Accounting for Growth
Subtitled Stripping the Camouflage from Company Accounts; second edition 1996.
Summary
Terry Smith wrote this in 1992 while working as an analyst at UBS Phillips and Drew, cataloguing the accounting techniques British companies used to inflate reported profits. The firm dismissed him after its corporate clients objected, which made the book a bestseller.
The content is a systematic catalogue of twelve techniques and a scoring system applying them to large British companies. The techniques include pre-acquisition write-downs, where an acquirer takes provisions against the acquired business immediately so that future costs bypass the income statement; extraordinary and exceptional item classification, which removed costs from the earnings figure analysts used; capitalisation of interest and of development costs; the treatment of brands as balance sheet assets to support borrowing; off-balance-sheet finance through associates and joint ventures; contingent liabilities excluded from the accounts; changes in depreciation policy; currency mismatching; pension holidays taken when the fund was in surplus, which reduced the reported charge; disposals timed to produce gains; deferred consideration on acquisitions; and stock and work in progress valuation.
Smith scored companies on how many techniques they used, and published the list. Several of the companies scoring highest subsequently collapsed, which is what gave the book its reputation.
The specific techniques are largely obsolete. British accounting standards changed substantially through the 1990s, the Accounting Standards Board addressed most of what Smith identified, and the adoption of international standards changed the framework again. The general method, which is to compare reported profit against cash generation and to treat every discretionary accounting choice as a signal about management, transfers entirely and is what Smith went on to apply as a fund manager.
Key takeaways 7
- Companies used provisions taken against acquired businesses to move future operating costs off the income statement permanently.
- Classifying costs as extraordinary or exceptional removed them from the earnings figure the market used while the cash still left the business.
- Capitalising interest and development costs shifts current expenditure into future periods and inflates present profit.
- Pension contribution holidays taken during fund surpluses reduced reported costs without any change in the underlying obligation.
- Counting the number of aggressive accounting techniques a company uses is itself a predictor of subsequent trouble.
- Several companies scoring highest on the author's list collapsed within a few years of publication.
- The specific techniques have been closed by accounting standards, but the incentive that produced them has not changed.
Who should read it
Analysts and investors who want a documented catalogue of accounting manipulation and the scoring method that identified companies using it.
About Terry Smith
Founder and CEO, Fundsmith LLP 2010-present; previously CEO of Collins Stewart and Tullett Prebon
Accounting for Growth outlived its news cycle as a forensic-accounting primer, and the Fundsmith annual letters are a widely read quality-growth record.
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