Accounting and accounts: Episode 1

Full disclosure up front – I am a qualified Chartered Accountant. Still a member of the ICAEW.  As such I think there is a story in most set of accounts and this story can be read and understood by a rational reader.

However accounts can also be used to mislead and in a series of occasional blogs I intend to list some of the ways that companies can and do use accounts to create a picture that may not be complete.

For a number of years many of the main accounting bodies around the world have been looking to standardise GAAP (Generally Accepted Accounting Principles) and IFRS (international Financial Reporting Standards).

They have been doing this for a number of reasons but two of the main ones are

(a) to enable accounts of different firms to be more easily compared between countries.

(B) to make it harder for directors to manipulate accounts to present a picture that does not accurately reflect the reality.

So when you next get a set of figures in the accounts that are non- GAAP, and there is a lot of this about, you really need to wonder whether what you are getting is not a deliberate attempt to manipulate you.  It is possible that a measure that does not comply with GAAP or IFRS really does better reflect this particular company.  But on a standalone basis it is unlikely.  It is for management to clearly prove to the user that the non compliant figures being used are relevant.

There are two particularly dodgy treatments that I want to mention today;

1 – Where the company tries to exclude share based payments (sbp) from costs and declare profits without recognising sbp.  It’s a complete con.  Any sane person can spot that whether you pay an employee in cash or shares of the company you have taken something from the shareholders, cash or a % of their ownership and given it to the employee.  It is remuneration and a cost and should be reflected as such.  Any set of figures that exclude sbp as a cost are a con and you should certainly be cautious about the management who allowed these figures.

2 – EBITDA measures.  (Earnings before Interest, Tax, Depreciation and Amortisation).  If you are a Venture Capital firm looking for an acquisition EBITDA has a place.  If you have the money to buy the business and restructure it EBITDA has a place.  But if you are investing in a company and they give you an EBITDA measure, either they or you are at best foolish.  If you cannot control the capital structure the interest bill matters.  It is the bit the bank will take before you get anything.  Do not pretend it does not exist because the bank is not going to forget it.  If the company makes £100 before interest and has an interest bill of £100 how much is left for the shareholders and how much does the company really make. £0.  Do not trust a manager who tells you he did a great job before interest unless he can also say he did a great job after interest.

Also do not pretend tax does not exist, it does.  It is not the first thing any business should consider but what use to you is a business that makes £100 pre tax and has a tax bill of £100.  As a shareholder you get nothing so tax matters and part of the managements responsibility is to ensure that the tax bill the company pays is as low as sensible planning and regulations allow.

Depreciation is the method by which the company writes off its capital asset purchases.  Land, buildings, vehicles, machinery, computers,  etc, etc.  It is a real cost.  There is clearly a lot of room to debate whether the depreciation rate is correct, even when management have set it sensibly, but anyone who intends to build a decent recurring business knows that they cannot do so without replenishing these assets.  Any management that strips out depreciation and presents figures before depreciation as more realistic is very dubious indeed.  They are basically saying that either the asset is very special and the GAAP rules on depreciation do not apply in this instance or that they are not competent to set a depreciation rate that sensibly reflects replacement.

Amortisation is similar to depreciation except that it gets used for the write off of intangible assets such as goodwill.  I do accept that some intangible write downs are more open to challenge.  If you associate an intangible with say the brand of Coca Cola or Disney are they really wearing out year on year.  Probably not.  But if you associated some intangible value with Tesco 5 years ago would you still be prepared to say there has been no decrease in value?  Also the current FRS (Financial Reporting Standard) 102 seems to say that software is an intangible and any banana can tell you that software gets old and needs replacement.  So unless it can be very clearly explained why ignore amortisation?  I believe a sensible user will include it in their consideration of a company and carefully consider management who try to fully exclude it in assessing their performance..

GAAP and IFRS exist in part to protect the user, the small shareholder and if management is suggesting other metrics better reflect their skill you should either agree with them or regard them with less than rose tinted glasses

By @jpsc01.

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