Company accounts can be difficult for private investors to fathom at the best of times: differing accounting approaches, different levels of prudence and changing accounting standards compound the problem.
1970s trade union leader Clive Jenkins called company accounts “totally and utterly useless” and in his 1992 book Accounting for Growth City legend Terry Smith exposed questionable practices exploiting Generally Accepted Accounting Principles (GAAP). Smith’s book excoriated many leading UK companies and helped kick off change in UK company accounting and reporting standards. Accounting standards are constantly evolving, seeking to make the presentation of results better reflect true performance and make comparisons across sectors, markets and (ideally) different countries possible.
However, as new standards emerge, companies increasingly present their accounts in ‘adjusted’ forms to tell their trading story the way they want it to be seen. While accounting standards can be tracked and quantified, companies’ adjustments are non-standard as each chooses what items to exclude or add back in order to ‘normalise’ their figures, creating something of a minefield.
There are three ways in which company accounts can fail to reflect the ‘true and fair view’ of a business and its affairs:
Fraud – rare (as far as we can tell), illegal and usually hard to spot externally, where parties aim to make an unsuccessful or failing business appear more successful.
Aggressive accounting – accounting practices that are designed to overstate a company's financial performance. Not always illegal and sometimes possible to spot, often by failing the ‘smell test’.
Alternative performance measures (APM) – showing results as they would have been either under an older accounting method or by in/excluding specific items. Legal, this aims to show trading in a more realistic, but in practice a more favourable, light.
Spotting when a company is misleading the markets is not easy, and we have recently been gifted two examples that show how even investment professionals and auditors don’t spot the problems: Carillion and Patisserie Valerie. At Patisserie Valerie, there was almost certainly fraud, with hidden bank accounts used to provide cash that created the illusion of well-being: this might seem to underline the mantra ‘always look at the cash’ but this was an extreme case. At Carillion, the problem was twofold: aggressive accounting and imprudent long-term contract recognition (see later) that meant profits and cash flow were misaligned: having £7bn of debt did not help.
Tricks of the trade
We will look at the most transparent of these three practices, APM, where with some (sometimes a lot) of digging private investors can see all the moving parts and begin to see the true trading picture. There are many wholly legitimate mechanisms that companies use to present their performance in a better light than that required by the accounting standards. Unlike statutory figures, there is no standardisation and if the numbers are not included in the report and accounts (only in press releases or other presentations) they may not be audited, although misuse of APMs can cause a run-in with the Financial Reporting Council (FRC). Some more common examples:
Leases – this is likely to be the most commonly encountered APM as it affects many businesses and entire sectors such as retail and hospitality: IFRS16 changes accounting for renting operating properties (or other major assets). Historically, rents were charged directly as a cost but today all future rental payments are capitalised as a liability (debt) then amortised across the life of the lease against profits. This increases apparent debt and can both increase and decrease profits (depending on the lease maturity profile) leading to unhelpful presentations of performance when adjustments are made.
Essentially, all retailers and other sectors with a lot of premises (eg leisure and hospitality) will also present results on the old GAAP basis. John Stevenson at Peel Hunt thinks that IFRS16 has made profits near-impossible to fathom, especially for private investors.
Goodwill accounting – goodwill is the difference between the price paid for a business and the physical assets purchased. Goodwill is held to be the value of brands, patents, unique technologies or key customer relationships. IFRS10 requires that the goodwill be amortised against profits over no more than 20 years, but many companies don’t. This a particular issue with pharmaceutical companies, but also others, for example housebuilder Barratt Developments (BDEV) carries over £800m of goodwill from an acquisition made in 2007 which has never been amortised. Failure to amortise will overstate returns as it ignores the cash or equity funding was used to purchase the business.
Provisions and exceptionals – where a charge is made in a single trading period against the estimated impact of a future single or string of negative events. In future periods, underlying losses would be offset against the provision, overstating the true trading position in those future periods. Banks and PPI are a good example here. This is also common for companies undertaking structural change, such as the major transition at SSE (SSE). Here, APMs using terms such as “non-recurring”, “unusual”, “infrequent” and “one-off” arise but in reality they occur in a number of years, which can misrepresent true performance.
Long-term contract accounting – this was a root cause of the issues at Carillion and is a commonplace problem in a number of industries, especially construction and defence procurement. The company assumes the total profit for a project and can recognise that in its accounts at any point: early, late or evenly spread. This misaligns profits with cash and will cause problems in later years if actual profit is lower than that assumed. Such businesses will have numerous contracts in hand concurrently making it almost impossible to determine how well or badly the business is actually performing.
Acquisition accounting – when buying another company there are many opportunities to undertake creative accounting. Assets or stock can be ‘fair-value adjusted’ to a lower level to allow larger profits, losses written off or contract values reassessed. These value changes can easily be hidden in the combination of the two companies’ accounts, leaving investors with a more positive view of trading.
Capitalised costs – costs, usually interest, are added to the value of long-term projects and show as an asset in the balance sheet rather than being charged against profits. Cash interest is still paid, but this leaves higher profits. This is OK if the project is to be sold (ie property development) as it will net off against the ultimate proceeds, but is misleading for profits if the asset is retained.
Asset value changes as profit – most typically for property assets where an increase in capital value of investment property is presented as profit. These are investment gains recognised but unrealised so there is no cash flow. This can also occur for final-salary pension scheme valuations.
Deferred income – any payment in advance (ie pre-paid service agreements) must be recognised across its life and carried as a liability for any outstanding value. Releasing this into the accounts as revenue can be manipulated to under- or overstate revenues.
Share-based payments – more common in young and fast-growing businesses, staff can be paid in shares rather than cash for salary or long-term bonuses. Under IFRS 102 these must be treated as revenue costs but many companies will eliminate the charge in an APM to boost profits.
Some APM examples
AstraZeneca (AZN): pharmaceutical stocks are held to be amongst the worst offenders with APMs often reporting the largest differences from statutory profits. A major adjustment is for goodwill, typically very large as much of the sector's investment is buying companies with few assets but high valuations. Ignoring goodwill amortisation, legal costs fighting for patents and endless restructuring makes for huge differences, for example at AstraZeneca:
|AstraZeneca quarterly APMs|
BAE (BAE): Revenues in BAE’s APM are actually consistently lower by eliminating turnover from ventures where the shareholding is below 50 per cent, a positive step in light of Carillion and issues with long-term contract accounting. Generally, however, the APM is higher than the statutory due to goodwill and minority stakes but BAE’s accounts do make it easy to track the differences.
Year to Dec
St James Place (SJP) presents two APMs: ‘cash’ and ‘EEV’. EEV (European Embedded Value) is a mechanism intended for life insurance companies so does not really apply and presents a large, misleading figure. The explanation in the accounts is a masterpiece of clarity with the ‘cash’ APM being: “ before shareholder tax (calculated elsewhere) adjusted to remove the impact of accounting for deferred acquisition costs (DAC), deferred income (DIR) and the purchased value of in-force business (PVIF).” What is notable is that the statutory result for H1 2021 showed a large fall but the ‘cash’ APM reported a large increase.
|St James Place statutory and alternative presentation of EBIT|
|Source: St James Place|
What is an investor to do?
Delving deep into accounts, and especially notes to the accounts, is a daunting prospect for most private investors. Account notes are not there to make things obvious for private investors but to fulfill an obligation to report. So what to do?
Take a detailed look at the cash flow statement: This merits a whole article in itself. This is a well-established approach to getting to what is really going on with a company’s trading. However, accounting policies might have been mis-applied, there needs to be a reconciliation between the profit and the movement in cash/net debt. Work backwards from the movement in debt/cash in the cash flow statement, adding back each element (ie tax paid) to try to reconcile stated profits.
Try to normalise the standardisation: it is never good to look at a stock in total isolation. It might look cheap, but its peers might be equally cheap, or cheaper. The sector may be cheap due to risk or regulation so if possible, investors looking at a single stock must contextualise both it and its sector.
Stop using PE: Most investors will look to price/earnings (PE) for valuation but many investment professionals use the more complex EV/Ebitda ratio. Here, instead of share price (P), enterprise value (EV) is used (market value plus debt) which reflects the company’s deployed capital. Ebitda is earnings before interest, tax, depreciation and amortisation and is a figure much closer to a cash profit than reported earnings.
Buy a focused fund rather than a single stock – something of a cop-out but it does relieve the pressure of needing to unravel the adjustments and restatements for a single stock. In a focused or biased fund, investors can spread the risk and ‘buy the sector’ or the theme and not have to worry about who is best at showing their results in the most flattering light.