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Can investors rely on audited financial statements?

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A British politician famously tried to distinguish between misleading impressions and lies by saying the former was perhaps being “economical with the truth”.

More recently, US counsellor to the president, Kellyanne Conway hit back after various media houses questioned her employer’s claim that the crowd at President Donald Trump’s inauguration was the biggest on record, saying the White House was presenting “alternative facts”.

So writes Ingè Lamprecht on Moneyweb.

The sad reality is that lies – whatever you would like to call them – are common, not just among those desperate to appease voters, but also among the management of corporates.

Just how sceptical investors have to be when presented with a set of “facts” was recently highlighted after furniture retailer Steinhoff International admitted that “accounting irregularities” would require its financial statements going back to at least 2015 to be restated.

Which bodes the question: To what extent can fund managers (and by implication investors) rely on audited financial statements when performing due diligence?

Iain McCombie, chief of investment staff at Baillie Gifford and a chartered accountant, said fund managers have to be cautious.

“The fact is if the audit was wrong, the auditors will say ‘well it has nothing to do with us’. You can’t be sued. So, one must be quite sceptical in some respects about the quality of it,” he told delegates at Glacier International’s Navigate Seminar.

But asset managers have to start somewhere, and his team did scrutinise financial statements as part of its process. They want to invest in companies with good financials.

“We don’t like companies with leverage particularly.”

Rob Forsyth, head of research for the quality team at Investec Asset Management, said while fund managers have to start with the audited financial statements, it is not the be all and end all.

Managers have to do fundamental analysis and consider the risks. His team uses various statistical measures and generally don’t invest in initial public offerings as these firms often don’t have an adequate track record to examine. It also analyses the cash flow and returns of a business over time to ensure that the earnings are backed up by cash flow.

“If you can get some degree of comfort on the return profile and the cash flows that the company is producing you can try and reduce your risk, but outright fraud – it is almost undetectable,” Forsyth said.

Alex Tedder, head and CIO of global and US large-cap equities at Schroders, said unfortunately managements do lie and auditors do not stop them.

“It just happens time and time again.”

Tedder said he strongly believes in considering environmental, social and governance (ESG) factors when analysing companies. Fund managers have to spend a lot of time analysing what companies are saying and cross-check it.

His team is also engaging a lot more with the companies that it invests in globally.

Asked whether a highly acquisitive company is a warning sign, Kevin Johnson, vice president at Dodge & Cox, said it could be, but it isn’t always the case.

“It depends on the company. It depends on the management. It depends on the industry. We would say that you learned a lot by looking at history.”

Some managements have demonstrated a very strong record of allocating capital at the right time for acquisitions.

“We would not conclude that just because they’ve acquired a lot they are necessarily destroying value. It really depends on whether they [are] making acquisitions at the right time and that is really a qualitative thing. We think it is hard to generalise too much,” Johnson said.

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