Build or burn?

Profit smoothing

Any finance person responsible for preparing the results in a quoted company knows the pressure to avoid surprises.  I recently listened to a colleague, who had just left such a position, swear that it was absolutely necessary to smooth profits and that anyone who suggests otherwise (my position) is being naive.  Within a year of our discussion, the AIM listed company where he had worked, after years of steady quarterly earnings growth, issued two profits warnings, lost its chief executive and finance director, and became a takeover target.  Such is the fate of companies that engage in too much profit smoothing.

Don’t mistake me for a puritan.  Managing expectations is important.  My beef is that whenever people engage in profit smoothing they become so distracted by the effort they end up more concerned with the reporting process than investigating what the results are telling them.

One of my earliest experiences in management was in a company that was doing very well against its targets.  Business was booming and there was windfalls from currency movements and other welcome developments.  My boss’s proudest story was the year lorries had been parked up around the site on 31 December (our year end), ready to leave the next day.  In this way profit from the sale was recognised in the following year.  Over time the business kept making more money and his schemes for moving profit around became ever more elaborate.  As I recall, the profits being rolled around in this way eventually amounted to about 15% of total annual profit.  By this time, we lost sight of what our true profitability was.  Whatever you might think of the consequences of falling short of market expectations, your finance team flying blind is more dangerous still.

Investment analysts like smooth, reliable earnings patterns but many analysts have never worked in line management positions outside the financial services sector and don’t really know what it’s like.  I recall a director of a blue-chip company dismissing analysts’ criticisms.  At the time I thought him horribly arrogant and out of touch but, as I got closer to his levels of responsibility, my attitude began to soften.  Analysts are bright as buttons and often their analysis is correct but, living inside spreadsheet models, they have little concept of how difficult it is to address the concerns they’re raising.  Being right and having the skills to do something about it are two different things.

Recently the current CEO of Unilever, Paul Polman, told the market he was no longer going to offer earnings guidance.  I read that and thought, ‘Good for him’, but couldn’t help wondering if several layers beneath him there wasn’t someone in the group reporting team that was starting to fidget.

View all blog articles