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Jun 26, 2023

Accounting for growth: Defending shareholder interests

Spotlight on the functioning of company audit committees

The late 1980s and early 1990s saw a period of growth in the performance of UK companies. But some constituents of the FTSE 100 index – Polly Peck, Maxwell Corporation – went bankrupt overnight, despite good accounting results.

Terry Smith, an analyst at UBS Phillips & Drew, published an analytical note in 1991 entitled ‘Accounting for Growth’. The report explained in detail some non-illegal accounting practices whose flexibility allowed companies to present investors with an apparent increase in results, while their cash generation deteriorated significantly. The success of the report – voted best analyst report of 1991 in the Extel survey – prompted Smith to publish a book of the same title, which sold more than 100,000 copies.

UBS fired Smith. Today he is one of the most famous fund managers in the UK. His investment vehicle, Fundsmith, has more than £25 bn ($32 bn) in assets under management and has achieved an average annual return of 15.6 percent since its creation in 2010.

‘Creative accounting’

Creative accounting, also known as accounting engineering, uses loopholes in regulations and their interpretative flexibility. It allows, without the auditor making any qualification in his/her reports, to disguise the results, giving a better image of the evolution of the company to favor a good performance on the stock market. As a result, investors make their decisions based on information that often comes to them with a watered-down image, especially in key metrics such as operating profit, net profit or free cash flow.

Changes in the accounting treatment of any item must be justified to and approved by the auditor, which adds new levels of interpretation. There is a fine line between creative accounting, which in principle presupposes a thorough knowledge of accounting and its possibilities, and accounting fraud, which is an illegal use of this practice for the benefit of the company.

Accounting for growth: Defending shareholder interests

Alphabet, Google’s parent company, has risen nearly 40 percent in 2023; first-quarter results have beaten analysts’ expectations. Much of the improvement is because it has lengthened the useful life of its equipment, reducing depreciation expense by more than $1 bn and boosting its book profits. In the last two years, Amazon has also resorted to this technique with a $6 bn higher operating profit impact.

In its 10K report, Microsoft has reported a change in its depreciation policy with an impact of approximately $3 bn higher net income in 2023. If we add to these changes the strong level of share buybacks and redemptions, it is clear that data such as earnings per share or ratios such as P/E are totally distorted.

Manipulation ‘disgrace’

It should not be forgotten that the compensation of top managers is linked to the accounting results of the companies. Microsoft’s CEO was paid more than $300 mn in 2021. The ease with which accounting results can be modified in order to beat market expectations and the acceptance by investors and analysts has led Warren Buffett to state in his 2023 letter to investors that this manipulation is one of the disgraces of capitalism.

Another way of disguising companies’ results is to explain them on the basis of ‘adjusted’ results –  the so-called alternative performance measures, in the language of regulators. This involves excluding from the accounting results all those factors the company considers distorting and that affect the interpretation of how the ‘recurring’ business evolves.

Accounting for growth: Defending shareholder interests

Items such as amortization of intangibles, stock-based compensation, restructuring costs, M&A costs, equity valuation or the impact of pension plans are often interpreted at the company’s discretion to produce these non-accounting metrics. A report published in early June by the research firm Calcbench on 200 companies in the S&P index estimates that the pro-forma net income of these companies is on average 38 percent higher than the actual accounting net income.

Lost in the appendices

The problem is that each company tends to make different adjustments, resulting in off-balance sheet metrics that are not comparable between companies under the same name. Such metrics often take pride of place in company earnings presentations, while the actual accounting data is lost in the appendices. The limited time managers have to analyze complex companies means all these metrics are commonly accepted, with the risk that this entails. If we read the presentations of Spanish companies, we come across numerous acronyms, such as OIBDA, RLFCF and BTS, which reflect metrics that are the company’s own.

Accounting for growth: Defending shareholder interests

These adjustments are not explicitly prohibited, but both the SEC in the US and European regulators have focused their attention on them, trying to avoid ‘tailor-made suits’ for each company. Regulators are asking for details and explanations. The SEC publishes the letters sent to companies, increasing the pressure on them. Lyft, a ride-hailing company, has been required by the SEC to amend its ‘adjusted net income’ for the last quarter of 2022. This pro-forma result, initially published at $126 mn, turned into a loss of $248 mn after including insurance premiums the company had excluded. The share price fell 36 percent on the news of this correction.

Auditing the auditors

This situation puts the spotlight on the functioning of companies’ audit committees, composed of independent directors. It is this committee that should be at the center of the defense of shareholders’ interests, curbing the possible temptations of management teams. We must avoid a major accounting scandal every 10 years: Polly Peck, Enron, Wirecard, Gowex, and so on.

Accounting is only the best opinion or criteria of the person who does it. If you have doubts about a company’s accounting, do not invest in it. If you do invest, it is better to follow the cash flow of the firm. It is the lack of cash generation that ends up killing companies, no matter how much their pro-forma results shine.

Ricardo Jiménez is an IR strategic adviser and commentator and the former award-winning director of IR at Ferrovial from its IPO in 1999 to 2020

Ricardo Jiménez Hernández

Ricardo Jiménez Hernández

Strategic adviser at Harmon and a former director of investor relations at Ferrovial