article 07-24-2015

Why transparent, conservative accounting is so important...

On Tuesday, July 21, Toshiba Corporation became embroiled in an accounting scandal that led to the resignation of its CEO following the results of an outside investigation which concluded that the company had overstated profits by more than $1.2 billion over a seven-year period.

None of our portfolios hold Toshiba, but the story captured our attention for two reasons. First, Charlie Dreifus and I share a keen interest in accounting issues. Secondly, Toshiba has a number of joint ventures with SanDisk Corporation, a stock which we currently do not own but which both Charlie and I have held in the past.

In fact, around the time that I joined Charlie as assistant portfolio manager for Royce Special Equity and Special Equity Multi-Cap Funds in October 2014, one of our initial discussions centered on the California-based company that provides data storage products and solutions, including flash memory, proprietary controller and firmware technologies, as well as USB drives, digital media players, and other components.

In 2014, we were enjoying a pleasantly positive experience with SanDisk, but our deep dive into its accounting began to raise questions. Specifically, we were concerned about two matters: the quality of its recent earnings and our own struggle to make sense of how certain Variable Investment Entities ("VIEs") in which both SanDisk and Toshiba held a share—Toshiba's being the majority—were being accounted for.

The VIEs were created to fund the building of large semiconductor fabrication facilities, also known as Fabs. SanDisk accounted for them under the equity method of accounting given that it had concluded that the company was not the primary beneficiary of the VIEs as they lacked a controlling financial interest.

In and of itself, this would not necessarily concern us. What was peculiar to us, however, was that Toshiba took the same position—in other words, neither SanDisk nor Toshiba consolidated the off-balance sheet VIEs.

Following several unsuccessful attempts to better understand the flow of funds among the VIEs, Toshiba, and SanDisk, we took the next step and contacted SanDisk's management. After a cordial and constructive discussion, Charlie and I nonetheless came away convinced that the considerable costs of building Fabs were not being adequately disclosed between the two parties.

We share a marked preference for companies with conservative, transparent accounting, so we made the decision to sell, especially in light of our other apprehensions. We become concerned if we believe a specific accounting issue is being treated aggressively (rather than conservatively), as we have often observed that there is usually a pattern of one or the other—aggression or conservatism—that permeates the documents.

In the context of Toshiba's recent problems, two points are critical: First, what SanDisk was doing simply did not meet our own high standards for transparency in accounting. Second, as of this writing, SanDisk is uninvolved in Toshiba's troubles.

The situation simply offered a timely reminder of why Charlie and I scrutinize financial statements so closely—sometimes even businesses we like do things that make us uncomfortable enough to look elsewhere—where we repeat the same exhaustive process.

Important Disclosure Information

The thoughts and opinions expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce Special Equity Fund invests primarily in small-cap stocks, and Royce Special Equity Multi-Cap Fund invests primarily in mid-cap and larger-cap stocks. Investments in small- and mid-cap stocks may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Funds generally invest a significant portion of their assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Funds' overall value to decline to a greater degree. Royce Special Equity Multi-Cap Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)

Royce Special Equity Fund and Royce Special Equity Multi-Cap Fund do not currently hold shares of Toshiba or SanDisk. 

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