Edmond Warner Saturday February 16, 2002 The Guardian
Companies and their auditors are splattered with mud. Little of it, curiously, has been flung by stockbrokers and fund managers. The investment community is usually quick to court publicity. Its relative silence on the issue of accounting practices reflects an inner unease that its analysts could and should have done better.
Enronitis is a term that has been coined in "celebration" of the grandiose accounting malpractice that, once exposed, brought down America's seventh largest company. The spread of Enronitis should not be regarded as the wildfire adoption by companies of dodgy financial practices, but as the increasingly breathless pursuit of companies suspected of already having something to hide. This week's victim, in Britain, was Cable & Wireless.
Fully disclosed The telecoms group stands accused of inflating its revenue figures by counting swaps of capacity with other carriers as sales, even though no cash changes hands, and, moreover, of crediting the entire contract "value" in year one, even though the contracts tend to run for many years. The sums involved run to hundreds of millions of pounds.
C&W's defence is that all of this is within the boundaries of British accounting standards, that the totality of cashless swaps is not significant given the group's overall scale, and that its accounting treatments are fully disclosed to investors in its report and accounts.
It might also have added that it is only doing what all of its competitors (many of whom are on the other side of the swaps) are also doing. The stock market worked this one out for itself. C&W shares fell, but not as much as those in other telcos with greater reliance on "revenue" from swaps.
The market's fascination with so-called "hollow swaps" in the telecoms sector is not an accident. Nor, unfortunately for the reputation of the investment industry, is it the result of excellent forensic analysis. Instead, it is the direct consequence of last month's collapse in the US of Global Crossing after one of its former employees chose to blow the whistle on what he alleged to be artificial transactions intended to boost the company's published results.
It would be unfair to expect the analytical community to unearth fraud. But it is surely right to expect it to dig sufficiently deeply beneath the surface of a company's published results to determine whether its business, as reported, is real. Footnotes to accounts are often in very small print because companies want to make it hard for you to read them, not because they are inherently irrelevant.
Of course, one could look to auditors to ensure that company accounts present an accurate picture of businesses. However, it should never be forgotten that auditors are hired and paid by the companies whose accounts they sign off.
In these circumstances it is understandable that, provided accounts conform to the letter of the prevailing standards, signoff is forthcoming. Prudence is in the eye of the beholder. Much of the debate between companies and their auditors boils down to differing opinions as to exactly how far definitions of prudence can be stretched. Footnotes in tiny font sizes can help effect compromises large enough to cover all backsides.
Some investment houses have made a virtue out of an approach to valuing companies that focuses on cash flow. Accounting sleight of hand might shape profits whichever way a management team desires, but it is hard to deny that a cash balance is what it is. No more, no less. Study a company's cash flow return on its investment (CFROI) over time and you can gauge management's ability to make an acceptable return on its investments on shareholders' behalf.
Jettisoned principles This is, in practice, no easy analysis to complete. Cash flows and investment spending in complex corporations are difficult enough for insiders to track let alone those reliant on financial statements buffed up by those insiders for external consumption.
A focus on CFROI also didn't prevent many of its advocates falling under the spell of the new economy at the height of the TMT boom. This may have been because, like many, they simply jettisoned their principles. For some, though, the problem was that investment is all about forecasting. Plugging optimistic forecasts into any model can result in a buy signal.
With many analysts and fund managers among the highest profile "stars" of the City, with all of the attendant rewards, one must ask how the system can fail fundamentally as the current accounting shocks would appear to suggest.
I can only offer two rather general answers. Firstly, given that the infrastructure of the financial markets is based on trust, the scepticism that should lie at the heart of all good analysis is too easily eroded by the ingrained assumption that one's counterparty is sticking to the rules.
Secondly, the market is a greedy place. It is also a brutally competitive one. The consequent hurly-burly rush for returns and reward can easily leave attention to detail in its wake. Let him who is without sin...
Edmond Warner is chief executive of Old Mutual Financial Services