QUALIPORT
Survival Techniques In The Accounting Jungle

By Maynard Paton (TMFMayn)
June 9, 2003

Accounting scandals are nothing new. Ever since the dawn of capitalism, there have been boardrooms trying to pull the wool over shareholders' eyes. Yet judging by last year's reaction to numerous US accounting frauds, anybody would have thought bookkeeping malpractices are something unique to the 21st century. Sad to say, 'recent event syndrome' remains as contagious as ever among investors and media pundits alike.

History of fraud

Who remembers Ivan Kreuger? Known as 'the Match King', Kreuger founded and ran Kreuger & Toll, a multi-billion match conglomerate. Aided by a complex structure of subsidiary shell companies, it's said that Krueger himself actually prepared the accounting statements and then asked his accountants to pass entries that would make the books balance.

It was later discovered that nearly $250m of reported Kreuger & Toll assets had never existed. When the company went under in 1932, the bankruptcy was the largest of its time. US investors lost millions.

Fast forward to the late 1960s. In his book, The Intelligent Investor, Ben Graham wrote:

"In the case of Penn Central, it had been paying no income taxes to speak of for the past 11 years! ... The fact that the company paid no income taxes over so long a period should have raised serious questions about the validity of its reported earnings."

Penn Central went bankrupt in 1970.

And surely you must recall Cendant? After a rapid string of acquisitions, Cendant amassed a dizzying array of shopping, travel, dining, hotel, car and finance businesses. But it all unravelled in 1998 as $100m-plus accounting irregularities began to surface. It all stemmed from how 'membership acquisition and advertising costs' were treated. Rather than being expensed in the profit and loss account, they were generously capitalised in the balance sheet. (Now that sounds familiar...)

Face up to reality

Of course, it's not just large US firms that have indulged in cavalier accounting practices over the years. In the UK, varying degrees of bookkeeping skulduggery have been discovered at Powerscreen, Coloroll, Versailles, Independent Insurance, Maxwell Communications, BCCI, British & Commonwealth, Polly Peck, Ferranti, Photo-Me International (LSE: PHTM) and Wiggins (LSE: WGG).

So what should ordinary investors do with all the dodgy accounting going on? By all means, castigate the directors, auditors and accountants involved. Yes, you can complain about the wrongdoings to the Accounting Standards Board, your MP, the Financial Times and other Motley Fool discussion board posters. Okay, you can set up a shareholder action group, too.

But here's the truth of the matter: accounting shenanigans are part and parcel of investing. Sure, they shouldn't occur. But investors have face up to reality. If plenty of money is involved, then there's going to be a few people willing to go to extreme lengths to get it. This is not a perfect world. Fraud happens -- and your job is simply to reduce the chances of it ever affecting your portfolio.

Welcome to the jungle

In his book Accounting For Growth, Terry Smith gave a handful of survival techniques for the accounting jungle. Here's a synopsis of the points. Read them carefully. Don't fall victim to creative bookkeeping.

1. Read the accounts backwards

When did you last read a Chairman's statement that described the performance of his business in a critical tone? When reading an annual report, avoid all the glossy photos and go straight to the back. Here you'll find the accounting notes, which contain all the important financial information the company management won't highlight in their annual comments. Pension deficits, contingent liabilities, additional borrowings, lease commitments and the rest. This is the important shareholder stuff.

2. Read the Accounting Policies -- and compare

Accounting policies differ from company to company. Perusing the Accounting Policies Note is a must when inspecting a set of accounts. Consideration to any changes in accounting policy must be given in respect of how reported profits are affected. One popular choice is altering the calculation of depreciation. Also compare a company's policies to those of its peers, and the policies used in prior years.

3. 'Screen' the Accounts using various 'filters'

Straightforward ratios can be used to highlight areas for further investigation. For instance, dividing interest income/expense by the average net cash/debt position during the year could highlight suspicious figures (it did with Versailles).

There's the company's tax bill, too. Taxable profits are different from accounting profits. If the accounting tax rate comes to much less than the statutory 30%, then the Inland Revenue has a different view of just how much profit was generated. Although there are plenty of innocent explanations, low tax rates should provoke questions.

4. Cash is King!

Accounting profits are somebody's opinion, but cash is fact. More often than not, large amounts of cash absorbed into working capital are a bad sign. As Independent Insurance showed, companies heading for trouble often have terrible working capital characteristics. So the bookkeeping has to get creative in order to distract investors from the unsold stock, bad debts and unhappy suppliers.

5. If in doubt, don't invest.

Enough said.

And finally...

"It should now be evident that you as an investor are on your own. None of the techniques that have been described [in this book] are in breach of UK GAAP so auditors will not warn you about them. Investors who believe that the way to prevent their losses from corporate collapses and creative accountancy piling up is to tighten standards of auditing would appear to be sadly mistaken given the evidence to date!

The investor must perform his own analysis. Much of the analysis... will lead to questions rather than answers. These questions should be posed directly to the company... If the answer is not satisfactory, the best solution is not to invest. This is the most effective sanction, not writing to your MP about standards of auditing." -- Terry Smith, Accounting For Growth, 1992.

This article was first published in July 2002.