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Take published financial statements with a bucket of salt

They’re riddled with self-serving estimates.

The accounting profession is having a crisis, and not just in South Africa.

The monumental wealth destruction at Tongaat and Steinhoff tells a story of fudged figures and accounting legerdemain (deception).

Read: Steinhoff, Tongaat woes raise South African auditor scrutiny

It’s a problem long recognised among stock analysts and bankers, who spend their days reconstructing published accounts to read past the PR fluff. Earnings before interest, tax, depreciation and amortisation (Ebitda) was supposed to be a partial solution to this dilemma, but even this no longer does the trick.

As much as the accounting profession tries to close loopholes through enforcement of International Financial Reporting Standards (IFRS), there is still enough room here to fly a Boeing through a balance sheet.

The US Public Company Accounting Oversight Board recently found that the Big Four accounting firms – EY, PwC, Deloitte and KPMG – bungled 31% of the most recent US audits analysed.

Most of these transgressions go unpunished, despite the board being set up in 2003 to avoid another Enron or WorldCom-type collapse. Because auditors are paid by the companies they audit, there is a clear incentive to deliver the results management wants. The UK’s public audit watchdog, the Financial Reporting Council, says it will make public its grading of audit inspections following high profile company failures, such as builder Carillion and retailer BHS.

Estimates and assumptions

Part of the problem is that accounting standards lean heavily on estimates and assumptions. Revenue can include amounts that are not yet banked, as appears to have happened at Tongaat.

Read: Suspension of Tongaat trading a potential crisis for other shares

When to recognise revenue involves making executive assumptions that do not always agree with reality. For example, there must be reasonable assurance that the proceeds of a transaction are collectible. When it comes to complex land sales, this leaves the door open for the counting of revenue (and hence profits) that doesn’t actually exist either now or in the foreseeable future.

And when executive bonuses are tied to profits, it’s easy to see how this system can be manipulated. Companies seldom disclose how much of their revenue is based on estimates.

Nicolaas van Wyk, CEO of the SA Institute of Business Accountants (Saiba), says the accounting standard-setters are under huge pressure to adjust the regulations and standards being used to prepare and report on financial statements. “In this process of adjustment, care should be taken to ensure we make progress in the right direction.

“Corporate scandals driven largely by CEOs and CFOs manipulating IFRS to obtain favourable revenue, profit and asset valuation numbers are causing havoc in the industry.

“The question that needs to be asked is this: is the problem an ethical one or is there something in IFRS that makes it prone to manipulation? We urgently need an answer.”

He adds that the accountant of the future will have to adopt the mindset of a stock analyst or banker, where common sense adjustments will have to be made to published accounts.

Usefulness, or not

In a study on the usefulness of published accounts, researcher Baruch Lev places much of the blame on the proliferation of estimates in financial reports: “To a large extent, financial reports are based on estimates, judgements, and models rather than exact depictions,” he says.

“Estimates increase the noise and error in financial information, particularly when they are made by persons [management] having strong incentives to affect the perceptions of investors.”

There is debate in the accounting community as to whether intangible assets such as goodwill should be written off against income. Great brands such as Coca-Cola increase the revenue-generating capacity of a company, so why expense it against income?

Case studies

Take Steinhoff as an example. It restated ‘errors’ for 2015 and 2016, writing down its asset values by R8.2 billion for 2015 and R11.4 billion for the 14 months to September 2016. That’s a nearly R20 billion write-down over two years, with most of this coming from evaporating intangible assets, followed by the effects of accounting irregularities. That restatement knocked R1.6 billion off the 2016 profit.

Yet these are the accounting standards to which all listed companies are held. A recent accounting change is IFRS 16, which brings billions of rands worth of leases, previously treated as expenses or ‘off balance sheet’ items, back onto the balance sheet where they rightfully belong.

In the past, leases were a way for companies to keep liabilities off the books, which is how you want it when approaching the bank for a loan.

Bankers understood the accounting game and would usually fix the problem by simply putting leases back on the balance sheet.

A PwC study of nearly 3 200 companies (‘A study on the impact of lease capitalisation’) estimates that the reported debt of these entities will rise by 22% as a result of IFRS 16. Many leases of fairly long duration, that were previously expensed to the income statement, are now shifted to the balance sheet as liabilities (with a corresponding asset entry). This can radically alter debt ratios – although, from a practical and cash standpoint, there is no real change.

It’s simply a matter of moving figures around on a spreadsheet.

By the time Tongaat’s shares were suspended at the company’s request in June, the share price had slid to a tenth of what it was two years ago, after information about its creative accounting practices surfaced. It seems land sales were counted as revenue before the deals were hatched, and stock was overcounted.

Tongaat share price

 

Its figures for the March 2019 year-end have yet to be released. In October, the company informed the market that it had conducted a six-year review process necessitating amendments to its accounting policies and practices. It is also reviewing key assumptions used in arriving at past results.

Therein lies the problem.

Despite the widespread adoption of IFRS – supposedly to settle on a common global language for business accounting – the feast of accounting scandals shows no sign of abating.

Steinhoff’s value destruction is Olympian in scale, with more than R200 billion in equity wiped out since 2017.

Steinhoff share price

 

For a time it was heralded as a great retailing success story, breaking out of its southern African shell to spar with the biggest and the best abroad. It gobbled up competitors and flew the South African flag across Africa and Europe with brands such as Pep, Ackermans and Poundland.

But the figures were a pack of lies. PwC investigated and found fictitious or irregular transactions worth about $7.4 billion over eight years. These fictitious transactions were concocted by senior managers to create phoney income that hid losses elsewhere in the group.

“The transactions identified as being irregular are complex, involved many entities over a number of years and were supported by documents including legal documents and other professional opinions that, in many instances, were created after the fact and backdated,” says Steinhoff on its website.

Manipulating figures is not confined to auditors and accountants. Investment bankers are prone to the same disease, as shown by the recent decision to pull the listing of US real estate company WeWork. Its listing documents repeatedly claimed it was a tech company rather than a renter of office space, in an attempt to mislead investors and justify a company valuation of $47 billion. What was to be the US’s “most valuable tech start-up” has observers now wondering whether it can avoid bankruptcy.

And all this in the space of weeks. That should trouble anyone relying on financial statements as a guide to corporate truth.

Damien Klassen of Nucleus Wealth, shows here how easy it is to double a company’s valuation by carefully rounding off assumptions. The tweaks are so slight you would barely notice them.

Analysts and investors rely on earnings-centred valuation models, but that becomes a problem if reported earnings deviate too far from actual business performance, says Lev. A 2017 study shows that even if you made perfect earnings predictions, your investment performance would not be significantly better than those who were poor predictors of earnings.

This perhaps explains the flight from managed to index funds.

Over the last five years Amazon missed almost half of the quarterly analyst consensus forecasts, while becoming one of the most valuable firms in the world.

Lev says the problem started when accounting standard-setters moved to the so-called balance sheet model, which “increased exponentially the number and impact of subjective managerial estimates underlying financial information”.

“A fair number of these estimates are of low quality and are sometimes manipulated, further eroding the usefulness of financial information.”

How to value goodwill and brands (and then expense them against income) has the veneer of scientific rigour, but is often as good as a guess.

Proposed solutions

The solution, suggests Lev, is a return to the “income statement” rule-making model, where revenues and the associated costs are matched. Income statements under the current regime include intangible asset expense write-offs that can massively distort actual enterprise performance.

No wonder auditors pad their accounting sign-offs with pages of explanations and caveats.

A better solution, says Van Wyk, is to have in independent body appoint auditors to companies, thereby denying management the ability to skew results in favour of their bonuses and egos.

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Where does the accountability and the responsibility of the accountant end, and where does it begin for the investor?

The business owner and her financial manager both put on their makeup before they come to work. Some even use makeup artists and plastic surgeons to improve their appearance. Can we honestly expect them not to use a “makeup artist” to improve the attractiveness of their business?

If you want to see that beautiful lady without her makeup, you have to spend time with her.

True, I guess the CEO appoints “her/his team” to execute of what the “vision” for the business is. Indepence/Integrity is not a requirement to be part of the inner cirlce. If you looked at the majority of consenus estimates of Revenue/Margin/EPS growth for JSE listed companies – many analysts were still forecasting growth and margin expansion ( if you took the estimates as of 2014/2015) – these are based on management guidance and expert analysis. We all witness how this ended.

“A better solution, says Van Wyk, is to have in independent body appoint auditors to companies, thereby denying management the ability to skew results in favour of their bonuses and egos.”

Agreed, also it shouldn’t be mandatory for a registered auditor to be someone who is also exclusively a member of SAICA.

Stand-alone professional body just like the IIA.

Wow what an insightful article and one with which I clearly identify.
The audit failures are substantially to do with IFRS adjustments, as the author states, and less work on the substance of the business.
Go back to historical accounting and ditch IFRS.
The page number and dividend amount are the only figures you can be sure of says Warren Buffet.
Cash flow statement is then the next best indicator of real performance.
Accountants have made accounting appear to be like brain surgery so they can remain relevant.

It’s why when you analyze a company you calculate cash flow for performance, and completely ignore all that stuff about notes, and push anything like fair value and realizations to below the line of normal ebitda.
Fraud is a different issue though… Are CEOs and execs paid too much and hence incentivized to manipulate for share options and bonuses?

Honest Joe:

The cashflow statement is where any analysis should begin and come back to. It is where estimates go to die.

An analyst with a brain cel will have seen the disparity between Steinhoff PowerPoint earnings and their cashflow from operations (a retailer should have simple enough cash flow).

But take care. Eg in US tech (where companies get a tax deduction for stock based compensation), a recent trick of the BS artists is that they add back the gross stock based compensation in their reported cashflow from operations but show the tax benefit under financing section. I think it was Lyft or Uber recently.

The substance is that the after tax cost of stock based compensation should be added back under cashflow from operations.

In the old days one of the pillars was Substance Over Form. Nowadays the hired help bash form until it achieves the goals their substantial pay packages need.

Why realise income which you haven’t banked yet? It sounds wrong but then again you have to pay tax on income accrued but not received. (Lategan’s case from 1926.)

Because financial statements are different from bank statements. Obviously.

I know Jnrb, it’s like the tax client arguing WHY he/she must pay tax on annual interest “accrued” on say a 5 yr fixed deposit, while it is physically received at maturity.

(The Lategan-case, dealing with tax on credit-sales of R6m of WINE, goes hand in hand with a later case “CIR v Peoples Stores” (1990) when a taxpayer is taxed on credit-sales. The ‘unconditional entitlement’ principle 😉

Another interesting tax case is “COT v G”(1981) where the court found that a government official, who STOLE money through fraud, CANNOT be tax on such ill-gotten gains, as he was not “entitled” to it. The stolen money simply needs to be paid back. (i.e. a thief cannot be taxed, sadly, as there was unilateral action)….but if a trader earns income from illegal cigarette or drugs, it is taxable….as he’s “entitled'” to his crime proceeds, as it satisfies the ‘trading’ principle being a business deal boils down to a multilateral action (even if dealings are illegal). Weird yes.

OK, the above implies to the Tax Court only, and the Criminal Court will dish out it’s own punishment 😉

Agreed, IFRS opened the door to way too much fluff. An attempt for the IASB to try to remain relevant??

Just more affirmation that the investors are going to continue to get more Royally Rogered by the fatcats, unless there is some jail time handed out and quickly!!

One thing you can be certain of is that financial statements are engineered and manipulated to ensure maximum bonuses for the fat cats at the expense of the shareholders and employees. If the audit- and accounting processes were done accurately and honestly, none of the management of any SOE or other state organ and many other public companies should have received any performance bonuses at all.

Remember the old saw. In the game of life accountants were never picked for any team and so were relegated to keeping the score. They kept it in such a convoluted way that no one understood it. They have now progressed to being creative about the scores.

Time to get over playing sport in primary school like everyone else. Your glory days are over.

What exactly does auditing entail? Is it for the auditor to check each and every assumption the Co’s management made? Is it to check each and every assumption other professionals (like valuers) made? Is it to check each and every entry in the books? No, that is not why they are hired. As it currently stands, the auditor’s job is to check (only a sample) the processes followed by a Co to ensure that they followed their own processes to the letter. They check (a sample) of entries in the books to ensure it is done according to international rules and regulations. They draw up a set of books that adhere to international rules and regulations, according to the information supplied to them. That is their job. It is not their fault (or their responsibility) when the CEO and CFO fudge information and assumptions. It is not for auditors to catch out crooks. If you want that, appoint forensic auditors who will gladly do it at a price. People seem to think the auditor is appointed by the state, investors, or who ever needs the information double-checked, to ensure the books reflect the reality – but they are in fact paid by the Co to do a completely different job. If we need the auditor to fulfill the role of ensuring accurate accounting, they can do it, but we will have to completely change the way in which auditors are used – and most probably who pays for that service. (An equally important discussion is whether, looking at the current contribution of auditors, they warrant the ridiculous amount of money they charge for doing virtually nothing of value.)

Batman, thank you for your comment. I agree 100%. I am an investor and not an accountant, but I agree that the investor should accept the responsibility for his side of the deal. When a deal goes bad we tend to shift blame. Some investors who owned Steinhoff, Mittal, Basil Read, Calgro, PPC, Aveng and Tongaat, sold their holdings months- or even years before the share prices crashed. Those investors employed a decision-making system that worked for them. They accepted the responsibility for their investment methodology. They don’t blame the accounting industry when they lose money.

We should realize that there are investment strategies that can protect us against misrepresentations and fraud before it is too late. Can we blame the auditing profession when we do not use these strategies to protect ourselves?

Sensei would be interested on your views of the InvestSure product on EasyEquities that protects against management misrepresentation – if you’re familiar with it.

Simple_Simon, I don’t have any knowledge of the product you are referring to. I will read up on it.

I am referring to the advantages of basic technical analysis. Some people are under the misconception that technical analysis is a cristal ball that supposedly predicts the future. In reality, it is more like tracking. A technical annalist is a tracker that inspects the spoor that is left behind by the movement of the share price. It is amazing what an experienced tracker can tell you about the animal that he is tracking.

Has the (global) accounting field become a victim of its own complexity?

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