Why Creative Accounting Will Lose You Money

Creative accounting is not something to be proud of. Sadly many firms are quick to recourse to it for short-term optic reasons. This leaves shareholders often nursing huge losses in future, all whilst management have increased their pay packet by boosting EPS. The amount of freedom to interpret accounting rules as they see fit, means firms can choose to ignore the spirit they are written in. Some firms push this to the full, and even create fake sales to boost their numbers, so as to report impressive results to investors. 

Takeaways

• Understanding why it happens

• Examples of creative accounting

• How to spot it and avoid the pain

You cannot be serious!

Some creative accounting will make you laugh! As the Covid-19 pandemic took hold, some firms have resorted to inventing a new accounting metric, to improve how their figures look. Enter EBITC or Earnings Before Interest Tax and Coronavirus! EBITC was made up. Earnings Before Interest and Tax is widely used and accepted.

Markets punish poor financial results severely.

Bank Covenants are so important, that companies are terrified of breaching them. These are measured against EBIT. The use of the new EBITC, is on the basis that the Coronavirus is a serious one-off event. Therefore the Covid-19 effect 'should be not be allowed to damage' financial figures. Is Force Majeure not just part and part of business?! Moving the goal posts to suit your needs is a hallmark of creative accounting.

Look away now

For years Deutche Bank has never come clean about its derivatives positions, which apparently are not as profitable as first reported. This has resulted in several equity raises, which have been painful for investors who have seen Deutche Bank's share price sell off. The downside risk is still high though!

The possibility that Deutche's derivative book is as big as major US banks such as Goldman Sachs or JP Morgan, whilst holding far less equity, would suggest it has serious financial issues. There is little appetite for another Lehman Brothers bankruptcy due to the systematic risk it could cause. As a result, Deutsche goes on destroying shareholder capital, without being completely clear as to how destructive its full derivative exposure is.

Creative accounting gone bad

The most infamous creative accounting in history was the Enron accounting scandal. Enron's finance team created layers of financial engineering so as to hide their true debts, which once revealed, made the company bankrupt. That a company was able to hide $40bn of debt should act as equity risk warning to you.

Their auditors, Arthur Andersen, were one of the top 5 audit companies in the world. The scandal as to how Arthur Andersen partners turned a blind eye, led to its dissolution. Be wary of trusting a set of financial accounts because the audit was performed by PWC, Deloitte, Ernst & Young or KPMG. KPMG was criticised for signing off Carillion's accounts despite it's "increasingly fantastical figures". The fact is, these accountancy firms are more interested in the advisory work they get from clients, than checking their accounts properly.

Red alert

Muddy Waters is famous for publicly revealing it which companies it has shorted. When it tweeted it had built a short in a UK listed company, there was an immediate reaction.

Within minutes, a couple UK listed share prices had gone down. Although this short position subsequently turned out to be Burford Capital, NMC health's shares were one of those affected. It subsequently went bankrupt.

Always investigate Large unexplained share price moves. If you still cannot find out what caused it, remember it happened, stay clear of the shares and see how the story develops. You can learn to avoid losing a lot of money that way.

How to spot it

There is no one way of doing so although hot stocks should be considered higher risk. Only forensic accounting can truly help you identify fraud. This means performing fundamental analysis on the financial accounts, in particular the balance sheet and the cash flow statement. Take the income statement with a pinch of salt.

Accounting principles are so often changed that companies often find a way of making them work for them, whilst keeping financial skeletons hidden away. Cash is king, so the cashflow statement should be your first port of call.

The industry knows creative accounting happens.

Terry Smith was even sanctioned by one employer, when he revealed in a report to clients how firms were displaying a great deal of creative accounting. Accounting for Growth is worth reading. Such blatant distortion of profitability is possible due to interpretations of accounting rules. Always keep an open mind. If something doesn't look right, it probably isn't.

Conclusion

There are occasions you simply cannot spot it. When Patisserie Valerie went bankrupt after a suggestion of fraudulent accounting by its finance director, few had expected it. There had been no doubts or rumours, and their financial accounts did not show any visible sign that something was amiss.

The best form of protection is diversification and giving yourself a margin of safety. Although demanding an equity risk premium will also help, this is not always possible. Occasionally, as you read through the financial accounts, something will not feel right.

Fundamentally, the more research you do on a company and the better feel you get, will give you the best chance of not losing part of your stock portfolio to creative accounting.