🔥Analyzing financial fraud of accounts receivable from the sharp decline in Poly Pharm's share price

Hainan Poly Pharm from China has engaged in financial fraud for three consecutive years (2021-2023). After being placed under investigation, its revenue and profits have risen year by year, turning into a sharp decline each year. In 2024, the company's profits turned into losses. As of 2024.09.04, the company was fined 1.7 million yuan, and the losses of shareholders exceeded 2.3 billion yuan.

In some stock markets, the cost of financial fraud is relatively low. Even if investors suffer losses of billions of dollars due to being misled, the company is only symbolically fined hundreds of thousands of dollars, or at most delisted. Since delisting does not require compensating investors for their losses, many companies deliberately resort to financial fraud and other means to intentionally seek delisting. There are numerous ways to commit financial fraud, among which using accounts receivable has become one of the mainstream methods, making it difficult for investors to fully guard against.

Given that accounts receivable are prone to financial fraud for various reasons, what are its characteristics and manifestations?

Strong operability and easy adjustment: Accounts receivable are payments owed to a company by buyers or service recipients for goods sold or services rendered, and possess creditor's rights attributes. This attribute allows flexibility and operability in financial handling. A company can affect relevant indicators in financial statements by adjusting the recognition timing and amount of accounts receivable, as well as the provisioning ratio for bad debts.

Easy to fabricate transactions: Compared to physical sales documents, the falsification of accounts receivable is more concealed and straightforward. Since accounts receivable do not involve physical delivery, they can be easily fabricated or exaggerated on paper. Companies can engage in false transactions with affiliated enterprises or fictional clients to create accounts receivable, thereby artificially inflating operating income and profits.

Easy to adjust bad debt provisions: The provisioning ratio for bad debts varies according to the aging of accounts receivable, providing opportunities for companies to manipulate profits through adjustments. By underestimating bad debt losses or deliberately not provisioning for them, companies can reduce the book value loss of accounts receivable, thus artificially inflating profits.

Difficult to supervise: Due to the complexity and concealment of accounts receivable, regulatory agencies need to invest significant human, material, and financial resources to verify their authenticity and reasonability, which is often constrained by time, resources, and technology. Therefore, some companies may exploit regulatory loopholes to commit financial fraud.

Lax internal control: Some enterprises have inadequate internal control systems with loopholes in managing accounts receivable. For example, the lack of effective customer credit evaluation mechanisms and imperfect tracking and collection systems for accounts receivable provide opportunities for financial fraud.

Management's embellishment of financial reports to cope with pressure: Under pressure from performance evaluations, listing requirements, etc., management may choose to embellish financial reports by artificially inflating accounts receivable to meet expected targets. This pressure can come from external stakeholders such as shareholders, investors, creditors, or regulatory agencies, or from management itself within the enterprise.

Fierce industry competition: In a highly competitive market environment, companies may relax credit policies and increase the proportion of credit sales to expand market share. While this helps boost sales, it also leads to an increase in accounts receivable. To cover up the financial risks behind sales growth, companies may artificially inflate accounts receivable to beautify financial reports.

Inflating accounts receivable for financing needs: Some companies may artificially inflate accounts receivable to enhance their financing capabilities when seeking bank loans, issuing bonds, etc. Financial institutions consider a company's accounts receivable when assessing its solvency. Inflated accounts receivable can make a company's financial reports appear healthier, thereby facilitating easier access to financing.

Fabricating transactions: Companies engage in false transactions with affiliated enterprises or fictional clients to create accounts receivable, thereby artificially inflating operating income and profits. This fraud method is concealed as both parties can collude beforehand and forge relevant documents and vouchers to cover up the truth. Investors should pay attention to whether the growth rate of accounts receivable is significantly higher than that of revenue and carefully verify the authenticity of clients and transaction records.

Adjusting credit policies: By relaxing credit policies and extending collection periods, companies increase the balance of accounts receivable to artificially inflate operating income. While this fraud method increases financial risks, it can temporarily boost sales and profits.

Underestimating bad debt provisions: By underestimating bad debt losses or deliberately not provisioning for them, companies reduce the book value loss of accounts receivable, thereby artificially inflating profits. This fraud method makes financial reports appear more robust and reliable but conceals potential financial risks.

As ordinary investors, unless they possess solid financial analysis knowledge, it is difficult to identify financial fraud. The best approach is to avoid problematic markets. If investors choose not to leave, they should diversify their investments as much as possible to spread risks, avoid concentrating all funds in a single stock, and reduce the risk of significant losses due to financial fraud by individual companies.