Truth or bulls**t in financial accounting

A company’s financial statements paint a picture of the profits that the company is generating. However, in many cases this picture is not the only plausible interpretation of the company’s profitability. In this article we discuss some of the indicators that investors can look at to understand the risks that the picture of profitability painted by a company’s accounts may not be the best interpretation of how it is performing.

The picture of profitability painted by a company’s accounts is typically most objective for simple cash in / cash out type businesses where a company sells a simple service and bears the cost of providing that service at approximately the same time, without incurring any longer-term obligations.

For example, consider a hair dressing business. It receives cash (or credit card payments, which quickly convert to cash) from customers and incurs cash expenses such as paying staff, paying rent, buying hair products, and occasionally replacing equipment. In any given year, the accounting profits of this hair dressing business will roughly reflect the cash that it generates, almost regardless of the peculiarities of its accounting policy. While there are different ways in which it could (for example) account for the value of small items of equipment such as scissors and clippers, and there are different ways to accrue its rental expense over time, these accounting policies would be unlikely to move the needle much in terms of reported profits.

But not all businesses are this simple. Accounting for profits becomes more arbitrary when a company undertakes to provide a bundle of services to a customer over a period of several years.

Construction

For example, construction contracts often involve the construction company constructing a building over a period of a few years whilst receiving progress payments along the way, with a final payment to the builder when the building is completed. Even after completion, the construction company will often bear a potential liability for several years in the event that any defects are discovered with the building. How to account for the earned revenues and expenses on partially completed buildings involves a lot of judgment, and investors in the construction company will need to trust the judgment and honesty of whoever is responsible for estimating what proportion of each building has been completed.

These judgments and scruples are not always beyond reproach. The construction industry has delivered more than its share of nasty surprises to investors and lenders, as many supposedly-profitable construction projects have only been revealed to be unmitigated disasters at about the time that the project was due for completion.

Life Insurance

Another sector that is notorious for complex multi-year contracts is life insurance, particularly traditional life insurance products which combine aspects of insurance, investment-linked savings products, and fixed interest investments, with a term that literally lasts for the remaining lifetime of the customer. While the buyers of these chimera products typically have a right to withdraw with relatively short notice, the insurance company is obliged to keep its end of the bargain, and cannot stop providing insurance or jack up insurance premiums if (for example) the customer develops a terminal disease. The compounding nature of these products combined with the certainty of eventual death mean that once a customer has been paying for their life insurance premiums for several years, they become a clear liability for the life insurance company – from that point, the insurer knows that the amount that they should be setting aside to cover the future cost of paying out insurance to the customer’s beneficiaries is likely greater than the insurance premiums that they can expect to get over the remaining life of insured person.

Hence, it is clear that life insurance companies ought to record a significant net liability for long-term customers. However, it is no simple matter working out exactly what liability is appropriate, so investors essentially have to trust the judgments of the firm’s actuaries in calculating the life insurance liability and the profitability of the life insurance company. Disclosures from life insurance companies generally leave analysts with insufficient data to second-guess the actuaries’ estimates. There are a few ratios we can look at to get a broad sense of whether the actuarial valuation is conservative or aggressive, but they will no always be reliable indicators.

Life insurance accounting can get really wacky in the early days of a life insurer, when the life insurance company might record an asset associated with their customers, on the basis the value of the premiums that those hapless mugs are expected to pay the insurer over the next several years is likely far higher than the present value of pay-out that the insurance company will make when their customers eventually die.

Partners Life

For example, my attention was caught recently by Dai-Ichi’s billion-dollar purchase of Partners Life. Looking at the financial statements of Partners Group, we can see that 73% of the equity of the company is represented by a (net) NZ$527 million balance sheet asset representing a share of the net cash that Partners expects to extract out of its customers in the future. Although these customers could simply stop paying their life insurance premiums, Partners’ actuaries assume they won’t, and record a balance sheet asset predicated on the assumption that the present value of premiums that these customers will pay Partners Group in the future amounts to $5.14 billion, whilst the present value of the amounts that Partners Group will pay-out to policy holders is less than half of this, at $2.48 billion. Reinsurance costs, other expenses, and tax subtract a further $1.48 billion from the net asset recognised on the balance sheet.

The assumptions that are required to make such assessments are highly subjective, and if I were in Dai-Ichi’s shoes, I would want to scrutinise these assumptions closely, as it looks like the game plan for Partners’ private equity owners may have always been to dress Partners Group up for sale. If you’re going to buy into a company with highly subjective financial accounting, you want to be sure that the people who held sway over the subjective accounting didn’t have an incentive to make it look better than it really was. An alternative viewpoint of Partners’ financial performance is that it has been recording negative operating cashflows, its obligations to policy holders have been growing each year, its claims costs have been growing faster than its premium income, and there is little reason why the customers that it expects to make money out of in the future should stick with it. If Partners Life followed the “Don’t count your chickens until they’ve hatched” principle that applies to accounting for customer relationships in pretty much every sector other than life insurance, it would have been recording accounting losses.

Although I have little knowledge of Partners Group, I would be unsurprised if Dai-Ichi’s purchase of Partners Group proves to be one of the worst billion-dollar purchases of a New Zealand company by a foreign buyer since their compatriots at Asahi Group paid a similar sum to purchase Independent Liquor.

Life insurance accounting is unusual in its on-balance-sheet anticipation of future premium revenue from existing customers. Few other businesses recognise anything on the balance sheet for future revenues. For example, property and casualty (“general”) insurers will not recognise revenue until it is received or invoiced, and they put aside a provision for the un-earned element of insurance premiums (which are typically paid a year in advance). Hence, accounting for property & casualty insurance is far easier to scrutinise than life insurance, and the main risk that investors have to be aware of with property and casualty insurers is the possibility that provisions for the future cost on unpaid claims may be inadequate. This risk is obviously greater for some types of insurance (particularly long-tailed insurance such as workers’ compensation) than it is for others (e.g. short-tailed insurance such as automotive insurance).

 Inventory Valuations

The valuation of inventories can also distort reported profits. In theory, companies record inventories at the lower of cost or net realisable value, but “net realisable value” can be a subjective concept for slow-moving items, and different companies clearly apply different levels of effort when it comes to identifying inventories that ought to be written down.

The risks associated with inventory valuations are highest when the dollar value of inventories is high relative to operating profits. This will often be the case when either inventory turnover is low or margins are low. In such cases, the reported profit over a period of a year may be entirely attributable to the movement in the valuation of inventories, rather than any actual cash generation.

For example, in looking at the largest holdings in a competitor’s fund the other day, I noticed that they had invested in a flooring company whose inventories had grown by 97% over the previous 12 months. The dollar growth in the valuation of inventories over this period was almost double the company’s pre-tax profits. This creates a dilemma for shareholders, as they have to figure out whether the reported increase in inventories is “real” or whether it is partly an artifact of lax accounting. If only half of this increase the inventory valuation is real, the company’s profits could be entirely fictitious. Businesses such as flooring are notorious for dodgy inventory valuations, as such businesses typically account for inventory cost on a per metre basis, but over time end up with a store room full of off-cuts that are essentially unsaleable, but still recorded as having significant value on the company’s balance sheet.

Empirically, high and rising inventories have often proven to be a good warning sign for investors.  New Zealand investors might remember the listed clothing retailer Pumpkin Patch, which in 2007 had a market capitalisation of over $800 million, when its annual sales were just $180 million. It was reporting significant operating profits, but a large component of these profits was represented by the growing balance sheet value attributed to its inventories, and by 2008, it was reporting inventories that represented close to 9 months of stock turnover. I remember looking around a Pumpkin Patch store and estimating that the store carried less than 5,000 items of clothing, yet Pumpkin Patch’s accounts carried an inventory valuation that worked at about 50,000 clothing items per store (assuming a cost of $10 per item). This all ended badly – after denying there was any issue with the level or valuation of inventories during its boom years, Pumpkin Patch ultimately acknowledged the problem, and by 2016 Pumpkin Patch’s shares were essentially worthless.

Inventory valuations need particular scrutiny when inventories are particularly difficult to assess. The salmon farming industry is perhaps the most extreme example of this, as salmon farmers spend three years throwing food into a fenced off part of the sea, and assume that the salmon living beneath the waves are getting fatter. The salmon farming industry has delivered numerous nasty shocks when salmon farming companies have suddenly realised that there weren’t as many large fish in their farms as they had previously thought.

How can Investors Spot Dodgy Accounting?

The majority of companies do a good job at preparing accounting reports that accurately reflect their profitability, so it would be a mistake to be cynical about every set of financial statements. When is some scepticism most warranted?

In my view it pays to think about whether the management, directors, and major shareholders of a company have an incentive to present an excessively rosy picture of a company’s performance. If they’re trying to sell the company or issue new shares, they may have a bias towards presenting a picture that increases the perceived value of those shares, and will therefore be more inclined to (for example) use optimistic assumptions to value future cashflows from life insurance policies or avoid writing off stale inventories. Management and directors can also feel pressure to present rosy accounts if there have been questions over their performance.

Investors should therefore take a more cynical approach to interpreting financial statements where there are grounds to suspect that management or the board might have wanted to present an optimistic view of the company’s performance.

As implied by some of the examples given in this article, a company’s financial statements are more likely to be misleading if the complexity or opacity of the business model means that there is more than one credible perspective on how much money the company is making.  In the absence of outright fraud, simple cash in / cash out businesses (such as the hairdresser example given earlier) can hardly avoid presenting an objective picture of their financial performance, whereas the accounts of more complex businesses (such as life insurers) often depend on subjective judgements. As the detail of many of these subjective judgments will not be disclosed to investors, the accounts of such businesses are more likely to mislead investors.    

Looking at the balance sheet (and how it has changed over time) can also help you to spot dodgy accounting. The flip side of optimistic reporting about profits is often excessive growth in reported assets or understated growth in liabilities. So it pays to be suspicious when certain balance sheet assets are growing rapidly. Investors should be particularly suspicious about growth in inventories and in assets that either involve the capitalisation of regular expenditures or assets that are valued based on some assessment of future economic value. Investors may also justifiably worry if provisions or other subjectively-determined liabilities are not growing as rapidly as a firm’s revenues.

Hard-to-interpret balance sheet items are most prevalent in business that have multi-year contracts but where revenue and cashflows do not necessarily accrue evenly over the life of the contract (for example, life insurance contracts, construction contracts, and retirement villages occupancy licences). Growth in the balance sheet items associated with these contracts should obviously be expected while the businesses are growing rapidly, and this fact can make dodgy accounting hard to spot during a period of rapid growth. In some cases it will not be until the revenue line stops growing that investors recognise that there is something fishy about the continued growth in asset values recorded in a company’s balance sheet.

Lastly, investors should be careful when investing in business models that generate near-term cash inflows, but also involve the accumulation of significant longer-term customer obligations or environmental obligations. For example, if a company is operating nuclear power plants, mines, or waste landfills, or selling products with lifetime warranties, it pays to think about whether it has made sufficient provision for future clean-up or warranty costs.

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited, and an investor in the Te Ahumairangi Global Equity Fund. Te Ahumairangi manages client portfolios (including the Te Ahumairangi Global Equity Fund) that invest in global equity markets.