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The meaning of Valeant’s accounting troubles

Schumpeter

The story and the numbers

The meaning of Valeant’s accounting troubles

IT IS fashionable to lament the vapidity and short-termism of institutional shareholders. Without them, it is argued, companies would invest for the long term, run by their enlightened managers. But a rash of creative-accounting incidents is a reminder that firms may go astray. On October 26th Valeant Pharmaceuticals, a drugs company, tried to rebut claims it was massaging its figures. A day later IBM said regulators were investigating how it books its sales. Tesco, a British grocer, is on the rack after admitting inflating its profits. Shares in Noble Group, a Singapore-listed commodities firm accused of questionable book-keeping, have collapsed. In May Hong Kong’s regulators suspended trading in Hanergy, a solar-panel firm. These episodes have had a brutal impact on shareholder wealth, with a total loss of $80 billion.

The last outbreak of outright book-cooking was in 2001-03 when Enron, MCI-WorldCom and Parmalat were found to be engaged in fraud. Together they had $170 billion of assets and all went bankrupt. So far, today’s scandals are different: the firms are accused not of breaking the law but of creative accounting, or stretching the rules to paint an optimistic picture to outside investors. The specific transactions under the microscope are mostly small. For Valeant, Tesco and Noble they accounted for less than 10% of total sales, profits or assets. Despite this, they have led to an outsized slump in market values. The magnified reaction betrays the mistrust in which many big firms are held.

A firm’s market value is supposed to equal the net present value of its future cash flows. In practice it reflects an unstable balance between two versions of the truth. First, the story managers tell, which is usually self-serving and emphasises their brilliance. Second, the numbers. They can be manipulated but are open to scrutiny. Over the years the gap between these two versions of reality has grown. Many bosses of big listed firms are now practised propagandists, in the same way campaigning politicians are, probably because their pay is linked to the share price. Plain talkers struggle. Lawyers script firms’ every utterance, making it hard to have frank discussions with outsiders. Investors have grown cynical and trigger-happy.

An extreme symptom of these tensions is the advent of firms whose integrity is continually contested, just like the character of a presidential candidate. Valeant is backed by two respected hedge funds, ValueAct and Pershing Square, whose boss, William Ackman, has publicly celebrated it. But Valeant has been accused of creative accounting by both James Chanos, a famed short-seller, and Allergan, a rival drugs firm it tried to buy in 2014. Herbalife, a direct-sales firm, has also been the subject of a war of words on Wall Street. Noble, when attacked by an ex-employee and short-sellers over its accounts, adopted the American tactics of indignant rebuttals and legal threats. Although couched in the politically correct language of transparency, the impression left by such cases is of a bunker mentality.



That some communication by bosses and big firms is now guff, or worse, is a huge regret. Rule-setters can only do so much, leaving creative accountants always a step ahead. In the 1980s and 1990s the most common ruses were the use of provisioning and capitalised costs to understate expenses in the profit-and-loss account, and dodgy pension accounting. Once these were stamped out, the game shifted to issuing debt disguised as equity, as practised by most banks in 2003-08 to disastrous effect. Today, four of the five cases in the news involve dealings with notionally arm’s-length entities—perhaps this is the latest area of innovation. With half of America’s big firms experiencing shrinking profits, the urge to juice the numbers may be rising. The boom in unlisted technology firms with billion-dollar valuations, the “unicorns”, is also a worry. Lacking outside scrutiny, showered with praise and supposedly worth a combined $200 billion-plus, there will surely be a few spectacular frauds. END

You can handle the truth

Yet despair is the wrong reaction, for three reasons. First, not all firms are going backwards. America’s big listed technology firms have long been criticised for their opacity and indiscipline. Some are responding. In April Amazon revealed figures for its cloud-hosting division, AWS, and it has put more emphasis on cash flow. In early 2016 Alphabet (formerly known as Google) will separate the results of its search business from its empire of experiments, which range from virtual-reality goggles to autonomous cars. Both firms have seen a jump in their share prices as investors grow more confident that they, and the managers, understand how capital is being allocated and costs controlled.

Second, there are still reliable ways to identify problem firms. Short-sellers such as Mr Chanos play a vital role. And it remains much harder for firms to fluff up the audited cash-flow figures— which measure the cash coming in less the cash paid out—than profits or the balance-sheet. Four of the five firms in trouble today have had weak cash flow. Other warning lights include repeated changes to the way the business is divvied up in the accounts, low levels of cash tax paid, regulatory investigations, the use of second-tier banks as underwriters, an emphasis on “adjusted” results and “pro-forma” numbers, payments made to other firms with links to the relatives of executives, high debt and serial acquisitions. Valeant is giving off worrying signals on all counts.

Lastly, companies’ books are not being cooked systematically: the aggregate audited cash flows of the S&P 500 index of big firms (excluding financial companies) mirror their reported profits. America’s government statisticians say that listed firms’ aggregate reported profits broadly reconcile with those computed by the tax authorities and those in the national GDP accounts. There will be some accounting implosions. But capitalism, especially in America, suffers from an epidemic of public-relations drivel and legalese, not an epidemic of fraud.

 


Date: 2015-12-24; view: 1018


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