Take published financial statements with a bucket of salt

Written by Ciaran Ryan. Posted in Journalism

They’re riddled with self-serving estimates. From Moneyweb.

Ethical problem – or is there something in IFRS that makes it prone to manipulation? We urgently need an answer, says Saiba CEO Nicolaas van Wyk. Image: Shutterstock
Ethical problem – or is there something in IFRS that makes it prone to manipulation? We urgently need an answer, says Saiba CEO Nicolaas van Wyk. Image: Shutterstock

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?

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.

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.

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, writing in Livewire Markets, shows 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.

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.

Ciaran Ryan

The Writer's Room is a curated by Ciaran Ryan, who has written on South African affairs for Sunday Times, Mail & Guardian, Financial Mail, Finweek, Noseweek, The Daily Telegraph, Forbes, USA Today, Acts Online and Lewrockwell.com, among others. In between he manages a gold mining operation in Ghana, and previously worked in Congo. Most of his time is spent in the lovely city of Joburg.