If you're looking to invest in a company, you want to know that you're getting a realistic view of its past performance and its growth prospects. The most obvious place to look for this is in the accounts. But there are many crafty and legitimate little tricks that smart directors can employ to flatter their reported profits.
Here are three of the most common methods that firms can use to cook the books without breaking any rules and how you as an invesor can see through them.
Booking long-term contracts
Let's say you are the head of a firm that has won a three-year contract to make and install industrial conveyor belts for a big aircraft manufacturer. You expect to make a total profit on the contract of £100m. But how do you show this over three years? To book a £100m profit the minute you win the work seems imprudent you may suffer huge cost overruns and never actually make it. Equally, only booking it once the work is done seems a little cautious.
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So you book it as you go along. But how? Accountants allow at least two methods. The first is to book profit on the basis of work completed. So say you expect to complete 40% of the work in year one, 30% in year two and 30% in year three. You could allocate your profits in proportion, so £40m, £30m and £30m. Nice and simple but it doesn't give a very flattering profits profile.
The other option is for the finance director to allocate profits on the basis of the percentage of total costs incurred. Say that's 20% in year one, 35% in year two and 40% in year three. Now the profit profile looks more like £20m, £35m and £40m. That's a better profile profits seem to be growing fast even if the end result is to allocate £100m of profits over three years in both cases.
Some firms love to buy other firms. It's more exciting than growing organically'; it's faster and it generates juicy fees for bankers. But there's another benefit too it allows the firm to flatter profits.
Let's say a firm buys another one on 30 June 2013. The target earned £100m in 2012, and expects to earn the same in 2013 and 2014. Under the accounting rules, the acquiring company should record none of the target's 2012 profits as its own, because it didn't own the company then. It should record half of 2013's profits (reflecting the six months for which it will own it) and all of 2014's profits when it is the full owner.
So the company gets to add £50m to its overall profits in 2013, and £100m in 2014. That makes the company look as if it's growing fast, even though profits for the acquired firm are flat in each year.
Provisions for shocks
A third way a firm can massage profits is by using provisions. Say a firm expects to shut down a key piece of plant and clean up the surrounding site. Accountants suggest the costs are taken as a hit to profit as soon as they are known, so that shareholders don't get a nasty shock later this is known as provisioning'. By taking the hit now, the firm creates a special reserve that can absorb the costs as they come through. But firms can also use this to smooth' their profit profile.
Say the firm makes an unusually high profit of £2m in 2013. It takes a £1m hit against that for cleaning costs. It then incurs actual decommissioning costs of £500,000 in 2014 and £400,000 in 2015. In 2014, operating profits drop back to £1m. The £500,000 in costs is paid from the special reserve. In 2015, operating profits fall further, to just £0.9m. But the £400,000 in costs is more than covered by the remaining £500,000, so an extra profit of £100,000 comes from the leftover provisions. So the firm has used provisions to turn an uninspiring profits profile of £2m, £1m, then £0.9m into £1m, £1m and £1m a big improvement.
The reorganisation costs will be shown as exceptional' on the profit-and-loss account, but can still easily fool an investor who focuses on the net profit result alone. So what should you do about all these sleights of hand?
How to see the real picture
Firstly, don't rely on just one, or even a few years' earnings, when making an investment decision. Most sets of accounts include a five-year summary, which will give you a broader picture. Yes, these can also still be made to present the picture the directors want you to see, but they represent a good starting point.
How you can be fooled by provisions
Companies can manipulate 'provisions' to create the profit profile they want investors to see.
When it comes to making a buying decision, many investors rely on price/earnings (p/e) ratios. The problem is, these use just one year's earnings, which could be subject to the kind of flattery I have described above. A Shiller (or cyclically adjusted') p/e, on the other hand, uses an earnings figure averaged over ten years. This takes out some of the impact of most short-term accounting funnies and is yet another reason we like it as a valuation measure.
Another good idea is to check a firm's cash flow, not just its profits. Cash flows are much harder to manipulate. An obvious red flag is where you see a smooth upward profits trend and very volatile cash flows energy giant Enron was a classic case in point just before it collapsed.
Overall, the thing to remember is that a profit-and-loss account allows a firm's directors to paint the picture they want you to see. Your job as an investor is see the real picture.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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