Trusting the financials

Can a company’s financial statements be trusted?

Can a company’s financial statements be trusted?

The simple answer is no. Falling profits, pressure to meet investor expectations, lucrative management share options, combined with a complicated business model, are just some of the conditions under which fraud can occur.

There are many ways to manipulate financial statements to give a false impression of their company’s health. These can range from relatively mild “window- dressing” techniques to mask falling revenues or excessive expenses, to outright fraud by faking invoices and documents. The recent accounting shenanigans at Steinhoff have made us aware that this happens – perhaps more than we would like to think.

I’m stating the obvious, but for investors financial statements are the last line of defence in protecting their investment (ahead of that many of us have financial advisors, asset managers and ETFs). Unlike analysts and asset managers who get face-to-face time with management, financial statements are the only opportunity that investors have to assess an organisation’s financial health and sustainability.

Most investors, naively it appears, trusted that the independent auditors who sign off on a company’s annual numbers are responsible for adjudicating the integrity of these. As we have seen, with intense competition for large audit clients, and given the potential fee generation from such long-term engagements, accountants face difficult ethical questions if they want to both “do the right thing” and continue to maintain their lucrative client relationships.

I read a report (to be fair it’s a bit dated but what’s changed?) that suggests that an audit firm’s blessing of company financials isn’t reliable 25% of the time because the auditors never performed the work necessary to provide their signoff. As a result material misstatements can go undetected.

The point I’m trying to make is that investors need to take a lot more responsibility for their investment decision-making. Financial boffins will tell you that there are ways to work around the weaknesses that we know exist – but I always assumed that these were for the very financially astute (and I’m not one).

I’ve started reading a fascinating book (if you are into this kind of thing) called Beyond Earnings (John Wiley & Sons 2018) that is accessible to both investment gurus and lay people. It is written by David Holland, a former MD at Credit Suisse and now senior advisor to the bank and adjunct professor at UCT’s Graduate School of Business and Bryant Matthews, the senior director of research at Credit Suisse.

The book starts off with the premise that reported earnings and financial metrics like return on equity are too easily ‘gamed’ and that investors pay way too much attention to these numbers. And it provides solutions – with examples – to work around the financial metrics that cannot always be trusted.

Instead of an emphasis on earnings (which drive markets from Asia to New York) the authors watch corporate cash flows like hawks. They introduce the concepts of Cash Flow Return on Investment (CRFOI) and Economic Profit. These can be a bit abstract, but they are brought to life using real world examples – Amazon is an example that is used throughout the book.

At its heart is a step-by-step framework (which is called HOLT), which Holland and Matthews use to identify effective management teams and well priced equity investments. The model is based on the premise that all companies go through a similar life-cycle of growth followed by maturing profits – and they share similar characteristics at each stage of development.

Using this model it is possible to identify the companies that are likely to deliver future profitability and growth. I haven’t finished the book yet, and I will come back to you with further thoughts on it, but it reminded me that if we wish to take charge of our own investment destinies the tools are available to do so.

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