An ex-rocker’s guide to spotting nasty surprises buried in results
Ialways get excited when I meet a chartered accountant. Honestly. I like to ask them what red flags they look for in a company’s accounts? I’ve received some good answers in the past. But nothing as comprehensive as that provided by The Signs Were There. In fairness, Tim Steer, the author of this book, is no ordinary accountant. He retrained as a number-cruncher after working as a sound engineer for Meatloaf, Diana Ross and Pink Floyd, going on to become a highly rated fund manager at New Star and Artemis. He has now written, and I worry that I may be damning him with faint praise here, the best book I have ever read about accounting.
Steer examines 22 companies whose shares took a nasty tumble and then looks at the financial statements they put out prior to that point in search of any warning signs. Among the companies to which he applies this reverse forensic approach are Sports Direct, Autonomy, Quindell, Conviviality, Carillion, Northern Rock and AO World. They are, to combine Steer’s two worlds, a Mötley Crüe.
Themes emerge. “It is often the use of optimistic estimates, coupled with a liberal interpretation of certain accounting standards, that are the problem,” writes Steer. “The trouble with the UK’S current accounting standards is that they are too principles-based and allow leeway in the way that they are interpreted and applied.”
In other words, company results are works of fiction. But, like all works of fiction, they have to adhere to their own internal rules of logic. Any shenanigans usually leave subtle telltale clues for those who know how to spot them. Taken together, the 22 case studies provide a how-to guide for looking at company results.
Income statements vs balance sheets. Steer likens a company’s income statement – revenues versus costs – to a shop window. If there are issues, they will be hidden on the balance sheet – assets versus liabilities – which is the equivalent of a dingy back-office storeroom.
Annual reports are hefty tomes and dry as dust. A cynic might suggest that this is a deliberate attempt to prevent people reading them all the way through. So, start from the back and pay particular attention to footnotes as this is where some of the juiciest stuff is to be found.
Monitor the quality of current assets. I haven’t done a full audit of Steer’s book but I’m pretty confident that the most frequently used phrase is “accrued income”. This is money a company says it has earned but for which it has not yet invoiced the client let alone been paid. It is particularly prevalent in companies with longdated contracts. And it can result in poor cash flow, which is one of the main reasons why companies go bust.
More importantly, accruals are only estimates and therefore highly reliant on the management team’s judgment. Steer recommends grading current assets. Best is cash – the only item in an annual report that is not “a matter of opinion or an estimate”, according to Steer. Second best is invoiced trade receivables. And a distant third best is accrued income. A company’s assets may remain constant, or even improve, but if the balance is shifting from cash to accrued income something may be amiss. A particular concern is if accruals are growing faster than sales. Steer points out that receivables (including prepayments and accrued income) at Carillion, the outsourcer that went bust earlier this year, grew by 114pc over the five years to 2016. During the same period, sales rose just 3pc. Carillion was waiting longer and longer to get paid, which was a precarious position to be in when it needed the cash to service its ever-increasing debt pile.
Capitalised costs. Accounting rules allow costs to be moved from the income statement to the balance sheet provided certain criteria are met. The costs are “capitalised” and become “intangible assets” which are “amortised”, slowly written off over their useful life.
This is, in most cases, reasonable. It encourages investment in big ticket items. But it can also allow management teams to keep operating costs away from the income statement and hence overstate profits. Particular red flags could be an abrupt spike in the value of intangible assets or capitalised costs being amortised over too long a period.
Steer highlights the example of NCC, a cyber security company, which capitalised the cost of developing software (a genuine asset) but then amortised it over anything from 18 to 45 years. How quickly does software become obsolete? Somewhat quicker than that.
The trend is your friend. Balance sheet items – like debtors and creditors – should move roughly in tandem with the company’s activity levels. If they don’t, ask why.
And investors need to look out for blips in the trends for particular items. For example, there was an intriguing detail in Sports Direct’s IPO prospectus that showed an unusual adjustment to inventories. In 2004 the company wrote down £2.1m of stock; in 2005 the figure was £5.9m. But in the year to the end of April 2006, just a year before its IPO, Sports Direct wrote down a full £20.2m of stock.
As Steer says, there may have been a completely legitimate explanation for this. But it would also mean that Sports Direct started the financial year before it was going public, with £20m of stock that, with an average mark up of 70pc, it could have sold for £34m. And, because there were no direct costs attached, this could potentially have generated £34m of pure profit and given the company’s finances a very healthy glow as it prepared to go public. The company’s shares fell 90pc in the months after its IPO and took five years to get back above its listing price of 300p.
Steer highlights lots of other red flags. There are the management teams that don’t own many shares in their own company and those that blame short sellers (and/or the media and/or analysts) for a falling share price. There are companies that raise more money for an acquisition than is actually needed for the purchase.
There are one-off and non-recurring items that are not one-off and keep recurring; bullish assumptions about goodwill ascribed to acquisition for which the company may have overpaid; sharp reductions in the discount rate applied to future cash flows; repeated attempts to make fair value provisions for onerous contracts; mushrooming debt; related party transactions.
The list goes on. Buy this book. It’s a worthwhile investment.
‘Any shenanigans usually leave some subtle telltale clues for those who know how to spot them’