LONDON -- Investors ought to know something about company accounts. You don't need to go to the extreme of qualifying as an accountant, or something similar that's even more exciting, but if you can't follow the basics of a profit and loss account and balance sheet, it's like being in a boxing match with one hand tied behind your back.
That said, when you understand basic accounting, you'll soon discover that there are many instances where the accounts do not paint a true and fair picture. That's because the figures often place wildly incorrect valuations upon certain assets -- notably brands.
Every year, companies are required by law to publish their statutory accounts. These are usually buried in the middle of their annual reports, after the management's commentary (which often reads like an advert) and before the often extensive and sometimes impenetrable notes to the accounts.
The problem investors face stems from the fact that accounting rules limit what companies can say in their accounts and so the values placed upon some assets can be highly misleading.
Accounting for brands
Let's say MegaCorp has patented a wonderful new product that cost 10 million pounds to develop and is expected to produce at least 2 billion pounds of profits a year for the next 20 years. So what is it worth? Tens of billions, according to the market, but MegaCorp's formal accounts won't value it at more than the 10 million pounds spent developing it.
Yet if MegaCorp sold all of the rights to this product to another company for 20 billion pounds, most of the purchase price would appear on that other company's balance sheet as goodwill. If MegaCorp then bought back the rights for the same price, it could then put 20 billion pounds on its own balance sheet.
Welcome to the world of brand accounting, where things are often worth nothing until they are sold!
Value mysteriously appears
If you've ever wondered why many companies' shares trade at a substantial premium to their net asset value, such as those of pharmaceutical group AstraZeneca, most of the difference is because the formal accounts fail to reflect the value of their intangible assets -- items such as brands, trademarks and patents.
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It's not unusual to come across a company whose pension scheme is worth more than the company's market value. Yet in most cases all you will see on its balance sheet is the difference between the scheme's assets and its liabilities.
So a company worth 400 million pounds that has a 1 billion-pound pension scheme with 1,002 million pounds worth of scheme liabilities will probably only put the 2 million-pound net scheme deficit on its balance sheet. Unless you looked closely at the notes to the accounts you'd miss the fact the pension scheme is worth more than two times the company's market value.
Another thing to watch out for is that changes to the scheme's surplus or deficit don't need to go through the profit and loss account. Pension issues have always put me off buying shares in defense contractor QinetiQ as it feels as if whatever the company makes in operating profits is gobbled up by the group's retirement scheme.
Pizza and oil
One of my larger shareholdings is Yum! Brands (NYS: YUM) , the owner of the KFC and Pizza Hut restaurants. Yum! Brands has been very successful in China and a major reason for this progress has been its superb distribution network. Needless to say, this network can't be valued in the accounts though if someone else bought Yum! Brands it would appear in their accounts as goodwill.
Another sector where the accounts don't reflect the true worth of an asset is oil. That's because the value placed upon an oil company's key assets, its reserves of oil and gas in the ground, is based upon the cost of finding them rather than their market worth.
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Problematic property valuations
Sometimes a company will value an asset by using the price paid rather than its market value. Normally the stock market takes this into account by marking up the shares, but it's possible if you read enough annual reports to find a company where this isn't the case. The most common example tends to be property assets that were bought many years ago and are still valued in the accounts at cost.
If the stock market hasn't marked up the company's shares to allow for this discrepancy, you may have stumbled across a real bargain!
Of course, the large property companies, such as Land Securities, regularly review the value of their properties, and update their accounts accordingly, but this is because property is their business and their shareholders like to have some idea of market valuations.
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The article Where Company Accounts Get It Wrong originally appeared on Fool.com.
Tony owns shares in AstraZeneca and Yum! Brands. The Motley Fool has adisclosure policy.
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