When I was completing my MBA back in 1996-1999, I read Terry Smith’s very influential book called “Accounting for Growth: Stripping the Camouflage from Company Accounts ”.
While the book was published back in 1992, its points are still very relevant today.
Terry Smith argues that many companies use accounting loopholes and manipulation (not fraud but misleading practices) to inflate profits and hide poor performance.
This means that it is essential to read beyond the headlines of financial reports and (a) focus on cash flow, return on capital, and consistency in reporting, and (b) be sceptical of companies with too-good-to-be-true profit numbers.
The book’s key points were as follows:
- Profit is an opinion, but cash is a fact – Reported profit can be engineered, but cash flow tells the truth. Smith emphasises the importance of operating cash flow and free cash flow. He warns against relying purely on P&L statements.
- Beware of Accounting Policy Changes – Companies often change accounting methods to flatter results (e.g. depreciation, inventory valuation). Smith highlights how changing revenue recognition rules can shift profits forward. Always read the accounting policy notes in annual reports.
- Capitalising vs Expensing – Companies may capitalise expenses (e.g. R&D, marketing, IT costs) to delay them hitting the income statement. This boosts profits temporarily but leads to weaker future returns. Real expenses hidden as assets distort profitability.
- Provisions & Reserves Games – Some companies build up “cookie jar” reserves in good years and release them in bad years to smooth earnings. This disguises true volatility in business performance.
- Depreciation Manipulation – Overly long asset life assumptions reduce annual depreciation, inflating profit. Remember, the asset life should match the useful life of the asset. Smith argues this understates true costs, particularly in capital-intensive industries.
- Off-Balance Sheet Financing – Be careful that companies may hide liabilities via leasing, special purpose vehicles (SPVs), or joint ventures. This masks real debt levels and overstates financial health.
- Earnings Per Share (EPS) Tricks – Companies may buy back shares to boost EPS, even if the underlying performance is weak. Therefore, it is important to note that EPS growth does not always mean better business performance.
- Timing of Transactions – Beware of “channel stuffing” such as early invoicing. Any last-minute sales can artificially boost period-end numbers. Also, look out for large, unexplained Q4 profits.
- Avoiding Tax Is Not Always Smart – Aggressive tax strategies may improve net profits, but create long-term risks. This means that tax provisions that seem too low can indicate future liabilities.
- Complex Structures and Poor Disclosure – Companies that obfuscate details in reporting often have something to hide. Avoid businesses with opaque disclosures or excessive footnotes.
I hope that you found this article helpful, and I welcome any feedback.
Recent Comments