Last updated: 20:25 / Tuesday, 29 October 2013
By Matthews Asia

The Science of Forensic Accounting

The Science of Forensic Accounting

Many investors have expressed concerns over the quality and general integrity of financial reports filed by Asian companies. Often cited as a reason to be less trusting are less stringent regulatory laws that have created a historical culture of accepting transgressions in corporate governance. Complicating matters are the size and maturity of capital markets in the region, particularly when compared to more advanced economies. Also, there are challenges faced by minority shareholders from company executives unaccustomed to outside interests in the management of their company. All of these are real concerns for investors in the region, and in many cases, can only be addressed through experience in different countries, industries and cultures—and even the variety of families that run each business.

As fundamental investors, being able to understand the myriad of complex accounting practices used in Asia, and ultimately being comfortable with them in order to make investment decisions, is critical for firms like ours. In what will be a series of commentaries, we will aim to dissect in more detail the often esoteric approach taken by many Asian companies to financial reporting and the communications around earnings management. This first issue will focus on “the numbers” and begin by looking at how we evaluate the quality of financial reporting. It will also explain what the role of forensic accounting—the process of taking a deeper look into a company’s accounting practices—plays within our firm.

At Matthews, the consistency with which a management team applies sensible and responsible accounting rules during both good times and bad is something we constantly evaluate and this presents a useful starting point for our discussion. Areas we pay specific attention to include determining whether the accounting policies a company elects to use increases management’s influence in setting executive compensation. For example, a company that incentivizes management with 10% growth in earnings per share (EPS), might see a consistent 10% improvement in its EPS year after year. In this instance, less volatile patterns of EPS are suspicious and we would tend to take a closer look into this area of their books.

We also pay attention to free cash flow generated by a company. While free cash flow is a fairly simple concept (cash flow from operations less capital expenditures), we tend to focus on those instances in which a company boosts cash flow from operations. For example, securitizing account receivables gives an exaggerated picture of the sustainable cash flow generated.

Related party transactions are another key area of concern. We tend to closely monitor these disclosures and try to understand the economic rationale behind these transactions. Corporate balance sheets are another factor to consider. For instance, there are many times when investors focus solely on the income statement. However, management might bypass the income statement altogether, and this may pose another red flag if the firm has unrecognized losses on its balance sheet without a credible economic explanation.

Opinion column by Sudarshan Murthy, CFA; Research Analyst at Matthews Asia

The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change.  It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquid­ity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.