The Book of Family Traditions on The Art of War, Yagyu Munenori
Earlier yesterday I was on BNN to talk about Valeant's alleged accounting manipulation (http://www.bnn.ca/Video/player.aspx?vid=736200). Valeant is the result of a merger between Biovail and Valeant, both of them had an accounting scandal in their history. I actually use Biovail as a case in my courses as an example of revenue manipulation, so one could argue that there is genetic tendency there.
The story here is whether Valeant has created specialized drug companies (remember Special Purpose Entities or SPE's in Enron) to book fictitious revenues. The company claims that it consolidated them, which could refute this claim. If this is true my question is why would employees of Valeant use pseudonymous like Peter Parker (seriously?) or Jack Reacher in emails from Philidor, one of such companies created by Valeant?
When one goes beyond simplistic heuristics and uses the Beneish Manipulation Index analysis (below) we can see that while the overall probability is between 1% and 2% (not so low as you'd think) the first index is highly suspicious:
| Weighted Predictor Ratios Annual | 2012 | 2013 | 2014 |
| Days Receivables Index | 1.01271 | 0.984018 | 0.792907329 |
| Gross Margin Index | 0.507612 | 0.56891 | 0.487203384 |
| Asset Quality Index | 0.382818 | 0.402746 | 0.391145484 |
| Sales Growth Index | 1.300824 | 1.529888 | 1.281557525 |
| Depreciation Index | 0.100797 | 0.126199 | 0.125124344 |
| Sell. & Admin. Exp. Index | -0.155772 | -0.173113 | -0.185863 |
| Leverage Index | -0.395363 | -0.334107 | -0.317103 |
| Total Accruals/Total Assets | -0.20139 | -0.31876 | -0.245703794 |
| Constant | -4.84 | -4.84 | -4.84 |
| Value of y | -2.28776 | -2.05422 | -2.510731907 |
| Probability of Manipulation | 1.11% | 2.00% | 0.60% |
The Days receivable Index is related to whether accounts receivables grow faster than sales. If they do, unless the credit policy has changed, it could potentially be the result of channel stuffing or booking of low quality sales. What is even more suspicious is the exponential growth of sales and that the rate that receivables grow is even greater than the rate that sales grow. So what we get here is that sales grow very rapidly but receivables even more.
Thus, when I looked at the growth in sales vs. receivables I got:
| 2012 | 2013 | 2014 | |
| Sales growth | 46% | 72% | 44% |
| AR Growth | 61% | 83% | 24% |
The same occurred when I looked at quarterly data:
When I charted Valeant's quarterly accounts receivables and sales I got the following stunning result:
The sales in each quarter from 2011 and the receivables are almost the same. As a matter of fact the correlation between the two series is 98%.
What can we conclude?
The sales in each quarter from 2011 and the receivables are almost the same. As a matter of fact the correlation between the two series is 98%.
What can we conclude?
That the overall probability of earnings management is inconclusive but there are red flags with respect to the revenue recognized by Valeant.
