40% of FTSE350 accounts are “aggressive”

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Philip Fisher
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This quote from Radio 4’s Today Programme at around 06:50 this morning (25 October 2017) was part of a short feature suggesting that many top executives go to considerable trouble to cover up the real financial status of the companies that they represent.

This cannot be good news for the profession.

It is necessary to emphasise that all of those interviewed agreed that companies and their executives are responsible for the preparation of accounts, while auditors merely audit them to present a true and fair view. As such, the fact that accounts often require considerable window-dressing to cover big holes is not regarded as the fault of auditors.

However, if I were a partner in one of the Big Four and a handful of smaller firms, which audit companies of this size, this will not have made for comfortable listening.

If a group of our peers “confirm” that the accounts of companies like Carillion, which were deeply flawed for year after year, present a true and fair view then surely that cannot be good for their reputation or that of an industry that should be, and be seen to be, beyond reproach.

The proposition that auditors are merely there to do little more than rubberstamp accounts prepared by those representing the company will come as a shock to members of the public. They presumably invest in shares on the basis that the accounts are materially correct, as verified by a group of highly respected professionals who effectively act as their eyes and ears.

It will be interesting to learn from colleagues who practice as auditors regarding their own experiences. There seems little doubt that many will have come under considerable pressure from clients of all sizes to sign off on accounts that might be regarded as “aggressive”.

This could come in one of two ways. Many will be desperate to show that a sick company is in rude health, perhaps to stave off the bank manager or please creditors, shareholders or others with a direct or indirect stake in the business. On the other hand, it would not come as surprise to many of us to learn that smaller companies might be keen to suppress profits in order to delay significant commitments to the taxman.

If 40% of the largest companies in the country are presenting accounts that show a better position than they should, this is a terrible indictment of everybody in the finance industry. It could explain why the stock market is looking so bullish and a serious downturn might be in prospect if the authorities actually take serious action to outlaw this practice.

When I qualified as an accountant, I was taught that it was necessary to prepare and sign off on accounts that were prudent but also accurately represented the financial position of the underlying company.

Perhaps in the intervening years, the position has changed and now it is necessary to ensure that accounts inaccurately represent a far more favourable financial position for the same underlying company. If that is the case, then I apologise for wasting your time with an unnecessary article.

Thanks to the BBC iPlayer, anyone interested in listening to Dominic O’Connell’s short piece should be able to do so. It is in equal measure entertaining and shocking.

About Philip Fisher

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By NLB
25th Oct 2017 13:13

There is sadly a lot of truth in this. Auditors are not important in the hierarchy of decision making when the board and executives are taking decisions about how their careers, bonus, LTIP etc are being judged based on the results.

The more complex the accounting the more wiggle room there is. Contract accounting, revenue recognition, deferred revenue/costs etc are all big opportunities to tweak policies here and there to have a big impact. After all most businesses operate on small net margins of 2-5% or so therefore changing policy which has a marginal positive revenue impact of say 0.5% can lead to profits going up 25% which leads to ready made hero's in the present day.

This is why when it goes wrong it often goes spectacularly wrong as all those little tweaks add up and before you know it you are wound so tight a slight hiccup, macro or market dynamic changes are suddenly profits collapse by huge %'s as it unwinds in reverse with the balance sheet revealing the cupboard of lies it has stored up.

It is not to say audit does not add any value but people are seriously misguided if they think it means a watertight set of numbers free from executive influence.

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26th Oct 2017 10:02

The auditors are paid by the company, so inevitably a conflict of interest always arises. Unfortunately the alternative of state-sponsored audits would seem even less palatable.

The finance industry employs a whole army of analysts that re-work the audited accounts to calculate the "true" position, with the hope of beating the market.

It seems to be a very real problem, as well highlighted by Philip and NLB, but I struggle to find a workable alternative.

The problem is that our pensions are invested in companies that may be worth a lot less than it appears, but while everyone holds faith the merry-go-round continues.

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By NLB
to alan.rolfe
26th Oct 2017 10:28

You make a good point about pensions. I view it as a bit like the sub prime credit issues. Pensions aggregate investment in these companies in UK and farther afield. If over time the proportion of these companies that is invested in has aggressive accounting (due to the stresses of running modern business and the need for returns etc) then the returns are ultimately diluted when things go south and therefore past returns can not be an indication of future returns. Whilst I accept pension investment strategies both vary and have different classes of investment it does make you think about where your lifetime retirement savings really are. Would I want them in some of these companies, no!

I agree an answer is more difficult that pin pointing the issue!

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By DJKL
01st Nov 2017 10:59

A move to using cash flow as a primary metric would go some way but as always it is deciding how to isolate the recurring and the one off and it is a lumpy measure except in very mature business entities with very steady income, so averages over a number of years advised.

My metrics with my SIPP investments used to be something like this:

1.select basket of candidates based on acceptable P/E, I tend to look range 10-18 but that is just me.

2.Review/rank by market cap > £1 billion

3. review dividend yields between 1-2 times average index yield, so maybe 3.5%-7%, anything yielding above take care, anything below not sure-depends if entity has growth potential or not.

4. Ensure dividend has been paid and never cut last 5 years, 10 is better, Shell is a god.

5. Look at dividend cover, looking for 1.5 or more but depending on company will accept less.

6. Read pensions notes to accounts to get a feel what is lurking.

7. If time permit have a look at cashflows but may really need to look at as a five year average which can take a bit of time to work out.

8. Subject to above, general feel re industry/market chatter/ watching for areas politicians may meddle (my pet hate currently is utility companies-ripe for intervention) and discussions re goat entrails, then take the plunge, buy the shares hold and try to forget.

So, I do use published accounts (we have no choice) re decisions but I do suspect I have become more wary of them since my first forays into equity investment in the 1980s. But none of this is new, Terry Smith's book Creative Accounting was probably when I lost my full belief in published accounts, they are now caveat emptor documents used as mere indicators in part re a company's strengths and stability.

Given all the above ,as I age and start running towards drawdown (5-9 years) I have decided that I prefer investment trust shares more than direct investments, where A N Other does all the analysis and I hope that whilst he/she gets the odd lemon they are few and far between. ITs also really help covering overseas markets and protecting assets from sterling devaluation ; direct share investment in some overseas markets can be risky to say the least.

IMHO accounts are becoming more and more devalued currency re investing but do have uses as long as read for what they are, mere indicative not gospel.

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