Beware of "funny" accounting practices – Leighton Holdings (ASX:LEI)

Although the process of deriving cash flows tends to be mechanical, we should not be sucked into thinking that mechanical equates to easy. What will separate an average valuation analysis from a good one will not be the modelling used, the type of risk analysis conducted, or the disaggregation of every financial account. What makes a good model is the attention to detail and the level of due diligence involved in ones work.

Let's look at Leighton Holdings. Leighton's has had a real hard time of it lately - they were involved in dramas like the Airport Link project in Brisbane and the Victorian Desalination plant, that have resulted in very large write-downs for the company (~$1 billion). In the last four months alone, the contractor has announced three profit downgrades, a staggering amount considering that over the last year economic conditions have begun stabilising. Having disappointed the market already several times this year, it isn't unusual to discover that for the financial year 2010 Leighton changed the way it recorded income from fixed-price construction contracts. Most construction companies use a twenty percent completion rule before profits are recognised, and this was certainly the way that Leighton previously recorded profits. In 2010 this requirement was removed completely.

Generally, firms recognise earnings when a sale is made, however, this cannot really be generalised across all industries. In industries like construction, earnings are generally recorded in stages of completion. This principle is based on conservatism - that is, we should only recognise earnings we expect to receive, and thus where there is uncertainty (i.e. and the construction industry is plagued with uncertainty) we should not be recording profits at very early stages of the construction process.

There is quite a substantial body of literature that investigates the behaviour of management dealing with short-term internal problems. This body of literature shows that management within these firms normally behave in one of two ways: the take a bath approach, or the earnings management (aka creative accounting) approach. The first approach is based on the fact that management, knowing they have missed the street consensus estimate will drop all their bad news into one pot. That is, get rid of the bad news all at once and start from a clean slate. If you miss your estimate, best to miss it by a long way so that next year’s figures only factor in the good news. The second approach is the Leighton approach.

The change in accounting practices adopted by Leighton's increased the group profit by $14 million in 2010 thus helping the firm meet particular earnings forecasts. Although earnings doesn't necessary translate into value, to the ill-informed investor, this change will transmit incorrect signals that will inevitably produce incorrect trading decisions. This change in accounting methods is not something picked up by scanning over financial statements and it certainly paints a steadier picture than the rocky road that the firm has trodden in recent times. It is therefore imperative that we undertake our fair share of due diligence when preparing our valuation analysis so that decisions that illuminate poor internal corporate governance don't result in bad trading decisions.