From The Economist, November 7:
Mischief is cyclical—it is bred in good times and uncovered in bad timesThe bad news just keeps coming. Ten months after America’s stockmarket peaked, its big technology companies have suffered another rout. Hopes that the Federal Reserve might change course have been dashed; interest rates are set to rise by more than previously thought. The bond market is screaming recession. Could things get any worse? The answer is yes. Stockmarket booms of the sort that crested in January tend to engender fraud. Bad times like those that lie ahead reveal it.
“There is an inverse relationship between interest rates and dishonesty,” says Carson Block, a short-seller. Quite so. A decade of ultra-low borrowing costs has encouraged companies to load up on cheap debt. And debt can hide a lot of misdeeds. They are uncovered when credit dries up. The global financial crisis of 2007-09 exposed fraud and negligence in mortgage lending. The stockmarket bust of the early 2000s unmasked the deceptions of the dotcom bonanza and the book-cooking at Enron, WorldCom and Global Crossing. Those with longer memories in Britain will recall the Polly Peck and Maxwell scandals at the end of the go-go 1980s.
The next downturn seems likely to uncover a similar wave of corporate fraud. Where, exactly, is hard to know in advance, fraud-busters concede. Everyone has a favourite hunch. The rush to comply with the demands of environmental, social and governance (ESG) investing seems ripe for more imbroglios; in May German police raided the offices of dws, an asset manager, over claims of greenwashing. The various government schemes to shore up businesses in the pandemic are another candidate. They were designed to be tapped quickly, so checks were by necessity lax. Evidence of fraud is already emerging. The archetypal sin revealed by recession is accounting fraud. The big scandals play out like tragic dramas: when the plot twist arrives, it seems both surprising and inevitable. No simple formula exists to sort the number-fiddlers from the rest. But the field can be narrowed by searching within the “fraud triangle” of financial pressure, opportunity and rationalisation.
Start with pressure. Sometimes this is self-imposed. If you make the cover of “Business Genius Monthly”, in Mr Block’s words, “the guy on the cover becomes your identity, the ceo of a high-flying firm.” Fessing up that the firm is not flying high becomes unthinkable. Often it is the result of external expectations, says Andi McNeal of the Association of Certified Fraud Examiners, a 90,000-strong professional body based in Texas.
The expectations to be met—or gamed—can be regulatory: think of how bankers pulled the wool over the eyes of their watchdogs before the financial crisis; or how Volkswagen deceived environmental agencies about the pollution from its cars in the “diesel-gate” scandal that blew up in 2015. For bosses of listed firms, the external eyes to please are often those of portfolio managers, analysts and traders—and the thing doing the pleasing are accounting earnings. The stockmarket uses profits as a rough-and-ready guide to how well a company is doing and at what price its shares should change hands. Earnings “misses” can be punished brutally. The shares of Meta, owner of Facebook, lost 25% of their value after disappointing quarterly earnings last month. A lot of ceo pay is tied to share prices, which creates the incentive to meet earnings forecasts.
That bosses feel pressure to deliver predictable earnings is well documented. Almost all of the 400 managers surveyed in the mid-2000s by John Graham, Campbell Harvey and Shiva Rajgopal, a trio of academics, said they had a strong preference for smooth earnings. Most admitted they would delay big spending line items to meet a quarterly earnings target. More than a third said they would book revenues this quarter rather than the next, or incentivise customers to buy more earlier. If anything, the rewards for smoothing earnings have grown. Investors attach rich valuations to the shares of dependable earners, or so-called “quality stocks”. Those that suddenly look unreliable have a long way to fall (see chart).Some bosses will resort to fraud to avoid that fate. Motive is not enough to lead people to commit fraud. The circumstances have to be right (or rather, wrong)....
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