Tunnocks, makers of the eponymous caramel wafers has reported a 44 per cent increase in profits.

When we hear so much about banks diversifying away from their core business, here is success found by concentrating on what you are good at. Or to put it another way, a great advert for ‘stick to the knitting’.

Tunnocks last introduced a new product (the delicious Tea Cakes) over fifty years ago. That is a prudent strategy by any stretch of the imagination, but one that is clearly paying off.

Of course, problems may lie ahead, most notably with increases in input prices. However, it appears that the company, established by Thomas Tunnock in 1890, is well placed to weather the economic storm.

However, how it deals with the Government`s latest “Change for Life” healthy living wheeze is another matter. It appears that fruit not Tunnocks must now be the order of the day.

In this household at least Mr Tunnock has no need to worry. Those packs of pleasure will continue to be devoured. Dear Minister, please understand that this is purely for the sake of animal welfare – a cat that just loves to play football with the rolled up wrappers.  

Forget the profit and loss; forget the balance sheet he in effect said. To understand business performance the cash flow is where it is at.

How true.

I give two reasons why I believe this cash flow approach to performance appraisal may increasingly become a point of focus.

1) The need for cash

Over the Christmas period news reports have highlighted how keen/desperate the retailers have been to generate cash in order to pay their quarterly rent bills. Forget the profit; just get cash in those tills.

So, prices have been slashed to the bone, possibly eliminating any hint of profitability but at least getting moolah into the coffers to ensure survival (if only temporarily).

2) The problem with profit

Of course profit is great, but what actually is profit? This really is an accounting challenge of our times.

The banking crisis of 2008 has highlighted the impact of our accounting rules on asset valuations and hence earnings. My previous post on pension schemes highlighted the impact of those rules on actuarial valuations and hence profitability.

Valuations are not the same as cash flows.

In short, profit is an amalgamation of so many choices, judgements, estimates, and calculations. Arguably, profit is becoming an increasingly complex concept to understand, and one which needs to be supported by more and more notes in the financial statements. This is unfortunate.

The cash flow statement quite simply is more objective. It strips out the impact of subjective estimates, valuations, etc.

It shows clearly how much cash has been generated (for example through day-to-day operations, raising finance, selling capital equipment) and how much has been utilised (for example by paying back debt, paying dividends on shares, paying pension contributions, replacing capital equipment).

This objectivity may well allow for a clearer analysis of past performance and from that, future expectations. In short, cash flow gives clarity. If ever there was a time for clarity then surely 2009 is it.

Already it has been reported in the press how the valuations of the final salary schemes run by British Airways may scupper their proposed merger with Iberia. BA`s schemes are due to have their actuarial valuations in March. This is not timely enough for Iberia, so they are employing their own consultants to value the schemes now. The reason for this urgency is a) to determine the size of the pension deficit b) to decide from the results of a) whether to pull out of, or renegotiate the merger terms (at the moment the merged entity is to be 65/35 in BA`s favour). Getting together is never easy.

(On a similar note, HBOS pension scheme trustees are prepared to challenge the Lloyds TSB merger over concerns about the ownership of the final salary deficit).

So, what is an Actuarial Valuation? Well, according to our accounting rules, a company must undergo an exercise to estimate the current size of its pension liability i.e. the size of the net obligation it has accumulated to pay out future retirement benefits.

How does this liability come about? Simple: as scheme members provide service to the company through their work, they become entitled to a future retirement pension. The longer they work the more benefit they accrue. This benefit generates a liability for the company. The company pays contributions into the scheme from which assets (such as equities) are purchased. Those assets will be used to pay the retirement benefits.

The value of the liability and the value of the assets are determined, and the resulting net figure is recognised om the company`s balance sheet.

At any one time, if the valuation of the assets exceeds the valuation of the liabilities then the company has a net pension surplus (and is good news for the balance sheet). Of course, if the reverse is true then the company has a net pension liability (and is bad news).

Why is this so important and why the highlighted words?

Not so simple.

For a start, by definition if asset values fall (as of course they are doing) the net pension situation reported in the balance sheet will deteriorate. A loss for this decline must be reported. Not good news for companies, especially when balance sheets are already being hit by stock write-downs, bad debts, trading losses (and debt covenants are near breaking point)

How the loss is reported depends on whether UK or International rules are followed as well as other choices within each set of rules. Not good for comparability or analysis.

The liability is based on future expectations of many variables determined scientifically by Actuaries. For example: future expectations of growth, inflation rates, interest rates, leavers, joiners. The asset values are based on market values which in these volatile times are likely to be immediately out of date.  Not good for comprehension this, especially when the amount that a company contributes to the scheme each year may bear little resemblance to the overall balance sheet position.

After September 11^th asset values took a mauling. Largely since then they have seen years of continuous improvement.

And then along came 2008.

Amazingly, it has been reported that the 200 largest private final salary schemes ended the year in surplus to the tune of £3 billion, turning around a £2 billion deficit at the year start.

Remember, what goes up ….

According to reports, he believes this accounting requirment should be suspended, and that it lead to the demise of Lehmans and Bear Stearns. Possibly so.

I do so hope that more financial big wigs will come forward with their views on this issue.

As I mentioned in my earlier post, this is such a complex area, and it may be that because of the current crisis, accounting convergence takes a big big big step backwards (which would be a shame) in the near term.

But, if more discussion of accounting rules is in the open, then the world of accountancy will really be performing a great service. There surely can be no better time to debate, inform, describe, educate.

For far too long, the real significance of accounting has been hidden – who does it have an impact on? Who should be interested?

All of us.

I`ve already mentioned elsewhere the similarities between our horrific financial times and the delightful 1970′s (see Fog On The Tyne).

Apparently, If the latest interest rate decreases don`t stimulate the economy (in the short term the chances of this happening are close to zero I believe- rather like the rate itself)  the Bank of England may well consider PRINTING MONEY to bang directly into the economy—–last seen—–in the 70′s!

According to reports, Vauxhall management bosses have already been in contact with the powers that be for financial assistance.

This reminded my of those cheerless days of critical meetings at No.10. between the PM and the Union Masters.

It can surely only be a matter of time before the Union Big Wigs are back, knocking on The PM`s front door.

So, should Gordon be ordering in  John Smiths and Cheese and Tomato?

Oh I don`t think so.

Some things do change. More likely to be Latte and Smoked Salmon and Cream Cheese Wraps these days, recession or no recession.

The State Opening, and the Budget (or Budgets these days) must be the viewing peaks of the PC year. Surely, any other day, the channel barely registers on the BARB radar.

Well – give it a go some time:

The night before, I had a really pleasant surprise. Purely by off-chance whilst trying to avoid The One Show I came upon UK PC showing a meeting of the Treasury Committee. Stick with this….

Here goes:

Before said Committee, for grilling by chief bulldog John McFall MP (oh boy does he love his job) was Sir David Tweedie, Chairman of the International Accounting Standards Board (IASB). With Sir David were Paul Boyle, head of the Financial Reporting Council and Michael Izza, Chief Executive of the Institute of Chartered Accountants. So a room of Accountants. Dull? – no way. 

End of part one.

 So – some facts:

1) Sir David and chums were there to suggest how certain accounting standards had been a factor in the banks` downfalls, and in the credit crisis.

2) Companies around the world are required to follow accounting standards in preparing their financial reports. There are basically two sets of standards in the world today: International Standards (prepared by the IASB, based in London); US standards set by the Financial Accounting Standards Board (based in Norwalk, Connecticut)

3) The two standard setters are trying to converge their rules, with the aim that there will be one set of standards to follow wherever in the world a company may be based (a great idea in theory– very difficult to put into practice)

4) The BIG problem, brought to vivd life in the credit crunch, is how to account for what banks actually deal in: deposits, loans, mortgages and their horrible offshoots known as DERIVATIVES (credit default swaps anyone?). The generic name for all of these is Financial Instruments. Really, “things” that are in essence ‘cash’. Still with me?

5) There are three accounting standards dealing with these “things”, but by far the most terror inducing, complex, and horrendous of these is the dreaded IAS 39. It deals with how to measure financial instruments.

End of part II

According to the rules, Financial Instruments in the main are “marked to market” – what? OK – they are valued at “Fair value”  – what?  OK – they are valued are “today’s value”,”current value”, “what someone would be prepared to pay for it today”. OK?

So, according to “mark to market”, if an asset (for example, a mortgage given to a house owner) has gone down in value then that lower value is reported (even if the mortgage has got many years before it is settled and thus many years to go back up in value). SO – the bank reports this loss in value, the profits fall, the balance sheet weakens, the financial reports are read by analysts, the market reacts, the share price goes down, no one will lend to the bank as it “appears” in trouble, the whirlwind of panic begins.

IF, on the other hand, the mortgages are reported not at market value, but at “nominal value” i.e.how much was lent less amounts paid off, then any loss in market value is not reported.

Any loss is hidden until final settlement meaning balance sheets are overstated. This creates the false impression of quality when possibly this does not exist.  OH MY. What complexity, what a dilemma.What to do? (And this is before getting into the real mess of DERIVATIVES!).

IAS 39 is so complex that Sir David (who helped to device it) is once reported to have said “if you understand the standard you obviously have not read it”

To make matters worse, our friends in the EU have decided that IAS 39 can be carved up by each EU member, so that IAS 39 in the UK is different from the one in France, Germany etc.

Mcfall looked enthralled, as well he might.

I well remember sitting on the train facing a strained looking number cruncher, as in turn he phoned each of “The Big Four” accountancy firms for advice on a certain financial instrument. Four different answers came back. I kept quiet.

The rage in the US about accounting standards, and their impact on bank balance sheets, is so intense that they are now likely to venture out on their own to “fix” the problem. A real shame, as Sir David pointed out, as convergence between the IASB and FASB has come a long way in a relatively short space of time.

The quizzing came to an end. All participants looked relieved. Was I the only excited viewer? Was I the only viewer!?!

There is a very important point with all of this. Accountants, and especially Corporate Reporters, must come from out of the shadows and really start telling the story of the financial statements. Accountancy is not just a numbers game. It is a communication process, which in these challenging times is going to take on a new significance. Those accountants, for the sake of us all, must start getting used to talking about their product – at every opportunity.

Finally, as morning broke, I felt sufficiently alert to switch over to the familiar voices of The Today Programme. James Naughtie was interviewing Minister for the Cabinet Office Liam Byrne and Unite General Secretary Derek Simpson.

The discussion I came in on: the recapitalisation of the Royal Bank of Scotland.

For the record, here are the facts. For the second time this year, RBS (owner of Natwest, amongst others) has gone to the market for more cash. Existing RBS shareholders were not tempted this time. Hardly surprising, when the offer price of the new shares is higher than the quoted price.

So, the government stepped in as underwriter, injecting billions into the troubled bank, acquiring a controlling stake in the process (AND immediately sitting on a sizeable paper loss, but that is another story).

This investment was made via the newly constituted ‘UK Financial Investments’, a commercially sounding name for what may be considered a quasi nationalising body. (I suppose “Bail Out Brothers” does not have quite the same ring).

The investments are to be at arms length. So, NO government interference then. And therein I believe lies a problem with this support mechanism.

I offer up an analogy.

We have a term in the radio room – Octopussing. This is the situation when the person driving the radio desk suddenly feels various hands approaching from different angles. Hands intending to help by adjusting various switches or knobs. You could call it “back seat driving”. You could call it “meddling”. There it is. I’ve said it.

Surely, there is now going to be the irresistible attraction of UK FI giving a ‘helping hand’, policy wise, to the bank ‘for the good of the economy’. This return to state ownership (even if it is only temporary until ‘market conditions improve’) worries me.

Back to the interview.

Derek Simpson, in a couple of sentences, provided the evidence for my concerns. Surely, he suggested, now that the state has majority ownerships in major banks it should use its influence to keep workers on, in these depressed times, rather than have job cuts. So then, the government should intervene, step inside the business and direct policy, even if it goes against commercial reasoning.

This analysis reminded me of the situation in the seventies. Comparisons have already been made this week with those times, what with the renewed focus on levels of government debt. It was a time of state ownership. British Coal, British Steel, and British Telecom to name a few of the previously state owned businesses and bureaucratic playgrounds. Not forgetting that champion of inefficiency, British Rail – “We’re getting there”.

I did agree with Simpson on one thing. He said that the troubled banks were not necessarily bad banks, merely badly managed banks. I believe that to be true. In more rational times, a hard and quick cull of those responsible for bad decision making, may well have given the markets the confidence to continue to offer up funding. That confidence of course is just not there now. It certainly appears that questions over the quality of the ABN Amro acquisition were left unanswered for far too long.

So where next for UK Financial Investments? Overseas investment arms have discovered a taste for football clubs. Well why not? Certainly this would offer a good route for diversification. A likely target? Surely, it is obvious. The Treasury knows Newcastle well. They should put a call in to Mike Ashley, and make a speedy return to the Tyne.