Looking at Libya and accounting lies

Well travelled readers may be familiar with the ancient city of Leptis Magna (pronounced Lepcis Magna). It was located on the Mediterranean Sea near the modern Libyan city of Al Khums. Associated with the Roman empire for more than 600 years, Leptis Magna housed huge and elaborate Roman-style baths, the remains of which can still be viewed today. But, in this article, we’ll be focusing on a different type of elaborate ‘big bath’—a financial one.

www.investopedia.com explains the concept of a financial big bath nicely: ‘The strategy of manipulating a company’s income statement to make poor results look even worse. The big bath is often implemented in a bad year to enhance, artificially, next year’s earnings. The big rise in earnings might result in a larger bonus for executives. New CEOs sometimes use the big bath so they can blame the company’s poor performance on the previous CEO and take credit for the next year’s improvements.’

Good summary

That’s a pretty good summary of a practice that’s been going on for decades. In the 1934 edition of Security Analysis, Ben Graham wrote: ‘An examination of the wholesale charges made against surplus in 1932 by American Machine and Metals … suggests the possibility that excessive provision for losses may have been made in that year with the intention of benefiting future income accounts.’

Take a trip across the Pacific Ocean and fast forward 71 years to the 2003 financial accounts of AMP. In that year the financial services giant recorded a loss of more than $5.5bn. Buried in the footnotes of that gigantic sea of red ink (footnote 2 relating to note 5 to the accounts on page 35 of the full financial report) was the following disclosure: ‘Operating expenses in 2003 includes (sic) $558m of restructuring and demerger costs. The costs comprise $197m of Staff and related expenses, $74m Information and communication, $112m Professional fees, $146m Occupancy and property maintenance, Advertising and marketing $21m and $8m Other operating expenses.’

That poorly-worded footnote begs the Goldilocks question; was $558m too much, too little or just the right amount to provision for these ‘restructuring and demerger costs’?. It’s a question that can’t be answered definitively and, in a sense, it doesn’t matter in any case.

In our namesake, The Intelligent Investor, Ben Graham explained: ‘In former times analysts and investors paid considerable attention to the average earnings over a fairly long period in the past—usually from seven to ten years. This “mean figure” was useful for ironing out the frequent ups and downs of the business cycle, and it was thought to give a better idea of the company’s earnings power than the results of the latest year alone. One important advantage of such an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits. They should be included in the average earnings.’

Graham’s reason for including such ‘special charges’ in average earnings was that ‘certainly most of these losses and gains represent a part of the company’s operating history.’

Not always a loss

While they often do, big baths don’t always coincide with huge bottom line losses. Take the accounts of National Australia Bank for the half-year to 31 March 2005. The bank’s $2.5bn net profit was up 17% on the prior year—not the kind of result you’d associate with big bath-type accounting. But the fine print revealed that NAB recorded a $1.1bn after tax profit on the sale of its Irish banks while simultaneously making a plethora of negative provisions.

Interestingly, we also counted no less than three separate reversals of prior year provisions. These are the kind of things shareholders should keep an eye out for in the years following a big bath. Like an archaeologist exploring the ruins of Leptis Magna, sometimes you need to dig below the surface to arrive at the truth about a company’s accounts.