Secrets of Bonding 163: Financial Statement Fraud

You’re familiar with the old saying, “Financial statements do not kill people. People kill people.”

Although there are instances of misrepresentation or deception in financial statements (FS), they are not necessarily bad. It is the evil intentions of the preparers and companies that are to be blamed.

Credit analysts always check and rely upon FSs when underwriting surety bonds. There may be deceitful or misleading statements. The need to assess the financial report is not an option. It is a valuable “report card” on management quality.

Certified Public Accounts (CPAs) offer three levels of financial presentation:

Compilation – A properly organized report in which the numbers are not verified or evaluated by the CPA.
Review – Includes some reviewing of critical elements.
Audit – This is the highest level. It includes the CPAs statement that the CPAs have verified and confirmed the accuracy of the numbers.
The reader of the FS has certain expectations. Do they have any other rights? Is it possible for the reader to expect too much?
Let’s take a look at what the FS really says and what it doesn’t.

The Balance Sheet

This shows the assets and liabilities. This shows the company’s assets (assets) and who has them (liabilities, stockholders equity). Many of the standard entries are familiar to you: Inventory, cash, accounts payable and accounts receivable. You also know the net worth/section stockholder’s equity.

Every balance sheet has a date. For example, 12/31/2017. This shows the current status of the accounts for the given day. Credit analysts calculate the Working Capital, also known as Net Quick (NQ), which is a measure of financial strength in the short term. The NQ is calculated by subtracting current liabilities and assets. The NQ number can be used in decision-making if it is available to the bond underwriter.

What bonds are approved for this applicant? What is the total capacity they can be allocated? NQ is used as a reference for the year.

Analysts believe that this number will have a significant impact on the next 12-15 months.

Let’s go forward in time, one day at a time, to 1/1/2018. “Happy New Year!” Let’s go to the bank and check it out. There is money in the bank! There have been changes in the accounts receivables and cash. There have been other changes. Therefore, if the 1/1 balance sheets are used to calculate the NQ, it will likely be different than 12/31. This is because the balance sheet shows how these accounts are performing on ONE day. It’s constantly changing!

It is a fact that the working capital figure is not accurate for more than a day. After that, it can be subject to change. However, this does not mean that the number is irrelevant or insignificant. Decision-makers need to have benchmarks and a process for making their decisions. This is an essential element, but there are many other elements.

Financial Statement Fraud

It is not us who commit the most common FS fraud. This is a self-deceit that we achieve when we rely too heavily on “one-day numbers”. This is a mistake that can lead to missing the bigger picture.

Underwriters love to see significant cash accounts sitting on the top line (of a balance sheet). However, this is only a snapshot. It’s even more important to know the average amount of funds that were deposited over the previous six months and one year. This information is often overlooked by analysts.

Accounts Receivables and Payables – this is another area where the “one day number” can be easily given a historical perspective. It is easy to find older schedules of A/R or A/P, and they provide a view over more than just one day. These documents may not be included in FSs, and underwriters might not ask for them.

Conclusion

We, as analysts and readers of these documents, should not overly on the balance sheets or think it is more than a snapshot. It should be analyzed and viewed together with other essential underwriting factors, such as financial reports from the mid-year and supporting documents.

This allows underwriters to make informed, realistic decisions.

Steve Golia, National Surety Director at Great Midwest Insurance Company, is an A-8 carrier that specializes in contract surety.