QUALIPORT
Balance Sheet Tricks And Treats

By Maynard Paton (TMFMayn)
March 22, 2004

Though revised accounting standards have gradually flushed away most of the skulduggery, balance sheets will always be sensitive to individual boardroom opinions. Investors therefore must always remain vigilant to bookkeeping that could prompt a misjudgement about a company's finances. Today's Qualiport outlines five balance sheet issues to look out for.

(For further information, this article reviews the basics of the balance sheet. In addition, a forthcoming Qualiport article will examine the limitations of some of the more popular balance sheet ratios and principles.)

1. Balance sheet date change: Beware the company that changes its financial year-end, especially if no reason or no notice is given. Such changes often make year-on-year comparisons difficult and can thereby help mask balance sheet difficulties.

The classic example is SSL International (LSE: SSL). During September 1999, the healthcare company suddenly announced it would change its year-end from February to March. No reason was provided. So what were complicated accounts already -- it was essentially created via a three-way merger -- suddenly became much more complex. A 'trade loading' scandal was subsequently rumbled.

2. Capitalising costs: A good ruse to increase earnings is to divert some expenses onto the balance sheet. So-called 'capitalised' costs typically involve intangible assets, as the associated accounting guidelines are often more open to interpretation.

Take Skyepharma (LSE: SKP). Within its latest interim statement, the pharmaceutical company revealed £2.2m was paid to Enzon (Nasdaq: ENZN) for 'access to its PEG modification technology'. This expenditure was capitalised as 'intellectual property' within Skyepharma's balance sheet and therefore bypassed the profit and loss account completely.

Sounds small beer, but when Skyepharma's first-half results contained just £23m of sales and pre-amortisation operating losses of £12m -- and were then followed up by a profit warning in January -- it seems every earnings penny counts at the company. It's anybody's guess as to whether Skyepharma's 'access' to this technology will have a residual value in future, and to how it differs from the research and development costs Skyepharma expenses against profits.

3. Mis-valued tangible assets: The 'historical cost' accounting convention can provide a balance sheet treat or two. Canny investors may be able to spot assets recorded way below their open market value.

In the 2003 annual report of J Sainsbury (LSE: SBRY) for instance, the supermarket declared land and building assets of £6b. However, closer inspection reveals the last group store revaluation took place in 1973. No wonder "the Directors believe that the aggregate open market value of Group properties exceeds the net book value of £6 billion by a considerable margin."

Fixed asset investments can also suffer from under-valuation. The directors of investment group Enterprise Capital (LSE: ERC) gave the firm's 10% holding in Wolfson Microelectronics (LSE: WLF) a value of £2m in their March 2003 balance sheet.

Yet in July, the then privately-owned Wolfson reported a £2m profit for 2002 and subsequently confirmed it intended to float. Enterprise's shares then surged five-fold during August as investors cottoned on to the hidden value.

(Of course, tangible assets may be over-valued. That specialised machinery bought years ago may in fact prove worthless today on the open market.)

4. Mis-categorised tangible assets: Book value investors must always investigate the quality of a company's reported assets. Don't assume what's defined as tangible is actually that tangible and likely to sport a readily realisable value.

Online travel agent Lastminute.com (LSE: LMC) is a particularly good example. Within Lastminute's 2003 annual report, the net book value of the group's tangible assets comes to £22m, of which £15m is categorised as 'computer software'. A potential liquidator may get the £7m book for Lastminute's land, buildings, furniture and office equipment, but the worth of bespoke software to another party is genuine finger-in-the-air stuff.

(Lastminute also capitalises costs a la Skyepharma: "Costs incurred in developing and enhancing the [lastminute.com] website are capitalised as incurred if the measurable economic viability of the expenditure can be determined and are amortised over the expected useful life of the website." Lots of subjectivity there, too.)

5. Seasonal cash pile: Companies tend to select financial year-ends with care, thereby ensuring the balance sheet is presented in the best possible light. For instance, large amounts of reported cash may in fact prove to be temporary. Clinton Cards (LSE: CC.), the greeting cards retailer, illustrates the phantom cash pile phenomenon.

Clinton's year-end is at the end of January, at which point a large mountain of Christmas cards has just been exchanged for cash. Clinton's 2003 results thus trumpeted end-of-year net cash of £9m, albeit down from £31m twelve months prior.

However, a net interest payment of £1m during the year tells shareholders not to put too much importance on the reputed cash pile. Clinton obviously runs most of the year with more debt than its final balance sheet lets on (the intermediate interim results showed net borrowings of £5m).

More: The Basics Of A Balance Sheet | Survival Techniques In The Accounting Jungle