Why the world no longer believes financial statements

It’s getting harder and harder to make sense of published financial accounts, and the relentless tweaking of accounting standards has done little to improve the situation. In fact, it has arguably made it worse.

If published accounts were a reliable reflection of the commercial health of companies, then trouble at Steinhoff and Tongaat would have been picked up years ago. Investors rely on analysts to reconstruct accounts to strip out distortions and hopefully provide better insights into each firm’s investment merits. But even analysts get it wrong sometimes, as happened with Steinhoff and Tongaat.

Nicolaas van Wyk, CEO of the SA Institute of Business Accountants (Saiba), says the accounting standard setters are under extreme 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”. Some researchers are now openly calling for a move away from the balance sheet approach favoured by IFRS to an income statement approach favored by some analysts and practitioners in the United States”.

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, judgments, and models rather than exact depictions.

“Estimates increase the noise and error in financial information, particularly when they are made by persons (i.e. managers) having strong incentives to affect the perceptions of investors.”

Analysts and investors rely on earnings-centred valuation models. Their spreadsheets are aimed at predicting earnings, and for this they seek guidance from company managers. But reported earnings no longer reflect actual enterprise 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.

If published accounts are leading investors astray, what’s the solution?

US Professor Joel Litman launched a service called The Truth Detector to reconstruct accounts with a view to separating gems from pebbles. He looks at more than 32,000 stocks around the world and makes upwards of 100 adjustments to the published financials to help him reach his conclusions. He uses what is called Uniform Accounting, where distortions and discrepancies like treatment of goodwill and expensing versus capitalising leases are removed. This is the result when applied to AT&T:

Source: Stansberry Research

Many analysts looked at the reported PE ratios and concluded AT&T was trading at a discount of nearly 50% to the market, but this analysis shows it’s pretty fairly priced.

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 a new accounting standard for leases, known as IFRS 16. Many leases of fairly long duration that were previously expensed o the income statement are now shifted to the balance sheet as liabilities (with a corresponding asset entry). This can radically alter debt ratios, though from a practical and cash standpoint, there is no real change.

According to the PwC study, more than half of the 3,200 companies surveyed will see an increase in their debt of over 25%. The sectors most affected are retail, airlines, professional services, health care, textiles and wholesalers. “For retailers, the reported debt balances are expected to increase by a median of 98% and the median leverage ratio (calculated as debt divided by EBITDA) will increase from 1,17 to 2,47. Solvency for retailers is expected to decrease from 40,8% to 27,5%. Approximately 35% of the retailers will see an increase of reported debt balances of over 25%,” says the PwC report.

Revenue recognition is one area where investors can be led astray. For example, General Electric’s latest annual report provides various estimates underlying its revenue recognition. But the most crucial information is left out: how much of its revenue is based on estimates?

Financial reports have suffered from two overriding weaknesses, says Lev:  

(1) Accounting standard-setters have abandoned the income statement rule-making model and its operating principle: revenue–cost matching, exacerbated by their failure to recognise the dramatic shift of corporate productive resources from tangible to intangible assets. The indiscriminate expensing of the latter largely stripped reported earnings of their ability to inform on enterprise performance and signal managerial capabilities.

(2) Accounting standard-setters have shifted to the 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. A sad state of accounting affairs, to be sure, but can anything be done about it?

This then calls for a serious reassessment of the balance sheet model pursued for three decades by accounting standard-setters.

How to fix the problem

There is obviously a sharp disconnect between Tesla’s $336 million second-quarter 2017 loss (almost $3 billion accumulated losses), and its current market value of about $50 billion, as well as a strong vote of confidence by institutional investors evidenced by a 62% ownership. Or, the less known Kite Pharma, reporting $630 million accumulated losses (mainly from R&D expensing), and its recent acquisition by Gilead Sciences, a leading biotech company, for $12 billion. Obviously, investors don’t consider these massive accounting losses, due to the expensing of long-term investments, as an indication of corporate value change or future performance. And this applies not only to early-stage firms:

Lev proposes a substantive rule change required to restore matching in the income statement: Firms’ expenditures on identifiable long-term investments (R&D, IT, customer acquisition costs, etc.) should be capitalised and amortised, thereby eliminating these investments in growth from the income statement, simply because there are no current revenues to match against them.

There is debate in the accounting community whether internally generated patents and copyrights, R&D or algorithms such as used to Amazon to recommend products to customers – should be expensed or capitalised. Currently, they are expensed, another example of the contradictions embedded in current accounting standards. The debates are likely to continue. Analysts tend to do their own reconstructions of accounts, often stripping out intangibles such as R&D for so-so performing companies and keeping them in for firms that perform well.

Lev proposes a radically new way to capitalise intangibles:

  1. The entity has a legal ownership of the intangible through patents, copyrights, trademarks, etc., or has a sole access to the intangible (namely, can restrict others from using the intangible) through a proprietary development process (e.g. internal R&D).
  2. The intangible is scarce, that is, in limited supply (e.g. wireless spectrum), and competitors cannot easily copy or imitate it.
  3. The intangible is expected, under normal circumstances, to produce benefits, either directly (like licensed patents) or indirectly, alone, or in combination with other firm resources.
  4. The entity is able to identify the investment (expenditure) in the intangible.

The fourth criterion excludes from capitalisation certain intangibles, particularly those related to ‘organisational capital’ – the value-creating business processes and procedures, like Amazon’s and Netflix’s widely successful customer recommendation algorithms – because the expenditures related to their development are difficult to trace. Same with on-the-job employee training, and most ‘big data’ developments. So, the capitalised intangibles under my proposal should be restricted to those whose expenditures are clearly identifiable.

Along with the proposed capitalisation of certain intangibles, there should be a considerable enhancement of the disclosure of investments in long-term, value-creating assets. Currently, there is an inexplicable ‘conspiracy of silence’ concerning these investments. With the exception of R&D, all other expenditures on intangibles (IT, brand enhancement, employee training, artistic designs, etc.) are ‘buried’ in SG&A and cost of sales items. Go figure: investment in tangible capital is clearly disclosed, while the far more consequential investment in, say, IT is concealed from investors. Shining light on these crucial innovative activities will significantly improve investors’ information.

The Steinhoff accounting problem

The 2017 Steinhoff annual report states: “The Group also revisited its depreciation estimates and applied these estimates to the revised property values. The various restatements led to the forecast information used in goodwill and brand impairment models having to be revised. The Management Board has also revised the WACC rates in line with the risk profile and revised size of the Group. The impairments of goodwill and brands are substantial.”

The 2016 and 2017 financial statement were impacted in several ways:

(i) Various restatements to correct prior period errors relating to initial recognition and valuation of investments in subsidiaries, affecting the 2016 comparatives in the financial statements;

(ii) Recognition of financial guarantees;

(iii) Adjustments to share based payment schemes;

(iv) Impairment of investments in subsidiaries;

(v) Impairment of affiliated-party loans; and

(vi) Impairment of related party loans.

When it came to restating “errors” for 2015 and 2016, Steinhoff wrote down its asset values by R8.2 billion for 2015 and by 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 the write-down of over-valued intangible assets, followed by the effects of accounting irregularities. That restatement knocked R1.6 billion off the 2016 profit.

This is the problem that accounting standard setters are trying to solve, but as we have already seen, it leaves many of us none the wiser.

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