Playing with Accounting Profits

The following is a case example of how to do accounting, corporate style, and get away with playing numbers.  All this is perfectly legal, and a reminder why we should not be taken in by the apparent numbers of a balance sheet, or any reports of profit and loss.

In early December 2012, SIA announced the sale of their entire 49% stake in Virgin Airlines to Delta for 360 million.  They bought this stake in December 1999 for $1.65 billion.  According to the press release, and the stock exchange filing, SIA booked a $322 million profit from the sale, after accounting for the writedown of its investment.  In summary, they sold the stake for a loss of $1.3 billion, yet recorded a net profit of $322 million.

Firstly, Virgin Atlantic is a private company.  That means its shares are not traded on any exchange, and there is no means to independently verify the value of the shares.  As such, when SIA bought those shares, they could value them at whatever number they wanted, as long as they could justify it.  I use the word “justify” very loosely.  SIA had the right to value the shares on its balance sheet according to its most optimistic assessment of future value.

The problem here is that to book the transaction at a profit of $322 million, on a sale of $360 million, this meant that the shares were valued at $38 million.  This is less than 2% of the value it paid for the same shares.  This level of accounting shenanigans is Enron-style booking profits.  By itself, there is nothing wrong.  But if there is a firm that does this with some regularity, it means that company is on the decline, and on the road to administration.  Eastman Kodak is an example that comes to mind.

Muddy Waters Research, in a report on Olam International, noted that the large growth of accounting profits relative to real profits is a cause of investor concern.  Olam International was eventually acquired by Temasek Holdings.  Temasek Holdings is a significant investor in SIA.  The significant growth of unlisted assets is an accounting staple in various companies under Temasek Holdings.  In the same period, we must also remember that SIA bought 25% of Air New Zealand.  They also wrote down the stake to oblivion.

Another point of consideration is the fact that in 2012, the year of the sale, Virgin Atlantic had $5.4 billion in revenue, on an operating loss of $158 million.  These are the numbers of a healthy airline having a difficult period.  To writedown the value of the stake to 2% of the purchase price is problematic.  This is certainly not a fair reflection of the value of that 49%, and looks designed to create an accounting profit.

I will not speculate on the reasons why, but I will say that it is useful.  Most investors never look at the story behind the numbers.  They see a profitable company, they invest.  Hyflux is an example of how well this strategy has worked.