Dressing Financial Statements – What Motivated Mr. Bean to Defraud Latte?
This is a guest article by Paramdeep, a financial modeling expert & teacher.
Did you know What Happened at Last Coffee Day?
Mr. Bean “dressed up” the financial statements and was caught in the fraud. But he was the CEO of Latte! So why did he commit fraud in his own company??
Take a cappuccino and I will give you a hint – How was Mr. Bean’s Bonus to be decided?
Hmm…, His Bonus was dependent on the Share Price and he had all the motivation in the world to increase it.
But How come Fraud?
There is nothing bad in motivating people to perform and as CEO of Latte, Mr. Bean had to make Shareholders happy and he is simply working towards his goal. But then what can possibly be wrong in that?
If you give wrong information to the target audience and mislead them to believe that you are performing better than you actually are, is a fraud.
But the financial statements (Income statements, Balance sheet and Cash Flow statements) are pure numbers, how can one possibly “window dress” them?
Yes, they are numbers – But surprisingly “interpreted” (jargon: Recognized) numbers. And people can interpret them to project better than actual numbers!Which is a fraud.
Implementation of Incentives – Stock Options
Typically top executive’s income is linked to the performance using stock options. Stock Option – as the name implies gives the executive an option to buy the shares of the company at some price X (Called as an Exercise price), typically at a pre-agreed discount to the market price. As the share price increases, they can sell these shares in the market and their take-home amount increases accordingly.
The good part about the options is that it is an Option. If the share price is below the exercise price, you need not exercise it and hence avoid the loss that you would have to bear because of non-performance.
In a nut-shell, it has all the upside and no downside. The employees are incentivized to perform in such a way that it boosts the company’s stock price.
The Pricing Mechanism P/E Ratio
Analysts say that the prices of shares are dependent upon the performance, which is captured in the Profit (PAT) of the company. This is again captured in a ratio called the PE (Price to Earnings Ratio). Latte has been trading at a PE of 10. Based on estimates, the earnings are projected to be:
Based on this the share Price (Price = EPS x PE) is projected to be:
What would Mr. Bean Take Home?
Mr. Bean has a fixed take-home salary of USD 1 Mn. Latte has also granted 50,000 stock options to him at an exercise price of USD 40. So, if the prices stay at 40, Mr. Bean’s payoff from the stocks would remain zero. The good part is that even if they are below 40, the payoff is still zero.
The bad part about this is that if Mr. Bean thinks that the price is going to be below 40 (even slightly), he has all the incentives in the world to make it look like its above 40, so that he can gain from the stocks. His fixed is any ways fixed at USD 1 Mn.
Modeling Options Payoff in Excel
Excel can do interesting stuff. You can use either the “if or the Max” functions Excel to get the options payoffs.
Payoff from options= Share price – Exercise price of stock option
Mr. Bean would execute an option only when Share price> Exercise Price of stock option.
Using Max Function for Options Modeling
To accommodate this feature of an Option in excel, we can use Max function.
Max Function Syntax:
Options Payoff= Max (((Share Price- Exercise Price of Option)* Number of Stock Options/10^6), 0)
This implies that, options payoff can never be negative.
Using If Function for Options Modeling
We can reach to same results using If Statement.
If Statement Syntax:
If(Logical Test, Value if True, Value if False)
Options Payoff = If (Share Price>Exercise Price of Stock Option), ((Share Price- Exercise Price of Option)* Number of Stock Options/10^6), 0)
How’s this Fraud Possible?
An obvious question in this case, would be – If this fraud is that simple? And if it is that easy to fudge, then why is everybody not doing it.
The answer is – It is definitely not easy (and simple), but it is possible. And people do play games to fudge the financial statements and hence increase their take-home amount. What can possibly be used (Some advanced accounting jugglery)
- Capitalizing costs
- Revenue Inflation
- Manipulation of Depreciation Provisions
- Manipulating lease agreements, etc.
Stay tuned and we would delve deeper into one of these.
This series gives you a flavor of some basics concepts on finance that are very important for professionals engaged in non-finance activities as well. To learn more about various financial concepts & how to do financial analysis using Excel, consider joining our Finance for non-finance people course.
Templates to download
I have created a template for you, where the subheadings are given and you have to link the model to get the cash numbers! You can download the same from here. You can go through the case and fill in the yellow boxes. I also recommend that you try to create this structure on your own (so that you get a hang of what information is to be recorded).
Also you can download this filled template and check, if the information you recorded, matches mine or not!
For any queries regarding the cash impact or financial modeling, feel free to put the comments in the blog or write an email to firstname.lastname@example.org
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