UK: Fudging for the plc.

UK: Fudging for the plc. - The authorities have tried to outlaw the worst abuses, but there's still a lot of scope for creativity in company accounting.

by Sarah Perrin.
Last Updated: 31 Aug 2010

The authorities have tried to outlaw the worst abuses, but there's still a lot of scope for creativity in company accounting.

Behind every successful man, they used to say, is a talented woman.

So behind many a set of glowing accounts lurks a creative accountant.

The men in grey suits can bring a rosy hue to the palest of corporate performances.

'Accounting has to be about judgment. There are those who think that a set of accounts can represent a black and white view of a business, but it just isn't like that,' says Christopher Pearce, finance director of Rentokil Initial. He should know. As chairman of the 100 Group of finance directors, he is at the corporate accountant's career summit. Pearce does not think things are in too bad a state: 'Accounting practices have been tightened up and these days there is much less scope for variations in accounting treatments generally.'

There was certainly a fair amount of tightening up to be done. The 1980s were notorious among students of accounting for witnessing the worst excesses of accounting laxity. Corporate giants such as Williams Holdings and Hanson were able to fund their acquisitive tendencies not with solid cash generation but with more paper-based profits, creating a market perception of improved performance.

While accounting rules in the '90s may offer fewer loopholes, there is still plenty of potential for creativity. 'One of my favourite fudges is still the massive reorganisation provisions people use,' says Terry Smith, the analyst giant-slayer who was sacked from UBS for publishing a book on the accounting tricks of the trade, including those of UBS's own clients.

The manipulation of provisions is a hangover from the excessive 1980s, when companies certainly made the most of acquisition accounting techniques.

Firms buying up their rivals could tut-tut loudly and create a large provision for all the costs they would incur knocking the business into shape, including closing plants and laying off staff. The Accounting Standards Board (ASB) closed this loophole but the potential remains to create provisions for expected costs unrelated to acquisitions. This allows companies to indulge in profit smoothing, a useful means of keeping the City happy. Firms simply take a hit and set up a 'big bath' provision in one year, then supposedly realise they have been too harsh and leak some back to profits in another year. Reported results are boosted regardless of true performance. Wise to this trick, the ASB's new guidance will require some clear commitment to the action triggering the costs. A board decision won't do.

How else can users of accounts have a clue as to what to expect in future?

One 'sophisticated fiddle' that ASB chairman Sir David Tweedie is keen to stop is the use of hedging to flatter year-end results. In theory, hedging should be a good thing since it is an attempt to mitigate the risk of future losses. A deal in dollars can be hedged against exchange rate movements by the firm taking out some form of financial instrument designed to counteract adverse currency fluctuations. Under normal hedge accounting, gains and losses on the hedge should be recognised in the same period as any gains and losses on the hedged positions. But hedging allows companies to make results look better than they are. For example, managements can retrospectively designate or cease to designate particular instruments as hedges. That way they can pick and choose between the gains and losses they recognise, or as Tweedie says, they can 'play their income'.

The case of Japan Airlines (JAL) demonstrates how badly a company can be affected by poor hedging, without the outside world having a clue.

In the mid-1980s JAL took out US$/yen forward currency contracts to hedge the cost of aircraft bought over the next 10 years. But then the US$ weakened.

JAL's losses on the deals soared, reaching Y176.3 billion (£1.1 billion) by the end of 1994. Hedge accounting allowed the airline to hide the extent of the damage. The losses were deferred until the aircraft were purchased and then added to the aircraft cost and depreciated over 15 years. A clearer response would have been to close the hedge sooner, minimising the losses. But because the losses would then have to be recognised immediately, JAL's incentive was to keep the hedges on and the losses increasing.

Other tricks of the reporting trade have been around much longer. Many of them rely on how realistic managerial judgment is. As Pearce says: 'For example, when you have a whole lot of stock lined up in a warehouse, which is selling slowly, and you have to decide what it is really worth, you have to use judgment. Anybody reading a set of accounts has to remember that.'

For anyone looking for ways to pep up results one year, erring on the side of generosity when estimating year-end stock values boosts both profits and the balance sheet. Year-end stock forms part of the cost of sales calculation, so increasing year-end stock reduces the cost of sales and boosts profit. Simple. The big problem with pumping up the stock valuation, though, is that it doesn't go away. Next year, the opening stock balance will be inflated, and profits will be hit. If reported results are even to stand still, real corporate performance will have to improve. The only alternative is to inflate stock again, or find another fudge.

Spring Ram, the kitchen and bathrooms company, is a famous example of what happens when stock valuation goes wrong. In the early '90s, its previously healthy profits suddenly started disappearing down the plug hole. The company had been over-valuing its stock, booking sales when customers placed an order rather than when they took delivery, and failing to register returns from distributors. In 1991, finished goods stock represented around 13% of turnover, compared to 7% four years before. In early 1993, the company's shares were suspended and profits warnings followed.

One general principle of fudging for the plc is that it is better to have an item on the balance sheet than charged through the profit and loss. If you have been spending cash on, say, product development, putting it down as an asset will look much better than writing it off as an expense.

Accounting rules attempt to set out the circumstances where capitalising an item is allowable. But judgment is always required. Depreciation charges will rise, but then the accounts team has to use judgment to decide over how long the new asset will be consumed, and so how long it will take to write off.

Speciality chemicals group MTM actually restated its published 1990 results after its auditors required a change to its accounting policies, notably the capitalisation of product registration and development costs. When the adjustments had gone through, and the development expenditure and product registration costs had been written off, MTM's 1990 profit fell to £7.9 million, while 1991 showed a loss before tax of £20.5 million.

While looking at fixed assets, it's worth checking whether a company has altered its depreciation method during the year. Cable & Wireless asserted its right to change its mind in the 1980s, extending the lives of its digital exchanges from 10 to 15 years. It also changed the method of depreciation from the straight line basis, charging an equal amount each year, to one calculating the charge on the basis of usage. In other words, as usage increased over the life of the exchanges, so did the depreciation charges. According to Smith, the effect of the two changes was to inflate the average growth in profits over the five years from 1985 to 1990 by 2.5%. C&W recorded average profit growth of 16.7% over those five years.

To match that rate of growth over the next five-year period, the company would have had to grow on average an extra 2.5% faster each year. Unless depreciation policy could be adjusted again.

Of course, if assets become undervalued, companies can sell them for a premium and a nice boost to profits. Those that prefer to keep their depreciation charge down risk carrying overvalued assets and suffering an unpleasant profit hit if they suddenly have to be sold. But if the finance director gets nervous, he or she can always change the accounting policy - again.

A change of approach can also help companies when looking at the values of accounting items denominated in a foreign currency. Companies have to choose between using the foreign exchange rate at the year end, or using an average for the whole year. This summer the British plasterboard company BPB switched to using an average exchange rate instead of a closing rate. The move halved the hit from sterling's strength, effectively boosting profits by £10 million.

Less easily fudged, bad debts are bad news for the company seeking a glowing set of accounts. At the end of the year companies have to decide which late payers are likely to turn into non-payers. Readers of accounts should beware over-optimism. Debts do go bad, as magazine and reference book publisher Sterling Publishing found out. Its 1994 profits totalled a healthy £7 million. But the next year's results told a different story - a pre-tax loss of £8 million. Much of the problem was attributed to a failure to collect debts from Eastern Europe, backed up by a £3-million provision for bad debts. Sterling swallowed its medicine and began demanding pre-payment for advertisements in the region.

To make it even more difficult to get a true picture, some of the trickiest fudges to spot occur off balance sheet - which is why they are tricky.

Off balance sheet liabilities are the main trouble-makers. Some may be disclosed as contingent liabilities in the notes to the accounts. 'Long-term contracting businesses provide a field day,' sums up Smith. B&C provides the classic example of a potential disaster that the accounts may not reveal. B&C's accounts in 1988 disclosed that the company had guaranteed bank overdrafts and other liabilities of certain subsidiaries. One of these was Atlantic Computers which was building up huge contingent liabilities due to the structure of its leasing contracts. The company could only meet its bank payments by leasing more computers. Both Atlantic and B&C went into administration.

Sometimes items appear in parts of the accounts where they shouldn't - or rather, when they shouldn't. One casualty of the premature income syndrome was DIY retailer Wickes, which last year announced that profits for the three years to 1995 had been overstated by £51 million. Wickes had been booking supplier rebates to profits in the year in which they were received, instead of spreading them over the life of the supply agreement.

When such extensive abuses come to light, there is always much head-shaking, but how genuine is the surprise? The subjectivity of corporate accounting means that there will always be pressure on the accountancy profession to be creative. As Geoffrey Whittington, professor of financial accounting at the University of Cambridge, says: 'The boundaries of creativity have retreated. But there are always people who will stretch credibility at the margins. The trouble is, it's always the crooks who want to stretch things.' After a pause, he adds: 'But even the most respectable companies do it'.

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