Abstract:
Accounting for Growth by Terry Smith, a top
broker at UBS Phillips & Drew, describes the
manipulation of corporate results in the boardrooms
of the UK's 200 largest firms. The
techniques identified by Smith are all perfectly
legal but, he argues, can be used to mislead
investors. All of the described practices
tend to do one of 2 things: increase reported profits
or make a company's balance sheet look stronger.
Smith says that investors should steer
clear of firms that use the criticized techniques.
However, many economists argue that in an
efficient market, accounting tricks should
have no effect on share prices. Most academic
studies suggest that shareholders do indeed
see through accounting tricks. Smith's most
controversial claim - that the enthusiastic
use of camouflage accounting can signal poor
stock market performance in the future - may
be his most incisive. A study by researchers at
the University of California at Berkeley shows
that share prices for American firms using
accounting ploys to boost earnings underperformed
the market by 20%-25% over the 5 years
after the trick was introduced.
Full Text:Copyright Economist Newspaper Group, Incorporated Aug 22, 1992
The publication of a book criticising the accounting
practices of British companies has caused a furore. Why all the
fuss?
"The book they tried to ban", trumpets the
cover. This time the forbidden topic is not the spooks of "Spycatcher"
or the erotica of "Lady Chatterley's Lover",
but the somewhat duller subject of massaging corporate results to
make them look better. "Accounting for Growth"*
by Terry Smith, a top analyst at UBS Phillips & Drew, a
London brokerage house, is the chilling tale
of "creative" accounting in the boardrooms of Britain's 200 biggest
firms. Published on August 18th, the book
has made national headlines and won an unrepentant Mr Smith
suspension from his job.
The 12 techniques identified by Mr Smith are
all perfectly legal but, he argues, can be used to mislead investors.
They include the inconsistent use of extraordinary
and exceptional items, some tricks of acquisition and disposal
accounting, off-balance-sheet financing, disguising
debt as equity, changing depreciation rules and capitalising
costs. These practices all tend to do one
of two things: increase reported profits or make a company's balance
sheet look stronger. So the shares of companies
using such ploys may be over-valued. As a crude rule of thumb,
investors should steer clear of firms that
use the criticised techniques, says Mr Smith.
He has a point. Maxwell Communications and
Polly Peck both produced a healthy-looking set of accounts
months before they collapsed--and both used
a full panoply of the tricks that Mr Smith spotlights. Accounting can
be as much art as science, however, and some
of Mr Smith's 12 techniques can be used in good faith, as well as
bad. In any case, the most misleading will
be outlawed soon by Britain's Accounting Standards Board.
Many economists have a more fundamental objection
to Mr Smith's views. In an efficient market, they argue,
accounting tricks should have no effect on
share prices. Provided a handful of clever analysts can find a way
through the accounting jungle to the firm's
true financial position and there are big investors willing to trade on
that
information, share prices will reflect the
firm's true value because the canny investors will continue to buy or sell
the
shares until the right price is reached. In
other words, a few informed people can set the correct price for
everyone, including investors who cannot tell
a profit-and-loss account from a balance sheet.
Most academic studies suggest that shareholders
do indeed see through accounting tricks. As an example, take
the widely held view that company analysts
are obsessed with profit figures, and so if a firm can use creative
accounting to beef up its earnings, its share
price should rise.
Do share prices rise when actual earnings turn
out higher than analysts' forecasts, and fall if profits are lower than
expected? Barely. According to research by
Yakov Amihud of New York University, unexpected profits and
losses explain no more than 7% of a company's
share price movement (relative to the market) in the two days
straddling an earnings announcement. This
may partly be because speculative trading dominates very short-run
share-price changes. More likely, says Mr
Amihud, analysts and shareholders dislike surprising earnings
statements and look at them with particular
care. Share prices were more responsive to small surprises than to the
bigger ones which, claims Mr Amihud, were
mostly accounting driven.
Economists have also looked at what happens
when new accounting rules are introduced that alter profits. In an
efficient market, these accounting changes
should affect share prices only if they change the firm's underlying value
(for example, by raising its tax bill). The
market should see through rule changes, such as a change in depreciation
rates, that are mostly presentational. And
this is indeed what a long string of studies stretching back to the early
1970s has found.
Does this mean that the market sees through
creative accounting? Most of these studies looked at large firms and
well-publicised accounting changes. The market
might take longer to spot subtler massaging of profits, especially
by small and medium-sized firms.
Accountancy regulators in Britain and America
are currently working on reforms. For them the message is clear.
Worry less about complaints that important
information is hidden away in footnotes where only experts can find it,
and rather more about making sure that the
information in the accounts, however it is presented, actually gives
those experts a true picture of the firm's
financial position. With Maxwell Communications in mind, most effort
ought to go into establishing mechanisms to
stop outright fraud, which no set of accounts, however presented, can
reveal.
As for Mr Smith, his most controversial claim--that
the enthusiastic use of camouflage accounting can signal poor
stockmarket performance in the future--may
be his most incisive. The short-term evidence is mixed. Several of the
firms singled out by Mr Smith in an earlier
version of his research published in January 1991 have since performed
spectacularly, though others have plunged
as predicted (see chart). (Chart omitted) But in the longer term the
shares of such companies do seem to struggle.
A new study** by Baruch Lev and Ramu Thiagarajan of the
University of California at Berkeley examined
American firms which started to use accounting ploys to boost
earnings. In the first year, share prices
were not affected. But over the five years after the trick was introduced,
the
firms' share prices underperformed the market
by an average of 20-25%.
When a firm uses accounting tricks to boost
earnings, it usually means that there is a lot more bad news to come,
says Mr Lev. Mr Smith's advice to avoid firms
that practise creative accounting may not be so crude after all.
*Published by Century Business.
**"Fundamental Information Analysis", by Baruch
Lev and Ramu Thiagarajan. University of California at
Berkeley working paper.