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Prof. Dr. Nick Gehrke

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In fact, when reading the cases described below, you would probably not be surprised if even some cats would prefer to pull the covers back up over their heads again. Still, the following scandals from the recent past show that balance sheet manipulation is by no means a phenomenon of the past and one company even managed to destroy about 85% of its market capitalization within just a few days in 2017. Read on to find out more.

 

Sex sells? Apparently not always that well, as the Steinhoff case shows

One of the biggest accounting scandals of recent years came to light at the Steinhoff Group in December 2017. Founded in 1964 by Bruno Steinhoff, the one-man company from Lower Saxony had developed over the years, with more than 40 retail chains, 130,000 employees and 12,000 stores worldwide, into the second largest retailer of furniture and household goods behind Ikea. In Germany, the blonde TV celebrity Daniela Katzenberger advertised Steinhoff's furniture discounter Poco. In the financial year of 2016, the Group generated sales of 13.4 billion euros – at least that was what the figure was assumed to be until December 2017. But then the auditing firm Deloitte refused to sign off on the balance sheet. Apparently, the group had doctored its figures and systematically reported excessive sales revenues. The annual reports for 2016 and 2015 were also withdrawn.

Within days, the share price collapsed by around 85 percent. More than 10 billion euros in market value went up in smoke. The victims range from small investors to the ECB, which had reached out to Steinhoff as part of its bond purchase program. Meanwhile, the economic crime thriller is keeping prosecutors and courts busy in Germany, South Africa, Austria and the Netherlands. And the parliament in Cape Town too – because South Africa's national pension fund has also suffered a loss on its books of around EUR 1 billion.

According to stock exchange news reports by the German national broadcaster ARD, experts have now reviewed more than 320,000 documents and held countless discussions with the parties involved. According to Steinhoff, certain patterns have been identified in transactions that, over a period of several years, would have led to a significant overstatement of company value and profits. The auditing company PwC expects results at the end of 2018.

 

Hess AG – when a mandatory announcement leads to your own downfall

The trigger in the case of Hess AG was a mandatory announcement from Hess: namely, that there was a suspicion that sales had been faked at least since 2011 and that the financial position, net assets and results of operations had been presented too positively. This was said to have been done with the knowledge of the Executive Board. As a consequence, the Supervisory Board dismissed Peter Ziegler and Christoph Hess – a member of the founding family, which still holds around one third of the shares – without notice. Till Becker became the sole new board member.

The Mannheim public prosecutor's office investigated the suspicion of balance sheet manipulation and capital investment fraud by making false statements in the IPO prospectus. The controversial consolidated financial statements in the prospectus were audited and confirmed by the auditing and tax consulting firm dhmp from Karlsruhe. The company specializes in medium-sized companies and family businesses[1].

 

When the flow runs out

Flowtex, a company from Baden-Württemberg, which sold horizontal drilling machines, manipulated the balance sheet between 1994 and 1999 by selling non-existent drilling machines to a leasing company. The sales were booked as sales revenues. The balance sheet showed approx. 3,000 horizontal boring machines in existence when in reality there were actually only around 300 of them. The fictitious purchase was financed by the banks. When bank employees or auditors wanted to see the equipment, the existing machines were repeatedly driven back and forth between the construction sites. Only the numbers of the machines were changed. Bank statements were also falsified in order to prove that credit was not available on bank accounts. It was also overlooked that the annual demand for such special machines in Europe was significantly below 3,000.

The cases of recent balance sheet manipulation cited here show that statutory regulations and provisions cannot prevent the deliberate falsification of balance sheets. Only greater vigilance can help. But how can such balance sheet frauds be detected at an earlier stage? The main hope lies in Big Data! While the auditors previously had to carry out random checks due to financial and time restrictions, Big Data now makes it possible to carry out a full audit. The automation of part of the audit creates scope to concentrate on the audit of complex accounting matters and to focus more intensively on management estimates. By fully checking the plausibility of the data, the risk of detection increases significantly, which may reduce the incentive to engage in falsification. However, the targeted use of big data requires specific skills in statistics and IT skills and is only a tool to aid in the process.

By contrast, a balance sheet picture can be "doctored" by a one-sided interpretation of discretionary powers so that it no longer corresponds overall to the actual asset, earnings and financial situation, though the persons responsible for the preparation still remain within the legally permissible framework. These discretionary powers continue to exist in German commercial law even after the introduction of the German Act to Modernize Accounting Law (Bilanzrechtsmodernisierungsgesetz –BilMoG). They are characterized by the fact that the person preparing the balance sheet has a certain room for maneuver for valuations due to an inability to establish objective standards. These can be plausibly justified by the specific situation of the company. Examples of such discretionary scope include the recognition and measurement of provisions, the probable duration of an impairment, the allocation of a leased asset or the accrual of capitalizable development costs[2].

In the last blog article, we have already discussed where the difference between balance sheet manipulation and cosmetics lies. If you missed it, you can read up on things on here.

German Sources:

[1] https://boerse.ard.de/boersenwissen/anlegerschutz/hess-ag-die-schlammschlacht-beginnt100.html

[2] Cf. Schettler (2014), p. 237