Evergrande's Epic Misstep: 11 Red Flags Accountants Can't Ignore
The downfall of the Evergrande Group
On the international front, the founder of China’s Evergrande Group is facing the spotlight being accused of inflating its revenue by a staggering $78 billion. This case is now considered one of the most significant financial fraud cases ever.
It is alleged that the overstatement occurred as Evergrande recognised sales relating to pre-sold properties that were not yet completed or delivered to the clients. The practice of recognising revenue prematurely during the past years culminated in default resulting in a fine of $581 million levied by the securities regulator. Adding to Evergrande's troubles is its overwhelming $332 billion debt, further strained by a large fine for recognizing sales too early. This financial distress has broad implications, affecting everyone from international investors to families waiting on their homes. The Evergrande story emphasises the essential role of strict accounting rules and regulatory enforcement in maintaining economic stability and safeguarding the interests of investors in uncertain times.
Where were the accountants?
We need to be reminded that accountants are professionals who should adhere high level of standards internationally. Auditors look at financial statements less frequently, mostly after they are compiled, Accountants, however, have more regular access to the entity and management. They are, therefore, in a position to identify and pinpoint problems and act on them promptly.
Responsibilities of accountants when preparing financial statements
Accountants, as ‘trusted advisors’ have strict responsibilities to ensure that the financial statements of the client comply with the relevant financial reporting framework. The International Standards for Related Services ISRS 4410 clearly states the responsibilities of accountants regarding the information provided by management. These include using professional judgment to understand the entity's business – including risks - and alerting management to any material misstatements or discrepancies found in the information provided. This means additional work to understand the client’s business which includes looking at:
Financial trends and ratios identifying risks relating to liquidity and cash flow, and
The pressures on management to misstate the figures should be considered.
While accountants are not required to provide assurance on the accuracy of information, they should ensure that management presents clear and accurate financial data that is compliant with reporting standards.
Early signs of trouble accountants should take note of
Accountants must go beyond mere number crunching; they are responsible for a comprehensive analysis of financial data, including scrutinising management's financial practices and ensuring adherence to international standards. Several signs of trouble at Evergrande could have served as red flags by accountants, as these may indicate underlying risks in the company's operations. Some of the warning signs accountants should spot when compiling financial statements are:
Rapid expansion into unrelated businesses: The company's diversification into sectors far removed from its core real estate business, such as electric vehicles and sports, could have been seen as an unsustainable diversion of focus and resources. Diving into new markets or sectors without solid financial grounding can dilute a company's focus and resources, diluting a company's expertise and financial stability.
Skyrocketing debt levels: Evergrande's aggressive expansion was significantly fueled by borrowing, leading to a high debt-to-equity ratio. Such elevated levels of leverage are a classic warning sign, indicating a company might be overextended and facing liquidity risks.
Risky revenue recognition practices: The practice of recognising revenue from pre-sold properties that were not yet completed or delivered is risky. The outcome depends heavily on the future financial health of the company and is also subject to the external real estate market. Accountants are responsible for ensuring that accounting policies applied by the clients are in line with the prescribed accounting framework, for example, the recognition criteria in IFRS 15 "Revenue from Contracts with Customers”. Applying professional judgement appropriately is crucial.
Repeated debt restructuring and extensions: Management regularly seeking to restructure debt or extend payment deadlines can indicate that a company is struggling to meet its obligations on time, reflecting potential financial distress.
Pressure on management to show profits: a critical fraud red flag, mostly overlooked by accountants, is the pressure on management to report higher profits to maintain and possibly increase their debts. Exactly how far is management willing to go to keep business going?
Cash flow concerns: Despite reporting high profits on paper, the company's actual cash flows from operations could have shown signs of strain. A discrepancy between reported earnings and cash flow is often a red flag, indicating that reported income may not be sustainable.
Reliance on presales for liquidity: Evergrande's reliance on the presale of properties to fund construction and repay debt could be risky if the real estate market slowed down. This model is vulnerable to downturns, as reduced demand for new properties can quickly lead to liquidity issues.
Warning from auditors: Matters raised by auditors in previous reports regarding its financial statements or accounting practices should be considered a serious concern by accountants. Auditor reservations can indicate complex issues with how the company is recognising revenue, valuing assets, or managing its finances.
Regulatory concerns and penalties: Increased scrutiny from regulatory bodies, along with fines for improper practices, can indicate systemic issues within the company's operational and financial management.
Changes in key financial ratios: Significant changes in key financial ratios over time, such as the debt-to-equity ratio, current ratio, and interest coverage ratio, could signal worsening financial health or increasing risk.
Market sentiment and analyst opinions: A significant shift in how market analysts and investors view the company, particularly if it diverges from the company's self-assessment, can signal that deeper issues are not being addressed or disclosed.
Conclusion
For accountants, vigilance is key. They must employ a critical eye towards financial trends, ratios, and management practices, ensuring that all financial reporting is transparent and in line with prescribed frameworks. The Evergrande debacle illustrates the need for strict compliance with accounting standards and active regulatory oversight to avert future financial crises. Accountants, equipped with professional judgment and a thorough understanding of the business landscape, are indispensable in navigating companies through the complexities of financial reporting, ultimately safeguarding economic stability and protecting investor interests.
Assist Your Clients Better: Enroll to CIBA’s Drafting Financial Statements course
Attending this webinar will equip you with the following skills:
Be refreshed on the key elements that all financial statements cover such as revenue and property, plant and equipment.
Evaluate the messaging conveyed to financial statement users through narrative notes, emphasizing effective communication of key information.
Gain awareness of significant areas identified for potential changes under the IFRS for SME Accounting Standard exposure draft, assessing the potential implications for their clients and companies.
Examine indicators of going concern and other non-financial disclosures, recognizing areas that may necessitate additional attention and consideration.
Scrutinise the financial statements being prepared, ensuring alignment with user objectives and meeting their needs effectively.
