Analysing accounts takes investors a long way but you need something extra

If you were one of the world’s largest manufacturers of contact lenses, then perhaps it would seem only natural – as opposed to gently ironic – to want to make your company’s numbers look better. Either way, back in the early 1990s, analysts and other market-watchers began to notice something different about the accounts of US eye health products giant Bausch & Lomb.

Specifically, there seemed to be something unusual about the growth rates of the company’s revenue line and its account receivables (the invoices for which a business has yet to receive payment). In 1992, these two key elements of the accounts grew 12% and 35% respectively while, in 1993, the corresponding growth rates were 10% and 39%.

Monitoring the relationships between such figures is important because it can help identify whether a company’s management team is accelerating the way revenue is recognised in its accounts – and indeed the reason such disparities were now appearing in Bausch & Lomb’s reporting is that its management had decided to change the way the company was recognising its revenue.

Previously, sales had only been booked when made to the end-customer but, in 1992 and 1993, they were booked when made to the business’s distributors. By the end of 1994, the US financial regulator had begun formal investigations into Bausch & Lomb’s accounting practices – eventually concluding management had artificially boosted the company’s earnings by improperly recognising top-line revenues.

Fast-forward two decades and, in 2013, Bausch & Lomb was acquired by Valeant Pharmaceutical – as it happens, a company whose own accounting practices have since attracted their fair share of scrutiny, as we highlighted ourselves, here on The Value Perspective, in Why are value gurus split on the merits of this pharma business?                        

While by no means unique, the way Bausch & Lomb treated revenue in its accounts was striking enough to be used as a case study in The Investment Checklist: the Art of In-Depth Research by Michael Shearn. As the book’s title implies, the episode is a good illustration of the importance of understanding – or at least being aware of – accounting treatment when assessing the merits of current or potential investments.

According to current accounting guidelines, for revenue to be recognised, four conditions must be met: evidence of an arrangement must exist; delivery of the product or service must have occurred; the price must be fixed or must be determinable; and the collectability of the proceeds should be reasonably assured. Not meeting any of these conditions would require deferral of revenue until all requirements have been satisfied.

Demanding reality

If confirming these conditions have been met looks simple at first glance, just read the accounting policy section in any company’s annual report and accounts and you will gain an idea of the rather more demanding reality. More often than not, you will find the wording paraphrases the four points mentioned above without ever really explaining or indeed giving much detail about any of the business’s actual practices.

As a result, divining whether a company is improperly booking revenue is fraught with difficulties – even for very experienced investors. What is more, the task becomes yet more difficult if the company under the microscope follows, as Valeant did, a growth strategy that is essentially underpinned by a programme of mergers and acquisitions.

Things may, however, be about to change. The US and global accounting standards watchdogs have teamed up to develop new rules that will replace virtually all current revenue-recognition requirements. These will cover all companies that enter into contracts to provide goods or services to their customers and also call for the disclosure of new information about customer contracts that has not previously been required.

The extent to which this will facilitate the investor’s task of analysing and understanding a company’s business model – particularly with regard to how, if and when an actual sale takes place – remains to be seen. After all, aggressive or improper accounting behaviour is difficult to detect, precisely because those doing the accounting know their stuff and make it as hard as possible to spot.

In the end, no matter how diligent you may be in your crunching of a business’s numbers, if somebody is deliberately setting out to deceive you or otherwise prevent you from understanding what is really going on with their accounts, there is always the possibility they will succeed. As such, you need to accept that analysing a company’s reports can only take you so far – which is why it pays to have more in your investment locker than a working knowledge of forensic accounting.

Here on The Value Perspective, of course, we remain committed to conducting a fundamental, bottom-up, value-driven analysis when assessing current and future investments – looking to understand all aspects of a company, including the way it conducts business, how liberal or conservative its management is about accounting, its earnings potential and, most importantly, its stock price relative to its intrinsic value.

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