Appeared in The Sunday Times on 16 August 1992
Terry Smith starts his controversial book with a question posed to him by his friends outside the City. "XYZ company went bust last week, but it was making profits. How can that happen?" How indeed?
On September 3, 1990, Polly Peck, the consumer electronics group, reported pre-tax interim profits of £110.5m, a rise of 71.4% on the previous year. Two weeks later, its shares were suspended after a raid by the Serious Fraud Office; and in October, administrators found that an immediate liquidation of Polly Peck would have produced a deficit for shareholders of £384m.
How can a company that produces half-year profits of £110.5m be worth minus £384m? At least part of the answer, as Smith argues, is "financial engineering" or dodgy accounting as it used to be called. Polly Peck is an extreme example, but even many reputable companies have adopted new-fangled accounting techniques to boost stated profits. At best, the result is a lack of comparability between the accounts of similar companies. At worst, the new techniques can give a completely misleading impression of a company's financial position.
It is surely no coincidence that many of the
firms identified by Smith as pioneers of financial engineering have
subsequently stumbled. They include LEP, Maxwell Communication Corporation,
Asda, British Aerospace, Ratners,
Admittedly other companies identified as
among the worst offenders such as Grand Metropolitan, Ladbroke and
What should be done? The first necessity is to regularise accounting practices. As long as the accounting guidelines allow companies to inflate profits by juggling the numbers, competitive pressures will ensure they do so. This is not a matter of honesty or dishonesty, just practical reality.
Acquisition accounting is one area that needs particular attention. Under present rules, it is often virtually impossible for investors to distinguish genuine profits growth from accounting trickery.
Equally important is the need to give accounting firms a stronger incentive to police the finances of companies more effectively.
With accounts worth millions of pounds on the line, auditors are highly reluctant to qualify a firm's accounts or raise any public queries about its practices. As a result, the public is kept in ignorance about potential disasters.
One solution would be to make it easier to sue accountants for negligence. At the moment it is virtually impossible, and incredibly expensive, to win a case against an accounting firm because the standards of proof are so tight. If they were relaxed, accountancy firms would have a strong incentive to blow the whistle.
The other issue arising from the Smith controversy relates to the conflicts of interest at all-service investment banks. UBS Phillips and Drew's attempt to stop publication of Smith's book, which is based on a broker's report he prepared for the firm, is reprehensible.
It follows a similar incident last year when Derek Terrington, a media analyst, left Phillips and Drew after Robert Maxwell attacked a circular he wrote about Mirror Group Newspapers. Despite UBS's denials, the suspicion must be that it is interested only in research that does not offend its corporate-finance clients.
It is not the only guilty party. Barclays de
Zoete Wedd also withdrew a research note after complaints from several of the
leading companies it mentioned. Such things are not supposed to happen because
of the "Chinese walls" between research and other areas, but the
lesson of the Smith affair is that investors should treat Chinese walls with
the same scepticism as company accounts.
(c) The Sunday Times