Higher, stronger, bluster II – Nine things businesses do to improve the look of their accounts
In Higher, stronger, bluster I, here on The Value Perspective, we found ourselves inspired by the Rio Olympics. True to our contrarian nature, however, we skirted past the excellence and excitement on show over the last few weeks to touch on the less uplifting issue of performance-enhancing drugs. From there it was, for us, not a very long jump to the subject of corporate accounting practices.
Our initial instinct was to name and shame the businesses that – wholly legitimately, of course – use various accounting techniques to try and present themselves in a more favourable light. Instead though, we decided it would be more in keeping with the Olympic spirit – and more useful for our readers – to run through the techniques to which companies, aided by their auditors, are increasingly resorting.
* The use of ‘exceptionals’: Companies use exceptionals as a way of claiming unhelpful numbers in their accounts are merely one-offs – a practice we find especially unsavoury when remuneration structures are based on supposedly ‘core’ profits. Of course anyone carrying less weight than their competitors is going to be able to go faster.
* Unsuitable use of leases: We have seen increasing instances of leases being used to move debt or capital employed off the balance sheet – and, much like tennis star Maria Sharapova, many businesses we speak to do not seem to realise the ramifications of what they are doing. The potential liabilities being assumed in this way mean return on capital, balance-sheet metrics and remuneration structures should adjust for leases – otherwise boards and managements can end up looking considerably more foolish than Sharapova.
* Discontinued items and restating of prior-year accounts: Many visitors to The Value Perspective would be amazed by the way companies will play around with the previous year’s reported accounts so that the latest set look more like progress. We could all claim to be record-breakers if we were allowed to tinker with the history books.
* Accounting obfuscation: Some businesses are becoming very skilled at making life as difficult as possible for anyone trying to dig into and reconcile their finances – for example, through joint ventures, associates and minorities and the use of ‘other’ sections in their accounts.
* Acquisitions followed by write-downs: Here a company will buy something and later claim it was not really worth what was paid. OK, everyone makes mistakes but what often happens is, because the write-down is stated as ‘non-cash’, most people ignore it and then celebrate the great returns on capital. Rather than celebrate this dopey practice, however, here on The Value Perspective, we are voting against it or avoiding those businesses making use of it.
* Year-end net debt markedly different from the average: Some companies like to try and time their year-end for ‘peak cash’, which makes them look less indebted and cheaper on enterprise value metrics. We analyse such attempts very carefully and adjust accordingly.
* Illogical cash-conversion metrics: Some companies present cash-conversion metrics that make no sense – for example, by adding back EBITDA (earnings before interest, taxes, depreciation and amortisation) to the profit element and comparing it to pre-capital expenditure cashflow, they appear to be converting much more cash than they actually are. This is well beyond ‘apple and pears’ accounting.
* Playing with depreciation rates: Companies often try to boost reported profits by lowering their depreciation charges, using different ones to their peers or reducing them through write-downs. To guard against this practice, here on The Value Perspective, we compare depreciation rates between peers and check to see who is trying to race over a lower set of hurdles than their competitors.
* Share options: A few years back, accounting standards were changed to force companies to include share option payments to employees as costs. Some companies will add these back to free cashflow while at the same time increasing the share count. It is an innovative approach but it is not fooling this particular group of analysers and testers.
It would be nice to think that company auditors – the people charged with keeping corporate accounting’s bloodstream free of artificial stimulants – might become tougher on the quality of their clients’ financial statements. Yet, to our eyes at least, the unpalatable truth is that such quality has been – to use a term the auditors will recognise – depreciating to a material extent.
There are of course many businesses that do not use any of the practices listed above and indeed plenty who deserve recognition for the Olympic-standard accounts they produce. Some of the gold medals we would award here on The Value Perspective include:
* Lack of exceptionals – Carnival Cruises
* Consistently good disclosure – Michael Page, Spirax Sarco and (relative to its peers) RBS
* Most improved disclosure – Tesco and all UK banks
* Consistently good capital allocation – IHG and Next
* Most improved capital allocation – Pearson, Tesco and M&S
Despite feeling able to award these gold medals for individual disciplines, however, we have yet to find the accounting equivalent of Jessica Ennis-Hills – a business that excels across multiple disciplines – so there remains much room for improvement.
In the meantime, here on The Value Perspective, we will continue our vigorous, forensic and unflinching programme of analysis and testing against questionable corporate accounting practices.
Fund Manager, Equity Value
I joined Schroders in 2008 as an analyst in the UK equity team, ultimately analysing the Media, Transport, Leisure, Chemicals and Utility sectors. In 2014 I moved into a fund management role and have had experience managing Global ESG and Pan-European funds. I joined the Value investment team in July 2016 to focus on UK institutional and ethical-value portfolios.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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