Creative accounting: Why it pays to be sceptical

In 2019, Muddy Waters shook up AIM by attacking the junior market’s then-biggest business, Burford Capital (LON:BUR). The investment firm, founded by famed short-seller Carson Block, had already enjoyed great success with its short reports on many Chinese companies listed in the US, but this was the first time it had gone after a British firm. In a scathing note, Muddy Waters said that “for years, it [Burford Capital] was the ultimate ‘trust me’ stock” and claimed that it had been “egregiously misrepresenting its profit figures”.

At the time, many private investors cried foul. Burford Capital had been a darling of AIM and here was a big, bad hedge fund from the US stomping in to ruin the run. But the points Muddy Waters made were prescient. Burford Capital’s share price fell 56% in the summer of 2019 and has never really recovered.

The difficulty is that, despite tight regulation, corporate accounting is open to interpretation and has numerous grey areas. While staying within generally accepted accounting rules, company directors can report their earnings in flattering ways - making investors believe that things are going better for the company than they actually are (Burford Capital never committed fraud, but misled its investors by using some generous reporting).

Creative accounting and earnings misrepresentation is a pervasive problem in the capital markets. According to a recent academic paper, 41% of companies misrepresent their financial statements, while 10% of all large public corporations commit securities fraud, most of which goes undetected.

This article will help you identify signs of earnings mis-representation and help you understand when dubious-looking numbers might be worth a closer look.

Warning Sign 1: Booking revenue before the cash comes in

Companies make money in many different ways and collect the cash from the sale of their products or services at different times. For example, a furniture retailer might sell a sofa to an individual who can pay for it with either cash or credit. A software company could offer a subscription which is paid for on a rolling monthly or annual basis. Companies account for this difference in timing by marking the balance of money due for goods or services which has been delivered but not yet paid for as accounts receivable.

Companies record accounts receivable as assets on their balance sheets because there is a legal obligation for the customer to pay the debt for the product or service they have used. Accounts receivable are liquid assets, expected to be collected within one year, and are part of a company’s working capital.

We discussed the useful ratios used for analysing receivables in our recent article on liquidity-based red flags. In brief, investors should be wary of companies which have a high proportion of receivables compared to total revenue, or a low receivables turnover ratio. This could be evidence of a company being too generous with the terms of its sale or, in the worst case, booking revenue on the income statement which might never be collected in cash. If a customer defaults on a payment which has already been booked on the balance sheet, the company must mark it down as an asset write-down.

Let’s take a closer look at a company whose receivables position is noteworthy: computing company, Softcat (LON:SCT). Now, this isn’t to say that the company is manipulating its earnings, but the receivables position is currently at a level which should cause investors to take a closer look. In the year to July 2022, Softcat’s net receivables rose 67% to £529m, but in the same time total sales rose just 38%. Thus, receivables as a proportion of total revenue has risen sharply. In the same time, receivables turnover has fallen from just over 6 to 2.4, meaning it is taking the company significantly longer to collect the debts owed by customers than it did previously.

Softcat sells both hardware and software to commercial customers. It blames the sharp increase in receivables on the fact that it recently changed its billing system, which means it is taking longer to receive the cash from customers. But this isn’t wholly satisfactory. If we look at the detail of the annual results, we can see that 8% of the receivables on the balance sheet have been due for over 90 days, up from just 1.6% last year. The longer it takes to collect cash from the sale of goods or services, the higher the likelihood of a company never receiving that money.

While the new billing system is integrated into the business, it might be worth giving Softcat the benefit of the doubt but investors should keep an eye on that receivables position.

Warning Sign 2: Capitalising costs which shouldn’t have been capitalised

Companies should invest in growing their business over the long term, either through research and development on new ventures or expanding their company footprint through the acquisition of tangible assets. Investors can check whether a company is investing sufficiently in its future by assessing research and development expenses as a percentage of revenue or capital expenditure (a cash flow item) as a percentage of revenue.

Poor figures on either of these metrics could be an early warning sign of slowing growth. But the issue becomes more problematic if there are accounting irregularities involved. Accounting rules allow companies to report their costs in two ways. The first (and arguably more simple and transparent) treatment of costs is to expense them. This means they are written onto the income statement in the year that they occur, meaning they have an immediate influence on the company’s profitability.

The second treatment is to capitalise the cost. This means they are reported on the cash flow statement, but not the income statement and won’t show up in the annual reporting of profits. Capitalisation is used for costs that are expected to provide long-lasting benefits, such as the investment in property or the development of new technology. The cost is recognised on the balance sheet in the year that it is incurred and then reduced by depreciation or amortisation over time.

But while both approaches are legitimate accounting methods, company finance teams can use some discretion when selecting whether or not to capitalise costs. This leaves room for some controversy.

For example, a company might opt to capitalise the research and development costs associated with a new drug. That is fair as the drug, if approved, will provide revenue to the company for far longer than the year in which the R&D takes place. But what if the drug fails a clinical trial? The investment which has been capitalised won’t in-fact provide any long-lasting benefits. Well managed companies should have strict policy on when they begin to capitalise investment - research and development expenditure should be expensed until the asset has a proven long term value. Companies which capitalise their expenditure too soon are in danger of misleading their investors.

AIM-traded company Advanced Oncotherapy (LON:AVO) is an interesting example of a company which could be slightly too generous with its cost treatment. Advanced Oncotherapy is working towards developing proton therapy centres for the treatment of advanced cancers but without any approvals it is currently pre-revenue. And yet it capitalises most of its research and development costs. In the financial year to December 2021 (the last full year of results we have available) the company expensed £140,000 of research and development costs, but capitalised a further £12.5m. The reported loss for the period of £29m would have been much bigger if the R&D costs had been run through the profit and loss statement.

Warning Sign 3: Mis-reporting of goodwill

Acquisitions can play a big role in company growth. But it is important to keep an eye on the value of acquisitions and how much companies spend on them - paying too much for acquisitions that then underperform can cause problems for a long time.

The amount that the acquiring company pays for the target company that is over and above the target’s net assets at fair value is accounted for using goodwill. This is written onto the acquiring company’s balance sheet as an intangible asset.

The trouble with goodwill is that it is very hard to measure. If an acquiring company overestimates the value of the target it will book a large value of goodwill on its balance sheet which may have to be written down in subsequent years. But the post-acquisition performance and the value of goodwill is reassessed only sporadically. Investors should be wary of companies which seek to acquire growth with expensive acquisitions, but fail to keep track of those acquisitions’ performance.

Warning Sign 4: Buying growth from unsustainable marketing initiatives

All long-term investors should seek companies which are growing. That doesn’t necessarily mean investors should seek high-growth companies (those which captured the most market attention during the recent bull run), but some form of gradual improvement in revenue, profits and cash flow is important for generating a meaningful return. Companies which operate in growing markets while systematically reporting a ROIC of over 20% are described as the ‘golden egg’ of investing.

But investors should also assess where the growth is coming from and question whether it can be sustained. Companies which buy all their growth through acquisitions (see warning sign three) or invest simply in expensive marketing initiatives which are unsustainable are best avoided.

One company that has been accused of questionable investment strategy is Darktrace (LON:DARK) , the London-listed cyber security company, which is currently in the clutches of a short attack. In the year leading up to its IPO in 2021, Darktrace had spent more on travel and entertainment ($20m) than on R&D ($8.8m). For a company that claims to be developing novel technology to improve cyber security, those figures are hard to justify. Travel and entertainment might be able to help the company sell more software in a given year, but it does not provide long-term benefits. Darktrace will likely have to keep paying hefty marketing costs to maintain its growth - something the short sellers at both Shadowfall and Quintessential Capital Management have been quick to point out.

It should be emphasised that not all the companies which show evidence of these issues are mis-reporting their accounts, but these are warning signs that investors can use to identify the problems.