Magazine article Management Today

Don't Be Fooled, Read the Rules

Magazine article Management Today

Don't Be Fooled, Read the Rules

Article excerpt

The ability to interpret a company's accounts is an essential investment skill and requires more than a simple understanding of accounting terms and techniques. Few people would expect accounts to show their subject in anything less than a flattering light, but sometimes the process goes much further. The investor who can recognise when it has will, at the very least, avoid some duds that might appear attractive on the outside.

Reports and accounts have improved measurably in the past 20 years and many techniques of flattery that were popular 10 years ago have disappeared. Nonetheless, it is interesting to review what accountants and their clients used to get away with because this gives a stark understanding of how different their objectives may be from those reading accounts.

For example, take the 1989 accounts of Leading Leisure. The profit and loss account showed profits before taxation of [pounds]6.7 million, and that is what the press reported. In smaller print a few pages further on, notes to the accounts revealed that this figure included a [pounds]10 million profit from the disposal of properties to joint ventures. Deeper still into the notes came the information that loans of [pounds]36 million had been made to the joint venture companies whose issued share capital amounted to just [pounds]430,000. In other words, by dint of a [pounds]36 million loan to ropey associates, Leading Leisure had transformed a [pounds]3.3 million loss into a [pounds]6.7 million profit. Hardly 'true and fair'. Were investors taken in? Indeed they were. On the basis of these results, Leading Leisure issued [pounds]22 million of new shares for cash. Despite this infusion, it was bust within six months.

Towards the end of the '80s, the committee that had developed the accounting rules since the '70s recommended that the rule-making process be independently reviewed. Sir Ron Dearing was appointed to investigate, and produced the present structure: an Accounting Standards Board (ASB) to overhaul the rules, a Financial Reporting Review Panel to enforce them, and a Financial Reporting Council of 'big guns' to oversee their work.

Under the chairmanship of Sir David Tweedie, the ASB produced the first new Financial Reporting Standard (FRS) in September 1991. This ushered in Cash Flow Statements to replace the old Source & Application of Funds statements. The difference is illustrated by Polly Peck (see below), whose year-ending December 1989 Source & Application of Funds statement shows as its bottom line an increase in liquid funds of $128 million. Many people would interpret this as a positive development, especially when the same statement contained the encouraging sub-total, total generated from operations - [pounds]172 million. However, any such conclusions were totally at odds with the facts. When the same figures get the FRS 1 treatment, it is immediately obvious that Polly Peck was running out of money: receivership soon followed.

In the old days the profit and loss account was just a single column, and there were plenty of ways of enhancing profits: for example, acquiring a nice profitable company just before your year end and merger accounting it, taking all the acquired company's profits into your results, rather than the profits from the date of acquisition, as you would do under acquisition accounting. The FRS on Acquisitions and Mergers lays down five strict criteria for defining a merger including, for example: 'The relative sizes of the combining entities are not so disparate that one party dominates the combined entity by virtue of its relative size.' Merger accounting is only allowed if all five criteria are met. An FRS on Reporting Financial Performance requires the P&L account to be presented in up to three columns: acquisitions, continuing operations, and discontinued operations.

BEFORE AND AFTER TREATMENT FOR POLLY PECK YEAR ENDING DECEMBER 1989

Original, confusing presentation

Source & application of funds                [pounds]m

Pre-tax profit                               161. … 
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