Financial Follies: Identifying Accounting Fraud

An annual report will tell an investor many important facts about a company. It will tell you what a company does, how it makes money, whether it's profitable, how big of a debt burden it has, the value of its assets, etc. If read correctly, it can also tell you whether a company is being lenient in its accounting, or just outright committing fraud.

Recently, I stumbled across a company that was waving bright red flags everywhere I looked. For the sake of this case study, I will not be using its real name. Instead, it will be referred to as "EZAccounting Corp." or "EZ."

Item 1. Business
We were incorporated in May 1999 as "Breezy Strategies." In May 2010, we merged with "Sweet N' Simple Co," and in June 2010, we changed our name to "Elementary Accounts." On August 2013, we filed for  our Initial Company Information and Disclosure Statements with the OTC Markets, and we changed our name to "Plain & Simple Co." On March 2016, we changed our name to "EZ Breezy Solutions." On December 2018, we changed our name to "EZ Accounting Corp."

Changing a company's name several times already indicates a red flag. We don't know what "Breezy Strategies" did, or what any of the other names in between did. Already the business is not being clear about stating what it does, but instead listing all of the names it used to be called. We don't know what the company it merged with, "Sweet N' Simple Co.", does, but let's say that it was a candy shop. Assuming that "EZ Accounting Corp" has something to do with accounting, how are they two even related? There's the other red flag. When a company merges with another from a completely different industry, and there's no explanation given as to why.

Item 6. Management discussion and analysis of financial condition and results of operation
Liquidity and Capital Resources
We had a working capital deficit of ($3,992,327) as of December 31, 2018, compared to a working capital deficit of ($2,154,380) as of December 31, 2017. Our primary source of liquidity has been proceeds from the issuance of debt securities and equity securities. We received $79,000 from the sale of common stock, $100,000 from the sale of preferred stock, $653,000 from proceeds of notes payable, and $3,914,000 from proceeds from convertible promissory notes.
Going Concern
The Company's revenue from operations is not sufficient to meet its working capital needs and will be dependent on funds raised in order to satisfy its ongoing capital requirements for the next twelve months. The company will require additional financing in order to executive its operating plan and continue as a going concern.

Although the information has been condensed, there's a lot to worry about. We know that this isn't a new company, so the working capital deficit is concerning. Startups often have a deficit in their working capital, because they haven't been around for long and don't have the resources of established companies. When a company that's been around for 20 years is acting like a startup, something's up. Notice that it's primary source of liquidity isn't its operations, but debt & equity financing. How has it been making money all this time? It looks like it gets its money from proceeds from convertible promissory notes. Who has been willing to lend to it, knowing full well it doesn't look like they're getting their money back? In this extreme example, this company is already coming off as a shell. Digging farther back into the annual report, there were 13 pages of other small corporations that were lending to it, and the firm repaying them back with common stock, & warrants in an Enron-esque situation.

Item 8. Financial Statements & Supplementary Data

Balance Sheet

As you can probably tell, this is a very small company, a micro-cap.
Look at the gigantic jumps in financing receivables, both current and long-term. Seeing financing receivables in a company without a financing division is a warning sign. Let's say that EZAccounting sells accounting services to customers. Most pay them cash, and it's not a big purchase. Therefore, It doesn't necessitate for any kind of financing to be done. What's their purpose?

Down in the current liabilities section, an increase in notes payables appear to be a significant a source of cash that offset the outlay of cash used to pay the convertible promissory notes. In long-term liabilities, both the increases in deferred revenue and convertible promissory notes also serve as unsustainable liquidity. When operations fail to provide sufficient liquidity, the firm is dependent on increases in deferred revenues and debt financing for sustenance.

Income Statement

Do the SGA look disproportionately large? That's because they probably are in relation to revenues. I would want to check management's compensation in the proxy or another section of the annual. When I had, it turned out that the CEO owned 50% of class A shares, and 100% of class B shares. The COO owned another 30% of the class A shares. Not only do they get compensated a little too well, they have an immense amount of voting power. Investors, beware.

Cash Flow Statement

Operations are indeed insufficient for liquidity. As noted on the balance sheet, deferred revenue is doing a huge favor to pull the company along. Other big items include amortization expense and the loss on extinguishment of debt. Nothing sustainable here...
A quick note on investing activities, those financing receivables are improperly classified as investing activities. They should be tucked back into financing activities.
Now to the heart of this company: financing activities. It's a huge positive number that serves to offset by the cash outflows from operating and investing combined. Those proceeds from convertible promissory notes are coming in handy for the time being.
In the supplemental activities, comparing interest expense to what the company actually pays in interest there is a huge divergence ($1.9 million versus $21 thousand). There's a source of cash in itself.

When you're reading through the annual, scrutinize each line item and every sentence carefully. Always question an item's the purpose is, and the timing of it, as well as the location from where it appears. Be sure to review the notes to the financial statements, as the notes will offer the story behind the numbers, and more context behind unsavory finds. Fraud doesn't happen often, and because it doesn't, most investors aren't accustomed to seeing when things are off. In this example it was pretty blatant, but often times, accounting shenanigans are more subtle.

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