A group of investors including Sarasin, Legal & General, Hermes and the UK Shareholders Association (UKSA) has written to Sir Donald Brydon who is undertaking a review of the audit market. They have yet again raised the question of whether the International Financial Accounting Standards (IFRS) are consistent with UK company law. In particular they question whether profits are sometimes being recognised, thus allowing the payment of illegal dividends. The particular issue is whether profits can arise on certain transactions under IFRS from transactions between parent and subsidiary companies or by the use of “mark to market” accounting. The problem is “unrealised profits” that might turn into cash in the future, but may not.
This may appear a somewhat technical question, but it can in practice lead to over-optimistic reporting of profits, leading to excessive bonus payments to managers, and the general misleading of investors. Actually calculating when a dividend can be paid as dividends are not supposed to be paid out of capital is not easy and is not self-evident to investors. The published accounts do not make it obvious. Regular mistakes are made by companies requiring later “whitewash” resolutions to be passed by shareholders. The ICAEW has previously rejected complaints on this issue but it is surely an area that requires more examination.
Incidentally I was reading a book yesterday entitled “White Collar Crime in Modern England” (from 1845-1929) which is most enlightening on common frauds that arose when limited companies became popular – many of the frauds still persist. In the “railway mania” of the 1840s it was common to set up companies and raise the capital to build a railway when the chance of it operating profitably was low. To keep the share price high, and the directors in jobs, dividends were paid out of capital. To quote from the book: “unscrupulous directors could easily pay dividends out of capital undetected – projecting a false image of profitability and enticing further investment in their lines”. That was an era when auditors did not have to be accountants and were often simply the directors’ cronies. Standards and regulations have improved since then, but there are still problems in this area that need solving.
There was an interesting discussion on Twitter recently on Burford Capital (BUR) with regard to their accounting methods. Not that I am an expert on the company as I do not hold shares in it, but as I understand it they recognise the likely future settlements from the litigation funding cases they take on. In other words, they estimate future cash flows based on projections of likely winning the case and the possible settlements. As I said on Twitter, lawyers will often tell you a case is winnable but they will also tell you the outcome of any legal case is uncertain.
It’s interesting to read what Burford say in their Annual Report under accounting policies where it spells it out: “Owing to the illiquid nature of these investments, the assessment of fair valuation is highly subjective and requires a number of significant and complex judgements to be made by management. The exit value will be determined for each investment by the contractual entitlement, the underlying risk profile of the litigation, a trial or an appellate outcome or other case events, any other agreements in respect of settlement discussions or negotiations as well as the credit risk associated with the investment value and any relevant secondary market activity”.
The auditors no doubt scrutinise the reasonableness of the estimates but any outside investor in the shares of the company will have great difficulty in doing so.
Neil Woodford’s Equity Income Fund has a big holding in Burford Capital. I commented on the Woodford Patient Capital Trust yesterday here: https://roliscon.blog/2019/06/11/woodford-patient-capital-trust-is-it-an-opportunity/ and suggested the Trust made a mistake in naming the Trust after him. It makes it more difficult to fire the manager for example. But the FT reported this morning that the Trust has indeed had conversations about doing just that. Woodford’s firm has a contract that only requires 3 months’ notice which is a good thing. At least they can keep the “Patient Capital” moniker because investors in this trust have already had to wait a long time for much return and it could take even longer to improve its performance under a new manager. But as Lex in the FT said, “patience is now in short supply” so far as investors are concerned.
Another major item of news yesterday was soon to be ex-Prime Minister May’s commitment to enshrine in law a target for net zero carbon emissions in the UK by 2050. This is surely a quite suicidal path for the UK to follow when most other major countries, including all the big polluters, will be very unlikely to follow suit. Even Chancellor Philip Hammond has said it will cost about £1 trillion. It will effectively make the UK completely uncompetitive in many products with production and jobs shifting to other countries. We might become the first really “de-industrialised” country which is not a lead that many will follow, and it will actually be practically very difficult to achieve if you bother to study what is required to achieve zero emissions. It will completely change the way we live with the transport network being a particular problem (trains, planes and road vehicles).
As I have said before, if we really want to cut air pollution and CO2 emissions, then we need to reduce the population as well as rely on such wheezes as electrification of the transport and energy systems. Mrs May’s last act as Prime Minister might be to commit the UK to economic suicide. It might not be a good time to invest in UK manufacturing companies.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
Actually Burford make clear that the balance sheet valuation of a case, is only marked up to Fair Value after and if there has been a significant judgements/evidentiary events, (like partial sales of owned interest in the secondary market. What they do NOT do is to make projections of final settlement outcomes and book those – there has to have been a crystallising event of some kind . Even then, the case is not marked up to some arbitrary aspirational final settlement. The 3rd party which buys an interest in the case presumably expects the final settlement to come in at a level somewhat in excess of the level they paid for that interest. Furthermore, the instances of them needing to write back partial profits that were wrongly taken, are (we are told by the Co) extremely rare. Arden, the Co brokers had this to say in their note of 03 May…….”Aggressive fair value accounting: We are aware of the varying fair value accounting policies of the litigation funders and provided detailed analysis in our March note, ‘Litigation, litigation, litigation’. We remind investors that a) should litigation funders have the appropriate inputs to fair value a case then they must under IFRS9 and
b) Burford have historically been conservative in their valuation. To reflect the lack of a
liquid secondary market Burford have historically only recognised 33% of total income one year prior to conclusion and only 0.2% of write-ups have ever turned into a loss.”
Freddie, There is some more info in the company’s annual report about the revenue recognition of outstanding cases which you may find worth reading. I believe that Cannacord have also raised the issue.
But to my mind, valuing a legal case that has just started, or is still in progress, is exceedingly dubious. There is no certainty of future cash flows until the legal case is completed, i.e. a final court award (after all appeals have been exhausted) or a settlement agreed with a credit worthy counterparty. There may be events that help to strengthen the case, i.e. preliminary judgements over parts of the case, but that does not alter the basic problem of judging the uncertainty of winning the case. The fact that some other punters are willing to bet on it, is hardly relevant.
But as I said, I am not an expert on the company and perhaps they are being conservative and prudent. But personally I am always wary of companies who recognise profits much before they receive the matching cash.