Ignacio de la Torre. Professor. IE Business School
31 March 2013
The controversy now surrounding Pescanova and the differences between its version of its profit and loss account and how the Bank and Spain sees it have once again put creative accounting on the front page.
In a recent communication to the Spanish Stock Market Commission (CNMV), Pescanova stated that “there are discrepancies between our accounting and the bank debt figures, and these discrepancies could be significant”. Pescanova’s profit and loss account showed a debt of €1.522 billion, while the Bank of Spain’s risk information center attributes a debt of €2.5 billion to the same food company, according to an article published recently in Spanish business daily Expansión.
How can these differences be explained?
For many years now companies have used different accounting engineering techniques, which are actually legal, and which permit them to reduce the debt level stated on the end of year accounts.
Let’s take a look at some of the most popular methods, which, for the sake of clarification, are not necessarily those employed by Galicia-based Pescanova.
First, the practice of using suppliers as a source of funding during the last weeks of the year, in order to use the cash to repay bank debt and thus ensure that the statement presented on December 31 looks more presentable. This technique explains why many listed companies systematically present statements with much higher levels of debt in the first, second and third quarters than those of the last quarter.
Second, shifting debt to entities that are not included in the group’s global consolidation, and to which the equity method of accounting is applied. Thus the subsidiary’s debt is not added to that of the matrix company. In order to do this the company has to demonstrate to the auditor that it has no effective control over the subsidiary, and this is often achieved by appointing “independent cronies” or by placing controlling shares under an intermediary. Banks, for their part, gain access to this mechanism if the matrix firm extends a guarantee for an amount equal to the subsidiary’s debt. The result is that the debt disappears from the end-of-year statement, but not from the footnotes, where said guarantee will continue to appear (the past relation between Telefónica and Vía Digital is a good example of this).
Third, the mass use of operative leases to fund assets. Operative leases, unlike finance leases, do not appear on the balance sheet. Thus the debt the company agrees to pay in order to be able to have use of an asset only appears in the footnotes, not the statement. In order for a lease to be considered operative it has to fulfill a series of percentages which tend to be calculated down to the last decimal to ensure that the debt does not appear on the company’s end of year statement, in spite of the fact that for a bank the company is a credit risk. A variation of this technique consists of entering into sale and lease back operations, whereby the company sells assets, pockets the cash paid for said assets that reduce its net debt, and then commits to rent the same assets for a set number of years, ensuring, of course, that said lease is operative. The end result is that debt goes down but the negative part (i.e. the commitment to rent the asset) disappears off the statement and is relegated to the footnotes. Once again, this is a focus of discrepancy between the Bank of Spain’s data and the company’s balance sheet.
How can an investor see such practices at a glance?
First by always remembering that the balance sheet is a snapshot, and before we have our photos taken we always fix our hair, so look at a profit and loss account as a video of a somewhat plain individual who has tried to make him or herself look as good as possible. Thus, if in order to work out a financial debt we limit ourselves to dividing the financial expenses on the profit and loss account by their average financial cost, we will obtain a figure far nearer the real one, which will mean that we can safely ignore the beautified version of the end of year statement. Second, a quick read of the footnotes, particularly those that refer to “commitments”, operative leases, and debt guarantees, can help us to have a much better idea of the company’s real total debt. Third, take a look at the consolidation perimeter of entities consolidated using the equity method (usually set out in a table at the end of the annual report) which will permit you to identify deadweights (firms making losses and with hardly any of their own funds, and where it is possible to store the debt listed in the guarantee note).
The former head of the International Accountancy Standards Board, said some time back that his dream was to travel in a plane that figured in the profit and loss account of an airline. This article provides a few clues about what Sir David Twede was talking about.
Have fun all you finance detectives – there are plenty more clues out there!