This is a good, practical book on accounting written by Terry Smith. It focuses on the different techniques used by UK companies to exaggerate their financial position during the late 1980’s. Accounting is the language of business and while the accounting rules have changed since the 1980s, human nature has not. Company directors can still be incentivised to legally fudge the numbers.
All of the accounting tricks employed by the companies in this book were within UK GAAP rules. It is important to remember that company directors, not auditors, prepare a company’s financial statements. Every major corporate fraud has had its accounts audited by a big auditor. This book emphasises the importance of analysing the numbers yourself.
While I do not short stocks and strongly advise against it, being able to spot dishonest accounting is helpful. Reading a book like this, it is important to not miss the forest for the trees. A sense of moderation is needed. Minor exaggerations in the financials are not important. You are looking for large exaggerations. This book also teaches you the most important skill for improving as an investor – how to ask good questions about a company’s accounts.
Smith identifies 12 different methods UK companies in the 1980s used to misstate their financial position:
- Pre-acquisition write down
- Deferred considerations
- Extraordinary and exceptional items
- Off balance sheet finance
- Contingent liabilities
- Capitalisation of costs
- Brand accounting
- Changes in depreciation policy
- Convertibles with puts
- Pension fund accounting
- Currency mismatching
The most popular method used by the 200 companies sampled by Smith in 1991 was No 4 – extraordinary and exceptional items.
A quick summary of some of the things I now watch out for in company accounts:
- Deferred considerations
If Company A acquires Company B upfront and promises to pay future amounts if certain growth or profit targets are met, there is a risk that the acquiring company will have to fork out large amounts of money for a poorly negotiated deal.
WPP made 30 acquisitions in 1990 and had deferred considerations of £130 through shares and cash. Its share price had fallen due to trading difficulties and it had to issue more shares to pay its acquired companies which was very dilutive to shareholders. WPP survived this episode however its share price suffered. Deferred considerations are important to consider for acquisitive companies. I rarely buy acquisitive companies however, when trying to determine if the acquirer is a disciplined capital allocator, it is important to look at the multiple paid for the acquired companies. This multiple should have the maximum possible deferred consideration factored in.
- Change in Depreciation
Between 1988 – 1990, the British Airports Authority (BAA) increased the useful live of its terminals from 16 years to 50 years. It also increased its runway life from 23.5 years to 100 years. By significantly increasing the useful life of its fixed assets, the yearly depreciation charge would be reduced, and annual reported profits will artificially increase. During this period, the BAA also invested heavily in maintenance and growth CapEx, including building a new terminal. This change in depreciation did not only increase current profits but significantly increased future profits since the new terminal will now be depreciated at a slower rate.
What’s more, CapEx for long lived tangible assets will always exceed the depreciation charge. Why? Because of inflation. If the BAA was to build a new terminal in 2019, wage and material cost inflation will mean they will spend more Pounds than that charged as depreciation in 1991.
How do you spot changes in depreciation? Look for significant changes in the useful life by reading older financials. Compare the typical useful life of certain assets by reading the financials of similar companies.
Alternatively, you can use a quantitative method to spot changes in depreciation. Measure the trend of depreciation charge to gross fixed assets over a 5-10 year period. A declining ratio could be indicative that the depreciation charge is growing slower than the gross fixed assets of the company. This could happen if there has been a change in the depreciation policy and the company is increasing the useful life of its fixed assets. There can be other reasons for this however, looking at this trend will help you ask the right questions.
- Extraordinary/ Exceptional items
Lookout for frequently occurring extraordinary/exceptional items. Quantitatively, you can do this by measuring the magnitude and frequency of extraordinary items as a percentage of pre-tax profits i.e. how large are these items and how frequent are they?
Since I do not short stocks, I don’t need to prove that a company is definitely fraudulent or significantly misstating its accounts. I only need to know enough to stay away from such an investment. Accounting for Growth is a good book that shows the different methods companies can use to exaggerate their performance.