Read on Twitter
I just listened to the PI world podcast with Tim Steer and Andy Brough on accounting.
For background, I have spent 8 years working in the big 4 - 4 years in audit and 4 years in M&A so I think I have something to add on the accounting / auditing side.
Thread below//
For background, I have spent 8 years working in the big 4 - 4 years in audit and 4 years in M&A so I think I have something to add on the accounting / auditing side.
Thread below//
I’d like to point out at the start, overall, I thought it was a great podcast.
I agree with almost all of what was said and spent most of the time nodding and agreeing.
I agree with almost all of what was said and spent most of the time nodding and agreeing.
Of course it would be boring to write about that so I’m only commenting where I disagree or want to say something more.
I could write pages on this really, but given it is Twitter, I’ll just stick to where to look for red flags.
I could write pages on this really, but given it is Twitter, I’ll just stick to where to look for red flags.
I'll do another thread on EBITDA later as that was mentioned in the podcast and I think that it is very misunderstood from what I have seen.
Anyway, onto red flags.
Anyway, onto red flags.
1. Where to look for red flags
In terms of the places investors should start looking, it was suggested on the podcast that the balance sheet is the place to start.
There is no right or wrong answer, but it’s not the way I like to start.
In terms of the places investors should start looking, it was suggested on the podcast that the balance sheet is the place to start.
There is no right or wrong answer, but it’s not the way I like to start.
In my opinion, there are two key checks you need to do:
1. Understand the movement in cash vs earnings (short term check)
2. Understand what the accounting judgements are (long term check) - with a particular focus on liabilities
1. Understand the movement in cash vs earnings (short term check)
2. Understand what the accounting judgements are (long term check) - with a particular focus on liabilities
As they said on the show, cash is the only thing you can definitively prove on the balance sheet.
I therefore think it’s logical that you use starting cash and closing cash as your two points of reference.
I therefore think it’s logical that you use starting cash and closing cash as your two points of reference.
There are a number of things that impact how cash moves - earnings, working capital, investment, financing and distributions.
I’d start with the cashflow statement and run down the detailed operating cashflow note and then the rest of the statement
I’d start with the cashflow statement and run down the detailed operating cashflow note and then the rest of the statement
The cashflow will guide you. A cashflow is largely built by calculating balance sheet variances so it does the detective work for you.
If there is a big variance in stock / debtors / creditors / loans / fixed assets etc, the cashflow shows this and tells you where to dig
If there is a big variance in stock / debtors / creditors / loans / fixed assets etc, the cashflow shows this and tells you where to dig
Another reason I prefer the cashflow is that its easier to link the relevant movements together.
Eg if your debtors reduce because you collect the cash, you might then pay off your creditors.
Looking at one or the other on the balance sheet in isolation gives half the picture.
Eg if your debtors reduce because you collect the cash, you might then pay off your creditors.
Looking at one or the other on the balance sheet in isolation gives half the picture.
From my time as an auditor, I can say one thing: When you look at things in silo, its remarkably easy to miss the wood for the trees
Looking at individual balance sheet items doesn’t give that overall commercial picture you need to answer the big q - does this all make sense?
Looking at individual balance sheet items doesn’t give that overall commercial picture you need to answer the big q - does this all make sense?
I’d also point out, it can more easily highlight where there are no real variances.
If the business has grown 10% but working capital as a whole is flat, that is potentially confusing.
If the business has grown 10% but working capital as a whole is flat, that is potentially confusing.
The second check I think you need to do is to understand the extent of management judgements.
As they say on the show, the real risk in accounting is that many balances are judgemental.
As they say on the show, the real risk in accounting is that many balances are judgemental.
It’s really hard (but clearly not impossible) to completely create a fraud from scratch (eg pretend you have sales that don't exist).
Manual adjustments to create sales stand out like a sore thumb in an audit.
Manual adjustments to create sales stand out like a sore thumb in an audit.
Where most fraud / error actually occurs is in that grey area of judgement. It’s much easier to bend the truth than it is to create a new truth from scratch.
Its also very easy to make a genuine mistake when it comes to estimating what will happen in the future (as we know)
Its also very easy to make a genuine mistake when it comes to estimating what will happen in the future (as we know)
All annual accounts include a section on “Judgements and sources of estimation uncertainty” in the accounting policies note.
This is the second place I would look as a starting point.
This is the second place I would look as a starting point.
This note will outline what key judgemental balances management have made in the numbers you are looking at.
You can then see how material these judgements are, which ones matter and go from there.
You can then see how material these judgements are, which ones matter and go from there.
What I particularly want to know is whether there are long term liabilities that management are estimating.
If this estimate is undercooked, some future cash I think is coming to me will actually need to go towards the liability instead.
Thats something I need to know.
If this estimate is undercooked, some future cash I think is coming to me will actually need to go towards the liability instead.
Thats something I need to know.
Bringing it back to the podcast, I’d just say again that overall, I thought the podcast was excellent.
For anyone that wants to learn about accounting in investing, the podcast is a must listen.
I'm also happy to try help with any accounting questions via DM if helpful
For anyone that wants to learn about accounting in investing, the podcast is a must listen.
I'm also happy to try help with any accounting questions via DM if helpful
