All accounting is pliable. Every single item on the balance sheet and P&L involve an element of human judgement. As Gareth showed in his post on Rolls Royce earlier this week, something as seemingly simple as revenue can involve a huge amount of discretion.
His post got me thinking, though, about the differences between various types of businesses. In short, some are a lot more malleable than others.
Rolls is one good example of a company where there is an abnormally large amount of discretion. There are plenty more listed on the ASX. Law firms Slater + Gordon and Shine are recording revenue today by estimating the results of legal cases that won’t be resolved for years. Litigation funder IMF Bentham capitalises all of its costs on cases until the case is resolved, again often many years into the future.
Work in progress (WIP) is a particular red flag in the construction industry. Most construction companies use a “percentage of completion” method to account for large projects, meaning if the job is half complete, they book half of the expected profit. Of course, you don’t really know how much profit you are going to make until all of the claims are in, which is why so many of those WIP balances end up being written off.
The common feature of all these businesses is a long period of time between when expenses are incurred, when services are provided, and when cash is actually received. And they don’t have any choice but to make estimates about what the future holds. To be clear, not every company that has a WIP balance is going to end up being a disaster.
But the more judgement involved in the accounting, the more opportunity for mischief. You may lose money buying Platinum Asset Management, but it’s unlikely to be the result of an accounting scandal. The revenue is the revenue and the costs are the costs (perhaps a few accruals for performance fees, staff entitlements and the like but you get the picture). Whenever you invest in a business where the revenue may or may not reflect economic reality, do so with a degree of scepticism.
A big part of the problems is the need (of accountants) to put things into specific boxes. If there were more categories – earned revenue, received revenue, estimated revenue etc – there’d be less of an issue. The problem in many cases is that it’s not obvious what’s what, especially when companies have a number of difffent types of business operation, some earning real cash revenue and others earning the more pliable forms. Enron is a good example – some real revenue, some estimated and some off the charts.
Arguably accountants could provide such a revenue breakdown in the notes to the accounts but they chose not to do so sometimes so that there is limited information available for competitors about their margins etc. (e.g. some companies chose to provide segment revenue in the notes to the accounts on a geographical basis in circumstances where the presentation on a business line basis would be more relevant and useful to financial report users).
I think that’s a convenient ‘red herring’ they use Ben. A public company by definition, and in practice, obtains money from the public, and as such it needs to provide the sort of information that enables the public to make informed decisions.
I’m not convinced that transparency means disguising or hiding or not even disclosing the really important data which I think is often the case. I think a quick review of some of the recent Bristlemouth articles will show that. Many of the questions raised by analysts do not relate to info. that should be privy because of competitors, rather it is trying to hide or misrepresent some poor management or board decisions, or to disguise the true state of the company.
I agree Richard. That is just one of many possible actions to make reporting more transparent and easier for investors to understand.
It’s also one of the main reasons I appreciate what Steve and the others at Forager say because they dig a little deeper to highlight the ways ‘pliable accounting leads us all astray’.
I am a CPA and am amazed at the way my professional organisation seems more concerned with promoting its CEO, and all sorts of soft views on leadership and disruptions (issues that you can talk about till the cows come home with no tangible or real resolution) yet seemingly ignore the ‘nuts and bolts’ accounting issues that are highlighted with pliable accounting.
I’d be interested to know if any of the CPA’s (and perhaps CA’s) have been hauled before the Ethics Committees at their organisations over some of these matters. I know their professional ethical obligations (CPA and CA) are reasonably onerous and clear cut in terms of where their ultimate responsibilities lie but somehow they seem to be able to get away with questionable actions.
I take the Dick Smith activities as an example. The CPA CEO came out and said he questioned the ethical integrity of what was done yet not a word on any follow up on disciplinary or oversight of the CPA’s involved (by my count at least 11 of the directors and senior managers at DSH and Anchorage fit the bill).
No wonder we have such pliable accounting continuing. And if you look at the four questions that Greg Hoffman highlighted that Buffett believes should be asked of auditors it makes you really question some of the financial reporting that is signed off as presenting a ‘true and fair view’.
Thought you’d move onto MYOB – looks like a lot of capital expenditure catching up and aggressive M&A expansion to mask numbers….
The next DSE?
It is in the nature of bureaucratic institutions to justify themselves with bureaucracy, and the AASB is no exception to this rule.
99% of the new rules that they come up with are either poorly thought out (cf disclosure of executive remuneration as a means of preventing excessive pay), address non-issues, create more hassles than they solve (e.g. the mountains of corporate governance BS that we all need to scroll through) or are plainly just changes for the sake of change (e.g. changing the name of the P&L and Balance Sheet to terms that nobody outside of the AASB freely uses).
Although the AASB hasn’t done a very good job for users of general purpose financial reports, they’ve done an excellent job of ensuring that their rule changes entail more work and hence more fees for the Big 4 accounting firms, which by sheer coincidence each have a representative on the AASB.
When the institution that sets accounting rules in Australia is incentivised to create complexity in those rules, and company managements are incentivised to create the best reported figures that they can, then you can be certain that managers will exploit the unnecessary complexity in accounting standards to shape the results that they want.
This trend is going to continue.
This is so true. I’ve been analysing services companies for a while and have always been sceptical about their P&L. However, one can get a good hang – about a legitimacy of the accounting number – by comparing backlog to revenue conversion rate and net profit to fcf conversion rate, over last 5 years. I tend to avoid companies where fcf conversion rate is less than 80%, and preferred those where fcf conversion is 90% or more.