Those wishing to juggle their financial results used to have plenty of scope to bend the rules - and they certainly used it. Has the latest set of accounting standards caught up with them at last? By Robert Outram.
'There were only three things wrong with company accounts in the 1980s,' Sir David Tweedie, who is now head of the Accounting Standards Board (ASB), the body which draws up financial reporting standards, is fond of saying, 'the profit and loss account, the balance sheet and the statement of sources and applications of funds.' In other words, everything was wrong in the financial statements on which investors were relying for a 'true and fair view' of company performance.
Call it what you will, creative accounting, financial engineering or window-dressing, it is the art of bending flexible accounting rules to present a flattering picture of the business in question. While there is a theory that the efficient market will not be fooled by presentation alone, sadly, the evidence is to the contrary. Witness a report which appeared in the Financial Times on 26 June 1987: 'Shares across the stores sector tumbled yesterday on fears of an onset of conservative accounting.
The widespread decline was triggered by the Argyll Group's decision to treat the £90 million cost of reorganising its Presto stores as an exceptional item rather than as an extraordinary one. The move, following the company's £681 million acquisition of Safeway in January, will reduce the company's pre-tax profits and earnings per share over the next four years.' There had been no underlying economic change affecting the retail sector; shares had slumped purely on a change in the way the accounts were presented.
Sometimes the financial risks which creative accounting concealed were enough in themselves to bring a company down. The collapse of British & Commonwealth (B&C) in 1990 was triggered by one of its acquisitions, Atlantic Computers, which had been making healthy profits - on paper - both before and after B&C took it over. But in 1989, less than a year after buying Atlantic for £416 million, B&C discovered that its acquisition was a black hole into which the whole group threatened to tumble. B&C wrote off £550 million and Atlantic was put into administrative receivership in early 1990, but that was not enough to save its parent and the whole group finally went under a few months later. In their report on the debacle, Department of Trade and Industry inspectors said: 'If Atlantic's business had been accounted for on a prudent basis, it is probable that it would not have been able to report any significant profits ... at any time from the commencement of its business.'
Creative accounting was by no means the only factor contributing to the corporate collapses and near-crashes of the 1980s and early 1990s but it did play a significant part in allowing bad business propositions to look good. Questionable accounting practices also encouraged the acquisition fever of this time. Companies showing a strong earnings per share (eps) growth saw their share prices rocket, and they used that in turn to fund paper-and debt-based takeovers of less favoured companies - steady and boring ones, that is - on a grand scale. Conglomerates like Hanson and Williams Holdings moved on from one deal to the next, following a logic based less on the concept of synergy and more on the so-called Indian rope trick, where the market's perception rather than actual cash generation was enough to fuel the growth of diversified business empires. As with eastern fakirs, what actually supported the whole share price was a mystery.
Another popular ploy in the 1980s was to ensure that the bottom line - the post-tax profit figure used as the basis for calculating eps - excluded as many costs as possible. Since bottom-line earnings are supposed to represent trading performance, one-off items such as reorganisation costs on an acquisition could be classed as extraordinary items. They would be reported below the line so that eps would be unaffected. Exceptional items, on the other hand, went above the line, depressing the eps figure as illustrated in the Argyll Group example above.
At the end of the 1980s over half the listed companies in the UK were reporting extraordinary items; the equivalent US figure, supposedly following the same principles, was just 5%. As examples of just how significant this could be, in 1990/91 the Costain Group, Saatchi & Saatchi, Storehouse and Unigate all reported extraordinary costs which actually exceeded their profits for the period.
Few areas in the 1980s provided such scope for creative accounting as acquisitions and mergers, however. Take Coloroll's acquisition in 1988 of textile business John Crowther, for example. Coloroll paid £215 million for Crowther. Since Crowther's assets only amounted to £70 million on paper, Coloroll could have written off the difference, £145 million, as goodwill (that is, the amount by which the cost of an acquired business exceeds its recorded net assets). But Coloroll actually wrote off £224 million, more than the purchase price. To the original figure was added £75 million in asset write-downs and provisions for costs such as relocation and redundancies, together with a reduction in Crowther's net asset value of £4 million. Coloroll was following accepted UK accounting practice in estimating a 'fair value' for its acquisition, with the resultant goodwill being written off against reserves. This reduced the balance-sheet worth of the acquirer, but had a number of advantages, namely that, because the balance sheet was reduced, return on capital employed looked better; any future impact from writing down the value of stock and assets did not have to be shown in the profit and loss account; and provisions included in the goodwill figure meant that future costs such as redundancies and even trading losses need never appear in the profit and loss account.
While it is often in a company's interest to protect earnings at the expense of the balance sheet, sometimes it is the balance sheet that needs massaging. This is especially so when the issue at stake is gearing. Broadly, a company will try to keep as much debt and other liabilities out of the accounts as it can. There are a number of ways to do this. One is so-called off-balance sheet financing where a vehicle is created to take on liabilities.
In the property sector, for example, joint ventures are often still used as a means of financing projects. They will be recorded as investments but the debt, even if it is guaranteed by the parent companies, will only appear in the notes to the accounts, not on the parent company's balance sheets.
Sale and repurchase arrangements can also be - and were - used to mask debt. A whisky distiller, for instance, may have to wait many years before assets are ready for sale. In the meantime, however, it can sell the maturing whisky to a bank, with the obligation to buy it back again at a certain date, at a fixed price. To all intents and purposes, this arrangement is a loan, with the whisky as security, but the debt is presented as a sale.
Debt can also be presented as equity through the use of certain financial instruments. Convertible preference shares, for example, begin as loan stock but may be converted by the holder to equity at a given date and price. Back in the 1980s, companies would routinely report this stock as equity, making the assumption that the decision would be to convert rather than call in the debt.
These and other abuses took place in a framework of rules which were flexible enough to be bent a long way without actually being broken. The mechanism for drawing up standards was often criticised as tortuously slow and, in any case, no independent body existed to enforce the standards that were established. Speaking in 1989 as a partner with accountants KPMG Peat Marwick McLintock, Tweedie warned: 'If we don't do something soon about the state of financial reporting, we will end up in a total mess.'
Tweedie was soon to have the opportunity to do something about it himself. The Companies Act of that year established the Accounting Standards Board which Tweedie was to chair. It also set up an enforcement body, the Financial Reporting Review Panel, with the power to order changes in company accounts. Companies which refused to toe the line faced being taken to the High Court. The whole regime came under the supervision of a new body, the Financial Reporting Council, which broke ground by including industry and investor representatives as well as accountants.
Since 1990 the ASB has embarked on an ambitious and often controversial reform programme. One of the most important reforms was to change the face of the P&L account completely. The extraordinary item is practically extinct now and companies must report their earnings from newly acquired businesses or recent disposals separately. Everything must be included in the bottom-line figure. And accounts now have to have a cash flow statement, which is much harder to fudge than earnings figures.
The financial engineering associated with acquisitions has also been tackled. The acquiring company is no longer able to set off the cost of an intended reorganisation against the book value of the acquired business; instead, it must be shown against future profits when the cost is incurred.
Proposals to restrict the use of provisions more generally are still at the discussion-paper stage - and they are already proving controversial.
Meanwhile off-balance sheet finance has been addressed by an insistence that associate companies under de facto ownership and control must be consolidated in the accounts. The debt/equity fudge, too, has been curtailed.
Under the reporting standard FRS 4, convertible shares are debt until they have been converted.
The ASB still has in its sights the way companies value their assets and it has yet to tackle the vexed question of how to account for intangible assets like goodwill and brands, a problem which so far none of the world's accounting standard-setters have succeeded in resolving.
The ASB has achieved a lot in a comparatively short time, helped in part by a string of company scandals and collapses. UBS analyst Terry Smith has also had his part to play by publishing Accounting For Growth back in 1992, an analysis of some of the more popular accounting wheezes.
Smith's 'blob test', in which major listed companies were rated by the number of potentially dubious accounting policies they employed, angered a number of UBS's corporate customers. Smith was sacked but his book - billed as 'the book they tried to ban' - shot immediately to the top of the business bestseller lists.
There has been an inevitable backlash. Critics of the ASB have argued that increased disclosures are burdensome to FDs; that the new bottom line is so volatile that it is of little use to investors looking for a measure of trading performance; and that the pace of change itself has caused unnecessary problems. And creative accounting is certainly not dead - far from it. Readers of company accounts should still be wary.
Headline figures, especially earnings, should be read in the light of other information. Much of the most important detail is to be found in the notes to the accounts. Changes in policy, for example, in the way assets are depreciated, will affect reported performance. Comparing company performance is still fraught with difficulty, since there are so many options. Whether or not interest charges on a property development are capitalised, for example, will affect both profits and balance sheet values, but different developers adopt different policies.
It all means that less mainstream, harder to massage measures are still worth scrutiny. It is harder, for instance, to fool the Inland Revenue's tax inspectors than it is to keep investors in the dark so a company's tax bill can be a good guide to what is really going on - especially if it seems to be out of line with the company's reported profits. A low tax charge may mean the corporation is well advised - or simply that its profits are overstated.
Smith, now an analyst with brokers Collins Stewart, is publishing a second edition of Accounting For Growth this July. He has had to amend some chapters, but believes that creative accounting is still thriving, thanks to the ignorance or laziness of those who read company reports.
In times of growth a little window-dressing may be all one needs to paper over the cracks. Perhaps only if we re-enter the boom-and-bust cycle of the 1980s will the new accounting regime really be put to the test.
A framework that is harder to bend
Trick Reason Response
Extraordinary items Bottom line earnings, Virtually all one-off costs
- costs deemed to and hence earnings must be shown above the
be one-off per share, are line (FRS 3 Reporting
could be excluded maximised Financial Performance)
Provisions on Reported profits Future reorganisation and
acquisitions- (and earnings per other costs may not be
take as many share) are maximised, provided for in acquisitions
future costs and return on (FRS 7 Fair Values in
(including trading capital employed Acquisition)
losses) as possible looks better
on balance sheet
Overestimating Profits can be This is still permitted, but
provisions smoothed between good an ASB discussion paper
such as bad debts and bad years published earlier this year
and reorganisation proposes much tighter rules
costs on what may be provided for
Off-balance sheet Debt and potential Accounts must now reflect
finance through liabilities are 'economic reality' not legal
joint ventures hidden away in notes form (FRS 5 Reporting the
and other to the accounts Substance of Transactions)
Capital instruments Gearing looks better Convertible stock is debt
which fudge because debt is unless and until conversion;
the distinction reduced, without certain types of instruments
between debt diluting share are classified as'non-equity
and equity (eg, capital shares' (FRS 4 Capital
FRS =Financial Reporting Standard.