Fund firm says on lookout for accounting shocks
By Jane Baird
LONDON, Jan 5 (Reuters) - British fund manager Schroders (SDR.L) has begun screening big European companies in an attempt to avoid those with imprudent accounting practices that are likely to run into trouble in the economic downturn.
"During a long bull market of the sort we experienced from 2003-2007 we believe the requirement for companies to 'make the numbers' leads to increasing pressure to take an assertive approach to accounting," Patrick McCullagh, Schroders' head of European and UK credit research, wrote in a note to investors.
"Only when the economy begins to contract does the accounting 'spin' become unsustainable, leading to accounting revisions and a collapse in confidence in the company," he added.
The investment manager in late October began developing a shortlist of potential danger signals and, in a trial programme, used them to analyse the balance sheets of a list of big European companies.
McCullagh is looking to the forthcoming results season over the next couple of months to provide an additional year's worth of data and help validate or refine the methodology, he said in an interview on Monday.
Almost every company triggers at least one of this handful of signals, but Schroders is looking for the companies that breach a large number of them when compared with sector peers.
One critical indicator, for example, is any long-term divergence between the growth of a company's net income and its cash flow generation.
"All else being equal, these should run in parallel," McCullagh wrote. "If not, we investigate why not."
The figures may diverge for a period of six to 18 months due to a big contract, he said. But if the divergence persists and cash flow continues to be significantly lower by comparison, Schroders sees it as a danger signal.
IFRS TO BE TESTED
Another potential indicator could be when a generic-looking item on the balance sheet such as "other current assets" jumps a lot from year to year, he said.
He declined for proprietary reasons to describe all of these indicators and the levels that Schroders uses as trigger points.
"Investors are in something of an arms race against savvy finance directors," he said.
Europe is now going through a recession for the first time since the introduction of IFRS (International Financial Reporting Standards) in 2004, and the new accounting framework is now being tested, McCullagh said.
While no such accounting missteps have come to light so far, that does not mean there will be none. "People will have made mistakes; we are sure of it", he said.
Out of 500 companies, Schroders' trial programme identified a couple that tick all the warning boxes. "We are very happy we don't own any", he said. He did not want to name these companies.
"By this time next year a lot of retail investors will be asking their fund manager, 'Why weren't you looking at this?', McCullagh predicted. "It is not rocket science but nobody has been talking about it."
Schroders is trying to identify imprudent, not fraudulent accounting.
"The latter, based on deception, leaves fewer fingerprints," McCullagh wrote. "Nonetheless, I believe our systematic stress on cashflow analysis does pick up some of the signs of corporate malfeasance too.
"It certainly gives us an advantage versus our competitors who approach matters with a greater stress on the P&L (profit and loss), with its greater opportunities for obfuscation and sleight-of-hand," he added. (Reporting by Jane Baird, Editing by Raji Menon)
