The urge to massage reported earnings remains strong, particularly among companies that have built their reputation by growth through acquisitions
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The Independent Online
What morals can one draw from the saga of Terry Smith? For those who are not familiar with the story, he is the one-time banking analyst at UBS, the Swiss-owned City broking house, who dared to publish research questioning the accounting practices of some of Britain's biggest quoted companies. Those highlighted included his own employer's clients, such as Grand Metropolitan, who took great and public umbrage.

When it became dear that he was pressing ahead with his plan to publish the research as a book, UBS promptly fired him. Mr Smith himself, an unrepentantly chippy character who likes a scrap, was sued for breach of contract. Nobody claimed his research was flawed or inaccurate, or denied that he was providing a valuable service to professional investors in showing how widespread the use of "creative accounting" had become. But he had committed the grave crime of saying publicly what blue-chip broking firms prefer only to have said in private, if at all. Faced with legal bills running to more than pounds 170,000, Mr Smith's destiny seemed unpromising - no job and no prospects.

Yet the story has had a happier ending. The legal case was eventually settled, Mr Smith found another job in a smaller boutique stockbroking firm without heavyweight corporate clients to complain about what he was saying in his research, and his reputation among investors and the media has soared.

His book, Accounting For Growth, sold a remarkable 55,000 copies - not bad for a work devoted to such arcane matters as the use of reorganisation provisions in the way companies account for acquisitions. This week he published a second edition, demonstrating that, while many of the loopholes he exposed in the first edition have now been eliminated, the urge to massage reported earnings remains strong, particularly among companies that have built their reputation by growth through acquisitions.

So what can investors learn from this episode? Well, I don't think anybody really ever thought that stockbroking houses were first and foremost centres of the relentless pursuit of truth. Their game is making money, which means taking fees from corporate clients and advising them on bids and deals, as well as producing buy and sell ideas for their investor clients. Research is one of the services they provide to their clients, but it is far from being their raison d'etre.

But, as the fund management business continues to grow in size and clout, the appetite for quality research is undoubtedly rising, forcing the biggest brokers to beef up their research departments. It is no coincidence that, while Mr Smith's original research put the barons at UBS in an awkward position, fund managers loved it. It demonstrated in gory detail, and with concrete examples, how easily some of the largest companies were able to use the UK's lax accounting rules to massage their reported earnings figures.

Of course, in an ideal world, professional investors should be able to work this out for themselves. But a surprisingly large number of fund managers are either too busy or too preoccupied with broad investment allocation decisions to spend their time poring through the notes at the back of the accounts of the companies in which they invest. An embarrassingly large number of blue-chip investment firms found themselves still holding shares when companies such as Polly Peck, Coloroll and British & Commonwealth went under.

These companies went bust despite producing audited accounts which appeared to show them making large profits only weeks before the debacle. Unsurprisingly, several of the firms highlighted in Smith's first book, including Tiphook, Queen's Moat, Ladbroke and Grand Met itself, have subsequently underperformed badly. Tiphook, another UBS client, even went into receivership. There is no doubt that the quality of reported accounting information is now improving. The Accounting Standards Board under Sir Colin Tweedie has made a spirited attempt in the last few years to eliminate the most obvious areas of abuse, such as off-balance-sheet finance and merger accounting. The introduction of standardised cash-flow statements has been a big help in allowing users of accounts to detect whether profits are being seriously massaged or not.

But the battle is far from over. The UK remains the only major economy which still allows companies to write off "goodwill" directly against reserves rather than depreciating it through the profit and loss account The result is that UK companies regularly report higher profits and return on equity than they would do under stricter US accounting rules.

So the investor's challenge is not to be duped. What does that mean in practice? Well, rule one is: be cautious about earnings. Always be prepared to put reported profits under the microscope. They may well not be all that they are cracked up to be. There is an overwhelming volume of evidence that reported profits are only a limited guide to a company's underlying economic performance. Discounted cash-flow measures are much more highly correlated with subsequent share price performance than earnings figures.

Secondly, therefore, always keep track of the cash flow. One of Terry Smith's many helpful tips is this: if a company's cash flow from operations is widely different from the reported operating profit, be suspicious. It is likely that there is some degree of creative accounting at work. Another of his pieces of advice is: avoid companies whose businesses you don't really understand.

But his best point, for cautious long-term investors at least, is also the simplest. Stick to quality and you will not go badly wrong. Which consumer companies do not feel the need to value their brands in their balance sheet? Step forward Unilever and Marks & Spencer. Which companies do not feel obliged to improve their reported profits by including a deferred tax charge? Come forward Reuters, GUS and Marks & Spencer (again). The best companies do not resort to creative accounting - they don't need to.

Accounting For Growth by Terry Smith. Published by Century Business, pounds 14.99.

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