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Analysis: dining out on the small print – how fund managers can find hidden gems in corporate accounts

According to Adam Rackley, Fund Manager, VT Cape Wrath Focus Fund, when fund managers are looking to spot the hidden gems in company accounts that inform their investment decisions the biggest issues are often in the tiniest font

As a young-buck equity analyst, my favourite book was Terry Smith’s ‘Accounting for Growth’.

Beyond an interest in accounting shenanigans, I enjoyed the backstory of one of the best-known figures in British finance. The book is a truth-to-power narrative that got Smith fired from – and sued by – UBS Phillips & Drew. Many of the book’s case studies were drawn from his employer’s corporate clients.

Recognising that the tasty stuff is typically buried in the small print, Smith advocated reading accounts from the back. If you ever think to invite me to dinner, be forewarned that much of my day is spent reading accounting endnotes.

Purplebricks, the UK’s largest online estate agent, came onto our screens because it was trading at net cash, with the shares having fallen over 95% from their peak. Here are some choice cuts from the company’s latest report and accounts.

Revenue recognition

International Financial Reporting Standard 15 (IFRS 15) – forgive the catchy name – requires that a company’s revenue recognition be consistent with the delivery of ‘performance obligations’ to the client.

Purplebricks applies this revenue recognition to the sale of property. From the customer’s point of view, the performance obligation is selling the property. Photos, floorplans, listings and viewings are necessary expenses, but not the objective of the exercise. The company acknowledges this by offering a money-back guarantee if a property fails to sell or achieve an acceptable offer within ten months. However, the accountants at Purplebricks argue that the performance obligation is the process of marketing the property, rather than the ultimate sale.

This approach allows revenue to be recognised sooner, while also introducing a meaningful degree of subjectivity. If the company decides to assume a shorter marketing period, revenues are recognised more quickly, with increased profits in the current period, but a reduction in profits in future periods.

In the six months to October 2021, instructions fell by 38%, but revenue came in only 7% lower thanks, in part, to an assumed reduction in the length of time it would take to sell those properties. While of benefit to the income statement, this assumption also left its mark on the balance sheet and cashflow statement with a £4.6m cash outflow to deferred income, a stark contrast to the £7.1m inflow during the previous year.

As such, it can be argued that Purplebricks’ revenue recognition is at odds with the reporting standard, with the substance of the agreement that it has with its customers and with the practice of other listed estate agents like Foxtons. As a result, I believe that a restatement is inevitable.

In response, a Purplebricks spokesperson said: “The policy has been applied consistently since the introduction of IFRS 15 and is part of our audited / reviewed financial statements. Following the introduction of the Money Back Guarantee, revenue is constrained to the amount which we do not expect to refund to customers under that arrangement.”

Factoring receivables

In its 2021 annual report, Purplebricks outlines how the debt arising from customers who choose to pay later is sold on to a factoring firm, at a discount to the face value of the debt. This allows Purplebricks to get cash into the business sooner, whilst making any bad debt issues someone else’s problem. On paper, this is a good idea, particularly if you have cashflow issues. Firms that factor their receivables usually do. But Purplebricks was sat on £58m net cash at the half-year mark, and factoring is expensive. In the 2021 financial year factoring cost Purplebricks £4.7m. That’s 5.2% of revenues.

Given that an estate agent aspires to 10% margins in a good year, and the fact that Purplebricks doesn’t need the cash, the question is why factor? By factoring, the company is pretty much condemning itself to be eternally loss-making. So, there must be a good reason for doing it.

The reason, I suspect, is that a meaningful number of ‘pay later’ customers are bad or non-payers. Without factoring, the firm would instead have to take a bad debt provision, which would be an operating cost. However, factoring receivables is a financing cost, which pushes this £4.7m charge below the line. In other words, the only thing worse than a £4.7m factoring charge below the line, is a £4.7m bad debt provision above the line.

In response, a Purplebricks spokesperson said: “Collecting debt is a specialist skill and is not a core process of an estate agent. It would have required considerable investment in central overhead which was not the right one for the business at the time. It also provides a significant cashflow benefit for the business.”

Unlike the proprietary information used by many institutional investors, accounting endnotes are freely available. When developing an investment thesis, these notes are an important piece of the puzzle. Getting to grips with them can make, or sometimes save, investors a lot of money, which is why reading the accounts from the back should be an essential part of every investor’s toolkit.

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