The Spillover Effect of a Market Bloodbath

On August 24, 2015, China’s Shanghai Composite index posted its biggest one-day percentage loss since 2007, closing down 8.5%. The smaller Shenzhen Composite closed down 7.7%. To quote a headline on this topic, “China sneezed, and the rest of the world went down with a cold on Monday” with the S&P 500 closing down 3.9%, the FTSE 100 down 4.7% and the ASX down 3.7%. The lowering of interest rates by the Chinese government and remarks from bullish commentators introduced some confidence back into markets, but the decline may not be necessarily over.

Prior to this week’s events, there have been growing concerns about China’s economy, with some foreign companies downgrading their targets for this year. In March, BMW’s then CEO, Norbert Reithofer, warned investors of slowing growth in China; indeed, according to data from the German Association of the Automotive Industry, new-car sales there have fallen two months in a row.

From conversations with our clients, we know that some have been giving careful thought to their next steps in China, and those companies most exposed to commodities, construction or cars are probably right to be concerned. Nonetheless, as the economy shifts toward a more consumption-led model, some companies most notably Apple have been reporting healthy growth. We ourselves have also seen clients pressing on with plans for acquisitions in other growing sectors, such as healthcare and education.

Of course, market volatility, as seen earlier this week, can provide opportunities for investors. In determining whether to invest at such times, one of the key issues is transparency at a macro and micro level. When markets are in an unpredictable state, clarity regarding the potential risks of any major investment is essential, including understanding your partners and what may sit behind published results.

Volatility is an issue not only for those considering an investment, but also for those already managing a business. As forensic accountants, we often deal with complex accounting issues and are usually first to discover how these intersect with the risk of fraud that every organization faces. The fraud triangle summarizes the environment in which fraud occurs: pressure, opportunity and rationalization. Volatility (in this instance within markets) can increase the risk of fraud, while an organization’s lack of a robust risk management framework provides opportunity. Market volatility can also increase pressure on staff to take steps not previously contemplated.

This was demonstrated recently when Toshiba was found to have overstated its previous financial results by over JPY 150 billion for the seven-year period 2008 2014. This resulted from accounting irregularities due to the improper use of the percentage-of-completion method of accounting on certain infrastructure projects, among other accounting methods of inflating sales and profit. One possible reason for this accounting scandal was Toshiba’s management attempting to avoid volatility in Toshiba’s profit by deferring expenses and not recording loss-making contracts that may have otherwise negatively impacted the share price.

A more prosaic example of this type of fraud is where companies overstate (or understate) assets and liabilities to meet banking covenants. In either case, smoothing financial results to avoid market volatility or breach of banking covenants can create a significant accounting scandal as well as ongoing regulatory and financial issues for the organization.

Fraud can also be more personal. There were numerous instances at the beginning of the 2007/08 global financial crisis of trader frauds within financial institutions, both by individuals and by traders in collusion seeking to maintain their lifestyles and bonuses by hiding losses in their trading books.

Kroll has seen the impact of market volatility in organizations since the 2007/08 global financial crisis. How individuals and teams within the organization respond is a combination of:

• Whether a company’s risk management framework, including a strong corporate governance structure (including appropriately remunerated and truly independent non-executive directors who are experienced, diligent, knowledgeable and questioning of the management) is sufficiently robust to deter opportunists;
• The implementation of appropriate detection mechanisms relating to financial statement manipulation (as well as other frauds); and
• Whether rationalization of fraudulent acts is condoned by the company culture.

The Kroll Financial Investigations team is a global team of specialist forensic accountants who assist clients with mitigating and identifying risks, preventing and investigating fraud and advising on complex accounting issues. Our team uses a combination of data analytics and forensic accounting skills to advise organizations in relation to risk by identifying “red flags” and ensuring sufficient safeguards are in place to mitigate risk.