Financial statement analysis requires ‘professional scepticism’
– David Wanis, August 2019
Normally economists talk about growing the pie – the amount of economic value available for everyone to share. That is seen as a good thing.
The only pies we appear to be seeing growing almost everywhere at the moment, evidenced by full year results just delivered to the market, are the porky pies. And this is decidedly not a good thing.
Management have always massaged results. Pro-forma versions of financial accounts, which rarely shows performance in a worse light than statutory accounts, have been with us for as long as management teams have been rewarded on outcomes different to those of shareholders. We are pragmatic about their existence. Allowing management all the rope they need to present results in ways they best see fit gives us insight into their character.
Statutory accounts however are more sacred. This is supposedly the truth against which forecasts, commentary and pro forma adjustments are measured. The auditors are supposed to be signing their reputational goodwill against an assessment of how accurate a picture of the business these accounts represent. Arthur Anderson is the scary story accounting partners tell their new employees around the campfire. A story of what happens when you rent your brand to the highest bidder with the intent of deceiving the owners of the business and to assist their appointed managers (and those signing the audit invoices) in the deception.
We are increasingly finding ourselves in situations where the truth of statutory accounts is slowly receding. The income statement – because of the assumptions allowed in the treatment of accruals – has long been suspect. Guilty until proven innocent by the cash flow statement. Markets are reflexive and management are not ignorant of the increased emphasis their owners place on cash flow, so it is probably no surprise they are looking for (and finding) ways to massage these numbers as well. The method de jour is ‘supply chain financing’ – a combination of receivables factoring and payables financing – and financial engineers are busy looking for ways of liberating capital from inventories as well.
Investors have to retreat further to the balance sheet and the notes to the accounts to look for the truth, but even these fronts are under attack as some seek ways to limit disclosure but stay within the letter of the law (the spirit having been abandoned some way back).
How do we manage this conflict? Our first approach is to exercise professional judgement and maintain professional scepticism throughout our financial statement analysis. These are similar words the Audit and Assurance Standards Board suggests are the responsibilities of the Auditor in compiling their report. Our team having had professional experience in equity research, credit research and professional audit, also apply analysis less common to equity investors – which helps to uncover risks.
Understanding incentives is also critical. Management with skin in the game – which means exposure to the downside through an existing and significant interest in ordinary shares – helps a great deal. Management who propose being incentivised by pro forma or underlying earnings, or sub-components of the financial accounts they can (and do) manipulate are at the opposite end of the spectrum. We are currently watching a number of small caps who exhibit more red flags than the parade at China National Day.
Ultimately the degree of deliberate obfuscation is a quality marker which speaks volumes about management quality, corporate governance and shareholder alignment that is on the public record and relatively objective to assess.
“Creative accounting is an absolute curse to a civilization. One could argue that double- entry bookkeeping was one of history’s great advances. Using accounting for fraud and folly is a disgrace. In a democracy, it often takes a scandal to trigger reform.” – Charlie Munger
We do not seem to be near scandal levels of concern to see any reform on this front, and we won’t be until investors suffer large losses if history is anything to go by. However, we remain diligent in trying to avoid those candidates heading for the wall when the revolution comes.
This communication is prepared by Longwave Capital Partners (‘Longwave’) (ABN 17 629 034 902), a corporate authorised representative (No. 1269404) of Pinnacle Investment Management Limited (‘Pinnacle’) (ABN 66 109 659 109, AFSL 322140) as the investment manager of Longwave Australian Small Companies Fund (ARSN 630 979 449) (‘the Fund’). Pinnacle Fund Services Limited (‘PFSL’) (ABN 29 082 494 362, AFSL 238371) is the product issuer of the Fund. PFSL is not licensed to provide financial product advice. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) (ABN 22 100 325 184). The Product Disclosure Statement (‘PDS’) and Target Market Determination (‘TMD’) of the Fund are available via the links below. Any potential investor should consider the PDS and TMD before deciding whether to acquire, or continue to hold units in, the Fund.
Link to the Product Disclosure Statement: WHT9368AU
Link to the Target Market Determination: WHT9368AU
For historic TMD’s please contact Pinnacle client service Phone 1300 010 311 or Email firstname.lastname@example.org
This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.
Whilst Longwave, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Longwave, PFSL and Pinnacle disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information. This disclaimer extends to any entity that may distribute this communication.
Any opinions and forecasts reflect the judgment and assumptions of Longwave and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future. Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Longwave. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.
This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Longwave.