Cooking the books may prove less than lucrative in the future if auditing groups have their way, reports Andy Duffy
CORPORATE South Africa’s often cavalier attitude to financial reporting can mislead investors and deter foreign interest, according to the firms which check companies’ accounts.
Though most of the companies’ accounting ploys are legitimate, they can make nonsense of gauging performance. In extreme cases, companies have come crashing down without warning, overnight beggaring the share price. Other mechanisms are often so complex, the understaffed and underskilled Receiver of Revenue struggles to check them.
Auditors say the main problem is that standards are wide open to interpretation: companies can embellish their performance quite legally, even if the result prejudices shareholders’ interest.
The leading auditing groups, including Deloitte & Touche, KPMG and Ernst & Young, have recently established an ”informal” committee to present a united front in dealing with such ”creative accounting”.
The South African Institute of Chartered Accountants (Saica) is also recommending to the government that a new watchdog be established, which is legally empowered to force companies to restate their figures.
”Virtually all companies window-dress,” KPMG partner, professional practice development, Gavin Tipper says. ”But if there are two or three different rules how can you qualify reports?
”The problem is we have to get our house in order. Generally accepted accounting practice (financial reporting’s primary rule of thumb) is whether three people agree on something.”
Deloitte & Touche, the largest auditing firm, says many companies are better judged by management reputation than earnings and dividends.
”Can you say they’re cooking the books? No,” says non-executive chairman Peter Wilmot. ”But should they be doing it? No, they shouldn’t.”
The institute and auditors identified the following as among the most common performance-enhancers:
* The treatment of extraordinary items. These encompass anything not obviously part of a company’s normal trading operation. If, for example, a company, which sells nuts and bolts, sells one of its factories, the profit or loss on the sale is judged to be extraordinary. Other examples include retrenchment costs.
Companies have usually taken extraordinary profits into attributable earnings, which the investor looks at, and buried losses in retained earnings, which the investor usually ignores.
Saica sought to protect shareholders from such sleight of hand by issuing accounting standard AC 103 in March 1995, which effectively abolished extraordinary items.
The practice continued, however, with companies tagging extraordinary items exceptional or abnormal, neither of which were defined in Saica’s new standard.
Saica then issued an opinion document – AC 306 – which suggested companies also a disclose headline earnings figure, in which such abnormal items were stripped out and itemised.
Saica’s thinking is in line with overseas practice. The institute is attempting to harmonise South African reporting standards with those issued by the International Accounting Standards Committee.
But companies canvassed by the Johannesburg Stock Exchange (JSE) were generally not enthusiastic about the headline earnings proposal. Many now present headline earnings figures alongside normal figures, but continue manipulating abnormal items to flatter the bottom line.
* The treatment of goodwill. Defined as the difference between what a company pays for an asset (which can include intangibles such as the value of a trade mark), and its fair value. There is currently no South African standard relating to the write-off of goodwill.
International practice is to write it off against earnings for up to 20 years: if goodwill is valued at R100-million, the write off would slice R5-million from earnings each year for the next 20 years.
Some companies are adopting this practice. Others are writing off the full amount to reserves, so avoiding the earnings figure, and usually investors’ notice.
”A number of them are doing it, and there’s not a lot we can do about it,” Saica technical director Rosanne Blumberg says.
The institute is planning to issue an exposure draft which will cover the treatment of goodwill in the next six months. Again, its take-up by companies is not assured.
* Provision for post-retirement benefit costs other than pensions. Companies are increasingly providing benefits for retired employees, but many have neither quantified nor disclosed their obligations.
The numbers involved, Blumberg warns, are huge – in many cases enough to swamp a company’s reserves.
* Under-reporting. Common in the past two years, where companies have skimmed from particularly strong earnings, and used the gains to revive the earnings performance in a less buoyant year. The argument comes when auditors and management debate how best to bring such fat back on to the books. Among auditors the practice is not seen as particularly harmful; Saica says it is unacceptable and not permitted.
There is also debate about whether smoothing out performance serves the interests of investors attempting to trade in a company’s share.
Such creativity aside, Saica, the JSE and the auditors are convinced the situation is gradually improving.
The recommendation for legal backing for Saica’s standards, including its watchdog, has been sitting with the Department of Trade and Industry since July. The institute is hoping it will be submitted to Parliament next year.
More pressure is coming from offshore investors. ”Investment banks dig,” Tipper says. ”If you’re doing anything funny with the figures they ask questions.”
Gold mining company Randgold & Exploration has begun presenting its accounts in the United States format – the logic being that if you want international funds you must play by international rules.
Major companies such as Anglo American and Sasol have also taken strides toward international reporting standards. Whether similar pressure is being exerted on companies by domestic investors is not obviously clear.
Among the more notable examples of creative accounting leaving investors poorer is W&A Corporation, brought down early in 1994 by debt which had been concealed from the public right until the end.
The reputation of its auditors Kessel Feinstein, later fired by W&A’s new management, remains bruised.
But the man largely responsible for presenting W&A as something it wasn’t, Jeff Liebesman, is enjoying a renaissance on the JSE, effortlessly building a new empire in a string of paper deals.