By Robert Bruce
Appeared in the The Sunday Times on 20 August 1992
"Analysts should go off and drive buses," said David Tweedie, chairman of the Accounting Standards Board, recently. "We'd all be much safer." Judging by the arguments following the affair of UBS Phillips and Drew and Terry Smith, its suspended head of research, about Mr Smith's book Accounting for Growth, many people hope that analysts will indeed head off. But their motives are rather different to Mr Tweedie's.
He argued that analysts are often useless at best and dangerously misleading at worst. The Terry Smith example shows how effective they could be if they tried. The problem is that criticising companies' accounting policies now seems to be taboo in the City.
Mr Smith's arguments are straightforward and well-known. They were aired early in 1991 in a research document that has been expanded and updated to book length. He summed them up by saying that "the name of the game is making sure your funds are not invested in the next accounting nightmare".
In the conclusion to his book, he takes the arguments further. Like Mr Tweedie, he is dismissive of most analysts' work. "Most stockbroking analysis would seem to have focused upon the magic earnings per share figure and ignored the wider issues of creative accounting used to generate that figure."
He suggests that, in effect, the investor is on his own. "The investor," he argues, "must perform his own analysis. Much of the analysis I have described in this book will lead to questions rather than answers. These questions should be posed directly to the company." If no satisfactory answers are forthcoming, the best course is not to invest. "This is your only effective sanction."
The question is, whether City analysts pay little attention to creative accounting because they are lazy and inept or because the broking firms for which they work have no interest in publishing research which undermines the financial credibility of existing or potential clients.
Mr Tweedie has always presumed the former. When he spoke at an analysts' dinner earlier in the year, he was even more heavily ironical than usual. "Understanding of accounting techniques is a major requisite for the work of the analysts," he said, "and I am delighted so much attention is now being paid to raising the accounting expertise of those analysts who hitherto had not been fully conversant with accounting practice." He then produced an example. "You may find it difficult to believe," he said, "but a few months ago I had to issue a statement that the ASB did not intend to abolish equity accounting in the next few weeks as share prices were apparently falling as a result of such a rumour. Yet equity accounting adds not a penny to a company's cash flow."
On the other hand, Mr Smith's book produces evidence that all the companies, except two, which he highlighted in his 1991 research as using five or more of the creative accounting techniques he identified, suffered in the markets. "With the notable exceptions of Dixons and Next, which performed well in 1991, the share price performance of the other companies has ranged from indifferent to disastrous, with Maxwell Communication Corporation representing a near-certain total loss to shareholders."
It may be that, at last, the markets are taking note of what the figures really mean, rather than following fashions or the hugely overvalued results of analysts' meetings with companies. Mr Tweedie would like what he refers to as "factory visits" banned; and the response of the Scottish chartered accountants to the Cadbury committee on corporate governance suggested it should scrutinise the impact such events had on share prices.
The key is the reality behind the figures. As Mr Smith makes plain in the opening pages of his book, he is more interested in "the impact of these practices upon the clarity of financial information than in whether or not they satisfy the letter of the law or regulation". In the past, most analysts ignored the accounting realities of the quality of a company's earnings. Broking firms, and their clients, were happy about this. Reading between the lines of financial reporting seemed to be of little importance to them. Suddenly, that appears to have changed. Since Accountancy Age published Mr Smith's findings on July 29, it has become obvious how hurt and angry companies become when they are criticised for creative accounting.
The affair may have exposed how feeble most analysts are and how beholden to the official company line they are. But it also suggests that if companies are so defensive and embarrassed about creative accounting, now is the time for audit firms to toughen up and insist that as much of it as possible is stripped out of reported figures.
The author is the associate editor of Accountancy Age.
© The Times