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.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.