David Prosser: The distorting impact of share buy-backs

Outlook Terry Smith is best-known these days as the chief executive of Tullet Prebon, the giant inter-dealer broker. It is often forgotten that Mr Smith first came to prominence in 1990, when he published Accounting for Growth, a book in which he revealed a string of accounting tricks through which companies had been pulling the wool over shareholders' eyes about how they were performing.

The book is well worth reading to this day and you won't need an accounting qualification to understand it. Equally, it's still worth listening to what Mr Smith has to say on the subject of accounting tricks – like the paper he published yesterday on share buy-backs.

Investors, broadly speaking, are fond of buy-backs. If a company has cash on its balance sheet for which it can't find a use, why shouldn't it be distributed among shareholders?

To which the answer is no reason at all, as long as the buyback process doesn't then distort investors' view of the company. Mr Smith's view is that on current accounting rules, it does. The effect of taking the shares bought off the balance sheet is to give an artificial boost to a company's earnings per share (earnings stay the same, the number of shares falls). Since the earnings per share ratio is one of the key yardsticks that investors look at when judging performance, that seems perverse.

What's the solution? Well, in an ideal world, one would change the accounting rules to counter the problem. But until that happens, this is a useful lesson for investors. Think carefully about the impact of share buy-backs – particularly, as Smith points out, where companies use eps as a basis for setting bonuses for senior executives.