The Fog of Accounting
Accounting standards do not guarantee investors will have access to the information they need in order to know what they own. In fact, there is so much flexibility in accounting that it enables firms to hide their true condition.
Back in the early 80s when I received the equivalent of an MBA, accounting professors made the argument you could learn all the techniques companies used so their financial statements presented them in the most flattering light. Therefore, you could take a financial statement and back in to the true condition of the company.
This is no longer the case.
The recent bankruptcy of Carillion, a large UK company, provides yet another example of how firms use the fog of accounting to hide their problems and create the appearance the firms are in much better condition than they really are. In this case, the company avoided recognizing it over paid for earlier acquisitions. It did this by engaging in accounting games to avoid recognizing the write down (technically known as impairment) of the goodwill generated at the time the acquisitions were made (goodwill is the excess of the purchase price over the value of the assets less any debt assumed in the acquisition). Writing down the goodwill would have told shareholders there were problems.
How was Carillion able to do this?
In the UK, companies used to amortise goodwill — meaning they took an annual charge against their profits, with a view to writing off the whole amount over a fixed period — generally about 20 years. But since 2005, they have been able to treat it as a permanent asset, only writing it down if it is deemed “impaired” by the company and its auditors. This is established by an annual impairment test.
The treatment is controversial….There are also problems with the idea that impairment tests can keep balance sheets honest.
Who would want an honest balance sheet? Dare I say investors?
One concern is its subjectivity. “Not surprisingly, a CEO who overpays in an [acquisition] is not particularly keen to publicly acknowledge that overpayment, so instances of firms declaring their goodwill as impaired are rare,” Prof Ramanna says….
Of course, CEOs aren’t going to want to admit to overpaying for an acquisition. So how do they hide this fact?
The accounting rules allow companies to inject purchases such as Eaga into accounting groupings called “cash flow generating units” when conducting impairment tests.These are not formal entities, but opaque constructs created by management containing assets they choose to bundle together. Bosses then produce business plans and cash flow forecasts for these units, from which they compute net present values, and thus test whether the underlying assets are worth more than the goodwill written up against them.
Not only does this process minimise the chance of an impairment, it depends heavily on the willingness of auditors to challenge the numbers plucked out by management.
“It is a bit like the banks before the financial crisis,” says one accountant. “There is no objective market value for the asset, so you mark it to model. And if it’s bullshit, well, it is up to the auditors to call it out.”
And the chances the auditors will call out this bullshit is effectively zero.
Recall the Big Four audit firms all have other sizable business lines that would be negatively impacted if they started calling out just how aggressive their clients’ accounting was.
“If there is one good thing to come out of Carillion, it’s that it offers a salutary reminder about why preventing overstatement matters,” says Ms Landell-Mills. “Perhaps the most pressing question for policymakers is that — given our accounting rules are no longer designed to protect capital — who is enforcing our capital protection regime?,” she asks. “Anyone?”
So who is enforcing the capital protection regime?
This is where the Transparency Label Initiative comes in. Before a label is rewarded indicating investors can know what they own, the question is raised about the extent to which management is relying on accounting games to hide the firm’s true condition.
For example, GE doesn’t qualify for a label. Since the days of Jack Welch, GE has relied heavily on accounting to hit its quarterly earnings number. Not only did it game the accounting numbers in its manufacturing divisions, but it used GE Capital to make up any shortfall (by recognizing gains) or hide any over performance (by recognizing losses).
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