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The Steinhoff scandal: Why due diligence alerts matter

The Steinhoff scandal: Why due diligence alerts matter

By Prof Daniel Malan

  • DEC 2020
12 minutes to read

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Due diligence reviews are there for a reason
All major frauds and financial scandals in the world come with warning signs that are “hard to miss”. So says forensic accountant and financial analyst Howard Schilit (2010).

Why, then, did nobody see the warning signs leading to the Steinhoff debacle, South Africa’s largest accounting scandal? Where was the due diligence?

Due diligence is an important part of investment decision making. Yet, there are no clear guidelines or rules on how to carry out a due diligence check. This raises the question: Could the Steinhoff scandal have been avoided if due diligence screening guidelines and follow-up procedures were applied using well-established fraud models and ratios?

Applying due diligence screening to Steinhoff
Management representations of a company’s financial state seem to be the lowest forms of evidence while an independent expert’s own analysis is one of the highest forms of evidence.

Management representations of a company’s financial state seem to be the lowest forms of evidence while an independent expert’s own analysis is one of the highest forms of evidence.

Various fraud models and red flag ratios are available for those who need to predict fraud, point out operating, liquidity and solvency problems, or carry out due diligence screenings. It is typically people like financial analysts, investment bankers, investment managers, auditors, forensic accountants, risk managers, board directors and government regulators who should be aware of these due diligence methodologies and tools.

Recently, these screening guidelines were applied to a number of cases in the USA and China where fraudulent companies had lost trillions of dollars in market capitalisation. The outcome was clear: Weak corporate governance was one of the key reasons for financial accounting fraud in these companies.

Grove, Clouse and Malan – in their 2019 paper titled Applying due diligence guidelines and procedures to Steinhoff International Holdings: Could South Africa’s largest accounting scandal have been avoided? – applied 16 well-known fraud models and red flag ratios to Steinhoff International Holdings’ business for the four years 2013 to 2016. This period also covers the investigation of accounting fraud which was initiated by German authorities in September 2015. Steinhoff stock was listed on both the German and South African stock exchanges. The German prosecutors were looking for, among others, overstated and possibly phony revenues from contracts that appeared to have been conducted with third parties but may have involved units within the company itself.

Steinhoff CEO Markus Jooste resigned in December 2017 while Steinhoff CFO Ben Le Grange resigned in January 2018. The CFO’s resignation was seen as a major red flag for fraud since CFOs specifically know “how the books have been cooked”.

Various fraud models and red flag ratios are available for those who need to predict fraud, point out operating, liquidity and solvency problems, or carry out due diligence screenings.

Here is a summary of the due diligence screening guidelines and follow-up procedures used to gauge Steinhoff’s financial standing.

The seven due diligence screening guidelines
Dan Sierra, Chief Investment Officer of American billionaire businessman John Malone, developed seven due diligence screening guidelines to help determine the financial health of a company. The guidelines were applied to Steinhoff International during the critical fraud period 2013 to 2016. These were the models that were used to pick up on alerts:

The CFO’s resignation was seen as a major red flag for fraud since CFOs specifically know “how the books have been cooked”.

  • Dechow et al.’s New Fraud Model was applied to determine whether there were any predictions of fraudulent financial reporting. For the four reporting periods in this case study, this model predicted fraud 50% of the time.
  • The Beneish Old Fraud Model was applied to check whether the New Fraud Model’s predictions were consistent. The results were somewhat similar.
  • The Schilit Quality of Revenues ratio was calculated since revenue recognition is the starting point for cash flow generation by business operations and is usually the number one manipulator in fraudulent financial statements. This ratio showed red flags 100% of the time for the four Steinhoff reporting periods.
  • The Schilit Quality of Earnings ratio was calculated to determine if cash was being generated from business operations. This ratio showed red flags only 25% of the time for the four reporting periods.
  • The Sales Growth Index (SGI) and the Days Sales Receivable Index (DSRI) were calculated because of the red flags for quality of revenue. The SGI showed definite and possible red flags 75% of the time. The DSRI did not show any red flags.
  • The Altman Bankruptcy Model was applied to determine if sufficient cash was being generated by the company to survive. This index strongly predicted bankruptcy over all four years.
  • The Sloan Accrual ratio and other traditional ratios were applied to detect red flags for fraud and operating problems. The Sloan Accrual emerged as a huge red flag in 2016 and 2014. The total liabilities to stockholder equity ratio indicated solvency red flags for all four years.
  • The cash conversion cycle was taken into account. The cash conversion cycle in days is recommended to be near zero. However, in all four years, red flags were shown, indicating a dangerous reliance on vendors to help finance Steinhoff’s working capital.

Competitive analyses of profitability: “If a story is too good to be true …”

Over the four years, 64 possible red flags were identified. When sufficient red flags exist, professional scepticism and analysis need to be expanded and follow-up procedures provided.

Follow-up procedures for due diligence
Five due diligence follow-up procedures were developed from these screening guidelines. These procedures, which relied heavily on the work of financial analysts and others who blew the whistle on company fraud, were:

  • Competitive analyses of profitability: “If a story is too good to be true …”
  • Competitive analyses of liquidity and solvency: “Management can overcome every major business problem, except … running out of cash.”
  • Additional revenue work: This includes looking for “massaged revenue recognition”.
  • Site visits and online visits: This is to determine, among others, if third-party contractors are not simply different subsidiaries of the company being investigated – i.e. if phantom accounts have not been created.
  • Corporate governance and ethics: This includes looking at the ethics of top management, toxic company culture, and board independence.

Corporate governance and ethics … looking at the ethics of top management, toxic company culture, and board independence.

What are the lessons in all of this?
In the case of Steinhoff, the due diligence screening guidelines led to the identification of serious red flags over the reporting period. These red flags should have led to the investigative follow-up procedures. But it did not happen in Steinhoff’s case. Sophisticated international banks such as JP Morgan Chase, Citigroup, Bank of America and HSBC lost millions of dollars in loans to Steinhoff.

The take-out? There are due diligence steps that board directors can follow to strengthen their corporate governance role as gatekeepers for their companies’ investors, and to avoid large investment losses. Financial statement users could increase their understanding of organisational risk and better meet their fiduciary responsibilities as board members, investment bankers, investment managers, auditors, and governmental regulators. It is important for board directors to heed alerts by both the new and the old fraud models as directors should not be in a position where they are surprised by fraud in their organisations.

It is important for board directors to heed alerts by both the new and the old fraud models as directors should not be in a position where they are surprised by fraud in their organisations.

  • Find the journal article here: Grove, H., Clouse, M., & Malan, D. P. (2019). Applying due diligence guidelines and procedures to Steinhoff International Holdings: Could South Africa’s largest accounting scandal have been avoided? Oil, Gas and Energy Quarterly, 70(1), 101-12.
  • Prof Malan is an expert in corporate governance. He was the head of the Centre for Corporate Governance in Africa at USB at the time of writing this paper.

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