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The company's book-keeping turmoil started in July 1999. Back then, the group agreed to purchase the remaining 49.8% of its Japanese subsidiary Nippon Auto Photo. The consideration for the stake was £25.2m, comprising £2.2m cash and 4,625 photobooths. These booths, according to the company at the time, had a value of £23m that "approximated to their written-down book value". Photo-Me commented one month later that the acquisition was performed on "very favourable terms". All well and good. Or so it seemed.
A year later, and the Japanese transaction now casts a dark cloud over the company. Photo-Me announced earlier this month that "the profit arising from the transfer of assets as consideration... for the minority interest in Nippon Auto Photo may not be recognised in the profit and loss account, but may be treated as a reduction of goodwill in the balance sheet. Moreover, should this profit be recognised in the profit and loss account, it will be shown as an exceptional item."
Er, what profit?
Hold on... what profit? Surely if assets have been disposed of at their "approximate" book value, shouldn't there be little or no profit involved? Not in this case. Photo-Me admitted in the August 3rd statement that a previously undisclosed "profit" of £10.4m was generated. And the real bean-counting skullduggery was the revelation that £4.5m of this gain was included in operating profits reported for the six months ended 31st October 1999.
Considering the company reported £22m of operating profit in that interim period, there was obviously an underhand boost to earnings. The transaction also contradicted the accounting notes to the interim results that stated "the acquisition of the minority interests in Nippon Auto Photo during the period has had no impact on operating profit."
Photo-Me come clean
From today's results, it transpires that the true "value" of the assets transferred bore no relation to the commensurate "book value" recorded in the accounts. Unsurprisingly, it was far less. After a reassessment, the assets transferred were valued at just £12.6m. Thus Photo-Me had bought a £25.2m stake for £2.2m cash and £12.6m of assets, and so "realised" a £10.4m "profit".
It has to be pointed out that the original asset undervaluation was not the problem. As we know, book value is a notoriously unreliable measure for investors to base investment decisions on. No, the problem stems from Photo-Me's accounting for the £10.4m gain. The "profit" should have been either recorded as an exceptional gain in the profit and loss account, or a goodwill reduction in the balance sheet. There's no place for one-off gains within operating profits.
In hindsight...
As is always the case with accounting troubles, there were one or two warning signs. Large director share sell-offs immediately after the controversial interim results should have rung alarm bells. At 400p per share, chief executive Serge Crasnianski unloaded 7m shares to raise £28m, the finance director sold half his holding raising £0.8m while a non-executive director also disposed of his entire £18m shareholding.
Perhaps more telling was one of the accounting notes within the questionable interim results. The disposal of fixed assets totalling £19m, significantly undershooting the supposed £23.2m minimum needed for the acquisition, may have surprised some investors at the time.
Summary
Because of the irregularities, Photo-Me shares have since slumped to 97.5p over the past months. On today's annual results, the shares stand on a historic price to earnings ratio (P/E) of 33. The company has some promising developments, including devices that process and print digital camera "film". On the other hand, the company has some rather doubtful operations, with Photo-Me's Internet kiosks surely to be superseded by WAP mobile phones sometime soon.
But all the valuation interpretation and business models can be put to one side. With the dubious management and their accounting practices still in place at Photo-Me, Foolish investors should stay well away.
Where Next?
Visit the very subdued Photo-Me discussion board