Financial Times: Remembering to play by the book

EXTRACTS: In the wake of the meltdowns at Enron and WorldCom, it was easy to find British voices saying: “It couldn’t happen here.”

Multi-billion pound blue chips have been largely free of reporting controversies since Royal Dutch Shell’s shock revision of its oil and gas reserves in early 2004.

THE ARTICLE

By Barney Jopson,

Published: August 19 2006 03:00 | Last updated: August 19 2006 03:00

In the wake of the meltdowns at Enron and WorldCom, it was easy to find British voices saying: “It couldn’t happen here.”

However, following a cluster of accounting mishaps, the refrain does not ring as true as it once did.
T
Interserve, a support services group, this week suspended six employees following the discovery of accounting irregularities.

Isoft, a software-maker, is facing an external probe over questionable numbers in its accounts while Sanctuary, the music group, is getting used to life without Andy Taylor, its founder and former chief executive, who the company says it dismissed in May over accounting errors and other issues.

The revelations have not shaken market confidence and do not threaten to match those in the US but the unusual confluence of troubles raises questions for investors about whether something rotten in the system is starting to eat away at market capitalisations.

Closer inspection reveals that, while the UK cases share a few points in common, there is little to suggest they can be classed together as a new breed of scandal-in-waiting.

Nonetheless, the cases serve as a reminder that pressure on management to meet short-term performance targets – a prime cause of the post-millennium scandals in the US – is as intense as ever.

In different ways and at different levels, managers appear to have dressed up the success of their businesses. It is reasonable to suspect performance-related pay as a possible influence, says Paul Nagy, European analyst at the Center for Financial Research and Analysis.

“The vast majority of senior management are compensated with stock options, which didn’t used to be so prevalent in Europe, so the share price is extremely important,” he says. “There is a lot of pressure to meet earnings expectations.”

Small-cap investors will also be troubled by the size of the companies involved.

The biggest is Interserve, capitalised at about £360m, which sits close to the bottom of the FTSE 250 index. Isoft is valued at £110m and Sanctuary at just £41m.

Multi-billion pound blue chips have been largely free of reporting controversies since Royal Dutch Shell’s shock revision of its oil and gas reserves in early 2004.

However, market watchers say it is not surprising to find more irregularitiesoutside of the big league. “Smaller companies probably have less developed accounting systems and controls than larger ones,” says Stuart Duncan, financials analyst at Numis Securities.

New regulations also mean multinationals are under more scrutiny. “Larger companies have done a lot of work on Sarbanes-Oxley and International Financial Reporting Standards in the past year and there would have been a lot of accountant and auditor involvement in this,” says Mr Duncan.

In terms of technicalities, the Interserve case is distinct from the other two.

The company, whose services include catering and building maintenance, uncovered misstated accounting balances in its industrial services unit last week, alleged to be linked to the booking of false invoices.

Interserve says it will have to reduce its net asset value by at least £25m from £120m, where it stood at the end of last year, and says some controls in its industrial unit have been “repeatedly circumvented for five or more years”. Its shares ended the week down 19 per cent.

Isoft and Sanctuary, meanwhile, are suspected of using aggressive accounting to recognise revenue too early.

Isoft, which provides software for the NHS, was this month forced to admit as much following an independent investigation by Deloitte.

In June, it announced a change in accounting policies that cut revenues by about £70m in 2005 and £55m in 2004. It denied the irregularities uncovered by Deloitte were connected with those changes. Having seen its share price slump by 90 per cent this year, it is now scrambling to compile its much-delayed results for the year to the end of April.

The auditors of Sanctuary said in February that its accounts for the year to September 2005 had understated the group’s pre-tax losses by almost £16m. Its shares have plummeted more than 90 per cent since the start of the year and, following an official probe, the Financial Reporting Review Panel said in July that there had been “fundamental errors” in the group’s 2004 and 2005 accounts, relating to the capitalisation of costs and revenue recognition.

Recognising revenue too soon, or too optimistically, is a familiar source of accounting problems. “In one sense the question is: do the fundamentals ever change?” says Ken Lee, accounting and valuation analyst at Citigroup. “Each of these things has been around forever and a day. It’s not derivatives. It’s the Plain Jane things. The broad-based principles that underpin accounting are subjective and pressure points still come from how they are applied.”

Surveying the restatements, Mr Nagy does not see anything fundamentally wrong. “If I saw a common thread I’d say maybe there is something systematic but because I don’t see that I wouldn’t consider it to be the beginning of a massive trend.”

Copyright The Financial Times Limited 2006