This is the sixth in a series of eight articles examining different forms of accounting manipulation. Previous articles included pieces on channel stuffing and improper revenue recognition.
Liability valuation refers to the process of determining the current worth of a company’s obligations or debts. This involves assessing various factors such as the nature of the liability, market conditions, interest rates, and the time value of money. The goal is to provide an accurate representation of what a company owes at a specific point in time, which is crucial for financial reporting and decision-making.
The goal is to provide an accurate representation of what a company owes at a specific point in time
Accurate valuation of liabilities is essential for maintaining transparency in financial statements and ensuring compliance with accounting standards. It is especially important if investors are to accurately determine a company’s solvency.
Depending on the nature of the liability, companies will use one of three methods to value liabilities:
- Present value: This method discounts future cash flows associated with liabilities back to their present value using an appropriate discount rate.
- The market approach: This method looks at similar liabilities in the market to estimate fair value based on comparable transactions or market prices.
- The income approach: This method estimates the value based on expected future income generated by the liability or related assets.
Companies with disturbing debt ratios are incentivised to present the lowest possible valuation of liabilities and will sometimes use financial engineering to choose approaches which offer the greatest discretion and the most opaque assumptions. Needless to say, the less the transparency in liability valuation, the greater the risk of manipulation.
The best way to learn about liability valuation is to see five real life examples. We provide five famous examples of improper asset valuation: AIG, General Motors, Freddie Mac, Tesco and Olympus. In each case, improper or inadequate liability valuation led to regulatory action and severe losses to investors.
Where appropriate, we complement these examples with readings from the Transparently Risk Engine, an AI-powered system that detects accounting manipulation. The TRE scores the quality of a company’s accounting on a 0-100% scale, in the process assigning them a rating of A+ to F. In some of the cases below, the TRE certainly picked up risky signals well before the problems bubbled to the surface.
American International Group (AIG)
American International Group was a multinational insurance corporation, during the mid-2000s.
AIG's Financial Products division had sold billions of dollars worth of credit default swaps (CDSs), which are essentially insurance contracts on debt securities. As the housing market began to decline, the value of these CDSs plummeted, increasing AIG's potential liability. Despite deteriorating market conditions, AIG significantly understated the reserves it needed to set aside to cover potential losses on these CDSs. The company used overly optimistic assumptions and downplayed the risks associated with these complex financial instruments.
AIG also engaged in off-balance-sheet transactions and complex accounting maneuvers to further obscure the true extent of its liabilities.
When the financial crisis hit in 2008, AIG's inadequate liability valuation caught up with them. The company faced a liquidity crisis and required a massive government bailout of $182 billion to avoid collapse.
The SEC investigated AIG's accounting practices and found that the company had engaged in misleading accounting and disclosure practices. AIG agreed to a $10 million settlement with the SEC. The AIG scandal further eroded public trust in the financial industry after the failure of Lehman Brothers and highlighted the dangers of aggressive liability valuation, especially for complex financial instruments.
While companies have some discretion in estimating liabilities, using overly optimistic assumptions or concealing risks can create a misleading picture of a company's financial health and eventually expose it to significant financial distress.
General Motors
A prominent example of a company that used aggressive accounting with respect to liability valuation is General Motors (GM), the American multinational automotive manufacturer.
In the 2000s, GM faced significant pension obligations to its retirees. However, the company used overly optimistic assumptions about investment returns and discount rates to calculate their pension liabilities. Using these unrealistic assumptions, GM was able to report a smaller pension liability on its balance sheet and reduce the amount of pension expense it had to recognize each year. This manipulation made its financial position appear stronger and their earnings higher than they actually were.
When the financial crisis hit in 2008, GM's pension liabilities, along with other financial problems, pushed the company to the brink of bankruptcy. It required a massive government bailout to survive. The SEC investigated GM's accounting practices and found that the company had misled investors about the true extent of its pension liabilities. GM agreed to pay a $50 million penalty to settle the charges. The accounting scandal further tarnished GM's reputation, which was already struggling due to the company's financial troubles.
The GM case highlights the risks associated with aggressive liability valuation in relation to complex long-term obligations like pensions.
Freddie Mac
Freddie Mac, as the government-sponsored Federal Home Loan Mortgage Corporation is known, played a major role in securitization in the US mortgage market during the early 2000s. Freddie Mac purchased and guaranteed mortgages from lenders, packaging them into mortgage-backed securities.
As the housing market boomed, Freddie Mac made overly optimistic assumptions about the creditworthiness of borrowers and the likelihood of mortgage defaults. As a result of these optimistic assumptions, Freddie Mac significantly understated the reserves it needed to set aside to cover potential losses from mortgage defaults. This practice allowed it to report higher profits and a stronger financial position than was warranted.
When the housing bubble burst in 2008, Freddie Mac faced catastrophic losses due to its inadequate loan loss reserves. The company, along with its counterpart Fannie Mae, required a massive government bailout of $187 billion to avoid collapse. The SEC investigated Freddie Mac's accounting practices and filed charges against the company and several former executives, alleging that they had misled investors about the true risks facing the company. The Freddie Mac scandal, along with the broader financial crisis, led to a significant loss of public trust in GSEs and prompted calls for reform of the housing finance system.
The Freddie Mac case highlights the dangers of underestimating liabilities, particularly in industries with inherent risks like the mortgage market. Companies operating in such sectors must exercise caution in making assumptions about future losses and should prioritize accurate liability valuation over short-term profit maximization.
Tesco
Tesco, a British multinational grocery and general merchandise retailer, suffered a major accounting scandal in 2014. Liability valuation played a role in the scandal, as did improper expense recognition.
Tesco was accused of understating provisions, which are liabilities set aside for anticipated future costs, such as restructuring expenses or potential losses from legal claims. The company allegedly delayed recognizing these liabilities, pushing them into future periods to make current earnings look better. This manipulation understated its true expenses and made the financial position appear stronger than it was.
After the Tesco scandal broke, the company was forced to restate its earnings by hundreds of millions of pounds and to restate its provisions by a similar magnitude. Tesco's share price plummeted and the company faced lawsuits from investors who claimed they had been misled by the company's accounting practices. The UK's Serious Fraud Office (SFO) launched an investigation into Tesco's accounting practices, and the company ultimately paid a fine of £129 million to settle the charges.
In 2014, the Transparently Risk Engine gave Tesco’s accounts a C rating, putting it in the bottom third of global consumer staples companies for accounting quality. The system’s top concerns for that year were margin signals and income quality. It recommended investigating Tesco’s sources of income.
Olympus
Olympus Corporation, the Japanese optics and reprography product manufacturer, engaged in improper liability valuation as part of a broader accounting fraud in the early 2010s that also included dubious use of cookie jar reserves.
Olympus had incurred substantial losses on investments dating back to the 1990s. Instead of recognizing these losses on the financial statements, the company used a complex web of transactions and inflated fees to hide them. By concealing these investment losses, Olympus effectively understated its liabilities. It failed to accurately reflect the true economic reality of the financial position, making the balance sheet appear stronger than it was.
When the scandal came to light in 2011, Olympus's share price plummeted by more than 80%, wiping out billions of dollars in market value. Several top executives, including the CEO, were arrested and convicted for their roles in the accounting fraud. Olympus faced significant fines from regulators and suffered severe reputational damage, shaking investor confidence in Japanese corporate governance.
The Olympus case demonstrates that aggressive liability valuation can be a key component of large-scale accounting fraud. It highlights the importance of scrutinizing a company's balance sheet and ensuring that liabilities are accurately recognized, not concealed to create a false impression of financial health.
The Transparently Risk Engine’s historical risk scores for Olympus averaged around 60% in the late 2000s and peaked at 70% in 2009, putting the company in the worst 7% of companies globally for accounting quality. The top concerns flagged by the system in Olympus’ 2009 accounts were smoothing activity, corporate governance and accruals management.
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