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Dark and Dirty World

The last few months have been colorful.

From the 1MDB case, the downfall of Luckin Coffee, Hin Leong, and now Wirecard. Who dare says now that the lack of transparency and fraud only exists in emerging markets? Firms in mature economies are equally susceptible to financial misconduct, and this is even if a Big 4 firm signs off on the accounts.

I've sat in a small part of an auditor's workflow many years back when I started my career in finance. It is not glamorous. But the partners and managers onsite make the entire process look and feel extremely professional. Don't get me wrong. I think audit is a decent job and an essential service for the proper functioning of all businesses globally. A lot of work goes behind organizing and presenting the 3 financial statements, and many shareholders and institutional investors often take this for granted when they download it off the company website to read or when they receive the hard copies in their mailbox.

But that said, very few really know the work of an auditor or even how finance processes in companies work e.g. how an invoice is being processed and reports generated, how cash is being deposited into a bank account and the corresponding salaries and expenses paid out to employees and suppliers. Not everyone appreciates this - especially when you are an employee sitting comfortably behind a desk.

As an employee, analyst or investor, you pick up the audited financial statements and you expect that the numbers to be "the Word". If the cash in bank line item on the balance sheet reads $100 million yesterday and the company isn't expecting a huge payment out to creditors today, you'd assume that there is really $100 million in the bank today. In reality, that $100 million is 'virtual' money. Unless you sight the bank accounts that contain the cash, there is no reasonable way to ascertain that this is correct. The same applies to trade receivables and inventories - have you tried walking into a manufacturing plant or warehouse to count and add up all the machines and stores? It's not so straightforward. I've counted machines on racks and also gone through the process of collating bank statements and validating the totals, ensuring that the total cash reconciles with the cash line item in the balance sheet. It's significantly under-appreciated and tedious. The rest of the world assumes that someone has gone and done this work.

So whenever a fraud happens, the first thing investors blame are the auditors who sign off on the numbers. Auditors then turn to the company directors and say the disclosures aren't accurate and adequate. The whole exercise turns into a domino of a blame game, unfortunately. But that's how the world works and at the end of the day, while you can seek recourse for negligence, misconduct, etc, the damage has been done. Investors are the ones who have lost their monies. The head of the snake (possibly) goes to jail, and everyone else working across the value chain got paid, and that is the moral hazard here. Where does the blame game stop?

In 2002, Enron's financial scandal resulted in the bankruptcy of long time accounting firm Arthur Andersen. While AA were the biggest casualty amongst third parties, many questioned whether or not those who played a part in advising Enron had a part to play in its downfall.

"What accountability does it--or any consulting firm--have for the ideas and concepts it launches into a company? If in fact McKinsey should share the blame because of the ideas and concepts it launched into Enron, then why stop there? Perhaps you should also blame the brilliant professors at the business schools from which McKinsey recruits many of its consultants and who may have taught the same concepts to Enron executives." - Bloomberg

One of the readers probably says it best:

"As a longtime management consultant, I must take issue with your understanding of the management-consulting process. A company will frequently seek advice and then argue for the opposite conclusion. Or the company will partially implement your suggestions, often because it has sought advice from other professionals who provide conflicting advice. In addition, you ignore the political dimension. Frequently, the client has the right solution in-house, and the consultant merely resolves the internal conflict--with the added bonus that management doesn't have to take responsibility should things go awry."

Consultants and auditors provide the appropriate check and balances required by every large organization. In good times, nobody cares. It is only when shit hits the fan that the relevant stakeholders come to light. Suddenly everyone wants to know the person who signed off on the books. So, consultants are effectively there to 'backstop' blame.

If someone on the inside wants to siphon money out, these people should be really careful and not be afraid to ask the difficult questions, even if it costs them. But then again, it's hard to bite the hand that feeds you. If you owe the bank a million dollars, the bank owns you, if you owe the bank a billion dollars, you own the bank. Ditto for credit agencies and auditors.

As cynical as it sounds, what this brutal cliche truth is: Be careful with your money. Most asset managers often invest using someone else's money. But that is never really the same as using your own money. Good market, you get more; bad market, you get less. Either way, at the end of the day, you still get paid. And since cash flow is the yardstick here, when an investment goes sideways, the guy who puts his money on the table ultimately gets the short end of the stick.

When money talks, people will try to pull wool over your eye and show you only what they want you to see. No banker sells a lousy product, they call it a "high risk" investment (there's a reason why they named risky fixed income instruments junk bonds). It is catchy in the world of finance and somehow for some reason, investors like the idea of dabbling in a game of probability every now and then when the stakes are high. But risk is perception based, and everyone's idea of risk is fundamentally different. It is not only a function of one's appetite to invest, but also reflects access to all available information. To make it even more complex - it is also driven by individual interpretation of that information, even if you did have access to it. Based on this definition, any investment made by an unsophisticated investor is almost always deemed high risk, regardless of the quality of the underlying investment. My high school friend who used to work in fixed income used to tell me:

Everyday we flip open the papers and read exactly the same stuff in the news, yet what you and I see and what others see is entirely different.

If you put your money down on the table and lose it, you only have yourself to blame. That is the only rule of the game.

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