Why Short Sellers are Important in the Marketplace

By Nicholas Wesley Yee, CPA
Director of Research at Gradient Analytics

When analyzing stocks, I am often amazed at the lack of understanding many sell-side analysts have in basic accounting concepts and their naivety to how easily managers can fabricate numbers.  In fact, when analysts ask about accounting discrepancies during earnings conference calls, they often refer to them as a “housekeeping item,” as if they are afraid to anger the revered CFO.  You really can’t blame them; analysts survive by building congenial relationships with Investor Relations and CFOs in order to ensure continued access.  If they were to get locked out of conference calls, their value to their sell-side firm would be greatly diminished.

Accounting fraud is a topic of great interest to the investing community, but the funny thing about short-sellers is that they are almost universally hated in the retail community.  It’s almost a case of “be afraid of what you do not understand” as shorts are blamed for every downturn in share price.  Contrary to this notion, I believe that shorts provide a valuable asset to the investing world, well beyond that of non-independent sell-side analysts or even regulators.

So how do we find companies suspected of “managing” earnings?  What metrics should we be eyeing?  Must there be a “smoking gun” to determine whether a company is truly a fraud or not?  These are all questions that I hope to briefly answer in this article.

First off, I cannot stress enough the importance of experience in studying history/case studies to predict future outcomes of companies based on their accounting practices. Our short-selling clients typically want to identify that proverbial smoking gun to show them that a company is a fraud and dub them as the next Enron.  However, I’m here to say that is rarely the case.  Instead, when analyzing a short candidate, I look for a culture of misrepresentation, i.e., manipulating financial statements to intentionally mislead investors.  While one suspicious metric may be somewhat concerning, I am more interested in the company that has a plethora of issues suggesting possible nefarious actions by management.

To understand how managers are able to manipulate earnings, we need to grasp one basic aspect of GAAP accounting – accruals.  An accrual at its core is a record of a transaction without an exchange of cash.  Why did we CPAs devise an accounting system that deviates from a hard-to-fake cash-based system to an accrual-based one that almost invites the taking of liberties?  Essentially, it was to harmonize the basic principles of GAAP, including matching, revenue recognition, conservatism, etc.  Would it conceptually make sense for a corporation to recognize revenue for cash they were paid upfront for a job that was to be completed over the next five years?  Under GAAP, accruals and deferrals are utilized to recognize revenues and expenses in the periods when earned or incurred, independent of when cash is received or paid.  We can debate the pros and cons of cash or accrual-based accounting another time, but that is not the point of the article.

The key aspect to understand is that cash-based accounting, for the most part, does not have any subjectivity when it comes to recognizing revenues or profits, whereas accrual-based accounting does.  This is where CEOs and CFOs can massage numbers to ensure they meet or beat quarterly estimates.  As forensic accountants, however, we have a major weapon in our toolkit to search out these unscrupulous executives, and that is the cash flow statement.  Here we can “re-create” the firm’s income statement as if it was done on a cash-based method. Using one basic practice, we need to focus on large deviations between cash and accrual-based accounting methods. Here are two formulas that achieve this:

Net income – Free-cash-flow = Total accruals

EBITDAS – Cash-from-operating-activities = Operating accruals

(Note: EBITDAS is earnings before interest, taxes, depreciation, amortization, and stock-based compensation)

The important thing to remember here is that any large bifurcation of these two formulas could indicate management’s overly-excessive use of subjectivity when determining revenue and/or profit recognition.  In layman’s terms, could you trust a company’s growing profits if there was no actual cash being collected for an extended period of time?

An example of how spiking accruals can lead to complications at an organization was Cubic Corporation (CUB) back in 2013-2014.  Throughout several periods showing positive net profits, Cubic reported quarter after quarter of negative free cash flow.  These deviations, as well as other material indicators, led us to believe that management had been recognizing revenue too early in its contracts and major delays were impacting the firm; all while the sell-side analysts covering the firm generally believed that every one of Cubic’s projects were on schedule as planned.  As a result, in mid-2014, the company as well as its auditor, Ernst & Young, finally decided to restate financials due to “errors in calculating revenues for a contract in the company’s transportation systems segment.”

While this result may not be the same for all instances of net income and free cash flow deviations, these metrics do point to a red flag that we as analysts and investors need to look into further.  One point I want to emphasize is that we should not short companies solely on a sharp rise in accruals.  The company could have a valid reason for the cash flow anomaly; it is our job as analysts to decipher the validity of their statements.

How does fraud occur despite auditor review of the company’s financials?

As an investor, should I be assured of my company’s financials if they have been audited by a Big 4 firm?

The short answer is no.  If that were the case, wouldn’t Arthur Anderson (a Big 5 accounting firm at the time) have figured out Enron’s scheming ways?

Do I have more confidence in a Big 4 audited company than otherwise?

Somewhat, but more important to me than the auditor are the following questions:

• Has the company changed auditors in the past couple years?

• Have they changed from a Big 4 accounting firm to a small, unknown firm?

• Why did they change auditors?

• Did the company list disagreements with the auditors before they were fired?

• Did the auditor resign? And if so, for what reason?

• Was the Big 4 audit performed by the International arm (less reliable) instead of the domestic?

Another factor to recognize is that auditors do not confirm 100% accuracy of the financial statements.  In fact, it is quite the opposite.  The exact boilerplate language auditors use in their report is:

“Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material aspects… Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.”

How confident!

Let’s be honest with ourselves here; auditors are people too.  They come straight out of college and go into the workplace of the firm they are auditing, and may even forget which company they work for.  Can we truly blame a green 22-year-old auditor for a fraudulent company he or she failed to detect on their watch?  The firm’s partner is out playing golf to bring in business, while the managers have to sift through the financials of numerous companies, often working as much as 90+ hours per week during busy season.

It should come as no surprise that the opportunity for fraud exists in these types of scenarios, and it highlights the important role short-sellers play in alerting the marketplace that something might be amiss.

Let me bring up the case of ZZZZ Best to show the lengths managers will go to conceal fraud.  If we are not already familiar with Barry Minkow, former CEO of ZZZZ Best, he can basically be described as a lifelong con-man who took public a small cleaning business in 1986.  While the company eventually unraveled due to cash shortages resulting from fake deals and double-charging customers, I actually want to focus on the cunning methods Mr. Minkow employed to conceal his fraudulent activities.  He and his wife ingrained themselves in the lives of the auditing partner and his wife.  The couples would have each other over for dinner constantly, and their wives would frequently get together minus the husbands.  Independence was obviously lacking here.  However, Mr. Minkow and, presumably, his wife knew exactly what they were doing.

There was another instance where Mr. Minkow needed to prove his business was restoring a large commercial building that accounted for a material amount of revenues.  The problem was that this building did not exist,and there was no contract.  It seems like Barry’s fraud would finally unravel; after all, how could he produce a building that didn’t exist?  Delving deeper into the fraud abyss, Mr. Minkow found an abandoned building and paid off a security guard to familiarly address him by first name when entering with the auditors.  Since this was discovered, auditors are now taught to conduct surprise visits to avoid the same situation.

Again, I am not here to disregard the job of auditors in the marketplace; I can only imagine how bad things would be at public companies without them.  However, I will make the point that we cannot rely on their unqualified opinions solely as a “fraud free” stamp of approval, no matter who the auditor is.  Similar to my example of Cubic Corporation above, most of the time short-sellers can find and lead auditors/investigators to issues that might otherwise go unnoticed.

My advice to each investor is to not shy away from the potential bear case in the company you are invested in; rather, embrace it and make sure you fully understand it.  Lastly, please don’t blame the short-seller for the depressed stock price.  They may have uncovered something quite important that the market needs to take into account, preferably sooner than later.

Disclosure: Nicholas Wesley Yee, CPA, is the Director of Research at Gradient Analytics. The author has no positions in the stocks or ETFs mentioned.

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