Feeding the beast

By Buttonwood

IN HER excellent play about Enron, Lucy Prebble portrays the shadow companies set up by the energy giant as raptors, kept in the basement, but endlessly needing to be fed. It is hard not to think of that scene when reading Tesco's interim results today, which show a fall in pre-tax profits of 92%. The key part of the statement is that

amounts have been pulled forward or deferred, contrary to Tesco Group accounting policies; there have been similar practices in prior reporting periods; the current and prior practices appear to be linked as income pulled forward grew period by period

Full details will await the Financial Conduct Authority's investigation. But anyone who has studied corporate accounts will realise this is one of two familiar issues; profits are recognised early and/or costs are recognised late. It is easy to see how the problem snowballs. Say the company is struggling to meet a quarterly earnings target. Profits are brought forward and the target is met. But of course those profits would have accrued in subsequent quarters so new wheezes need to be found to keep profits rising.

The problem is that accounting is a very subjective business. If you sell goods, some may be faulty and need returning, which will hurt profits. But what proportion? And when? These are not answers to which the question can reliably be known in advance. Under pressure, it is easy to take the optimistic view.

There is a revealing passage in the autobiography of Jack Welch, onetime head of GE, about the Kidder Peabody scandal (when a rogue trader at the group's investment banking subsidiary lost the group $350m) which shows how subjective accounts can be. He wrote that

The response of our business leaders to the crisis was typical of the GE culture. Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap. Some said they could find an extra $10m, $20m, and even $30m from their businesses to offset the surprise.

Readers should be deeply cynical of suggestions that accounts are much more reliable these days and that therefore historic valuation measures, like the cyclically-adjusted or Shiller price-earning ratio, are irrelevant. This is very hard to believe in an era when the short-term incentive to meet quarterly earnings target is so high, because executive share options depend on it; why would this lead to less accounting manipulation than the mid-20th century when the average holding period for investors was measured in years, not months, and executives got paid regardless of the share price?

One study, for example, found that nearly half of all companies shifted their financial year end by a month or two between 1993 and 2008. When this happens

Companies tend to report disproportionately high recurring operating expenses, such as the cost of goods sold, as well as high selling, general and administrative expenses (SGA) in the missing months, the study found. In fact, a subset of 224 companies in the study reported an an average extra after-tax loss equal to 4.7 percent of beginning book value of equity per month in the missing-month period.

A further irony is that analysts want to eliminate the 2008 earnings numbers from the Shiller comparison because they artificially deflate the figures. One would have thought that a period of steadily rising profits, followed by a collapse, is a pretty good indicator that earnings manipulation is afoot. James Montier of GMO dealt fairly neatly with this issue in a recent note (this is a link to the website, look for the CAPE crusader piece)

Another current criticism of the Shiller P/E is that the impact of goodwill impairment accounting (FASB 142) has led to a situation in which earnings are much more volatile than has been the case historically, thus invalidating the earnings series that underpins the calculation.

To some extent this criticism is already rebutted by the analysis above: 10-year average earnings are significantly above their trend. This is not suggestive of a situation whereby average earnings are being dragged down by the very low numbers recorded during the Global Financial Crisis. Much as it is tempting for those of a bullish nature to focus on the extent of the drawdown in earnings in 2008, they happily ignore the peak levels of earnings seen before the crisis, or indeed the rapid recovery in earnings (helped as it was by the suspension of FASB 157 on financials’ mark-to-market assets). This is why we average – it smooths out the highs and lows.

The volatility of reported (GAAP) earnings is neatly captured in a paper that compares them with the profits numbers reported in the national accounts (NIPA). It finds that

Using a sample of aggregate GAAP and NIPA earnings over 1950-2010, the main findings are as follows. GAAP and NIPA earnings are in remarkable sync in the early years, with similar means and standard deviations, and with earnings changes correlating at 0.89 during 1950-1980. This close relation greatly deteriorates, however, during the second half of the sample, 1981-2010. While the behavior of NIPA earnings remains roughly the same over these two periods, the volatility of GAAP earnings increases ten-fold, and the correlation between GAAP and NIPA earnings changes falls to 0.35. Additional tests reveal that the increase in the volatility of GAAP earnings is mostly due to rapid earnings reversals, and especially the effect of large transient items during economic downturns

Some of this volatility may indeed be down to the use of mark-to-market accounting which means that changes in asset prices can affect the numbers. But why should that make one more relaxed about today's profits? First, the last 15 years have shown that asset prices can change abruptly and second, central banks have done their best to prop up asset prices since 2008. Bulls also argue that there is no need to worry about the high ratio of US corporate profits to GDP because it is partly down to overseas profits. But that is another odd argument when the main worry in the markets is that the US economy is doing so much better than elsewhere.

What investors should take from the Tesco saga is a degree of caution. That Britain's premier retailer, one of the most widely held stocks that is followed by almost 50 analysts can restate its profits so dramatically, is a sign that it can happen anywhere.