acquisition of PhytoSphere Systems, LLC in 2013.?

In January 2013 CannaVEST closed a deal to purchase PhytoSphere Systems from Medical Marijuana, Inc. and planned to focus on producing and selling products containing cannabidiol.

The nominal purchase price for PhytoSphere was $35 million, payable mostly in CannaVEST stock. CannaVEST paid $0.9 million in cash and issued 5,825,000 shares of stock to complete the purchase, valuing the stock at $5.85 per share. At the time of the purchase, however, CannaVEST stock did not trade on an active market, trading volume was “miniscule,” and the price was volatile. As a result, the $5.85 per share valuation of the company’s stock was inflated artificially to increase the company’s assets.

CannaVEST’s report for the first quarter of 2013 was the first to include the PhytoSphere transaction. The balance sheet included $33.6 million in net intangible assets, and the statement of cash flow recorded a $34 million investment for the purchase of PhytoSphere’s goodwill. These intangible assets represented over 90% of CannaVEST’s total assets.?

The company had to impair $27 million of the goodwill in less than 1 year.

In this case CannaVEST deliberately overstated its consideration and inflated its assets and equity.

5) Purchase accounting: rollups.? Another very famous case on this issue is the scandal with Wirecard, up to 2020, a rapidly growing publicly traded company (German stock exchange) audited by E&Y.

The cooking-the-books aspect of WIrecard can be formulated as “Fraudulent conversion of assets and financial results of newly acquired group entities from local GAAP into US GAAP/IFRS with corresponding inadequate pressure on the Group auditor to accept inter-office opinion on these international segments”.??

Wirecard's global acquisitions were used as a means to mask trouble with organic growth by adding revenues from external sources, a tactic referred to as a?roll up.?

Wirecard purchased smaller businesses at significantly above market value at huge speed. For example, in 2015, Wirecard purchased an Indian payments group for €340m, despite the founders of those businesses failing to raise funding while valuing their key assets at €46m. Later independent journalist investigations revealed that more than half of the purchase price was as a result not transferred to the sellers.

We have listed several areas, which can be of interest when analyzing the consolidated reporting. However, due to complexity of the business practices and diversity of shareholders’ agreements the number of potential issues arising on consolidated reporting is endless.