• Arne

The failure of underestimating accounting figures

Accounting is often subject of ridicule to finance professionals. Unfortunately, this mindset is toxic for the professional investor. If you want to start active investing you should know about accounting in more detail.

As an investor you likely to start analyze a business by looking at its financial statements. Those financial are written in the form of general accepted account principles (GAAPs) applicable to the jurisdiction of the business. The most common GAAPs for publicly traded companies are the International Financial Reporting Standards (IFRS) and US-GAAP.

The objective of accounting in a nutshell.

Accounting needs to fulfill different objectives which, occasionally, are mutually exclusive. Among the most important ones is the requirement to provide reliable information to external stakeholders, e.g., investors, so that they can make rational decisions with regards to the business. To fulfill this, it is necessary to come up with informative figures which are comparable across companies and that represent a true and fair view.

Another important object of accounting is to protect the company's creditors by being prudent. That is, you would not account for certain business transactions that are still uncertain - even though it might be a relevant information to the investors.

The tricky part of accounting.

The existence of different GAAPs plus the contradictory objectives make it even harder for investors to analyze the financial statement properly. Very frequently, especially when reading newspapers (even the most reputable ones), I see articles stating that a company suffers from a breakdown in earnings by say 20 percent. Just yelling out such a statement without putting it into any context is nonsense. How would you know the 20 percent drop in earnings is not coming from a new reporting standard which must be applied? Sure, the same is true when newspapers title a company to increase earnings by say 50 percent. How would you know it is a sustainable increase in its operations? Could it also be a one time sale of a subsidiary or a change in the accounting principle?

"When you want to analyze the reporting figures of any business you must well understand the underlying account principles."

To underlay how huge the gap between different accounting principles can be have a look at this New York Times article.

Inconsistencies in accounting.

To some extent, accounting principles allow for options. Wherever those options exist, you can be sure that the company takes them to its advantage. However, for the external investor they might be tricky to discover. For instance, occasionally, a company has the option to value its stock (resp. inventory) by applying either the last in first out (LIFO) or the first in first out (FIFO) method. At least in stock intensive businesses, this could make huge difference in the reported figures.

Another examples of inconsistencies in accounting is how you as a company would account for your investments. Basically, you can categorize them in the following groups:

  • Affiliated companies, are companies you can control, because you own more than 50 percent in their equity. Normally, you would account for their results by doing a full consolidation. That is, all the assets, liabilities, revenues, and expenses will be shown in a full consolidated financial statement. For instance, when you only earn 80 percent of a company you still account for the full revenue etc. as if you owned 100 percent. The other 20 percent, belonging to other investors, would be shown as a separate line on your corporations equity called something like "attributable to other shareholders".

  • Equity participations of less than 50, but more than 20 percent, are investments which you usually account for at their respective equity value. This is called at-equity accounting, because you would only show your stake in the equity value of the business as an asset on your balance sheet. If your investment distributes some of its profits, e.g., in the form of dividends, it would reduce its equity and, hence, your asset too.

  • Equity participations of less than 20 percent are usually called financial assets. At least under US-GAAP and IFRS, they will be shown based on their fair-value. In most cases, where you as a company hold equity stocks of another publicly traded company, the fair-value at given point in time is the market value.

Maybe you have already noticed the issue. That is, it does not really matter which type of company you invest in, but depending on your share of interest you would apply different account methods and, hence, show different results. Don't get me wrong, I think these differences, from an accounting perspective, have a proper right to exist. However, from an investors perspective, they can be misleading. That being said, why should it make a difference if a business owns 18, 25 or 55 percent in stake of another entity? Sure, from a legal, i.e., controlling interest, point of view it matters a lot, but not with regards to the intrinsic value of that same company.

If you try to tackle this topic also from a practical perspective you find a great chapter in the Essays of Warren Buffett* - of course, among other interesting thoughts.