READING
BETWEEN
THE LINES OF
CORPORATE
FINANCIAL
REPORTS
In Search of
Financial Misstatements
JACEK WELC
Reading Between the Lines of Corporate
Financial Reports
Jacek Welc
Reading Between
the Lines of Corporate
Financial Reports
In Search of Financial Misstatements
Jacek Welc
SRH Berlin University of Applied Sciences
Berlin, Germany
Wroclaw University of Economics
Wrocław, Poland
ISBN 978-3-030-61040-1
ISBN 978-3-030-61041-8
https://doi.org/10.1007/978-3-030-61041-8
(eBook)
© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland
AG 2020
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Preface
“There are more things in heaven and earth,
than are dreamed of…” by financial statement users
—William Shakespeare (paraphrased)
Corporate financial reports are involved in so many business and investment
activities that it is impossible to overestimate their relevance for managerial
decision-making. They are used by both corporate insiders (e.g. managers
of corporations), for instance in budgeting and performance evaluation, as
well as by external parties (e.g. stock market investors, creditors, suppliers
or governmental agencies) which are interested in an assessment of a given
company’s achievements and financial position. In fact, financial statements
constitute a primary source of information used in an examination of
corporate past results, but also in making investigations of a given entity’s
long-term perspectives, simulations of its future economic performance and
quantification of its business risk exposures.
However, even though corporate financial reports constitute an invaluable
source of information about an economic performance of companies, they
are far from being perfect. Multiple weaknesses of financial statements stem
from objective flaws of contemporary accounting methods (which always
entail rough simplifications of an often very complex business reality), as
well as from lacking immunity of corporate financial reporting to deliberate
manipulations and fraudulent acts. Consequently, reading, interpreting and
analyzing accounting numbers (e.g. when picking stocks or making credit risk
v
vi
Preface
evaluation) should never be done mechanically and financial reports should
not be trusted blindly. While reading the lines of primary financial statements (income statement, balance sheet and cash flow statement) is usually
quite simple and often does not consume much time, it is a skill of reading
between the lines that enables an insightful assessment of a given company’s
past results and likely future performance.
This book is aimed at guiding its reader, in a step-by-step way, through
multiple nuances and “backshores” of corporate financial reporting. Its
first four chapters deal with objective flaws of accounting and analytical
methods (Chapters 1 and 2) as well as with selected techniques of deliberate accounting manipulations, including aggressive and fraudulent financial reporting (Chapters 3 and 4). Then, the following four chapters offer
a manual of analytical tools useful in assessing sustainability, reliability and
comparability of reported accounting numbers. The book closes with two
chapters that present selected techniques helpful in increasing comparability
and reliability of corporate financial statements.
The main body of the text of this manuscript is supplemented by an extra
supplementary material, in a form of the online appendix that includes almost
eighty additional tables and charts, which directly correspond to various reallife case studies presented in the book. The contents of those tables and
charts are not absolutely essential for understanding the issues dealt with in
this publication. However, the author believes that reading the main body
of the text in combination with data and narratives included in the online
appendix significantly contributes to understanding the discussed topics and
enriches the educational value of this manuscript. All illustrations included
in the appendix are referenced in the book with the use of the acronym “A”
(for instance, “Table 1.1A”), so that the reader is not confused about where a
particular table or chart may be found (e.g. within the main body of the text
vs. in the online appendix).
The author’s mail goal was to offer a book that is strongly biased toward
practical applications of methods discussed in it, and which is understandable
for all those interested in analyzing financial statements, who do not have a
deep accounting background. Therefore, the author hopes that his book will
be “digestible” for a broad universe of non-accountants, who deal or intend to
deal with corporate financial reports. However, a reader’s basic knowledge of
the fundamental accounting concepts (including the content and substance of
three primary financial statements, i.e. income statement, balance sheet and
cash flow statement) will be needed in going smoothly through the content
of this manuscript. Also, understanding the most commonly applied financial statement analysis tools (such as profitability, liquidity and indebtedness
Preface
vii
ratios), although not absolutely essential, will be helpful in comprehending
the topics and problems discussed in this publication. Accordingly, those
readers who do not have any accounting background (and are not familiarized
with the three abovementioned primary financial statements), are suggested
to first learn the basics of accounting and corporate financial statements,
before reading this book. A good and clear coverage of the basic accounting
and financial statement analysis concepts may be found e.g. in the textbook
offered by Jill Collis (“Financial Accounting ”, Palgrave Macmillan, 2015).
The author’s business consulting practice has taught him that unskilled and
mechanical interpretation of data extracted from corporate financial reports
may be very hazardous and may result in very poor business and investment
decisions. Therefore, the content of this book is biased toward discussing
and illustrating the most typical problems and pitfalls associated with financial statement analysis. To the author’s knowledge, some of the issues dealt
with in this manuscript are overlooked by majority of other books on financial statement analysis (e.g. distortions caused by non-controlling interests or
manipulations of reported cash flows). This book also presents some analytical techniques which are not covered by most other available publications
(e.g. adjustments for long-term contracts, discussed in Chapter 10).
Huge majority of real-life case studies presented in this book are based
on accounting numbers (and narrative disclosures) extracted from corporate financial reports prepared in accordance to either International Financial
Reporting Standards (abbreviated to IFRS across the text) or US Generally
Accepted Accounting Principles (abbreviated to US GAAP). However, most
of the issues and analytical techniques, discussed in this publication, are applicable to other accounting systems as well. Therefore, the author believes that
the content of this manuscript is universal, in a sense that it may be interesting
for all financial statement users around the world.
Jelenia Gora, Poland
February 2020
Jacek Welc
Contents
1
Most Common Distortions in a Financial Statement
Analysis Caused by Objective Weaknesses of Accounting
and Analytical Methods
1.1
Introduction
1.2 Undervaluation or Omission of Relevant Assets
on Balance Sheet
1.2.1 L’Oréal SA
1.2.2 AkzoNobel
1.2.3 Hudson’s Bay Company
1.3 Undervaluation or Omission of Relevant Liabilities
on Balance Sheet
1.3.1 Rental and Operating Lease Obligations
1.3.2 Contingent Liabilities of BP Plc
1.3.3 Contingent Liabilities of PG&E Corp
1.4 Inventory Write-Downs as an Imperfect Signal
of Problems with Excess or Obsolete Inventories
1.5 Distortions Caused by a Leeway in a Financial
Statement Presentation
1.5.1 Volkswagen and Daimler
1.5.2 Astaldi Group
1.6
Distortions of Turnover Ratios Caused by Seasonality,
Growth and Tax-Related Factors
1.6.1 Distortions Caused by Seasonality of Sales
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Contents
1.6.2
1.6.3
Distortions Caused by Growth Rates of Sales
Distortions Caused by Changing Sales
Breakdown
Appendix
References
2
3
Other “Distortions” in a Financial Statement Analysis
Caused by Objective Weaknesses of Accounting
and Analytical Methods
2.1
Distortions Caused by Inventory Flow Methods
2.1.1 Incomparability of Results When Inventory
Prices Change
2.1.2 Distortions of FIFO-Based Profits When
Inventory Prices Change
2.1.3 Distortions of LIFO-Based Profits When
Inventory Turnover Changes
2.1.4 Conclusions
2.1.5 Distortions Caused by Noncontrolling
Interests
2.2
Distortions Caused by Changes in Accounting
Principles, Changes in Accounting Estimates
and Corrections of Accounting Errors
2.2.1 Incomparability of Results When
Accounting Principles Are Changed
2.2.2 Incomparability of Results When
Accounting Estimates Change
2.2.3 Incomparability of Results Caused
by Accounting Errors
2.3 Distortions Caused by Non-Mandatory Early
Adoption of New or Revised Accounting Standards
2.3.1 Boeing, General Dynamics, Lockheed
Martin and Raytheon
2.3.2 Kinaxis Inc. and Tieto Oyj
Appendix
References
Deliberate Accounting Manipulations: Introduction
and Revenue-Oriented Accounting Gimmicks
3.1
Quality of Earnings as One of the Major Problems
of Contemporary Accounting
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46
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62
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Contents
Links Between Earnings Manipulations and Balance
Sheet Distortions
3.3
Overstatement of Profits by Overstatement
of Revenues
3.3.1 Introduction
3.3.2 Overstatement of Profits by Premature
Recognition of Revenues Which Should Be
Deferred
3.3.3 Overstatement of Profits by Premature
Recognition of Revenues Which Are
Conditional on Future and Uncertain Events
3.3.4 Overstatement of Profits by Aggressive
Usage of Percentage-of-Completion Method
of Revenue Recognition
3.3.5 Overstatement of Profits by Artificial
Sale-and-Buy-Back Transactions
Appendix
References
xi
3.2
4
Deliberate Accounting Manipulations: Expense-Oriented
Accounting Gimmicks and Intentional Profit
Understatements
4.1
Overstatement of Profits by Understatement
of Expenses
4.1.1 Overstatement of Profits by Understating
Write-Downs of Inventories and Receivables
4.1.2 Overstatement of Profits by Capitalizing
Excess Manufacturing Overheads
in Carrying Amount of Inventory
4.1.3 Overstatement of Profits by Aggressive
Capitalization of Costs in Carrying Amounts
of Operating Fixed Assets
4.1.4 Overstatement of Profits by Artificial
“Outsourcing” of R&D Projects
4.1.5 Overstatement of Profits by Delays
in Depreciating Fixed Assets
4.1.6 Overstatement of Profits by Understating
Provisions for Liabilities
4.2
Understatement of Profits by Overly Conservative
Accounting
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109
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xii
Contents
4.2.1
4.2.2
4.2.3
Motivations for Profit Understatements
Four Approaches to Accounting
Real-Life Examples of (More or Less
Deliberate) Profit Understatements
Appendix
References
5
6
Evaluation of Financial Statement Reliability
and Comparability Based on Auditor’s Opinion,
Narrative Disclosures and Cash Flow Data
5.1
Introduction
5.2
Auditor’s Opinion
5.2.1 L’Oreal
5.2.2 Agrokor Group
5.2.3 LumX Group Limited
5.2.4 CenturyLink Inc.
5.2.5 Hanergy Thin Film Power Group Limited
5.2.6 Conclusions
5.3
Narrative Information Disclosed in Financial
Statements
5.3.1 OCZ Technology Group Inc.
5.3.2 Sino-Forest Corp.
5.3.3 AbbVie Inc.
5.3.4 Fresenius Group
5.3.5 Electronic Arts Inc. and Take-Two
Interactive Software Inc.
5.4 Discrepancies Between Operating Profits
and Operating Cash Flows
5.4.1 Toys “R” Us Inc.
5.4.2 21st Century Technology Plc
5.4.3 Pescanova Group
5.4.4 Carillion Plc
5.4.5 Cowell e Holdings Inc.
5.4.6 Conclusions
Appendix
References
Problems of Comparability and Reliability of Reported
Cash Flows
6.1
Introduction
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Contents
Unreliability of Reported Cash Flows When Cash
Balances Themselves Are Falsified
6.2.1 China MediaExpress Holdings Inc.
6.2.2 Satyam Computer Services Limited
6.2.3 Patisserie Holdings Plc
6.2.4 Conclusions
6.3
Spurious Improvements in Operating Cash Flows
of Shrinking Businesses
6.3.1 Admiral Boats S.A.
6.3.2 Claire’s Stores Inc.
6.3.3 Cowell e Holdings Inc.
6.3.4 Conclusions
6.4
Distortions of Reported Cash Flows Caused
by Non-controlling Interests
6.4.1 Distorting Impact of Non-controlling
Interests on Reported Cash Flows
6.4.2 Real-Life Example of Rallye SA
6.5
Distortions of Reported Cash Flows Caused
by Capitalized Intangible Assets
6.6
Distortions of Reported Cash Flows Caused
by off-Balance Sheet Financing Schemes
6.7
Distortions of Reported Cash Flows Caused
by Customer Financing Schemes
6.8
Distortions of Reported Cash Flows Caused
by Business Combinations
6.8.1 Distorting Impact of Business Combinations
on Reported Cash Flows
6.8.2 Real-Life Example of Conviviality Plc
6.9
Example of Eroded Intercompany Comparability
of Reported Cash Flows
Appendix
References
xiii
6.2
7
Evaluation of Financial Statement Reliability
and Comparability Based on Quantitative Tools Other
Than Cash Flows: Primary Warning Signals
7.1
Introduction
7.2 Signal No 1: Discrepancies Between Revenue Growth
and Inventory Growth
7.2.1 Burberry Group Plc
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xiv
Contents
7.2.2 Pittards Plc
7.2.3 Toshiba Corp
7.2.4 Conclusions
7.3 Signal No 2: Discrepancies Between Revenue Growth
and Receivables Growth
7.3.1 Ingenta Plc
7.3.2 Aegan Marine Petroleum Network Inc
7.3.3 OCZ Technology Group Inc
7.3.4 Conclusions
7.4 Signal No 3: Discrepancies Between Growth
Rates of Revenues and Unbilled Receivables
from Long-Term Contracts
7.4.1 General Electric Co
7.4.2 Carillion Plc
7.4.3 Astaldi Group
7.4.4 Conclusions
7.5 Signal No 4: High or Fast Growing Share
of Intangibles in Total Assets
7.5.1 GateHouse Media Inc
7.5.2 OCZ Technology Group Inc
7.5.3 Starbreeze AB
7.5.4 Conclusions
7.6 Signal No 5: Systematically Falling Turnover
of Property, Plant and Equipment
7.6.1 Sino-Forest Corp
7.6.2 Icelandair Group
7.6.3 Jones Energy Inc
7.6.4 Conclusions
7.7 Signal No 6: Falling Ratio of Depreciation
and Amortization to Carrying Amount of Operating
Fixed Assets
7.7.1 Lufthansa Group
7.7.2 Netia S.A
7.7.3 Toshiba Corp
7.7.4 Conclusions
Appendix
References
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Contents
8
Evaluation of Financial Statement Reliability
and Comparability Based on Quantitative Tools Other
Than Cash Flows: Additional Warning Signals
8.1
Signal No 7: Changing Growth Rates of Deferred
Revenues
8.1.1 US Airways Group Inc.
8.1.2 GateHouse Media Inc.
8.1.3 Dart Group Plc
8.1.4 Conclusions
8.2
Signal No 8: Unusual Behavior of Provisions
for Future Costs and Liabilities
8.2.1 OCZ Technology Group Inc.
8.2.2 Nortel Networks Corp.
8.2.3 Takata Corp
8.2.4 Conclusions
8.3 Signal No 9: Discrepancies Between Accounting
Earnings and Taxable Income
8.3.1 GetBack S.A
8.3.2 General Electric Co.
8.3.3 Aventine Renewable Energy Holdings Inc.
8.4
Signal No 10: Related-Party Transactions
8.4.1 GetBack S.A.
8.4.2 Hanergy Thin Film Power Group Limited
8.4.3 Astaldi Group
8.5 Signal No 11: Suspected Behavior of Allowances
for Impairments of Inventories and Receivables
8.5.1 OCZ Technology Group Inc.
8.5.2 EServGlobal Ltd.
8.5.3 Delta Apparel Inc.
8.6
Signal No 12: Suddenly Changing Breakdown
of Inventories
8.6.1 Volkswagen Group
8.6.2 Nokia Corporation
8.6.3 Cowell e Holdings Inc.
8.7
Signal No 13: Other Significant and Unusual Trends
8.8
Importance of Investigating Combinations
of Warnings Signals
8.9 When Detecting Accounting Manipulations May Be
Difficult
xv
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xvi
Contents
Appendix
References
9
Techniques of Increasing Comparability and Reliability
of Reported Accounting Numbers: Selected Simple Tools
9.1
Introduction
9.2 Adjustments for Differences in Inventory Accounting
Methods
9.3
Adjustments for off-Balance Sheet Liabilities
9.3.1 Introduction
9.3.2 Example of Southern Cross Healthcare
9.4
Adjustments for Capitalized Development Costs
and Other Intangible Assets
9.5 Adjustments for Differences in Depreciation Policies
Applied to Property, Plant and Equipment
Appendix
References
10 Techniques of Increasing Comparability and Reliability
of Reported Accounting Numbers: Some More Advanced
Tools
10.1 Introduction
10.2 Adjustments for Non-controlling Interests
10.3 Adjustments for Long-Term Contracts Accounted
for with the Use of the Percentage-of-Completion
Method
10.3.1 Complexities of Accounting for Long-Term
Contracts
10.3.2 Possible Profit Overstatements Caused
by Unprofitable Long-Term Contracts
10.3.3 Adjusting Reported Earnings for Contract
Assets and Liabilities
10.3.4 Real-Life Examples of Warnings Signals
Generated by “Invoiced Earnings”
10.4 Increasing Comparability and Reliability of Financial
Statement Numbers with the Use of Data on Current
and Deferred Income Taxes
10.4.1 Accounting (Book) Earnings vs. Taxable
Income
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365
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367
376
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377
379
383
389
389
Contents
10.4.2 Increasing Financial Statement
Comparability and Reliability with the Use
of Income Tax Disclosures
Appendix
References
xvii
396
405
415
References
417
Index
425
List of Charts
Chart 2.1
Chart 3.1
Chart 3.2
Chart 3.3
Hypothetical example of a group of companies (Source
Author)
Hypothetical non-manipulated income statement
and balance sheet (* including income taxes. Source
Author)
Hypothetical manipulated income statement and balance
sheet, after recognizing a fictitious sales transaction
amounting to 100 units (and boosting net earnings
by the same amount) (*including fictitious revenue of 100
units; **including fictitious [non-existent] receivable
accounts, amounting to 100 units. Source Author)
Hypothetical manipulated income statement and balance
sheet, after understating expenses by 100 units (due
to a nonrecognition of salaries payable to employees)
(* understated by non-recognition of payable salaries,
amounting to 100 units; **understated by an omission
of payroll-related liabilities, amounting to 100 units.
Source Author)
49
80
81
82
xix
xx
List of Charts
Chart 3.4
Chart 6.1
Chart 6.2
Chart 9.1
Chart 10.1
Chart 10.2
Hypothetical manipulated financial statements,
after a simultaneous overstatement of revenues by 100
units (due to a recognition of fictitious sales transaction)
and an understatement of expenses by 50 units (due
to a nonrecognition of payroll costs) (*including fictitious
revenue of 100 units and a corresponding fictitious
[non-existent] receivable account, amounting to 100 units;
**understated by an omission of payroll-related expenses
and liabilities, amounting to 50 units. Source Author)
Hypothetical cascading ownership structure within a group
of companies (*The only assets held by Subsidiary
B are shares in Subsidiary C; **The only assets held
by Subsidiary C are shares in Subsidiary D. Source Author)
Equity relationships between Rallye SA and its selected
non-wholly owned subsidiaries (as at the end of fiscal year
2018) (Source Annual reports of Rallye SA and Casino
Group for fiscal year 2018)
Five inflation indexes (expressed as percent changes
in prices, year over year) for metal and metal
products, in the period between January 2009
and January 2017 (Abbreviations of price indexes used:
PPICMM—Producer Price Index by Commodity
Metals and Metal Products: Primary Nonferrous
Metals, WPU10—Producer Price Index by Commodity
for Metal and Metal Products, WPU101—Producer Price
Index by Commodity for Metals and Metal Products:
Iron and Steel, WPU101707—Producer Price Index
by Commodity for Metals and Metal Products: Cold
Rolled Steel Sheet and Strip, WPU10250105—Producer
Price Index by Commodity for Metals and Metal
Products: Aluminum Sheet and Strip. Source Authorial
computations based on data published by Federal Reserve
Bank of St. Louis)
Equity relationships between Asseco Poland S.A.,
Formula Systems (1985) Ltd. and Sapiens International
Corporation N.V. (as at the end of fiscal year 2016) (Source
Annual reports of Asseco Poland S.A., Formula Systems
(1985) Ltd. and Sapiens International Corporation N.V.
for fiscal year 2016)
Differences between Carillion’s “invoiced earnings” and its
reported profit before taxation (in GBP million), based
on data presented in Table 10.6 (Source Annual reports
of Carillion plc for fiscal years 2009–2016 and authorial
computations)
83
182
184
358
369
406
List of Examples
Example 1.1
Example 2.1
Example 2.2
Example 2.3
Example 3.1
Example 3.2
Example 3.3
Example 3.4
Example 3.5
Example 4.1
Problem with excess inventories (followed by a collapse
of profitability) which does not require the inventory
write-down
Impact of different inventory accounting methods
on comparability of financial results in a period
of rising inventory prices
Distortions caused by FIFO in a time-series analysis
of results of a single company in periods of changing
inventory prices
Distortions caused by “inventory digging” (or “LIFO
liquidation”) in periods of changing inventory prices
Overstatement of profits by premature recognition
of revenues which should be deferred
Overstatement of profits by premature recognition
of revenues when their final amount is uncertain (i.e.
when it is contingent on unknown future events)
Overstatement of profits by premature recognition
of revenues when a customer retains a right to return
the goods purchased from the vendor
Overstatement of profits by aggressive usage
of percentage-of-completion method
Overstatement of profits by artificial sale-and-buy-back
transactions of inventories
Overstatement of profits by understating inventory
write-downs
12
42
44
47
85
88
90
93
96
104
xxi
xxii
List of Examples
Example 4.2
Example 4.3
Example 4.4
Example 4.5
Example 4.6
Example 4.7
Example 6.1
Example 6.2
Example 6.3
Example 6.4
Example 6.5
Example 6.6
Example 10.1
Example 10.2
Example 10.3
Example 10.4
Example 10.5
Example 10.6
Overstatement of profits by capitalizing (in inventory)
costs of unused capacity
Overstatement of profits by aggressive capitalization
of routine maintenance costs in carrying amount
of fixed assets
Overstatement of profits by artificial “outsourcing”
of R&D projects
Overstatement of profits by artificial delays
in depreciating fixed assets
Overstatement of profits by understatement
of a warranty provision
Understatement of profits by overstating inventory
write-downs (alternation of Example 4.1)
Distortions of reported cash flows caused
by non-controlling interests (NCI)
Overstatement of operating cash flows caused
by aggressive capitalization of routine maintenance
costs in carrying amounts of fixed assets (extension
of Example 4.3 from Chapter 4)
Overstatement of operating cash flows caused
by artificial “outsourcing” of R&D projects (extension
of Example 4.4 from Chapter 4)
Overstatement of operating cash flows caused
by transfers of borrowed funds through unconsolidated
entities
Overstatement of operating cash flows caused by loans
granted by a company to its customers
Distortions of reported consolidated operating cash
flows caused by an acquisition of an inventory-intensive
subsidiary
Application of the percentage-of-completion method
An aggressive application of the percentageof-completion method for an unprofitable long-term
contract
“Invoiced earnings” and their estimation with the use
of financial statement disclosures (based on data
presented in Example 10.2)
Accounting for book-tax differences related
to depreciation
Accounting for book-tax differences related to warranty
provisions
Accounting for tax-loss carry-forwards
108
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115
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128
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191
193
197
199
378
380
382
392
394
395
List of Examples
Example 10.7
Reversing book-tax differences on the ground
of deferred tax disclosures (continuation of Example
10.4)
xxiii
400
List of Tables
Table 1.1
Table 1.2
Table 1.3
Table 1.4
Table 1.5
Table 1.6
Table 1.7
Table 1.8
Table 1.9
Table 1.10
Results of discontinued operations of AkzoNobel in fiscal
years 2017 and 2018
Selected consolidated balance sheet data of PG&E Corp.
for fiscal years 2017 and 2018
H&M’s sales, gross profit and inventories between fiscal
years 2014 and 2018
An extract from Note 6 to Daimler’s consolidated
financial statements for the fiscal year 2008, explaining
its other financial income (expense)
Note 9 to the financial statements of Volkswagen Group
for fiscal year 2008 (other financial results)
Adjustment of Volkswagen Group’s and Daimler’s
operating profitability for profits and losses
from equity-accounted investments and other financial
results
Revenues, receivable accounts and receivables’ turnover
ratios (in days) of a nonseasonal Firm A and a deeply
seasonal Firm B
Revenues, receivable accounts and receivables’ turnover
ratios (in days) of a no-growth Firm A and a fast-growth
Firm B
Gross and net sales and receivables’ turnover ratios
(in days) of a hypothetical agribusiness
Segmental breakdown of Lufthansa Group’s revenues
in fiscal years 2014–2017
4
9
13
17
17
18
21
24
25
28
xxv
xxvi
Table 1.11
Table 1.12
Table 1.13
Table 1.14
Table 1.15
Table 1.16
Table 1.17
Table 1.18
Table 1.19
Table 1.20
Table 1.21
Table 1.22
Table 1.23
Table 1.24
Table 1.25
Table 2.1
Table 2.2
List of Tables
Consolidated assets of L’Oréal SA as at the end of fiscal
years 2015–2017
Extract from Note 7.2 to consolidated financial
statements of L’Oréal SA for fiscal year 2017
Selected financial statement data of AkzoNobel for fiscal
years 2017 and 2018
Calculation of the gain on the sale of AkzoNobel’s
Specialty Chemicals business
Condensed consolidated income statement of Hudson’s
Bay Company for the first quarter of fiscal years ended
May 4/5, 2018 and 2019
Extract from Note 6 to quarterly consolidated financial
statements of Hudson’s Bay Company for the first quarter
of the fiscal year ended May 4, 2019
Extract from Note 4 to annual consolidated financial
statements of Hudson’s Bay Company for the fiscal year
ended May 4, 2019
Examples of significant off-balance sheet liabilities
Extract from BP’s annual report for fiscal year 2010,
referring to the oil spill in Gulf of Mexico (and its
possible financial consequences for the company)
Extracts from Note 2 to consolidated financial
statements of BP plc for fiscal years 2012–2016, related
to the company’s costs and obligations stemming
from the Gulf of Mexico oil spill
Extract from Note 13 (Wildfire-related contingencies)
to PG&E’s consolidated financial statements for fiscal
year 2018, referring to the wildfires allegedly caused
by the company’s operating equipment
Extract from Note 10 (Wildfire-related contingencies)
to PG&E’s consolidated financial statements for the first
quarter of the fiscal year 2019
Extracts from annual reports of H&M, relating
to the company’s inventories
Condensed income statements of Volkswagen Group
and Daimler for fiscal years 2007 and 2008
Condensed income statements of Astaldi Group for fiscal
year 2013–2015, as reported in its annual reports
for 2014 and 2015
Three hypothetical scenarios of the intragroup structure
of Fiat’s consolidated trading profit as reported for fiscal
year 2013
Current liquidity ratios of Fiat Group, computed
on the ground of its consolidated balance sheet
29
29
30
30
31
31
32
32
33
34
35
36
36
37
38
52
53
List of Tables
Table 2.3
Table 2.4
Table 2.5
Table 2.6
Table 2.7
Table 2.8
Table 2.9
Table 2.10
Table 2.11
Table 2.12
Table 2.13
Table 2.14
Table 2.15
Table 2.16
Fiat’s adjusted current liquidity ratios at the end
of fiscal year 2013, under two hypothetical scenarios
of the intragroup structure of Fiat’s current assets
Extract from annual report of WestJet for fiscal year
2011, referring to the company’s change in accounting
principles (from Canadian GAAP to IFRS)
Selected financial statement data of WestJet, reported
for fiscal years 2009–2011, before and after change
of the company’s accounting principles (from Canadian
GAAP to IFRS)
Selected income statement numbers of Lufthansa Group
for fiscal year 2012–2014, extracted from the company’s
annual report for the fiscal year ended December 31, 2014
Adjustment of selected income statement numbers
of Lufthansa Group for fiscal years 2012–2014, related
to the company’s change of the useful lives of its
aircraft-related assets
Extract from Form 8-K current report, published by Ford
Motor Company on November 14, 2006, reconciling its
previously reported (erroneous) net income with its net
income after restatement
Comparison of operating profits reported by The Boeing
Company, General Dynamics Corp., Lockheed Martin
Corp. and Raytheon Company for fiscal year 2017
Raw and adjusted indebtedness ratios of Kinaxis Inc.
and Tieto Oyj, as at the end of fiscal year 2018
Consolidated income statement of Fiat S.p.a. for fiscal
years 2012–2013
Consolidated balance sheet of Fiat S.p.a. for fiscal years
2012 and 2013
Extract from Note 23 to the financial statements of Fiat
S.p.a. for fiscal years 2012 and 2013
Examples of significant share of noncontrolling interests
(NCI) in consolidated net earnings and consolidated
shareholder’s equity
Extract from annual report of WestJet for fiscal year
2011, referring to the company’s change in accounting
principles applied to depreciation of aircrafts
Extract from annual report of Lufthansa Group for fiscal
year 2014, referring to the company’s cost savings
resulting from prior change of the useful lives of its fixed
assets
xxvii
54
57
57
60
61
63
66
67
68
69
69
70
70
71
xxviii
Table 2.17
Table 2.18
Table 2.19
Table 2.20
Table 3.1
Table 4.1
Table 4.2
Table 4.3
Table 4.4
Table 4.5
Table 4.6
Table 4.7
Table 5.1
Table 5.2
Table 5.3
Table 5.4
Table 5.5
List of Tables
Extract from Note 2 to consolidated financial
statements of Lufthansa Group for fiscal year 2013,
referring to the company’s change of useful lives of its
aircraft-related fixed assets
Extract from Form 8-K current report, published by Ford
Motor Company on November 14, 2006, explaining
the nature of its accounting error
Extracts from notes to financial statements of The Boeing
Company, General Dynamics Corp., Lockheed Martin
Corp. and Raytheon Company for fiscal year 2017,
regarding their adoption of the new revenue recognition
policies
Extracts from notes to financial statements of Kinaxis
Inc. and Tieto Oyj for fiscal year 2018, regarding their
adoption and reporting effects of the IFRS 16 (Leases)
Selected accounting scandals
Four approaches to accounting
Selected income statement data of Pittards plc for fiscal
years 2016 and 2017
Extracts from annual reports of Pittards plc for fiscal
years 2016 and 2017, regarding its inventory impairment
charges
Selected financial statement data of Takata Corporation
for fiscal years 2014–2016
Extract from consolidated income statements of Mesa Air
Group for fiscal years ended September 30, 2006, 2007
and 2008
Extract from the annual report of Mesa Air Group
for fiscal year 2008, regarding its loss contingency
and settlements of lawsuits
Extract from the annual report of Takata Corporation
for fiscal year 2016, regarding its warranty reserve
Extract from unqualified auditor’s opinion to consolidated
financial statements of L’Oreal for fiscal year 2017
Extract from qualified auditor’s opinion to consolidated
financial statements of Agrokor Group for fiscal year 2017
Extract from qualified auditor’s opinion to consolidated
financial statements of LumX Group Limited for fiscal
year ended December 31, 2018
Extract from qualified auditor’s opinion to consolidated
financial statements of CenturyLink Inc. for fiscal year
ended December 31, 2018
Extract from Note 2 to consolidated financial statements
of CenturyLink Inc. for the first quarter of fiscal year 2019
71
72
73
74
99
126
129
130
133
135
135
136
141
142
144
145
146
List of Tables
Table 5.6
Table 5.7
Table 5.8
Table 5.9
Table 5.10
Table 5.11
Table 5.12
Table 5.13
Table 5.14
Table 5.15
Table 5.16
Table 5.17
Table 5.18
Table 5.19
Table 5.20
Table 5.21
Table 5.22
Table 6.1
Extract from qualified auditor’s opinion to consolidated
financial statements of Hanergy Thin Film Power Group
Limited for fiscal year 2015
Selected extracts from the narrative information disclosed
in the annual report of OCZ Technology Inc. for fiscal
year ended February 29, 2012
Selected extracts from Note 2 to consolidated financial
statements of OCZ Technology Inc. for fiscal year ended
February 28, 2013
Extracts from Note 1 to consolidated financial statements
of Sino-Forest Corp. for fiscal year 2012
Extract from a description of major business risks faced
by AbbVie Inc., included in the company’s annual report
for fiscal year 2018
Net revenues, operating expenses and operating earnings
of AbbVie Inc. in fiscal years 2016–2018
Extracts from Note 7 to consolidated financial statements
of AbbVie Inc. for fiscal year 2018
Extracts from Note 1 to consolidated financial statements
of Fresenius Group for fiscal year 2018
Selected financial statement data of Fresenius SE & Co.
KGaA (the parent company within Fresenius Group)
and Fresenius Medical Care for fiscal year 2018
Extract from Note 1 to consolidated financial statements
of Electronic Arts Inc. for fiscal year 2018
Extract from Note 1 to consolidated financial statements
of Take-Two Interactive Software Inc. for fiscal year 2018
Selected financial statement data of Toys “R” Us Inc.
for fiscal years ended January 28–31, 2015, 2016
and 2017
Selected financial statement data of 21st Century
Technology plc for fiscal years 2011–2014
Selected financial statement data of Pescanova Group
for fiscal years 2008–2011
Selected financial statement data of Carillion plc for fiscal
years 2013–2016
Selected financial statement data of Cowell e Holdings
Inc. for fiscal years 2013–2016
Extract from the Ontario Securities Commission’s
investigation report, regarding accounting practices
applied by Sino-Forest Corp
Selected financial statement data of China MediaExpress
Holdings Inc. for fiscal years 2007–2009
xxix
147
149
151
153
154
154
156
157
159
160
160
162
163
164
165
166
167
170
xxx
Table 6.2
Table 6.3
Table 6.4
Table 6.5
Table 6.6
Table 6.7
Table 6.8
Table 6.9
Table 6.10
Table 6.11
Table 6.12
Table 6.13
Table 6.14
Table 6.15
Table 6.16
Table 6.17
Table 6.18
List of Tables
Selected financial statement data of Satyam Computer
Services Limited for fiscal years 2006–2008
Selected financial statement data of Patisserie Holdings
plc for fiscal years 2016–2018
Selected financial statement data and ratios of Admiral
Boats S.A. for fiscal years 2013–2016
Selected financial statement data of Claire’s Stores Inc.
for fiscal years 2016 and 2017
Selected financial statement data of Cowell e Holdings
Inc. for fiscal years 2016–2018
Cash-based debt-coverage ratios of Rallye SA,
as at the end of its fiscal years 2017 and 2018, based
on the company’s consolidated numbers unadjusted
for the non-controlling interests
Selected consolidated financial statement data of Rallye
SA and its three non-wholly owned subsidiaries,
as at the end of its fiscal years 2017 and 2018
Adjustments of Casino Group’s consolidated operating
cash flows for non-controlling interests (NCI) in its two
subsidiaries
Adjustments of Rallye’s consolidated operating cash
flows for non-controlling interests (NCI) in its three
non-wholly owned subsidiaries
Adjustments of Rallye’s reported consolidated cash
and cash equivalents for non-controlling interests (NCI)
in the Casino Group’s equity
Cash-based debt-coverage ratios of Rallye SA, adjusted
for non-controlling interests (NCI) in the equities of its
three non-wholly owned subsidiaries
Selected cash flow statement data reported by Conviviality
plc for its fiscal years 2014–2016
Changes in working capital reported by Conviviality plc
in its balance sheet and cash flow statement
Extract from Note 28 to the consolidated financial
statements of Conviviality plc for fiscal year ended May
1, 2016
Adjustments of consolidated operating cash flows
reported by Conviviality plc, for estimated impacts of its
business combinations on reported changes in working
capital
Coverage of total liabilities by reported operating cash
flows of four car manufacturers in fiscal year 2009
Adjustments of operating cash flows of four car
manufacturers reported for fiscal year 2009
171
172
175
177
178
184
186
187
187
188
188
201
202
203
204
205
209
List of Tables
Table 6.19
Table 6.20
Table 6.21
Table 6.22
Table 6.23
Table 6.24
Table 7.1
Table 7.2
Table 7.3
Table 7.4
Table 7.5
Table 7.6
Table 7.7
Table 7.8
Table 7.9
Table 7.10
Table 7.11
Table 7.12
Coverage of total liabilities by adjusted operating cash
flows of four car manufacturers in fiscal year 2009
Extract from the US District Court’s conclusions
of its investigation of the accounting fraud committed
by China MediaExpress Holdings Inc
Extract from the U.S. Securities and Exchange
Commission’s announcement regarding the accounting
fraud committed by Satyam Computer Services Limited
Extract from the announcement published by Patisserie
Holdings plc on October 12, 2018
Operating and investing cash flows of four car
manufacturers reported for fiscal year 2009
Cash flows reported by Volkswagen Group for fiscal year
2008 in its two annual reports
Selected financial statement data of Burberry Group plc
for fiscal years ended March 31, 2006–2009
Selected financial statement data of Pittards plc for fiscal
years 2012–2016
Revenues, cost of sales and gross profit of Pittards plc
for fiscal years 2015–2016
Selected financial statement data (before their
retrospective restatement) of Toshiba Corp. for fiscal years
(ended March 31) 2008–2012
Selected financial statement data of Ingenta plc for fiscal
years 2011–2015
Selected financial statement data of Aegan Marine
Petroleum Network Inc. for fiscal years 2013–2016
Selected financial statement data of OCZ Technology
Group Inc. for fiscal years ended February 28/29,
2010–2012
Selected financial statement data of General Electric Co.
for fiscal years 2014–2017
Extract from Note 9 to consolidated financial statements
of General Electric Co. for fiscal year 2015, explaining
the substance of the company’s contract assets
Composition of GE’s contract assets as at the end of fiscal
years 2015–2017
Extracts from Note 9 to consolidated financial statements
of General Electric Co. for fiscal years 2016 and 2017,
explaining the reasons staying behind increases in carrying
amounts of the company’s contract assets
Selected financial statement data of Carillion plc for fiscal
years 2011–2016 (rounded)
xxxi
210
211
212
212
213
214
219
220
221
222
225
225
227
229
230
230
231
232
xxxii
Table 7.13
Table 7.14
Table 7.15
Table 7.16
Table 7.17
Table 7.18
Table 7.19
Table 7.20
Table 7.21
Table 7.22
Table 7.23
Table 7.24
Table 7.25
Table 7.26
Table 7.27
Table 7.28
Table 7.29
Table 7.30
List of Tables
Current assets of Carillion plc as at the end of fiscal years
2015 and 2016
Note 17 (Trade and other receivables) to financial
statements of Carillion plc for fiscal year 2016
Extract from Note 31 to financial statements of Carillion
plc for fiscal year 2016
Selected financial statement data of Astaldi Group
for fiscal years 2013–2017 (rounded)
Selected financial statement data of GateHouse Media
Inc. for fiscal years 2005–2009
Operating cost breakdown of GateHouse Media Inc.
in fiscal years 2007–2009
Selected financial statement data of OCZ Technology
Group Inc. for fiscal years ending February 29/28,
2011–2013
Extract from Note 8 to consolidated financial statements
of OCZ Technology Group Inc. for fiscal year ended
February 28, 2013, referring to impairment of goodwill
Extract from Note 4 to financial statements of OCZ
Technology Group Inc. for fiscal year ended February 29,
2012, referring to its takeover of Indilinx Co. Ltd.
Selected financial statement data of Starbreeze AB
for fiscal years 2015–2017
Extract from Note 1 to financial statements of Sino-Forest
Corp. for fiscal year 2009, related to the company’s
accounting for timber holdings
Selected financial statement data of Sino-Forest Corp.
for fiscal years 2003–2008
Selected financial statement data of Icelandair Group
for fiscal years 2011–2018
Selected financial statement data of Jones Energy Inc.
for fiscal years 2013–2018
Depreciation and amortization, on the background
of depreciable and amortizable fixed assets of Lufthansa
Group, in fiscal years 2009–2015
Depreciation and amortization, on the background
of depreciable and amortizable fixed assets of Netia S.A.,
in fiscal years 2012–2018
Depreciation and amortization, on the background
of depreciable property, plant and equipment of Toshiba
Corp., in fiscal years 2008–2014
An inventory-related extract from annual report
of Burberry Group plc for fiscal year ended March 31,
2009
233
233
233
235
237
239
240
242
243
245
249
249
252
253
256
258
259
260
List of Tables
Table 7.31
Table 7.32
Table 7.33
Table 7.34
Table 7.35
Table 7.36
Table 8.1
Table 8.2
Table 8.3
Table 8.4
Table 8.5
Table 8.6
Table 8.7
Table 8.8
Table 8.9
Table 8.10
Restatement of past income (loss) before income taxes
of Toshiba Corp., for fiscal years (ended March 31)
2009–2012
Extract from the revised financial statements of Toshiba
Corp., for fiscal year ended March 31, 2012, regarding
the company’s inventory-related restatements
Extract Form 6-K report, issued by Aegan Marine
Petroleum Network Inc. in June 2018 and addressing
the results of the company’s internal investigation
regarding its receivable accounts and revenues
Extract from notes to consolidated financial statements
of GateHouse Media Inc. for fiscal year 2009, referring
to impairment charges of long-lived assets
Extract from Note 4 to financial statements of OCZ
Technology Group Inc. for fiscal year ended February 29,
2012, containing pro forma financial information
Restatement of past income before income taxes
of Toshiba Corp. for fiscal years (ending March 31)
2008–2014
Selected financial statement data of US Airways Group
Inc. for fiscal years 2004–2013
Selected financial statement data of GateHouse Media
Inc. for fiscal years 2005–2012
Selected financial statement data of Dart Group plc
for fiscal years 2007–2018
Extract from Note 11 to financial statements of OCZ
Technology Group Inc. for fiscal year ended February 29,
2012, referring to the company’s warranty provisions
Warranty provisions of OCZ Technology Group Inc.
in relation to the company’s annual sales revenues
Extract from Note 9 to financial statements of OCZ
Technology Group Inc. for fiscal year ended February 28,
2013, referring to the company’s warranty provisions
Selected financial statement data of Nortel Networks
Corp. for fiscal years 2001 and 2002
Extract from Note 6 (Special charges) to financial
statements of Nortel Networks Corp. for fiscal years 2002
and 2003
Pre-tax accounting earnings (as reported in income
statement) and estimated taxable income of GetBack S.A.
in fiscal year 2016 and the first half of fiscal year 2017
Pre-tax earnings (on continued operations) and current
income taxes of General Electric Co. for fiscal years
2011–2016
xxxiii
261
261
262
262
262
263
268
269
271
274
274
275
276
276
280
283
xxxiv
Table 8.11
Table 8.12
Table 8.13
Table 8.14
Table 8.15
Table 8.16
Table 8.17
Table 8.18
Table 8.19
Table 8.20
Table 8.21
Table 8.22
Table 8.23
Table 8.24
Table 8.25
Table 8.26
Table 8.27
Table 8.28
List of Tables
Pre-tax earnings and current income taxes of Aventine
Renewable Energy Holdings Inc. for fiscal years
2004–2009
Related-party transactions and total operating revenues
of GetBack S.A. between fiscal years 2015 and 2017
Selected accounting numbers of Hanergy Thin Power
Group Limited for fiscal years 2012–2015
Extract from Note 34 (Related-party transactions)
to the consolidated financial statements of Hanergy Thin
Power Group Limited for fiscal year 2013
Extracts from Note 20 (Trade and other receivables)
to consolidated financial statements of Hanergy Thin
Power Group Limited for fiscal year 2013
Selected accounting numbers of Astaldi Group for fiscal
years 2013–2017
Inventory reserves and allowances for doubtful accounts
of OCZ Technology Group Inc., on the background
of the company’s revenue, inventory and receivables
growth
Allowance for doubtful receivable accounts of eServGlobal
Ltd., on the background of the company’s net sales
and receivables growth
Aging structure of past due but not impaired receivables
of eServGlobal Ltd
Revenue and profit before tax of eServGlobal Ltd.
for fiscal years 2012–2016
Inventory reserves of Delta Apparel Inc.,
on the background of the company’s net sales
and inventory growth
Selected income statement numbers of Delta Apparel Inc.
for fiscal years 2008–2012
Selected accounting numbers of Volkswagen Group
for fiscal years 2005–2009
Selected accounting numbers of Nokia Corporation
for fiscal years 2005–2009
Selected accounting numbers of Cowell e Holdings Inc.
for fiscal years 2013–2018
Selected financial statement data of Folli Follie Group
for fiscal years 2015–2017
Calculation of Folli Follie’s turnover of net trade payables
between fiscal years 2013 and 2017
Growth of Folli Follie’s sales and adjusted inventories*
between fiscal years 2015 and 2017
284
286
287
288
289
290
293
294
295
296
297
297
299
300
301
303
305
307
List of Tables
Table 8.29
Table 8.30
Table 8.31
Table 8.32
Table 8.33
Table 8.34
Table 8.35
Table 8.36
Table 8.37
Table 8.38
Table 8.39
Table 8.40
Table 8.41
Selected financial statement data of AgFeed Industries
Inc. for fiscal years 2008–2010
Breakdown of the AgFeed’s inventories between fiscal
years 2008 and 2010
Extract from Note 1 to financial statements of US
Airways Group Inc. for fiscal year 2012, related
to the company’s revenue recognition policy
Extract from Note 1 to financial statements of GateHouse
Media Inc. for fiscal year 2012, related to the company’s
revenue recognition policy
Extracts from notes to financial statements of OCZ
Technology Group Inc. for fiscal years ending February
28/29, 2012 and 2013, explaining the company’s
accounting policy toward warranty provisions
Extract from the U.S. Securities and Exchange
Commission’s announcement of findings
of the investigation of accounting manipulations
in Nortel Networks Corp
Extract from Note 14 (Income taxes) to consolidated
financial statements of General Electric Co. for fiscal year
2016, explaining causes of its unusually high income tax
rate in fiscal year 2015
Extract from Note 2 (Significant accounting policies)
to consolidated financial statements of Delta Apparel
Inc. for fiscal year ended June 30, 2012, explaining
the company’s inventory write-down
Extract from Note 10 (Trade receivables and other
current assets) to financial statements of Folli Follie
Group for fiscal year 2017, including the composition
of the company’s other current assets*
Extract from Note 10 (Trade receivables and other current
assets) to financial statements of Folli Follie Group
for fiscal year 2017, referring to its advances to suppliers
Extract from the U.S. Securities and Exchange
Commission’s press release regarding the accounting fraud
committed by managers of AgFeed Industries Inc
Selected financial statement data of Redcentric plc,
reported for fiscal years ended March 31, 2015 and 2016,
in its two consecutive annual reports
Extract from Note 28 (Error restatement) to financial
statements of Redcentric plc for the fiscal year ended
March 31, 2017
xxxv
309
310
313
313
314
315
315
316
316
316
317
317
318
xxxvi
Table 9.1
Table 9.2
Table 9.3
Table 9.4
Table 9.5
Table 9.6
Table 9.7
Table 9.8
Table 9.9
Table 9.10
Table 9.11
Table 9.12
List of Tables
Gross margin on sales* and inventory turnover
(in days)** of Reliance Steel & Aluminum, Klöckner
and Worthington Industries between fiscal years 2008
and 2017
Coefficients of variation of gross margin on sales
and inventory turnover of Reliance Steel & Aluminum,
Klöckner and Worthington Industries, as well
as correlations of gross margin on sales and inventory
turnover with metal price inflation
Adjustments of Klöckner’s and Worthington’s costs
of goods sold (CoGS) and gross margins on sales**
from weighted-average and FIFO methods (respectively)
to LIFO
Comparison of gross margin on sales* of Reliance Steel
& Aluminum, Klöckner and Worthington Industries
Total financial commitments under non-cancellable
operating leases of Southern Cross Healthcare,
as at the end of September 2009 and September 2010
(from Note 30 to the company’s consolidated financial
statements)
Discounted value of non-cancellable operating lease
commitments of Southern Cross Healthcare, as at the end
of September 2010
Discounted value of non-cancellable operating lease
commitments of Southern Cross Healthcare as at the end
of September 2009
Adjustment of reported financial statement numbers
of Southern Cross Healthcare (for fiscal year ended
September 30, 2010) for the company’s off-balance sheet
liabilities
Raw vs. lease-adjusted values of selected financial risk
ratios of Southern Cross Healthcare (as at the end of fiscal
year ended September 30, 2010)
Selected financial statement data and accounting ratios
of Toyota and Volkswagen Group for fiscal years 2007
and 2008
Formulas for adjusting income statement, balance sheet
and cash flow statement for capitalized development costs
Data on capitalized development costs of Volkswagen
Group (as at the end of fiscal years 2006, 2007 and 2008)
as well as the amounts of adjustment’s of the VW’s
reported financial statement numbers for fiscal years 2007
and 2008
325
326
329
330
334
336
339
341
342
344
347
349
List of Tables
Table 9.13
Table 9.14
Table 9.15
Table 9.16
Table 9.17
Table 9.18
Table 9.19
Table 9.20
Table 9.21
Table 9.22
Table 9.23
Table 9.24
Table 9.25
Table 9.26
Table 9.27
Adjustments of reported financial statement numbers
of Volkswagen Group (for fiscal years 2007 and 2008)
for the company’s capitalized development costs
Selected raw and adjusted ratios of Toyota and Volkswagen
Group for fiscal years 2007 and 2008
Adjustments of annual depreciation charges and annual
operating profits of easyJet, Regional Express and WestJet
Raw and depreciation-adjusted operating margins
of easyJet, Regional Express and WestJet in their
respective fiscal years 2010
Descriptions of core business activities of Reliance Steel
& Aluminum, Klöckner and Worthington Industries
(extracted from their annual reports for fiscal year 2016)
Inventory accounting methods used by Reliance Steel &
Aluminum, Klöckner and Worthington Industries
Correlation coefficients between five inflation indexes
(as shown on Chart 8.1) for metal and metal products,
in the period between January 2009 and January 2017
The reported and adjusted (from FIFO to LIFO)
operating profit of Worthington Industries in fiscal years
2009–2018
Selected financial statement data of Southern Cross
Healthcare for fiscal year ended September 30, 2010
Average cost of debt of Southern Cross Healthcare,
as at the end of September 2010 (from Note 30
to the company’s consolidated financial statements)
Description of accounting policies related to research
and development expenditures of Volkswagen Group
and Toyota Motor Corporation
Gross values and carrying amounts of Volkswagen Group’s
intangible assets, as at the end of fiscal years 2006,
2007 and 2008 (extracted from notes to the company’s
consolidated financial statements for fiscal years 2007
and 2008)
Accounting policy applied by easyJet to its aircraft-related
fixed assets
Accounting policy applied by Regional Express to its
aircraft-related fixed assets
Accounting policy applied by WestJet to its aircraft-related
fixed assets
xxxvii
350
351
356
357
359
360
360
361
361
362
362
363
363
364
364
xxxviii
Table 10.1
Table 10.2
Table 10.3
Table 10.4
Table 10.5
Table 10.6
Table 10.7
Table 10.8
Table 10.9
Table 10.10
List of Tables
Selected accounting numbers extracted from consolidated
financial statements of Asseco Group, Formula Systems
(1985) Ltd. and Sapiens International Corporation N.V.
for fiscal years 2015 and 2016 (as presented in Table
10.15), after their conversion from USD to PLN
Adjustments of selected accounting numbers (converted
from USD to PLN) reported by Formula Systems,
for non-controlling interests in the equity of Sapiens
International (with the NCI’s share in Sapiens’ equity
of 50,87% and 51,15% in 2015 and 2016, respectively)
Adjustments of selected accounting numbers of Asseco
Group, for non-controlling interests in the equity
of Formula Systems (with the NCI’s share in Formula’s
equity of 53,67% in both fiscal years 2015 and 2016)
Selected financial risk ratios of Asseco Group in fiscal
years 2015 and 2016, computed on the basis
of the company’s reported and adjusted consolidated
accounting numbers*
Reported profits, contract assets (“Amounts due
from customers” ), contract liabilities (“Amounts due
to customers” ) and “invoiced earnings” of Astaldi Group
in fiscal years 2011–2017 (data in EUR million)
Reported profits, contract assets (“Amounts owed
by customers on construction contracts” ), contract liabilities
(“Amounts owed to customers on construction contracts”)
and “invoiced earnings” of Carillion plc in fiscal years
2008–2016 (data in GBP million)
Pre-tax profitability of three car manufacturers in fiscal
year 2009 (computations based on unadjusted income
statement data, as reported in their consolidated financial
statements for fiscal year 2009)
Accounting policies applied to selected classes of property,
plant and equipment by BMW Group, Daimler
and Volkswagen Group
Calculation of the amount of BMW’s adjustment
for book-tax temporary differences, related to its tangible
and intangible fixed assets (based on data disclosed
in Table 10.22)
Calculation of the amount of Daimler’s adjustment
for book-tax temporary differences related to its tangible
and intangible fixed assets (based on data disclosed
in Tables 10.23 and 10.24)
371
374
375
376
385
387
397
398
401
402
List of Tables
Table 10.11
Table 10.12
Table 10.13
Table 10.14
Table 10.15
Table 10.16
Table 10.17
Table 10.18
Table 10.19
Table 10.20
Table 10.21
Table 10.22
Table 10.23
Calculation of the amount of Volkswagen Group’s
adjustment for book-tax temporary differences, related
to its tangible and intangible fixed assets (based on data
disclosed in Table 10.25)
Comparison of “raw” and adjusted (for book-tax
differences related to tangible and intangible fixed assets)
profitability ratios of the three-car manufacturers in fiscal
year 2009
Asseco’s justification of treating Formula Systems as its
controlled entity
Asseco’s justification of treating Sapiens International
as its controlled entity
Selected accounting numbers extracted from consolidated
financial statements of Asseco Group, Formula Systems
(1985) Ltd. and Sapiens International Corporation N.V.
for fiscal years 2015 and 2016
Currency rates used in converting financial results
of Formula Systems and Sapiens International from USD
into PLN
Extract from notes to consolidated financial statements
of Astaldi Group for 2017, describing the company’s
accounting policy regarding its long-term contracts
Reported profits, operating cash flows and “invoiced
earnings” of Astaldi Group in fiscal years 2014–2017
(data in EUR million)
Extract from notes to consolidated financial statements
of Carillion plc for fiscal year 2016, describing
the company’s accounting policy regarding its long-term
contracts
Reported profits, operating cash flows and “invoiced
earnings” of Carillion plc in fiscal years 2013–2016 (data
in GBP million)
Accounting policies applied to capitalized development
costs by BMW Group, Daimler and Volkswagen Group
Deferred tax assets and deferred tax liabilities of BMW
Group, as at the end of fiscal years 2008 and 2009 (data
extracted from Note 15 to BMW’s consolidated financial
statements for fiscal year 2009)
Deferred tax assets of Daimler Group, as at the end
of fiscal years 2008 and 2009 (data extracted from Note
8 to Daimler’s consolidated financial statements for fiscal
year 2009)
xxxix
403
404
406
407
408
408
409
410
411
412
412
413
413
xl
List of Tables
Table 10.24
Table 10.25
Deferred tax liabilities of Daimler Group, as at the end
of 2008 and 2009 (data extracted from Note 8
to Daimler’s consolidated financial statement for fiscal
year 2009)
Deferred tax assets and deferred tax liabilities
of Volkswagen Group, as at the end of fiscal years
2008 and 2009 (data extracted from Note 10 to VW’s
consolidated financial statement for fiscal year 2009)
414
414
1
Most Common Distortions in a Financial
Statement Analysis Caused by Objective
Weaknesses of Accounting and Analytical
Methods
1.1
Introduction
Even financial statements which are prepared in a full compliance with the
effective accounting regulations may not be entirely reliable or comparable (in
time or between various firms), since they are prone to objective weaknesses
of accounting methods (Penman, 2003). Therefore, any financial statement
user must be aware that financial reports constitute only a simplification of
often very complex business activities and that no accounting system is able
to perfectly reflect a reality. Consequently, when examining companies it is
important to bear in mind that both the accounting numbers as well as the
analytical metrics (e.g. financial ratios) may be materially distorted, either by
inherent imperfections of accounting methods (discussed below as well as in
Chapter 2) or by deliberate misstatements (discussed in Chapters 3 and 4),
or both. Accordingly, the remaining part of this chapter, as well as the entire
content of the following one, will guide the reader through selected pitfalls
of a financial statement analysis, which do not result from any intentional
accounting manipulations.
1.2
Undervaluation or Omission of Relevant
Assets on Balance Sheet
One of the weaknesses of contemporary accounting is an omission of some
relevant and valuable assets (particularly intangibles) on corporate balance
sheets. This issue will be illustrated with the information extracted from
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_1
1
2
J. Welc
financial statements of L’Oréal SA, one of the major global players in a beauty
and personal products industry. The other assets, even though appearing on
corporate balance sheets, may be reported at carrying amounts which are
much lower than their real recoverable (market) values. This problem, which
is a by-product of a conservativeness bias embedded in financial reporting,
will be discussed with the use of financial statement disclosures of AkzoNobel
(a chemical firm) and Hudson’s Bay Company (a retailer of consumer goods).
1.2.1 L’Oréal SA
L’Oréal SA is a name of a French company which is one of the leaders of
a global personal products industry. However, L’Oréal is also a very valuable
brand (trademark), owned and managed by L’Oréal SA. Indeed, according to
Forbes magazine, in 2017 L’Oréal was ranked as 25th most powerful global
brand, with its estimated market value of 14,5 USD billion. If L’Oréal brand
constitutes such a valuable asset, one might logically suppose that it should
have a significant carrying amount and high share in the consolidated total
assets of L’Oréal SA.
Table 1.11 (in the appendix) presents consolidated assets of L’Oréal SA
as at the end of 2015, 2016 and 2017. From the face of the consolidated
balance sheet one might conclude that L’Oréal brand is included in “Other
intangible assets”. However, if this is the case, then the first confusion may
appear. Namely, the total carrying amount of all other intangible assets, which
probably include not only the L’Oréal brand but some other intangibles too,
amounts to 2,5 EUR billion (as at the end of 2017), which is significantly less
than the alleged market value of the L’Oréal brand itself (of 14,5 USD billion,
according to Forbes magazine). One might suppose that a possible reason for
such a wide discrepancy between the carrying amount of L’Oréal brand and
its estimated market value is a historical cost basis of the former one (i.e. an
inclusion of the brand on the balance sheet at the amount corresponding to
its historical cost, instead of its current market value). In order to obtain more
information on it, one might skip to Note 7.2 of the consolidated financial
statement of L’Oréal SA for 2017.
According to that note, L’Oréal SA subdivides its intangible assets (other
than goodwill) into the following classes: brands with indefinite useful
life, amortizable brands and product ranges, licenses and patents, software,
customer relationships, key money and other intangibles. If any of those
categories includes the L’Oréal brand, this would be brands with indefinite
useful life, whose total gross value at the end of 2017 amounted to 1.761,0
EUR million, with the accumulated amortization and provisions amounting
1 Most Common Distortions …
3
to 154,8 EUR million (with the resulting total carrying amount of 1.606,2
EUR million). Consequently, if the L’Oréal brand is included in brands with
indefinite useful life, then its carrying amount (which must be no higher than
1.606,2 EUR million) constitutes less than 15% of its estimated market value
of 14,5 USD billion. Fortunately, an interesting and more detailed information about a breakdown of this class of intangibles may be found in the
narrative part of Note 7.2, cited in Table 1.12 (in the appendix). As might
be read there, there is no any mentioning of the L’Oréal brand among the
brands with indefinite useful lives owned by L’Oréal SA, which means that
its carrying amount on the company’s consolidated balance sheet equals zero.
A reason for an omission of the L’Oréal brand (in contrast to an inclusion
of several much less valuable trademarks) on the consolidated balance sheet of
L’Oréal SA is simple. Namely, this corporate brand was launched and internally developed, through many decades, by the company itself. In contrast, all
brands mentioned in Note 7.2 (and cited in Table 1.12) have been purchased
by L’Oréal SA from external entities, either individually or as part of business combinations (takeovers). Meanwhile, under most accounting standards
(including IFRS and US GAAP) a capitalization of internally developed
intangible assets is prohibited, with only few limited exceptions (e.g. software
development costs). As a result, expenditures on creation and development
of such intangibles (whether these are brands, product formulas, artworks,
databases, customer relationships or unique technologies) are expensed as
incurred (except for limited exceptions), with resulting zero carrying amounts
on the balance sheets. Generally speaking, only purchased intangibles are
recognized on corporate balance sheets and they are reported on a historical
cost basis (which means that even in their case there may be wide discrepancies between carrying amounts and current market values). Consequently,
some minor intangibles may have positive carrying amounts, while major and
highly valuable internally generated assets (such as the L’Oréal brand) are not
recognized at all.
Obviously, the omission of relevant and valuable intangible assets on
balance sheets of many contemporary corporations constitutes a very serious
weakness of accounting, particularly in case of intellectual capital-intensive
businesses. Unfortunately, usually analytical adjustments (which would capitalize such off-balance sheet assets) are impossible, due to lacking data (except
for rare cases when some estimates of market values of those omitted assets
are available).
4
J. Welc
1.2.2 AkzoNobel
A good example of significant discrepancies between carrying amounts and
market values of assets is a disposal of a specialty chemicals business unit by
AkzoNobel, whose selected financial statement data for fiscal years 2017 and
2018 are presented in Table 1.13 (in the appendix).
As may be seen, at the end of 2017 the AkzoNobel’s indebtedness
(measured as a quotient of total liabilities and total assets) exceeded 60%,
but during the following year it dropped sharply, to below 36%. Such a
deep reduction of a share of debts in the company’s capital structure was
attributable to both an increase in equity (which almost doubled between the
end of 2017 and the end of 2018) as well as to a decrease in the carrying
amount of total liabilities (which fell from 9,9 EUR billion to 6,7 EUR
billion). As may be observed in the lower part of Table 1.13, in 2018 the
company reported a huge net earnings (6,7 EUR billion), of which more
than 93% (6,3 EUR billion) came from discontinued operations.
In one of the notes to its financial statements for 2018 the company stated
that “the results and cash flows from discontinued operations in 2017 as well
as 2018 […] almost completely relate to the Specialty Chemicals business”. The
same note discloses more detailed data, shown in Table 1.1, regarding discontinued operations. As may be seen, a major contributor to a large total profit
from discontinued operations (of 6.274 EUR million) was a gain on the
sale of the Specialty Chemicals business, amounting to 5.811 EUR million
[=6.074–263] on an after-tax basis.
A gain on sale of a business unit is driven mostly by a difference between
proceeds received from this disposal and carrying amount of derecognized
(sold) net assets on a transaction date. The calculation of the AkzoNobel’s
gain on the sale of its Specialty Chemicals business in 2018 is presented
Table 1.1 Results of discontinued operations of AkzoNobel in fiscal years 2017 and
2018
Data in EUR million
2017
2018*
Revenue
4.963
3.791
Profit before tax
561
633
Profit for the period
393
463
-
6.074
Gain on the sale of the Specialty Chemicals business
Income tax on the sale
Total profit for the period from disconƟnued operations
*2018 represents nine months
Source Annual report of AkzoNobel for fiscal year 2018
-
−263
393
6.274
1 Most Common Distortions …
5
in Table 1.14 (in the appendix). As may be seen, the company sold net
assets with a total carrying amount (on a transaction date) of about 2,1
EUR billion, for a total price of almost 8,3 EUR billion. Accordingly, before
their disposal these net assets were held in the AkzoNobel’s balance sheet at
the carrying amount which constituted merely about one fourth [=2,1 EUR
billion/8,3 EUR billion] of their recoverable amount.
The example of AkzoNobel’s disposal of the Specialty Chemicals business
confirms that carrying amounts of net assets reported on corporate balance
sheets may be seriously understated, in a sense that they may dramatically
deviate from real market values. In 2018 AkzoNobel sold its business unit
for a price as many as almost four times higher than its pre-transaction
book value (i.e. 8,3 EUR billion vs. 2,1 EUR billion), which boosted the
company’s consolidated earnings and equity and enabled a deep reduction of
its indebtedness ratio (which fell from 61,0 to 35,9%).
1.2.3 Hudson’s Bay Company
AkzoNobel offered an example of a gain on disposal of the whole business
unit, whose net assets (i.e. a difference between total assets and total liabilities)
had a carrying amount much lower than a recoverable amount (reflected in a
transaction value). However, significantly understated carrying amounts may
be also observed in case of individual assets. A good example is a disposal
of property by Hudson’s Bay Company, whose condensed interim income
statement is presented in Table 1.15 (in the appendix).
As may be seen, in the first quarter of its fiscal year 2019 Hudson’s Bay
Company recognized a significant gain on a sale of property, in the net
amount of 817 CAD million. This one-off transaction had a material impact
on the company’s reported results, since it exceeded the amount of its operating income. This means that in the absence of the sale of property the
company would report quarterly losses, instead of profits.
In Note 6 to its quarterly financial statements, Hudson’s Bay Company
provided a narrative information about that property sale transaction. These
disclosures are quoted in Table 1.16 (in the appendix). Table 1.17 (also in
the appendix), in turn, contains an information extracted from Note 4 to the
company’s annual report for the fiscal year ended February 2, 2019, regarding
the carrying amount of that property. As may be read, the building sold in
February 2019 had a book value of 279 CAD million, which constituted
only about one-fourth of its recoverable amount (the transaction value) of
1,1 CAD billion.
6
J. Welc
Similarly as in the case of AkzoNobel, the example of Hudson’s Bay
Company’s gain from a disposal of its real-estate property teaches that
multiple business assets are reported on corporate balance sheets at carrying
amounts which may constitute only a small fraction of their real market
values. The possibility of such material book-market discrepancies should
be always taken into consideration when investigating financial statements,
particularly those published by heavily indebted firms (which may “release”
some hidden, although real gains, by disposing of assets with understated
book values).
1.3
Undervaluation or Omission of Relevant
Liabilities on Balance Sheet
Not only relevant assets may have understated (or zero) book values on corporate balance sheets, but also many liabilities (often contractually noncancelable and nontransferrable) may be omitted as well (Leder 2003). The most
common classes of such real or potential obligations are:
• Rental and operating lease obligations,
• Contingent liabilities.
1.3.1 Rental and Operating Lease Obligations
Under most accounting standards company’s lease contracts must be classified as either operating lease or capital lease. While obligations resulting from
capital leases are recognized on the lessee’s balance sheet (together with leased
assets, even though their legal ownership is maintained by the lessor), liabilities stemming from operating lease contrasts stay off-balance sheet. The same
applies to most rental contracts, e.g. for commercial space in shopping malls.
The result is that many real financial obligations are kept off the balance
sheets, with a corresponding omission of related assets (used by the company
under rental or operating lease agreements).
As might be seen in Table 1.18 (in the appendix), in case of some bankrupt
corporations nominal values of off-balance sheet liabilities significantly exceed
carrying amounts of their total liabilities recognized on balance sheet. Obviously, it entails significant distortions of indebtedness and liquidity ratios,
computed for those firms on the basis of numbers reported on their balance
sheets. In such cases the amounts reported on the face of the balance sheet
should be adjusted, by capitalizing off-balance sheet obligations as well as
1 Most Common Distortions …
7
related assets. However, such capitalization should not be based on nominal
amounts of contracted future lease payments, since it would ignore a time
value of money (which is a significant factor in the case of long-term financial obligations). Instead, the future payments should be discounted to their
current values, with the use of a discount rate which reflects a given company’s
credit risk. This technique will be discussed with details in Sect. 9.3 of
Chapter 9.
However, it must be kept in mind that since 2019 operating leases and
rental contracts must be capitalized on balance sheets of companies which
prepare their financial statements in accordance with the IFRS. Therefore,
the IFRS-based accounting numbers no longer are distorted by those kinds
of financial commitments and should not be adjusted (since it would result
in a double counting of rental and operating lease obligations).
1.3.2 Contingent Liabilities of BP Plc
The second type of off-balance sheet obligations relates to contingent liabilities, i.e. liabilities whose final amount and/or timing of settlement is
unknown and dependent on uncertain future events. In such cases, probable amounts of future cash outflows (to settle obligations) often cannot be
simply calculated. Instead, they must be estimated (or rather guesstimated).
A good example of a scope of an uncertainty of such “guesstimates” is BP’s oil
spill in the Gulf of Mexico, which happened in April 2010. The company’s
description of this event, extracted from its annual report for 2010, may be
found in Table 1.19 (in the appendix).
As may be read in Table 1.19, the event not only killed and injured several
people, but also caused far-reaching environmental damages. Consequently,
it exposed BP plc to large future costs of compensating individuals, businesses, government entities and others who have been impacted by the oil
spill. In its fiscal year 2010 the company recognized a provision for these obligations, expensed in its income statement and reported on its balance sheet,
amounting to 40,9 USD billion. However, that provision did not cover all
of the probable future costs, since, according to the company, at that time it
was “not possible to estimate reliably any obligation in relation to natural resource
damages claims under the OPA 90, litigation and fines and penalties except for
those in relation to the CWA”. Accordingly, these likely future cash outflows
were treated as contingent liabilities and kept off-balance sheet.
Table 1.20 (in the appendix), which contains extracts from the BP’s annual
reports for the following years (until 2016), illustrates development of the
8
J. Welc
company’s estimates of the costs and liabilities caused by the oil spill. The
information provided in that table may be summarized as follows:
• In 2010 the company recognized provision for liabilities, amounting to
40,9 USD billion, which in the following year was partially reversed (by
the pre-tax amount of 3,8 USD billion) and in 2012 increased again (by
about 5 USD billion). Accordingly, at the end of 2012 a cumulative pretax impact of the oil spill on the BP’s income statement summed to 42,1
USD billion [=40,9 − 3,8 + 5,0].
• According to the company, at the end of 2014 the cumulative pretax income statement charge since the incident amounted to 43,5 USD
billion, which means that between the end of 2012 and the end of 2014
it grew quite insignificantly. The reason was that the recognized provisions for liabilities still did not include amounts for obligations that BP
considered impossible, at that time, to measure reliably.
• In the following two years (2015–2016) BP expensed another 18,3 USD
billion [=11,7 + 6,6] of costs expected to be incurred as a consequence of
the oil spill which happened in 2010. However, this time the company
stated that “following significant progress in resolving outstanding claims
arising from the 2010 Deepwater Horizon accident and oil spill, a reliable
estimate has now been determined for all remaining material liabilities arising
from the incident ”.
• Consequently, the probable obligations which in the preceding years were
treated by BP plc as contingent liabilities and kept off-balance sheet
(since, according to the company, it was not possible to estimate their
amounts reliably), finally went through the company’s income statement
and contributed heavily to the company’s losses reported for 2015 and
2016.
As the example of the BP’s oil spill shows, some very significant and probable contingent liabilities may stay off-balance sheet for as long as several
years, if making reliable estimates of their final amounts is impossible. This
impossibility, in turn, stems from a contingent nature of these obligations,
which means that their final amounts (as well as timing of a settlement)
may be dependent on very uncertain future events, such as court verdicts or
governmental decisions. Nevertheless, even if absent on balance sheet, contingent obligations may imply likely future cash outflows, which may seriously
affect corporate results, financial liquidity and even a company’s survival (as
the following example of Pacific Gas and Electric Company shows).
9
1 Most Common Distortions …
1.3.3 Contingent Liabilities of PG&E Corp
Another good lesson regarding relevance of contingent liabilities, and an
uncertainty of their underlying estimates, is offered by PG&E Corp., which
filed for a bankruptcy in January 2019. According to its annual report
for fiscal year 2018, the company, incorporated in California, is a holding
company whose primary operating subsidiary is Pacific Gas and Electric
Company (further referred to as Utility), which generates revenues mainly
through the sale and delivery of electricity and natural gas to customers.
Table 1.2 presents the company’s selected balance sheet data, as at the end
of 2017 and across all quarters of 2018. As may be seen in the last row
of the table, the PG&E’s indebtedness ratio rose materially (by more than
ten percentage points) in the last three months of the fiscal year 2018, from
an already rather high level observed at the end of the preceding quarter.
This resulted mostly from an increase in total liabilities by 11,8 USD billion
[=63,5 USD billion − 51,7 USD billion), which in turn was driven mainly
by a fivefold increase in wildfire-related claims (whose carrying amount rose
from 2,8 USD billion to 14,2 USD billion).
An explanation of causes of such a huge and sudden increase in the
company’s indebtedness (driven mainly by the skyrocketing wildfire-related
claims) may be found in Note 13 to the company’s consolidated financial
statements for fiscal year 2018. The narratives from that note are quoted
in Table 1.21 (in the appendix). As may be read, in 2017 and 2018 two
huge wildfires burst in California, allegedly ignited by PG&E’s operating
equipment. Both fires caused huge damages, including fatalities. The damages
caused by the Camp Fire, which burst in November 2018, gave rise to the
observed increase in provisions for future obligations (which the company
Table 1.2 Selected consolidated balance sheet data of PG&E Corp. for fiscal years
2017 and 2018
December
31,
2017
March
31,
2018
June
30,
2018
September
30,
2018
December
31,
2018
48.137
48.171
50.828
51.689
63.516
561
0
2.860
2.794
14.226
Total assets
67.884
68.154
69.889
71.385
76.471
Indebtedness raƟo*
70,9%
70,7%
72,7%
72,4%
83,1%
Data in USD million
Total liabili es, including:
Wildfire-related claims
*Total liabilities/Total assets
Source Annual and quarterly reports of PG&E Corp. and authorial computations
10
J. Welc
labels as wildfire-related claims), in light of the company’s alleged role in ignition of the fire. A probable incapability of settling all these claims gave ground
to the company’s management’s decision to file for a bankruptcy in January
2019.
However, no one should be trapped in thinking that the provision for
the wildfire-related claims, recognized by PG&E Corp. on its consolidated
balance sheet at the end of 2018, includes all probable future cash outflows
which may be needed to settle all these obligations. This is due to an omission
of some contingent liabilities whose likely amounts the company was not able
to estimate reliably so far. This is confirmed by explanations extracted from
Note 10 to the company’s quarterly report for the first quarter of fiscal year
2019 (published after PG&E filed for the bankruptcy protection), quoted in
Table 1.22 (in the appendix). Reading these narratives leads to the following
conclusions (among others):
• In the aftermath of the 2018 Camp Fire the company recognized new
provisions for wildfire-related claims, totaling 10,5 USD billion (expensed
in 2018 and reported on the company’s balance sheet).
• According to the company’s statement, this amount “corresponds to the
lower end of the range of PG& E Corporation’s and the Utility’s reasonably
estimated losses”. Consequently, that estimate was biased downward (since
it corresponded to the lower end of the range of the company’s estimates), which in turn implied a high probability that the final claims would
significantly exceed the amount of recognized provisions.
• Furthermore, the amount of the recognized provisions for wildfire-related
claims entirely ignored some “potential penalties or fines that may be imposed
by governmental entities […], or any losses related to future claims for damages
that have not manifested yet, each of which could be significant ”.
• Thus, only time could tell how much money the company would finally
have to spend to settle all its wildfire-related claims. However, in light of
the cited explanations it seems very likely that this would be much more
than the amount of the recognized provisions. Consequently, it is obvious
that the indebtedness ratio of 83,1% (as at the end of the first quarter of
the fiscal year 2019) may have dramatically understated the PG&E Corporation’s real financial challenges, faced as a consequence of the wildfires it
was involved in.
1 Most Common Distortions …
1.4
11
Inventory Write-Downs as an Imperfect
Signal of Problems with Excess or Obsolete
Inventories
Under most accounting standards inventories are to be reported in balance
sheet at the lower of their cost or net realizable value. This means that as
long as inventories may be marketed above their historical costs (of purchase
or manufacturing), their carrying amounts reflect historical costs. However,
when net realizable values of inventories (i.e. prices for which they could
be sold, less costs of disposal) fall below their historical costs, carrying
amounts are to be written down to net realizable values. Such write-downs of
inventories are also labeled as inventory impairment charges.
However, inventory write-downs are mandatory only when their net realizable values fall below their historical costs. Therefore, if a company is
stockpiled with inventories and has to cut its sales prices deeply (to get rid of
those excesses), but to the levels which still exceed historical costs of inventories, no any write-down is required. In such circumstance a following collapse
of company’s earnings, caused by its eroded margin on sales, often constitutes a negative earnings surprise to those analysts or inventors, who are not
diligent enough when reading corporate financial reports. This problem is
illustrated in Example 1.1.
As might be seen, in the first two periods the company sold its merchandise
for prices which exceeded their purchase costs by 150% (2,50 EUR vs. 1,00
EUR). However, in Period t + 1 it experienced an unbalanced growth of
inventories, which rose by over 130% y/y (from 1.500 to 3.500), much faster
than sales. In consequence, to reduce its stockpile of excess inventories, in the
following year the company had to cut its sales prices by 50% (from 2,50
EUR to 1,25 EUR). This, in turn, dramatically eroded its margin on sales
and resulted in a deep operating loss. However, such a deep cut of sales prices
in Period t + 2 does not mean that the company’s inventories should have
been written down before, since their reduced prices (net realizable values) of
1,25 EUR still exceeded their carrying amounts (historical costs of purchase)
of 1,00 EUR.
A good real-life exemplification of the problem discussed in this section is
H&M in 2014-2018. The company’s selected financial statement numbers,
as well as some ratios, are presented in Table 1.3. As might be seen, between
2014 and 2018 the company’s inventory turnover (in days) was in a negative trend, which implied more and more inventories in relation to costs of
goods sold. The average time during which inventories stayed on shelves in
12
J. Welc
Example 1.1 Problem with excess inventories (followed by a collapse of profitability)
which does not require the inventory write-down
Company A is a retailer of a single product. It purchases it from its supplier for 1 EUR per
unit and under normal circumstances it sells it in its retail stores for 2,50 EUR per unit. In
Period t the company sold 4.000 units, with a resulng gross profit on sales of 6.000 EUR. In
Period t + 1 its sales grew by 10%, which boosted its gross profit on sales to 6.600 EUR. The
company also incurs general and administrative expenses, which have an enrely fixed
nature and stay at an annual amount of 5.000 EUR. Under such condions the company’s
operang profit earned in Period t amounted to 1.000 EUR, but in the following year it grew
by an impressive 60% y/y, to 1.600 EUR.
However, in light of the favorable market condions prevailing in Period t + 1, the company
over-opmiscally forecasted its future sales and ordered too many inventories. As a result,
the carrying amount of its inventories (reported at a cost of purchase) grew from 1.500 EUR
at the end of Period t to as much as 3.500 EUR at the end of the following year.
To get rid of its excess inventories, in Period t + 2 the company decided to cut its sales prices
by a half, i.e. to 1,25 EUR per unit. Such a move boosted demand and resulted in a sale of
6.000 units in Period t + 2. However, a deep cut of a sales price also entailed a dramac
erosion of the company’s gross profit on sales, which pushed the company below its breakeven point (given the fixed nature of its general and administrave costs) and resulted in a
deep loss (surprising to many analysts and shareholders) incurred in Period t + 2.
In the aermath of the events in Period t + 2, some investors accused the company’s auditor
for a poor quality of its audit of the company’s results reported for Period t + 1. Those
investors claimed that such deep price cuts, needed in Period t + 2 to get rid of excess
inventories stockpiled at the end of Period t + 1, jusfied deep inventory write-downs in
Period t + 1 (which would result in much lower profits, or even losses, reported for Period t +
1, instead of in Period t + 2). Are they right?
In those circumstances the company’s results looked as follows:
Period t
Period t + 1
Period t + 2
Revenues
10.000
= 4.000 x 2,50
11.000
= 4.400 x 2,50
7.500
= 6.000 x 1,25
Cost of goods sold
4.000
= 4.000 x 1,00
4.400
= 4.400 x 1,00
6.000
= 6.000 x 1,00
Gross profit on sales
6.000
6.600
1.500
General and administrave costs*
5.000
5.000
5.000
Operang profit
1.000
1.600
−3.500
Inventories
1.500
3.500
1.500
*Assumed to have entirely fixed nature
Source Author
1 Most Common Distortions …
13
Table 1.3 H&M’s sales, gross profit and inventories between fiscal years 2014 and
2018
SEK million
2014
2015
2016
2017
2018
Net sales (excluding VAT)
151.419
180.861
192.267
200.004
210.400
Costs of goods sold (CoGS)
62.367
77.694
86.090
91.914
99.513
Gross profit
89.052
103.167
106.177
108.090
110.887
Inventory (Stock-in-trade)
19.403
24.833
31.732
33.712
37.721
112,0
115,1
132,7
132,0
136,5
242,8%
232,8%
223,3%
217,6%
211,4%
Inventory turnover (days)*
Net sales to CoGS
*= [(Inventory/CoGS) × 360 days]
Source Annual reports of H&M Hennes & Mauritz AB (for various fiscal years) and
authorial computations
the company’s stores (including transit to points of sales) lengthened from
112 days in 2014 to over 136 days (i.e. over three weeks more) in 2018.
That stubborn multiple-year trend of a lengthening inventory turnover was
reflected in a gradually falling gross margin on sales, which in the bottom part
of Table 1.3 is expressed as a quotient of net sales to costs of goods sold. While
in 2014 the company’s sales prices exceeded its inventory purchase costs by
over 140% (with a ratio of 242,8%), on average, in the following years this
proportion fell monotonically, to less than 112% in 2018. As regards the
company’s gross profit, the eroding margins were between 2014 and 2018
offset by increasing net sales, which kept the gross profit growing (although
slower and slower). Obviously, it seems that the growing stockpile of the
company’s inventories put an ongoing pressure on its profits and margins.
However, as might be read in Table 1.23 (in the appendix), which contains
extracts from the company’s annual reports for 2016, 2017, and 2018, so far
it did not entail any significant inventory write-downs.
According to the extracts cited in Table 1.23, the company’s managers were
fully aware of its stockpiling inventories, since they repeatedly admitted that
the stock levels were growing. However, despite that, the scope of inventory
write-downs to net realizable values was immaterial in all three years. This was
because the company still enjoyed sufficiently high margins on sales, which
ensured enough space for accommodating any necessary price cuts. In fiscal
year 2018 the ratio of net sales to costs of goods sold (i.e. 211,4%) meant
that even price cuts as deep as by 50% would not suffice to push the reduced
sales prices to below inventory purchase costs. However, a legitimate lack of
inventory write-downs (as long as sales prices stood above inventory costs)
did not mean the lack of significant problems with excess inventories (which
14
J. Welc
were manifested in eroding margins). Therefore, it is always important to
watch for inventory turnover trends when analyzing financial statements of
inventory-intensive businesses (with the use of techniques discussed later in
the book).
1.5
Distortions Caused by a Leeway
in a Financial Statement Presentation
Many accounting systems (including IFRS and US GAAP) allow companies
to design their own “templates” of primary financial statements, including
their structures, levels of detail and labels used for various reported items. This
entails significant intercompany differences in how and where in financial
statements various items are presented. For instance, some firms report profits
and losses from equity-accounted investments (i.e. their proportional shares
in profits or losses of associates) below operating profit, while others treat
them as part of their operations and accordingly include them in a calculation
of their operating income. Some entities report all general and administrative expenses under a single line item of income statement, while others split
them into R&D expenditures and other general and administrative expenses
(and report both under separate line items). Likewise, while some companies treat all financial items, such as interest costs, currency gains/losses or
results of investments in derivatives, as part of their financial income reported
beneath operating profit, others include some of those items (e.g. gains or
losses on derivatives used to hedge against currency risks faced by exporters
or importers) in their operating income.
All such presentational differences may bring about an incomparability
of reported accounting numbers, sometimes labeled very similarly in financial statements of various companies. Therefore, in a comparative analysis of
several businesses it is important to check an extent to which these compared
firms differ in presenting their key numbers (and to make analytical adjustments, if necessary). This will be exemplified with the use of financial
statements published by Volkswagen Group and Daimler. However, firms
sometimes change the way in which they present their financial results (e.g.
by reclassifying some items, previously treated as nonoperating, to their operating activities), which may also erode a time-series comparability of numbers
reported by the same firm. This problem will be illustrated with the income
statement data of Astaldi Group.
1 Most Common Distortions …
15
1.5.1 Volkswagen and Daimler
Suppose than an analyst is interested in comparing an operating profitability
of Volkswagen Group and Daimler. Table 1.24 (in the appendix) contains
extracts from income statements of both “peers”, for fiscal years 2007 and
2008. As may be seen, Volkswagen Group reported an item, labeled outright
as “Operating profit ” and amounting to 6.151 EUR million and 6.333 EUR
million, in 2007 and 2008, respectively. In contrast, Daimler’s income statement does not include any line item whose title includes a term “operating”.
However, it does include an item labeled as “Earnings before interest and
taxes (EBIT)”, amounting to 8.710 EUR million and 2.730 EUR million, in
2007 and 2008, respectively. Many analysts and investors use terms “EBIT”
and “operating profit” interchangeably, treating them as synonyms, on the
ground that the numbers reported under them omit the same nonoperating factors, such as financial expenses (interest costs) and income taxes.
Therefore, it is very likely that some financial statement users (particularly
inexperienced ones) would treat the Volkswagen’s “Operating profit ” and
Daimler’s “Earnings before interest and taxes (EBIT)” as counterparts to each
other. Consequently, many of them would just extract the numbers reported
under these two labels, without any adjustments, as inputs to computing the
operating profitability ratios of both firms.
However, a more thorough investigation of both income statements reveals
some other items, which may significantly erode the comparability of the
Volkswagen’s reported operating profit and Daimler’s reported EBIT. In
particular, there are two items which seem to be treated differently by both
firms. These are:
• Results of equity investments in associates, labeled by Volkswagen as “Share
of profits and losses of equity accounted investments” and by Daimler as “Share
of profit (loss) from companies accounted for using the equity method, net ”
(which the former reported beneath its operating profit while the latter
above its EBIT),
• Other financial items, labeled by Volkswagen as “Other financial result ” and
by Daimler as “Other financial income (expense), net ” (which, similarly to
equity-accounted investments, Volkswagen reported beneath its operating
profit while Daimler above its EBIT).
If the Daimler’s earnings before interest and taxes (EBIT) are blindly
treated as the proxy for its operating income, then an inclusion of the
16
J. Welc
company’s equity-accounted investments and other financial results in calculating EBIT (given their above-EBIT presentation) means that these two
items are deemed a part of the Daimler’s core business operations. In contrast,
Volkswagen’s reported operating profit is stripped out from the results on
equity-accounted investments as well as other financial results, which implies
treating them as nonoperating contributors to pre-tax earnings.
Analytical adjustment of the equity-accounted investments seems straightforward. There are two options which may be considered here:
• either the Volkswagen’s share of profits of equity-accounted investments
is transferred upward in the company’s income statement and added to
its reported operating profit (which would make it comparable to the
Daimler’s reported EBIT, which already includes the share in profits and
losses of its associates), or
• the Daimler’s share of profit (loss) from companies accounted for using the
equity method is transferred downward and eliminated from the company’s
reported EBIT (making it comparable to the Volkswagen’s operating
profit, which is already stripped out from the results of equity-accounted
investments).
The latter of these two alternative approaches will be followed below,
which implies treating all profits and losses from equity-accounted investments as unrelated to core business operations of both Volkswagen Group as
well as Daimler.
Before making an adjustment for other financial results (reported by Volkswagen above its operating profit and by Daimler beneath its EBIT), it is
recommendable to find out what items are included there. Table 1.4 contains
the extract from Note 6 to Daimler’s consolidated financial statements for
fiscal year 2008, explaining its other financial income (expense). As may be
read, the company broke down this item of its income statement into expense
from compounding of provisions and miscellaneous other financial income
(net). The company did not provide any more information regarding the
nature of the former one (e.g. what types of provisions are referred to here),
so it may only be guessed (on the ground of the title of Note 6) that these are
some provisions related to the Daimler’s financial operations. Accordingly,
it seems acceptable to treat the compounding of provisions as unrelated to
Daimler’s profit on core business operations. Miscellaneous other financial
income (net), in turn, includes such items as impairments of loans, receivables
and other assets, as well as revaluations of derivative financial instruments.
1 Most Common Distortions …
17
Table 1.4 An extract from Note 6 to Daimler’s consolidated financial statements for
the fiscal year 2008, explaining its other financial income (expense)
NOTE 6: Other financial income (expense), net
In EUR millions
Expense from compounding of provisions
Miscellaneous other financial income, net
2008
(429)
(1.799)
(2.228)
2007
(444)
216
(228)
2006
(418)
518
100
In 2008, miscellaneous other financial income, net, includes expenses of €1.7 billion in
connec on with the impairment of loans, receivables and other assets rela ng to Chrysler.
In 2007, the mark-to-market valua on of the deriva ve financial instruments in connec on
with EADS shares resulted in a gain of €121 million (2006: unrealized gain of €519 million)
which is included in miscellaneous other financial income, net.
Source Annual report of Daimler for fiscal year 2008
Table 1.5 Note 9 to the financial statements of Volkswagen Group for fiscal year
2008 (other financial results)
In millions of EUR
2007
2008
Income from profit and loss transfer agreements
17
20
Cost of loss absorp on
16
36
Other income from equity investments
38
45
Other expenses from equity investments
182
35
Income from securi es and loans*
505
15
Other interest and similar income
976
1.475
Gains (+) and losses (−) from fair value re-measurement and
−49
−244
impairment of financial instruments
Gains (+) and losses (−) from fair value re-measurement of
ineffec ve deriva ves
45
Gains (+) and losses (−) on hedges
Other financial results
−52
−29
−8
1.305
1.180
*Including disposal gains/losses
Source Annual report of Volkswagen Group for fiscal year 2008
These seem to be nonoperating contributors to Daimler’s pre-tax earnings
and as such they deserve being adjusted for.
Table 1.5 presents Note 9 to the financial statements of Volkswagen Group
for 2008, breaking down its other financial result (which the company
reported beneath the operating profit). As may be seen, this line of the
Volkswagen’s income statement included such items as revaluations of financial instruments (which under IFRS embrace receivables), remeasurements of
derivatives and gains and losses on hedges, which seem to be counterparts
to the Daimler’s miscellaneous other financial income (included in Daimler’s
18
J. Welc
reported EBIT). This seems to justify adjusting the Daimler’s EBIT, to make
it more comparable to the Volkswagen’s operating profit, be eliminating other
financial income (expense) from it.
Table 1.6 presents a comparison of operating profitability ratios of both
firms, based on their reported and adjusted accounting numbers. As was
stated before, no any data revisions are done for the Volkswagen’s reported
numbers. In contrast, the Daimler’s reported earnings before interest and
taxes (EBIT) are stripped out from the results of equity-accounted investments and other financial income (expense), in order to make these numbers
more comparable to the Volkswagen’s operating profit.
As may be seen, the Volkswagen’s operating profitability was flat, at 5,6%,
in both investigated periods. Daimler, in contrast, in 2007 reported much
better operating profitability (meant as a quotient of its reported EBIT to
revenues) of 8,8%, followed by a sharp decrease (down to 2,8%) in the
Table 1.6 Adjustment of Volkswagen Group’s and Daimler’s operating profitability
for profits and losses from equity-accounted investments and other financial results
Data in EUR million
2007
2008
108.897
113.808
6.151
6.333
Volkswagen Group
Sales revenue
Opera ng profit
OperaƟng profitability*
5,6%
5,6%
= 6.151/108.897
= 6.333/113.808
99.399
95.873
1.053
−998
−228
8.710
−2.228
2.730
Daimler
Revenue
Share of profit (+)/loss (−) from companies
accounted for using the equity method, net
Other financial income (+)/expense (−), net
Earnings before interest and taxes (EBIT)
7.885
Opera ng profit (EBIT) adjusted for equity-accounted
= 8.710 − 1.053 +
investments and other financial income (expense)
228
OperaƟng profitability
based on reported data
OperaƟng profitability
based on adjusted data
5.956
= 2.730 + 998
+ 2.228
8,8%
2,8%
= 8.710 /
99.399
= 2.730 /
95.873
7,9%
6,2%
= 7.885 /
99.399
= 5.956 /
95.873
*Operating profit/Revenues
Source Annual reports of Volkswagen Group and Daimler for fiscal year 2008 and
authorial computations
1 Most Common Distortions …
19
following year. In other words, while Daimler seemed to outperform its “peer”
in 2007, its reported operating profitability contracted much more dramatically in 2008, to the level which constituted only half of the value of the
VW’s ratio for that period. The comparison based on the adjusted data gives
a completely different picture. While Volkswagen’s operating profitability
stayed at 5,6% in both years (since no revisions of its reported numbers have
been done), the Daimler’s adjusted operating profitability in 2008 now equals
6,2% (as compared to mere 2,8% in case of its reported numbers) and beats
that of its competitor.
To conclude, extracting and comparing financial statement data reported
by several companies, without checking their comparability, may dramatically distort inferences from a comparative analysis. Even though no two
firms use identical “templates” (with identical labels used for various items)
in their financial reporting, they do use terms which may suggest that some
items in their financial statements are directly comparable. In the above
example of Volkswagen Group and Daimler, an analyst could be trapped in
a seeming comparability of the former’s “Operating profit ” and the latter’s
“Earnings before interest and taxes (EBIT)”. In reality, however, these two
lines of their income statements should not be considered as counterparts,
since they include (and exclude) different items, depending on a financial
reporting policy adopted by a particular company. Thus, in order to ensure
the reliability of comparative financial statement analysis, such intercompany
differences in presentational aspects of financial reporting should be taken
into account.
1.5.2 Astaldi Group
Even more risky is to blindly assume an inter-period comparability of financial numbers reported by the same firm. This risk will be illustrated by
selected income statement data of Astaldi Group (an Italian construction
company), presented in Table 1.25 (in the appendix).
The upper part of Table 1.25 presents an extract from the income statement published by Astaldi Group in its annual report for 2014, while its
lower part contains the company’s income statement reported one year later
(i.e. in the annual report for 2015). As may be seen, according to the annual
report for 2014, between 2013 and 2014 the company’s operating profit
stayed almost perfectly flat, at about 234–235 EUR million. Under its financial reporting policy applied at that time, Astaldi Group reported its results
from equity-accounted investments (labeled as “Net gains on equity-accounted
20
J. Welc
investees”) beneath the operating profit, whereby this item’s positive contribution to earnings affected reported pre-tax income, but not the operating
profit. In the following year, however, the company changed its approach and
began including its results on equity-accounted investments, now relabeled to
“Quota of profits (losses) from joint ventures, SPVs and investee companies”, in
calculating its operating profit. This resulted in boosting the operating profit
for 2013 (reported earlier at 234,8 EUR million) upward, to as high as 269,6
EUR million. The difference is entirely attributable to the relocation of the
equity-accounted investments within the company’s income statement.
However, a by-product of such a relocation was a change in the picture of
the company’s earnings growth. According to the lower part of Table 1.26, in
2015 the Astaldi Group’s operating profit grew by almost 3% y/r (i.e. from
269,6 EUR million to 277,5 EUR million). However, now it included the
profits of equity-accounted investments, which grew from 34,8 EUR million
in 2014 to 54,1 EUR million. Without the company’s relocation of that
item (upward in the income statement), i.e. under its previously applied
reporting policy, the operating profit in 2015 and 2014 would amount
to 223,4 EUR million [=277,5 EUR million − 54,1 EUR million] and
234,8 EUR million [=269,6 EUR million − 34,8 EUR million], respectively.
Accordingly, without the presentational change (i.e. without relocating the
results of equity-accounted investments from beneath the operating profit to
above it), the Astaldi Group’s reported operating income would fall in 2015
by almost 5% y/y (i.e. from 234,8 EUR million to 223,4 EUR million),
instead of growing by almost 3%. This confirms the importance of examining
the presentational aspects of financial reporting when analyzing corporate
accounting numbers.
1.6
Distortions of Turnover Ratios Caused
by Seasonality, Growth and Tax-Related
Factors
Most turnover ratios (including those discussed in this book) are computed
on the ground of reported annual financial statements. However, the nature
and origin of inputs to turnover ratios, of which one comes from a balance
sheet while another one from an income statement, may lead to serious
distortions of the obtained values of ratios. As will be shown below, these
distortions may be dangerous in both intercompany comparisons as well as
in a time-series analysis of a single company’s data. In the remaining part of
1 Most Common Distortions …
21
this section the possible distortions caused by sales seasonality, sales growth
and sales taxes will be illustrated.
1.6.1 Distortions Caused by Seasonality of Sales
If company’s operations are deeply seasonal, e.g. featured by an evident peak
of sales in any particular quarter, then its annual revenues and expenses on
one side, and carrying amounts of assets and liabilities (at a year-end) on the
other side, may only very weekly correspond to each other. This is caused by
the fact that the level of some assets (e.g. inventories or receivables) may be
unusually low or high at the end of a year, as compared to their averages across
the whole year. In other words, while annual revenues and costs reflect a
company’s activity during the whole year, the year-end values of some current
operating assets and liabilities are driven by a scale of its activity (possibly
seasonally low or high) at end of the fiscal year. Possible distortions brought
about by such seasonal factors will be exemplified by receivable turnover ratios
of two hypothetical firms, whose data are presented in Table 1.7.
Suppose that Firm A and Firm B are “peers” operating in an apparel business, with identical annual revenues of 80.000 EUR million. However, while
Firm A concentrates on geographical markets featured by flat sales across the
Table 1.7 Revenues, receivable accounts and receivables’ turnover ratios (in days) of
a nonseasonal Firm A and a deeply seasonal Firm B
FIRM A
(no sales seasonality)
Q1
Q2
Q3
Q4 Whole year
Revenues
20.000
20.000
20.000
20.000
80.000
Receivables
10.000
10.000
10.000
10.000
10.000
Receivables’ turnover (days) based on quarterly data*
45,0
Receivables’ turnover (days) based on annual data**
45,0
FIRM B
(deep sales seasonality)
Revenues
Receivables
Q1
Q2
Q3
Q4 Whole year
10.000
10.000
10.000
50.000
80.000
2.500
2.500
2.500
12.500
12.500
Receivables’ turnover (days) based on quarterly data*
22,5
Receivables’ turnover (days) based on annual data**
56,3
*= (Receivables at the year-end/Revenues in the last (fourth) quarter of the year) ×
90 days
**= (Receivables at the year-end/Revenues in the whole year) × 360 days
Source Author
22
J. Welc
whole year (i.e. with no significant seasonal variations), Firm B dominated a
market on which sales peak in the fourth quarter (when they rise fivefold, as
compared to the remaining three quarters). Both firms do not operate their
own retail stores. Instead, they sell their output to independent wholesalers
and retailers (B2B operations) and offer them deferred payment terms.
Suppose that both firms have the following actual patterns of receivables’
collection:
• Firms A offers its customers a 45-days deferred payment terms and all of
its receivable accounts are settled on the last three days of that time interval
(with no past due accounts).
• Firm B offers its customers a 23-days deferred payment terms and, similarly
as in the case of Firm A, all of its receivable accounts are settled on the last
three days of that time interval (with no past due accounts).
Accordingly, Firm A must wait almost twice as long as Firm B (45 days
vs. 23 days) for a collection of its receivable accounts. It also implies Firm A’s
higher share of the quarter-end receivable accounts in its quarterly revenues,
averaging 50% (reflecting the fact that approximately half of its quarterly sales
are collected in the following quarter), as compared to Firm B’s 25%.
As may be seen in Table 1.7, the ratios computed for both firms on the
ground of their quarterly numbers reflect the reality. Firm A’s and Firm B’s
estimated quarterly turnover ratios of 45,0 days and 22,5 days, respectively,
correspond to their actual deferred payment terms. Accordingly, any analyst
examining their quarterly accounting numbers would obtain accurate estimates of their respective receivables’ collection periods. However, the findings
change dramatically when annual accounting numbers are used as inputs to
turnover ratios. Obviously, while receivable accounts at the end of the year
are the same as at the end of its fourth quarter (higher in the case of Firm
B, due to its peak of sales occurring in the last quarter of the year), annual
revenues constitute sums of quarterly revenues, amounting to 80.000 EUR
million for both firms. A result of significantly different seasonal sales patterns
of both firms is a dramatic distortion (overstatement) of Firm B’s turnover
ratio, driven by its accumulation of receivables at the year-end (led, in turn,
by its seasonally peaking sales in that period).
As may be seen, although the annual revenues of both companies do not
differ, their year-end receivables do. However, the observed differences in
their carrying amounts stem not only from their varying collection periods
(i.e. 45 days vs. 23 days), but also from their differing seasonal patterns.
1 Most Common Distortions …
23
While Firm A’s fourth-quarter sales of 20.000 EUR million drive its yearend receivables to 10.000 EUR million (consistent with its 45-day deferred
payment terms), Firm B’s revenues, peaking at 50.000 EUR million in the last
quarter of the year, lift its year-end collectible accounts to as high as 12.500
EUR million (i.e. to approximately one-fourth of these quarterly sales, consistent with the company’s 23-day collection period). Consequently, while Firm
A’s turnover ratio based on its annual data does not deviate from its quarterly
number, the seasonality of Firm B’s sales ruins the reliability of its receivables’
turnover based on the annual data (inflated to as high as 56,3 days).
As clearly shown in Table 1.7, in the case of the examined hypothetical companies the observed differences in seasonality patterns may lead to
completely unreliable analytical findings, if annual data are used. While Firm
B enjoys a much shorter actual receivables’ collection period than Firm A
(23 days vs. 45 days, respectively), the turnover ratios based on the annual
data suggest something entirely opposite (i.e. 56,3 days and 45,0 days for
Firm B and Firm A, respectively).
It must be noted that similar distortions to those illustrated above may be
observed in the case of other working capital components. Manufacturing
or merchandising firms with revenues peaking in the last quarter of their
fiscal years (followed by a quarter with seasonally low sales) tend do report
relatively low year-end carrying amounts of inventories (below their averages
across the whole fiscal year), as compared to their “peers” featured by less
seasonal sales patterns. Likewise, if in a seasonally low quarter a company
accumulates inventories for an expected increase in sales in the following
quarter, its operating payables (driven by stockpiling inventories) will show
discernible seasonal variations as well. Thus, any comparative analyses of businesses featured by significantly different seasonality of operations should be
conducted carefully, with an awareness of possible distortions caused by these
seasonal factors.
1.6.2 Distortions Caused by Growth Rates of Sales
Equally dangerous distortions to those illustrated above may be brought
about by significantly different sales growth rates achieved by two or more
“peers”. If company’s revenues grow fast from quarter to quarter, then its
year-end receivables (driven by relatively high sales volume achieved near
a year-end) will seem incommensurately high, as compared to its annual
revenues (which include relatively low sales recorded in earlier quarters). Similarly as in the case of seasonality, possible distortions brought about by a
24
J. Welc
company’s fast growth will be exemplified by receivable turnover ratios of
two hypothetical firms, whose data are presented in Table 1.8.
Suppose that Firm A and Firm B are “peers” which in a given fiscal
year reported annual revenues of 80.000 EUR million each. Both operate
on markets featured by lack of any discernible seasonal patterns. However,
while Firm A’s sales are stagnant (with no changes from quarter to quarter
and from year to year), Firm B is an emerging industry “disrupter” which
enjoys triple-digit quarterly sales growth rates. Furthermore, due to its deteriorating competitive position, Firm A not only report flat revenues, but it also
must accept relatively long deferred payment terms (45 days) of its receivable
accounts. In contrast, due to Firm B’s product innovativeness, its customers
are willing to settle their trade receivables after 23 days, on average.
As may be seen in Table 1.8, Firm A’s and Firm B’s turnover ratios based
on their quarterly numbers may be deemed reliable (equaling 45,0 days
and 22,5 days, respectively). However, similarly as in the case of seasonal
factors discussed before, the analytical findings are misleading when annual
accounting numbers are used. A direct consequence of Firm B’s fast revenue
growth rate is a dramatic overestimate of its receivables’ turnover ratio, caused
by its relatively high sales recorded at the end of the year (as compared to
earlier periods). While Firm B enjoys a much shorter actual receivables’ collection period than Firm A (23 days vs. 45 days, respectively), the turnover ratios
Table 1.8 Revenues, receivable accounts and receivables’ turnover ratios (in days) of
a no-growth Firm A and a fast-growth Firm B
FIRM A
(no sales growth)
Q1
Q2
Q3
Q4
Whole
year
Revenues
20.000
20.000
20.000
20.000
80.000
Receivables
10.000
10.000
10.000
10.000
10.000
Receivables’ turnover (days) based on quarterly data*
45,0
Receivables’ turnover (days) based on annual data**
FIRM B
(fast sales growth)
45,0
Q1
Q2
Q3
Q4
Whole
year
Revenues
5.000
10.000
20.000
45.000
80.000
Receivables
1.250
2.500
5.000
11.250
11.250
Receivables’ turnover (days) based on quarterly data*
22,5
Receivables’ turnover (days) based on annual data**
50,6
*= (Receivables at the year-end/Revenues in the last (fourth) quarter of the year) ×
90 days
**= (Receivables at the year-end/Revenues in the whole year) × 360 days
Source Author
25
1 Most Common Distortions …
based on the annual data suggest something entirely opposite (i.e. 50,6 days
and 45,0 days for Firm B and Firm A, respectively).
Similar distortions would be observed in the case of both firms’ inventory and payables’ turnover ratios. Fast growing firms tend to report relatively
high year-end carrying amounts of inventories and payable accounts (when
related to their annual cost of sales), as compared to their “peers” featured by
much slower growth rates. Consequently, any comparative analyses of businesses featured by significantly different pace of growth should be conducted
carefully, with an awareness of possible distortions caused by these variations.
1.6.3 Distortions Caused by Changing Sales Breakdown
A final issue discussed in this section deals with possible distortions of
receivables’ turnover ratios observed when a given company’s sales breakdown changes, in terms of the share of revenues subject to different VAT
(value-added tax) rates.
Suppose that a conglomerate operating in a broad range of food-related
businesses recorded shifts in its sales breakdown as shown in Table 1.9. The
Table 1.9 Gross and net sales and receivables’ turnover ratios (in days) of a
hypothetical agribusiness
Net sales
2015
2016
2017
2018
Basic commodi es (0% VAT rate)
50.000
40.000
30.000
20.000
Semi-processed foodstuffs (5% VAT rate)
25.000
20.000
15.000
10.000
Fully processed products (25% VAT rate)
5.000
20.000
35.000
50.000
80.000
80.000
80.000
80.000
2015
2016
2017
2018
Basic commodi es (0% VAT rate)
50.000
40.000
30.000
20.000
Semi-processed foodstuffs (5% VAT rate)
26.250
21.000
15.750
10.500
Fully processed products (25% VAT rate)
6.250
25.000
43.750
62.500
82.500
86.000
89.500
93.000
90,0
88,0
86,0
84,0
20.625
21.022
21.381
21.700
92,8
94,6
96,2
97,7
Total net sales in a year
Gross sales*
Total gross sales* in a year
Actual receivables’ turnover in days**
Receivables based on total gross sales***
EsƟmated receivables’ turnover in days****
*i.e. including VAT tax, based on 0%, 5% and 25% rates
**Assumed for the example
***= (Actual receivables’ turnover in days/360 days) x Total gross sales in a year
****= (Receivables based on gross sales/Net sales) × 360 days
Source Author
26
J. Welc
company operates only on its domestic market, in the following segments of
its agribusiness:
• Low-margin basic commodities (e.g. harvested and unprocessed grains,
fruits and vegetables), which in the company’s tax jurisdiction are subject
to a preference zero percent VAT tax rate, and whose share in net sales was
gradually declining between 2015 and 2018.
• Semi-processed foodstuffs (e.g. frozen packaged fruits, ready-to-fry potatoes or packaged barbecue meat), which are subject to a 5% VAT tax rate
and whose contribution to the company’s net sales also gradually fell in the
investigated period.
• Fully processed products (e.g. wine, canned soups or cheese), which are
subject to a 25% VAT tax rate and whose net sales grew tenfold (with an
increased share in total net sales breakdown) between 2015 and 2018.
One of the problems of receivables’ turnover ratio is a measurement inconsistency of its both inputs, since one of them (receivables) is disclosed on a
balance sheet on a gross invoiced basis, that is including VAT tax (and similar
burdens such as sales tax or excise tax), while another one (revenues) is typically reported net of any directly related taxes (with rare exceptions, such as
H&M, who reports both revenues with and without VAT tax on its income
statement). This entails the following analytical distortions:
• In cases of nonzero VAT tax rates the receivables’ turnover tends to be
overstated (i.e. suggesting longer average collection periods as compared
to the reality), with the extent of the bias being positively correlated with
an applicable VAT rate (i.e. the higher the tax rate, the more inaccurate a
computed turnover ratio is).
• Changing sales breakdown from period to period (e.g. featured by
increasing share of highly taxed products or services) results in a false
trend of the computed receivables’ turnover ratio, which may move in the
opposite direction than the company’s actual collection period.
As may be seen in the upper part of Table 1.9, the investigated conglomerate’s sales breakdown changed dramatically within the analyzed four-year
timeframe. While in 2015 the highly taxed products made up only slightly
more than 6% of its total net sales [=5.000/80.000], their share rose to as
much as over 62% [=50.000/80.000] in 2018. Correspondingly, a contribution of goods subject to lower VAT rates contracted dramatically. As a
1 Most Common Distortions …
27
result, even though the company’s net sales stayed flat across these four years
(amounting to 80.000 annually), its gross revenues grew steadily.
Suppose now that at the same time the company was able to gradually
shorten its actual receivables’ collection period, from 90 days in 2015 to
84 days in 2018, as shown in the lower part of Table 1.9. Without simultaneous changes of its VAT tax position, driven by a systematic increase in
a share of highly taxed goods in its sales breakdown, such an improvement
of the actual receivables’ turnover would result in a steady decrease of the
carrying amount of the company’s collectible accounts. However, since receivables are reported in a balance sheet on their gross (invoiced) basis, rising VAT
taxes payable inflate the carrying amount of the company’s reported receivables, even though its annual net sales stay intact. A result is a flawed and
misleading trend of the computed receivables’ turnover ratio (presented in
the last row of Table 1.9), based on the company’s reported gross receivables
and net sales, which moves in the opposite direction than the actual collection period (suggesting a gradual deterioration, rather than improvement).
Furthermore, a scale of the distortion widens systematically, in tune with the
company’s increasing VAT tax burdens.
It must be emphasized, however, that distortions of turnover ratios may be
caused not only by tax-related issues, but also by purely economical factors
(including sharp or gradual changes of corporate business models). Table 1.10
displays a revenue breakdown (by operating segments) of Lufthansa Group,
in its fiscal years 2014–2017.
In its annual report, Lufthansa Group splits its whole business operations
into four different business segments, as listed in the upper part of the table.
These individual segments differ in many aspects, including their working
capital requirements. In particular, while logistics, MRO and catering services
are associated with significant receivable accounts (since they are rendered to
other firms, mostly other airlines), the Passenger Airline Group may have
different cash flow characteristics. In contrast to the remaining three business
segments, the passenger flights are featured by advance cash collections (on
a ticket sale date), probably without significant receivables (except for those
from credit card companies, who process the Lufthansa’s payments.
As may be seen in Table 1.10, a contribution of the Lufthansa Group’s
receivables-generating revenues (coming from logistics, MRO and catering
segments) to its total revenues was gradually falling (from 28,7% to 24,0%)
between 2014 and 2017. At the same time, the carrying amount of the
company’s trade and other receivables was in a constantly growing trend.
These two tendencies, when combined, could have caused material distortions of findings of the company’s receivables’ turnover analysis, based on its
28
J. Welc
Table 1.10 Segmental breakdown of Lufthansa Group’s revenues in fiscal years
2014–2017
Data in EUR million
2014
2015
2016
2017
23.320
24.499
23.891
27.358
(2) Logis cs
2.435
2.355
2.084
2.524
(3) MRO*
4.337
3.256
3.517
3.568
(4) Catering
2.633
2.386
2.550
2.556
32.725
32.496
32.042
36.006
(1) Passenger Airline Group
Total revenues**
Receivables-genera ng revenues (2 + 3 + 4)
9.405
7.997
8.151
8.648
Passenger Airline Group (with lower receivables)
23.320
24.499
23.891
27.358
Total revenues**
32.725
32.496
32.042
36.006
Share of receivables-generaƟng revenues
in total revenues
28,7%
24,6%
25,4%
24,0%
Trade receivables and other receivables
3.995
4.389
4.570
5.313
43,9
48,6
51,3
53,1
152,9
197,6
201,8
221,2
Receivables’ turnover (in days)
based on total revenues***
Receivables’ turnover (in days)
based on receivables-generaƟng revenues****
*Maintenance, repair and overhaul services
**The revenues reported on the company’s consolidated income statement may
differ from the sums shown here, due to intragroup transactions (eliminated on
consolidation)
***= (Trade receivables and other receivables/Total revenues) × 360 days
****= (Trade receivables and other receivables/Receivables-generating revenues) ×
360 days. Source: Annual reports of Lufthansa Group (for various fiscal years) and
authorial computations
total consolidated revenues. While the next-to-last row of the table suggests a
lengthening of the Lufthansa Group’s receivable collection period by 9,2 days
[=53,1 − 43,9], an alternative calculation shown in the last row (and based
on the company’s receivables-generating revenues) points to a much more
significant change, i.e. an extension of an average collection period by as
many as 68,3 days [=221,2 − 152,9]. Accordingly, not only the turnover
ratios based on the company’s total revenues suggested much shorter (less
than two months) average collection periods, but also pointed to its much
milder lengthening trend.
Appendix
See Tables 1.11, 1.12, 1.13, 1.14, 1.15, 1.16, 1.17, 1.18, 1.19, 1.20, 1.21,
1.22, 1.23, 1.24, and 1.25.
1 Most Common Distortions …
29
Table 1.11 Consolidated assets of L’Oréal SA as at the end of fiscal years 2015–2017
Data in EUR million
Non-current assets
Goodwill
Other intangible assets
Property, plant and equipment
Non-current financial assets
Investments in associates
Deferred tax assets
Current assets
Inventories
Trade accounts receivable
Other current assets
Current tax assets
Cash and cash equivalents
TOTAL
Notes
7.1
7.2
3.2
8.3
6.3
3.3
3.3
3.3
8.2
December
31, 2015
December
31, 2016
December
31, 2017
24.457,6
8.151,5
2.942,9
3.403,5
9.410,9
1,0
547,9
9.253,7
2.440,7
3.627,7
1.486,9
298,6
1.399,8
25.584,6
8.792,5
3.179,4
3.756,9
9.306,5
1,0
548,3
10.045,6
1.698,6
3.941,8
1.420,4
238,8
1.746,0
24.320,1
8.872,3
2.579,1
3.571,1
8.766,2
1,1
530,3
11.019,0
2.494,6
3.923,4
1.393,8
160,6
3.046,6
33.711,3
35.630,2
35.339,1
Source L’Oréal Registration Document. 2017 Annual Financial Report—Integrated
Report Corporate and Social Responsibility
Table 1.12 Extract from Note 7.2 to consolidated financial statements of L’Oréal SA
for fiscal year 2017
Note 7.2: Other intangible assets
On 31 December 2017, brands with an indefinite useful life consist mainly of Matrix (€298.3
million), IT Cosmetics (€201.5 million), CeraVe (€173.7 million), Kiehl’s (€132.4 million), Shu
Uemura (€103.8 million), NYX Professional Makeup (€95.0 million), Clarisonic (€92.1 million),
Decléor and Carita (€81.4 million), and Magic (€80.8 million).
Source L’Oréal Registration Document. 2017 Annual Financial Report—Integrated
Report Corporate and Social Responsibility
30
J. Welc
Table 1.13 Selected financial statement data of AkzoNobel for fiscal years 2017 and
2018
Item (data in EUR million)
Balance
sheet
data
2017
2018
Total assets
Group equity
Total liabilities, including:
Long-term and short-term borrowings
16.178
6.307
9.871
3.273
18.784
12.038
6.746
2.398
Indebtedness ratio*
61,0%
35,9%
9.612
9.256
Operating income
825
605
Profit (after tax) from continuing operations
511
455
Profit for the period from discontinued
Profit for the period
393
904
6.274
6.729
Revenue
Income
statement
data
*Total liabilities/Total assets
Source Annual report of AkzoNobel for fiscal year 2018
Table 1.14
business
Calculation of the gain on the sale of AkzoNobel’s Specialty Chemicals
Data in EUR million
Consideration for shares sold
Net assets and liabilities
Liabilities assumed and cost allocated to the Deal,
realization of cumulative translation and cash flow
hedge reserves
Income tax on the sale
Deal result after tax
Source Annual report of AkzoNobel for fiscal year 2018
2018
8.284
−2.112
−98
−263
5.811
1 Most Common Distortions …
31
Table 1.15 Condensed consolidated income statement of Hudson’s Bay Company for
the first quarter of fiscal years ended May 4/5, 2018 and 2019
Thirteen weeks ended
Data in CAD million
Total revenue
Cost of goods sold
(exclusive of depreciation shown separately below)
Gross profit
Selling, general and administrative expenses
Depreciation and amortization
Transaction, restructuring and other (costs) income
Gain on sale of property, net
Impairment
Operating income (loss)
Income (loss) before income tax
Income tax (expense) benefit
Net income (loss)
May 5,
2018
May 4,
2019
2.188
2.116
−1.315
−1.291
873
−876
−119
14
−7
−115
−175
43
−398
825
−822
−110
−36
817
674
493
−218
275
Source Hudson’s Bay Company: 2019 Q1 Interim Consolidated Financial Statements
for the Thirteen Weeks Ended May 4, 2019
Table 1.16 Extract from Note 6 to quarterly consolidated financial statements of
Hudson’s Bay Company for the first quarter of the fiscal year ended May 4, 2019
Note 6d: 424 LLC
On February 8, 2019, the Company closed the sale of the Lord & Taylor Fifth Avenue building
with a transaction value of $1.1 billion (U.S. $850 million) to an affiliate of WeWork Property
Investors […]. The carrying value of the property was classified as an asset held for sale as ofat
February 2, 2019. […]
The Company recorded a gain on sale of the property of $817 million during the thirteen weeks
ended May 4, 2019, net of transaction costs of $23 million.
Source Hudson’s Bay Company: 2019 Q1 Interim Consolidated Financial Statements
for the Thirteen Weeks Ended May 4, 2019
32
J. Welc
Table 1.17 Extract from Note 4 to annual consolidated financial statements of
Hudson’s Bay Company for the fiscal year ended May 4, 2019
Note 4: Asset held for sale
(Millions of Canadian dollars)
Lord & Taylor Fifth Avenue building
2018
279
2017
263
On October 24, 2017, the Company announced the sale of the Lord & Taylor Fifth
Avenue building with a transaction value of U.S. $850 million (approximately $ 1.1
billion) to an affiliate o f WeWork Prop erty Advisors […].
Source Hudson’s Bay Company: 2019 Q1 Interim Consolidated Financial Statements
for the Thirteen Weeks Ended May 4, 2019
Table 1.18
Examples of significant off-balance sheet liabilities
Company
Carrying
amount
Fiscal
of total
Currency
year
liabilities on
balance sheet
(millions)
Nominal
amount
Date
of
of
off-balance
bankruptcy
sheet
filing
liabilities
(millions)*
Corinthian Colleges
2013
USD
458
676
2015
H.H. Gregg
2016
USD
264
455
2017
Gordmans Stores
2016
USD
195
365
2017
Mesa Airlines
2008
USD
850
1.892
2010
Southern Cross
Healthcare
2010
GBP
385
5.776
2012
*Undiscounted sum of future minimum payments
Source Annual reports of individual companies and authorial computations
1 Most Common Distortions …
33
Table 1.19 Extract from BP’s annual report for fiscal year 2010, referring to the oil
spill in Gulf of Mexico (and its possible financial consequences for the company)
Gulf of Mexico oil spill
Incident summary
On 20 April 2010, following a well blowout in the Gulf of Mexico, an explosion and fire
occurred on the semi-submersible rig Deepwater Horizon and on 22 April the vessel sank.
Tragically, 11 people lost their lives and 17 others were injured. Hydrocarbons continued to flow
from the reservoir and up through the casing and the blowout preventer (BOP) for 87 days,
causing a very significant oil spill. […]
Financial consequences
The group income statement for 2010 includes a pre-tax charge of $40.9 billion in relation to the
Gulf of Mexico oil spill. This comprises costs incurred up to 31 December 2010, estimated
obligations for future costs that can be estimated reliably at this time, and rights and obligations
relating to the trust fund, described below.
[…]
Under US law BP is required to compensate individuals, businesses, government entities and
othe rs who h ave bee n impacted by the oil spill. […] BP has established a trust fund o f $20
billion to be funded over the period to the fourth quarter of 2013, which is available to satisfy
legitimate individu al and business claims […] and natural resource damages and related costs
arising as a con sequ ence of the Gulf of Mexico oil spill. […]
BP has provided for all liabilities that can be estimated reliably at this time, including fines and
penalties under the Clean Water Act (CWA). The total amounts that will ultimately be paid by
BP in relation to all obligations relating to the incident are subject to significant uncertainty.
BP considers that it is not possible to estimate reliably any obligation in relation to natural
resource damages claims under the OPA 90, litigation and fines and penalties except for those in
relation to the CWA. These items are therefore contingent liabilities.
Source BP Annual Report and Form 20-F 2010
34
J. Welc
Table 1.20 Extracts from Note 2 to consolidated financial statements of BP plc for
fiscal years 2012–2016, related to the company’s costs and obligations stemming from
the Gulf of Mexico oil spill
BP Annual Report and Form 20-F 2012
As a consequence of the Gulf of Mexico oil spill […] BP continues to incur costs and
has also recognized liabilities for future costs. […]
The financial impacts of the Gulf of Mexico oil spill on the income statement, balance
sheet and cash flow statement of the group are shown in the t able b elow. […]
The cumulative income statement charge does not include amounts for obligations that
BP cons iders are not po ssible, at this time, to measure reliably. […]
$ million
Income statement
Production and manufacturing
expenses
Profit (loss) before interest and
taxation
Finance costs
Profit (loss) before taxation
2012
2011
2010
4.995
(3.800)
40.858
(4.995)
3.800
(40.858)
19
(5.014)
58
3.742
77
(40.935)
BP Annual Report and Form 20-F 2014
As a consequence of the Gulf of Mexico oil spill in April 2010, BP continues to incur
costs and has also recognized liabilities for certain future costs. Liabilities of uncertain
timing or amount, for which no provision has been made, have been disclosed as
contingent liabilities.
The cumulative pre-tax income statement charge since the incident amounts to $43.5
billion. […] The cumu lative income stat ement charge does not include amoun ts for
obligations that BP considers are not possible, at this time, to measure reliably.
BP Annual Report and Form 20-F 2016
As a consequence of the Gulf of Mexico oil spill in April 2010, BP continues to incur
costs and has also recognized liabilities for certain future costs. Following significant
progress in resolving outstanding claims arising from the 2010 Deepwater Horizon
accident and oil spill, a reliable estimate has now been determined for all remaining
material liabilities arising from the incident.
The cumulative pre-tax income statement charge since the incidence amounts to $62.6
billion. […] The pre -tax income statement charge for the year of $7.1 billion is
primarily attributable to the recognition of additional provisions for these claims.
The impacts of the Gulf of Mexico oil spill on the income statement, balance sheet and
cash flow statement of the group […] are shown in the table below.
$ million
Income statement
Production and manufacturing
expenses
Profit (loss) before interest and
taxation
Finance costs
Profit (loss) before taxation
2016
2015
2014
6.640
11.709
781
(6.640)
(11.709)
(781)
494
(7.134)
247
(11.956)
38
(819)
Source Annual reports of BP plc (for various fiscal years)
1 Most Common Distortions …
35
Table 1.21 Extract from Note 13 (Wildfire-related contingencies) to PG&E’s
consolidated financial statements for fiscal year 2018, referring to the wildfires
allegedly caused by the company’s operating equipment
Note 13: Wildfire-related liabilities
PG&E Corporation and the Utility have significant contingencies arising from their operations,
including contingencies related to wildfires. A provision for a loss contingency is recorded when
it is both probable that a liability has been incurred and the amount of the liability can be
reasonably estimated. PG&E Corporation and the Utility evaluate which potential liabilities are
probable and the related range of reasonably estimated losses and record a charge that reflects
their best estimate or the lower end of the range, if there is no better estimate. The assessment of
whether a loss is probable or reasonably possible, and whether the loss or a range of losses is
estimable, often involves a series of complex judgments about future events. Loss contingencies
are reviewed quarterly and estimates are adjusted to reflect the impact of all known information,
such as negotiations, discovery, settlements and payments, rulings, advice of legal counsel, and
other information and events pertaining to a particular matter. […] PG&E Corporation’s and the
Utility’s financial condition, results of operations, liquidity, and cash flows may be materially
affected by the outcome of the following matters.
[…]
2018 Camp Fire Background
On November 8, 2018, a wildfire began near the city of Paradise, Butte County, California (the
“2018 Camp fire”), which is located in the Utility’s service territory. Cal Fire’s Camp Fire
Incident Information Website as of January 4, 2019, (the “Cal Fire website”), indicated that the
2018 Camp fire consumed 153,336 acres. On the Cal Fire website, Cal Fire reported 86 fatalities
and the destruction of 13,972 residences, 528 commercial structures and 4,293 other buildings
resulting from the 2018 Camp fire. […]
Although the cause of the 2018 Camp fire is still under investigation […], PG&E Corporation
and the Utility believe it is probable that the Utility’s equipment will be determined to be an
ignition point of the 2018 Camp fire.
2017 Northern California Wildfires Background
Beginning on October 8, 2017, multiple wildfires spread through Northern California […].
According to the Cal Fire California Statewide Fire Summary dated October 30, 2017, at the
peak of the 2017 Northern California wildfires, there were 21 major fires that, in total, burned
over 245,000 acres and destroyed an estimated 8,900 structures. The 2017 Northern California
wildfires resulted in 44 fatalities.
Cal Fire has issued its determination on the causes of 19 of the 2017 Northern California
wildfires, and alleged that all of these fires, with the exception of the Tubbs fire, involved the
Utility’s equipment. The remaining wildfires remain under Cal Fire’s investigation, including the
possible role of the Utility’s power lines and other facilities.
Source Annual report of PG&E Corp. for fiscal year 2018
36
J. Welc
Table 1.22 Extract from Note 10 (Wildfire-related contingencies) to PG&E’s
consolidated financial statements for the first quarter of the fiscal year 2019
2018 Camp Fire and 2017 Northern California Wildfires Accounting Charge
Following accounting rules, PG&E Corporation and the Utility record a liability when a loss is
probable and reasonably estimable. In accordance with U.S. generally accepted accounting
principles, PG&E Corporation and the Utility evaluate which potential liabilities are probable
and the related range of reasonably estimated losses, and record a charge that is the amount
within the range that is a better estimate than any other amount or the lower end of the range, if
there is no better estimate. The assessment of whether a loss is probable or reasonably possible,
and whether the loss or a range of losses is estimable, often involves a series of complex
judgments about future events.
In light of the current state o f the law and the in formation current ly available […], PG&E
Corporation and the Utility have determined that it is probable they will incur a loss for claims in
connection with the 2018 Camp fire, and accordingly PG&E Corporation and the Utility
recorded a charge in the amount of $10.5 billion for the year ended December 31, 2018. This
charge corresponds to the low er end of the range of PG&E Corporation’s and the Utility’s
reasonably estimated losses, and is subject to change based on additional information.
[…] As more informati on becomes available, management estimate s and assumpt ions regarding
the financial impact of the 2018 Camp fire may change, which could result in material increases
to the loss accrued.
The $ 10.5 billion charge does not include any amounts for potential penalties or fines that may
be imposed by governmental entities on PG&E Corporation or the Utility, or punitive damages,
if any, or any losses related to future claims for damages that have not manifested yet, each of
which could be significant.
Source Quarterly report of PG&E Corp. for the first quarter of fiscal year 2019
Table 1.23 Extracts from annual reports of H&M, relating to the company’s
inventories
Note 14 to Annual Report 2016: Stock-in-trade
The composition of the stock-in-trade as of the closing date is judged to be good, but the stock
level is assessed as being too high. Significant write-downs are rare. There were no material
write-downs in the current or previous financial years. Only an insignificant part of the stock-intrade is measured at net realizable value. The stock-in-trade is not considered to have any
material degree of obsolescence.
Note 14 to Annual Report 2017: Stock-in-trade
As of 30 November 2017, the closing stock level was higher than planned as a result of sales
development during the autumn being considerably below the group’s sales plan. Significant
write-downs are rare. There were no material write-downs during the financial year 2017. Only
an insignificant part of the stock-in-trade is measured at net realizable value. The stock-in-trade
is not considered to have any material degree of obsolescence.
Note 15 to Annual Report 2018: Stock-in-trade
Stock-in-trade amounted to SEK 37,721 m (33,712), an increase of 12% in SEK compared with
the same point in time last year. In local currencies the increase was 10%.
Significant write-downs are rare. There were no material write-downs in the current or previous
financial years. Only an insignificant part of the stock-in-trade is measured at net realizable
value. The stock-in-trade is not considered to have any material degree of obsolescence.
Source Annual reports of H&M Hennes & Mauritz AB (for various fiscal years)
37
1 Most Common Distortions …
Table 1.24 Condensed income statements of Volkswagen Group and Daimler for
fiscal years 2007 and 2008
Data in EUR million
2007
2008
108.897
92.603
16.294
9.274
2.453
5.994
4.410
6.151
734
1.647
1.305
6.543
113.808
96.612
17.196
10.552
2.742
8.770
6.339
6.333
910
1.815
1.180
6.608
99.399
75.404
23.995
8.956
4.023
3.158
27
95.873
74.314
21.559
9.204
4.124
3.055
780
1.053
−998
−228
8.710
471
9.181
−2.228
2.730
65
2.795
Volkswagen Group
Sales revenue
Cost of sales
Gross profit
Distribution expenses
Administrative expenses
Other operating income
Other operating expenses
Operating profit
Share of profits and losses of equity-accounted
Finance costs
Other financial result
Profit before tax
Daimler
Revenue
Cost of sales
Gross profit
Selling expenses
General administrative expenses
Research and non-capitalized development costs
Other operating income (expense), net
Share of profit (+)/loss (−) from companies accounted for
using the equity method, net
Other financial income (+)/expense (−), net
Earnings before interest and taxes (EBIT)
Interest income (expense), net
Profit before income taxes
Source Annual reports of Volkswagen Group and Daimler for fiscal year 2008
38
J. Welc
Table 1.25 Condensed income statements of Astaldi Group for fiscal year 2013–2015,
as reported in its annual reports for 2014 and 2015
Data reported in annual report for 2014 (in EUR
thousand)
Total revenue
Purchase costs
Service costs
Personnel expenses
Amortization, depreciation and impairment losses
Other operating costs
Total costs
Internal costs capitalized
Operating profit
Financial income
Financial expense
Net gains on equity-accounted investees
Data reported in annual report for 2015 (in EUR
thousand)
Total operating revenue
Purchase costs
Service costs
Personnel expenses
Other operating costs
Total operating costs
Quota of profits (losses) from joint ventures, SPVs and
investee companies
EBITDA
Amortization, depreciation and impairment
Provisions
Capitalisation of internal construction costs
Operating profit
2013
2014
2.508.360
423.566
1.403.297
320.512
85.235
43.293
2.275.903
1.652
234.108
96.827
208.365
7.386
2.652.565
401.399
1.488.958
420.006
70.633
37.252
2.418.249
516
234.832
98.286
237.156
34.769
2014
2015
2.652.565
401.399
1.488.958
420.006
35.718
2.346.081
2.854.949
456.635
1.511.869
548.249
35.919
2.552.672
34.769
54.131
341.252
70.633
1.534
516
269.601
356.408
74.897
4.060
0
277.452
Source Annual reports of Astaldi Group for fiscal years 2014 and 2015
1 Most Common Distortions …
39
References
Leder, M. (2003). Financial Fine Print: Uncovering a Company’s True Value.
Hoboken: Wiley.
Penman, S. H. (2003). The Quality of Financial Statements: Perspectives from the
Recent Stock Market Bubble. Accounting Horizons, 17, 77–96.
2
Other “Distortions” in a Financial Statement
Analysis Caused by Objective Weaknesses
of Accounting and Analytical Methods
2.1
Distortions Caused by Inventory Flow
Methods
2.1.1 Incomparability of Results When Inventory Prices
Change
Most accounting standards permit using several alternative methods of
accounting for inventory flow. The most popular of them are first-in-first-out
(FIFO), weighted-average and last-in-first-out (LIFO). The former two are
allowed by both IFRS and US GAAP, while the latter one is prohibited under
IFRS. As illustrated in Example 2.1, in periods of rising or falling inventory
prices the usage of different inventory accounting methods may dramatically
erode the inter-company comparability of reported financial results.
As might be seen, under identical economic conditions all three alternative
inventory accounting methods produce different results (although they do
not differ in terms of sales revenues recognized):
• Under FIFO, the oldest inventory layers are transferred to cost of goods
sold, at their purchase prices (i.e. 150 units bought for 15 EUR in the first
quarter, followed by 70 units from the second supply, and so on), which
entails a bias of cost of goods sold toward the old and outdated inventory
costs. This results in an overstatement of reported profits in periods
of rising inventory prices (and understatement of reported profits in
periods of deflation), but with relatively updated carrying amount of
ending inventory (based on most recent purchase prices).
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_2
41
42
J. Welc
Example 2.1 Impact of different inventory accounting methods on comparability of
financial results in a period of rising inventory prices
Company A is a retailer of a single product. It started its operaons on January 1, Period t. In each of four
quarters of Period t it sold 100 units of products purchased from its supplier. The company’s inventory
turnover equals three months, which means that in a given quarter it sells inventories purchased in the
preceding quarter.
In the first two quarters of Period t the inventory purchase price stood at 15 EUR per unit. However, in the
middle of the year it started rising, to 17 EUR per unit in a third quarter and 20 EUR per unit in the fourth
quarter. However, the company was able to fully pass an inventory price inflaon to its customers (and
keeping its gross profit on sales intact), by rising its sales prices. Accordingly, the sales price of 20 EUR effecve
in the first half of Period t was raised to 22 EUR and 25 EUR in the third and fourth quarter, respecvely.
Under those circumstances the company’s revenues and inventory changes look as follows:
Quarter of
Period t
Sales volume
(units sold)
Inventory
Ending inventory
purchased (units
(units)*
bought)
Inventory price
(EUR per unit)
Inventor
y
purchas
e cost
(EUR)
Sales
price
(EUR per
unit)
Sales
revenue
(EUR)
I q.
100
150
50
15
2.250
20
2.000
II q.
100
70
20
15
1.050
20
2.000
III q.
100
100
20
17
1.700
22
2.200
IV q.
100
120
40
20
2.400
25
2.500
Total
400
440
–
–
7.400
–
8.700
*beginning balance of inventory is zero, since the company launched operaons at the beginning of Period t
Under three alternave inventory accounng methods the company’s results reported for Period t would look
as follows:
FIFO (first-in-first-out):
Revenues
Cost of goods sold
Gross profit on sales
Ending inventory
8.700
6.600 = (150
2.100 20)
15) + (70
800 = 40 units le
15) + (100
17) + (80
20 EUR per unit
Weighted-average method:
Revenues
8.700
Cost of goods sold
6.727 = (Inventory cost of 7.400/440 units)
Gross profit on sales
1.973
Ending inventory
LIFO (last-in-first-out):
Revenues
Cost of goods sold
Gross profit on sales
Ending inventory
400 units
673 = (Inventory cost of 7.400/440 units) 40 units
8.700
6.800 = (120 x 20) + (100 x 17) + (70 x 15) + (110 x 15)
1.900
600 = 40 units le 15 EUR per unit
Source Author
• Under LIFO, the newest inventory layers are transferred to cost of goods
sold, at their purchase prices (i.e. 120 units bought for 20 EUR in the
fourth quarter, followed by 100 units bought for 17 EUR in the third
quarter, and so on), which entails a bias of cost of goods sold toward
the most recent inventory costs. This results in a distortion of carrying
amount of ending inventory (which is based on outdated inventory
2 Other “Distortions” in a Financial Statement …
43
prices), but produces reported profits which reflect current replacement costs of inventories and satisfy the matching principle (i.e.
the coherence of measurement bases of reported revenues and reported
expenses).
• Under the weighted-average method the results (both the reported profit
as well as carrying amount of ending inventory) fall within ranges set by
FIFO and LIFO. Consequently, the weighted-average method tends to
understate the cost of goods sold and overstate profits in periods of
rising inventory prices (similarly as FIFO but to a lower extent), while
overstating costs and understating profits in periods of deflation.
Obviously, the usage of different inventory accounting methods may seriously erode an intercompany comparability of reported financial results.
Under the economic conditions assumed in Example 2.1 (identical for all
three scenarios), FIFO produced profit which exceeds the profit reported
under LIFO by one third (800 EUR vs. 600 EUR). However, while LIFO
better reflects an economic reality in income statement (where current inventory replacement costs are matched with current sales prices), it distorts
carrying amounts of inventories in balance sheet (which are based on their
outdated prices). The results reported by firms which use the weightedaverage method are distorted similarly to FIFO, but with more moderate
magnitude.
2.1.2 Distortions of FIFO-Based Profits When Inventory
Prices Change
An erosion of intercompany comparability of financial statements, brought
about by different inventory accounting methods applied by various firms, is
broadly discussed in the literature. However, the income statement distortions
caused by FIFO (and its mismatch between measurement bases for revenues
and cost of goods sold) may be equally damaging to a reliability of conclusions inferred from a time-series analysis of financial numbers reported by a
single company. This problem, which seems to be neglected by a finance and
accounting literature, is illustrated in Example 2.2.
As might be seen, under the economic conditions assumed in the example,
the FIFO method successfully cheats a financial statement user about changes
of profitability of an investigated business. In the first three months the
company sells for 20 EUR the products bought for 15 EUR, with a resulting
gross profit on sales of 5 EUR per unit. However, in the second quarter it
faces a sharp increase in its inventory purchase price, which grows to 21
44
J. Welc
Example 2.2 Distortions caused by FIFO in a time-series analysis of results of a single
company in periods of changing inventory prices
(continued)
2 Other “Distortions” in a Financial Statement …
45
Example 2.2 (continued)
Source Author
EUR per unit (with a quarter-to-quarter inflation of 40%). The company
reacts to the rising input costs by increasing its sales prices. However, in
light of the high price elasticity of demand it is unable to fully accommodate to the increasing inventory costs. Instead, a 1 EUR increase in inventory
price is followed by a 50 cents increase in the sales price. Consequently, the
company’s unit margin shrinks sharply, from 5 EUR in the first quarter to
only 2 EUR [= 23−21] in June. Obviously, the firm faces harsh economic
conditions in the second quarter. However, under the FIFO method the
company’s reported profit and margin on sales grow in that period! The
reason is that the rising sales prices and revenues, which already reflect
the company’s reaction to the inventory inflation, are mismatched with the
outdated cost of goods sold, which lags behind and is based on the inventory
46
J. Welc
prices observed in the first quarter (with an assumed inventory turnover of
two months). Consequently, the FIFO-based profit reported in the second
quarter is artificially inflated and grows, instead of shrinking in tune with
deteriorating real economic conditions. The opposite pattern is observed in
the last three months, when the company’s economic environment improves
(thanks to a sharp deflation of inventory prices), while its reported FIFObased profits and margins collapse. It is worth noting that gross profit on
sales in the fourth quarter (400 EUR), when the company’s economic environment improves, constitutes only 21% of its gross profit reported for the
second quarter (1.900 EUR).
Equally striking conclusions may be derived from comparing the
company’s quarterly numbers, computed under both FIFO and LIFO and
presented in the bottom part of Example 2.2. As might be seen, in the
first quarter the results reported under both methods are identical, which
is a consequence of a stable inventory cost (of 15 EUR per unit) in that
period. However, in the following three months the inventory inflation
boosts the LIFO-based cost of goods sold, with resulting contraction of the
company’s reported profits and margins. The erosion of LIFO-based income
is continued in the third quarter, when the inventory price stabilizes near a
record high level of 21 EUR per unit. In contrast, in the last three months
the company benefits from plummeting inventory prices, which are reflected
in a falling LIFO-based cost of goods sold and improving margins.
2.1.3 Distortions of LIFO-Based Profits When Inventory
Turnover Changes
An apparent advantage of LIFO (over FIFO) lies in its better matching of
revenues, which are based on the current sales prices, with reported expenses,
which are based on the most recent inventory costs. This better matching
results in lower distortions (as compared to FIFO) of the reported profits, in
times of significantly rising or falling inventory costs. However, under inflationary conditions the LIFO-based results may be significantly distorted as
well (Bergevin 2002), if at the same time the company reduces its production or purchases of new inventories (and instead digs deeper into its older
inventory layers). This problem, which may be labeled as “inventory digging”
or “LIFO liquidation” is illustrated in Example 2.3.
As might be seen, as long as the inventory turnover stays intact (at four
months assumed in the example), the month-to-month changes of LIFObased profit on sales perfectly reflect the shifting inventory costs. In the
first three months the company’s monthly profit stays flat (at 500 EUR),
2 Other “Distortions” in a Financial Statement …
47
Example 2.3 Distortions caused by “inventory digging” (or “LIFO liquidation”) in
periods of changing inventory prices
(continued)
48
J. Welc
Example 2.3 (continued)
Source Author
but between the fourth and seventh month it gradually falls, in tune with
a steadily rising inventory purchase price. Then, since the seventh month
onward, the profit stabilizes at its lowered level, due to the stabilization of
the inventory price on its inflated level. In contrast, when the company
temporarily suspends its purchases of new inventories in April (when the
inventory price starts growing), which implies shortening of the inventory
turnover (and digging into older and older layers of inventories, purchased at
their prior lower prices), the cost of goods sold no longer matches rising sales
prices. As a result, in the three consecutive months (from April to June) the
2 Other “Distortions” in a Financial Statement …
49
company’s gross profit on sales increases artificially and unsustainably, only
to collapse suddenly in the seventh month, when the company starts refilling
its inventory supplies.
It must be emphasized that no additional cash flow is generated only
because the LIFO method (instead of FIFO or weighted-average or any other
method) is used in accounting for the inventory flow, in a period of an
“inventory digging”. In some circumstances (e.g. when company uses LIFO
in computing its taxable income), the additional profit resulting from the
LIFO liquidation may even result in a higher tax payment (Mulford and
Comiskey 1996).
2.1.4 Conclusions
The hypothetical examples discussed in this section corroborate an importance of taking into account possible distortions caused by inventory
accounting methods, both in inter-company comparisons as well as in
time-series examinations of single company’s results. The issues discussed
in this section are particularly relevant when investigating businesses with
high volumes of inventories, volatile inventory prices (e.g. steel wholesalers,
apparel distributors, oil refineries, food retailers or car manufacturers) or
significantly changing inventory turnover. In Sect. 9.2 of Chapter 9 the technique of analytical adjustments of financial numbers, reported under various
inventory accounting methods, will be presented with details.
2.1.5 Distortions Caused by Noncontrolling Interests
Let’s imagine the hypothetical group of companies, as presented on Chart 2.1.
Within such a group of firms the financial results of all subsidiaries (Company
Company A
Share in equity
of 100%
Company B
Share in equity
of 6%
Share in equity
of 60%
Company C
Chart 2.1
Share in equity
of 30%
Company E
Company D
Hypothetical example of a group of companies (Source Author)
50
J. Welc
A and Company B) are always fully consolidated with the results of their
parent company (Company A), regardless of the parent’s share in the equity
of its controlled entities. It means that in the case of the structure of relationships presented on Chart 2.1 the results of both Company B as well
as Company C are fully consolidated with the results of Company A, after
adjusting for intragroup transactions (if any). Consequently, the full consolidation of B and C by their parent company entails summing full amounts of
all items of assets, liabilities, revenues, expenses and cash flows of Company
A and both its subsidiaries (with adjustment for effects of intragroup transactions), regardless of the fact that Company A possesses 60% share in
Company C’s equity (and thus there are other parties entitled to participate
in economic benefits generated by this non-wholly owned subsidiary). In
such cases, these noncontrolling (minority) shareholders of a subsidiary are
reflected in only one item of Company A’s consolidated income statement
and only one item of its consolidated balance sheet.
The only consolidation adjustments which take into account a less-thanfull share of the parent company in the equity of its subsidiary are:
• Adjustment of consolidated shareholders’ equity by presenting the share of
entities other than the parent in the equity of its subsidiary in the item
labeled as “non-controlling interests” (also called “minority interest ”),
• Adjustment of consolidated net earnings and consolidated total comprehensive income by presenting the share of entities other than the parent in
earnings of its subsidiary in the items labeled as “net earnings attributable
to non-controlling interests” and “total comprehensive income attributable to
non-controlling interests”.
All other items of the consolidated balance sheet and the consolidated
income statement may be distorted and may significantly limit the usefulness
of consolidated financial statements in the company’s analysis and valuation.
A high share of noncontrolling interests in total consolidated net earnings erodes the credibility and usefulness of consolidated income statement.
This is so because in such circumstances an analyst lacks the information on
where the individual line items of the income statement (e.g. revenues or
operating profit) are generated: by a parent company or by its non-wholly
owned subsidiaries. Likewise, a high share of noncontrolling interests in total
consolidated shareholder’s equity may erode the credibility and usefulness of
consolidated balance sheet. This is so because in such a circumstance an
analyst lacks any information on a real proportional co-ownership of the
2 Other “Distortions” in a Financial Statement …
51
parent company in individual line items of assets and liabilities reported in
its consolidated balance sheet.
A possible distorting impact of noncontrolling interests on reported financial numbers will be illustrated with a real-life example of Fiat Group, as
discussed in the paper by Welc (2017). Table 2.11 (in the appendix) presents
shortened consolidated income statement of Fiat S.p.a. for 2012 0061nd
2013, while Table 2.12 (in the appendix) presents the company’s shortened
consolidated balance sheet for the same years.
In case of the company’s consolidated income statement, all reported
numbers from the very top (Net revenues) down to the income tax expense
constitute simple sums of values of respective line items reported in separate income statements of Fiat S.p.a. itself (i.e. a parent company) and all its
wholly owned and non-wholly owned subsidiaries. Only at the very bottom
of the Fiat’s consolidated income statement (i.e. at the after-tax profit level) it
may be seen that some other shareholders own a nontrivial share in the equity
of Fiat’s subsidiaries. As regards the company’s consolidated assets, no information about the noncontrolling interest’s share in individual classes of assets
of Fiat’s subsidiaries is disclosed in the consolidated balance sheet. Only total
consolidated equity is split into its part attributable to Fiat’s shareholders and
to noncontrolling shareholders of Fiat’s subsidiaries.
More detailed information about the noncontrolling interests may be
found in Note 23 (Equity) to the financial statements of Fiat S.p.a. for 2013.
The extract from this note is presented in Table 2.13 (in the appendix). It
may be concluded from these disclosures that the noncontrolling interests are
attributable mainly to Chrysler Group (where Fiat’s share in equity, as at the
end of 2013, was 58,5%).
The presented disclosures extracted from the Fiat’s consolidated financial
statements suggest that:
• In both 2012 and 2013 the noncontrolling interests had high share in Fiat’s
consolidated net earnings (53,7% in 2013 and as much as 95,1% in 2012).
• In both years the noncontrolling interests had also a significant share in
Fiat’s consolidated equity (33,8% in 2013 and 26,1% in 2012).
• It seems that the main reason staying behind it was the full consolidation
of Chrysler Group, in which Fiat owned 58,5% share in equity.
• The Fiat’s consolidated financial statements for both years did not contain
any information about the noncontrolling interest’s shares in other line
items of the consolidated income statement and consolidated balance
sheet, which may significantly distort the conclusions from the financial
statement analysis (as illustrated below).
52
J. Welc
Table 2.1 Three hypothetical scenarios of the intragroup structure of Fiat’s
consolidated trading profit as reported for fiscal year 2013
EUR million
Reported consolidated trading profit, including:
Scenario 1
3.394
Scenario 2
3.394
Scenario 3
3.394
(1) Fiat (parent) and subsidiaries other than Chrysler
2.000
5.000
−8.000
(2) Chrysler Group
1.394
−1.606
11.394
Trading profit aributable to Fiat's shareholders (with
Fiat’s 58,5% share in the equity of Chrysler Group)*
2.815
4.060
−1.335
* = (1) + 58,5% × (2)
Source Authorial computations
Suppose that an analyst is investigating the Fiat’s consolidated trading
profit (which is often deemed to represent the most sustainable company’s
income, generated by its “core business”) of 3.394 EUR million, as reported
in the company’s consolidated income statement for 2013. Under the
full consolidation method, this number constitutes a simple sum of the
entire amounts of stand-alone trading profits of Fiat S.p.a. itself and
all its subsidiaries, including Chrysler Group (after eliminating the intragroup transactions, if any). However, an intragroup structure of this profit,
i.e. where within a group it was generated (in a parent company or its
subsidiaries), is undisclosed in the consolidated financial report. In this light
the following hypothetical scenarios (among others), presented in Table 2.1,
may be considered.
As those three hypothetical scenarios show, depending on circumstances,
an actual consolidated profit from a “core business” (i.e. excluding unusual
items, financial income/expense, etc.), earned by Fiat for its shareholders,
may be either substantially higher or considerably lower (even negative)
than reported in the company’s consolidated income statement. However,
the actual consolidated trading profit attributable to Fiat’s shareholders is
not disclosed in the company’s consolidated financial statements, which may
significantly distort the credibility of those accounting ratios, in which case
consolidated profits other than after-tax earnings constitute one of the inputs.
However, also the accounting metrics based on numbers reported in
consolidated balance sheet may be significantly distorted in a presence
of significant noncontrolling interests. One of such indicators is current
liquidity ratio, which is usually computed as a quotient of company’s total
current assets to its total current liabilities. In this ratio both numerator as
well as denominator constitute inputs which are unadjusted for a parent
2 Other “Distortions” in a Financial Statement …
53
company’s actual share in individual classes of assets and liabilities of its nonwholly owned subsidiaries. Moreover, no data are usually available (unless
an analyst has an access to stand-alone financial statements of non-wholly
owned subsidiaries), which could enable adjusting the numbers reported in
the consolidated balance sheet. This is so because the only one line item of
the consolidated balance sheet, which is split into its part attributable to the
parent and to the noncontrolling interests, is shareholder’s equity. However,
an undisclosed share of noncontrolling interests in consolidated current assets
may deviate from their share in the consolidated shareholder’s equity. The
absence of disclosures about the parent’s actual share in consolidated current
assets may distort liquidity ratios computed on the basis of the consolidated
balance sheet, as exemplified in Tables 2.2 and 2.3.
As might be seen, the Fiat’s raw (unadjusted) current ratio, entirely
based on the numbers reported in the company’s consolidated balance sheet,
amounted to 1,16 and 1,20 at the end of 2013 and 2012, respectively.
Accordingly, it seemingly lied near a lower safety threshold, which is often
assumed at about 1,20. However, under the two hypothetical scenarios
shown in Table 2.3, which take into account Fiat’s less-than-full participation
in Chrysler’s current assets, a less positive picture emerges. Depending on
Table 2.2 Current liquidity ratios of Fiat Group, computed on the ground of its
consolidated balance sheet
In EUR million
December 31, 2012
December 31, 2013
Reported consolidated current assets
36.587
39.154
Reported consolidated current liabilies:
30.381
33.630
Debt due within one year (from Note 27)
5.811
7.138
16.558
17.235
231
314
Other current liabilies
7.781
8.943
Current rao based on reported numbers
(current assets/current liabilies)
1,20
1,16
= 36.587/30.381
= 39.154/33.630
Trade payables
Current tax payables
Source Annual report of Fiat S.P.A. for fiscal year 2013 and authorial computations
54
J. Welc
Table 2.3 Fiat’s adjusted current liquidity ratios at the end of fiscal year 2013, under
two hypothetical scenarios of the intragroup structure of Fiat’s current assets
EUR million
Scenario 1
Scenario 2
Reported current assets, including:
39.154
39.154
(1) Fiat (parent) and subsidiaries other than Chrysler
30.000
10.000
9.154
29.154
Current assets aributable to Fiat's shareholders
(with 58,5% share in Chrysler)*
35.355
27.055
Reported current liabilies**
33.630
33.630
Adjusted liquidity rao (current assets/current
liabilies)
1,05 =
0,80
35.355/33.630
= 27.055/33.630
(2) Chrysler
* = (1) + 58,5% x (2)
**reported liabilities are not adjusted for noncontrolling interests, since they must
be settled in full amounts, regardless of the share of noncontrolling interests on the
equity of Fiat’s subsidiaries
Source Annual report of Fiat S.P.A. for fiscal year 2013 and authorial computations
circumstances, the Fiat’s actual current ratio may equal 1,05 (when majority
of its consolidated current assets is owned by the parent or its subsidiaries
different than Chrysler) or it may be as low as 0,80 (when majority of the
fully consolidated current assets are owned by Chrysler Group). However,
the actual current assets attributable to the parent company are not disclosed
in its consolidated financial statements, which means that the only way of
making the reported consolidated numbers less distorted is to adjust them
with the use of financial statements of the non-wholly owned subsidiaries
themselves (as presented in Sect. 10.2 of Chapter 10).
In the author’s opinion, financial statement distortions caused by noncontrolling interests constitute one of the most neglected issues of contemporary
accounting. As shown in Table 2.14 (in the appendix), this problem is not
marginal and may distort consolidated numbers reported by many global
corporations (operating in diverse industries).
2 Other “Distortions” in a Financial Statement …
55
It is worth noting that sometimes the share of noncontrolling interests in
total consolidated net earnings may exceed 100% (which implies negative
profit attributable to shareholders of the parent), while in other cases the
carrying amount of noncontrolling interests in the balance sheet may exceed
total consolidated shareholder’s equity (which implies negative book value of
net assets attributable to the shareholders of the parent).
As will be shown in Sect. 6.4 of Chapter 6, distortions caused by noncontrolling interests affect not only consolidated income statement and consolidated balance sheet, but consolidated cash flow statement as well. Therefore, it is always recommendable to adjust reported consolidated numbers
(if possible) for their likely distortions brought about by the noncontrolling interests (with the use of techniques demonstrated in Sect. 10.2 of
Chapter 10), if financial statements of the parent’s subsidiaries are available.
2.2
Distortions Caused by Changes
in Accounting Principles, Changes
in Accounting Estimates and Corrections
of Accounting Errors
2.2.1 Incomparability of Results When Accounting
Principles Are Changed
Sometimes companies change their accounting principles. Such shifts may be
either mandatory or voluntary. Mandatory changes may be caused either by
new accounting standards being approved (or old ones being revised) or by a
change of the whole accounting system effective in a particular jurisdiction.
An example of the former is a replacement in 2017 of two old standards, i.e.
IAS 18 (Revenue) and IAS 11 (Construction Contracts), by the new standard
IFRS 15 (Revenue from contracts with customers). An example of the latter is
an adoption of the whole set of International Financial Reporting Standards
(IFRS), in place of the formerly applied national accounting regulations, by
a given country.
However, changes in accounting principles applied by a particular firm
may also have a voluntary character. In such cases a company may switch
from one accounting principle to another one, without any accounting regulations requiring it to do so. For example, a company which so far used FIFO
(first-in-first-out) method of accounting for its inventories, may switch to a
weighted-average method. However, such voluntary changes are allowed only
56
J. Welc
if the newly adopted principle offers a better and more relevant measurement
and presentation of the company’s financial results.
Regardless of whether the changes in accounting principles applied by a
given firm are mandatory or voluntary, they may erode inter-period and intercompany comparability of reported financial statements. The reason is that
changes in accounting principles require retrospective application (i.e. revision of previously published numbers, which were based on “old” principles,
to their amounts as if the newly adopted principles have been applied before),
but only for the most recent accounting periods. For instance, if a company
switches from FIFO to weighted-average method at the beginning of 2019,
in its annual report for 2019 it must revise its previously reported data for
2018 (which were based on FIFO, but now must be based on the weightedaverage method). In such circumstances the numbers reported for earlier
periods (before 2018) are not adjusted, which implies their likely incomparability with the numbers reported for 2018 and 2019 under the newly adopted
accounting principle. The result of such a limited retrospective adjustment is
a distorted long-term trend analysis, since in such a dataset the numbers of
the same variable, but for different periods, are based on different accounting
principles.
This issue will be illustrated with the use of financial statement disclosures of WestJet airlines, which switched from Canadian GAAP (Canadian
Generally Accepted Accounting Principles) to IFRS (International Financial
Reporting Standards) in 2011. Selected narratives from the company’s annual
report for 2011 are quoted in Table 2.4. As might be read, the adoption of
IFRS has not affected the company’s previously reported cash flows, but it
has impacted its balance sheet and income statement data. Since changes
in accounting principles are applied retrospectively, WestJet has revised its
previously reported income statement numbers for 2010, as well as the
opening statement of financial position (balance sheet) as of January 1, 2010.
However, as may be concluded, the company’s accounting data for earlier
periods (before 2010) have not been revised.
The narratives quoted in Table 2.15 (in the appendix) deal with the
WestJet’s accounting policies applied to its aircraft-related fixed assets, both
before and after switching from Canadian GAAP to IFRS. As might be read,
under previously applied Canadian GAAP the company used to depreciate its
aircrafts on the basis of so-called “aircraft cycles”, which seems to be just an
alternative term to number of flights (in light of the company’s explanation,
according to which one cycle is defined as “the aircraft leaving the ground
and landing ”). This means that under the Canadian GAAP the company’s
aircraft depreciation had a substance of a semi-variable expense, since the
57
2 Other “Distortions” in a Financial Statement …
Table 2.4 Extract from annual report of WestJet for fiscal year 2011, referring to
the company’s change in accounting principles (from Canadian GAAP to IFRS)
Transion to IFRS
The following discussion describes the principal adjustments made by the Corporaon in
restang its Canadian GAAP consolidated financial statements to IFRS for the year ended
December 31, 2010 as well as the opening statement of financial posion as of January 1,
2010.
[…]
Transion impacts
IFRS employs a conceptual framework that is similar to Canadian GAAP however, significant
differences exist in certain maers of recognion, measurement and disclosure. While
adopon of IFRS has not changed the Corporaon’s actual cash flows, it has resulted in
changes to the Corporaon’s reported financial posion and results of operaons. In order
to allow the users of the financial statements to beer understand these changes, the
Corporaon’s Canadian GAAP consolidated statement of financial posion as of January 1,
2010 and December 31, 2010, and the Corporaon’s consolidated statement of earnings,
consolidated statement of cash flows and consolidated statement of comprehensive income
for the 12 months ended December 31, 2010, have been reconciled to IFRS with the
resulng differences explained.
Source Annual report of WestJet for fiscal year 2011
Table 2.5 Selected financial statement data of WestJet, reported for fiscal years
2009–2011, before and after change of the company’s accounting principles (from
Canadian GAAP to IFRS)
Data in CAD million
Data reported in annual report for
2010*
Data reported in annual report
for 2011**
2009
2010
2010
2011
2.281,1
2.609,3
2.607,3
3.071,5
Depreciaon and amorzaon
141,3
132,9
170,5
174,8
Earnings from operaons
210,6
247,5
191,4
256,6
98,2
136,7
90,2
148,7
Revenues
Net earnings
*under Canadian GAAP, with a depreciation of aircraft based on aircraft cycles
**under IFRS, with a straight-line depreciation of aircraft and components
Source Annual reports of WestJet for fiscal years 2010 and 2011
more flights have been done, the higher depreciation has been charged (with
likely “savings” on depreciation cost in recessionary times, when more flights
are canceled and a larger fraction of fleet is kept temporarily grounded). In
contrast, adoption of IFRS entailed a change to a straight-line method of
depreciation of aircrafts and their components, which converted a previously
semi-variable cost into a purely fixed one.
58
J. Welc
Finally, Table 2.5 presents selected income statement data of WestJet
airlines, for 2009–2011, extracted from the company’s annual reports for
2010 and 2011. As may be seen, there are two datasets for 2010: one
extracted from the annual report for 2010 (where the aircraft depreciation
has been based on the Canadian GAAP and aircraft cycles) and another one
extracted from the annual report for 2011 (where previously reported data for
2010 have been converted from Canadian GAAP to IFRS, with a resulting
adoption of a straight-line method of aircraft depreciation).
The adoption of IFRS left the company’s revenues, reported for 2010,
virtually intact. However, the amount of depreciation and amortization, as
well as reported profits, changed noticeably. Depreciation and amortization expensed in 2010 rose by over 28% (i.e. from 132,9 CAD million to
170,5 CAD million), while reported earnings from operations fell by almost
23% (i.e. from 247,5 CAD million to 191,4 CAD million). Consequently,
reported net earnings contracted by approximately one third.
As might be been, the adoption of IFRS (in place of the Canadian GAAP)
has had a nonnegligible impact on the financial results, reported for 2010 by
WestJet airlines. In light of the data shown in Table 2.5 it seems very likely
that the company’s financial results, reported previously for earlier periods
(2009 and before), would under the new standards look significantly different
as well. However, there is no possibility of assessing a monetary impact of
switching from the Canadian GAAP to IFRS on the accounting numbers
reported by WestJet for 2009, since the change of the company’s accounting
principles has been applied retrospectively only for one year backward (i.e.
only for 2010).
Consequently, there may be no comparability between the accounting
numbers reported by WestJet (and disclosed in Table 2.5) for a three-year
period between 2009 and 2011. Comparing financial results reported for
2009 and 2010 is possible, on the basis of data published in the annual report
for 2010 (under Canadian GAAP). Likewise, evaluating trends between 2010
and 2011 is possible, with the use of IFRS-based numbers reported by
WestJet in its annual report for 2011. However, there is no possibility of
making any reliable comparisons of financial results reported for 2009 and
2011, since they were based on different accounting principles.
It is worth noting that for this particular timeframe an erosion of an interperiod comparability of WestJet’s reported numbers may have been serious.
As discussed before, under Canadian GAAP the company’s depreciation had
a substance of a semi-variable expense (since it was linked to the number of
flights in a given period), while under IFRS it is a purely fixed cost (with its
straight-line pattern). Meanwhile, in 2009 the Canadian economy fell into
2 Other “Distortions” in a Financial Statement …
59
recession and contracted by 2,8% y/y (according to International Monetary
Fund), while in 2010 and 2011 it grew by 3,2% and 2,5% y/y, respectively. This means that in a recessionary 2009 under the Canadian GAAP
the company may have obtained some “savings” on depreciation of aircraft,
if its capacity utilization fell in that time. In contrast, since the adoption of
IFRS (and the straight-line method of depreciation) the capacity utilization
rates no longer affect WestJet’s depreciation charges.
2.2.2 Incomparability of Results When Accounting
Estimates Change
The example of WestJet airlines, discussed above, illustrated distortions of
financial statement comparability stemming from changes in accounting
principles (which require retrospective revision of previously reported
accounting numbers, even if only for the most recent prior periods).
However, there exists another type of change, which is change in accounting
estimates. Under most accounting regulations this type of change requires
only a prospective application, with no revisions of previously reported
numbers. Consequently, in contrast to changes in accounting principles
(where numbers reported in the same financial report for consecutive periods
must be based on the same accounting principles, after revising previously
reported statements), changes in accounting estimates may bring about
incomparability of data for two or more comparative periods, disclosed in
the same financial report. Distortions stemming from such a treatment of
changes in accounting principles will be illustrated with extracts from annual
reports published by Lufthansa Group.
But first, nature of the change in accounting estimate should be explained.
International Financial Reporting Standards (IAS 8: Accounting Policies,
Changes in Accounting Estimates and Errors) define such a change as “an
adjustment of the carrying amount of an asset or a liability, or the amount of the
periodic consumption of an asset, that results from the assessment of the present
status of, and expected future benefits and obligations associated with, assets
and liabilities”. According to this definition, changes in accounting estimates
result from new information or new developments and are not corrections of
errors.
Paragraph 36 of IAS 8 explains that the effect of a change in an accounting
estimate should be generally recognized prospectively, by including it in profit
or loss in:
a. the period of the change, if the change affects that period only; or
60
J. Welc
b. the period of the change and future periods, if the change affects both.
Accordingly, if a company changes its accounting estimates, these changes
affect only current and future periods, with no retrospective adjustments of
past accounting numbers. Obviously, even if changes in accounting estimates
are legitimate (e.g. due to changing economic environment of the company),
a prospective character of their application may distort inter-period comparability of accounting numbers, even for consecutive periods reported in the
same financial statements.
Let’s now look at the selected income statement data of Lufthansa Group,
extracted from its annual report for 2014. They are shown in Table 2.6. As
might be seen, between 2012 and 2014 the company’s annual revenues stayed
almost flat. In contrast, its profits on all the investigated levels of the income
statement were evidently falling. However, in all three years Lufthansa Group
stayed above its break-even points, on both operating as well as after-tax level.
A diligent reading of narrative parts of the Lufthansa’s annual report for
2014 leads to the crucial information, quoted in Table 2.16 (in the appendix).
According to these disclosures, the company’s reported earnings benefited
from reduced depreciation charges, which in turn stemmed from an adjustment to useful lives of aircraft-related assets. These adjustments were done in
the previous year (2013) and boosted earnings reported for 2013 and 2014
by 63 EUR million and 351 EUR million, respectively. Consequently, the
numbers presented in Table 2.6, even though coming from the same annual
report, are based on different useful lives of Lufthansa’s aircraft-related assets.
According to information quoted in Table 2.16, profits reported for 2012
were based on pre-change useful lives of twelve years (with residual values of
15%), while profits reported for 2013 and 2014 were based on the extended
useful lives of twenty years (with residual values of 5%).
Table 2.6 Selected income statement numbers of Lufthansa Group for fiscal year
2012–2014, extracted from the company’s annual report for the fiscal year ended
December 31, 2014
Income statement item
2012
2013
2014
30.135
1.622
30.027
851
30.011
767
Profit before income taxes
1.296
546
180
Net profit
1.228
313
55
(data in EUR million)
Revenue
Profit from operang acvies
Source Annual report of Lufthansa Group for fiscal year 2014
61
2 Other “Distortions” in a Financial Statement …
A prospective application of that change in Lufthansa’s accounting estimates is confirmed by disclosures cited in Table 2.17 (in the appendix),
extracted from the company’s annual report for 2013. In these narratives the
company explains concisely the reasons for the change in estimates, as well as
a background for its prospective application (i.e. IAS 8).
The amounts of “savings on depreciation” (as Lufthansa labeled them),
disclosed in narratives quoted in Table 2.16, may be used to analytically
adjust the company’s reported numbers, in order to increase their inter-period
comparability. In such adjustments, profits reported by Lufthansa for 2013
and 2014 are reduced by the amounts of “savings on depreciation” (63 EUR
million and 351 EUR million in 2013 and 2014, respectively), brought about
by changes (extensions) of the assumed useful lives. In contrast, numbers
reported for 2012 (both published in the annual report for 2014, as well
as in prior years) stay intact, since they were based on the company’s previous
assumptions regarding useful lives and residual values.
As might be seen in Table 2.7, the analytical adjustments (i.e. reversals
of changes in accounting estimates done by Lufthansa in 2013) affect the
company’s profits rather significantly. According to the reported numbers,
Lufthansa’s operating profit in 2014 constituted slightly less than 50% of its
Table 2.7 Adjustment of selected income statement numbers of Lufthansa Group
for fiscal years 2012–2014, related to the company’s change of the useful lives of its
aircraft-related assets
Income statement item
2012
2013
2014
Profit from operang acvies
1.622
851
767
Profit before income taxes
1.296
546
180
–
−63
−351
Adjusted numbers
Profit from operang acvies
1.622
788
416
Profit before income taxes
1.296
483
−171
(data in EUR million)
Numbers reported by Luhansa
Amounts of adjustments for changes useful
lives of aircra-related fixed assets*
*according to disclosures quoted in Table 2.16 (in the appendix)
Source Annual report of Lufthansa Group for fiscal year 2014 and authorial
computations
62
J. Welc
amount reported for 2012 (i.e. 767 EUR million vs. 1.622 EUR million),
while on the corrected numbers basis the erosion of operating profit was
much deeper, since its adjusted amount in 2014 (416 EUR million) constituted only slightly more than 25% of profit earned in 2012 (1.622 EUR
million). The impact on profit before income taxes is even more material.
While Lufthansa’s published data suggested that the company in 2014 still
stayed above its pre-tax break-even point (with a profit before income taxes of
180 EUR million), the adjusted numbers point out that without the change
in accounting estimates the company would report a loss before income taxes
of -171 EUR million.
To conclude, investigating changes in accounting estimates (and their
impact on reported financial results) should constitute an integral part of a
thorough financial statement analysis. Their prospective application means
that if significant, changes in accounting estimates may erode not only an
intercompany comparability of reported accounting numbers, but may also
distort a time-series analysis of trends of data of the same company (even
reported in the same financial report).
2.2.3 Incomparability of Results Caused by Accounting
Errors
Unintentional accounting errors constitute another possible cause of an
erosion of inter-period and intercompany comparability of reported financial
results. This issue will be exemplified by a current report published by Ford
Motor Company in 2006. Selected narratives, coming from this document,
are quoted in Table 2.18 (in the appendix).
As may be read in the quoted report, Ford Motor Company found some
accounting errors in its previously issued financial statements (for fiscal years
2001–2005). Consequently, the company had to revise its prior reports, “to
correct accounting for certain derivative transactions […], after discovering that
certain interest rate swaps that Ford Credit had entered into did not satisfy the
specific requirements of […] SFAS 133 […] ”. According to the company’s
statement, “the restatement ’s cumulative impact on net income was an increase
of about $850 million”. However, although the restatement has boosted the
company’s cumulative net income and shareholders’ equity, it was not evenly
distributed across the affected periods (i.e. fiscal years from 2001 through
2005). For 2001 and 2002, “when interest rates were trending lower, Ford is
now recognizing large derivative gains in its restated financial statements”. In
contrast, “the upward trend in interest rates from 2003 through 2005 caused
63
2 Other “Distortions” in a Financial Statement …
the interest rate swaps to decline in value, resulting in the recognition of derivative losses for these periods”. Accordingly, while the restatement has increased
earnings reported for earlier years (2001 and 2002), it depressed the financial
results of more recent periods (2003 through 2005).
Table 2.8 presents a monetary impact of the Ford’s accounting error on the
company’s net income reported for its individual fiscal years between 2001
and 2005. As may be seen, consistently with the narratives cited in Table 2.18,
the revised loss incurred in 2001 was not as deep as announced before, while
the net loss of 1,0 USD billion reported previously for 2002 has turned into
an after-tax profit, amounting to 0,9 USD billion. In contrast, the restatement of the results reported for the following years affected the company’s
earnings in the opposite direction. While the previously reported cumulative
after-tax profits earned between 2003 and 2005 amounted to 6,0 USD billion
[= 0,5 + 3,5 + 2,0], they have been revised downward to 4,6 USD billion
[= 0,2 + 3,0 + 1,4], that is by almost one fourth. It is worth noting that the
absolute values of these downward restatements increased with time, from 0,3
USD billion in 2003 to 0,6 USD billion in 2005. Consequently, a percentage
difference between the restated and previously reported net income in 2005
amounts to 30% (i.e. 1,4 USD billion vs. 2,0 USD billion).
Obviously, the monetary amounts of the discussed restatements deserve
being considered material. Their scale means that prior overstatements
(caused by the accounting error) of the Ford Motor Company’s net earnings
reported for 2003–2005 (i.e. the most recent periods within the investigated five-year timeframe) could have significantly distorted the values of any
net income-based financial statement metrics, such as price-to-earnings or
return-on-equity (ROE) ratios.
Table 2.8 Extract from Form 8-K current report, published by Ford Motor Company
on November 14, 2006, reconciling its previously reported (erroneous) net income
with its net income after restatement
Data in USD billion
2001
2002
Previously Reported Net Income
(5.5)
(1.0)
0.5
3.5
2.0
0.7
1.9
(0.3)
(0.5)
(0.6)
(4.8)
0.9
0.2
3.0
1.4
Total Change in Net Income/(Loss)
Net Income Aer Restatement
2003
2004
2005
Source Ford Motor Co.: Form 8-K (Current report filing) Filed November 14 2006 For
Period Ending November 14 2006
64
2.3
J. Welc
Distortions Caused by Non-Mandatory
Early Adoption of New or Revised
Accounting Standards
Accounting standards change from time to time (perhaps more frequently
than needed), implying new rules for revenue and expense recognition being
put in place of the previously effective ones. As was shown in the preceding
section, changes in accounting principles may erode a comparability of
corporate financial results, in their multi-period time-series analysis. This is
because the retrospective restatements, which accompany the adoption of new
accounting standards, are done only for one or two preceding years (for which
the results have been reported previously under the old and no longer effective
principles). However, equally important may be distortions brought about by
some leeway offered to companies in terms of a timing of the adoption of new
standards.
In the case of most changes of accounting regulations some mandatory
adoption date is announced. For instance, when a given regulator approves
a new accounting standard (or revises an existing one) in, e.g. June 2018,
it usually becomes mandatory after some lag (e.g. since January 1, 2020),
so that companies and their accountants have enough time to prepare to
the adoption of a new rule and its following application. In other words,
the new regulation must be obligatorily adopted no later than at that preannounced mandatory adoption date. However, it is not uncommon that an
early adoption possibility is offered by regulators, and some companies decide
to implement new accounting principles before their mandatory adoption
date. This may severely distort an intercompany comparability of published
financial results, since during a transition period (i.e. between an announcement of a new or revised standard by regulatory body and the date of its
mandatory implementation) the early adopters report their results under
these new rules, while other firms (those who decided to follow the mandatory adoption date) continue applying the old (soon expiring) regulations.
This problem will be exemplified with the use of financial statement disclosures of two sets of companies: fours firms from the aviation and aerospace
industry (The Boeing Company, General Dynamics Corp., Lockheed Martin
Corp. and Raytheon Company) and two IT businesses (Kinaxis Inc. and
Tieto Oyj).
2 Other “Distortions” in a Financial Statement …
65
2.3.1 Boeing, General Dynamics, Lockheed Martin
and Raytheon
In May 2014 the US Financial Accounting Standards Board (FASB) issued
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts
with Customers (Topic 606), which revised revenue recognition rules followed
by entities reporting under US GAAP. Its mandatory implementation date
has been set at January 1, 2018. However, an early adoption possibility has
been offered to companies affected by the new regulation.
The new rules impacted the revenue recognition policies applied by
companies operating in an aviation and aerospace industry (among others),
including The Boeing Company, General Dynamics Corp., Lockheed Martin
Corp. and Raytheon Company. However, as may be read in Table 2.19 (in the
appendix), they decided to implement the new regulations (ASU No. 201409) at different points in time: while Boeing and Lockheed Martin postponed
their adoption of the new revenue recognition rules until their mandatory
adoption date (i.e. January 1, 2018), their “peers” (General Dynamics and
Raytheon) took advantage of an opportunity of the early adoption possibility
and implemented the new guidelines on January 1, 2017. Consequently, even
though all these firms report under US GAAP, their financial statements
issued for fiscal year 2017 were based on different accounting rules (i.e. the
old revenue recognition policies in the case of Boeing and Lockheed Martin
and the newly adopted ASU No. 2014-09 in the case of General Dynamics
and Raytheon).
Table 2.9 compares all four companies’ operating profits reported for
2017. In the case of General Dynamics Corp. and Raytheon Company
the reported numbers (amounting to 4.177 USD million and 3.318 USD
million, respectively) were prepared after their optional early adoption of the
new accounting rules (i.e. ASU No. 2014-09, Revenue from Contracts with
Customers, Topic 606 ). Accordingly, they were already compliant with those
new rules. In contrast, results reported in income statements of The Boeing
Company and Lockheed Martin were still based on the old (expiring soon)
accounting principles, since these firms decided to delay their implementation of the new standard until its mandatory adoption date (i.e. January 1,
2018). Only in the notes to financial statements they disclosed their estimates
of likely effects of the new regulation on their reported numbers. As may be
seen in the next-to-last column of Table 2.9, while Lockheed Martin expected
insignificant impact of the new rules on its accounting earnings, in the case
of The Boeing Company their implementation would reduce the company’s
66
J. Welc
Table 2.9 Comparison of operating profits reported by The Boeing Company,
General Dynamics Corp., Lockheed Martin Corp. and Raytheon Company for fiscal
year 2017
Operang profit
Revenue
Data in USD million
recognion
rules applied
The Boeing Company
General Dynamics Corp.
Lockheed Marn Corp.
Raytheon Company
Adjusted for
the esmated
As reported in
effect
the annual
Difference
of adopng
report for 2017
ASU Topic
606
Old
10.278
8.906
−13,3%
New (ASU Topic 606)
4.177
–
–
Old
5.921
5.898
−0,4%
New (ASU Topic 606)
3.318
–
–
Source Annual reports of individual companies for fiscal year 2017
operating profit reported for 2017 by as much as 13,3% (which seems rather
material).
2.3.2 Kinaxis Inc. and Tieto Oyj
In January 2016 the International Accounting Standards Board (IASB) issued
International Financial Reporting Standard (IFRS) 16, providing guidance
on accounting for leases. It became effective since January 1, 2019, however,
with an early adoption option. The new standard dramatically changed the
accounting for leases, since it requires virtually all lease and rental contracts
to be reported on the balance sheet (instead of treating them as off-balance
sheet items, as it used to be before). As may be read in Table 2.20 (in the
appendix), Kinaxis Inc. (a Canadian provider of cloud-based IT solutions)
decided to implement the new standard as early as on January 1, 2018, while
its Finnish “peer” (Tieto Oyj) announced that it would delay the adoption of
IFRS 16 until its mandatory deadline (December 30, 2018). Consequently,
even though both firms apply International Financial Reporting Standards,
2 Other “Distortions” in a Financial Statement …
67
their balance sheets as at the end of 2018 were based on different accounting
principles regarding accounting for leases.
Table 2.10 compares indebtedness ratios of both firms. As may be seen in
its upper part, at the end of 2018 the raw (i.e. based on the numbers reported
on the balance sheet) indebtedness ratios of Kinaxis and Tieto Oyi equaled
38,0% and 59,7%, respectively. However, these numbers were not entirely
comparable since they were based on different policies applied by both firms
in accounting for leases. Therefore, in the lower part of the table the Tieto
Oyi’s data are adjusted for its off-balance sheet leases, on the ground of the
note disclosures quoted in Table 2.20. Since the company’s estimates of the
IFRS 16’s impact on the carrying amounts of assets and liabilities differ only
Table 2.10 Raw and adjusted indebtedness ratios of Kinaxis Inc. and Tieto Oyj, as at
the end of fiscal year 2018
Data as of December 31, 2018
Kinaxis Inc.
Tieto Oyj
(data in CAD million)
(data in EUR million)
Numbers reported in financial statements*
Total liabilies
113,1
715,0
Total assets
297,8
1.197,6
Raw indebtedness rao**
38,0%
59,7%
Amount of adjustment of total liabilies for
the esmated impact of adopng IFRS 16
+165,0
Not applicable***
Amount of adjustment of total assets for the
esmated impact of adopng IFRS 16
+165,0
Adjusted numbers
Total liabilies
113,1
880,0
Total assets
297,8
1.362,6
Adjusted indebtedness rao**
38,0%
64,6%
*after the early adoption of IFRS 16 by Kinaxis Inc. and before the mandatory
adoption of IFRS 16 by Tieto Oyi
** = Total liabilities/Total assets
***since the company already implemented IFRS 16, based on the early adoption
option
Source Annual reports of individual companies for fiscal year 2018 and authorial
computations
68
J. Welc
marginally, a single amount of adjustment (i.e. 165 EUR million) has been
applied to both sides of the balance sheet.
As may be seen, the Tieto Oyj’s adjusted indebtedness, as at the end of
2018, is higher by about five percentage points from its equivalent value
based on the numbers reported on its balance sheet (i.e. 64,6% vs. 59,7%).
The company which looked relatively more indebted on the ground of both
firms’ reported (and incomparable) numbers, now appears even more leveraged. This shows that it is always advisable to pay attention to possible erosion
of financial statement comparability, brought about by early vs. mandatory
adoptions of new accounting regulations, when comparing financial results
of various firms.
Appendix
See Tables 2.11, 2.12, 2.13, 2.14, 2.15, 2.16, 2.17, 2.18, 2.19, and 2.20.
Table 2.11
Consolidated income statement of Fiat S.p.a. for fiscal years 2012–2013
EUR million
Net revenues
2012
2013
83.957
86.816
TRADING PROFIT/(LOSS)
3.541
3.394
Results from investments
107
97
Gains (+)/losses (−) on the disposal of investments
−91
8
Restructuring costs
Other unusual income/(expenses)
EBIT
Financial income (+)/expenses (−)
PROFIT/(LOSS) BEFORE TAXES
15
28
−138
−499
3.404
2.972
−1.885
−1.964
1.519
1.008
Tax income (−)/expenses (+)
623
−943
PROFIT/(LOSS), ATTRIBUTABLE TO:
896
1.951
Owners of the parent
Noncontrolling interests
Source Annual report of Fiat S.P.A. for fiscal year 2013
44
904
852
1.047
69
2 Other “Distortions” in a Financial Statement …
Table 2.12 Consolidated balance sheet of Fiat S.p.a. for fiscal years 2012 and 2013
On December 31,
2012
On December 31,
2013
45.464
36.587
55
82.106
47.611
39.154
9
86.774
Equity:
8.369
12.584
Aributable to owners of the parent
6.187
8.326
Noncontrolling interests
2.182
4.258
Provisions
20.276
17.360
Debt
27.889
29.902
201
137
16.558
17.235
Current tax payable
231
314
Deferred tax liabilies
801
278
7.781
8.943
–
21
82.106
86.774
EUR million
Total noncurrent assets
Total current assets
Assets held for sale
TOTAL ASSETS
Other financial liabilies
Trade payables
Other current liabilies
Liabilies held for sale
TOTAL EQUITY AND LIABILITIES
Source Annual report of Fiat S.P.A. for fiscal year 2013
Table 2.13 Extract from Note 23 to the financial statements of Fiat S.p.a. for fiscal
years 2012 and 2013
Note 23: Equity
The noncontrolling interest of €4,258 million on 31 December 2013 (€2,182 million on 31
December 2012) refers mainly to the following subsidiaries:
On 31 December 2013
On 31 December 2012
Chrysler Group LLC*
Ferrari S.p.A.
(% held by noncontrolling interest)
41.5
10.0
41.5
10.0
Teksid S.p.A.
15.2
15.2
* It should be noted that on January 21, 2014, Fiat acquired the remaining ownership interest of Chrysler
(41.5%) […]
Source Annual report of Fiat S.P.A. for fiscal year 2013
70
J. Welc
Table 2.14 Examples of significant share of noncontrolling interests (NCI) in
consolidated net earnings and consolidated shareholder’s equity
Company
Asseco Group
Colgate-Palmolive
Deutsche Telekom
E.On
GDF Suez
Heineken
Panasonic
PSA (Peugeot / Citroen)
RWE
Sony
Telefonica
Fiscal year
2011
2014
2017
2016
2012
2015
2010
2016
2015
2010
2017
Share of NCI
in consolidated
net profit/loss (%)
34,6
6,8
37,7
47,2
43,7
11,6
39,2
19,5
125,4
415,0
7,3
Share of NCI
in consolidated
equity (%)
31,1
17,3
27,6
182,0
16,1
10,2
24,1
13,4
23,6
9,7
36,4
Source Annual reports of individual companies and authorial computations
Table 2.15 Extract from annual report of WestJet for fiscal year 2011, referring to
the company’s change in accounting principles applied to depreciation of aircrafts
Depreciaon
Canadian GAAP: Depreciaon of owned aircra was based on aircra cycles. Aircra were
amorzed over a range of 30,000 to 50,000 cycles with one cycle being defined as the
aircra leaving the ground and landing.
IFRS: As a result of componenzaon […], the Company was required to assess the useful
lives and depreciaon methods of each newly idenfied aircra component. The result was
a change to the depreciaon method for aircra components to the straight-line method.
The Corporaon determined that the expected useful life of the aircra under IFRS in 20
years based on the expected paern of consumpon of future economic benefits embodied
in the aircra components. […]
Impact: Total depreciaon over the life of the aircra is unchanged under IFRS. There is only
a ming difference in expense recognion.
Source Annual report of WestJet for fiscal year 2011
2 Other “Distortions” in a Financial Statement …
71
Table 2.16 Extract from annual report of Lufthansa Group for fiscal year 2014,
referring to the company’s cost savings resulting from prior change of the useful
lives of its fixed assets
Depreciaon and amorzaon down sharply due to adjustment to useful lives of aircra
the previous year
Depreciaon and amorzaon fell by 14.4% to EUR 1.5bn in the financial year 2014. The
decline in the depreciaon of aircraft was even steeper down by 20.2% to EUR 1.1bn. It was
due to the changes made the previous year, which extended the useful lives of aircra and
reserve engines from twelve to 20 years and reduced their residual value from 15 to 5% at
the same me. The reason that adjusng the useful lives produced greater savings on
depreciaon of EUR 351m in the reporng period (previous year: EUR 63m) is that in the
previous year, the effect was migated by reducing residual values from 15 to 5%.
Source Annual report of Lufthansa Group for fiscal year 2014
Table 2.17 Extract from Note 2 to consolidated financial statements of Lufthansa
Group for fiscal year 2013, referring to the company’s change of useful lives of its
aircraft-related fixed assets
Unl the end of the financial year 2012, new commercial aircra and reserve engines were
depreciated over a period of twelve years to a residual value of 15%. Technological
developments and the higher demands made of their cost-effecveness due to increasing
compeon have resulted in significant changes to the forecast useful economic life of the
commercial aircra and reserve engines used in the Luhansa Group. In line with the fleet
strategy, which takes these aspects into account, as well as with external consideraons,
commercial aircra and reserve engines have been depreciated over a period of 20 years to
a residual value of five percent since 1 January 2013. The adjustment to their useful lives
was made prospecvely as a change in an accounng esmate in accordance with IAS 8.32.
The change was therefore not made retrospecvely for past reporng periods. As a result of
the change in the accounng esmate of the useful economic life of these assets,
depreciaon and amorzaon was EUR 68m lower in the financial year 2013 and
impairment losses were EUR 76m lower. In future reporng periods, the adjustment to
useful lives will reduce depreciaon and amorzaon by around EUR 340m for the financial
year 2014, by EUR 350m for the financial year 2015 and by around EUR 250m p. a. for the
five subsequent financial years.
Source Annual report of Lufthansa Group for fiscal year 2013
72
J. Welc
Table 2.18 Extract from Form 8-K current report, published by Ford Motor Company
on November 14, 2006, explaining the nature of its accounting error
FORD […] COMPLETES RESTATEMENT OF 2001–2005 FINANCIAL RESULTS
[…] Ford Motor Company [NYSE: F] today filed with the Securies and Exchange Commission
its 2006 third-quarter 10-Q Report and an amended 2005 10-K Report to restate its
previously reported financial results from 2001 through 2005 to correct accounng for
certain derivave transacons under Paragraph 68 of the Statement of Financial Accounng
Standards (SFAS) 133, Accounng for Derivave Instruments and Hedging Acvies. […]
[…] The company also filed today a Form 10-K/A for the year ended December 31, 2005,
which includes amended financial statements for each of the years ended December 31,
2003, 2004 and 2005, and selected financial data for each of the years 2001 through 2005.
[…]
The restatement’s cumulave impact on net income was an increase of about $850 million.
The change in accounng for the Ford Credit interest rate swaps did not affect the
economics of the derivave transacon involved, nor have any impact on Ford Motor
Company’s cash.
Ford restated its results aer discovering that certain interest rate swaps that Ford Credit
had entered into did not sasfy the specific requirements of […] SFAS 133 […].
As a result, the restatement of the company’s financial results reflects changes in fair value
of these hedging instruments as derivave gains and losses during affected periods […].
Changes in the fair value of interest rate swaps are driven primarily by changes in interest
rates. […] For 2001 and 2002, when interest rates were trending lower, Ford is now
recognizing large derivave gains in its restated financial statements. The upward trend in
interest rates from 2003 through 2005 caused the interest rate swaps to decline in value,
resulng in the recognion of derivave losses for these periods.
“Aer a review of our internal controls, we determined a material weakness did exist with
relaon to SFAS 133. That material weakness has been fully remediated with the compleon
of this restatement”, said Don Leclair, Ford’s execuve vice president and chief financial
officer. […]
Source Ford Motor Co.: Form 8-K (Current report filing) Filed 11 November2006 For
Period Ending 11 November 2006
2 Other “Distortions” in a Financial Statement …
73
Table 2.19 Extracts from notes to financial statements of The Boeing Company,
General Dynamics Corp., Lockheed Martin Corp. and Raytheon Company for fiscal
year 2017, regarding their adoption of the new revenue recognition policies
THE BOEING COMPANY
We are adopng ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) in
the first quarter of 2018 using the retrospecve transion method which will require 2016
and 2017 financial statements to be restated. […]
[…]
Because revenue will be recognized under the new standard as costs are incurred for most
of our defense and military derivave airplane contracts, approximately $10,000 of
revenues and $1,300 of associated operang earnings will be accelerated into years ending
prior to January 1, 2016. The restatement will result in a cumulave adjustment to increase
retained earnings by $900 effecve January 1, 2016. […]
GENERAL DYNAMICS CORP.
The majority of our revenue is derived from long-term contracts and programs that can span
several years. We account for revenue in accordance with ASC Topic 606. […]
We adopted ASC Topic 606 on January 1, 2017, using the retrospecve method. […] For our
contracts for the manufacture of business-jet aircra, we now recognize revenue at a single
point in me when control is transferred to the customer, generally upon delivery and
acceptance of the fully ouied aircra. Prior to the adopon of ASC Topic 606, we
recognized revenue for these contracts at two contractual milestones: when green aircra
were completed and accepted by the customer and when the customer accepted final
delivery of the fully ouied aircra. The cumulave effect of the adopon was recognized
as a decrease to retained earnings of $372 on January 1, 2015.
LOCKHEED MARTIN CORP.
We adopted the requirements of the new standard on January 1, 2018 using the full
retrospecve transion method, whereby ASC 606 will be applied to each prior year
presented and the cumulave effect of applying ASC 606 will be recognized at January 1,
2016 […].
[…] we expect to recognize revenue over me for substanally all of our contracts using a
method similar to our current percentage-of-compleon cost-to-cost method. […]
RAYTHEON COMPANY
Effecve January 1, 2017, we elected to early adopt the requirements of Accounng
Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). […]
Effecve January 1, 2017, we elected to early adopt the requirements of Topic 606 using the
full retrospecve method […].
Source Annual reports of individual companies for fiscal year 2017
74
J. Welc
Table 2.20 Extracts from notes to financial statements of Kinaxis Inc. and Tieto Oyj
for fiscal year 2018, regarding their adoption and reporting effects of the IFRS 16
(Leases)
KINAXIS INC.
IFRS 16 specifies how to recognize, measure, present and disclose leases. The standard
provides a single lessee accounng model, requiring lessees to recognize assets and
liabilies for all major leases.
Effecve January 1, 2018, the Company early adopted IFRS 16 using the modified
retrospecve approach and accordingly the informaon presented for 2017 has not been
restated. […]
On inial applicaon, the Company has elected to record right-of-use assets based on the
corresponding lease liability. Right-of-use assets and lease obligaons of $7,234 were
recorded as of January 1, 2018, with no net impact on retained earnings. […]
TIETO OYJ
IFRS 16 will result in almost all leases being recognized on the statement of financial
posion, as the disncon between operang and finance leases is removed. Under the new
standard, an asset (the right to use the leased item) and a financial liability to pay rentals are
recognized in the statement of financial posion. […]
The Group will adopt the modified retrospecve approach upon transion, resulng with all
transion impact being reported as adjustment to opening retained earnings […]. The Group
will use praccal expedient not to reassess definion of a lease and apply IFRS 16 to all
exisng operang leases as of 31 Dec 2018.
On the reporng date, the Group has non-cancellable operang lease commitments of EUR
182.0 million, see note 27. It is esmated that IFRS 16 has the following impact on the Group
financial statements:
Statement of financial posion (EUR million)
Lessee reporng
IFRS 16 Impact
Right-of-use assets (Increase)
EUR 155–165 million
Lease liabilies (Increase)
EUR 158–168 million
Deferred rent and Accrued lease payments as of 31 Dec 2018
(decrease)
EUR 1.5–2.0 million
Source Annual reports of individual companies for fiscal year 2018
2 Other “Distortions” in a Financial Statement …
75
References
Bergevin, P. M. (2002). Financial Statement Analysis. An Integrated Approach. Upper
Saddle River: Prentice Hall.
Mulford, C. W., & Comiskey, E. E. (1996). Financial Warnings. Detecting Earnings
Surprises, Avoiding Business Troubles, Implementing Corrective Strategies. New York:
Wiley.
Welc, J. (2017). Impact of Non-Controlling Interests on Reliability of Consolidated
Income Statement and Consolidated Balance Sheet. American Journal of Business,
Economics and Management, 5, 51–57.
3
Deliberate Accounting Manipulations:
Introduction and Revenue-Oriented
Accounting Gimmicks
3.1
Quality of Earnings as One of the Major
Problems of Contemporary Accounting
One of the most serious problems of contemporary accounting is a temptation faced by corporate managers and accountants to abuse a leeway and
huge load of subjective judgments, which are embedded in accounting standards (such as IFRS or US GAAP), in order to manipulate reported numbers.
Such manipulations are typically aimed either at artificially inflating (i.e.
overstating) reported profits or at achieving smoother time-series patterns
of reported financial results. However, as will be discussed in Section 4.2 of
Chapter 4, sometimes companies also deliberately understate their reported
profits (although this is a rarer phenomenon, as compared to profit overstatements). Obviously, any such earnings manipulations erode the usefulness and
reliability of financial statements (Naser 1993; Whelan 2004; Graham et al.
2006; Chi and Gupta 2009).
Researchers found that corporate managers manipulate financial statements mostly due to the following motivations (Griffiths 1990; Holthausen
et al. 1995; Cahan et al. 1997; Key 1997; Stlowy and Breton 2004; Cheng
and Warfield 2005; Zack 2009; Shah et al. 2011; Zhang 2018):
• To meet internal targets, e.g. internal goals set by higher management
with respect to sales of profitability.
• To increase managerial pay bonuses, which are often based on some
target results (e.g. specified profit or stock price level).
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_3
77
78
J. Welc
• To meet external expectations, e.g. analysts’ profit forecasts or a given
company’s own prior performance guidance.
• To achieve income smoothing, in order to show allegedly steady income
stream, to impress investors and to maintain a stable trend of a share price.
• To “window dress” (i.e. artificially “improve” reported results), before
an Initial Public Offering (IPO) or before borrowing new debts.
• To obtain better credit ratings from rating agencies, thanks to reporting
inflated earnings and cash flows.
• To create reserves (for releasing them in the future) by new company
managers, by reporting losses allegedly caused by poor prior management.
• To avoid anti-company actions initiated by regulatory bodies, e.g. antitrust governmental agencies.
Not only reported corporate earnings and profitability ratios are often
distorted or manipulated, but financial risk metrics as well. Reliability and
inter-company comparability of liquidity and indebtedness ratios may be
eroded by accounting policy choices as well as by operating and financial
decisions. For example, current ratio over the term of the lease is lower
under the capital lease approach than it would be under the operating lease
approach (Revsine et al. 2002). Consequently, in an effort to appear less
risky, firms often attempt to structure financing in a manner that keeps debt
off-balance sheet, e.g. through operating leases instead of capital ones (Ketz
2004; Stickney et al. 2004; Giroux 2004), provided that the former do not
have to be reported on the balance sheet (as was the case under IFRS until
2019). Subjective judgments required by IFRS for classifying some assets and
liabilities (into long-term or short-term categories) may also affect the comparability and reliability of reported current assets and liabilities (Mackenzie
et al. 2012). Kraft (2012) found that in a broad sample of companies the
indebtedness ratio adjusted for off-balance sheet liabilities (with an application of the adjustment approaches presented in Section 9.3 of Chapter 9)
exceeds the reported leverage ratio by at least 20%, on average.
Other studies found that firms near thresholds of EBITDA-based ratios
are more likely to temporarily reduce some discretionary expenditures (such
as research and development or selling, general and administrative costs), in
order to boost EBITDA prior to bond issuance (Begley 2013). Also, firms
with loan contracts that contain covenants based on EBITDA are more likely
to misclassify core expenses as special items, in order to increase EBITDA
(Fan et al. 2016).
To sum up, empirical studies confirm that many corporate managers do
their best to stretch accounting principles to the extent possible (sometimes
3 Deliberate Accounting Manipulations: Introduction …
79
even blatantly violating them), if it may bring them some personal benefits. A history of corporate finance knows hundreds of cases of aggressive or
fraudulent application of accounting rules, followed by sudden negative earnings surprises (and often also corporate defaults). Therefore, when analyzing
financial statements it is very important to be familiarized with a plethora
of accounting gimmicks which companies may use to misstate their reported
results. This chapter, as well as Chapter 4, guide the reader through selected
set of techniques of earnings manipulations (based on hypothetical examples), while the following chapters offer a detailed manual (supported by
multiple real-life case studies) on various tools useful in assessing reliability
and comparability of corporate financial statements.
It must be noted that accounting gimmicks discussed in this chapter (as
well as in Chapter 4) may bear varying tax consequences, whose type and
scope differ between various tax jurisdictions. Significant tax burdens implied
by an application of a given accounting trick (e.g. an increased income tax
payable as a result of an overstatement of reported profits) may limit managerial incentives to get involved into such earnings manipulations. However,
as the empirical research documents, even higher tax burdens are not able
to discourage some managers from committing accounting frauds (Erickson
et al. 2004).
Table 3.1 (in the appendix) contains selected examples of accounting scandals which broke out in the last ten years or so. Of course, the table does
not provide an exhaustive list of all instances of accounting irregularities
which occurred worldwide during that timeframe. However, even within this
limited sample it may be noted that earnings manipulations are observed in
case of small and not very known companies (e.g. Longtop Financial Technologies, OCZ Technology Group or Puda Coal) as well as in case of much
larger, globally recognized corporations (e.g. General Electric, Monsanto,
Tesco or Toshiba). Also, it may be noted that an employment of even the
most recognized auditing companies does not guarantee integrity, reliability
and fairness of audited financial statements.
The following factors constitute main reasons responsible for the auditor’s
inability to detect all cases of earnings manipulations:
• lack of a sufficient auditor’s independence (e.g. due to a high share of nonaudit and consulting fees in total auditor’s revenues),
• lack of a sufficient auditor’s knowledge and experience (e.g. because of
staff limitations and overdone reliance on relatively inexperienced audit
assistants),
80
J. Welc
• an auditor’s inability to fully understand complex business operations of
many contemporary corporations.
However, as will be shown in Section 5.2 of Chapter 5, an auditor’s
opinion still constitutes a useful tool of an earnings quality assessment. Nevertheless, the well-documented audit failures teach that the auditors should not
be trusted blindly and that an understanding of aggressive accounting techniques (and analytical tools helpful in detecting them) should constitute an
integral part of professional skills of any financial statement user.
3.2
Links Between Earnings Manipulations
and Balance Sheet Distortions
Income statement and balance sheet are linked via the former’s bottom line
(net earnings), which is a component of shareholder’s equity reported on the
latter’s right-hand side. Consequently, any manipulation (e.g. overstatement)
of reported earnings must also affect a company’s equity. However, as will be
illustrated below, a misstated equity entails misstated assets or liabilities (or
both).
Imagine a fictitious condensed financial statements as depicted on
Chart 3.1. As may be seen, company’s total revenues and gains in a period
amounted to 900 units, while its total expenses and losses amounted to
800 units. As a result, the company reported an after-tax earnings of 100
units. These earnings constitute part of the company’s shareholders’ equity,
BALANCE SHEET
EQUITY AND
LIABILITIES (E+L)
ASSETS
Equity, incl.:
Various
assets
Total
assets
1.000
Net earnings
Liabili es and
provisions
1.000
Total
E+L
INCOME STATEMENT
300
100
Revenues and gains
900
Expenses* and losses
800
700
Net earnings
100
1.000
Net earnings for a period is a “bridge”
between a balance sheet
and an income statement
* including income taxes
Chart 3.1 Hypothetical non-manipulated income statement and balance sheet
(*including income taxes. Source Author)
81
3 Deliberate Accounting Manipulations: Introduction …
amounting to 300 units. This equity, combined with liabilities and provisions of 700 units, reconcile with the company’s total assets, with their total
carrying amount of 1.000 units.
Now suppose that the investigated company’s managers intentionally overstate its net earnings by 100 units, e.g. by recording fictitious sales of that
amount (while keeping total expenses and losses intact). Now the company’s
overstated revenues and gains of 1.000 units, matched against its expenses
and losses of 800 units, result in an inflated net earnings, amounting to 200
units. However, it also implies an overstatement of the equity by the same
amount, that is by 100 units. As a result, at the moment (before further
booking entries) the company’s total equity and liabilities amount to 1.100
units [= equity of 400+ liabilities and provisions of 700], while its unchanged
total assets amount to 1.000 units. Consequently, total values of both sides
of the company’s balance sheet lost their equality.
However, this reasoning is incorrect, since a double entry principle of
accounting requires each transaction to affect (by a debit and credit) two
financial statement items. If the investigated hypothetical company inflated
its profit by recognizing fictitious revenues of 100 units, the most likely
corresponding result is an overstatement of its receivable accounts (by the
same 100 units), since the fabricated revenues are very rarely accompanied by
any real cash flows. Consequently, after such an earnings manipulation the
company’s financial statements would look as depicted on Chart 3.2. As may
be seen, now not only the company’s revenues and profits are inflated, but
BALANCE SHEET
EQUITY AND
LIABILITIES (E+L)
ASSETS
Various
assets**
Total
assets
1.100
1.100
INCOME STATEMENT
Equity, incl.:
400
Revenues and gains*
Net earnings
200
Expenses and losses
800
Liabili es and
provisions
700
Net earnings
200
Total
E+L
1.100
1.000
Inflated earnings (and equity) by 100 units
correspond to an overstatement of assets
by the same amount
Chart 3.2 Hypothetical manipulated income statement and balance sheet, after
recognizing a fictitious sales transaction amounting to 100 units (and boosting net
earnings by the same amount) (*including fictitious revenue of 100 units; **including
fictitious [non-existent] receivable accounts, amounting to 100 units. Source Author)
82
J. Welc
also the carrying amount of its assets is overstated (due to an inclusion of a
nonexistent receivable account of 100 units).
Now suppose that instead of inflating revenues, the managers manipulated
the reported earnings by understating the company’s payroll expenses (by not
accruing salaries which the company owes to its employees) by 100 units. In
such a circumstance the falsified financial statements would look as shown on
Chart 3.3. As may be seen, now the carrying amount of the company’s assets
is intact (as compared to a base-case scenario of no earnings manipulation),
but its liabilities and provisions are understated by 100 units, since they do
not include the payroll-related liabilities (which are real payables) of the same
amount.
Finally, suppose that the company boosts its reported earnings by recognizing a fictitious revenue of 100 units and at the same time it understates
its payroll-related expenses by 50 units (with a resulting profit overstatement
amounting to 150 units). The financial statement effects of such a combination of accounting gimmicks is illustrated on Chart 3.4. As may be seen, the
recognition of fictitious revenues is mirrored in a boosted carrying amount of
total assets, while the understated payroll expenses (payable to employees) are
reflected in undervalued liabilities. Even though both sides of the company’s
balance sheet have identical period-end carrying amounts, their totals are
inflated (i.e. higher than in a base-case scenario). Also, a structure of the righthand side of the balance sheet is distorted, since it displays overstated equity
and understated liabilities. All in all, the company looks more profitable and
healthier, as compared to reality.
BALANCE SHEET
EQUITY AND
LIABILITIES (E+L)
ASSETS
Various
assets
Total
assets
1.000
1.000
INCOME STATEMENT
Equity, incl.:
400
Revenues and gains
900
Net earnings
200
Expenses and losses*
700
Liabili es and
provisions**
600
Net earnings
200
Total
E+L
1.000
Now earnings (and equity),
which are inflated by 100 units,
correspond to an understatement
of liabili es by the same amount
Chart 3.3 Hypothetical manipulated income statement and balance sheet, after
understating expenses by 100 units (due to a nonrecognition of salaries payable
to employees) (*understated by non-recognition of payable salaries, amounting to
100 units; **understated by an omission of payroll-related liabilities, amounting to
100 units. Source Author)
83
3 Deliberate Accounting Manipulations: Introduction …
BALANCE SHEET
EQUITY AND
LIABILITIES (E+L)
ASSETS
Various
Assets*
Total
assets
1.100
1.100
INCOME STATEMENT
Equity, incl.:
450
Revenues and gains*
Net earnings
250
Expenses and losses**
750
Liabili es and
provisions**
650
Net earnings
250
Total
E+L
1.100
1.000
Now a profit overstatement by 150 units
corresponds to an overstatement of assets
(by 100 units) and an understatement of
liabili es (by 50 units)
Chart 3.4 Hypothetical manipulated financial statements, after a simultaneous
overstatement of revenues by 100 units (due to a recognition of fictitious sales transaction) and an understatement of expenses by 50 units (due to a nonrecognition of
payroll costs) (*including fictitious revenue of 100 units and a corresponding fictitious [non-existent] receivable account, amounting to 100 units; **understated by
an omission of payroll-related expenses and liabilities, amounting to 50 units. Source
Author)
A lesson offered by these hypothetical considerations is that any manipulations of reported income simultaneously affect carrying amount of shareholders’ equity. This, in turn, means that inflated accounting earnings must
be accompanied by either overstated assets or understated liabilities (or a
mix of both). Likewise, understatements of reported profits must entail
either understated carrying amounts of assets or inflated values of liabilities (or both). A knowledge of these mutual interrelationships between
an income statement and a balance sheet is helpful in understanding the
mechanics of techniques of aggressive and fraudulent accounting (presented
in the following sections of this chapter, as well as in Chapter 4), as well
as in learning the analytical tools useful in assessing the financial statement
reliability and comparability (discussed in the following chapters).
Since most cases of accounting manipulations are related to an overstatement of reported earnings (rather than their understatement), hypothetical
examples discussed in the following two subsections will show how the
accounting profits may be inflated. However, Section 4.2 of Chapter 4 will
deal with issues related to deliberate earnings understatements (which are also
observed sometimes).
Due to space limitations, the following abbreviations of the names of
primary financial statements will be used:
• the abbreviation “BA” will be used for the balance sheet,
84
J. Welc
• the abbreviation “IS” will be used for the income statement,
• the abbreviation “CFS” will be used for the cash flow statement.
3.3
Overstatement of Profits by Overstatement
of Revenues
3.3.1 Introduction
As was demonstrated in a preceding section, reported accounting earnings
may be boosted either by an overstatement of revenues or by an understatement of expenses (or a combination of both). Therefore, in this section the
selected techniques of inflating revenues will be presented. In contrast, the
following section will discuss accounting gimmicks aimed at boosting profits
by understating expenses.
3.3.2 Overstatement of Profits by Premature
Recognition of Revenues Which Should Be
Deferred
One of the most important foundations of contemporary accounting is a
matching principle, according to which expenses (in an income statement)
should be matched with revenues related to those expenses. This means that
when revenues are obtained but some products or services, related to those
revenues, remain to be delivered (in the future), all or part of those revenues
should be deferred (and included in liabilities on a balance sheet, instead of
being reported in an income statement).
An overstatement of reported profit appears when revenues, which should
be deferred, are prematurely recognized in an income statement. This technique of earnings manipulation results in the overstated earnings with a
corresponding understatement of liabilities (in their part related to deferred
revenues). Example 3.1 illustrates the overstatement of profits by premature
recognition of revenues which should be deferred to a later period.
It may be noted that under the incorrect booking entries:
• Pre-tax profit in Period t is overstated by 500.000 EUR, with a corresponding understatement of deferred revenues (which are part of the
company’s liabilities in a balance sheet), at the end of Period t, by the same
500.000 EUR.
Source Author
Pre-tax profit (IS)
+1.000.000
Pre-tax profit (IS)
* = (200 / 300) x 500.000 EUR = 333.333 EUR
** = 200 hours x 1.000 EUR = 200.000 EUR
*** = (100 / 300) x 500.000 EUR = 166.667 EUR
**** = 100 hours x 1.000 EUR = 100.000 EUR
Net sales (IS)
Cost of goods sold (IS)
Pre-tax profit (IS)
Period t
+1.000.000
+1.000.000
+500.000
Cash / receivables (BS)
Net sales (IS)
Incorrect booking entries:
Pre-tax profit (IS)
-200.000
Period t+1
0
+100.000
+133.333
Pre-tax profit (IS)
Net sales (IS)
Cost of goods sold (IS)
Pre-tax profit (IS)
-100.000
Period t+2
0
+100.000
+66.667
On January 1, Period t, a software company sold to its customer a software for 1.000.000 EUR. However, a total contract price covered, apart from
the software itself, also a pre-paid fee for 300 hours of optional consulting services which must be rendered to the customer on demand within the
following 24 months.
The company estimated that 50% of the total price (i.e. 500.000 EUR) is attributable to the software license, while the remaining 50% should be
allocated to the consulting services (which are to be delivered in future periods).
The hourly cost of consultants’ work is 1.000 EUR.
In the first 12 months the customer ordered 200 hours of consulting services, while in the next 12 months it utilized the remaining 100 hours.
Correct booking entries:
Period t
Period t+1
Period t+2
Cash / receivables (BS)
+1.000.000
Net sales (IS)
+333.333
Net sales (IS)
+166.667
Net sales (IS)
Deferred revenue (BS)
-333.333*
Deferred revenue (BS)
-166.667***
+500.000
Deferred revenue (BS)
+500.000
Cost of goods sold (IS)
+200.000**
Cost of goods sold (IS)
+100.000****
Example 3.1 Overstatement of profits by premature recognition of revenues which should be deferred
3 Deliberate Accounting Manipulations: Introduction …
85
86
J. Welc
• This is because net sales recognized in income statement in Period t include
500.000 EUR of prepaid consulting revenues, which should be deferred in
order to comply with a matching principle (given that those consulting
services will have to be rendered in the future and expenses related to them
will have to be incurred).
• The resulting overstatement of profit in Period t (by 500.000 EUR) will
have to be reversed in the following periods, when costs of consulting
services are incurred without any related revenues (which have already been
prematurely recognized before).
• Therefore, the total impact of the whole transaction (in the whole threeyear period) on profit before taxes is the same under both scenarios and
equals 700.000 EUR.
3.3.3 Overstatement of Profits by Premature
Recognition of Revenues Which Are Conditional
on Future and Uncertain Events
According to most accounting standards, a timing of revenue recognition
in income statement should be linked to a transfer of all major economic
benefits and risks, related to the products or services embraced by a given
transaction. This means that in many circumstances, where the transfer of
all the major benefits, and especially all the major risks, remains incomplete,
revenue shouldn’t be recognized in full.
Examples of circumstances, when products or services are delivered
without a complete transfer of all relevant economic benefits and risks, are:
• Sale when a final price or a final customer’s acceptance is conditional on
future but uncertain events (e.g. a permission from government to use the
product).
• Sale when a product installation is to be done by a vendor in a customer’s
location and the customer’s acceptance is contingent on successful results of
product testing (e.g. tests of quality of output from the machine delivered
by its manufacturer).
• Sale when a customer retains a right to return its unsold inventories back
to their provider (a consignment sale).
It must be noted that in some circumstances part of revenue collected
from a sale transaction may be recognized immediately (with its remaining
part being deferred), while in other situations it may be legitimate to defer
the recognition of the whole revenue until later periods. An example of the
3 Deliberate Accounting Manipulations: Introduction …
87
former is a sale of clothing by its retailer when an expected volume of product
returns may be estimated reliably (e.g. within a relatively narrow range of estimates, based on a company’s prior experience). For instance, suppose that in
the last couple of years a given company observed that between 3% and 4% of
its sold apparel was returned by customers after sale. With such a narrow and
stable range, an unbiased estimate of an amount of revenues which should
be deferred may be obtained as 3,5% of sales in a given period (or 4%, if
the company’s managers prefer to be more conservative). In contrast, if the
volume of returns tends to be “capricious” and unpredictable (e.g. due to
external and unforeseeable factors), then a more prudent approach is justified,
with the whole amount of revenue being deferred, at least until when reasonable estimates of returns may be obtained. Such circumstances may be faced
by a manufacturer of sunscreens (or umbrellas), who delivers its products to
wholesale agents (with a right of return) in a spring, without being able to
predict the end-users’ demand (which, in turn, will be driven by unknown
weather conditions during an upcoming summer).
An overstatement of earnings when a final amount of revenues is uncertain
(conditional on future events) is presented in Example 3.2. Example 3.3, in
turn, illustrates the overstatement of earnings by premature recognition of
revenues from a consignment sale, i.e. when customer retains a right to return
the goods purchased from the vendor.
As regards Example 3.2, it may be noted that under the incorrect booking
entries in Scenario 1:
• Pre-tax profit in Period t is overstated by 1.000.000 EUR, due to a premature recognition of an expected (but contingent on uncertain event) success
fee of 1.000.000 EUR [=1% of the expected value of transaction of 100
EUR million).
• This overstatement must be reversed in Period t + 2, when the contract for
advisory services terminates and 1.000.000 EUR of revenues prematurely
recognized in Period t no longer may be treated as earned.
• The total impact of the whole contract (in a three-year period) on pretax profit is the same under the correct and incorrect booking entries and
equals 1.000.000 EUR.
It may be noted that under the incorrect booking entries in Scenario 2:
• Again, pre-tax profit in Period t is overstated by 1.000.000 EUR, due to a
premature recognition of the expected (but contingent on uncertain event)
success fee.
+1.000.000
+2.000.000
Pre-tax profit (IS)
Net sales (IS)
Cash / receivables (BS)
Pre-tax profit (IS)
0
Period t+1
0
0
0
Pre-tax profit (IS)
Operating costs (IS)
Receivables (BS)
Pre-tax profit (IS)
0
-1.000.000
Period t+2
+1.000.000***
-1.000.000***
* to reflect only that revenue which was actually earned in Period t ** premature recognition of expected (contingent) success fee of 1.000.000 EUR
*** write-off of revenue of 1.000.000 EU R (from a success fee) which was prematurely recognized in preceding periods
Pre-tax profit (IS)
Incorrect booking entries under Scenario 1:
Period t
Net sales (IS)
+2.000.000**
Cash / receivables (BS)
+1.000.000
+1.000.000**
Receivables (BS)
Pre-tax profit (IS)
On January 1, Period t, a management consulting company won a contract under which it will render advisory services to a big industrial holding,
which intends to sell all shares of one of its subsidiaries. Under the terms and conditions of the contract, the final total price for the advisory services
consists of two elements: a fixed fee for analytical, legal and auditing work (1.000.000 EUR) plus variable (conditional) success-fee, equaling 1% of
the final value of a transaction (but only when the transaction is finalized within a 24-months time since the contract is signed). Consequently, the
contracted success-fee is contingent on a finalization of the transaction (and will equal 0 EUR if the transaction is not finalized within 24 months) and
should be recognized only after an actual closure of the transaction.
The company estimated that probability of finalization of the transaction is high and that its most likely value amounts to 100.000.000 EUR.
Accordingly, the company expects to earn a total revenue of 2.000.000 EUR, i.e. the sum of 1.000.000 EUR of the fixed fee and 1.000.000 EUR of the
success-fee [= 1% x 100.000.000 EUR].
Suppose two alternative scenarios:
1) Scenario 1: the transaction is not finalized within 24 months (and as a result the expected success-fee is lost forever).
2) Scenario 2: the transaction is finalized after 12 month and its value amounts to 150.000.000 EUR (and as a result the final amount of the
success-fee earned exceeds the amount originally expected by the company)
Correct booking entries under Scenario 1:
Period t
Period t+1
Period t+2
Net sales (IS)
0
Net sales (IS)
0
Net sales (IS)
+1.000.000*
Cash / receivables (BS)
+1.000.000*
Cash / receivables (BS)
0
Cash / receivables (BS)
0
Example 3.2 Overstatement of profits by premature recognition of revenues when their final amount is uncertain (i.e. when it is
contingent on unknown future events)
88
J. Welc
Source Author
+1.000.000
Pre-tax profit (IS)
+1.000.000
+2.000.000
+1.000.000***
Pre-tax profit (IS)
Cash / receivables (BS)
Net sales (IS)
+500.000
+500.000****
Period t+1
+500.000****
+1.500.000
+1.500.000**
Cash / receivables (BS)
Pre-tax profit (IS)
Period t+1
+1.500.000**
Net sales (IS)
Pre-tax profit (IS)
Receivables (BS)
Operating costs (IS)
Pre-tax profit (IS)
Cash / receivables (BS)
Net sales (IS)
0
0
Period t+2
0
0
0
Period t+2
0
* to reflect only that revenue which was actually earned in Period t
** to reflect a success fee [= 1% x 150.000.000] earned in Period t+1
*** premature recognition of expected (contingent) success fee of 1.000.000 EUR
**** recognition of an incremental revenue from a final success fee of 1.500.000 EUR (= 1.500.000 EUR of a total success fee less 1.000.000 EUR prematurely
recognized in revenues in Period t)
Pre-tax profit (IS)
Receivables (BS)
Cash / receivables (BS)
Incorrect booking entries under Scenario 2:
Period t
Net sales (IS)
+2.000.000***
+1.000.000*
Cash / receivables (BS)
Correct booking entries under Scenario 2:
Period t
Net sales (IS)
+1.000.000*
3 Deliberate Accounting Manipulations: Introduction …
89
90
J. Welc
Example 3.3 Overstatement of profits by premature recognition of revenues when
a customer retains a right to return the goods purchased from the vendor
In Period t company ABC sold to its consignment agent 100.000 units of a product, for a unit
price of 2 EUR. A contract between the company and its agent states that the agent can
unconditionally return all its products unsold, within a 12-month time. Consequently, from
the ABC’s point of view the revenue from this sale is earned when:
either the agent re-sells the products further (e.g. to their final users), or
the 12-month time, during which the agent can return the products, elapses.
In Period t+1 the agent sold to its customers half of the products purchased from ABC and
returned to the company the remaining half of the unsold goods.
The products sold by ABC to its agent were manufactured (by ABC itself) for 1 EUR per unit.
Correct booking entries look as follows:
Period t
Net sales (IS)
0
Cost of goods sold (IS)
0
Profit before tax (IS)
0
Period t+1
Net sales (IS)
+100.000*
Cash / receivables (BS)
+100.000*
Cost of goods sold (IS)
+50.000*
Inventory (BS)
-50.000*
Profit before tax (IS)
+50.000
Incorrect booking entries look as follows:
Period t
Period t+1
Net sales (IS)
+200.000**
Net sales (IS)
-100.000***
Cash or receivables (BS)
+200.000**
Cash or receivables (BS)
-100.000***
Cost of goods sold (IS)
+100.000**
Cost of goods sold (IS)
-50.000***
Inventory (BS)
+100.000**
Inventory (BS)
+50.000***
Profit before tax (IS)
+100.000
Profit before tax (IS)
-50.000
* revenues = 50.000 units sold x 2 EUR each; cost of goods sold = 50.000 units x 1 EUR each
** revenues = 100.000 units sold x 2 EUR each; cost of goods sold = 100.000 units x 1 EUR each
*** to reflect the return of 50.000 units of products by the agent back to the company
Source Author
• However, this time the overstatement of profit in Period t is not reversed
in the following periods, since the contract ends successfully (with a final
transaction value of 150 EUR million, i.e. above the company’s initial estimate of 100 EUR million) which in turn means that 1.000.000 EUR
of revenues prematurely recognized in Period t underestimates the final
success fee of 1.500.000 EUR.
As might be noted in Example 3.3, the pre-tax profit in Period t is overstated by 100.000 EUR and the profit actually earned (in Period t + 1,
when the conditions for revenue recognition are satisfied), amounts to 50.000
EUR.
3 Deliberate Accounting Manipulations: Introduction …
91
3.3.4 Overstatement of Profits by Aggressive Usage
of Percentage-of-Completion Method of Revenue
Recognition
Under the percentage-of-completion method contract revenues and costs are
recognized in income statement as the contract progresses, but before it is
completed. An idea of this approach is to recognize profits from long-term
contracts in proportion to their progress. Accordingly, production activity
and progress of the contract (rather than delivery or cash collection) are
deemed critical in signaling a completion of an earnings process.
This method is used for long-term projects, in industries such as construction, shipbuilding or manufacturing of airplanes, when there exists a detailed
contract between a vendor and its customer (which guarantees a demand for
a product as well as determines its final price) and when reliable measurement
of the progress of the contract is possible.
Under the percentage-of-completion method a measurement of the
progress toward completion of the contract may be based on the following
bases (although some accounting standards prohibit using some of them):
• simple physical measures (such as miles of a road completed),
• engineering estimates,
• proportion of contract costs incurred to date to expected total costs.
It must be noted that simple physical measures, although intuitively
appealing, often have limited practical applicability, since they are suitable in
rather rare circumstances when a progress of a project is correlated with some
physical metrics. For instance, a stage of completion of a straight flat highway
may be approximated by its length built so far (e.g. 200 km out of contracted
500 km), but the same approach would not provide any reliable estimates in
case of a curvy mountain road, going through multiple tunnels and bridges.
Complex engineering estimates (of a given project’s stage of completion), in
turn, may be relatively precise, but very costly and difficult to verify (e.g. by
auditors). Consequently, contract costs incurred to date are very often used
in measuring a progress of long-term contracts toward their completion.
As a result, the main problem of the percentage-of-completion method
lies in a difficulty (and sometimes impossibility) of verifying the estimated
progress toward completion, except for rare cases when the progress in
easily “visible” even for nonspecialists. Usually auditors are not able to verify
complex engineering estimates (on basis of which the contract progress is
measured and income recognized) presented to them by an audited company.
92
J. Welc
Typically auditors are not also able to precisely verify whether total contract
costs incurred so far are justified, given a real physical progress of the project
(vs. to what extent they reflect cost overruns).
According to most accounting standards, which allow for the percentageof-completion method, when a loss on a given contract is expected (e.g. due
to cost overruns), it should be immediately recognized in income statement in
a period when an amount of the loss can be estimated. However, the problem
is that in case of complex long-term contracts only company’s managers (and
not its auditors) know that the loss can be expected. Therefore, if a company
intends to temporarily inflate its earnings, it may pretend that everything
goes well and that the progress of contract costs is consistent with an initial
budget. This problem is illustrated in Example 3.4.
As might be seen in Example 3.4, under the scenario of incorrect booking
entries:
• The cost overrun (by 3.000 EUR million in Period t + 1) brings about a
significant overstatement of pre-tax profits in Period t + 1 and results in
reporting positive profit instead of a loss.
• The total contract loss is the same under both scenarios (i.e. 1.000 EUR
million) which means that an overstatement of earnings in Period t + 1
entails an understatement of earnings in Period t + 2.
• The negative impact of this aggressive application of the percentage-ofcompletion method is postponed until the completion of the project (in
Period t + 2), i.e. until when all the revenues and costs of the project pass
through the income statement.
• Consequently, this scheme enabled inflating earnings in Period t + 1 (by
3.600 EUR million and not just the 3.000 EUR million resulting from
cost overrun) at the cost of future earnings (which in Period t + 2 are
understated by the same 3.600 EUR million).
• If a given company works on multiple complex long-term contracts and
faces problems with costs control, an overall reliability of its financial
statements may be ruined.
It should be kept in mind that unreliable estimates of a given contract’s
stage of completion may result not only from its cost overruns (which appear
during the contract realization), but also from overly optimistic (understated)
initial estimates of expected contract costs.
7.000
2.000
2.000
Costs incurred to date (cumulatively)
13.000
4.000
Period t+2
As might be seen, the total cumulative costs of the whole project amounted to 13.000 EUR million, instead of their initially expected amount of
10.000 EUR million. This brought about an actual loss on the contract of 1.000 EUR million, instead of the expected pre-tax profit of 2.000 EUR
million.
The cost overrun of 3.000 EUR million resulted from incurring additional unexpected expenses in Period t+1, when the actual costs amounted to
7.000 EUR million, while the company budgeted only 4.000 EUR million for that particular year.
If at the end of Period t+1 the company still expected 4.000 EUR million to be spent in Period t+2, it knew that the total cumulative costs of the
project will exceed the contracted revenues of 12.000 EUR million, with the resulting loss of 1.000 EUR million.
In such circumstances, the company should recognize its full expected loss on the contract in its income statement in Period t+1, by expensing the
cost overrun as incurred (instead of using it in measuring the progress of the contract).
The correct and incorrect booking entries are presented below.
9.000
Period t+1
Period t
Costs incurred in the period:
On January 1, Period t, a construction company started working on a long-term project of building a power plant. The total construction time was
estimated to be 2,5 years, which means that the construction should be completed in Period t+2.
The contracted fixed (non re-negotiable) price for all works amounts to 12.000 EUR million, while the total budgeted (expected) costs of the contract
have been estimated at 10.000 EUR million (with a resulting expected pre-tax profit of 2.000 EUR million).
The company recognizes profits on its long-term contracts with the use of a percentage-of-completion method, on the basis of contract costs
incurred to date.
Actually incurred costs of the contract look as follows:
Example 3.4 Overstatement of profits by aggressive usage of percentage-of-completion method
(continued)
3 Deliberate Accounting Manipulations: Introduction …
93
Source Author
Example 3.4 (continued)
Pre-tax profit recognized in the period
800
4.800
= 7.200 - 2.400
7.000
(as incurred in a period)
-2.200
2.400
= 2.400 - 0
2.000
(as incurred in a period)
Revenues recognized in the period
Pre-tax profit recognized in the period
* includes only costs of the project budgeted for the year (4.000) and excludes the cost-overrun amounting to 3.000 EUR
400
4.000
(as incurred in a period)
7.200
= 60% x 12.000
2.400
= 20% x 12.000
Revenues recognized (cumulative)
Costs recognized in the period
60,0%*
= 6.000 / 10.000
20,0%
= 2.000 / 10.000
4.800
= 12.000 - 7.200
12.000
= 100% x 12.000
100,0%
(end of the project)
Period t+1
Period t
Period t+2
-2.800
4.000
(as incurred in a period)
Estimated percentage of completion
Correct booking entries:
1.400
7.000
(as incurred in a period)
2.000
(as incurred in a period)
400
1.200
= 12.000 - 10.800
8.400
= 10.800 - 2.400
2.400
= 2.400 - 0
Revenues recognized in the period
Costs recognized in the period
12.000
= 100% x 12.000
10.800
= 90% x 12.000
2.400
= 20% x 12.000
Revenues recognized (cumulative)
Period t+2
100,0%
(end of the project)
Period t+1
90,0%
= 9.000 / 10.000
Period t
20,0%
= 2.000 / 10.000
Estimated percentage of completion
Incorrect booking entries:
94
J. Welc
3 Deliberate Accounting Manipulations: Introduction …
95
3.3.5 Overstatement of Profits by Artificial
Sale-and-Buy-Back Transactions
If a company wants to temporarily boost its reported profits and if it has
some “friendly” (mostly related) entity to deal with, it may arrange artificial
round-trip transactions of sale-and-buy-back of inventories (or other assets),
as illustrated in Example 3.5.
It may be noted that:
• The result of those artificial sale-and-buy-back transactions is an overstatement of PC’s earnings reported for Period t by 7.000 EUR, with a
corresponding artificial decrease of carrying amount of PC’s inventory, as
the end of Period t, by 5.000 EUR,
• In Period t + 1 a repurchase of those inventories, for the same price
at which the artificial sale in Period t was arranged, does not have any
immediate impact on PC’s earnings reported for Period t + 1 (since this
repurchase is only reflected in balance sheet: an increase in inventory is
offset by a corresponding increase in trade payables),
• The negative impact on PC’s earnings (of the artificial inventory sale made
in Period t ) is delayed until when the inventories are sold further to a third
party (in Period t + 2) or until when those inventories can no longer be
kept in the PC’s balance sheet at their inflated carrying amounts (e.g. when
an auditor forces the company to write-down the inventories),
• Consequently, such a scheme enables inflating Period t earnings (by 7.000
EUR in this case) at the cost of future earnings (which in Period t + 2 are
understated by the same 7.000 EUR),
• If a given company is very keen on keeping its reported income growing,
it may repeatedly inflate earnings in several consecutive periods, by selling
and buying back the same inventory several times (each time at higher
prices than in prior periods), unless its auditors detect and stop it,
• Thus, this is a typical gimmick which creates an “asset bubble”, that
usually ends up with a dramatic and unexpected (for analysts and investors)
collapse of the company’s earnings.
Similarly as in the previous two examples, a summed profit in all three
periods is the same under both scenarios (i.e. a total loss of −3.000 EUR),
but with a different timing: the artificial sale-and-buy-back transactions result
in an overstatement of profit reported for Period t (by 10.000 EUR), followed
by a loss in Period t + 2. In contrast, an absence of such arrangements,
combined with a timely write-down of the obsolete inventory, results in a
loss on inventory being recognized in Period t.
100%
PC (public company)
70%
John
OC
(a “friendly” company, owned by
John or his relatives or his friends)
John serves also as chief executive officer (CEO) at PC. Consequently, OC should be treated as related party to PC. However, from an accounting
point of view, financial results of OC are not consolidated with those of PC, since the results and dividends of OC are not attributable to PC’s
shareholders.
Suppose that:
at the end of Period t inventories of PC (with their carrying amount of 10.000 EUR) include obsolete items (with carrying amount of 5.000
EUR),
in order to inflate the PC’s earnings in Period t (and to temporarily get rid of its “toxic” inventories from balance sheet), at the end of Period
t PC sells all its obsolete inventories to OC, for an artificial (out of thin air) price of 12.000 EUR (recording an artificial gross profit of 7.000
EUR),
however, John wants this transaction to be cash-neutral for OC, so in Period t+1 OC sells all these inventories back to PC, for the same price
of 12.000 EUR (so that receivables and payables between PC and OC, resulting from these round-trip transactions, zero out),
if those inventories are indeed obsolete and if they were sold by PC to OC at artificially inflated prices, their ultimate sale to a third party
(for, say, their real recoverable value of 2.000 EUR) entails a loss for PC in the following periods.
Such a series of sale-and-buy-back transactions could look as presented below.
30%
Free Float
(minority investors)
PC is the public company, controlled by a private person, John, who holds 70% interest in PC’s equity (while the remaining 30% of shares are floated
on stock exchange). John holds also a controlling (100%) equity interest in another company (OC), which is his private venture, not listed on any
stock market. These relationships look as follows:
Example 3.5 Overstatement of profits by artificial sale-and-buy-back transactions of inventories
96
J. Welc
1) Transaction in Period t:
sale of inventory by PC to OC,
with a book value of 5.000 EUR for 12.000 EUR
OC
(private company,
wholly-owned by John)
An impact of such artificial sale-and-buy-back transaction on the PC’s financial results would look as presented below.
Third party
3) Transaction in Period t+1 (or later):
sale of inventory by PC to a third party,
with a book value of 12.000 EUR for 2.000 EUR
PC (public company)
2) Transaction in Period t+1 (or even in Period t):
repurchase of inventory by PC from OC,
for the same 12.000 EUR
(continued)
3 Deliberate Accounting Manipulations: Introduction …
97
Source Author
Example 3.5 (continued)
-3.000
Impact on inventories
Pre-tax profit (IS)
Pre-tax profit (IS)
Impact on inventories
0
0
Net sales (IS)
Receivables (BS)
Cost of goods sold (IS)
Inventory (BS)
Impact on inventories
Pre-tax profit (IS)
Net sales (IS)
Receivables (BS)
Cost of goods sold (IS)
Inventory (BS)
-2.000
0
Period t+2
+2.000*****
+2.000*****
+2.000*****
–2.000*****
-12.000
-10.000
Period t+2
+2.000***
+2.000***
+12.000***
-12.000***
* to reflect the artificial sale of inventories, with overstated carrying amount of 5.000 EUR, to the related entity, for 12.000 EUR
** to reflect the buy-back of inventories sold in Period t, from the related entity, for the same price as in the preceding period
*** to reflect the sale of inventories, with their overstated carrying amount of 12.000 EUR, to the third party, for the actual market value of 2.000 EUR
**** to reflect the write-down of inventories, from their carrying amount of 5.000 EUR, to the recoverable value of 2.000 EUR
***** to reflect the sale of inventories, with an impaired (written down) carrying amount of 2.000 EUR, to a third party, for their market value of 2.000 EUR
-3.000
PC’s results without those sale-and-buy-back transactions:
Period t
0
Inventory (BS)
Net sales to OC (IS)
Payables (BS)
Receivables (BS)
0
Operating costs (IS)
+3.000****
Net sales (IS)
Inventory (BS)
-3.000****
Cost of goods sold (IS)
Pre-tax profit (IS)
Period t+1
0
0
0
0
Impact on inventories
-5.000
Impact on inventories
+12.000
Pre-tax profit (IS)
+7.000
Impact on inventories
0
Period t+1
+12.000**
+12.000**
-
Pre-tax profit (IS)
Impact of those sale-and-buy-back transactions on PC’s financial statements:
Period t
Net sales to OC (IS)
+12.000*
Inventory (BS)
Receivables (BS)
Payables (BS)
+12.000*
Net sales (IS)
Cost of goods sold (IS)
+5.000*
Inventory (BS)
Cost of goods sold (IS)
-5.000*
98
J. Welc
3 Deliberate Accounting Manipulations: Introduction …
99
Appendix
See Table 3.1.
Table 3.1 Selected accounting scandals
Country of
company’s
primary offices
Timing of
accounting
misstatements
The company’s
auditor
Aegan Marine Petroleum Network Inc.
Greece
2015-2017
Deloitte, PwC*
Agrokor Group
Croatia
2014-2015
Baker Tilly
Carillion plc
United Kingdom
2015-2016
KPMG
Company
Celadon Group
USA
2016
BKD LLP
Folli Follie Group
Greece
2016-2017
Ecovis
General Electric Co.
USA
2016-2017
KPMG
GetBack S.A.
Poland
2016-2017
Deloitte
Hertz Global Holdings Inc.
USA
2012-2014
PwC
Iconix Brand Group Inc.
USA
2014
BDO
Longtop Financial Technologies Ltd.
Hong Kong
2008-2010
Deloitte
MiMedx Group Inc.
USA
2012-2016
Cherry Bekaert
Monsanto Company
USA
2009-2011
Deloitte
OCZ Technology Group Inc.
USA
2011-2012
Crowe Horwath
Pattiserie Holdings plc
United Kingdom
2018
Grant Thornton
Penn West Petroleum Ltd.
Canada
2012-2014
KPMG
Pescanova
Spain
2007-2013
BDO
Puda Coal Inc.
China
2010
Moore Stephens
Redcentric plc
United Kingdom
2015
PwC
Rino International Corp.
China
2008-2010
Frazer Frost
SLZKW&B**
Quadrant 4 System Corp.
USA
2015-2016
Quindell plc
United Kingdom
2013-2014
KPMG
Samsung BioLogics
South Korea
2015-2016
KPMG, Deloitte
Satyam Computer Services Ltd.
India
2005-2009
PwC
Sino Clean Energy Inc.
China
2010
Weinberg & Co.
Sino Forest
China
2006-2012
Ernst & Young
Steinhoff International Holdings N.V.
South Africa
2014-2016
Deloitte
Ted Baker plc
United Kingdom
2018-2019
KPMG
Tesco plc
United Kingdom
2014
PwC
Toshiba Group
Japan
2010-2014
Ernst & Young
Valeant Pharmaceuticals Intl. Inc.
Canada
2014-2015
PwC
Wirecard AG
Germany
2018-2019
Ernst & Young
* PricewaterhouseCoopers; ** Schulman
Lobel Zand Katzen Williams & Blackman LLP
Source Author (based on annual reports, announcements of regulatory bodies and
media sources)
100
J. Welc
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4
Deliberate Accounting Manipulations:
Expense-Oriented Accounting Gimmicks
and Intentional Profit Understatements
4.1
Overstatement of Profits
by Understatement of Expenses
4.1.1 Overstatement of Profits by Understating
Write-Downs of Inventories and Receivables
According to most accounting standards, inventories are reported in a balance
sheet at their historical costs (e.g. a cost of purchase or cost of manufacturing).
Consequently, in normal circumstances, when inventories can be sold with
positive margins (i.e. at prices above their historical costs), carrying amounts
of inventories do not reflect their current recoverable values. However, when
the recoverable values of inventories (i.e. the amounts for which they could
be sold in the market) fall below their current book values, the inventories
should be written down to their estimated recoverable values. Such inventory write-downs reduce their carrying amounts in balance sheet, with a
corresponding loss recognized in income statement (usually reported under
an item labeled as “Other operating expenses / losses” or similarly). Consequently, delaying or understating inventory write-downs is one of the
ways of overstating reported earnings, as shown in Example 4.1.
As might be seen, an expected loss on inventory of 300 EUR (equal to a
difference between estimated recoverable amount of 700 EUR and historical
purchase cost of 1.000 EUR) is to be recognized in a financial statement when
it becomes probable (i.e. in Period t ), instead of when inventories are actually
sold. Under scenario of incorrect booking entries the inventory impairment
is ignored in Period t, with a resulting loss (of the same 300 EUR) incurred
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_4
103
104
J. Welc
Example 4.1 Overstatement of profits by understating inventory write-downs
Company X is a distributor of mobile phones, i.e. products which are generally characterized
by price deflaon. In Period t the company purchased mobile phones for 1.000 EUR. On a
day of purchase the retail market price (i.e. recoverable value) of these phones equaled
1.200 EUR. At the end of Period t the company sll held in its inventory the unsold phones,
bought in Period t. However, before the end of Period t the market value of those phones
fell to 900 EUR. Given the quanty of unsold phones in the company’s stores, it expected
that in order to get rid of those obsolete inventories in Period t + 1, their total market value
will have to be lowered further (i.e. to less than the current value of 900 EUR).
Assuming that the company’s knowledge and experience suggest correctly that the prices of
excess inventories will have to be lowered further (in order to dispose of them in Period
t + 1), to their total recoverable amount of 700 EUR, the correct booking entries look as
follows:
Period t
Inventories (BS)
–300*
Operang costs (IS)
+300*
Profit before tax (IS)
–300
Period t + 1
Net sales (IS)
+700**
Cash/receivables (BS)
+700**
Cost of goods sold (IS)
+700***
Inventory (BS)
–700***
Profit before tax (IS)
0
The incorrect booking entries (which ignore the impairment of inventories) look as follows:
Period t
Inventories (BS)
0
Operang costs (IS)
0
Profit before tax (IS)
0
Period t + 1
Net sales (IS)
Cash or receivables (BS)
+700
+700
Cost of goods sold (IS)
+1.000
Inventory (BS)
–1.000
Profit before tax (IS)
–300
*to reflect the write-down of inventories from their historical (purchase) cost of 1.000 EUR, down to
their esmated recoverable value of 700 EUR
**to reflect the sale of inventories for the prices which are equal to the esmated recoverable value
***transfer of the carrying amount (aer the write-down) of inventory to cost of goods sold
Source Author
in the following period, when the excess inventories are disposed of. Therefore, a delay or understatement of inventory write-down results in overstating
income in Period t (here by 300 EUR), at the cost of the income reported
in the following periods. A total two-period impact of inventory impairment on reported profits is the same under both scenarios (i.e. the loss of
300 EUR), but the timing differs: under correct booking entries the loss is
recognized when it becomes probable, while incorrect booking entries delay
it until later periods. Thus, usually significant and repeated overstatements of
4 Deliberate Accounting Manipulations: Expense-Oriented …
105
inventories and profits generate an “asset bubble” (from inflated inventories),
which bursts sooner or later and brings about sudden (and often unexpected)
collapse of the company’s profits.
When reading Example 4.1 it is worth noting that:
• An inventory write-down is to be based on expected recoverable values (i.e.
estimated amounts for which a company will be able to sell its inventories
on the market), and not on observable prices as at the end of a reporting
period (consequently, in the example the carrying amount of inventory is
written down to 700 EUR, instead of 900 EUR, which was the market
value of phones as at the end of Period t ),
• The inventory write-down should not be based on observed or estimated
recoverable values of single units of inventory, but should also take into
account a volume of excess inventory held, since the more excess inventories a company holds (particularly if they quickly become obsolete), the
deeper will have to be a reduction of their sale-off prices necessary to get
rid of them,
• In many circumstances the recoverable values of inventories may not be
directly observable (e.g. in case of specialized industrial components, spare
parts, rare commodities, unique consumer goods, etc.), which entails a
huge load of subjective judgments necessary to estimate the recoverable
values.
Consequently, inventory write-downs are often based on very subjective
(and difficult to verify by auditors) management’s and accountant’s assumptions about likely prices, for which excess inventories will be disposed of in
the future. From an analytical perspective, the problems of inventory impairments (and their impact on reliability and comparability of reported financial
numbers) are particularly important in the following types of businesses:
• Where inventories constitute a major value-adding class of company’s assets
(e.g. in retail or wholesale industry),
• Where prices of products tend to show long-term deflationary trends or
are regularly depressed by fast technological progress (e.g. electronic goods
or fashion industry),
• Where supply and demand do not change in tune and where price bubbles
tend to emerge (e.g. commodities, real-estate properties or industrial
chemicals).
106
J. Welc
As regard receivable accounts, under most accounting standards they are
reported in a balance sheet on a net amount basis, i.e. a difference between
the gross amount (resulting from invoices, contracts, etc.) and an allowance
for bad debts (uncollectible amounts). Consequently, managers and accountants must make regular estimates of expected customer defaults on receivable
accounts. An underestimation of these reserves brings about an overstatement
of reported assets and earnings. Therefore, scrutiny in analyzing receivables is
particularly important in case of those businesses where sales with deferred
payment terms is a norm (e.g. wholesale, installment sales, construction
companies).
As regards write-downs of receivables it is worth noting that:
• An overstatement of reported profits by inadequate write-downs of receivables is similar to an overstatement of profits by understating (or delaying)
impairments of inventories.
• However, estimating reserves for bad debts (uncollectible receivables) is
often more subjective and more unverifiable than estimating recoverable
values of inventories (since usually the estimates of recoverable values of
receivables cannot be based on any objective and observable market data).
It must be also noted that excessive (exaggerated) write-downs of inventories and receivables are a popular way of deliberately understating corporate
earnings in “good” times. Then, in poorer times those excessive reserves can
be easily reversed, with a resulting artificial “income smoothing” effect. This
issue will be illustrated in Sect. 4.2 of this chapter.
4.1.2 Overstatement of Profits by Capitalizing Excess
Manufacturing Overheads in Carrying Amount
of Inventory
According to most accounting standards, carrying amounts of finished goods
held by manufacturing companies include direct manufacturing costs (e.g.
raw materials consumed and direct labor costs) as well as indirect manufacturing overheads, such as depreciation of production lines, salaries of
production supervisors or electric energy consumed by machines. However,
most accounting regulations state also that only that part of indirect manufacturing costs should land in a carrying amount of inventory, which is
representative of a normal level of capacity utilization (while any excess of
actual unit overhead costs over their normative amounts should be expensed
as incurred).
4 Deliberate Accounting Manipulations: Expense-Oriented …
107
Nowadays most indirect manufacturing overheads tend to have a fixed cost
nature (i.e. they do not change in tune with changing volume of output),
which implies an increase of total unit manufacturing cost in periods of below
normal capacity utilization. When output volume falls (below normal levels),
the fixed indirect manufacturing costs are spread across fewer manufactured
units of product, which boosts total unit manufacturing costs. When costs
of unused capacity are capitalized in carrying amounts of inventories (instead
of being expensed as incurred), they inflate not only inventories in a balance
sheet but also profits reported in an income statement. This is illustrated in
Example 4.2.
As might be seen, under incorrect booking entries the inventories and earnings in Period t + 1 (when the company entered an economic slowdown)
are overstated by 25.000 EUR. This is because in that period the total unit
production cost rises to 1.50 EUR (due to the fall of the output to 50.000
units), from its normal level of 1.00 EUR per unit (when the company
produced 100.000 units). The increase of unit manufacturing cost is caused
by a fixed nature of indirect manufacturing costs (which in Period t + 1 stay
at the same level of 50.000 EUR), in combination with a reduced volume
of output in Period t + 1. The costs of excess capacity in Period t + 1 equal
0.50 EUR per unit [=1.50 EUR of total unit cost in Period t + 1 less 1.00
EUR of total unit cost in “normal” times), which results in a total cost of an
unused capacity of 25.000 EUR [=50.000 units manufactured in Period t +
1 multiplied by a unit cost of unused capacity of 0.50 EUR]. An incorrect
capitalization of those costs of unused capacity brings about an overstatement
of both inventories as well as profits in Period t + 1, by 25.000 EUR. In the
following period all inventories manufactured in Period t + 1 (with the overstated carrying amount of 75.000 EUR) are sold for 60.000 EUR, with a
resulting pre-tax loss of 15.000 EUR.
Under correct booking entries, the costs of excess capacity in Period t + 1
(of 25.000 EUR) are expensed as incurred, and the carrying amount of inventories at the end of that period equals 50.000 EUR [=50.000 units × 1.00
EUR of “normal” unit cost). As a result, both profits as well as inventories in
Period t + 1 are lower by 25.000 EUR, as compared to the incorrect booking
entries. In the following period all inventories manufactured in Period t + 1
(with a carrying amount of 50.000 EUR, i.e. without any costs of unused
capacity) are sold for 60.000 EUR, with a resulting pre-tax profit of 10.000
EUR.
Consequently, the summed profit in all three periods is the same under
both scenarios (25.000 EUR), but with a different timing: under incorrect
booking entries the overstatement of profit in Period t + 1 (by 25.000 EUR)
Source Author
Example 4.2 Overstatement of profits by capitalizing (in inventory) costs of unused capacity
108
J. Welc
4 Deliberate Accounting Manipulations: Expense-Oriented …
109
is followed by a loss in Period t + 2, while under correct booking entries
the costs of unused capacity depress earnings in Period t + 1. Thus, usually
significant and repeated capitalization of costs of unused capacity in inventories generate an “asset bubble” (from inflated inventories) which sooner or
later brings about a collapse of the company’s profits.
4.1.3 Overstatement of Profits by Aggressive
Capitalization of Costs in Carrying Amounts
of Operating Fixed Assets
Accounting rules offer a lot of leeway in capitalizing vs. expensing many
expenditures. It relates especially to property, plant and equipment, in
which case companies sometimes aggressively capitalize routine maintenance
expenditures (which should be expensed as incurred).
Most accounting standards permit capitalizing in carrying amounts of
fixed assets only those expenditures incurred on them, that increase longterm economic benefits which can be obtained from using these assets.
In contrast, expenditures related to a routine maintenance of fixed assets
should be expensed as incurred. However, a necessity to classify expenditures
incurred on fixed assets as either current expenses or long-term investments
implies a substantial dose of subjectivity and offers a lot of leeway to managers
and accountants. Abuses of that leeway may bring about overstatements
of reported profits, with corresponding overstatements of carrying amounts
of fixed assets (as shown in Example 4.3). It must be kept in mind that
the more technologically sophisticated fixed assets of a given company are,
the more difficult it is to audit the company’s capitalization policy. From
an analytical perspective this issue is particularly important in analyzing
capital-intensive businesses, such as airlines, telecoms, hotels, power plants
or chemical companies.
It may be noted that:
• An aggressive capitalization of routine maintenance expenditures results in
inflating earnings in all periods between Period t + 1 and Period t + 4,
with a corresponding overstatement of carrying amounts of fixed assets.
• This is a recurring artificial boost to reported earnings (by creating fictitious and nonexistent assets), which means that it is unsustainable and
sooner or later must be followed by a large write-down. Accordingly, this
is another gimmick which creates an “asset bubble”, that usually ends up
with a dramatic and unexpected (for analysts and investors) collapse of
company’s earnings.
0
0
0
0
0
0
4) DepreciaƟon of reproducƟon expenditures****
expenditures incurred in Period t+1
expenditures incurred in Period t+2
expenditures incurred in Period t+3
expenditures incurred in Period t+4
5) Total depreciaƟon (2 + 4)
10.000
1.000
0
0
0
0
0
1.000
1.000
11.000
10.000
1.100
100
100
0
0
0
1.100
1.000
12.100
10.000
1.210
210
100
110
0
0
1.210
1.000
13.310
10.000
1.331
331
100
110
121
0
1.331
1.000
14.641
* iniƟal 10.000 EUR + cumulaƟve reproducƟon expenditures
** 10% from the iniƟal gross value of fixed assets (airplanes)
*** equaling annual depreciaƟon (in order to ensure full asset reproducƟon)
**** assuming 10-year useful lives and straight-line depreciaƟon starƟng at the
beginning of the following year ***** carrying amount of fixed assets at the end of the previous year + reproducƟon expenditures - total depreciaƟon in a year
10.000
0
3) Reproduc on expenditures***
6) Carrying amount of “real” fixed assets*****
0
10.000
2) Annual depreciaƟon of iniƟal fixed assets**
1) Gross amount of fixed assets*
At the end of Period t an airline purchased several new airplanes for 10.000 EUR million. The opera ons (charter flights) with a use of those machines
started at the beginning of Period t+1. Useful lives of those assets have been assumed at 10 years. The company applies a straight-line deprecia on,
with zero residual values. Consequently, an annual deprecia on reflected in an income statement amounts to 1.000 EUR million [= 10 EUR million /
10 years]. The company’s annual sales revenues (from charter flights) are 3.000 EUR million.
Suppose for simplicity that in order to ensure a reproduc on of its fixed assets, in each year the company incurs capital expenditures equaling annual
deprecia on of those assets. However, in each year the company must also spend another 1.000 EUR million on a rou ne maintenance of its aircra ,
which is necessary to maintain a permission for flights within the European Avia on Area. These are typical current expenditures which should be
treated as necessary for maintaining a current state of the assets, rather than extending the future economic benefits from them. Consequently,
those rou ne maintenance expenditures should be expensed (in opera ng costs) as incurred. However, the company’s aggressive accoun ng policy
assumes that those expenditures increase the assets’ market values, which jus fies capitalizing them and deprecia ng over 5 years.
It is assumed for simplicity that there are no other costs than deprecia on and rou ne maintenance expenditures.
Deprecia on and carrying amounts of ini al investment on aircra (and capital expenditures on reproduc on of those assets) look as follows:
Period t Period t+1 Period t+2 Period t+3 Period t+4
Example 4.3 Overstatement of profits by aggressive capitalization of routine maintenance costs in carrying amount of fixed assets
110
J. Welc
0
0
0
expenditures incurred in Period t+3
expenditures incurred in Period t+4
1.800
2.400
0
0
200
200
400
1.000
2.800
0
200
200
200
600
1.000
10.000
0
10.000
11.000
1.000
10.000
11.800
1.800
10.000
12.400
2.400
10.000
12.800
2.800
10.000
Period t Period t+1 Period t+2 Period t+3 Period t+4
1.000
0
0
0
200
200
1.000
* assuming 5-year useful lives and straight-line depreciaƟon starƟng at the beginning of the following year
** carrying amount of capitalized maintenance expenditures at the end of the previous year + maintenance expenditures incurred in a given year - depreciaƟon of
previously capitalized maintenance expenditures
Total carrying amount of fixed assets
Carrying amount of capitalized maintenance expenditures
Carrying amount of „real” fixed assets
0
0
0
expenditures incurred in Period t+2
3) Carrying amount of capitalized maintenance expenditures**
0
0
expenditures incurred in Period t+1
0
0
0
2) Annual depreciaƟon of capitalized maintenance expenditures*
1.000
0
1) RouƟne maintenance expenditures
Period t Period t+1 Period t+2 Period t+3 Period t+4
Computa on of deprecia on and carrying amounts of aggressively capitalized rou ne maintenance expenditures:
(continued)
4 Deliberate Accounting Manipulations: Expense-Oriented …
111
Source Author
Example 4.3 (continued)
0
0
0
Deprecia on of fixed assets
Costs of rou ne maintenance expenditures
Pre-tax profit
2.000
0
1.000
3.000
0
0
0
Deprecia on of fixed assets
Costs of rou ne maintenance expenditures
Pre-tax profit
1.000
1.000
1.000
3.000
10.000
0
10.000
11.000
1.000
10.000
Total carrying amount of fixed assets
Capitalized rou ne maintenance expenditures
“Real” fixed assets (i.e. aircra and their reproduc on expenditures)
1.069
0
1.931
3.000
1.000
790
900
1.210
3.000
1.000
1.100
3.000
669
1.000
1.331
3.000
11.800
1.800
10.000
12.400
2.400
10.000
12.800
2.800
10.000
10.000
0
10.000
10.000
0
10.000
10.000
0
10.000
10.000
0
10.000
10.000
0
10.000
Period t Period t+1 Period t+2 Period t+3 Period t+4
Carrying amounts of fixed assets without the aggressive capitaliza on of rou ne maintenance expenditures:
Total carrying amount of fixed assets
Capitalized rou ne maintenance expenditures
1.390
0
1.610
3.000
Period t Period t+1 Period t+2 Period t+3 Period t+4
Carrying amounts of fixed assets with the aggressive capitaliza on of rou ne maintenance expenditures:
0
Sales revenues
“Real” fixed assets (i.e. aircra and their reproduc on expenditures)
1.700
0
1.300
3.000
Period t Period t+1 Period t+2 Period t+3 Period t+4
Selected income statement data without the aggressive capitaliza on of rou ne maintenance expenditures:
0
Sales revenues
Period t Period t+1 Period t+2 Period t+3 Period t+4
Selected income statement data with the aggressive capitaliza on of rou ne maintenance expenditures:
112
J. Welc
4 Deliberate Accounting Manipulations: Expense-Oriented …
113
• As long as it is not detected by auditors, this scheme enables inflating earnings at the cost of future earnings (since the future write-down must be
equal to the sum of cumulative earnings overstatements in prior periods).
• Unfortunately, given a substantial dose of subjectivity embedded in most
accounting standards, it is often difficult to make a clear-cut distinction
between expenditures which should be expensed as incurred and those that
could be capitalized (especially in case of capital-intensive companies with
very specialized, sophisticated and high-tech fixed assets).
When reading Example 4.3 it is also worth noting that:
• In each period a difference between profits with capitalization and without
capitalization of routine maintenance expenditures equals a difference
between the maintenance expenditures incurred in a given year and
the depreciation of previously capitalized maintenance expenditures. For
instance, in Period t + 4 this difference equals 400 [=1.069 − 669],
and is identical to the difference between maintenance expenditures (of
1.000), incurred in Period t + 4, and depreciation of previously capitalized
expenditures (of 600).
• The carrying amount of the capitalized maintenance expenditures, as at
the end of Period t + 4 (i.e. 2.800), equals the difference between the
cumulative expenditures (i.e. 4.000) and cumulative depreciation of those
artificial “assets” (i.e. 1.200 = 200 in 2011 + 400 in 2012 + 600 in 2013).
• Given a fictitious nature of these assets, a reversal of their cumulative
overstatements must occur sooner or later (often after an auditor’s intervention). If the company writes off those improperly capitalized “assets” at
the end of Period t + 4 (via other operating costs), it reports in that period
a seemingly one-off operating loss of 1.731 [=1.069 − 2.800].
A frequently used accounting gimmick in some industries, particularly
in construction and in manufacturing of specialized industrial equipment,
is a falsified treatment of some operating expenditures (e.g. salaries of
construction workers) as incurred on developing the company’s own fixed
assets (instead of treating them as direct costs of processing inventory). For
instance, a construction company which builds commercial real estate for
its customers, but also owns its own real-estate properties, may deliberately
misallocate part of expenditures incurred on projects ordered by its customers
as if they were incurred on a development of the company’s own production facilities (whereby those expenditures are illegitimately capitalized in
carrying amounts of the company’s fixed assets and then depreciated, instead
114
J. Welc
of landing in carrying amount of inventory). An impact on earnings of such
a scheme is similar to the one exemplified in Example 4.3.
4.1.4 Overstatement of Profits by Artificial
“Outsourcing” of R&D Projects
Most accounting standards require expensing expenditures on internally
developed intangibles (such as patents, brands, customer relationships or new
production technologies) as incurred, with only limited exceptions left for
some specific assets such as software (or development costs under IFRS). In
contrast, intangible assets purchased from other entities (either on a standalone basis or as part of a business combination) are recognized on a balance
sheet at cost, and afterward either amortized (if they have determinable useful
lives) or periodically tested for impairment (if they have indefinite useful
lives).
This implies a significant incomparability of financial results of various
firms with differing development strategies, since those of them who focus on
an internal (organic) growth expense most of their intangible-related expenditures as incurred, while their more acquisitive (i.e. takeover-intensive) “peers”
capitalize most of their acquired intangibles on their balance sheets. However,
the capitalization of acquired intangibles may also create a temptation to
arrange artificial “outsourcing” transactions (with resulting profit and asset
overstatement), such as those illustrated in Example 4.4.
When reading Example 4.4 it is also worth noting that:
• The effect of those artificial “outsourcing” transactions is a capitalization
of fictitious “assets” (which are de facto PC’s operating costs) and an overstatement of PC’s reported earnings for both years during which the R&D
projects are conducted.
• A side-effect is an overstatement of fixed assets (intangibles), by 1 EUR
million in Period t and 1.8 EUR million in Period t + 1 [=1.000 +
1.000 − 200].
• An overstatement of earnings lasts as long as the cost capitalization is
continued and as long as capitalized amounts in a given period exceed
amortization of previously capitalized costs, charged to earnings in the
same period. However, after the “outsourcing” of R&D expenditures is
terminated (in Period t + 2) the prior overstatements of earnings begin
reversing (in Period t + 2 the profit under scenario with cost capitalization
is lower than profit with no capitalization, by 0.4 EUR million, which
results from amortization of previously capitalized costs).
100%
PC (public company)
70%
John
OC
(a “friendly” company, owned by
John or his rela ves or his friends)
Suppose that PC regularly incurs R&D expenditures (amoun ng to 1 EUR million annually), which should be expensed as incurred (according to
accoun ng standards applicable for the company). If John intends to boost PC’s earnings, by capitalizing (instead of expensing) its R&D expenditures,
he may arrange the following ar ficial transac ons:
• in each of the two consecu ve years (Period t and Period t + 1) PC “outsources” to OC the PC’s R&D expenditures, amoun ng to 1 EUR
million annually (i.e. 2 EUR million in total), and grants to OC a loan (payable in the same year) necessary to finance those R&D projects,
• at the end of each year PC purchases those R&D projects from OC (in the form of e.g. licenses, technical documenta on, product formulas,
etc.), for 1 EUR million.
According to most accoun ng standards, such “externally purchased” intangibles, if they have finite useful lives, are subject to a periodic
amor za on. Let’s assume therefore that PC applies to them a five-year straight-line amor za on schedule, with zero residual values. Suppose also,
for simplicity, that the amor za on of those “assets” commences with a beginning of the year following their purchase.
Such a series of transac ons would affect the PC’s reported results as follows.
John serves also as chief execu ve officer (CEO) at PC. Consequently, OC should be treated as a related party to PC. However, from an accoun ng
point of view, the results of OC are not consolidated with those of PC, since the results and dividends of OC are not a ributable to the PC’s
shareholders.
30%
Free Float
(minority investors)
PC is a public company, controlled by a private person, John, who holds 70% share in PC’s equity (while the remaining 30% of shares are traded on a
stock exchange). John holds also a controlling (100%) equity interest in another company (OC), which is his private venture, not listed on any stock
market. These rela onships look as follows:
Example 4.4 Overstatement of profits by artificial “outsourcing” of R&D projects
(continued)
4 Deliberate Accounting Manipulations: Expense-Oriented …
115
Source Author
Example 4.4 (continued)
0
0
R&D amor za on (IS)
Pre-tax profit (IS)
–200
Pre-tax profit (IS)
–1.000
Pre-tax profit (IS)
Pre-tax profit (IS)
R&D expenses (IS)
Cash (BS)
–1.000
+1.000****
–1.000
Pre-tax profit (IS)
R&D expenses (IS)
Cash (BS)
Pre-tax profit (IS)
Amor za on (IS)
R&D expenses (IS)
Cash (BS)
Fixed assets (BS)
0
0
0
Period t + 2
–400
400***
0
0
–400***
Period t + 2
*annual amorƟzaƟon of R&D projects purchased from OC in Period t [=1.000 EUR/5 years]
**expenditures on R&D purchased from OC in Period t + 1 (1.000 EUR) less annual amorƟzaƟon of R&D purchased from OC in Period t (200 EUR)
***annual amorƟzaƟon of R&D purchased from OC in Period t (200 EUR) plus annual amorƟzaƟon of R&D purchased from OC in Period t + 1 (200 EUR)
**** to reflect expensing of all R&D expenditures incurred internally
+1.000****
–1.000
Period t
R&D expenses (IS)
Cash (BS)
Period t + 1
200*
0
–1.000
+800**
Period t + 1
Amor za on (IS)
R&D expenses (IS)
Cash (BS)
Fixed assets (BS)
PC’s results without the ar ficial “R&D outsourcing” transac ons:
0
–1.000
Cash (BS)
R&D expenses (IS)
+1.000
Fixed assets (BS)
Period t
Impact of the “R&D outsourcing” on the financial results reported by PC:
116
J. Welc
4 Deliberate Accounting Manipulations: Expense-Oriented …
117
4.1.5 Overstatement of Profits by Delays
in Depreciating Fixed Assets
Tangible fixed assets (such as buildings, machinery or transportation vehicles) are depreciated from a moment when they are ready to be used in a
given company’s operations. Before they are ready, however, they are treated
as assets under construction and not subject to any depreciation (unless an
impairment is stated). This may create a temptation to artificially lengthen
a period during which fixed assets are classified as under construction, even
though they may be already used in company’s operations. Such misclassification results in overstated reported earnings, since no depreciation is charged
during this “construction” period.
However, delays in depreciating fixed assets may overstate earnings via two
related channels: by understating depreciation charges and by understating
financing expenses. This is so because many accounting standards (including
IFRS) require capitalization of interest costs associated with funds borrowed
to finance those long-term assets. However, borrowing costs may be capitalized only as long as the related assets are still treated as under construction.
This issue is illustrated in Example 4.5.
When reading Example 4.5 it is worth noting that:
• The result of this improper delay in depreciating the new factory is an
overstatement of pre-tax earnings in Period t + 1 by 1.770, i.e. the sum of
the understated depreciation of 1.070 and capitalized borrowing costs of
700.
• In the following periods (since Period t + 2 onward) the overstatement
of profit reported for Period t + 1 reverses continuously and as a result
earnings in those future years are lower than under the correct booking
scenario (due to higher depreciation charges).
• Accordingly, this scheme implies inflating current earnings at the cost of
future earnings (since the higher future depreciation gradually reverses the
initial overstatement of earnings).
• By using this accounting gimmick, capital-intensive firms may overstate
their earnings through several consecutive years, if their asset-development
periods are long enough. Accordingly, this trick is particularly dangerous
in case of capital-intensive companies with long asset-development periods
(e.g. power plants, hotels, pharmaceutical firms).
• Like many other techniques presented in this chapter (as well as in the
previous one), this gimmick creates an “asset bubble”, which usually ends
up with a sudden and surprising collapse of future earnings.
Source Author
0
Carrying amount
of factory (BS)*
Pre-tax profit (IS)
0
Pre-tax profit (IS)
Pre-tax profit (IS)
Carrying amount
of factory (BS)*
Interest cost (IS)
Deprecia on (IS)
Pre-tax profit (IS)
Carrying amount
of factory (BS)*
Interest cost (IS)
Deprecia on (IS)
8.560
=9.630 – 1.070
–1.770
=–1.070 – 700
Pre-tax profit (IS)
–1.770
=–1.070 – 700
700
Period t+2
1.070
(straight line)
–1.840
=–1.140 – 700
10.260
=11.400 – 1.140
700
Period t + 2
1.140
=11.400/10 years
Carrying amount
of factory (BS)*
Interest cost (IS)
Deprecia on (IS)
Pre-tax profit (IS)
Carrying amount
of factory (BS)*
Interest cost (IS)
Deprecia on (IS)
9.630
=10.700 – 1.070
700
Period t+1
1.070
=10.700/10 years
0
11.400
=10.700 + 700
0
Period t + 1
0
(under construcƟon)
*=expenditures incurred on building the factory (10.000 EUR) + capitalized borrowing (interest) costs - depreciaƟon in the period
0
10.700
=10.000 + 700
Carrying amount
of factory (BS)*
Period t
0
(under construcƟon)
Interest cost (IS)
Deprecia on (IS)
Correct booking entries look as follows:
0
10.700
=10.000 + 700
Interest cost (IS)
Incorrect booking entries look as follows:
Period t
0
Deprecia on (IS)
(under construcƟon)
Total expenditures incurred in Period t on a development of the factory amounted to 10 EUR million. The factory’s useful life was es mated to be 10
years. The construc on was fully financed from bank borrowings of 10 EUR million. The interest rate charged on those debts is 7% and the repayment
of principal amounts is postponed un l Period t + 3.
A company was building its new factory between January 1, Period t, and December 31, Period t. On January 1, Period t + 1, the company launched
its manufacturing opera ons in this new facility. However, for accoun ng purposes the factory was ar ficially held as s ll under construc on un l
the end of Period t + 1.
Example 4.5 Overstatement of profits by artificial delays in depreciating fixed assets
118
J. Welc
4 Deliberate Accounting Manipulations: Expense-Oriented …
119
4.1.6 Overstatement of Profits by Understating
Provisions for Liabilities
Liabilities on the balance sheet may be divided into document-backed liabilities and provisions for liabilities. Carrying amounts of the former, although
subject to estimates, are derived mostly from relatively objective information included in formal documents, such as contracts with suppliers, bank
loan agreements, invoices or legal regulations. In contrast, provisions for
liabilities correspond to highly probable future obligations, in which case
either a timing or monetary amounts of future payments (or both) are
highly uncertain and must be estimated (sometimes “guesstimated”), usually
with substantial subjective judgments. Examples of provisions for liabilities
include:
• Provisions for product returns—when customers are granted a right of
return and when likely volume of product returns may be estimated reliably (e.g. on the ground of historical data), provision for expected future
product returns should be recognized.
• Warranty provisions—when customers are granted warranties related
to quality and functionality of products or services purchased from a
company, the provision for likely future warranty costs (i.e. expected
expenditures which will have to be incurred to repair the flawed products)
should be estimated and recognized.
• Provisions related to loyalty programs—when a company offers its
customers a possibility of obtaining some future benefits linked to their
past purchases (e.g. “frequent flier” programs by which airlines offer future
price discounts to those customers who collect some number of bonus
points for their frequent flights), a provision for likely future costs of those
incentives must be estimated.
• Provisions for employee benefits—when employees are entitled, by law or
by the company’s internal policies, to obtain future benefits of some kind
(e.g. jubilee rewards), a provision for expected future expenditures related
to those employee benefits should be estimated and recognized.
• Provisions for customer incentive programs—sometimes firms offer their
customers price-adjustment schemes, based on their total volume of orders
within a specified period (e.g. a fiscal year) and settled at the end of that
period, with provisions for future liabilities (to customers which qualify for
price adjustments) being recognized before their final settlement.
120
J. Welc
• Provisions related to litigations—when a company is sued (e.g. by a
government, former employee or customer), with a likely future settlements resulting from those litigations (e.g. penalty fines for excessive air
pollution), it should estimate and recognize a provision for those future
expenditures.
Due to a significant input of subjective judgments and assumptions in
estimating provisions, they are prone to manipulations which affect reported
earnings. This is illustrated in Example 4.6. As might be seen, when provisions have a significant share in corporate expenses, changing their underlying
assumptions may be an effective way of manipulating reported earnings. In
the presented example, when the assumptions about warranty provisions stay
intact (i.e. when the recognized provision constitutes 10% of sales revenues,
as before), the company’s pre-tax profit in Period t + 1 shrinks by 40%.
However, the aggressive accounting based on an alleged improvement in
product quality (and the reduction of the warranty provision from 10 to 5%
of revenues) helps in keeping the company’s profits in Period t + 1 seemingly
stable (or even improving).
It must be emphasized that changing assumptions underlying provisions
(from more conservative to more optimistic ones) may be entirely legitimate,
if a company indeed achieved a proven improvement of its product quality.
For instance, its internal tests may have confirmed a significant reduction of
a share of flawed products in total output. In such a case the likely costs
of future product repairs may indeed have fallen from 10 to 5% of sales
revenues. However, if switching the assumptions is ungrounded and reflects
an aggressive accounting only, then the result in an overstatement of reported
earnings. For instance, if in the presented example the share of flawed products in total output did not change from Period t to Period t + 1, then the
unbiased estimate of a warranty provision in Period t + 1 equals 90.000
EUR [=10% × 900.000]. In such a circumstance an aggressive reduction
of a percentage of the warranty provision from 10% to 5% brings about the
overstatement of reported profit by 45.000 EUR [=90.000 − 45.000], with a
likely reversal in the following period, when the company will have to spend
90.000 EUR (instead of 45.000 EUR) on repairs of products sold in Period
t + 1.
121
4 Deliberate Accounting Manipulations: Expense-Oriented …
Example 4.6 Overstatement of profits by understatement of a warranty provision
Company ABC is a manufacturer of electronic goods. For each product sold it grants a
warranty for one year. In Period t its revenues amounted to 1.000.000 EUR, with cost of
goods sold of 800.000 EUR. However, due to a fierce compe on, in the following year its
revenues contracted to 900.000 EUR, with a cost of goods sold of 750.000 EUR.
Historically, actual costs of product repairs cons tuted between 5% and 10% of revenues
obtained from their sale. Un l Period t the company applied a conserva ve accoun ng
approach and in each year it recognized a warranty provision amoun ng to 10% of sales
revenues, to recognize likely expenditures to be incurred in a following year on repairing the
flawed goods sold before. Indeed, in Period t+1 the company had to spend 100.000 EUR (i.e.
10% of revenues generated in Period t) on its product repairs. However, in Period t+1 it
switched its accoun ng policy to a more op mis c one, by reducing the amount of its
warranty provision from 10% to 5% of annual revenues (on the ground of the alleged
improvement of its product quality, resul ng in an expected reduc on of a share of flawed
products in total sales).
The company’s financial results without a change of its warranty provision assump ons look
as follows:
Period t
Net sales (IS)
1.000.000
Period t+1
Net sales (IS)
900.000
Cost of goods sold (IS)
800.000
Cost of goods sold (IS)
750.000
Warranty provision (IS)
100.000*
Warranty provision (IS)
90.000*
Profit before tax (IS)
100.000
Profit before tax (IS)
60.000
The company’s financial results with a change of its warranty provision assump ons look as
follows:
Period t
Net sales (IS)
1.000.000
Period t+1
Net sales (IS)
900.000
Cost of goods sold (IS)
800.000
Cost of goods sold (IS)
750.000
Warranty provision (IS)
100.000*
Warranty provision (IS)
45.000**
Profit before tax (IS)
*=10% of annual revenues
**=5% of annual revenues
Source Author
100.000
Profit before tax (IS)
105.000
122
4.2
J. Welc
Understatement of Profits by Overly
Conservative Accounting
4.2.1 Motivations for Profit Understatements
All fictitious examples presented in the preceding section illustrated overstatements of profits, with corresponding overstatements of carrying amounts of
assets or understatements of carrying amounts of liabilities and provisions.
Accordingly, they required overly optimistic assumptions regarding values
of assets (which were reported at amounts exceeding their real recoverable
values) or values of financial obligations (which were reported at amounts
lower than actual economic sacrifices needed to satisfy them). According to
an intuition and in light of managerial motivations discussed in Sect. 3.1
of Chapter 3, deliberate overstatements of reported profits (usually followed
by negative earnings surprises and, in some cases, corporate bankruptcies)
constitute the most common class of earnings manipulations. However,
sometimes companies also intentionally understate their reported profits (by
either understating carrying amounts of assets or by overstating reported
liabilities), which also erodes reliability and comparability of financial statements (Penman and Zhang 2002). Such behavior is labeled a conservative
accounting, in opposition to an aggressive accounting (which aims at inflating
the reported earnings).
The overly conservative accounting is usually aimed at:
• Income smoothing—many empirical studies found that smooth corporate earnings are viewed favorably by capital market participants, and firms
with smoother income series are perceived as being less risky (Wang and
Williams 1994). Others found that institutional investors and analysts tend
to prefer companies with smooth earnings (Badrinath et al. 1989; Previts
et al. 1994; Carlson and Bathala 1997). Relatively smooth earnings might
be associated with relatively low cost of debt, since reduced volatility in
earnings lowers the assessment of the possibility of a firm’s bankruptcy
(Trueman and Titman 1988; Beattie et al. 1994; Gu and Zhao 2006;
Li and Richie 2009; Jung et al. 2012). Also, many other studies discovered an existence of a negative statistical relationship between variability
of reported earnings and stock values (Barth et al. 1999; Hunt et al. 2000;
Francis et al. 2004; Rountree et al. 2008). Consequently, the observed positive impact of earnings smoothness on company’s value and its perceived
credit risk creates a temptation for managers to artificially depress reported
profits in “good times”, in order to obtain some hidden reserves which
4 Deliberate Accounting Manipulations: Expense-Oriented …
123
may be released in “rainy days”. Indeed, researchers found that majority
of CFOs prefer smooth earnings (Fudenberg and Tirole 1995; Graham
et al. 2006; Suda and Hanaeda 2008) and empirical studies support the
notion that managers tend to engage in accounting income smoothing
(Dascher and Malcolm 1970; Barefield and Comiskey 1972; Beidleman
1973; Barnea et al. 1975; Myers et al. 2007).
• Creating “big-bath reserves” in unusually bad times or when
company’s management changes—the income smoothing discussed
above required understating earnings in unusually “good times”, to release
the obtain hidden reserves in poorer times. However, managers may be
tempted to apply overly conservative accounting in unusually bad circumstances as well, particularly in periods of an economy-wide turbulence,
such as the global economic turmoil of 2008–2009. Under such tough
conditions most businesses suffer from deteriorating results to a large
extent due to external factors (rather than prior managerial errors). Consequently, a market tolerance for poor performance (including deep losses)
becomes much higher than in the “normal times”. This, in turn, motivates
many managers to create so-called “big-bath reserves” (e.g. by excessive
write-downs of allegedly impaired assets or by recognizing restructuring
provisions), which may be released in the future in order to show an alleged
improvement in profitability. Another temptation for “big-bath reserves”
appears when management of a troubled enterprise suddenly changes (e.g.
when previous directors are fired due to the shareholders’ disappointment),
with a restructuring and turnaround of a business being primary tasks set
for the newcomers. In such circumstances the newly employed team cannot
be accused of errors made be their predecessors. Quite the reverse, they
may be tempted to emphasize a scale of problems which arose before they
came (e.g. by announcing exaggerated asset write-downs, whereby it will
be easier to show faster growing income in the following periods).
• Maximizing benefits from management bonuses—remuneration
arrangements of most contemporary managers consist of two parts:
fixed salary and variable element based on selected performance metrics.
The latter is usually linked to several variables, including stock price
changes and profitability measures. Consequently, the total remuneration
of managers of a given business in a given period is positively correlated
with their company’s performance in that period. As was stated is Sect. 3.1
of Chapter 3, it often creates a temptation to artificially inflate the reported
profits, in order to maximize the managers’ compensation from remuneration bonuses. However, most bonus schemes fix some caps (upper
limits) on the amount of annual bonuses which managers may earn. This,
124
J. Welc
in turn, may motivate greedy managers to deliberately depress reported
earnings in periods with particularly good financial results (when the
bonuses linked to performance reach their caps), in order to obtain some
hidden reserves which may be released later in “rainy days” (to increase the
amount of bonuses earned in those poorer times, which otherwise would
fall significantly).
• Defending against governmental anti-monopolistic actions—some
corporations enjoy monopolistic or oligopolistic positions on their
markets, typically as a result of a combination of economies of scale and
networking effects (e.g. Google or Microsoft). With high market shares
and limited competition they may abuse their strong bargaining power
against customers, by setting prices of their goods or services on illegitimately (from a perspective of the society) high levels. This, in turn, results
in reporting an exceedingly high profitability, which benefits shareholders
at the cost of customers. Most countries, therefore, have some regulatory
bodies whose role is to intervene when such abuses are observed. One
of the ways to avoid a litigation launched by such governmental agencies
against the company (which enjoys such privileged market position) is to
pretend that its profitability does not differ positively from its competitors.
Accordingly, managers of such businesses may be tempted to artificially
depress reported profits, so that they look like profits which reflect much
more fierce competition (and do not exceed earnings of other firms by
much).
• Obtaining approval for price increases by regulated businesses—some
firms operate in regulated industries, to that extent that they cannot freely
set their selling prices. For instance, in most countries the utility businesses (e.g. electric energy providers, water suppliers or distributors of
home heating gas) must apply to governmental agencies, if they intend
to increase the rates charged on their customers. The agency’s approval (or
lack of it) for a price increase is based on its evaluation of an argumentation provided by a given applicant (e.g. accelerated inflation of global
gas prices, which may endanger a gas supplier’s existence if it continues to
distribute gas at the prices charged in a prior period). Regulations which
set the rules for such an evaluation typically require some profitability
metrics (e.g. return on assets) to be taken into account. Consequently, to
increase a likelihood of obtaining a governmental agency’s approval for a
price increase, managers of utility businesses may be tempted to artificially
understate accounting profits reported by their companies in the preceding
periods (to depress return on assets and to create an impression that the
company’s sustainability is indeed jeopardized).
4 Deliberate Accounting Manipulations: Expense-Oriented …
125
• Reducing dividend payouts—while shareholders enjoy receiving regular
dividends, managers prefer to keep more money on their companies’ bank
accounts. While the managers’ motivation for increasing the amount of
retained earnings may be fully reasonable (e.g. safeguarding funds for
investments in new prospective business ventures or creating some financial
cushion necessary to withstand possible but unpredictable negative shifts
in external economic environment), it may also stem from their egoistic
willingness to make their lives easier. It is generally less demanding to steer
a company which enjoys high financial liquidity (e.g. due to significant
excess cash), as compared to when it lacks such reserves. Given that dividends constitute distributions of prior periods profits, managers may be
tempted to deliberately understate reported earnings (to keep more money
on the company’s bank accounts).
As might be seen, there may be multiple incentives for managers to depress
(and not only to inflate) accounting earnings reported by their enterprises.
Consequently, depending on a period and particular circumstances, corporate
financial numbers may be either biased upward (when aggressive accounting
techniques are utilized) or downward (when company employs overly conservative accounting assumptions). In this context it is very important to be
aware that both biases are unwelcome and erode usefulness and reliability of
financial statements. As shown in the examples discussed in the preceding
section, an overstatement of earnings in a given period is usually followed by
their understatement in the following periods. In contrast, as shown later
in this section, deliberate understatements of reported profits tend to be
followed by their overstatements, which may create a false impression of positive trends in corporate financial results (Feleaga et al. 2010). Accordingly,
an unbiased (neutral) accounting, which is featured by lack of any material
understatements or overstatements of reported revenues, expenses, assets and
liabilities, is the only approach to accounting which guarantees reliability,
relevance and comparability of financial statements.
4.2.2 Four Approaches to Accounting
Table 4.1 contains two examples of accounting areas, where the following four
alternative approaches may be applied in the same economic circumstances:
• Conservative accounting, which, as explained before, depresses profits
reported in a given period, with an overstatement of profits reported in
the following periods,
Four approaches to accounting
Source Author
Table 4.1
126
J. Welc
4 Deliberate Accounting Manipulations: Expense-Oriented …
127
• Neutral accounting, which results in unbiased reported earnings,
• Aggressive accounting, which inflates profits reported in a given period
(but still within the boundaries of accounting regulations, although on the
verge of their violation), with a resulting reversal and understatement of
earnings reported later on,
• Fraudulent accounting, whose purpose is the same as in the case of the
aggressive one (i.e. to inflate income), but which involves an outright fraud
(e.g. fabricated documents or artificial transactions), instead of overly optimistic assumptions. It must be noted, however, that often a borderline
between the aggressive and fraudulent accounting is blurred (Powell et al.,
2005).
It must be stressed that the aggressive and fraudulent approaches to
accounting have the same ultimate goal: to boost reported profits. However,
they employ different tools. While the aggressive accounting is based on
overly optimistic assumptions (e.g. about recoverable amounts of inventories
or receivable accounts), the fraudulent one goes further and requires falsification of some documents (e.g. invoices or sales contracts), which underlie
the accounting booking entries. Nevertheless, both are equally disastrous to a
reliability of financial statements.
It must be emphasized also that all four alternative approaches to
accounting, exemplified in Table 4.1, are applicable to majority of accounting
issues (and not just to the two areas discussed in the table). Other examples
are:
• Depreciation of fixed assets, where conservative and aggressive accounting
may imply overly short and overly long useful lives, respectively (while
fraudulent accounting may entail reporting of nonexisting items of property, plant and equipment),
• Provisions for product returns, where conservative and aggressive
accounting would assume overly high and overly low expected volumes
of returns, respectively (while fraudulent accounting could be based on a
claim that no rights of returns are granted to customers, accompanied by
keeping the actual sales contracts away from the auditor’s eyes).
An erosion of financial statement reliability and comparability, caused by
an overly conservative accounting, is illustrated in Example 4.7 (which is
an alternation of Example 4.1, discussed in the previous section). As might
be seen, the neutral approach to financial statement preparation calls for
128
J. Welc
Example 4.7 Understatement of profits by overstating inventory write-downs
(alternation of Example 4.1)
Company X is a distributor of mobile phones, i.e. products which are generally characterized
by price defla on. In Period t company purchased mobile phones for 1.000 EUR. At the
moment of purchase the retail market price (i.e. recoverable value) of these phones equaled
1.200 EUR. At the end of Period t the company s ll held in its inventory the unsold phones,
bought in Period t. However, before the end of Period t the market value of those phones
fell to 900 EUR. Given the quan ty of unsold phones in the company’s stores, its managers
expected that in order to get rid of all those obsolete inventories in Period t+1, their total
market value will fall further (i.e. to less than the current value of 900 EUR).
The company’s knowledge and experience suggest that the prices of excess inventories will
have to be lowered further (in order to dispose of them in Period t+1), to their total
recoverable value of 700 EUR. However, to stay conserva ve, the company decided to write
down the carrying amount of its inventories to 300 EUR.
The neutral (unbiased) booking entries look as follows:
Period t
Inventories (BS)
Opera ng costs (IS)
Profit before tax (IS)
Period t+1
-300*
+300*
-300
Net sales (IS)
+700**
Cash / receivables (BS)
+700**
Cost of goods sold (IS)
+700
Inventory (BS)
-700
Profit before tax (IS)
0
The overly conserva ve booking entries look as follows:
Period t
Period t+1
Inventories (BS)
-700***
Opera ng costs (IS)
-700***
Profit before tax (IS)
-700
Net sales (IS)
+700**
Cash or receivables (BS)
+700**
Cost of goods sold (IS)
+300
Inventory (BS)
-300
Profit before tax (IS)
+400
* to reflect the write-down of inventories from their historical (purchase) cost of 1.000 EUR, down to
their esƟmated recoverable value of 700 EUR
** to reflect the sale of inventories for the prices which are equal to the esƟmated recoverable value
*** to reflect the exaggerated write-down of inventories from their historical (purchase) cost of 1.000
EUR, down to their alleged recoverable value of 300 EUR
Source Author
an unbiased write-down of inventory, by 300 EUR in Period t (i.e. recognizing the full expected loss on inventory, but not more, when it becomes
likely). This write-down is followed by a zero profit or loss from the disposal
of this inventory in the following period, when those goods are sold. In
contrast, overly conservative accounting (reflected in an excessive write-down
of inventory by 700 EUR in Period t ) entails an overstatement of income
reported for the following period, when the goods are sold for prices which
exceed their overly depressed carrying amounts. Obviously, such an approach
4 Deliberate Accounting Manipulations: Expense-Oriented …
129
may mislead anyone who investigates the company’s financial statements for
Period t + 1, by showing an alleged (and perhaps impressive) improvement
of its profitability.
Good educative real-life examples, illustrating dangers associated with
an overly conservative accounting, are Pittards plc, Mesa Air Group Inc.
(which filed for bankruptcy in early 2010) and Takata Corp. (which filed for
bankruptcy in 2017). The first of these firms illustrates effects of an overly
pessimistic impairment of inventories. The Mesa Air Group’s case shows that
in some circumstances an overly conservative accounting, even if eroding the
relevance and comparability of financial statements, may constitute the only
sensible way of maintaining the reliability of reported profits on a reasonable level. Takata’s example, in turn, illustrates the scope to which subjective
judgments embedded in estimating provisions may be used in an income
smoothing.
4.2.3 Real-Life Examples of (More or Less Deliberate)
Profit Understatements
4.2.3.1 Example of Pittards plc
The annual report of Pittards plc for fiscal year 2017 constitutes a good reallife illustration of financial statement distortions, caused by overly conservative inventory-related estimates. Table 4.2 presents selected income statement
data, reported by Pittards plc, for its fiscal years 2016 and 2017.
As might be seen, in 2016 Pittards plc incurred an operating loss of 3.6
GBP million, which was to a large extent attributable to a special charge to
Table 4.2 Selected income statement data of Pittards plc for fiscal years 2016 and
2017
Data in GBP thousands
Revenue
Cost of sales
Cost of sales—excep onal stock provision
Gross profit
Profit/(loss) from operaƟons
Source Annual report of Pittards plc for fiscal year 2017
2016
2017
27.009
–20.554
30.287
–23.194
–4.307
–
2.148
7.093
–3.591
934
130
J. Welc
cost of sales (amounting to 4.3 GBP million), related to an inventory writedown. This is confirmed by extracts from Note 14 to the company’s annual
report for 2017, as well as Note 14 and Note 4 to its annual report for 2016,
presented in Table 4.3.
As may be concluded from Note 14 to the company’s financial statements
for 2016, the total charges debited (expensed) in 2016 in relation to inventory
write-downs amounted to 4.5 GBP million, of which 0.2 GBP million was
included in line item “Cost of sales”, while the remaining 4.3 GBP million was
reported under the separate line item “Cost of sales - exceptional stock provision”. In the following year, however, the company credited its cost of sales
by 528 GBP thousands (as compared to a previous-year debit of 4.5 GBP
million), which probably reflected a partial reversal of the prior write-down.
Regardless of whether the reversal was legitimate or not (and regardless of
whether the previous write-down was overstated intentionally or not), such
an impairment reversal boosted the operating profit reported for 2017 by as
much as 528 GBP thousands. Given that the operating profit reported for
2017 amounted to 934 GBP thousands, a contribution of a one-off gain
from the reversal of inventory write-down (making up more than 56% of
operating profit reported for 2017) should be obviously considered significant and deserving separate disclosure on the face of the income statement.
In contrast, while the write-down in 2016 was disclosed in its own line item
(“Cost of sales - exceptional stock provision”), its income-boosting reversal a
year later was hidden and treated as part of general cost of sales (which,
Table 4.3 Extracts from annual reports of Pittards plc for fiscal years 2016 and 2017,
regarding its inventory impairment charges
Note 14 (Inventories) to Annual Report for fiscal year 2016
During the year £0.207m in respect of a stock provision was debited to the Income Statement
(2015: £0.059m) as part of cost of sales and a further £4.307m as part of excep onal cost of
sales. See note 4 for further details.
Note 4 (ExcepƟonal items) to Annual Report for fiscal year 2016
The Board has conducted a detailed review of the stock holding and has decided to take a
£4.307m provision reducing the year end stock to £17.353m. This takes into account: the
impact of currency transla on, slow moving stock and the poten al strategic shi in the
business moving towards a higher propor on of hide business. The provision relates to low
end dress and sport glove leather, with a write down of £1.271m in the UK and £3.036m in
Ethiopia.
Note 14 (Inventories) to Annual Report for fiscal year 2017
During the year £0.528m in respect of a stock provision movements and write offs was
credited to the Income Statement (2016: debited £4.514m) as part of cost of sales.
Source Annual reports of Pittards plc for fiscal years 2016 and 2017
4 Deliberate Accounting Manipulations: Expense-Oriented …
131
in turn, could have misinformed a financial statement user about the real
improvement of the company’s operating profitability in 2017).
4.2.3.2 Example of Mesa Air Group
Table 4.5 (in the appendix) contains an extract from consolidated income
statement of Mesa Air Group for fiscal years ended September 30, 2006, 2007
and 2008. As might be seen, in its 2008 fiscal year the company reported an
operating income of 10.0 USD million, which seemed to be a significant
improvement from a loss of 73.8 USD million incurred in the preceding
period. However, in 2008 the company’s earnings were boosted by a partial
reversal of a provision for loss contingency and settlement of lawsuits (whose
positive contribution to income amounted to 31.3 USD million), recognized
in the preceding year and totaling 86.9 USD million. Accordingly, without
this single expense item, the operating income in 2008 and 2007 would
amount to −21.3 USD million and +13.1 USD million, respectively. Quite
a significant difference, reflecting a deterioration (rather than improvement)
of the company’s core profitability between 2007 and 2008.
Of course, the reversal of previously overestimated provision for liabilities, even with such a dramatic impact on the amount of reported operating
income, does not automatically mean that a deliberate fabrication of the
company’s financial statements happened in the past. However, by their definition provisions constitute likely liabilities which are featured by a significant
uncertainty regarding amounts of future settlements or their timings (or
both). Therefore, they are always sensitive to subjective judgments, which
open a room for some “big bath reserves”. Table 4.6 (in the appendix)
contains an extract from Mesa Air Group’s annual report, which explains the
origin of its loss contingency recognized in 2007 (and partially reversed in
the following period).
As might be concluded from disclosures cited in Table 4.6, in 2007 the
company recognized provision for a liability, whose amount covered 100%
of potential cash outflows, even though it did not feel guilty and did not
admit any fault. If the company could have filed a notice of appeal and, as
a result, only few months later could reach a settlement with the plaintiff
(whereby the amount ultimately paid became much lower than the amount
of a provision for that settlement, recognized few months before), then it
could have been supposed that there existed a significant probability of a
much lower amount of the final settlement (as compared to the amount
sentenced by the court in October 2007). In other words, at the end of its
fiscal year 2007, when the company recognized a litigation-related expense
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J. Welc
of 86.9 USD million, the most likely amount of the final settlement was
probably lower than the amount announced by the court in October 2007.
Furthermore, if a likelihood of reaching a settlement with the plaintiff was
high, then the initially expensed amount of 86.9 USD million could have
been the least likely value of a final payment (with anything between zero
and 86.9 USD million being more probable). However, both the exact probability of reaching a settlement, as well as its final agreed-upon amount, were
unknown. Thus, even though it could have been very likely that an expense
ultimately incurred will be significantly lower than 86.9 USD million, any
estimate of any lower amount would have to come “out of thin air”. Consequently, to keep its financial statements reasonably reliable (and to avoid any
accusations of manipulating its results reported for fiscal year 2007), Mesa
Air Group decided to recognize the expense and provision amounting to
the maximum likely future reimbursements, even though it could have been
almost certain that in the following year a significant (but unknown) portion
of that provision will have to be released and boost the company’s income
reported for 2008. In other words, given an impossibility of obtaining any
reliable estimate of the final settlement, the only solution to ensure a financial
statement reliability (although at the cost of its relevance) was to overshoot
the litigation-related provision in fiscal year 2007 and to reverse part of it
(with a boost to income) when the final amounts are known.
The Mesa Air Group’s example illustrates a legitimate application of
an overly conservative accounting (with its distorting impact on reported
profits), when a maximum amount of future payments is known but rather
unlikely, while anything more likely and falling between zero and that
maximum amount cannot be reliably estimated. In such circumstances a
recognition of inflated provision is justified, even though it brings about a
likely understatement of a profit in one period and an overstatement of profits
in future periods. In contrast, the Takata’s case, discussed below, exemplifies
a distorting impact of those kinds of provisions where both the upper and
lower bounds of likely range of future expenses are unknown (and must be
estimated on the basis of historical data and some subjective judgments).
4.2.3.3 Example of Takata Corp.
Table 4.7 (in the appendix) contains extracts from Takata’s annual report for
2016, which refer to its warranty reserves. As might be concluded from that
extract, Takata’s warranty provisions are estimated on the basis of its historical
experience combined with present economic conditions, which make those
reserves prone to multiple subjective judgments. In the quoted narratives the
4 Deliberate Accounting Manipulations: Expense-Oriented …
133
Table 4.4 Selected financial statement data of Takata Corporation for fiscal years
2014–2016
*omitted data for fiscal year 2014 have not been reported in the company’s annual
report for fiscal year 2016
** = warranty reserve at the end of 2015 (75.244)—Increase in warranty reserve in
2015 (17.002)
Source Annual reports of Takata Corporation for fiscal years 2015–2016 and authorial
computations
company also admitted that changes of warranty reserves constitute one of the
major reasons for the observed discrepancies between its accounting profits
and operating cash flows. A combination of these two facts (i.e. relevance of
warranty provision for the company’s results and its sensitivity to subjective
judgments) calls for an evaluation of possible contributions of this expense
item into the reported earnings. Table 4.4 portrays Takata’s selected financial
statement numbers for 2014–2016.
The data presented in Table 4.4 confirm huge impact of changing warranty
reserves on the company’s reported income. In 2015 it reported a pre-tax loss
of 18.0 JPY billion, which to a large extent was attributable to an increase
in warranty provisions by 17.0 JPY billion. In contrast, in the following
year the company’s reported loss before taxes contracted to 4.8 JPY billion,
but it benefited from a reduction of the warranty reserve balance by 30.2
JPY billion. Accordingly, if Takata’s warranty provisions stayed intact in the
investigated three-year timeframe, in 2015 and 2016 it would report losses
of 1.0 JPY million and 35.0 JPY million, respectively (with an implied
deterioration, rather than improvement, in the company’s pre-tax earnings).
As might also be seen, in 2016 the company dramatically reduced its ratio
of warranty reserves to annual net sales. In both preceding years this metric
stood within a range between 10.5 and 11.7%. Accordingly, it was kept on
a rather unusually high double-digit levels, which seem unlikely for a normal
course of business (since no firm would probably be able to survive in the
134
J. Welc
long run if its costs of repairs of faulty products repeatedly exceed 10% of
annual revenues). This does not mean that the company’s warranty provisions have been manipulated and deliberately overstated in 2014 and 2015.
However, given their very high share in net sales in these periods, followed
by a sharp decrease (in both the monetary amount as well as the percentage
of revenues) in 2016, it seems likely that some overly conservative assumptions, regarding warranty expenses, were applied in 2014 and 2015. If that
was the case, then the company’s results reported for 2014–2015 could have
been understated, with a corresponding overstatement (as a result of a release
of excessive warranty reserves) in the following period.
If in 2016 Takata’s ratio of warranty provisions to annual revenues was kept
at, say, 11% (i.e. near the middle of the range observed in the prior two years),
instead of 5.6%, then the carrying amount of the provision as at the end of
2016 would amount to 78.980 JPY million [=11% × 718.003], instead of
42.755 as reported. In this hypothetical scenario a release of the previously
recognized provisions (despite growing sales) would imply an overstatement
of pre-tax earnings reported for 2016 by 36.225 JPY million [=78.980 −
42.755]. Accordingly, with the warranty reserves staying at 11% of revenues,
the pre-tax loss reported for 2016 would amount to −41.001 JPY million
[=−4.776 − 36.225], instead of −4.776 JPY million. Quite a different
picture, which corroborates an importance of possible financial statement
distortions caused by the overly conservative accounting.
Appendix
See Tables 4.5, 4.6 and 4.7.
135
4 Deliberate Accounting Manipulations: Expense-Oriented …
Table 4.5 Extract from consolidated income statements of Mesa Air Group for fiscal
years ended September 30, 2006, 2007 and 2008
Data in USD thousands
Fiscal years ended September 30
2006
2007
2008
Total net operating revenues
1.284.903
1.298.064
1.326.111
Operating expenses, including:
1.182.514
1.371.836
1.316.106
Flight operations
368.023
382.504
364.659
Fuel
446.788
438.010
517.907
Maintenance
213.317
254.626
262.868
72.615
82.248
76.284
1.990
3.605
4.682
General and administrative
56.940
71.818
83.115
Depreciation and amortization
Loss contingency and settlement of
l
it
Bankruptcy and vendor settlements
34.939
39.354
37.674
Aircraft and traffic servicing
Promotion and sales
Impairment and restructuring charges
Operating income/loss
–
86.870
–31.265
–12.098
434
–27
–
12.367
209
102.389
–73.772
10.005
Source Annual report of Mesa Air Group for fiscal year ended September 30, 2008
Table 4.6 Extract from the annual report of Mesa Air Group for fiscal year 2008,
regarding its loss contingency and settlements of lawsuits
Loss ConƟngency and SeƩlement of Lawsuit
On October 30, 2007, the United States Bankruptcy Court for the District of Hawaii found that
the Company had violated the terms of a confiden ality agreement with Hawaiian Airlines and
awarded Hawaiian $80.0 million in damages and ordered the Company to pay Hawaiian’s cost
of li ga on, reasonable a orneys’ fees and interest. The Company filed a no ce of appeal to
this ruling in November 2007 and posted a $90.0 million bond pending the outcome of this
li ga on. As a result, the Company recorded $86.9 million as a charge to the statement of
opera ons in the fourth quarter of fiscal 2007. On April 29, 2008 the Company reached a
se lement with Hawaiian Airlines. While admi ng no fault, the Company agreed to pay $52.5
million to Hawaiian Airlines. As a result of the se lement, the Company recorded a $34.1
million credit to the statement of opera ons in the second quarter of fiscal 2008. The $34.1
million credit is net of $0.3 million in fees incurred related to the bond.
Source Annual report of Mesa Air Group for fiscal year ended September 30, 2008
136
J. Welc
Table 4.7 Extract from the annual report of Takata Corporation for fiscal year 2016,
regarding its warranty reserve
Warranty reserve
Es mated future warranty reserve and product liability obliga ons are accrued based on
historical experience and present circumstances.
Cash flows from operaƟng acƟviƟes
Net cash provided by opera ng ac vi es was ¥8,576 million compared with net cash of ¥3,831
million provided in the previous fiscal year. This outcome was mainly influenced by the net loss
before income taxes recorded for the period, a decrease in product warranty reserve, and an
increase in inventory assets, which was par ally offset by the recording of deprecia on
expenses and an increase in accrued expenses.
Source Annual report of Takata Corporation for fiscal year 2016
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5
Evaluation of Financial Statement Reliability
and Comparability Based on Auditor’s
Opinion, Narrative Disclosures
and Cash Flow Data
5.1
Introduction
This chapter is the first of several chapters which deal with tools of evaluating financial statement reliability and comparability. In this book the terms
“reliability” and “credibility” of financial statements are used interchangeably.
Accounting numbers are deemed reliable if they may be relied upon, i.e. if
they present a fair and true picture of a given company’s performance. In
that sense the reliable financial statements may be also described as credible.
The terms “reliability” and “credibility” refer to a complete set of financial
statements, including income statement, balance sheet, cash flow statement
and notes. A related term “sustainability”, in turn, is narrower, since it refers
only to corporate earnings. Reported earnings are sustainable if they may be
reasonably extrapolated into a foreseeable future. In other words, sustainable
earnings may be reliably expected to recur in incoming periods. In contrast,
unsustainable reported earnings are those in which case it is more likely than
not that they will fall in the foreseeable future.
The reported earnings which have been deliberately inflated (e.g. with
the use of some accounting gimmicks exemplified in the preceding two
chapters) are neither reliable nor sustainable. In such cases a reversal of
prior overstatements (i.e. the fall of earning) must come sooner or later. In
contrast, when accounting profits are intentionally understated, they may
be deemed unreliable but sustainable (in a sense that their increases, rather
than decreases, should be expected in the future). However, since majority
of deliberate earnings manipulations boil down to profit overstatements, the
following discussion (as well as the contents of Chapters 7 and 8) will focus
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_5
139
140
J. Welc
on symptoms of inflated earnings. In such cases the terms “reliability” and
“sustainability” of earnings may be used interchangeably.
It must be stressed that reported earnings may be unsustainable without
any deliberate managerial actions aimed at inflating them (by means of some
accounting gimmicks). This is due to multiple business-related (in contrast
to accounting-related) factors which may cause an erosion of future earnings,
without any intentional overstatements of prior earnings. Examples of such
circumstances were discussed in the first two chapters of this book, which
dealt with objective weaknesses of accounting methods.
As was mentioned in the preceding chapters, reported financial results of
various firms may be reliable (and sustainable) but not comparable. This
may be observed even in case of companies reporting under the same set
of accounting regulations (e.g. IFRS). Although financial statement reliability
and comparability are two different issues, most tools discussed in this chapter
(as well as in the following ones) are useful in assessing both these aspects of
corporate financial reporting.
The following sections will discuss the usefulness of the auditor’s opinion,
narrative financial statement disclosures and cash flow information in
assessing financial statement reliability and comparability. Given that cash
flow statements, often used (and abused) as a check for the accounting
quality, are also not entirely immune to distortions and manipulations, the
following chapter (i.e. Chapter 6) will demonstrate examples of circumstances
under which reported cash flows themselves may not be reliable.
5.2
Auditor’s Opinion
The first (although imperfect) check on the reliability of financial statements
is an auditor’s opinion. An audit may be defined as an investigation or a
search for evidence (by persons independent of the preparer of the audited
accounts), to enable reasonable assurance to be given on the truth and fairness
of financial and other information, followed by the issue of a report on that
information, with the intention of increasing the credibility and usefulness of
the audited financial statements (Gray and Manson 2011).
Accordingly, the main objective of the audit procedures is to enable the
auditor to express an opinion on whether financial statements are prepared,
in all material respects, in accordance with an applicable financial reporting
framework (Doris 1950; Millichamp and Taylor 2008). Auditors check
whether a company has kept proper accounting records and report if they
5 Evaluation of Financial Statement Reliability …
141
have not received all the information and explanations required for their audit
(Howard 2008).
An unqualified opinion, which significantly reduces (but not eliminates)
the risk of severe misstatements, should clearly state that the audited financial statements present a true and fair view of the company’s financial results
and position. “True” means compliant with the facts that pertain at the
time (either at the year’s end or at the time when the auditor’s report was
signed), while “fair ” implies that the applicable accounting standards have
been applied impartially, objectively and with a view to presenting the facts
of the financial situation of the company in as balanced, reasonable and
unbiased way as is possible (Millichamp and Taylor 2008).
Obviously, if the auditor’s opinion has any qualification, it dramatically
erodes credibility of a given financial report. Since such qualifications may
relate to very diverse areas of financial reporting (including a legitimacy of
a given company’s going concern assumption), they will be illustrated with
several different real-life examples.
5.2.1 L’Oreal
An example of an unqualified auditor’s opinion is presented in Table 5.1.
As may be read, according to the quoted narratives the audited financial
statements “give a true and fair view of the assets and liabilities and of the
financial position” of L’Oreal Group, as at the end of 2017. Those financial
statements were also compliant with accounting regulations effective for the
audited company (i.e. International Financial Reporting Standards). As will
be illustrated by the following case studies, any deviations from such a clearly
positive and unqualified auditor’s opinion should be interpreted as strong “red
flags”.
Table 5.1 Extract from unqualified auditor’s opinion to consolidated financial
statements of L’Oreal for fiscal year 2017
Opinion
In compliance with the engagement entrusted to us […], we have audited the accompanying
consolidated financial statements of L’Oreal for the year ended December 31, 2017.
In our opinion, the consolidated financial statements give a true and fair view of the assets
and liabilities and of the financial position of the Group as of December 31, 2017 and of the
results of its operations for the year then ended in accordance with International Financial
Reporting Standards as adopted by the European Union.
Source Annual report of L’Oreal Group for fiscal year 2017
142
J. Welc
5.2.2 Agrokor Group
The first example of a negative audit opinion is Agrokor Group (a Croatian conglomerate operating in a broadly defined food industry, who filed
for bankruptcy in 2018), whose auditors issued multiple qualifications to
its financial statements for fiscal years 2016 and 2017. The most material
(subjectively selected) of those qualifications are cited in Table 5.2.
Table 5.2 Extract from qualified auditor’s opinion to consolidated financial
statements of Agrokor Group for fiscal year 2017
Basis for Qualified Opinion
1. As explained in Note 1.2 to the consolidated financial statements, the reporting entity is
unable to continue operating on a going concern basis. […] Consequently, presentation
of assets and liabilities as non-current items in the statement of financial position as of
31 December 2017 is not appropriate. In addition, the Group did not disclose a maturity
analysis of financial liabilities as required by IFRS 7, Financial Instruments: Disclosures.
Further, as of 31 December 2016 management did not assess compliance with debt
covenants related to its borrowings. In the absence of information to assess the
compliance of the Group with debt covenant restrictions, we were unable to satisfy
ourselves as to the proper classification between current and non-current borrowings as
of 31 December 2016 or the completeness of disclosures on debt covenant breaches. […]
2. […].
3. We were unable to obtain sufficient appropriate audit evidence of the recoverable value
of intangible assets, property, plant and equipment and investment property totaling
HRK 2,887,738 thousand at 31 December 2017 […].
4. […] We were unable to satisfy ourselves concerning inventory quantities held as of 31
December 2016 by any other means because a substantial period of time had passes
between the end of the financial reporting period and the date when we were appointed
as auditors […].
5. The consolidated statement of financial position includes non-current loan receivables of
HRK 191,713 thousand (2016: HRK 208,617 thousand). Management did not carry out an
impairment review of these assets to assess their recoverability. We were unable to
satisfy ourselves by other means as to the carrying amount of these non-current loans
receivable […].
6. […] the Group did not recognize a liability for penalty interest of HRK 2,017,687
thousand. Since the Group has not yet been released from those obligations through
approval of the settlement or completion of bankruptcy proceedings, financial liabilities
and loss for the year are understated by HRK 2,017,687 thousand.
7. […]
8. […]
We conducted our audit in accordance with International Standards on Auditing (ISAs). […]
We believe that the audit evidence we have obtained is sufficient and appropriate to
provide a basis for our qualified opinion.
Source Annual report of Agrokor Group for fiscal year 2017
5 Evaluation of Financial Statement Reliability …
143
Clearly, such a long litany of auditor’s doubts, stretching from ongoing
concern issues through likely asset overstatements to understatement of liabilities and expenses, make these financial statements virtually useless. Such
accounting data cannot be considered a reliable source of information for
any analysis of the investigated company’s financial standing and prospects.
5.2.3 LumX Group Limited
Another educative example is an adverse review of financial statements
published by LumX Group Limited (a financial services company). Selected
statements, extracted from the auditor’s opinion included in the company’s
annual report for fiscal year 2018, are quoted in Table 5.3.
As might be read, in the auditor’s opinion the company’s reported
accounting numbers cannot be deemed reliable, due to a material overstatement of goodwill (and resulting understatement of reported loss) combined
with an illegitimate recognition of deferred tax assets. Moreover, the auditors express a doubt regarding the company’s ability to continue as a going
concern. Obviously, any inferences about a financial standing of LumX
Group Limited, based on the company’s published financial statements for
2018, are prone to a high risk of error (unless the company’s reported data
are adjusted analytically, in order to better reflect an economic reality).
5.2.4 CenturyLink Inc.
An interesting example of the qualified auditor’s opinion, referring to consolidated financial statements published by CenturyLink Inc., is presented in
Table 5.4. As may be read, in a quoted review the auditors did not qualify
the company’s accounting policies themselves, but negatively opined on a
design and execution of its internal control procedures. In particular, the
auditors expressed their concerns regarding the CenturyLink’s material weaknesses related to “ineffective design and operation of process level controls over
the fair value measurement of certain assets acquired and liabilities assumed in
a business combination” and to “ineffective design and operation of process level
controls over the existence and accuracy of revenue transactions”.
Such an opinion meant that the CenturyLink’s auditors were not sure if the
company’s consolidated assets and liabilities (particularly those which were
measured at fair values and were related to the company’s past takeovers), as
well as its consolidated revenues (and, effectively, profits) were reported at
144
J. Welc
Table 5.3 Extract from qualified auditor’s opinion to consolidated financial
statements of LumX Group Limited for fiscal year ended December 31, 2018
Adverse Opinion
[…]
In our opinion, because of the significance of the matter discussed in the Basis for Adverse
Opinion section of our report, the accompanying consolidated financial statements do not
give a true and fair view of the consolidated financial position of the Group as of 31
December 2018, and its consolidated financial performance and its consolidated cash flows
for the year then ended in accordance with International Financial Reporting Standards
(IFRS) […].
Basis for Adverse Opinion
As explained in Note 12, the Management has performed an impairment test of the
goodwill on 31 December 2018 and concluded that no impairment is required.
Management estimated cash flow projections over a period of five years using a strong
growth rate. […]
We are of the opinion that the risks linked to the recoverable amount of the goodwill are
not sufficiently reflected in the impairment considerations applied by the Group, and are of
the opinion that the carrying value of the goodwill is overstated by USD 21.1 mios resulting
in an understatement of the Loss of the year and an overstatement of the Total equity in
the same amount. […] In our opinion, this has a pervasive and material impact on the
financial statements.
In addition, the Group recognizes deferred tax asset (DTA) of its subsidiaries […]. The
recognition of the DTA depends on the ability […] to generate taxable profit in the near
future. We are of the opinion that the deferred tax asset is overstated in the amount USD
1.8 mios, resulting in an understatement of the Loss of the year and an overstatement of
the Total equity in the same amount.
Material uncertainty related to going concern
We draw attention to note 1c) in the financial statements which describes the material
uncertainties related to achieving the business plan and cash flow forecasts that may cast
significant doubt upon the Group’s ability to continue as a going concern. Our opinion is not
modified in respect of this matter.
Source Annual report of LumX Group Limited for fiscal year 2018
correct amounts. Obviously, such flawed financial statements should not be
relied upon.
An unreliability of financial statements issued by CenturyLink Inc. in its
annual report for fiscal year 2018 was confirmed by the events that happened
in the first quarter of 2019. As may be read in an extract from the company’s
quarterly report, cited in Table 5.5, in that period the company conducted
impairment tests for its goodwill, resulting in goodwill impairment charges
totaling 6,5 USD billion (which constituted 29% of the company’s annual
revenues reported for the whole 2018 and over 9% of its total consolidated
assets as at the end of 2018). As a result, in the first three months of 2019
CenturyLink reported an operating loss of 5,5 USD billion, compared to a
5 Evaluation of Financial Statement Reliability …
145
Table 5.4 Extract from qualified auditor’s opinion to consolidated financial
statements of CenturyLink Inc. for fiscal year ended December 31, 2018
Opinion on Internal Control Over Financial Reporting
We have audited CenturyLink, Inc. and subsidiaries’ (the Company) internal control over
financial reporting as of December 31, 2018 […]. In our opinion, because of the effect of the
material weaknesses, described below, on the achievement of the objectives of the control
criteria, the Company has not maintained effective internal control over financial reporting
as of December 31, 2018 […].
[…]
A material weakness is a deficiency, or a combination of deficiencies, in internal control
over financial reporting, such that there is a reasonable possibility that a material
misstatement of the company’s annual or interim financial statements will not be
prevented or detected on a timely basis. Material weaknesses have been identified related
to (i) ineffective design and operation of process level controls over the fair value
measurement of certain assets acquired and liabilities assumed in a business combination,
which arose because the Company did not conduct an effective risk assessment to identify
and assess changes needed to process level controls resulting from the business
combination, did not clearly assign responsibility for controls over the fair value
measurements, and did not maintain effective information and communication processes
to ensure the necessary information was available to personnel on a timely basis so they
could fulfill their control responsibilities related to the fair value measurements; and (ii)
ineffective design and operation of process level controls over the existence and accuracy
of revenue transactions, which arose because the Company did not conduct an effective
risk assessment to identify risks of material misstatement related to revenue transactions,
and included in management’s assessment.
[…]
Source Annual report of CenturyLink Inc. for fiscal year 2018
positive operating profit (amounting to 750 USD million) earned one year
before.
When reading the narratives quoted in Table 5.5 it is worth paying attention to some disclaimers which the company added to its explanation of
the goodwill write-down. Namely, the company warned that its impairment
tests incorporated “significant estimates and assumptions related to the forecasted
results for the remainder of the year ” and that its “failure to attain these forecasted
results or changes in trends could result in future impairments”. In other words,
the company stated that its deep impairment charges in early 2019 may be
followed by another write-down in the future.
5.2.5 Hanergy Thin Film Power Group Limited
The final example deals with the accounting information reported by
Hanergy Thin Film Power Group Limited (the company listed on the Hong
146
J. Welc
Table 5.5 Extract from Note 2 to consolidated financial statements of CenturyLink
Inc. for the first quarter of fiscal year 2019
Goodwill, Customer Relationships and Other Intangible Assets
We are required to perform impairment tests related to our goodwill annually, which we
perform as of October 31, or sooner if an indicator of impairment occurs. Due to our
January 2019 internal reorganization and the decline in our stock price, we incurred two
events in the first quarter of 2019 that triggered impairment testing. […]
[…] Because our low stock price was a trigger for impairment testing, we estimated the fair
value of our operations using only the market approach. Applying this approach, we utilized
company comparisons and analysts reports within the telecommunications industry […]. We
selected a revenue and EBITDA multiple for each of our reporting units […]. For the three
months ended March 31, 2019, based on our assessment performed with respect to the
reporting units […], we concluded that the estimated fair value of certain of our reporting
units was less than our carrying value of equity as of the date of each of our triggering
events during the first quarter. As a result, we recorded noncash, non-tax-deductible
goodwill impairment charges aggregating to $6.5 billion for the three months ended March
31, 2019.
[…]
The market multiples approach that we used incorporates significant estimates and
assumptions related to the forecasted results for the remainder of the year, including
revenues, expenses, and the achievement of other cost synergies. In developing the market
multiple, we also considered observed trends of our industry participants. Our failure to
attain these forecasted results or changes in trends could result in future impairments. Our
assessment included many qualitative factors that required significant judgment.
Alternative interpretations of these factors could have resulted in different conclusions
regarding the size of our impairments. Continued declines in our profitability, cash flows or
the sustained, historically low trading prices of our common stock, may result in further
impairment.
Source CenturyLink Inc.: Quarterly Report Pursuant to Sections 13 or 15(d) of the
Securities Exchange Act of 1934, for the Quarterly Period Ended March 31, 2019
Kong Stock Exchange). Selected extracts from the auditor’s opinion to the
company’s financial statements for 2015 are presented in Table 5.6.
As may be read, the Hanergy’s auditor’s doubts touch different issues
than those discussed above. Namely, the qualified opinion here is related to
a scope of transactions between the audited company and its related entities, including its affiliates and its parent company (Hanergy Holding Group
Limited). According to the quoted statements, the auditors were unable to
obtain sufficient appropriate evidence about recoverability of the company’s
trade receivables, resulting from those related-party transactions. In light of a
significant share of trade receivables in Hanergy’s current and total assets, such
qualifications cast a doubt on a general reliability of the company’s financial
statements.
5 Evaluation of Financial Statement Reliability …
147
Table 5.6 Extract from qualified auditor’s opinion to consolidated financial
statements of Hanergy Thin Film Power Group Limited for fiscal year 2015
Basis for Qualified Opinion
As disclosed in notes 18 and 19 to the consolidated financial statements, the Group’s trade
receivables and gross amount due from contract customers were mainly related to
contracts with Hanergy Holding Group Limited (“Hanergy Holding”) and its affiliates
(collectively referred to as “Hanergy Affiliates”) and a third-party customer. As of 31
December 2015, the Group’s trade receivables from Hanergy Affiliates was
HK$2,596,781,000, the Group’s other receivables due from Hanergy Affiliates was
HK$200,835,000 (note 20), the Group’s trade receivables from the third-party customer was
HK$995,194,000 and the gross amount due from contract customers related to both of
them was HK$2,930,836,000. […] We were unable to obtain sufficient appropriate audit
evidence about the recoverability of the Group’s trade receivables and gross amount due
from contract customers for contract works of Hanergy Affiliates and the aforesaid thirdparty customer of HK$4,926,759,000, the other receivables due from Hanergy Affiliates of
HK$6,441,000 and prepayments made to Hanergy Affiliates of HK$663,943,000.
Consequently, we were unable to determine whether any adjustments to these amounts
were necessary. Any under-provision for the recoverability of these balances would reduce
the net assets of the Group as of 31 December 2015 and increase the Group’s net loss for
the year ended 31 December 2015.
Qualified opinion
In our opinion, except for the possible effects of the matter described in the Basis for
qualified opinion paragraph, the consolidated financial statements give a true and fair view
of the financial position of the Company and its subsidiaries as of 31 December 2015, and of
their financial performance and cash flows for the year then ended in accordance with Hong
Kong Financial Reporting Standards […].
Source Annual report of Hanergy Thin Film Power Group Limited for fiscal year 2015
5.2.6 Conclusions
As the above examples show, opinions of auditors may contain very useful
insights about a reliability of an investigated company’s accounting information. Therefore, any concerns expressed by auditors should be interpreted
seriously and diligently, since they may cast doubt on a credibility of the
whole financial report.
It must be mentioned here that auditors are rarely able to detect all
misstatements or errors which flaw financial statements. This is due to
inherent audit limitations, stemming from such factors as the use of testing
and the fact that most audit evidence is persuasive (rather than conclusive),
meaning that the work performed by an auditor is permeated by judgment
(Hayes et al. 2005). Therefore, it is not uncommon that particular issues
addressed in an auditor’s opinion constitute only a fraction of a whole list
of a given company’s accounting irregularities. But this only strengthens an
importance of investigating audit opinions in a financial statement analysis.
148
J. Welc
It must be also emphasized that auditors are far from being perfect
in detecting cases of even an outright accounting fraud (O’Glove 1987;
Becker 1998; Jones 2011; Vause 2014; Jackson 2015). Many (if not most)
accounting scandals and fraudulent financial reports are accompanied by
unqualified audit opinions. Moreover, weaknesses of accounting standards
themselves may cause situations in which sustainability of reported financial results may be seriously endangered even without any misstatements in
reported numbers. Thus, lack of any auditor’s qualifications does not guarantee a credibility of investigated financial statements. Due to this, reading
auditor’s opinion should constitute only a prologue to a full-blown evaluation
of a reliability of financial statements issued by an analyzed company.
5.3
Narrative Information Disclosed
in Financial Statements
Narrative parts of financial reports offer an invaluable source of information,
both about a reporting company (e.g. its business model, investment plans,
markets served, etc.) as well as about relevant financial reporting issues. This
section, based on five real-life cases, illustrates usefulness of narrative disclosures in intercompany comparisons as well as in an evaluation of financial
statement reliability.
Admittedly, evaluation of narratives often requires a lot of patience, diligence and expert knowledge. However, a reward may come in the form
of invaluable insights gained about a given company as well as about its
accounting numbers. As will be shown below, sometimes even just a single
sentence, hidden deeply in an annual report, may constitute a very important
warning signal.
5.3.1 OCZ Technology Group Inc.
OCZ Technology Group Inc. is a company which is mentioned repeatedly in this book, since multiple warning signals may have been found in
its published financial statements, before their restatement (followed by the
company’s bankruptcy) in 2013. The company specialized in designing and
manufacturing various types of computer hardware (particularly Solid State
Drivers) and reported a fast growth of revenues in its fiscal years ending
February 29/28, 2010–2012. Table 5.7 contains selected extracts from the
narrative part of the OCZ Technology Group’s annual report for fiscal year
ended February 29, 2012.
5 Evaluation of Financial Statement Reliability …
149
Table 5.7 Selected extracts from the narrative information disclosed in the annual
report of OCZ Technology Inc. for fiscal year ended February 29, 2012
Customer Service
We seek to build brand loyalty by offering product warranties, comprehensive return and
replacement policies and accessible technological support. […]
Backlog
Sales of our products are generally made pursuant to purchase orders. Since orders
constituting our current backlog are subject to changes in delivery schedules or cancelation
with only limited or no penalties, we believe that the amount of our backlog is not
necessarily an accurate indication of our future net sales.
Sales to a limited number of customers represent a significant portion of our net sales,
and the loss of any key customer would materially harm our business
[…] We have experienced cancellations of orders and fluctuations in order levels from period
to period and expect that we will continue to experience such cancellations and fluctuations
in the future. Customer purchase orders may be canceled and order volume levels can be
changed, canceled or delayed with limited or no penalties. We may not be able to replace
canceled, delayed or reduced purchase orders with new orders.
Order cancellations or reductions, product returns and product obsolescence could result
in substantial inventory write-downs
To the extent we manufacture products in anticipation of future demand that does not
materialize, or in the event a customer cancels or reduces outstanding orders, we could
experience an unanticipated increase in our inventory. Slowing demand for our products
may lead to product returns which would also increase our inventory. In the past, we have
had to write-down inventory due to obsolescence, excess quantities and declines in market
value below our costs.
Risk related to our debt
[…]
On May 10, 2012 we signed an agreement with Wells Fargo Capital Finance (“WFCF”) for a
$35 million senior secured credit facility […]. As in the SVBA Agreement, borrowings under
the WFCF facility are limited to a borrowing base based on our receivables.
Revenue recognition
[…] Revenue is recognized when there is persuasive evidence of an arrangement, product
shipment by a common carrier has occurred, risk of loss has passed, the terms are fixed and
collection is probable. We generally use customer purchase orders and/or contracts as
evidence of an arrangement and the underlying payment terms to determine if the sales
price is fixed. […]
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
29, 2012
The following general conclusions may be formulated on the ground of
disclosures quoted in Table 5.7:
• The company granted product warranties and offered product return
and replacement options. Consequently, it must have regularly estimated
and recognized some provisions for warranties and returns (which are
150
J. Welc
always prone to multiple subjective judgments and should be scrutinized
diligently).
• The company accepted customer orders which could have been be
canceled “with only limited or no penalties”. It admitted that in the past
it “experienced cancellations of orders and fluctuations in order levels from
period -to-period ”. This made forecasting revenues, cost of sales, inventories and cash flows very difficult, if not impossible at all. This also entailed
an increased risk of stockpiling excess inventories of goods with a very fast
pace of technological obsolescence. In fact, the company confirmed that
in the past it had to “write down its inventory due to obsolescence, excess
quantities and declines in market value”.
• The company had debts whose outstanding amounts were directly linked
to carrying amount of its receivable accounts (which, as may be supposed,
constituted a primary collateral for these borrowings). Accordingly, in
times of deteriorating market conditions (e.g. during an economic slowdown), when the company’s backlog and sales prices got under pressure,
its managers could have been tempted to push sales aggressively, in order
to protect revenues, earnings and receivables from falling. Furthermore, a
direct link between the company’s receivables and its borrowing capacity
may have constituted an incentive to keep estimated allowances for uncollectible accounts (bad debts), as well as a provision for product returns, as
low as possible (which implied an increased risk of earnings and net asset
overstatements).
All in all, the OCZ Technology Group’s business operations implied significant accounting risks. Any investor or analyst, investigating the company’s
financial statements included in its annual report for the fiscal year ended
February 29, 2012, should have been aware of an increased load of subjective
judgments and rather high risk of accounting misrepresentations, caused by
the company’s sales policy (featured by a generous product return and order
cancelation options granted to customers), limited predictability of inventories (and consequently revenues and cost of sales) and direct linkages between
the company’s receivable accounts and its borrowing capacity. A legitimacy of
such concerns was corroborated one year later, when OCZ Technology Group
published its annual report for fiscal year ended February 28, 2013, in which
it restated its previously issued financial statements.
Table 5.8 contains selected extracts from Note 2 to consolidated financial
statements of OCZ Technology Inc. for fiscal year ended February 28, 2013,
regarding the company’s restatement of previously issued financial statements.
5 Evaluation of Financial Statement Reliability …
151
Table 5.8 Selected extracts from Note 2 to consolidated financial statements of OCZ
Technology Inc. for fiscal year ended February 28, 2013
Note 2: Restatements of Previously Issued Financial Statements
[…] In October 2012, the Audit Committee engaged a legal firm to lead an independent
investigation into certain accounting practices. In turn, the independent legal firm engaged a
forensic accounting firm to provide consulting services in connection with the independent
investigation […]. As a result of the internal assessment and the evaluation of the substance
of information obtained during the independent investigation (collectively the
“Investigation”), as discussed further below, the Company concluded that errors had been
made in its previously issued consolidated financial statements. Accordingly, […]
adjustments were made, and the Company’s consolidated financial statements as of and for
the fiscal years ended February 28/29, 2012, and 2011, […] are being restated. These
adjustments are described below:
a) […]
b) The Company’s revenue recognition policy provides for revenue to be recognized
upon shipment, provided certain criteria are met. In connection with the results of
the Investigation, the Company determined that there were some sales that did not
meet the criteria for revenue recognition in the period in which the sale had
originally been recognized. These sales were primarily related to distributor
customers who either were offered return rights, were not able to pay the
Company until they were able to resell to their end customers or who required the
Company to perform postdelivery obligations. Consequently, since the Company
had originally recorded these sales as revenue upon shipment, it recorded
adjustments to defer these sales […].
c) The Company received a significant increase in product returns from its customers
beginning in the second quarter of fiscal 2013. In connection with the results of the
Investigation, management and the Audit Committee concluded that due to the
amount and product mix of inventory the Company’s customers were holding,
these sales had not met the criteria for revenue recognition as the fees were
considered to not be fixed and determinable at the time of shipment. Consequently,
as these sales had been accounted for as revenue in financial periods beginning in
the third quarter of fiscal 2012 through the first quarter of fiscal 2013, the Company
reversed the revenue in the period in which the sales had originally been
recognized. […]
d) In connection with the Investigation, the Company reevaluated its original estimate
of the allowance for the product it expected to be returned, and consequently,
increased its allowance for sales returns. This increased estimate for sales returns
accounted for reductions of revenue and accounts receivable […].
e) After recording the adjustments to revenue described above, the cost of revenue
exceeded the net revenue recognized for certain sales transactions. […], the
Company evaluated whether this negative gross margin might indicate an
impairment of existing inventory at each prior financial period. This analysis
resulted in increases to cost of revenue and the corresponding inventory reserves
[…].
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
28, 2013
152
J. Welc
The main conclusions, which may be derived from reading of these narratives,
can be summarized as follows:
• In its prior financial statements the company applied an aggressive revenuerelated accounting policy, resulting in a premature recognition of some
sales (which, in turn, boosted not only the company’s reported revenues
and earnings, but also overstated its receivable accounts, that constituted a
contractual base for the company’s borrowings).
• The aggressive revenue recognition policy was related not only to product
return options, granted to the company’s customers, but also to arrangements regarding the final sales prices (which, as it has turned out in the
case of some transactions, were not fixed or determinable at the time of
product shipment).
• The increasing volume of product returns brought about not only a
downward restatement of the company’s previously reported revenues and
earnings, but also resulted in increased inventory write-downs.
To summarize, the case of OCZ Technology Group Inc. teaches that
a careful reading of narratives included in corporate annual reports may
reveal a lot of relevant information, regarding not only nuances of a given
company’s financial reporting policy, but also its business model and resulting
accounting uncertainties.
5.3.2 Sino-Forest Corp.
Sino-Forest Corp. was a Chinese wood industry business, whose managers
committed an accounting fraud. The company’s reported growth, followed
by its sharp demise, constitutes a valuable educative case study, which will be
investigated with more details later in this book. In this section, an attention
will be paid to the company’s accounting policy.
As may be read in Table 5.9, which refers to the Sino-Forest’s approach to
revenue recognition, the company booked revenues from a standing timber
when it entered a sales contract. Such a policy is definitely unusual and should
be considered aggressive, since a recognition of revenues and profits from any
sales should be deferred until when all major risks and rewards (economic
benefits), related to a subject of a transaction, are transferred from vendor to
its customer. Any revenue recognized earlier should be treated as premature
and resulting in an overstatement of reported profits and net assets, particularly in a standing wood business, where significant product-related risks
(e.g. a fire) are at least shared by a seller until when its customer obtains a full
5 Evaluation of Financial Statement Reliability …
153
Table 5.9 Extracts from Note 1 to consolidated financial statements of Sino-Forest
Corp. for fiscal year 2012
Note 1: Significant accounting policies
Revenue recognition
Revenue from standing timber is recognized when the contract is entered into which
establishes a fixed and determinable price with the customer, collection is reasonably
assured and the significant risks and rewards of ownership have been transferred to the
customer.
Revenue from wood product contracts is recorded based on the percentage-of-completion
method, determined based on total costs incurred to expected total cost of the project and
work performed. Revenues and costs begin to be recognized when progress reaches a stage
of completion sufficient to reasonably determine the probable results. Any losses on such
projects are charged to operations when determined.
Revenue from the sale of logs and other products is recognized when the significant risks
and rewards of ownership of the logs and other products have been transferred to the
customer, usually on the delivery of the goods when a fixed and determinable price is
established.
Source Annual report of Sino-Forest Corp. for fiscal year 2012
physical possession of the products. In other words, a single sentence in Note
1 to Sino-Forest’s financial statements should have warned anyone investigating its reported numbers about their likely low reliability and a high risk
of revenue and profit overstatements.
These legitimate concerns were confirmed in a long and detailed fraud
investigation report, published in 2017 by the Ontario Securities Commission (which oversees the Canadian capital market, where Sino-Forest’s shares
have been listed). An extract from this document is presented in Table 5.22
(in the appendix). As may be read there, the market supervisor concluded
that Sino-Forest’s “sales contract process was fundamentally flawed ”. According
to the investigator’s findings, the company’s revenue recognition policy was
not only premature, but also deceitful in that it included booking revenues
from contracts which contained significant conditions and which could have
been canceled.
To conclude, the Sino-Forest’s example shows that sometimes even a single
sentence in the whole annual report may constitute a significant “red flag” and
may warn a financial statement user against likely earnings manipulations.
5.3.3 AbbVie Inc.
Another interesting example is AbbVie Inc., a pharmaceutical company
featured by a high product concentration (meant as a high share of a single
154
J. Welc
Table 5.10 Extract from a description of major business risks faced by AbbVie Inc.,
included in the company’s annual report for fiscal year 2018
Risks Related to AbbVie’s business
The expiration or loss of patent protection and licenses may adversely affect AbbVie’s
future revenues and operating earnings.
AbbVie relies on patent, trademark and other intellectual property protection in the
discovery, development, manufacturing and sale of its products. In particular, patent
protection is, in the aggregate, important in AbbVie’s marketing of pharmaceutical products
in the United States and most major markets outside of the United States. Patents covering
AbbVie products normally provide market exclusivity, which is important for the profitability
of many of AbbVie’s products.
As patents for certain of its products expire, AbbVie will or could face competition from
lower priced generic or biosimilar products. The expiration or loss of patent protection for a
product typically is followed promptly by substitutes that may significantly reduce sales for
that product in a short amount of time. […]
[…] The United States composition of matter patent for HUMIRA, which is AbbVie’s largest
product and had worldwide net revenues of approximately $19.9 billion in 2018, expired in
December 2016, and the equivalent European Union patent expired in the majority of
European Union countries in October 2018.
Source Annual report of AbbVie Inc. for fiscal year 2018
Table 5.11 Net revenues, operating expenses and operating earnings of AbbVie Inc.
in fiscal years 2016–2018
Data in USD million
Net revenues
2016
2017
2018
25.638
28.216
32.753
Cost of products sold
5.832
7.042
7.718
Selling, general and administrative
5.881
6.295
7.399
Research and development
Acquired in-process research and
d
Otherl expense
4.385
5.007
10.329
200
327
424
–
–
500
16.298
18.671
26.370
9.340
9.545
6.383
17,1%
17,7%
31,5%
Total operating costs and expenses
Operating earnings
Share of R&D expenses in net
revenues
=4.385/25.638 =5.007/28.216 =10.329/32.753
Source Annual report of AbbVie Inc. for fiscal year 2018 and authorial computations
product in the company’s sales breakdown). As may be read in Table 5.10,
which contains an extract from the company’s description of its major
business risks, worldwide revenues it obtained from sales of Humira drug
amounted to 19,9 USD million in 2018. Table 5.11, in turn, informs that in
the same period the AbbVie’s total revenues amounted to 32,8 USD billion.
5 Evaluation of Financial Statement Reliability …
155
Accordingly, the Humira’s share in the company’s total revenues was 60,7%
[=19,9 USD billion/32,8 USD billion] in 2018.
The narratives quoted in Table 5.10 also address business risks implied
by such a high weight of a single drug in the AbbVie’s product portfolio.
According to the company’s statements, “patent protection is […] important in
AbbVie’s marketing of pharmaceutical products”, since patents “provide market
exclusivity, which is important for the profitability”. However, the last paragraph of these narratives informs that the patent protection for Humira drug
expired in December 2016 in the United States and in October 2018 in
the European Union. Obviously, in light of the high prior contribution of
Humira to the company’s total revenues, combined with the recent expiration of its patent protection, at the beginning of 2019 the company faced a
turnaround moment in its history. As it stated outright, “the expiration or loss
of patent protection for a product typically is followed promptly by substitutes that
may significantly reduce sales for that product in a short amount of time ”.
Consequently, the only way to bridge an expected gap in sales, brought
about by a likely erosion of Humira-driven revenues, was either to discover
and patent new drugs or to acquire such patents from others (or a combination of both). Each of these approaches, however, requires significant cash
outflows, either on research and development (if the new patents are to
be internally developed) or on purchases of already patented drugs. In that
light anyone examining the AbbVie’s income statement numbers, shown in
Table 5.11, would probably have paid his or her attention to a doubling of a
monetary amount of the company’s research and development costs, between
2017 and 2018. Not only the amount of those expenses grew from 5,0 USD
billion to 10,3 USD billion, but also their share in the company’s annual
revenues rose from below 18% (in both 2016 and 2017) to 31,5%. In other
words, crude numbers reported in the company’s income statement could
have suggested that in 2018 AbbVie Inc. dramatically intensified its R&D
efforts, aimed at discovering and patenting new products (intended to replace
Humira as prospective revenue drivers).
However, the reality was somewhat different. A careful reading of notes
to the company’s financial statements for fiscal year 2018 would reveal the
narrative explanations quoted in Table 5.12. As may be read, in 2018 the
company conducted an impairment test for one of its IPR&D (in-process
research and development) intangible assets, Rova-T, which it acquired as
part of its takeover of the Stemcentrx company. According to the company’s
estimates, recoverable value of that asset fell to 1,0 USD billion, from its
earlier carrying amount of 6,1 USD billion, entailing the asset impairment
charge (expensed in the income statement) of 5,1 USD billion. As may be
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J. Welc
Table 5.12 Extracts from Note 7 to consolidated financial statements of AbbVie Inc.
for fiscal year 2018
Note 7: Goodwill and Intangible Assets
Indefinite-Lived Intangible Assets
During the fourth quarter of 2018, the company made a decision to stop enrollment for the
TAHOE trial, a Phase 3 study evaluating Rova-T as a second-line therapy for advanced small
cell lung cancer following a recommendation from an Independent Data Monitoring
Committee. This decision lowered the probabilities of success of achieving regulatory
approval across Rova-T and other early-stage assets and represented a triggering event
which required the company to evaluate for impairment the IPR&D assets associated with
the Stemcentrx acquisition. The company utilized multi-period excess earnings models of
the “income approach” and determined that the current fair value was $1.0 billion as of
December 31, 2018, which was lower than the carrying value of $6.1 billion and resulted in a
pre-tax impairment charge of $5.1 billion ($4.5 billion after tax). The fair value
measurements were based on Level 3 inputs. Some of the more significant assumptions
inherent in the development of the models included the estimated annual cash flows for
each asset (including net revenues, cost of sales, R&D costs, selling and marketing costs and
working capital/contributory asset charges), the appropriate discount rate to select in order
to measure the risk inherent in each future cash flows stream, the assessment of each
asset’s life cycle, the regulatory approval probabilities, commercial success risks,
competitive landscape as well as other factors. This impairment charge was recorded to
R&D expense in the consolidated statement of earnings for the year ended December 31,
2018. AbbVie continues to evaluate information as it becomes available with respect to the
Stemcentrx-related clinical development programs and will monitor the remaining IPR&D
assets for future impairment.
Source Annual report of AbbVie Inc. for fiscal year 2018
read in the bottom part of Table 5.12, “this impairment charge was recorded
to R& D expense in the consolidated statement of earnings for the year ended
December 31, 2018”.
In other words, the total amount of research and development expenses
reported on the face of the AbbVie’s income statement for 2018 (i.e. 10,3
USD billion) included the asset impairment charge (amounting to 5,1 USD
billion), related to estimated erosion of recoverable value of one of the
company’s acquired R&D projects. This meant that “real” research and development expenditures, incurred by the company in 2018, amounted to 5,2
USD billion [=10,3 USD billion – 5,1 USD billion], i.e. constituted slightly
more than a half of total amount expensed on the face of the company’s
income statement. This also meant that the research and development costs
incurred in 2018 constituted 15,9% of the company’s annual revenues [=5,2
USD billion/32,8 USD billion], i.e. less than in the preceding two years
by approximately 1,2–1,8 percentage points. The company which seemed to
increase its R&D intensity significantly (by doubling the amount “spent” on
research and development), now presents a different picture.
5 Evaluation of Financial Statement Reliability …
157
The case study of AbbVie Inc. differs from the examples of OCZ Technology Inc. and Sino-Forest Corp., discussed earlier in this section, in that it
does not relate to any accounting irregularities or financial statement fraud.
Instead, it teaches that a composition of individual line items of primary
financial statements may be “deciphered” not only on the basis of numerical
data disclosed in notes, but also with the use of narratives dispersed across
corporate annual reports.
5.3.4 Fresenius Group
The example of Fresenius Group, a German healthcare company, deals with
yet different issues than those illustrated by the preceding case studies.
Namely, it relates to objective weaknesses of accounting regulations, regarding
financial statement consolidation and accounting for noncontrolling interests
(discussed with more details in Sect. 2.2 of Chapter 2, Sect. 6.4 of Chapter 6
and Sect. 10.2 of Chapter 10). Table 5.13 contains an extract from Note 1 to
Table 5.13 Extracts from Note 1 to consolidated financial statements of Fresenius
Group for fiscal year 2018
Note 1: Principles
I: Group Structure
Fresenius is a global health care group with products and services for dialysis, hospitals and
outpatient medical care. In addition, the Fresenius Group focuses on hospital operations
and also manages projects and provides services for hospitals and other health care facilities
worldwide. Besides the activities of the parent company Fresenius SE & Co. KGaA, Bad
Homburg v. d. H., the operating activities were split into the following legally independent
business segments in the fiscal year 2018:
• Fresenius Medical Care
• Fresenius Kabi
• Fresenius Helios
• Fresenius Vamed
[…]
Fresenius SE & Co. KGaA owned 30,75% of the subscribed capital of Fresenius Medical Care
AG & Co. KGaA [FMC-AG & Co. KGaA] at the end of the fiscal year 2018. Fresenius Medical
Care Management AG, the general partner of FMC-AG & Co. KGaA, is a wholly owned
subsidiary of Fresenius SE & Co. KGaA. Through this structure, Fresenius SE & Co. KGaA has
rights that give Fresenius SE & Co. KGaA the ability to direct the relevant activities and,
hence, the earnings of FMC-AG & Co. KGaA. Therefore, FMC-AG & Co. KGaA is fully
consolidated in the consolidated financial statements of the Fresenius Group.
[…]
Source Annual report of Fresenius Group for fiscal year 2018
158
J. Welc
the company’s financial statements for fiscal year 2018, explaining its group
structure.
As may be read, one of the major subsidiaries of Fresenius SE & Co. KGaA
(a parent company within Fresenius Group) is Fresenius Medical Care, in
which case the controlling entity holds only 30,75% of shares. Accordingly,
the parent company controls its subsidiary despite holding a minority interest
in its subscribed capital. The remaining shares reflect noncontrolling interests,
which constitute a free float traded on the Frankfurt Stock Exchange (since
both the parent, as well as its subsidiary, are public companies).
As was explained in the preceding chapters, despite holding only 30,75%
of shares in the subsidiary’s equity, the parent company fully consolidates
its results. Consequently, consolidated revenues, profits and net assets of
Fresenius Group include 100% of respective amounts reported by Fresenius Medical Care, despite the fact that almost 70% of these amounts
are attributable to noncontrolling shareholders of the subsidiary. As was
illustrated in Sect. 2.2 of Chapter 2, such a high share of noncontrolling
(although majority) interests in equity of one of the parent’s controlled entities may seriously distort a reliability of the parent’s consolidated financial
statements. Therefore, the narrative disclosures cited in Table 5.13 are useful
in making crude estimates of a given subsidiary’s contribution to the amounts
reported in various line items of consolidated financial statements.
Table 5.14 presents selected accounting numbers, extracted from consolidated financial statements of Fresenius SE & Co. KGaA (the parent company
within Fresenius Group) and its major subsidiary, Fresenius Medical Care. As
clearly seen, the subsidiary which is controlled despite the parent’s minority
interest (30,75%) in its equity, contributed significantly to the consolidated financial results reported for 2018 by the whole Fresenius Group. For
instance, the subsidiary’s operating profit, included in full in the consolidated results, made up 57,9% [=3.038 EUR million/5.251 EUR million]
of the Fresenius Group’s operating profit, even though as much as 2.104
EUR million from that amount [=69,25% × 3.038 EUR million] was
attributable to noncontrolling interests. Likewise, the Fresenius Group’s
current liquidity ratio, computed as a quotient of current assets to current
liabilities and equaling 1,11 [=14.790 EUR million/13.275 EUR million],
was inflated by the Fresenius Medical Care’s ratio of 1,25 [=7.847 EUR
million/6.268 EUR million], even though 69,25% of the subsidiary’s current
assets were attributable to shareholders other than its controlling entity.
Clearly, the narrative disclosures cited in Table 5.13 are valuable in assessing
the possible distortions of the Fresenius Group’s consolidated accounting
5 Evaluation of Financial Statement Reliability …
159
Table 5.14 Selected financial statement data of Fresenius SE & Co. KGaA (the parent
company within Fresenius Group) and Fresenius Medical Care for fiscal year 2018
Data in EUR million
Income
statement
data
Balance
sheet data
Cash flow
statement
data
Sales revenues
Operating income
Net income, including:
Noncontrolling interests
Current assets
Total assets
Current liabilities
Total liabilities
Operating activities
Investing activities
Financing activities
Consolidated Consolidated
data of
data of
Fresenius
Fresenius
Group Medical Care
33.530
16.545
5.251
3.038
3.714
2.226
1.687
244
14.790
7.847
56.703
26.242
13.275
6.268
31.695
13.340
3.742
2.062
−1.464
−245
−1.273
−682
Share of parent
in the equity of
Fresenius
Medical Care
30,75%
*Noncontrolling interests
Source Annual reports of Fresenius Group and Fresenius Medical Care for fiscal year
2018
numbers, brought about by high participation of noncontrolling interests in
its subsidiary’s subscribed capital.
5.3.5 Electronic Arts Inc. and Take-Two Interactive
Software Inc.
The final example in this section of the chapter is based on extracts from
annual reports of two video game makers, Electronic Arts Inc. and TakeTwo Interactive Software Inc. Both firms operate in the same industry and
both report their financial results under US GAAP (US Generally Accepted
Accounting Principles). However, as will be seen, this does not guarantee that
their financial statements are fully comparable.
Table 5.15 contains an extract from Note 1 to consolidated financial
statements of Electronic Arts Inc., describing its accounting policy toward
software development costs. As may be read, the company’s approach seems
to be rather conservative, given that its “software development costs that have
been capitalized to date have been insignificant ”. This, in turn, is due to the
company’s practice of developing new games, under which “the technological feasibility of the underlying software is not established until substantially all
product development and testing is complete, which generally includes the development of a working model ”. In other words, the company expenses virtually
160
J. Welc
Table 5.15 Extract from Note 1 to consolidated financial statements of Electronic
Arts Inc. for fiscal year 2018
Note 1: Description of Business and Summary of Significant Accounting Policies
Software Development Costs
Research and development costs, which consist primarily of software development costs,
are expensed as incurred. We are required to capitalize software development costs
incurred for computer software to be sold, leased or otherwise marketed after technological
feasibility of the software is established or for the development costs that have alternative
future uses. Under our current practice of developing new games, the technological
feasibility of the underlying software is not established until substantially all product
development and testing is complete, which generally includes the development of a
working model. Software development costs that have been capitalized to date have been
insignificant.
Source Annual report of Electronic Arts Inc. for fiscal year 2018
Table 5.16 Extract from Note 1 to consolidated financial statements of Take-Two
Interactive Software Inc. for fiscal year 2018
Note 1: Basis of Presentation and Significant Accounting Policies
Software Development Costs and Licenses
[…]
We capitalize internal software development costs […] , subsequent to establishing
technological feasibility of a software title. Technological feasibility of a product includes the
completion of both technical design documentation and game design documentation.
Significant management judgments are made in the assessment of when technological
feasibility is established. For products where proven technology exists, this may occur early
in the development cycle. Technological feasibility is evaluated on a product-by-product
basis.
[…]
Source Annual report of Take-Two Interactive Software Inc. for fiscal year 2018
all of its software development expenditures as they are incurred (with only
insignificant amounts of these expenditures landing on the balance sheet as
intangible assets).
In contrast, Table 5.16 informs that Take-Two Interactive Software Inc.
capitalizes its internal software development costs, “subsequent to establishing technological feasibility of a software title”. According to the company’s
statement, “technological feasibility […] includes the completion of both technical design documentation and game design documentation”, which means
that “significant management judgments are made in the assessment of when
technological feasibility is established ”.
Comparison of both companies’ statements leads to a conclusion that
Take-Two Interactive Software applies a less conservative approach, since
5 Evaluation of Financial Statement Reliability …
161
it begins capitalizing software development costs on earlier stages in the
R&D process (i.e. once the technical and game design documentation is
completed), as compared to Electronic Arts, who defers its cost capitalization
until almost the end of the whole work on a new product. Consequently,
even though both video game makers report under the same accounting
standards (US GAAP), their reported earnings, net assets and operating cash
flows should not be compared blindly, due to significant differences in their
accounting treatment of software development expenditures.
This example illustrates the usefulness of narrative disclosures in comparative financial statement analyses, as well as in a relative valuation of businesses
(on the basis of multiples such as price-to-earnings or price-to-book value).
Any significant intercompany differences in an accounting treatment of
similar economic items (such as R&D or software development costs) should
be adjusted for, if possible, with the use of analytical techniques presented in
Sect. 9.4 of Chapter 9.
5.4
Discrepancies Between Operating Profits
and Operating Cash Flows
In the short-run corporate accounting earnings may deviate significantly from
cash flows. There may be multiple causes of such short-term discrepancies,
including business-related factors (e.g. an accumulation of inventories as a
result of a launch of new points of sales) as well as accounting issues (e.g.
asset write-downs or revenue deferrals). However, in the longer run changes of
earnings and cash flows of healthy businesses tend to be positively correlated,
particularly in case of operating profits and operating cash flows. Therefore,
one of the crude symptoms of unsustainability of reported operating profits is
their growth at a pace which significantly exceeds the pace of growth of operating cash flows (Sloan 1996; Lee et al. 1999; Xie 2001; Chan et al. 2006).
If the latter lags behind the former for several periods in a row (particularly if
rising profits are accompanied by shrinking or negative cash flows), then the
reported profits deserve a high dose of skepticism.
In all the following examples operating cash flows will be compared to
EBITDA-level earnings. This is aimed at increasing a measurement coherence
between both compared variables. While profits reported in income statements (including operating, pre-tax and after-tax earnings) are reduced by
depreciation and amortization charges (which constitute part of total operating expenses), reported operating cash flows are arrived at after adding
back these noncash depreciation and amortization costs. Therefore, EBITDA
162
J. Welc
Table 5.17 Selected financial statement data of Toys “R” Us Inc. for fiscal years
ended January 28–31, 2015, 2016 and 2017
Fiscal years ended
Data in USD million
January 31,
2015
January 30,
2016
January 28,
2017
191
378
460
Operating earnings
Income
statement
data
Depreciation and amortization
377
343
317
EBITDA*
568
721
777
Cash flow
statement
data
Cash flows from operating activities
476
238
−1
Cash flows from investing activities
−193
−210
−210
Cash flows from financing activities
−191
−27
81
*Operating earnings + Depreciation and amortization
Source Annual report of Toys “R” Us Inc. for fiscal year ended January 28, 2017, and
authorial computations
(computed by adding back depreciation and amortization to reported operating income), instead of reported operating profit, will be used in all the
following comparisons of accounting earnings and cash flows.
5.4.1 Toys “R” Us Inc.
Table 5.17 contains data reported by Toys “R” Us Inc. for three fiscal years
before its bankruptcy filing (submitted at the court in September 2017).
As might be seen, in the three years preceding the company’s default its
reported operating profits and operating cash flows showed opposite trends.
While operating earnings and EBITDA grew steadily, cash flows from operating activities eroded systematically, to a slightly negative amount in fiscal
year ended January 28, 2017 (for which the company reported positive operating earnings of 460 USD million). Obviously, such discrepancies were not
sustainable for longer and must have been followed either by a reversal (i.e.
an improvement of cash flow-generation capability) or by a loss of financial
liquidity. The latter happened in the case of Toys “ R” Us Inc., which filed
for a bankruptcy protection in September 2017.
5.4.2 21st Century Technology Plc
Another educative illustration of warning signals emitted by discrepancies
between accounting earnings and cash flows is 21st Century Technology plc
(the company listed on the London Stock Exchange). Table 5.18 presents
its selected accounting data reported for 2011–2014. As might be seen, in
5 Evaluation of Financial Statement Reliability …
163
Table 5.18 Selected financial statement data of 21st Century Technology plc for
fiscal years 2011–2014
Data in GBP thousands
2011
2012
2013
2014
1.496
1.820
−223
−418
485
184
426
91
EBITDA*
1.981
2.004
203
−327
Cash flows from operating activities
1.811
−2
602
1.377
Cash flows from investing activities
−135
2.048
−320
−44
Cash flows from financing activities
0
−3.154
−653
0
Operating profit/loss
Income
statement
data
Cash flow
statement
data
Depreciation, amortization and
write-downs
*Operating earnings + Depreciation, amortization and write-downs
Source Annual reports of 21st Century Technology plc for fiscal years 2012–2014 and
authorial computations
2011 the company’s cash flows from operating activities seemed quite consistent with its reported profits. Although EBITDA exceeded operating cash
flows, the discrepancy was not very wide. In contrast, in 2012 an increase in
EBITDA (and even higher increase in reported operating profit) was accompanied by a collapse of operating cash flows, which fell to a marginally
negative amount. Such a sudden and wide gap between accounting earnings
and operating cash flows should have been treated as a strong warning signal,
suggesting a high likelihood of an incoming deterioration of the company’s
profitability. Indeed, in the following two years 21st Century Technology plc
reported operating losses.
5.4.3 Pescanova Group
Pescanova Group was a Spanish fish-product company which filed for
bankruptcy in early 2013. Later on the Spanish investigators found that
the company’s managers committed a massive accounting fraud, based on
multiple round-trip transactions, similar to those discussed in Sect. 3.3.5 of
Chapter 3. In a series of these transactions, which lasted for several consecutive years, Pescanova Group artificially “sold” its products to seemingly
unrelated but “friendly” firms. Then these goods have been repurchased by
the company, with several other “friendly” entities serving as intermediaries.
These artificial round-trip transactions were arranged with an intention to
overstate the company’s revenues and earnings, as well as to “improve” its
financial liquidity.
Selected Pescanova Group’s accounting data, for several years prior to the
company’s bankruptcy and detection of its accounting manipulations, are
164
J. Welc
Table 5.19 Selected financial statement data of Pescanova Group for fiscal years
2008–2011
Data in EUR million
Income
statement
data
Cash flow
statement
data
2008
2009
2010
2011
Operating income
97,0
101,7
106,5
121,9
Depreciation and amortization
41,4
48,0
56,9
61,7
138,4
149,7
163,4
183,6
Cash flows from operating activities
44,0
29,5
33,1
−89,0
Cash flows from investing activities
−212,5
−97,5
−30,9
−69,2
Cash flows from financing activities
297,3
17,7
29,4
169,3
EBITDA*
*Operating income + Depreciation and amortization
Source Annual reports of Pescanova Group for fiscal years 2009–2011 and authorial
computations
shown in Table 5.19. As may be seen, a simple comparison of the company’s
reported EBITDA and operating cash flows have generated repeated warning
signals. In each of the four investigated years the operating cash flows lagged
behind the constantly growing EBITDA by a significant margin. In the whole
four-year timeframe the cumulative operating cash flows, amounting to 17,6
EUR million [=44,0 + 29,5 + 33,1−89,0], constituted only 2,8% of the
company’s cumulative EBITDA of 635,1 EUR million [=138,4 + 149,7
+ 163,4 + 183,6]. Furthermore, the gap between the reported EBITDA
and operating cash flows widened gradually. While the operating cash flows
constituted 31,8% of the EBITDA in 2008, this quotient fell to 19,7 and
20,3% in 2009 and 2010, respectively. Finally, in 2011 the company’s operating cash flows turned deeply negative (from a positive amount in 2010),
despite the EBITDA growth by 12,4% y/y (i.e. from 163,4 EUR million to
183,6 EUR million). Clearly, in the Pescanova Group’s case a simple observation of the company’s reported EBITDA and cash flows (and their relative
trends) was able to warn financial statement users that something must have
been going wrong within the company.
5.4.4 Carillion Plc
Carillion plc was a British construction contractor who issued several profit
warnings in late 2017, and then filed for bankruptcy in early 2018. As may
be seen in Table 5.20, in all four fiscal years prior to the company’s default its
cash flows from operating activities lagged behind its EBITDA by significant
margins. While between 2013 and 2016 the Carillion’s cumulative reported
EBITDA amounted to 921,8 GBP million [=195,2 + 244,9 + 254,8 +
226,9], at the same time its operating cash flows totalled 192,0 GBP million
5 Evaluation of Financial Statement Reliability …
165
Table 5.20 Selected financial statement data of Carillion plc for fiscal years 2013–
2016
Data in GBP million
Income
statement
data
Cash flow
statement
data
2013
2014
2015
2016
150,9
200,1
209,4
181,9
44,3
44,8
45,4
45,0
EBITDA*
195,2
244,9
254,8
226,9
Cash flows from operating activities
−78,4
123,8
73,3
73,3
Profit from operations
Depreciation and amortization
Cash flows from investing activities
107,2
0,8
26,0
0,2
Cash flows from financing activities
−265,9
−71,7
−105,4
−84,4
*Profit from operations + Depreciation and amortization
Source Annual reports of Carillion plc for fiscal years 2014–2016 and authorial
computations
[=−78,4 + 123,8 + 73,3 + 73,3]. Accordingly, within the investigated fouryear timeframe the Carillion’s operating cash flows covered only about one
fifth [=192,0/921,8] of its accounting earnings (EBITDA). It is very important to emphasize that the company’s EBITDA exceeded its operating cash
flows sizeably in each of the four analyzed periods.
It is also worth noting that in the last two years prior to the company’s
collapse its cash flows from operating activities showed no trend (i.e. they
stood flat at 73,3 GBP million). At the same time the Carillion’s EBITDA
contracted moderately, by about 11% (i.e. from 254,8 GBP million in 2015
to 226,9 GBP million in 2016). However, a lack of any visible contrasts
between directions of period-to-period changes of reported profits and cash
flows does not mean that the latter did not generate significant warning
signals, since a continued very low coverage of EBITDA by operating cash
flows (less than one third in 2015 and 2016) constituted a strong “red flag”
itself.
5.4.5 Cowell e Holdings Inc.
A final example illustrating the usefulness of reported cash flows in spotting
turning points of corporate profitability is Cowell e Holdings Inc., one of the
major suppliers of front camera modules (components of smartphones) to
Apple Inc. The company reported a trend of growing revenues and earnings
until its fiscal year 2015, when a reversal of that prior trend came, followed
by several consecutive years of eroding revenues and profits.
As may be seen in Table 5.21, in 2014 a modest growth of the company’s
EBITDA (from 80,0 USD million to 83,8 USD million) was accompanied
by an impressive increase of its operating cash flows (which rose from 46,8
166
J. Welc
Table 5.21 Selected financial statement data of Cowell e Holdings Inc. for fiscal
years 2013–2016
Data in USD million
Income
statement
data
Cash flow
statement
data
2013
2014
2015
2016
Profit from operations
69,0
70,7
78,6
35,4
Depreciation and amortization
11,0
13,1
15,2
19,2
EBITDA*
80,0
83,8
93,8
54,6
Operating cash flows
46,8
87,6
61,0
1,3
Investing cash flows
−15,8
−22,6
−48,0
−67,0
Financing cash flows
0,6
−27,9
−15,9
72,9
*Profit from operations + Depreciation and amortization
Source Annual reports of Cowell e Holdings Inc. for fiscal years 2014–2016 and
authorial computations
USD million to 87,6 USD million). However, in the following period the
continued increase in EBITDA by almost 12% y/y (i.e. from 83,8 USD
million to 93,8 USD million) contrasted with shrinking cash flows from
operations, which fell by over 30% y/y (i.e. from 87,6 USD million to 61,0
USD million). As it turned out later on, that observed discrepancy between
the company’s profit and cash flow growth rates constituted a good predictor
of an upcoming contraction of its earnings in 2016 (when EBITDA fell by
almost 42% y/y, i.e. from 93,8 USD million to 54,6 USD million).
5.4.6 Conclusions
Comparison of operating profits with operating cash flows (together with an
auditor’s opinion) usually constitutes one of the first rough checks on sustainability of reported corporate earnings. Indeed, operating cash flows which lag
behind accounting earnings (particularly if the gap widens from period to
period) often precede negative earnings surprises. However, as will be shown
in the following chapter, reported cash flows are not always entirely reliable
and may emit false signals. It is not uncommon for bankrupt firms, as well as
those which commit a financial statement fraud, to report cash flows seemingly consistent with accounting earnings. Therefore, trends of profits and
cash flows should not be used as a sole indicator of reliability of the former.
They should always be investigated in combination with a more comprehensive set of other relevant signals, which will be presented in Chapters 7 and
8.
5 Evaluation of Financial Statement Reliability …
167
Appendix
See Table 5.22.
Table 5.22 Extract from the Ontario Securities Commission’s investigation report,
regarding accounting practices applied by Sino-Forest Corp
The sales contract process was fundamentally flawed. We find Sino-Forest employed
a deceitful documentation process whereby Sino-Forest drafted and executed sales
contracts in the quarter after they were dated and the revenue was recognized. We
find this resulted in Sino-Forest recognizing revenue […] in a manner that was
deceitful. In addition, we find Sino-Forest misled the Commission regarding its
revenue recognition process.
[…]
[…] the Panel heard expert testimony that sales contracts contained conditions (for
example, assisting the buyer to obtain harvesting permits) which, if not fulfilled,
would have the effect of rescinding the contract, the effect of which would be the
parties would return to their original positions, as if the contract between them never
existed. […]
Source Ontario Securities Commission: Sino-Forest Corporation (Re), 2017 ONSEC 27
(In the Matter of Sino-Forest Corporation, Allen Chan, Albert Ip, Alfred C.T. Hung,
George Ho, Simon Yeung and David Horsley), July 13, 2017
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6
Problems of Comparability and Reliability
of Reported Cash Flows
6.1
Introduction
As was stated in the preceding chapter, one of the crude symptoms of unsustainability of reported operating profits is their growth at the pace which
significantly and/or repeatedly exceeds the pace of growth of operating cash
flows. Accordingly, corporate cash flows constitute a standard tool used as a
check on credibility of earnings reported in an income statement. However,
as will be demonstrated in the following sections of this chapter, cash flow
statement itself is not immune to distortions and deliberate manipulations.
Weaknesses of reported cash flows may have an objective nature, i.e. they
may be related to inherent flaws of accounting methods. However, cash flow
data may become unreliable and incomparable also as a consequence of intentional use of some accounting gimmicks. As will be demonstrated, some of
the techniques of aggressive accounting, presented with details in Chapters 3
and 4, bring about equally (or even more) dangerous distortions of reported
cash flows.
6.2
Unreliability of Reported Cash Flows When
Cash Balances Themselves Are Falsified
Reported cash flows may be deemed reliable only as long as the company’s
reported cash balances themselves remain reliable. Fraudulent overstatements
of cash and cash equivalents, although relatively rare, happen from time to
time. Such manipulations constitute an outright accounting fraud, since they
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_6
169
170
J. Welc
must be accompanied by fabricated underlying documents, such as bank
confirmations of a given company’s cash deposits. Obviously, when cash
balances themselves are overstated, then the whole cash flow statement cannot
be relied upon. The cases of China MediaExpress Holdings Inc., Satyam
Computer Services Limited and Patisserie Holdings plc constitute great illustrations of dangers stemming from such fraudulent activities. Section 8.9
of Chapter 8 will provide another educative example of a ruined quality of
reported financial statements, brought about by falsified cash holdings.
6.2.1 China MediaExpress Holdings Inc.
Table 6.1 presents selected financial statement data of China MediaExpress
Holdings Inc. (a company which was listed on New York Stock Exchange).
As may be observed, between 2007 and 2009 both the company’s
accounting earnings as well as its cash provided by operating activities grew
fast. Therefore, its reported profits seemed to rise in tune with cash flows. As
a result of that seemingly high cash-generating capability, the company’s cash
balances (reported in its balance sheet) accumulated from 6,4 USD million
as at the end of 2007 to as much as 57,2 USD million as at the end of 2009.
One could obviously argue that the operating cash flows reported by China
MediaExpress Holdings Inc. did not cover its EBITDA in none of the three
investigated years, but these discrepancies seemed not to be that alarming
(given a continued growth of operating cash flows).
However, as may be read in Table 6.20 (in the appendix), all the numbers
disclosed in Table 6.1 turned out to be fabricated and had no relationship with the reality. The investigation conducted by the US Securities and
Table 6.1 Selected financial statement data of China MediaExpress Holdings Inc. for
fiscal years 2007–2009
Data in USD thousand
Income
statement
data
Cash flow
statement
data
Income from opera ons
Deprecia on of property and equipment
EBITDA*
2007
2008
2009
11.016
35.121
56.643
1.621
2.875
3.226
12.637
37.996
59.869
Net cash provided by opera ng ac vi es
12.105
27.396
46.244
Cash flows used in inves ng ac vity
−6.594
−1.315
−4.216
0
−1.884
−17.162
6.364
29.997
57.151
Net cash used in financing ac vi es
Cash at the end of the year
*Income from operations + Depreciation of property and equipment
Source Annual report of China MediaExpress Holdings Inc. for fiscal year 2009 and
authorial computations
6 Problems of Comparability and Reliability …
171
Exchange Commission and the US Court found that China MediaExpress
Holdings Inc. grossly inflated its reported cash balances. For instance, at the
end of its fiscal year 2009 it reported cash balances of 57,1 USD million,
while actually holding only 141 USD thousand. Since, as may be seen in
Table 6.1, an alleged increase in the company’s cash balances (from almost 30
USD million at the end of 2008 to over 57 USD million one year later) was
entirely attributable to its allegedly positive reported operating cash flows, the
latter must have been grossly overstated as well.
6.2.2 Satyam Computer Services Limited
Satyam Computer Services Limited, whose selected accounting numbers are
displayed in Table 6.2, constitutes a similar case to China MediaExpress
Holdings Inc. (discussed above). As may be seen, between 2006 and 2008
the company’s EBITDA, as well as its reported cash from operating activities, were in evident rising trends. Also, similarly to China MediaExpress, the
operating cash flows did not cover the company’s EBITDA in none of the
three investigated years (however, most analysts would probably not deem it
a very strong warning signal, in light of a steady growth of operating cash
flows).
As may be read in Table 6.21 (in the appendix), most of what was shown
in Table 6.2 was fake. According to the US SEC’s findings, the Satyam’s
managers committed a massive accounting fraud, based on multiple phony
invoices and bogus bank statements. As a result, the company’s reported
cash and cash-related balances have been inflated by as much as one USD
Table 6.2 Selected financial statement data of Satyam Computer Services Limited
for fiscal years 2006–2008
Data in USD million
2006
2007
2008
Income
statement
data
Opera ng income
219,7
291,6
408,7
Deprecia on and amor za on
EBITDA*
Net cash provided by opera ng ac vi es
31,5
251,2
162,7
33,6
325,2
261,5
41,5
450,2
339,1
Cash flow
statement
data
Net cash used in inves ng ac vity
−5,2
−422,7
−156,3
6,1
16,1
(54,6)
696,5
152,2
1.117,2
Net cash (used in)/provided by financing ac vi es
Cash and bank deposits at the end of the year**
*Operating income + Depreciation and amortization
**Including “Investments in bank deposits”, reported in a separate line item on the
company’s balance sheet
Source Annual reports of Satyam Computer Services Limited for fiscal years 2007–
2008 and authorial computations
172
J. Welc
billion. Obviously, such accounting shenanigans also meant a complete loss
of reliability of its reported cash flows.
6.2.3 Patisserie Holdings Plc
The final example presented in this section is Patisserie Holdings plc, a British
operator of a chain of cafeterias. As may be seen in Table 6.3, in its fiscal
years 2016–2018 the company reported positive earnings and operating cash
flows. Although its cash flows from operating activities were lower than its
EBITDA, the discrepancies seemed not very significant. The result of the
company’s alleged cash-generating capability (driven mostly by positive and
growing reported operating cash flows) was a gradually increasing balance of
its cash and cash equivalents.
However, as may be read in Table 6.22 (in the appendix), the financial
statements published by Patisserie Holdings plc (including its cash flows and
cash balances) were completely unreliable, since they were infected by an
accounting fraud. As it turned out in late 2018, instead of 28,8 GBP million
of cash holdings (as reported in the company’s interim financial report), it
had a net debt amounting to almost 10 GBP million. Cash shortages uncovered by the company’s managers were so huge that they endangered its very
existence. Obviously, when this type of an accounting fraud (i.e. a falsification
of corporate cash balances) is committed, then reported cash flow statement
loses its usefulness as a tool of evaluation of a financial statement reliability.
Table 6.3 Selected financial statement data of Patisserie Holdings plc for fiscal years
2016–2018
*Operating profit + Depreciation and amortization
Source Annual and interim reports of Patisserie Holdings plc and authorial
computations
6 Problems of Comparability and Reliability …
173
6.2.4 Conclusions
As was evidenced by published accounting data of China MediaExpress
Holdings, Satyam Computer Services and Patisserie Holdings, the cash flow
statement is not immune to fraudulent activities. When cash balances themselves are falsified (e.g. with use of fake documents allegedly confirming
balances of bank accounts), then reported operating cash flows may lose any
relationship with economic reality. This means that the corporate cash flows
should never be interpreted blindly and that their level and growth should
never be used as entirely trustful proxies for reliability of the whole financial
report. Instead, other analytical tools (such as those presented in Chapters 7
and 8) should also be applied in reviewing earnings sustainability. However,
as will be shown in Sect. 8.9 of Chapter 8 (with another real-life example, of
Redcentric plc), when cash balances and cash flows are manipulated, then
detecting such a fraud on the ground of published financial reports (i.e.
without access to corporate internal documents) may be very difficult.
6.3
Spurious Improvements in Operating Cash
Flows of Shrinking Businesses
Managers of some almost-bankrupt businesses attempt to rescue their enterprises (or at least delay a probable bankruptcy filing) by “clutching at straws”
and undertaking fire-sales of some assets. This is particularly common in
case of manufacturing firms, which stockpiled excess inventories (e.g. due to
overly optimistic sales forecasts) and/or huge receivable accounts, in periods
prior to a loss of liquidity. In fact, money tied up in those excess inventories
and receivables often constitutes a direct cause of the following financial troubles, since a company’s inability to convert those assets into cash in a normal
course of business entails an inability to repay its trade payables to suppliers
(as well as to cover current operating expenses, such as payroll).
In such near-bankruptcy circumstances some activities undertaken by
managers (e.g. intensified factoring of receivable accounts or fire-sales of
inventories at deeply discounted prices), aimed at boosting financial liquidity
and rescuing the company, may be entirely legitimate. However, they may
also create a false impression that the company is improving its cashgenerating efficiency. This is because of positive one-off contributions of
changes in inventories and receivables to operating cash flows reported by
such troubled businesses in those periods. While the fire-sales of current
assets depress operating income, they also boost operating cash flows. This, in
174
J. Welc
turn, results in spurious improvements of some earnings quality ratios (such
as coverage of EBITDA by operating cash flows), as well as some financial
risk metrics (e.g. coverage of liabilities by operating cash flows). Consequently, when analyzing distressed businesses it is crucial to be aware that
such boosts to operating cash flows, brought about by managerial “emergency
actions”, are unsustainable if they are not accompanied by real and durable
improvements in a working capital efficiency (e.g. more accurate inventory
planning or more efficient collection of overdue receivables). Otherwise a
financial statement user may misinterpret positive and growing operating cash
flows (particularly if they stay above reported profits) as a signal of a given
company’s improving liquidity and earnings quality.
Similar problems are caused by unusually deep write downs of inventories and receivables, which reduce reported profits with no immediate real
cash flow implications. In such circumstances the depressed earnings (caused
by those one-off impairment charges) lag behind reported operating cash
flows, which may falsely suggest an improving reliability of the former. Also,
when corporate revenues fall with a fast pace (which is obviously unsustainable in the long-run), collections of receivables from past sales may surpass
the amounts of new receivables (resulting from current period sales), with a
spuriously positive but unsustainable contribution of changing receivables to
reported operating cash flows.
6.3.1 Admiral Boats S.A.
These problems will be firstly illustrated with the use of accounting data of
Admiral Boats S.A., a Polish public firm, which filed for bankruptcy (and
was liquidated afterwards) in 2017. It operated in a business of designing
and manufacturing motorboats (with over 60 models in its catalogue), in
several shipyards in Poland. The company’s output was distributed mostly on
Western European markets. Table 6.4 presents selected financial statement
data and accounting ratios of Admiral Boats for its 2013–2016 fiscal years.
As may be seen, in the investigated period the company’s revenues were
in a strong falling trend, which entailed a steady erosion of its operating
profit (from positive amounts in 2013–2014 to below a break-even point
in the following two years). Quite surprisingly, between 2013 and 2015 the
company’s reported gross margin on sales improved, despite falling sales.
However, it was accompanied by a sharply deteriorating turnover of inventories and receivables, with an operating cycle (i.e. summed turnovers of both
classes of current assets) extending from an already high level of 285,8 days
[=110,8 + 175,0] in 2013 to as many as 469,3 days [=177,6 + 291,7] in
6 Problems of Comparability and Reliability …
175
Table 6.4 Selected financial statement data and ratios of Admiral Boats S.A. for
fiscal years 2013–2016
*Gross profit on sales/Net sales
**(Inventories/Cost of goods sold) × 360
***(Receivables/Net sales) × 360
Source Annual reports of Admiral Boats S.A. for fiscal years 2014–2016 (published in
Polish only) and authorial computations
2015. Obviously, the investigated business suffered from an unsustainably
long time interval elapsing from a purchase of raw materials, through manufacturing and sale of finished goods, to a collection of receivable accounts.
Despite that, in 2015 the company’s reported operating cash flows stayed
positive (and much above the reported operating loss), and were boosted
positively by both inventories and receivables.
One might wonder how it was possible that in all three years between 2014
and 2016 the company’s turnover of receivables lengthened (from an already
high level in 2013), with changes in receivables positively contributing to
operating cash flows reported for all those years. The reason is that with such
a long and still lengthening receivables collection period (near or over 300
days in 2015–2016), a large fraction of receivables collected in a given year
stemmed from sales done in the preceding year. This, combined with deeply
falling annual revenues, entailed excesses of receivables collected or written
off in a given year (which to a large extent were related to prior year’s sales)
over newly recognized receivables, stemming from sales done in that year.
In other words, despite longer and longer time needed to collect receivables
(which is an unsustainable trend), contributions of changes in receivables to
operating cash flows stayed repeatedly positive, since the amounts of new
receivable accounts recognized in a given period (as a result of sales of goods
176
J. Welc
in that particular period) were lower than the amounts of collected receivables
(which to a large extent related to higher revenues generated in prior period).
Such inflows of cash from gradually falling receivables could not be
deemed sustainable, given a continued lengthening of the receivables
turnover. In Admiral Boat’s case, the annual revenues contracted by as much
as 67,9% between 2013 and 2016 (i.e. they fell from 48.460 PLN million to
15.565 PLN million), while the company’s receivables fell in the same period
by mere 41,2% (i.e. from 23.559 PLN million to 13.854 PLN million).
Consequently, despite falling carrying amounts of receivable accounts, it took
more and more days to collect them. Clearly, in such circumstances the positive contributions of changes in receivables to operating cash flows should
not be interpreted as a signal of a strong cash-generating capability.
Equally spurious signals may be generated by sudden inventory reductions,
which may result either from their deep write downs or extensive fire-sales
(or both). As might be seen, in 2014 the Admiral Boat’s inventories grew,
despite falling net sales and cost of goods sold. Consequently, the inventory turnover lengthened from 110,8 days in 2013 to 185,4 days in 2014.
In the following year, the company deeply reduced its inventories, but due
to the accompanying contraction of sales (and cost of goods sold) the inventory turnover improved only marginally. Despite that, inventories contributed
positively (by 6.222 PLN million) to operating cash flows, which would
otherwise be negative. Accordingly, as a result of deeply shrinking sales, in
2015 the inventory reduction boosted the company’s cash flows, without any
significant improvement in the inventory turnover (similarly as in the case of
receivables, discussed above). In contrast, in 2016 the company’s inventory
turnover improved strikingly (from almost half a year to 83,3 days), with
another positive contribution to the operating cash flows. However, a seemingly impressive shortening of the inventory turnover was accompanied by
a collapse of the company’s gross margin on sales, to a negative value (from
double-digit levels reported in prior years). This suggests an inventory firesale (at prices below unit manufacturing costs), which causes an immediate
injection of cash but does not necessarily reflect a real improvement in efficiency. Obviously, such cash inflows from one-off asset liquidations cannot
be deemed sustainable.
In both 2015 and 2016 the Admiral Boat’s operating cash flows stood
positive (with a total two-year amount of 5.746 PLN million), despite deep
operating losses (totaling 10.282 PLN million) reported for the same periods.
However, as explained above, it was mostly driven by unsustainable positive
contributions from reductions of receivables (which in turn resulted from
rapidly contracting sales, instead of improvements in receivable collection),
6 Problems of Comparability and Reliability …
177
combined with significant reductions of inventories (including likely fire-sales
at deeply discounted prices). All in all, such allegedly positive operating cash
flows could not be considered a sustainable source of financing. No wonder,
therefore, that the company had to file for bankruptcy in 2017.
6.3.2 Claire’s Stores Inc.
Another interesting lesson about spurious improvements in operating cash
flows is offered by Claire’s Stores Inc., a US-based retailer of jewelry and
accessories for women, teens and kids, which filed for bankruptcy in March
2018. Its selected financial statement data for fiscal years 2016 and 2017 are
shown in Table 6.5.
As may be seen, between the two investigated fiscal years the company’s
operating losses deepened, from 14,6 USD million to 63,7 USD million.
As a result, its EBITDA fell from 46,0 USD million to a negative amount
of 8,2 USD million. However, at the same time the company’s operating
cash flows seemingly improved, rising from a negative amount of 21,2 USD
million to a positive amount of 7,9 USD million. Accordingly, if “profit is an
accounting opinion, while cash is king ” (according to an old saying), then the
observed increase in the company’s operating cash flows should have preceded
the following improvement of its general financial position. However, a more
thorough investigation leads to a different conclusion.
As may be observed in the lower part of Table 6.5, the operating cash flows
reported by Claire’s Stores in its fiscal year ended January 28, 2017, were
hugely boosted by a deep reduction (by 19,5 USD million) of its inventories.
Table 6.5 Selected financial statement data of Claire’s Stores Inc. for fiscal years
2016 and 2017
Fiscal year
ended
January 30,
2016
Fiscal year
ended
January 28,
2017
Opera ng income (loss)
Income
statement Deprecia on and amor za on
data
EBITDA*
−14,6
−63,7
Cash flow Opera ng cash flows, including:
statement Increase (−)/decrease (+) in inventories
data
Increase (−)/decrease (+) in trade accounts payable
Data in USD million
60,6
55,5
46,0
−8,2
−21,2
−9,6
19,5
5,4
−3,2
7,9
*Operating income (loss) + Depreciation and amortization
Source Annual report of Claire’s Stores Inc. for fiscal year ended January 28, 2017,
and authorial computations
178
J. Welc
Without such a significant contribution of falling inventories, the company’s
operating cash flows would be negative and would amount to −11,6 USD
million [=7,9 USD million−19,5 USD million]. However, that boost to
the operating cash flows was unusual and unsustainable, since it reflected a
reduction of excess inventories accumulated in a prior fiscal year (when the
company’s inventories grew by 4,1% y/y, while at the same time its annual
net sales fell by 6,1% y/y). In other words, the operating cash flows reported
by Claire’s Stores Inc. for its fiscal year ended January 28, 2017, were boosted
by an unusually high reduction of inventories, which in turn reflected a oneoff “catch-up” adjustment of the company’s inventory level to its constantly
falling revenues. As it turned out, it could have not protected the company
from its bankruptcy (filed for in early 2018).
6.3.3 Cowell e Holdings Inc.
A final illustration of pitfalls of mechanical comparisons of trends in profits
and cash flows is based on the accounting numbers reported by Cowell e
Holdings Inc., whose selected data are presented in Table 6.6. As was demonstrated earlier, a comparison of the company’s EBITDA and operating cash
flows accurately indicated a turning point of its income trend. While in 2015
the company’s EBITDA grew by almost 12% y/y, its cash flows from operations contracted in the same period by over 30% y/y (which preceded an
erosion of its earnings in the following years). However, as may be seen in
Table 6.6, between 2016 and 2018, when the company’s revenues and profits
contracted continuously, the signals generated by its operating cash flows were
no longer that reliable.
Table 6.6 Selected financial statement data of Cowell e Holdings Inc. for fiscal years
2016–2018
Data in USD million
Revenue
2016
2017
2018
914,5
740,7
535,9
Income
statement
data
Profit from opera ons
35,4
31,1
14,3
Deprecia on and amor za on
19,2
22,7
24,2
EBITDA*
54,6
53,8
38,5
Cash flow
statement
data
Opera ng cash flows, including:
17,6
60,4
87,4
Decrease (+)/increase (−) in inventories
41,3
−47,3
40,7
Decrease (+)/increase (−) in receivables
−124,5
91,2
80,1
*Profit from operations + Depreciation and amortization
Source Annual reports of Cowell e Holdings Inc. for fiscal years 2017–2018 and
authorial computations
6 Problems of Comparability and Reliability …
179
In 2018 the revenues of Cowell e Holdings Inc. fell by 27,6% y/y (i.e. from
740,7 USD million to 535,9 USD million), after shrinking by almost one
fifth (i.e. from 914,5 USD million to 740,7 USD million) one year earlier.
Accordingly, within just two years the company’s annual net sales fell by as
much as over 41% (i.e. from 914,5 USD million to 535,9 USD million).
Such a huge contraction of a scale of operations must have affected reported
earnings. Indeed, the reported profit from operations eroded by 60% (i.e.
from 35,4 USD million in 2016 to 14,3 USD million in 2017), depressing
the company’s EBITDA. Meanwhile, within the same three-year timeframe
the company’s operating cash flows grew steadily, from 17,4 USD million in
2016 to as much as 87,4 USD million in 2018.
As may be observed in the lower part of Table 6.6, in the fiscal year 2016
(i.e. just after the company’s prior trend of growing revenues and earnings
suddenly reversed) the operating cash flowsgenerated by Cowell e Holdings
Inc. were heavily depressed by a huge accumulation (by as much as 124,5
USD million) of trade and other receivables. However, a significant erosion
of revenues experienced in the following years meant that the amounts of the
company’s receivables collected (stemming from higher prior sales) exceeded
the amounts of new receivables recognized (from lower and lower sales), with
materially positive contributions of decreases in receivables to the total operating cash flows. While in 2017–2018 the total cumulative operating cash
flows amounted to 147,8 USD million [=60,4 USD million + 87,4 USD
million], the balance of the company’s receivables fell in the same time by as
much as 171,3 USD million [=91,2 USD million + 80,1 USD million]. In
other words, without a reduction in the balance of the company’s receivables,
its total cumulative operating cash flows in 2017–2018 would be negative
and would amount to −23,5 USD million [=147,8 USD million − 171,3
USD million]. While collecting receivable accounts is obviously positive, in
this particular case it mostly reflected a rapidly eroding scale of business
operations of Cowell e Holdings Inc.
Similar, although not identical tendencies, were observed in case of the
company’s inventories, which also boosted its operating cash flows significantly (by almost 41 USD million) in 2018, after contributing negatively
in the preceding year. Cumulatively, between 2016 and 2018 the operating cash released by Cowell e Holdings Inc. from its inventories amounted
to 34,7 USD million [=41,3 USD million − 47,3 USD million + 40,7
USD million], which was consistent with a downscaling of the company’s
operations in those years.
180
J. Welc
6.3.4 Conclusions
As clearly shown by the examples of Admiral Boats S.A., Claire’s Stores Inc.
and Cowell e Holdings Inc., blind comparisons of period-to-period changes
in operating cash flows and accounting income may emit severely misleading
signals, as regards reliability of the latter. Relatively high (e.g. significantly
above EBITDA) or fast-growing cash flows from operations do not guarantee
a sustainability of reported profits, particularly if the former is boosted by
material one-off items (e.g. liquidations of stockpiled excess inventories) or
is featured by recurring positive contributions from falling working capital,
which in turn reflect an ongoing downscaling of a given company’s business
operations. However, as shown in the following sections, these are not the
only pitfalls of reported cash flows (as one of the tools of an earnings quality
assessment).
6.4
Distortions of Reported Cash Flows Caused
by Non-controlling Interests
6.4.1 Distorting Impact of Non-controlling Interests
on Reported Cash Flows
As was shown in Sect. 2.2 of Chapter 2, non-controlling interests (if significant) may seriously weaken the reliability and comparability of reported
consolidated income statement and consolidated balance sheet. However, as
presented in Example 6.1, reported consolidated cash flows may be seriously
distorted as well (Mulford and Dar 2012).
Suppose a hypothetical cascading ownership structure as the one presented
on Chart 6.1. Assume also that subsidiaries B and C do not run any operating
activities. Instead, their only assets are shares in other entities (Subsidiary B
owns 51% interest in equity of Subsidiary C, which in turn holds 51% shares
in equity of Subsidiary D). With such cascading relationships, Company
A controls all three subsidiaries, either directly (in case of Subsidiary B) or
indirectly (in case of companies C and D). If there are no any intragroup
transactions between these four firms, then the only stand-alone (separate)
cash flows generated within this group of companies are cash flows of the
parent Company A and its Subsidiary D.
Now imagine that in a given period companies A and D generated financial results as depicted in Example 6.1. As may be seen, in an investigated
period a parent entity generated negative operating cash flows of −4.200
181
6 Problems of Comparability and Reliability …
Example 6.1 Distortions of reported cash flows caused by non-controlling interests
(NCI)
Hypothe cal stand-alone and consolidated cash flows of Controlling En ty A, as well as its
subsidiaries, with the assumed group structure as presented on Chart 6.1 (no intragroup
transac ons have been assumed):
Cash flow statement
Stand-alone (separate)
statements
Consolidated
statements
Parent
EnƟty A
Subsidiary
D (owned
in 15%)
Full
consolidaƟon
ProporƟonal
consolidaƟon*
OperaƟng profit
1.000
2.500
3.500
1.375
Income tax
−200
−500
−700
−275
−3.000
0
−3.000
−3.000
−2.000
−4.200
2.500
500
4.500
300
−1.625
−3.525
Proceeds from disposal of
fixed assets**
3.000
0
3.000
3.000
InvesƟng cash flows
3.000
0
3.000
3.000
0
Financing cash flows
−1.500
−1.500
0
−1.500
−1.500
−1.500
−1.500
TOTAL CASH FLOWS
−2.700
4.500
1.800
−2.025
Gain on disposal of fixed
assets**
Change of inventory
OperaƟng cash flows
Interest on debt
*stand-alone cash flows of Parent EnƟty A + 15% of stand-alone cash flows of Subsidiary D
**assuming zero carrying amount of the sold PP&E (which implies an equality of the gain on a sale of PP&E
and cash proceeds from the disposal)
Source Author
EUR. It earned an operating profit of 1.000 EUR, but it was boosted by a
one-off gain (of 3.000 EUR) from a disposal of some fully depreciated fixed
assets. Consequently, on its core business a parent company incurred a loss
amounting to −2.000 EUR. Furthermore, the company was drained of cash
by an increase of its inventories by 2.000 EUR. Clearly, the parent company
does not seem to be very efficient in generating cash from core business operations. Its negative operating cash flows, combined with negative financing
cash flows (driven by payments of interest costs on debts) and mitigated by a
one-off cash inflow from a sale of fixed assets, resulted in a total cash outflow
of 2.700 EUR.
182
J. Welc
Controlling En ty A
Share in equity
of 57,7%
Subsidiary B („shell” company*)
Share in equity
of 51%
Subsidiary C („shell” company**)
The resul ng share of
Controlling En ty A
in shareholder’s equity
of Subsidiary D:
57,7% x 51% x 51% ≈ 15%
Share in equity
of 51%
Subsidiary D
Chart 6.1 Hypothetical cascading ownership structure within a group of companies
(*The only assets held by Subsidiary B are shares in Subsidiary C; **The only assets
held by Subsidiary C are shares in Subsidiary D. Source Author)
In contrast, the company’s fully consolidated but non-wholly owned
Subsidiary D reported much better (and more sustainable) stand-alone cash
flows in the same period, thanks to the operating profit of 2.500 EUR,
combined with a reduction of inventories by another 2.500 EUR. The
company seems to be free from any material debts, given its zero interest
costs. As a result, its total cash flows were positive and amounted to 4.500
EUR.
Under full method of consolidation, the Subsidiary D’s cash flows are fully
consolidated with those of its parent, despite the fact that the latter holds only
15% interest in the former’s equity. Consequently, consolidated total cash
flows are positive (despite an outflow of cash experienced by the parent) and
amount to 1.800 EUR. Payments of interest costs of 1.500 EUR are offset by
proceeds from a disposal of assets (of 3.000 EUR) and allegedly positive operating cash flows amounting to 300 EUR. Although such a breakdown of total
cash flows constitutes a warning signal (due to the operating cash flows being
on a level insufficient to cover debt-related payments), this signal does not
have a power it deserves. In this hypothetical case the entire interest payments
are incurred by the parent (who is unable to generate any positive cash flows
from its core business), while the entire operating cash inflows are generated
by its non-wholly owned subsidiary. Not only the total consolidated operating
cash flows are distorted by significant non-controlling interests, but also the
consolidated change in inventory gives a misleading signal (by hiding the fact
that the parent’s inventories stockpiled in the investigated period).
6 Problems of Comparability and Reliability …
183
Under proportional method of consolidation, which is prohibited by most
accounting standards (including IFRS and US GAAP), only 15% of the
subsidiary’s cash flows are consolidated with those of the parent. Consequently, the proportionally consolidated numbers seem to better reflect an
economic reality. In the investigated period the controlling entity burned
4.200 EUR on its operations, but it is entitled to benefit from 15% of positive
operating cash flows of its subsidiary (i.e. 15% out of 4.500 EUR). As a result,
the operating cash flows attributable to the parent’s shareholders amount to
−3.525 EUR (instead of 300 EUR, as under the full consolidation method).
Obviously, in the presence of significant non-controlling interests (NCI)
the full method of consolidation may entail dramatic distortions of reported
consolidated cash flows. In this context it is worth reminding that in consolidated financial statements only one item of a balance sheet (i.e. shareholder’s
equity) and only two items of an income statement (i.e. net earnings and total
comprehensive income) are adjusted for non-controlling interests (NCI). All
other items of these two statements are distorted and may lose reliability and
comparability. However, in case of the balance sheet and the income statement the financial statement users receive at least some limited information
about the NCI’s shares in consolidated earnings and net assets. In contrast, no
adjustments for non-controlling interests are done in consolidated cash flow
statement. As a result, material non-controlling interests may dramatically
erode usefulness of this statement in business analysis and valuation.
6.4.2 Real-Life Example of Rallye SA
Rallye SA is a French holding company, who owns and manages several retail
businesses and who filed for a bankruptcy protection in May 2019. Suppose
that You are an analyst who evaluates the Rallye’s financial condition in early
2019, based on its consolidated data, displayed in Table 6.7. Among Your
evaluated metrics are ratios of coverage of the company’s consolidated current
financial liabilities (i.e. interest-bearing debts, owed to lenders and repayable
within the next twelve months) by its consolidated operating cash flows and
its consolidated cash and cash equivalents.
As may be seen, in both investigated fiscal years the company’s consolidated operating cash flows covered only a little more than a half of its
consolidated short-term financial debts, with a significant deterioration of
the ratio between the end of 2017 and the end of 2018. However, the
company’s obligations do not have to be repaid from operating cash flows
only, but also from the liquid assets (such as cash and cash equivalents) held
by the company. According to the last row of Table 6.7, the Rallye’s combined
184
J. Welc
Table 6.7 Cash-based debt-coverage ratios of Rallye SA, as at the end of its fiscal
years 2017 and 2018, based on the company’s consolidated numbers unadjusted for
the non-controlling interests
Data in EUR million
2017
2018
(1) Consolidated net cash flow from opera ng ac vi es
1.509
1.466
(2) Consolidated cash and cash equivalents (at year-end)
3.511
3.801
(3) Consolidated current financial liabili es (at year-end)
2.352
2.839
Coverage of consolidated current financial liabili es by
consolidated opera ng cash flows
[=(1)/(3)]
64,2%
51,6%
Coverage of consolidated current financial liabili es by
consolidated opera ng cash flows and cash holdings
[=((1)+(2))/(3)]
213,4%
185,5%
Source Annual report of Rallye SA for fiscal year 2018 and authorial computations
Rallye SA
Share in equity of 52,1% at the end of 2018
(51,1% at the end of 2017)
Casino Group
Share in equity
of 33,1%
Total GPA Brazil
Share in equity
of 55,3%
Exito Colombia
Chart 6.2 Equity relationships between Rallye SA and its selected non-wholly owned
subsidiaries (as at the end of fiscal year 2018) (Source Annual reports of Rallye SA
and Casino Group for fiscal year 2018)
consolidated operating cash flows and consolidated cash and cash equivalents
were able to cover all its current financial liabilities with a high margin of
safety (although with some deterioration observed between 2017 and 2018).
Consequently, it could have been concluded that the company should be able
to settle its incoming debt repayments (payable in 2019). However, a deeper
investigation of its consolidated report, combined with the annual report of
its major subsidiary (Casino Group), reveals the group structure as shown on
Chart 6.2.
As may be seen, Rallye SA controls Casino Group by holding slightly more
than a half of its equity shares. Casino Group, in turn, controls its two Latin
American subsidiaries. One of them (Exito Colombia) is controlled by means
6 Problems of Comparability and Reliability …
185
of a majority interest (of 55,3%) in its equity, while the other one (Total GPA
Brazil) is controlled despite the Casino Group’s minority interest (33,1%). In
the latter case the control stems from a status of the Casino’s shares, which
give it majority of voting rights (despite holding a minority interest).
However, as discussed before in this book, a control held over non-wholly
owned subsidiaries does not imply an entitlement to participate in 100% of
their earnings, net assets and cash flows. This is due to non-controlling interests, which are also entitled to participate in economic benefits generated by
those entities. In Exito Colombia’s case (which is indirectly controlled by
Rallye SA), only 28,8% [=52,1% × 55,3%] of its profits, net assets and cash
flows are attributable to Rallye SA. In the case of Total GPA Brazil this participation is even lower, since Rallye’s share in the equity of this subsidiary is as
low as 17,2% [=52,1% × 33,1%]. However, separate (stand-alone) financial
results of all these subsidiaries are fully consolidated with the Rallye’s standalone numbers, despite their large non-controlling interests. Accordingly, it is
recommended to check an extent to which the Rallye’s reported consolidated
numbers could have been distorted by these non-controlling interests.
Table 6.8 presents selected financial statement data of Rallye SA and
its three non-wholly owned subsidiaries. A comparison of the consolidated
accounting numbers reported by Rallye SA and its three controlled entities
leads to the following relevant findings:
• Virtually all of the Rallye’s operating cash flows are generated on its
subsidiary’s level, which means that a significant part of those cash flows is
attributable to shareholders other than Rallye SA.
• Likewise, almost all of the Rallye’s reported consolidated cash and cash
equivalents are held by its subsidiaries, which means that non-controlling
shareholders of these subsidiaries are entitled to participate in a significant
part of the Rallye’s consolidated cash holdings.
• A majority of the Casino Group’s reported consolidated operating cash
flows is generated by its own non-wholly owned subsidiaries, which means
that significant part of those cash flows is attributable to non-controlling
shareholders of these subsidiaries.
Accordingly, it is advisable to adjust the consolidated data reported by
Rallye SA, for non-controlling interests in the equity of Casino Group (whose
data, in turn, should be adjusted for non-controlling interests in its own
subsidiaries, i.e. Total GPA Braziland Exito Colombia). The adjustments of
the latter’s numbers are shown in Table 6.9.
186
J. Welc
Table 6.8 Selected consolidated financial statement data of Rallye SA and its three
non-wholly owned subsidiaries, as at the end of its fiscal years 2017 and 2018
Data in EUR million
2017
2018
Consolidated net cash flow from opera ng ac vi es
1.509
1.466
Consolidated cash and cash equivalents
3.511
3.801
Consolidated current financial liabili es
2.352
2.839
Consolidated net cash flow from opera ng ac vi es
1.506
1.492
Consolidated cash and cash equivalents
3.391
3.730
Consolidated current financial liabili es
1.493
2.211
952
810
324
193
Rallye SA*
Casino Group**
Total GPA Brazil***
Net cash flow from opera ng ac vi es
Exito Colombia***
Net cash flow from opera ng ac vi es
*As reported in consolidated financial statements of Rallye SA for fiscal year 2018
**As reported in consolidated financial statements of Casino Group for fiscal year
2018
***As reported in Note 12.8 (Non-controlling interests) to consolidated financial
statements of Casino Group for fiscal year 2018 (only cash flow data are presented
here for these two subsidiaries, since their cash and cash equivalents, as well as
current financial liabilities, are not disclosed in the referenced note)
Source Annual reports of Rallye SA and Casino Group for fiscal year 2018
As may be concluded from Table 6.9, in 2017 and 2018 the Casino
Group’s operating cash flows adjusted for non-controlling interests (NCI)
constituted only 48,1% [=724/1.506] and 57,9% [=864/1.492], respectively, of its reported consolidated cash flows. Now these adjusted numbers
may be used as inputs in adjusting the parent company’s reported consolidated cash flows. These adjustments are presented in Table 6.10. As may
be seen, in 2017 and 2018 the Rallye’s operating cash flows adjusted for
non-controlling interests (NCI) constituted merely 24,7% [=373/1.509] and
28,9% [=424/1.466], respectively, of its reported consolidated cash flows.
Now all these estimates may be used in adjusting the Rallye’s debtcoverage ratios, which were presented in Table 6.7. However, beforehand the
company’s consolidated cash and cash equivalents must be corrected for the
non-controlling interests (since part of these cash holdings is attributable to
the non-controlling interests as well), as shown in Table 6.11.
Finally, Table 6.12 presents the Rallye’s adjusted debt-coverage ratios.
As may have been seen in Table 6.7, in both 2017 and 2018 the group’s
6 Problems of Comparability and Reliability …
187
Table 6.9 Adjustments of Casino Group’s consolidated operating cash flows for noncontrolling interests (NCI) in its two subsidiaries
Data in EUR million
2017
2018
Casino Group’s reported consolidated opera ng cash flows*
1.506
1.492
66,9%
66,9%
952
810
637
=66,9% x 952
542
=66,9% x 810
44,7%
44,7%
324
193
145
=44,7% x 324
724
=1.506 − 637
86
=44,7% x 193
864
=1.492 − 542
− 145
− 86
Total GPA Brazil
Share of NCI in the equity of Total GPA Brazil**
Total GPA Brazil’s reported opera ng cash flows*
Total GPA Brazil’s operating cash flows a ributable to noncontrolling interests
Exito Colombia
Share of NCI in the equity of Exito Colombia**
Exito Colombia’s reported opera ng cash flows*
Exito Colombia’s opera ng cash flows a ributable to noncontrolling interests
Casino Group’s consolidated opera ng cash flows, adjusted
for NCI’s shares in equi es of its two subsidiaries
*As shown in Table 6.8 (based on disclosures included in Note 12.8 to consolidated
financial statements of Casino Group for fiscal year 2018)
**According to shareholdingrelationships presented on Chart 6.2
Source Annual reports of Rallye SA and Casino Group for fiscal year 2018 and
authorial computations
Table 6.10 Adjustments of Rallye’s consolidated operating cash flows for noncontrolling interests (NCI) in its three non-wholly owned subsidiaries
Data in EUR million
2017
2018
Rallye’s reported consolidated opera ng cash flows*
1.509
1.466
1.506
3
=1.509 − 1.506
1.492
−26
=1.466 − 1.492
51,1%
52,1%
724
864
370
=51,1% x 724
450
=52,1% x 864
424
=−26 + 450
Casino Group’s reported opera ng cash flows**
Rallye’s consolidated opera ng cash flows
without the consolidated cash flows of Casino Group
Casino Group
Share of Rallye’s in the equity of Casino Group***
Casino Group’s NCI-adjusted opera ng cash flows****
Total Casino Group’s opera ng cash flows a ributable
to Rallye SA
Rallye’s consolidated opera ng cash flows, adjusted for
NCI’s shares in equi es of its three subsidiaries
373
=3 + 370
*As shown in Table 6.8 (based on consolidated financial statements of Rallye SA for
fiscal year 2018)
**As reported in consolidated financial statements of Casino Group for fiscal year
2018
***According to shareholding relationships presented on Chart 6.2
****As computed in the last row of Table 6.9
Source Annual reports of Rallye SA and Casino Group for fiscal year 2018 and
authorial computations
188
J. Welc
Table 6.11 Adjustments of Rallye’s reported consolidated cash and cash equivalents
for non-controlling interests (NCI) in the Casino Group’s equity
Data in EUR million
2017
2018
Rallye’s consolidated cash and cash equivalents*
3.511
3.801
Share of Rallye’s in the equity of Casino Group
3.391
120
= 3.511 − 3.391
51,1%
3.730
71
= 3.801 − 3.730
52,1%
Casino Group’s cash and cash equivalents a ributable
to Rallye SA**
1.733
= 51,1% x 3.391
1.943
= 52,1% x 3.730
Rallye’s cash and cash equivalents, adjusted for NCI’s
share in the Casino Group’s equity
1.853
= 120 + 1.733
2.014
= 71 + 1.943
Casino Group’s consolidated cash and cash equivalents*
Rallye’s consolidated cash and cash equivalents without
cash and cash equivalents held by Casino Group
*As shown in Table 6.8
**Due to data availability, a simplifying assumption has been taken, according to
which all consolidated cash and cash equivalents of Casino Group are held by
Casino Group itself (i.e. none of these cash holdings belong to its non-wholly owned
subsidiaries)
Source Annual reports of Rallye SA and Casino Group for fiscal year 2018 and
authorial computations
Table 6.12 Cash-based debt-coverage ratios of Rallye SA, adjusted for noncontrolling interests (NCI) in the equities of its three non-wholly owned subsidiaries
Data in EUR million
2017
2018
373
424
(2) Rallye’s cash and cash equivalents, adjusted for NCI’s shares in
the Casino Group’s equity**
1.853
2.014
(3) Consolidated current financial liabili es***
2.352
2.839
Coverage of current financial liabili es by opera ng cash flows
adjusted for non-controlling interests
[=(1)/(3)]
15,9%
14,9%
Coverage of current financial liabili es by opera ng cash flows
and cash holdings adjusted for non-controlling interests
[=((1)+(2))/(3)]
94,6%
85,9%
(1) Rallye’s consolidated opera ng cash flows, adjusted for NCI’s
shares in the equity of its three subsidiaries*
*As computed in the last row of Table 6.10
**As computed in the last row of Table 6.11
***As reported on the consolidated balance sheet of Rallye SA (and shown in Table
6.7)
Source Annual reports of Rallye SA and Casino Group for fiscal year 2018 and
authorial computations
6 Problems of Comparability and Reliability …
189
reported operating cash flows covered seemingly more than half of its consolidated current liabilities. Furthermore, when combined with consolidated cash
holdings, the reported 2018 operating cash flows constituted over 185% of
the group’s short-term financial obligations. However, the adjusted numbers
show a completely different picture, since now the consolidated operating
cash flows (both with and without cash holdings) cover much smaller part of
the group’s current liabilities.
As may be seen in the last row of Table 6.12, in 2018 the combined
cash flows and cash balances, adjusted for non-controlling interests, covered
only 85,9% of the Rallye SA’s consolidated short-term financial obligations. Evidently, an increased risk of insolvency (which materialized in
2019) was much better visible in the adjusted data, as compared to the
company’s fully consolidated cash flow numbers reported in accordance with
the International Financial Reporting Standards.
6.5
Distortions of Reported Cash Flows Caused
by Capitalized Intangible Assets
Aggressive capitalization of operating costs (i.e. costs which should be
expensed as incurred) in carrying amounts of fixed assets, described in Sects.
4.1.3 and 4.1.4 of Chapter 4, has the following distorting effects:
• Overstatement of current earnings at the cost of future earnings.
• Overstatement of fixed assets.
• Overstatement of operating cash flows and understatement of investing
cash flows.
Overstatement of operating cash flows, caused by the capitalization of
costs in fixed assets, results from the fact that operating expenditures which
should decrease current earnings (i.e. they should be expensed as incurred)
are artificially treated as investments in fixed assets. If those expenditures were
properly expensed as incurred, they would immediately reduce reported operating profits and reported operating cash flows (since operating profits are
part of operating cash flows). In contrast, when those expenditures are treated
as investments in fixed assets, they are reported in a cash flow statement as
investing cash outflows. This is illustrated in Example 6.2, which constitutes
an extension of Example 4.3 from Chapter 4.
The following conclusions may be inferred from Example 6.2:
190
J. Welc
Example 6.2 Overstatement of operating cash flows caused by aggressive
capitalization of routine maintenance costs in carrying amounts of fixed assets
(extension of Example 4.3 from Chapter 4)
In Example 4.3 the airline improperly capitalized (and depreciated through five years) its rou ne maintenance expenditures. The result was an
overstatement of assets and a corresponding overstatement of reported earnings. However, a side-effect of such a cost capitaliza on is also an
overstatement of the company’s reported opera ng cash flows, with a corresponding understatement of its inves ng cash flows.
Cash flow statement data, with the aggressive capitaliza on of rou ne maintenance expenditures, look as follows:
Period t Period t+1 Period t+2 Period t+3 Period t+4
Pre-tax profit
0
2.000
1.700
1.390
1.069
DepreciaƟon of fixed assets
OperaƟng cash flows
Expenditures on “real” fixed assets
0
0
0
1.000
3.000
1.300
3.000
1.610
3.000
1.931
3.000
Capitalized maintenance expenditures
0
−1.100
−1.000
−2.100
−1.210
−1.000
−2.210
−1.331
−1.000
−2.331
900
790
669
InvesƟng cash flows
0
−1.000
−1.000
−2.000
Total cash flows
0
1.000
Cash flow statement data, without the aggressive capitaliza on of rou ne maintenance expenditures, look as follows:
Period t Period t+1 Period t+2 Period t+3 Period t+4
Pre-tax profit
0
1.000
900
790
669
DepreciaƟon of fixed assets
0
1.000
1.100
1.210
1.331
OperaƟng cash flows
0
2.000
2.000
2.000
2.000
Expenditures on “real” fixed assets
0
−1.000
−1.100
−1.210
−1.331
Capitalized maintenance expenditures
0
0
0
0
0
InvesƟng cash flows
0
−1.000
−1.100
−1.210
−1.331
Total cash flows
0
1.000
900
790
669
Source Author
• Total cash flows (i.e. a sum of operating and investing cash flows) are the
same under both scenarios.
• However, operating cash flows under the cost capitalization scenario are
permanently higher than under the non-capitalization scenario (by 1.000
EUR, which is exactly equal to an amount spent annually on routine
maintenance of the aircraft).
• In contrast, investing cash flows under the cost capitalization scenario are
permanently lower than under the non-capitalization scenario (by 1.000
EUR).
• Accordingly, by capitalizing its routine maintenance expenditures the
company not only overstates its reported earnings and assets, but also
creates a false impression of being a strong generator of operating cash flows
(indeed, some unskilled analysts would even conclude that “the company
invests a lot, as compared to competition, but these investing outflows are
quickly transformed into high positive cash flows from operations”).
Similarly distorting impact of the cost capitalization will be observed when
a company “outsources” significant part of its expenditures on intangible
assets (e.g. research and development activities) to other, nonconsolidated
entities. This is illustrated in Example 6.3, which constitutes an extension
of Example 4.4 from Chapter 4. The following conclusions may be inferred
from reading this example:
Source Author
−1.000
Cash (BS)
−1.000 Inves ng cash flows
−1.000 Total cash flows
0 Opera ng cash flows
−1.000 Inves ng cash flows
−1.000 Total cash flows
Opera ng cash flows
Inves ng cash flows
Total cash flows
Inves ng cash flows
Opera ng cash flows
−1.000
−1.000
−1.000
−1.000
Pre-tax profit (IS)
−1.000 Total cash flows
0 Inves ng cash flows
Opera ng cash flows
−1.000 Total cash flows
0 Inves ng cash flows
Opera ng cash flows
Pre-tax profit (IS)
+1.000 R&D expenses (IS)
+1.000 R&D expenses (IS)
R&D expenses (IS)
Pre-tax profit (IS)
−1.000
Cash (BS)
Period t+1
−1.000
Cash (BS)
Pre-tax profit (IS)
Period t
−200
Cash (BS)
PC’s cash flows without these ar ficial “R&D outsourcing” transac ons look as follows:
Total cash flows
0 Opera ng cash flows
0 Pre-tax profit (IS)
Pre-tax profit (IS)
200 Amor za on (IS)
0 Amor za on (IS)
R&D amor za on (IS)
0 R&D expenses (IS)
Cash (BS)
0 R&D expenses (IS)
−1.000
+800 Fixed assets (BS)
Period t+1
R&D expenses (IS)
Cash (BS)
+1.000 Fixed assets (BS)
Fixed assets (BS)
Period t
Impact of these “R&D outsourcing” transac ons on cash flows reported by PC looks as follows:
0
0
0
0
0
0
Period t+2
0
0
0
−400
400
0
0
−400
Period t+2
In Example 4.4 the company ar ficially “outsourced” its R&D projects, which were later purchased (in the form of e.g. licenses or product formulas).
The result was an overstatement of assets and a corresponding overstatement of reported earnings. However, the side-effect of such a
capitaliza on is an overstatement of the company’s reported opera ng cash flows, with a corresponding understatement of its inves ng cash flows.
Example 6.3 Overstatement of operating cash flows caused by artificial “outsourcing” of R&D projects (extension of Example 4.4 from
Chapter 4)
6 Problems of Comparability and Reliability …
191
192
J. Welc
• The effect of artificial transactions (“R&D outsourcing”) is a capitalization
of fictitious “assets” (which are de facto PC’s operating costs), and as a
result an overstatement of PC’s reported earnings for both years, during
which the works on these R&D projects are conducted.
• A side-effect is an overstatement of fixed assets (intangibles), by 1 EUR
million in Period t and by 1,8 EUR million in Period t + 1 [=1.000 +
1.000−200].
• An overstatement of earnings lasts as long as the cost capitalization is
continued (and as long as the capitalized amounts exceed the amortization of previously capitalized costs). Once the “outsourcing” is ceased (in
Period t + 2), prior overstatements of earnings begin reversing.
• Another side-effect of those artificial transactions is an overstatement of
the company’s operating cash flows reported for Period t and Period t +
1 (by 2 EUR million in total) and a corresponding understatement of its
investing cash flows, reported for the same periods (by the same 2 EUR
million).
As both examples show, the capitalization of operating expenses (in
carrying amounts of tangible and intangible fixed assets) may be distortive
not only to balance sheet and income statement, but also to reported cash
flows. Therefore, it is always recommended to be watchful when analyzing
cash flow data of capital-intensive or intangible-intensive businesses. It must
be also remembered that cash flow statements reported by various firms may
be incomparable even without any deliberate manipulations, e.g. due to capitalization of development costs, mandatory under IFRS but prohibited under
US GAAP. In such circumstances the techniques of adjustments, presented
in Sect. 9.4 of Chapter 9, may be very helpful.
6.6
Distortions of Reported Cash Flows Caused
by off-Balance Sheet Financing Schemes
Under the full consolidation method liabilities of all companies within a
group are summed. Consequently, an increasing external indebtedness of any
of those group members is immediately reflected in a consolidated balance
sheet. However, in order to avoid an increase in its reported indebtedness,
a company may arrange a series of artificial transactions with unconsolidated entities, which under such schemes serve as vehicles for keeping the
company’s debts out of its consolidated balance sheet (Healy and Wahlen
1999; De La Torre 2009). Also, as shown in Example 6.4, artificially arranged
Indebtedness raƟo (L/A)
=1.300/1.800
72%
1.300
500
1.800
2) Company A gives to the Bank a
guarantee of repayment of a loan
borrowed by B
Company A
Bank
1) Company A arranges an agreement
with an allegedly non-controlled enƟty
B (which may be a “shell” company,
with no any business operaƟons)
4) A loan granted by Bank to Company B (and guaranteed
by Company A) is transferred to Company A via arƟficial
transacƟons (e.g. arƟficial sale of services from A to B)
3) AŌer obtaining the guarantee from
Company A, Bank may lend 800 EUR to
Company B (which could otherwise not
qualify for any loan, due to its poor
credit quality)
Company B
(“friendly” to Company A,
but not its subsidiary)
As may be seen above, such a direct borrowing results in an immediate increase of the company’s indebtedness ra o, from 50% to 72% (i.e. close to
or above typically assumed “safety thresholds” of about 60–66%). However, the company may try to apply the following arrangements:
=500/1.000
50%
500 Total liabili es (L)
Total liabili es (L)
Indebtedness raƟo (L/A)
500 Total equity (E)
Total equity (E)
Post-borrowing balance sheet
1.000 Total assets (A)
Total assets (A)
Pre-borrowing balance sheet
Suppose that Company A intends to borrow 800 EUR (in a form of a bank loan) to invest in its opera ng assets (e.g. property, plant and equipment),
with the following impact on its consolidated balance sheet:
(continued)
Example 6.4 Overstatement of operating cash flows caused by transfers of borrowed funds through unconsolidated entities
6 Problems of Comparability and Reliability …
193
Source Author
Example 6.4 (continued)
=500 / 1.000
1.800
=500 / 1.800
28%
500
1.300*
Inves ng cash flows
0 Total cash flows
800 Financing cash flows
−800
0 Opera ng cash flows
0
0
−800
800*
Cash flow statement when Company A
transfers its loan through
nonconsolidated enƟty
*including fabricated net earnings, realized on the ficƟƟous transacƟon of sales by Company A to Company B
Total cash flows
Financing cash flows
Inves ng cash flows
Opera ng cash flows
Cash flow statement when Company A
borrows directly from the Bank
Also, such ar ficial arrangements would have the following impact on Company A’s reported cash flows:
* = prior equity of 500 EUR + net earnings booked on the ficƟƟous transacƟon of sales by Company A to Company B (income ta xes are ignored for simplicity)
Indebtedness raƟo (L/A)
500 Total liabili es (L)
50%
Total liabili es (L)
Indebtedness raƟo (L/A)
500 Total equity (E)
Total equity (E)
Post-borrowing balance sheet
1.000 Total assets (A)
Total assets (A)
Pre-borrowing balance sheet
In the following periods, Company A retransfers (in regular transac ons) to Company B funds necessary to enable schedule repayments of
Company B’s bank debt.
Such ar ficial arrangements would have the following impact on Company A’s reported indebtedness:
A loan of 800 EUR, granted by the Bank to Company B, is transferred to Company A through ar ficially arranged sale transac ons (e.g. sale
of fic ous “managerial consul ng” services, by Company A to Company B, with a fabricated profit amoun ng to 800 EUR).
Company B borrows 800 EUR from the Bank (a loan which is guaranteed by A, given that B lacks any assets and any business opera ons).
Suppose now that in order to keep a loan, amoun ng to 800 EUR, off its balance sheet (while having access to those borrowed funds), but also to
boost its reported profits and opera ng cash flows, Company A arranges the following sequence of transac ons:
194
J. Welc
6 Problems of Comparability and Reliability …
195
transfers of borrowed funds from a bank to a borrower via some artificial intermediary (which may be a “shell” company, with no any operating
activities) may significantly overstate the borrower’s consolidated profits and
consolidated operating cash flows (with a corresponding understatement of
financing cash inflows).
The following conclusions may be inferred from Example 6.4:
• Artificial arrangements, that involve an unconsolidated third-party (which
serves as a vehicle through which borrowed funds are transferred from bank
to Company A), result not only in avoidance of an increase in Company A’s
indebtedness (from its pre-borrowing level of 50%) but even bring about a
significant artificial reduction of its indebtedness ratio (which falls to 28%,
instead of growing to 72%). This is because the artificial sale of services
by Company A to Company B generates a fictitious profit, which boosts
Company A’s earnings and shareholder’s equity.
• However, such artificial arrangements not only overstate Company A’s
earnings and understate its indebtedness, but also result in an overstatement of Company A’s operating cash flows (with a corresponding
understatement of its financing cash flows). This is because the “profit”
of 800 EUR, generated on an artificial sale of services by Company A to
Company B, constitutes part of Company A’s operating cash flows (while
a borrowing the same 800 EUR directly from the bank would be reported
as a financing cash inflow).
• A loan guarantee granted by Company A in relation to debts borrowed by
Company B does not constitute Company A’s liability, as long as Company
B stays solvent and liquid (and continues its timely payments of interest
costs and principal amounts). In financial reporting by Company A such
guarantees would be reported as off-balance sheet contingent obligations
(and would be disclosed only in notes to financial statements).
• However, if Company B does not run any significant and profitable operating activities (which is a common feature of such artificial “special
purpose entities”, launched merely to serve as vehicles for off-balance sheet
liabilities), then in the following periods Company A must arrange the
series of reverse transactions, i.e. purchases of some goods or services from
Company B (so that the latter receives regular payments from Company
A, necessary to serve its borrowings obtained from the bank).
Possible distortions of all three primary financial statements, brought about
by such artificial arrangements, call for increased analytical vigilance when
196
J. Welc
examining firms which report significant contingent obligations stemming
from loan guarantees.
6.7
Distortions of Reported Cash Flows Caused
by Customer Financing Schemes
When company offers deferred payment terms to its customers, the resulting
increases in trade receivables reduce its operating cash flows. However,
customer financing may also be arranged differently: a company may transfer
a loan to its customer, from which the customer finances purchases of the
company’s products or services (allegedly for cash). Due to a form (and in
spite of an economic substance) of such loans, some companies treat them
as investing (not operating) activities, which results in inflated operating cash
flows (as illustrated in Example 6.5).
The following conclusions may be inferred from Example 6.5:
• If a loan granted to the customer, to support the ABC’s sales, is correctly
treated as a trade receivable, then a transaction is neutral for the ABC’s
operating cash flows reported for Period t. This is because the revenues and
profits of 100 EUR million are in Period t offset by an increase in receivable accounts (by the same 100 EUR million). In the following period,
when a related payment is collected, the operating cash flows are increased
(again thanks to the change in receivable accounts) by 100 EUR million.
• However, if ABC mistreats its loan granted to the customer as allegedly
unrelated to its sales (despite its real economic substance), then its operating cash flows reported for Period t are inflated by 100 EUR million.
This is because the loans granted to other entities, as well as their repayments, are normally treated as non-operating cash flows (that is, resulting
from investments of excess cash, rather than from operating transactions).
As such, they may be reported as investing cash flows, even though their
substance may suggest that they support the operating activities (e.g. foster
sales).
• An overstatement of the ABC’s operating cash flows in Period t is followed
by their corresponding understatement in the following period (when a
debt owed by the customer is collected).
It is important to note that a problem with classifying customer financing
schemes in cash flow statement (i.e. as either an operating activity or an
investing one) does not relate only to receivables from direct loans to
6 Problems of Comparability and Reliability …
197
Example 6.5 Overstatement of operating cash flows caused by loans granted by a
company to its customers
Suppose that in December of Period t company ABC (an IT business) sold a so ware and
some IT services to company XYZ, for 100 EUR million, with a deferred payment term of 30
days. Alterna vely, if ABC is interested in ar ficially boos ng its opera ng cash flows
reported for Period t, it might arrange the following allegedly unrelated transac ons:
gran ng to its customer (XYZ) a loan, before a sale of so ware and services,
amoun ng to 100 EUR million,
selling its so ware and IT services to XYZ, for 100 EUR million, payable
immediately in cash.
Impact of such a customer financing scheme on the ABC’s reported cash flows looks as
follows:
Cash flows from:
Period t
Period t+1
100
100
0
0
0
0
−100
−100
100
100
Financing ac vi es
0
0
Net cash flows
0
100
Opera ng ac vi es*, including:
Opera ng profit*
Change in receivable accounts
Inves ng ac vi es, including:
Loans granted and collected
*Income taxes are ignored for simplicity
The ABC’s reported cash flows without such customer financing scheme look as follows:
Cash flows from:
Period t
Period t+1
0
100
−100
100
0
100
Inves ng ac vi es, including:
Loans granted and collected
0
0
0
0
Financing ac vi es
0
0
Net cash flows
0
100
Opera ng ac vi es*, including:
Opera ng profit*
Change in receivable accounts
*Income taxes are ignored for simplicity
Source Author
customers. It is valid also for other forms of financing customer’s purchases,
such as operating leases (when a company is a lessor). Both forms of customer
financing schemes (i.e. granting loans to customers and financing their
purchases by operating leases) are very common in a car manufacturing
industry, sometimes with a disastrous impact on intercompany comparability
of cash flows reported by global car manufacturers.
198
6.8
J. Welc
Distortions of Reported Cash Flows Caused
by Business Combinations
6.8.1 Distorting Impact of Business Combinations
on Reported Cash Flows
In business combinations (termed also as mergers, acquisitions or takeovers),
in which one entity obtains a control over another entity, a whole amount
paid by an acquirer for a controlling interest in a target business is treated
as an investing cash outflow. This means that increases of the acquirer’s
consolidated working capital (inventories, receivable accounts and operating
payables), stemming from business combinations, do not reduce its reported
operating cash flows (as is the case when the acquirer itself invests in its
own working capital). Instead, they are included in a total amount paid for
an acquisition and consequently constitute part of the acquirer’s investing
cash outflow. However, changes in the acquired subsidiary’s working capital,
recorded in the following periods (i.e. after a business combination), affect
the acquirer’s consolidated operating cash flows, in the same way as changes
in its own working capital. Consequently, significant investments in working
capital through takeovers of other entities may inflate consolidated operating
cash flows reported by the acquirer.
This problem will be illustrated by a fictitious as well as a real-life example.
For simplicity, the fictitious example discussed below will be focused only
on distortions brought about by inventories, acquired by a parent company
as part of its takeover of new subsidiary. However, as documented by the
following real-life example of Conviviality plc, such distorting effects may be
attributable to all elements of corporate working capital (including receivable
and payable accounts), purchased as part of a business combination.
As may be seen in Example 6.6, when the acquirer (ABC company)
purchases only inventories from another entity (XYZ), an associated payment
of 100 EUR million is reported as an increase in ABC’s inventories in Period
t, with an accompanying reduction of the ABC’s operating cash flows by the
same amount. In the following period, in turn, a disposal of that inventory
for 110 EUR million is reported as an operating cash inflow, with an inventory change amounting to +100 EUR million and a corresponding profit of
10 EUR million. In contrast, when the company purchases 100% shares in
its new subsidiary, a whole amount paid in Period t (i.e. 100 EUR million) is
reported as inventing cash outflow (with no impact on the parent’s reported
operating cash flows), while the following disposal of inventories acquired via
6 Problems of Comparability and Reliability …
199
Example 6.6 Distortions of reported consolidated operating cash flows caused by
an acquisition of an inventory-intensive subsidiary
Suppose that in Period t company ABC acquired 100% shares in equity of its liquidated excompe tor, XYZ. As a result of this business combina on, XYZ became a new wholly owned
subsidiary of ABC. The acquisi on was se led in cash, at the transac on price amoun ng to
100 EUR million.
Since XYZ is being liquidated, its business opera ons have been terminated. Consequently,
its only assets are inventories amoun ng to 100 EUR million, funded with an equity of 100
EUR million (with no any liabili es and goodwill). Consider two scenarios:
In Period t ABC acquires 100% shares in XYZ, for 100 EUR million, and funds it from a
short-term bank loan of 100 EUR million. A erwards (in Period t+1) it sells all the
acquired inventories for 110 EUR million and repays the bank loan (plus 3 EUR
million of interest cost).
In Period t ABC purchases inventories from XYZ, for 100 EUR million, and funds it
from a short-term bank loan of 100 EUR million. A erwards (in Period t+1) it sells all
the acquired inventories for 110 EUR million and repays the bank loan (plus 3 EUR
million of interest cost).
Impact of the acquisi on of shares in XYZ on the ABC’s reported consolidated cash flows
looks as follows:
Cash flows from:
Period t
Period t+1
0
0
0
+110
10
+100
Inves ng ac vi es, including:
Purchase of shares in other en ties
−100
−100
0
0
Financing ac vi es, including:
Bank loans (with interest payments)
+100
+100
−103
−103
0
+7
Opera ng ac vi es*, including:
Opera ng profit*
Change in inventories
Net cash flows
*Income taxes are ignored for simplicity
Impact of the purchase of inventories from XYZ on the ABC’s reported cash flows look as
follows:
Cash flows from:
Opera ng ac vi es*, including:
Opera ng profit*
Change in inventories
Inves ng ac vi es, including:
Purchase of shares in other en
es
Financing ac vi es, including:
Bank loans (with interest payments)
Net cash flows
*Income taxes are ignored for simplicity
Source Author
Period t
Period t+1
−100
+110
10
+100
0
−100
0
0
0
0
+100
+100
−103
−103
0
+7
200
J. Welc
this takeover is reported as an increase in the acquirer’s consolidated operating cash flows in Period t + 1. In other words, while two-period changes in
inventories are zeroed out under inventory purchase scenario (the inventory
increase in Period t is followed by the inventory decrease by the same amount
in Period t + 1), a transaction of the same substance but different form (i.e.
purchase of shares in the new subsidiary) inflates the two-period operating
cash flows by 100 EUR million. Obviously, such a treatment of business
combinations may dramatically distort reported cash flows of acquisitive
companies, as will be shown in the following real-life example.
6.8.2 Real-Life Example of Conviviality Plc
Conviviality plc was a British retailer of alcoholic drinks, listed on the
London Stock Exchange since 2013. The company’s growth between 2015
and 2017, largely fuelled by acquisitions of other firms, was followed by
its sudden collapse in 2018. The Conviviality’s major problem lied in an
inconsistent and poor business strategy, which gradually eroded its operating efficiency (Steer 2018). However, as demonstrated below, in 2016 the
company’s deteriorating operating cash flows were dramatically distorted by
its large takeover of another business. As a result, the company reported positive and growing consolidated operating cash flows, while in reality its core
business was burning money.
Table 6.13 presents selected cash flow statement data, as reported by
Conviviality plc for its fiscal years 2014–2016. As may be seen, in the
investigated three-year timeframe the company reported steadily increasing
operating cash flows, which rose from 5.956 GBP thousand in the fiscal year
ended April 27, 2014, to as much as 21.828 GBP thousand two years later.
Its market expansion entailed rising amounts of money tied up in inventories
and receivables, particularly in fiscal year ended May 1, 2016, when these two
asset classes combined drained as much as 13.342 GBP thousand [=−5.358
− 7.984], partly offset by rising payables (which grew by 11.904 GBP thousand). Consequently, in its fiscal year 2016 the Conviviality’s working capital
(including provisions), as reported in its cash flow statement, increased by
1.848 GBP thousand [=5.358 + 7.984 − 11.904]. However, that amount
did not take into account any changes in working capital brought about by
the company’s acquisitions of other entities. Meanwhile, as may be seen in
the lower part of Table 6.13, in its two consecutive fiscal years the company
spent significant amounts of money on business combinations, with related
expenditures reported as part of its investing cash flows. In particular, in its
fiscal year 2016 it spent over 200 GBP million (nine times more than its
6 Problems of Comparability and Reliability …
201
Table 6.13 Selected cash flow statement data reported by Conviviality plc for its
fiscal years 2014–2016
Fiscal year
ended April
27, 2014
Fiscal year
ended April
26, 2015
Fiscal year
ended May
1, 2016
Net cash generated from operaƟng
acƟviƟes, including:
5.956
9.776
21.828
Change in inventories
2.722
649
−1.342
−6.002
−1.169
−296
−5.358
−7.984
Data in GBP thousand
Change in trade and other receivables
Change in trade and other payables
11.904
0
0
−410
Change in working capital reported in
cash flow statement*
−4.622
−816
−1.848
Net cash used in invesƟng acƟviƟes,
including:
−3.298
−13.309
−232.669
−
−6.495
−200.412
Change in provisions
Purchase of subsidiary undertakings (net
of cash acquired)
*Change in inventories + Change in trade and other receivables + Change in trade
and other payables
Source Annual reports of Conviviality plc for fiscal years 2015 and 2016
operating cash flows reported for that period) on “purchase of subsidiary undertakings”. Obviously, such huge amounts spent on mergers and acquisitions
suggest likely distortions of the Conviviality’s reported operating cash flows,
caused by an inclusion of the acquired working capital of its new subsidiaries
in the amounts reported as part of consolidated investing cash flows.
When a company obtains control over another entity, with a significant
amount of working capital acquired as a consequence of such takeover, then
period-to-period changes in individual elements of working capital, seen
in an acquirer’s consolidated balance sheet, deviate significantly from their
respective changes reported in its consolidated cash flow statement. This is
because of an inclusion of the acquired working capital of its new subsidiaries
in carrying amounts of the parent company’s consolidated assets, accompanied with their omission in its consolidated operating cash flows. Therefore,
discrepancies between changes in working capital, as shown in consolidated
balance sheet and consolidated cash flow statement, may serve as proxies for
distorting impact of mergers and acquisitions on amounts reported in the
latter. Table 6.14 contains a calculation of such discrepancies, based on financial statement numbers reported by Conviviality plc, for its two consecutive
fiscal years.
202
J. Welc
Table 6.14 Changes in working capital reported by Conviviality plc in its balance
sheet and cash flow statement
Data in GBP thousand
Fiscal year
ended April
27, 2014
Fiscal year
ended April
26, 2015
Fiscal year
ended May
1, 2016
11.778
12.357
61.825
Balance sheet data
Inventories
Trade and other receivables (noncurrent)
0
0
6.424
Trade and other receivables (current)
31.685
33.669
151.928
Trade and other payables
43.733
46.231
183.253
0
0
5.361
Provisions
−270
−205
31.563
Change in working capital implied from the
company’s balance sheet**
−
−65
−31.768
Change in working capital reported in the
company’s cash flows statement***
−
−816
−1.848
Working capital*
*Inventories + Trade and other receivables (noncurrent and current) − Trade and
other payables − Provisions
**Increase/decrease shown with a negative/positive sign
***As calculated in Table 6.13
Source Annual reports of Conviviality plc for fiscal years 2015 and 2016 and authorial
computations
As may be seen, for its fiscal year ended April 26, 2015, the company
reported in its cash flow statement a net increase in working capital by 816
GBP thousand, while a growth in working capital implied for the same
period from the company’s consolidated balance sheet amounted to 65 GBP
thousand. In light of the reported total operating cash flows of 9.776 GBP
thousand (as shown in Table 6.13), a resulting discrepancy of 751 GBP thousand [=816−65] seems not to be very distortive. In contrast, according to
the last column of Table 6.14, in the next fiscal year the company’s balance
sheet-based increase in working capital amounted to as much as 31.768 GBP
thousand, compared to merely 1.848 GBP thousands reported in its consolidated cash flow statement. In light of the Conviviality’s huge expenditures on
acquisitions of subsidiaries (exceeding 200 GBP million) it seems very likely
that the observed discrepancy was attributable to the company’s takeover
activity.
In its fiscal year ended May 1, 2016, Conviviality plc acquired several
new subsidiaries. However, according to disclosures offered in Note 28 to
the company’s annual consolidated financial statements, majority of these
takeovers were individually very small. As a result, almost whole amount
spent on business combinations (totaling 200,4 GBP million, net of cash
6 Problems of Comparability and Reliability …
203
acquired) was attributable to the takeover of Matthew Clark (which has cost
almost 199 GBP million).
Table 6.15 contains an extract from Note 28 to the Conviviality’s financial statements for fiscal year ended May 1, 2016. According to these
disclosures, Matthew Clark was taken over in October 2015, for a total
amount (satisfied by cash) of 198.976 GBP thousand. The acquired net assets
included, at fair values, inventories (43.972 GBP thousand), trade and other
receivables (116.379 GBP thousand), trade and other payables (124.063
thousand) and provisions (5.770 GBP thousand). Accordingly, the Matthew
Clark’s working capital, acquired by Conviviality as part of that business
combination, amounted to 30.518 GBP thousand [=43.972 + 116.379 −
124.063−5.770].
According to these computations, a distorting impact of the Matthew
Clark’s takeover on change in the Conviviality’s working capital, reported in
its consolidated operating cash flows, amounted to 30.518 GBP thousand.
However, as was shown in Table 6.14, the discrepancy between the change in
Table 6.15 Extract from Note 28 to the consolidated financial statements of
Conviviality plc for fiscal year ended May 1, 2016
Note 28: Business combinaƟons
MaƩhew Clark (Holdings) Limited
On 7 October 2015, the Group entered into an agreement to acquire the en re issued share
capital of Ma hew Clark (Holdings) Limited for a total considera on of £199.0m in cash.
Ma hew Clark (Holdings) Limited is a leading independent wholesaler in the drinks industry.
[…]
The following table summarizes the considera on paid for Ma hew Clark (Holdings)
Limited, and the amount of assets acquired and liabili es assumed recognized at the
acquisi on date.
Fair value
Book value
adjustment
Fair value
£000
£000
£000
Property, plant and equipment
4.074
(891)
3.183
Intangible assets
3.624
(311)
3.313
Inventories
44.238
(266)
43.972
Trade and other receivables
116.738
(359)
116.379
Net debt and debt-like items
(10.838)
(247)
(11.085)
Trade and other payables
(122.979)
(1.084)
(124.063)
Deriva ves
(634)
(634)
−
Deferred tax liability
Provisions
Total idenƟfiable net assets
Total consideraƟon saƟsfied by cash
402
(603)
34.022
(11.859)
(5.167)
(20.184)
(11.457)
(5.770)
13.838
198.976
Source Annual report of Conviviality plc for fiscal year ended May 1, 2016
204
J. Welc
working capital reported in the company’s balance sheet and cash flow statement amounted to −29.920 GBP thousand [=−31.768 − (−1.848)]. A gap
between these two numbers, amounting to 598 GBP thousand [=30.518 −
29.920], was probably attributable to the Conviviality’s other business combinations (much smaller in scale than the takeover of Matthew Clark) closed in
the fiscal year ended May 1, 2016.
Table 6.16 presents adjustments of operating cash flows reported in consolidated financial statements of Conviviality plc, for estimated distorting effects
of the company’s takeovers of other entities. As expected, the impact of these
adjustments on the numbers reported for the fiscal year ended April 26, 2015,
is rather small, since the reported operating cash flows, amounting to +9.776
GBP thousand, are increased to 10.527 GBP thousand (i.e. by less than 8%).
This is consistent with a small scale of business combinations done by the
company in that period. In contrast, the effect and direction of these analytical adjustments on operating cash flows reported for the fiscal year ended
May 1, 2016, is evidently stunning. In that period the Conviviality’s reported
operating cash flows amounted to +21.828 GBP thousand (much more than
in the preceding two fiscal years), while our analytical adjustments turn it into
Table 6.16 Adjustments of consolidated operating cash flows reported by
Conviviality plc, for estimated impacts of its business combinations on reported
changes in working capital
Fiscal year
ended April
27, 2014
Fiscal year
ended April
26, 2015
Fiscal year
ended May 1,
2016
Reported opera ng cash flows*
5.956
9.776
21.828
Change in working capital reported in the
company’s cash flow statement*
−4.622
−816
−1.848
Change in working capital implied from the
company’s balance sheet**
−
−65
−31.768
Es mated amount of cash flow adjustment
for the effects of business combina ons***
−
751
= −[−816 −
= −[−1.848 −
Data in GBP thousand
Opera ng cash flows
adjusted for the es mated effects
of business combina ons****
(−65)]
5.956
10.527
−29.920
(−31 768)]
−8.092
*As presented in Table 6.13
**As calculated in Table 6.14
***=−[Change in working capital reported in the company’s cash flow statement—
Change in working capital implied from the company’s balance sheet]
****=Reported operating cash flows + Estimated amount of cash flow adjustment
for the effects of business combinations
Source Annual reports of Conviviality plc for fiscal years 2015 and 2016 and authorial
computations
6 Problems of Comparability and Reliability …
205
a negative number of −8.092 GBP thousand. The amount of this downward correction (i.e. −29.920 GBP thousand) is based on the gap between
changes in working capital reported by the company in its balance sheet and
cash flow statement. That gap, in turn, was almost entirely attributable to the
takeover of Matthew Clark, which boosted the Conviviality’s consolidated
working capital by as much as 30.518 GBP thousand, without being reflected
in changes in working capital reported in the company’s consolidated cash
flow statement. This proves that reported operating cash flows of businesses
which grow by significant acquisitions of other entities may be dramatically
distorted (particularly in case of serial acquirers) and should not be relied
upon blindly.
6.9
Example of Eroded Intercompany
Comparability of Reported Cash Flows
Finally, this section of the chapter will illustrate a problem of intercompany
incomparability of reported cash flows. Suppose that at the beginning of
2010 a credit analyst was investigating and comparing insolvency risks faced
by four global car manufacturers. One of the metrics used in this process
was a debt-coverage ratio, computed as a quotient of operating cash flows
to total liabilities. Table 6.17 presents a computation of that ratio, based on
data reported in annual reports for 2009. As might be seen, in 2009 BMW
seemed to outperform its three “peers” in terms of its coverage of total debts
Table 6.17 Coverage of total liabilities by reported operating cash flows of four car
manufacturers in fiscal year 2009
BMW (data
in EUR
million)
Opera ng cash flows (OCF)*
Fiat (data in
EUR million)
Ford (data in
USD million)
Volkswagen
(data in EUR
million)
10.271
4.601
16.042
12.741
101.953
67.235
194.850
177.178
Total shareholder’s equity
19.915
11.115
−6.515
37.430
Total liabili es
82.038
56.120
201.365
139.748
Total assets
Coverage of total liabili es
by opera ng cash flows
12,5%
8,2%
8,0%
9,1%
=10.271/
82.038
=4.601/
56.120
=16.042/
201.365
=12.741/
139.748
*As reported in published cash flow statements
Source Annual reports of individual companies for fiscal year 2009 and authorial
computations
206
J. Welc
by total operating cash flows. Ford Motor Company, in contrast, appeared to
be facing the highest financial risk (as measured by the investigated ratio).
However, as the American company, Ford reports its results under US
GAAP (where all research and development costs are expensed as incurred),
while its three European rivals present their financial performance in accordance with IFRS (which require capitalization of development costs). Accordingly, first area of a possible incomparability of reported cash flows (as
well as computed financial risk metrics) emerges, which stems from differences between US GAAP and IFRS in how development expenditures
are accounted for. Such expenditures, when expensed as incurred, land in
cash flow statement in its operating section. In contrast, under IFRS the
amounts spent on development projects (and capitalized as intangible assets)
are reported as investing cash outflows. However, significant differences in
accounting assumptions related to development costs exist also between firms
reporting under IFRS (for instance, some entities capitalize both direct and
indirect development expenditures, while others claim to capitalize only
direct development costs and to expense development overheads). Therefore,
when comparing any metrics based on operating cash flows, it is recommended to check for possible distortions of comparability, stemming from
different accounting policies applied to development expenditures.
However, accounting for development expenditures does not constitute the
only possible factor which may have eroded the comparability of cash flows
reported by the investigated four competitors. Another problematic area is a
classification of customer financing schemes (as part of either operating or
investing activity), such as customer loans or operating leases, which constitute important sales drivers in the car industry. To check if such schemes
could have distorted the computed debt-coverage ratios, Table 6.23 (in the
appendix) discloses selected extracts from cash flow statements (and selected
notes) reported by the analyzed firms.
The following conclusions may be inferred from the reading of Table 6.23:
• In contrast to its three European rivals, Ford Motor Company does not
capitalize any research and development costs, which means that all such
expenditures are treated as operating cash outflows (which is also reflected
in a very low carrying amount of intangible assets on Ford’s consolidated
balance sheet).
• In 2009 BMW treated all its customer financing schemes (i.e. both
customer loans as well as investments in operating leases) as part of its
investing activity, with a total negative contribution to investing cash flows,
6 Problems of Comparability and Reliability …
207
amounting to −5.700 EUR million [=−10.433 + 6.515 − 49.629 +
47.847].
• In 2009 Fiat Group treated investments in operating leases as part of its
operating activity (but with an insignificant contribution to its reported
operating cash flows), while reporting cash movements resulting from its
customer loans in an investing section (with a positive contribution to
investing cash flows, amounting to 882 EUR million).
• Similarly as BMW, in 2009 Ford Motor Company treated all its customer
financing schemes as part of its investing activity, with a total positive
contribution to its investing cash flows, amounting to +13.492 USD
million [=−26.392 + 39.884].
• In contrast to BMW and Ford, in 2009 Volkswagen Group treated all its
customer financing schemes (i.e. both loans granted to customers as well
as investments in lease and rental assets) as part of its operating activity,
with a total negative contribution to operating cash flows amounting to −
3.290 EUR million [=−2.571−719].
Obviously, such multiple accounting differences between all four car
manufacturers may have dramatically eroded comparability of their cash flow
statements, as well as any metrics computed on the basis of those reported
numbers. Therefore, to produce reliable results, any comparative analysis of
their cash flow-based financial risk metrics require making some analytical
adjustments to the reported data.
In order to restore the comparability of operating cash flows of all four
businesses, the following adjustments will be done:
• In the case of all three European firms, capitalized development expenditures will be treated as part of operating expenses, which implies
transferring them from investing cash flows to operating ones.
• All cash movements related to customer financing schemes will be treated
as part of operating activities, which implies:
– Transferring BMW’s investments and disposals of leased products, as
well as additions and payments of receivables from sales financing, from
investing cash flows to operating ones,
– Transferring Fiat’s changes in financing receivables from investing cash
flows to operating ones (with no adjustment of Fiat’s changes in
operating leases, which are already reported as part of the company’s
operating cash flows),
– Transferring Ford’s acquisitions and collections of finance receivables and
operating leases from investing cash flows to operating ones,
208
J. Welc
– No any adjustments of Volkswagen’s cash flows for its leasing and rental
assets, as well as for its financial services receivables (since they are
already reported as part of the company’s operating cash flows).
Table 6.18 presents the reported and adjusted operating cash flows of all
four competitors. Table 6.19, in turn, contains adjusted debt-coverage ratios,
calculated on the ground of those revised cash flow data.
As might be seen, a picture based on the adjusted (and more comparable)
numbers changes dramatically. BMW, which seemed to face the lowest financial risk (as measured by coverage of the company’s total liabilities by its
reported operating cash flows), now turns out to enjoy the lowest value of
the investigated metric. This is caused by negative amounts of all three of
its adjustments, which sum up to −6.787 EUR million [=−1.087 − 3.918
− 1.782] and reduce the company’s reported cash flows by two thirds (i.e.
from 10.271 EUR million to 3.484 EUR million). In contrast, Ford Motor
Company, whose reported data suggested the lowest coverage of liabilities by
cash flows, now emerges as the only firm with a double-digit value (of almost
15%) of the adjusted ratio. This was brought about by huge net collections of
the company’s finance receivables (including lease-related receivables), which
in 2009 boosted the company’s cash flows by as much as almost 13,5 USD
billion. In case of the remaining two businesses the adjustments of reported
numbers have less significant impact on the obtained values of debt-coverage
ratios (although in both cases the revised numbers are less favorable than the
reported ones).
The presented example of an intercompany comparative analysis clearly
confirms a necessity of being diligent when analyzing reported cash flows,
even when examining businesses which report under the same set of
accounting standards. One of the most common myths in corporate finance
relates to the alleged immunity of cash flow statements to manipulations and
distortions. As might be seen, cash flow statements should not be deemed as
entirely reliable and comparable. However, as Table 6.24 (in the appendix)
shows, this relates not only to intercompany investigations, but to timeseries analyzes we well. As might be seen, the operating and investing cash
flows, reported by Volkswagen Group for 2008, differed dramatically between
its two annual reports (with no differences in reported financial and total
cash flows). Apart from some other minor revisions (related to investment
properties), this stemmed from a reclassification of the company’s cash flows
from leasing/rental assets and financial services receivables from investing to
operating activity.
6 Problems of Comparability and Reliability …
209
Table 6.18 Adjustments of operating cash flows of four car manufacturers reported
for fiscal year 2009
Items of cash flows
Amounts
BMW (data in EUR million)
Reported operaƟng cash flows
10.271
Adjustments of reported operaƟng cash flows for:
Capitalized development costs
Net change in leased assets (addi ons minus payments)
Net change in finance receivables (investments minus disposals)
Adjusted operaƟng cash flows
−1.087
−3.918
−1.782
3.484
Fiat (data in EUR million)
Reported operaƟng cash flows
4.601
Adjustments of reported operaƟng cash flows for:
Capitalized development costs
−1.216
Change in finance receivables
+882
Adjusted operaƟng cash flows
4.267
Ford (data in USD million)
Reported operaƟng cash flows
16.042
Adjustments of reported operaƟng cash flows for:
Net change in finance receivables and opera ng leases (acquisi ons—
collec ons)
Adjusted operaƟng cash flows
+13.492
29.534
Volkswagen (data in EUR million)
Reported operaƟng cash flows
12.741
Adjustments of reported operaƟng cash flows for:
Capitalized development costs
−1.948
Adjusted operaƟng cash flows
10.793
Source Annual reports of individual companies for fiscal year 2009 and authorial
computations
210
J. Welc
Table 6.19 Coverage of total liabilities by adjusted operating cash flows of four car
manufacturers in fiscal year 2009
Adjusted opera ng cash flows
Total liabili es
Coverage of total liabili es by
adjusted opera ng cash flows
BMW (data
in EUR
million)
Fiat (data in
EUR million)
Ford (data in
USD million)
Volkswagen
(data in EUR
million)
3.484
4.267
29.534
10.793
82.038
56.120
201.365
139.748
4,2%
7,6%
14,7%
7,7%
=3.484/
82.038
=4.267/
56.120
=29.534/
201.365
=10.793/
139.748
Source Annual reports of individual companies for fiscal year 2009 and authorial
computations
Appendix
See Tables 6.20, 6.21, 6.22, 6.23, and 6.24.
6 Problems of Comparability and Reliability …
211
Table 6.20 Extract from the US District Court’s conclusions of its investigation of the
accounting fraud committed by China MediaExpress Holdings Inc
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
UNITED STATES SECURITIES AND EXCHANGE COMMISSION, Plaintiff,
vs. CHINA MEDIAEXPRESS HOLDINGS, INC., and ZHENG CHENG,
Defendants
SUMMARY
1. From its inception as a public company, China Media Express Holdings, Inc.
[…] massively overstated its cash balances in filings with the Commission and press
releases issued to the investing public.
2. […].
3. Beginning in at least November 2009 and continuing thereafter, China
Media—led by Cheng—materially overstated its cash balances in press releases and
public filings with the Commission by a range of approximately 452% to over
40,000%. For example, on March 31, 2010, China Media filed its 2009 Form 10-K
and reported $57 million in cash on hand for the fiscal year ended December 31,
2009 when it actually had a cash balance of only $141,000. On November 9, 2010,
the Company issued a press release announcing a cash balance of $170 million for
the period ended September 30, 2010 when it actually had a cash balance of merely
$10 million.
4. […].
5. As China Media made materially false representations about its business
operations and financial condition, including its cash balances, the Company’s stock
price spiked. On October 15, 2009, the date China Media became a publicly traded
company, its stock closed at $7.59 per share. Slightly more than one year later—
when China Media, on November 9, 2010, falsely reported a cash balance of $170
million—the stock closed at $20.18 per share.
6. China Media’s falsely reported increases in its cash balances allowed the
Company to attract investors and raise money from stock sales. […]
Source United States District Court for the District of Columbia: Case 1: 13-cv-00927
Document 1 Filed 06/20/13
212
J. Welc
Table 6.21 Extract from the U.S. Securities and Exchange Commission’s
announcement regarding the accounting fraud committed by Satyam Computer
Services Limited
U.S. SECURITIES AND EXCHANGE COMMISSION
SEC Charges Satyam Computer Services With Financial Fraud
FOR IMMEDIATE RELEASE 2011–81
Washington, D.C., April 5, 2011—The Securities and Exchange Commission today
charged India-based Satyam Computer Services Limited with fraudulently overstating
the company’s revenue, income and cash balances by more than $1 billion over five
years.
[…]
According to the SEC’s complaint, Satyam’s former senior managers engineered a
scheme that created more than 6,000 phony invoices to be used in Satyam’s general
ledger and financial statements. Satyam employees created bogus bank statements to
reflect payment of the sham invoices. This resulted in more than $1 billion in
fictitious cash and cash-related balances, representing half the company’s total assets
[…]
Source U.S. Securities and Exchange Commission: SEC Charges Satyam Computer
Services With Financial Fraud. For Immediate Release 2011-81 (dated April 5, 2011)
Table 6.22 Extract from the announcement published by Patisserie Holdings plc on
October 12, 2018
Patisserie Holdings plc
Patisserie Holdings plc […] announces that the Company, in conjunction with its
professional advisers, has now further progressed its initial investigation into the
shortfall between the Group’s previously reported financial status and the actual
financial status of the Group.
The board of directors of the Company […] believes that the current financial
position of the Company is such that it requires an immediate cash injection of no less
than £20 million without which there is no scope for the Group to continue trading in
its current form and would therefore need to appoint administrators.
Following the initial investigation, the Directors can confirm that the Group has net
debt of approximately £9.8 million. Historical statements on the cash position of the
Company were mis-stated and subject to fraudulent activity and accounting
irregularities […].
Source Patisserie Holdings plc: Trading Update and Proposed Placing (released on
October 12, 2018)
6 Problems of Comparability and Reliability …
213
Table 6.23 Operating and investing cash flows of four car manufacturers reported
for fiscal year 2009
Item of reported cash flows
Reported
numbers
BMW (data in EUR million)
Operating cash flows
Investing cash flows, including:
Development costs (additions)—Source: Note 19 *
Investment in leased products
Disposals of leased products
Additions to receivables from sales financing
Payments received on receivables from sales financing
10.271
−11.328
−1.087
−10.433
6.515
−49.629
47.847
Fiat (data in EUR million)
Operating cash flows, including:
Change in operating lease items
Investing cash flows, including:
Development costs (additions)—Source: Note 14**
Net change in receivables from financing activities
4.601
−41
−2.559
−1.216
882
Ford (data in USD million)
Operating cash flows
Investing cash flows, including:
Acquisitions of retail and other finance receivables and operating
lCollections of retail and other finance receivables and operating
l
Volkswagen (data in EUR million)
16.042
6.469
−26.392
39.884
Operating cash flows, including:
12.741
Change in leasing and rental assets
−2.571
−719
−9.675
−1.948
Change in financial services receivables
Investing cash flows, including:
Additions to capitalized development costs
*In the BMW’s reported cash flow statement this item was included in “Investment
in intangible assets and property, plant and equipment”
**In the Fiat’s reported cash flow statement this item was included in “Investment
in property, plant and equipment and intangible assets […]”
Source Annual reports of individual companies for fiscal year 2009 and authorial
computations
214
J. Welc
Table 6.24 Cash flows reported by Volkswagen Group for fiscal year 2008 in its two
annual reports
2008 as
2008 as
reported in reported in
In millions of EUR
Annual
Annual
Report
Report
Profit before tax
6.608
6.608
Income taxes paid
−2.075
−2.075
Depreciation and amortization expense*
5.191
5.198
Amortization of capitalized development costs
1.392
1.392
Impairment losses on equity investments
32
32
Depreciation of leasing and rental assets and investment
1.823
1.816
Gain/loss on disposal of noncurrent assets
347
37
Share of profit or loss of equity-accounted investment
−219
−219
Other noncash income/expense
765
765
Change in inventories
−3.056
−3.056
Change in receivables (excluding financial services)
Change in liabilities (excluding financial liabilities)
Change in provisions
Change in leasing and rental assets
Change in financial services receivables
Cash flows from operating activities
Investments in property, plant and equipment, and intangible
Additions to capitalized development costs
Acquisition of equity investments
Disposal of equity investments
Change in leasing and rental assets and investment property*
Change in financial services receivables
Proceeds from disposal of noncurrent assets
(excluding leasing and rental assets and investment property)*
Change in investments in securities
Change in loans and time deposit investments
Investing activities
−1.333
−1.333
815
509
815
509
−
−
−2.734
−5.053
10.799
2.702
−6.883
−2.216
−2.597
−6.896
−2.216
−2.597
1
1
−3.055
−5.053
−
−
93
95
2.041
2.041
−1.611
−19.280
−1.611
−11.183
Cash flows from financing activities
8.123
8.123
Effect of exchange rate changes on cash and cash equivalents
Net change in cash and cash equivalents
−113
−471
−113
−471
Cash and cash equivalents at end of period
9.443
9.443
*Minor reclassifications (without significant impact on reported numbers) related to
investment properties, were done in 2009
Source Annual reports of Volkswagen Group for fiscal years 2008 and 2009
6 Problems of Comparability and Reliability …
215
References
De La Torre, I. (2009). Creative Accounting Exposed . London: Palgrave Macmillan.
Healy, P. M., & Wahlen, J. M. (1999). A Review of the Earnings Management
Literature and Its Implications for Standard Setting. Accounting Horizons, 13,
365–383.
Mulford, C. W., & Dar, M. (2012). Misleading Signals from Operating Cash Flow
in the Presence of Non-controlling Interests. The Journal of Applied Research in
Accounting and Finance, 7, 2–13.
Steer, T. (2018). The Signs Were There. The Clues for Investors That a Company Is
Heading for a Fall. London: Profile Books.
7
Evaluation of Financial Statement Reliability
and Comparability Based on Quantitative
Tools Other Than Cash Flows: Primary
Warning Signals
7.1
Introduction
Chapter 5 presented three tools useful in evaluating reliability and comparability of corporate financial reports. Two of those tools (auditor’s opinion and
narrative disclosures in financial reports) had a qualitative nature, while the
third one was based on quantitative accounting inputs (i.e. relative changes
of cash flows and accounting earnings). In this chapter (as well as in the
following one) the latter analytical approach, based on a numerical information extracted from financial reports, will be developed further, with a
set of simple metrics. These metrics will be called “signals”, since they are
aimed at signaling some problematic or doubtful areas, either related to
accounting issues (e.g. an aggressive application of accounting principles) or
to some business-related factors (such as unbalanced growth of inventories or
overinvestment in fixed assets).
All analytical tools demonstrated in this chapter (as well as in the following
one) are aimed at warning a financial statement user against a rising risk that
an investigated company’s reported earnings are not sustainable. As will be
seen, in case of some companies used as our real-life examples, the unsustainability which was signaled meant an upcoming collapse of the accounting
earnings, without causing a company’s demise. In other, more extreme cases,
the presented warning signals pointed to various problematic areas, which
ultimately drove the investigated firms to bankruptcy.
Majority of the warning signals demonstrated in the following sections (as
well as in the next chapter) use inputs which come from primary statements
only, usually from both an income statement and a balance sheet. The others
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_7
217
218
J. Welc
call for some additional data, typically extracted from notes to financial statements or from a cash flow statement. In any case, however, a construction
of these signals makes their practical application very simple and intuitive.
Nevertheless, as will be seen, despite their simplicity these signals constitute
a very powerful set of analytical tools.
7.2
Signal No 1: Discrepancies Between
Revenue Growth and Inventory Growth
In case of majority of manufacturing or merchandising businesses inventories tend to change, from period to period, in tune with changes of revenues
(apart from seasonal variations). A healthy growth of revenues is usually
accompanied by a balanced growth of inventories, while shrinking sales are
usually followed by falling inventory balances. Therefore, if in any period the
inventory growth (year over year) significantly exceeds the revenue growth,
one or more of the following factors are in play:
• Market-related issues—a given company manufactures or purchases more
inventories than it is able to sell, with resulting stockpile of excess inventories (in which case, however, no impairment, meant as a fall of recoverable
value below a historical cost, is stated).
• Accounting-related issues—a company reports inventories at overstated
carrying amounts (i.e. above their recoverable values), for instance as a
result of:
– Inadequate write-downs of impaired inventories (e.g. obsolete ones),
– Aggressive capitalization of fixed manufacturing expenses (e.g. production overheads) in carrying amounts of inventories, in periods of
unusually low level of output,
– Inclusion of nonexistent (fictitious) items in a carrying amount of
inventory.
• Intended increase of inventory balances—when managers deliberately
increase its supplies of inventories, e.g. during an expansion into new
markets (which requires putting inventories on shelves in new points of
sales, before any revenues are generated in those new locations) or in order
to make a company’s offer more attractive to customers (e.g. by offering
more product categories).
7 Evaluation of Financial Statement …
219
In case of the latter of the three factors, inventory growth may temporarily
exceed revenue growth by a high margin, with no negative consequences for
profitability and liquidity (as long as a given company’s market strategy is
successful). However, if inventories grow significantly faster than sales due to
market-related or accounting-related issues, then such a tendency should be
interpreted as a warning signal, suggesting a rising likelihood of an upcoming
negative earnings surprise (or even a loss of financial liquidity). This observation is confirmed by empirical studies, which found that firms with excessive
inventory increases usually experience significant deterioration of profitability
in the following periods (Thomas and Zhang 2002; Spathis et al. 2002). A
collapse of earnings, following periods of an unbalanced growth of inventories, is usually triggered either by a “fire sale” of excess inventories (at deeply
discounted prices) or by write-downs of their carrying amounts (or both).
7.2.1 Burberry Group Plc
Our first real-life example of the unbalanced inventory growth as a warning
signal, preceding an off-sale of excess inventories (with a depressing impact on
profits), is Burberry Group plc, whose selected accounting data are presented
in Table 7.1.
In its fiscal year ended March 31, 2007, the company’s sales revenues grew
by 14,5% y/y, while the carrying amount of its inventories rose by 20,6% y/y.
A gap between the two growth ratios, equaling approximately six percentage
points, should have been interpreted as a symptom of some possible weaknesses (e.g. eroding competitiveness), but not yet as a strong warning signal.
Table 7.1 Selected financial statement data of Burberry Group plc for fiscal years
ended March 31, 2006–2009
*Burberry Group plc uses term “Turnover” for net sales
Source Annual reports of Burberry Group plc for fiscal years ended March 31, 2007–
2009 and authorial computations
220
J. Welc
However, in the following fiscal year the revenue growth speeded up to 17,1%
y/y, while inventories rose by almost 80% y/y (i.e. more than four times
faster than sales). This, in turn, should have been considered a very strong
predictor of probable incoming collapse of the company’s earnings. Indeed,
in its fiscal year ended March 31, 2009, the company reported an operating loss of almost 10 GBP million (as compared to a profit of 201,7 GBP
million reported one year earlier), despite its continued double-digit growth
of revenues.
Table 7.30 (in the appendix) contains an extract from the narrative part of
the Burberry’s annual report for its fiscal year ended March 31, 2009, referring to the company’s activities undertaken with an aim of reducing the level
of its inventories. As might be read, a reduction of inventory levels entailed
an erosion of the Burberry’s gross margin on sales (which, in turn, depressed
the company’s operating result).
7.2.2 Pittards Plc
Another interesting inventory-related example is Pittards plc, whose selected
accounting data are disclosed in Table 7.2.
As may be seen in Table 7.2, the company’s revenues fell systematically
between 2012 and 2016. In spite of this, a carrying amount of its inventories grew in every single year between 2012 and 2015. Obviously, such
multi-year “scissors” of trends of revenues (falling) and inventories (growing)
should have been interpreted as a very strong symptom of stockpiling excess
inventories, which sooner or later would have to be either disposed of at
discounted prices or written down. Indeed, as shown in Table 7.3, a collapse
of the company’s operating result in 2016 (to a loss of 3,6 GBP million)
was almost entirely attributable to a special one-off charge to cost of sales
Table 7.2 Selected financial statement data of Pittards plc for fiscal years 2012–2016
*Pittards plc uses term “Revenue” for net sales
Source Annual reports of Pittards plc for fiscal years 2013–2016 and authorial
computations
7 Evaluation of Financial Statement …
221
Table 7.3 Revenues, cost of sales and gross profit of Pittards plc for fiscal years
2015–2016
Data in GBP thousands
Revenue
Cost of sales
Cost of sales - excep onal stock provision
Gross profit
2015
2016
30.523
27.009
−23.902
−20.554
–
−4.307
6.621
2.148
Source Annual report of Pittards plc for fiscal year 2016
(labeled by the company as “exceptional stock provision”), which reflected its
write-down of impaired inventories and amounted to 4,3 GBP million.
7.2.3 Toshiba Corp
On September 7, 2015, the Toshiba Corporation’s board of directors
announced its detection of a falsification of the company’s financial statements, published before for fiscal years 2008–2014. It has been found that
Toshiba manipulated its past financial reports by using multiple techniques
of “creative accounting”, from an aggressive application of percentageof-completion method, through inappropriate accounting for multiplearrangement contracts (component transactions) to overstating inventories.
Table 7.31 (in the appendix) contains a reconciliation of the Toshiba’s previously reported (before a correction) and then revised pre-tax earnings, for the
company’s fiscal years 2009–2012 (even though the Toshiba’s revisions have
been done for seven years, only those four periods are investigated here for
which material inventory overstatements had been detected).
As may be concluded from Table 7.31, in fiscal years 2009–2012 inappropriate inventory valuation in the semiconductor business boosted the
Toshiba’s reported pre-tax income by a total amount of 52,9 JPY billion [=
4,4 + 1,6 + 10,3 + 36,6]. This constituted 10% of the company’s cumulative income before income taxes, amounting to 526,9 JPY billion [= 27,2 +
194,7 + 145,4 + 159,6]. As explained in Table 7.32 (in the appendix), which
contains an extract from the company’s annual report (after a retrospective
restatement) for fiscal year ended March 31, 2012, the multi-period overstatement of inventory was attributable to work-in-progress items, in which
case a recognition of impairments was delayed until the time of an actual
222
J. Welc
Table 7.4 Selected financial statement data (before their retrospective restatement)
of Toshiba Corp. for fiscal years (ended March 31) 2008–2012
Source Annual report of Toshiba Corp.(before retrospective restatement) for fiscal
year ended March 31, 2012, and authorial computations
disposal of finished goods. Such an approach resulted in understated cost of
goods sold.
Table 7.4 presents Toshiba’s net sales and inventories (before their retrospective restatements) for five consecutive periods. As may be seen, in fiscal
year ended March 31, 2009, the company’s net sales fell by 12% y/y, which
was accompanied by a reduction of carrying amount of its inventories by
almost 11% y/y. Accordingly, no significant warning signal, based on a gap
between growth rates of sales and inventories, could have been detected at
that time (even though the company already overstated its earnings reported
for that period, in correspondence to its inventories, by 4,4 JPY billion).
However, in the following three years the gap between revenue and inventory growth widened to several percentage points each year. Cumulatively,
between 2009 and 2012 the Toshiba’s reported annual net sales fell by 6,3%
(i.e. from 6.512,7 JPY billion to 6.100,3 JPY billion), while at the same time
the carrying amount of its inventories grew by as much as 16,6% (i.e. from
758,3 JPY billion to 884,3 JPY billion). Accordingly, it may be concluded
that even before the Toshiba’s official announcement of its past accounting
manipulations (in September 2015), some evident inventory-related “red
flags” could have been observed much earlier.
7.2.4 Conclusions
As shown by all three real-life examples discussed above, an evaluation of
inventory changes (relative to revenue growth) should constitute an essential
element of a financial analysis of any inventory-intensive business. Unbalanced inventory growth (particularly when recurring several periods in a
7 Evaluation of Financial Statement …
223
row) often precedes a collapse of reported earnings, either because of inventory sell-offs (Burberry Group) or deep inventory write-downs (Pittards) or
restatements of previously published financial results (Toshiba).
7.3
Signal No 2: Discrepancies Between
Revenue Growth and Receivables Growth
Most businesses which operate in a B2B (business-to-business) environment
offer their customers deferred payment terms. Such trade credits are also
offered by some firms which sell consumer goods or services (e.g. utilities
supplying water or electric energy to households). An existence of deferred
payment terms means that collections of customer payments for delivered
goods or services lag behind revenue recognition in income statement (with a
resulting presence of receivable accounts on balance sheet). Such businesses,
however, tend to report changes of receivables (from period to period) which
correspond to changes of revenues (apart from seasonal variations). Thus,
similarly as in the case of inventories discussed earlier, a healthy sales growth
is usually accompanied by a balanced growth of receivable accounts, while
contracting revenues are typically followed by falling receivables. Therefore,
if in any period growth (year over year) of receivables significantly exceeds
growth of revenues, then one or more of the following factors are in play:
• Market-related issues—a company faces increasing competitive pressures,
e.g. due to deteriorating macroeconomic conditions or aggressive pricing
policies adopted by its competitors or worsening customer perception of
the company’s product quality, with a resulting accumulation of uncollected receivables (in which case, however, no any impairment, meant as a
fall of recoverable value below carrying amount, is stated).
• Accounting-related issues—a company reports receivables at inflated
carrying amounts (i.e. above their recoverable values), for instance as a
result of:
– Inadequate write-downs of uncollectible accounts (so-called bad debts),
– Aggressive revenue recognition policy (e.g. pre-mature recognition of
revenues from sales with a right of product return),
– Inclusion of nonexistent accounts in a carrying amount of receivables
(e.g. resulting from prior recognition of revenues from fictitious sales).
• Intended increase of receivable accounts—a given company’s managers
deliberately extend a length of deferred payment terms offered to customers
224
J. Welc
(in order to boost sales and increase market share) or the company’s revenue
breakdown shifts from retail operations toward higher share of wholesale
operations.
In case of the latter of the three factors, receivable accounts may
temporarily grow significantly faster than revenues, with no negative consequences for profitability and liquidity (provided that a firm adopts an effective
credit risk management policy). However, if receivables grow significantly
faster than sales due to market-related or accounting-related issues, then such
a tendency should be deemed a warning signal, implying a rising risk of future
negative earnings surprise or incoming problems with financial liquidity
(Persons 1995; Dechow et al. 1996; Beneish 1999; Marquardt and Wiedman
2010). A collapse of earnings, following periods of an unbalanced growth of
receivables, is usually caused either by write-offs of carrying amounts of those
accounts, which no longer may be deemed recoverable (when prior growth of
receivables was driven by accounting-related issues), or by an ultimate loss of
a profit-generation ability, reflected in falling sales and shrinking margins (if
an earlier growth of receivables stemmed from mounting market pressures).
7.3.1 Ingenta Plc
Ingenta plc (a provider of software and software-related services to global
publishing industry) constitutes a good illustration of an unbalanced growth
of receivables as a leading indicator of incoming collapse of earnings. Its
selected accounting data are presented in Table 7.5.
As may be seen, between 2011 and 2013 the company’s receivables grew
several times faster than its net sales, with a rising portion of the reported
revenues being uncollected at the end of the year. In particular, in 2013 the
company’s sales growth slowed down significantly (to only slightly above 2%
y/y), while carrying amount of its receivable accounts continued to rise with
a double-digit pace. Such a repeated (multi-period) unbalanced growth of
uncollected invoices should have been interpreted as a strong symptom of
a doubtful sustainability of the company’s revenues and profits. In fact, in
the following year the company’s revenues contracted sharply (by 17% y/y),
with a resulting loss on operations amounting to more than 3,5 GBP million
(i.e. more than twice the summed amount of operating profits reported
for the preceding three years). As the data for 2015 show, the prior-year
decline of revenues and operating results was not a temporary one (and probably reflected some longer-term problems with the company’s competitive
position).
7 Evaluation of Financial Statement …
225
Table 7.5 Selected financial statement data of Ingenta plc for fiscal years 2011–2015
*Ingenta plc uses term “Revenue” for net sales
Source Annual reports of Ingenta plc for fiscal years 2012–2015 and authorial
computations
Table 7.6 Selected financial statement data of Aegan Marine Petroleum Network
Inc. for fiscal years 2013–2016
Source Annual reports of Aegan Marine Petroleum Network Inc. for fiscal years 2014–
2016 and authorial computations
7.3.2 Aegan Marine Petroleum Network Inc
Another educative real-life example of a doubtful accumulation of receivable
accounts is Aegan Marine Petroleum Network Inc. (a marine fuel logistics company, headquartered in Greece and listed on the New York Stock
Exchange), whose selected accounting data are presented in Table 7.6.
In 2014 the Aegan Marine’s revenues rose by 5,2% y/y, while a carrying
amount of its receivable accounts fell by almost one fourth. Clearly, in that
period the relative changes of the company’s receivables and revenues did not
generate any warning signal. However, in the following year the company’s
net sales plummeted by over 36%, while its accounts receivable fell by only
12,4% y/y. Such a deep erosion of revenues, combined with a sluggish reduction of a balance of uncollected invoices, could have suggested an existence
226
J. Welc
of some market-related issues (for instance, financial troubles faced by some
of the company’s customers, manifested in a reduced volume of orders and
delayed settlements of amounts owed to Aegan Marine). However, a really
strong warning signal appeared in the company’s annual report for 2016,
when the fall of revenues by 3,7% was accompanied by a ballooning of
receivables, which rose by as much as almost 63%. Obviously, such a wide
gap between changes of revenues (falling) and receivables (growing very
fast) should have been interpreted as a very strong symptom of a possible
overstatement of reported receivable accounts and profits.
These legitimate doubts have been confirmed by a Form 6-K report, issued
by Aegan Marine Petroleum Network Inc. in June 2018. Table 7.33 (in the
appendix) contains an extract from that document, referring to the company’s
receivable accounts. As may be read, the company’s Audit Committee found
that at the end of 2015, 2016 and 2017 the company included in its trade
receivables some accounts (with carrying amounts growing from period to
period), allegedly owed by the company’s four customers. However, according
to the Audit Committee’s findings, the underlying transactions between the
company and these counterparties lacked an economic substance (which
effectively means that the company recognized revenues from fictitious
sales, probably aimed at a deliberate overstatement of its reported revenues
and earnings). Obviously, such fabricated receivables could have not been
collected, which entailed a necessity of their write-off, amounting to approximately 200 USD million (which made up about 87% of the summed
operating income reported by Aegan Marine Petroleum Network for 2014,
2015 and 2016).
7.3.3 OCZ Technology Group Inc
A final real-life example which corroborates an importance of examining
growth of receivables (relative to changes of revenues) is OCZ Technology
Group Inc. As might be remembered from a discussion in Sect. 5.3 of
Chapter 5, the company manufactured a computer hardware and filed for
bankruptcy in 2013. In its annual report for fiscal year ended February 28,
2013, the company restated its previously published financial statements,
due to multiple prior accounting misstatements. In Note 2 to consolidated
financial statements for fiscal year ended February 28, 2013, the company’s
managers admitted that in the past it applied a very aggressive revenue-related
accounting policy, resulting in a premature recognition of some sales (which,
in turn, boosted not only the company’s reported revenues and earnings,
but also overstated its receivable accounts, which constituted a contractual
7 Evaluation of Financial Statement …
227
Table 7.7 Selected financial statement data of OCZ Technology Group Inc. for fiscal
years ended February 28/29, 2010–2012
Fiscal years ending
Data in USD thousand
Data reported
in financial
statements
Growth y/y
February 28, 2010
February 28,
2011
February 29,
2012
143.959
190.116
365.774
20.380
31.687
72.543
Net revenue
–
+32,1%
+92,4%
Accounts receivable, net
–
+55,5%
+128,9%
Net revenue
Accounts receivable, net
Source Annual report of OCZ Technology Group Inc. for fiscal years ended February
28, 2011, and February 29, 2012, and authorial computations
base for its borrowings). In other words, the company inflated its previously reported revenues, earnings and receivable accounts, by prematurely
recognizing revenues which should have been deferred.
Table 7.7 presents selected accounting numbers (before their restatements),
reported by OCZ Technology Group Inc. in its consolidated financial statements for fiscal years ending February 28/29, 2010–2012. As may be seen,
during the analyzed three-year period the company’s reported annual revenues
rose cumulatively by over 154% (i.e. from 144,0 USD million to 365,8 USD
million), while a carrying amount of its receivables increased in the same time
by as much as 256% (i.e. from 20,4 USD million to 72,5 USD million). In
the last two investigated periods the growth of receivable accounts exceeded
the growth of sales by as many as 23,4–36,5 percentage points, with the gap
widening from period to period. Accordingly, it may be concluded that an
observation of the OCZ Technology Group’s receivable accounts and revenue
trends could have generated timely and accurate signals, warning inventors
and other financial statement users against the company’s aggressive revenue
recognition policy.
7.3.4 Conclusions
As illustrated by all three real-life examples, an evaluation of trends in
receivable accounts (relative to sales revenues) should constitute an essential element of a financial analysis of any firm reporting significant amounts
of receivables. Suspiciously fast growth of these accounts often precedes a
collapse of reported earnings, either because of a loss of a competitive position
or due to deep write-offs.
228
7.4
J. Welc
Signal No 3: Discrepancies Between
Growth Rates of Revenues and Unbilled
Receivables from Long-Term Contracts
Trade receivable accounts, discussed above, constitute the most common type
of receivables recognized on balance sheets of those businesses, which sell
their goods or services with deferred payment terms. Usually such receivables originate from billings of customers, once a transfer of goods or services
to a customer is completed. A common feature of most such trade receivables is timing of a revenue recognition, typically at a single point in time.
In contrast, businesses involved in long-term contracts (e.g. construction or
heavy equipment companies) recognize another type of receivables, which
have a substance of unbilled receivable accounts. These receivables result
from an application of the percentage-of-completion method, under which
revenues and profits from a given contract are booked in tune with a progress
toward completion of a contracted work.
As was illustrated in Sect. 3.3.4 of Chapter 3, under the percentage-ofcompletion method the contract revenues (and profits) are recognized on a
ground of estimated progress of the contract toward its completion. Such
measurements may be based either on some engineering estimates or on
contract costs incurred to date. For instance, if total budgeted (expected)
costs of a given contract amount to 10 EUR million, while 7 EUR million
has been spent to date, then the estimated percentage of completion equals
70% [= 7/10]. As was demonstrated in Sect. 3.3.4 of Chapter 3, a major
risk of such an approach to accounting for long-term contracts lies in its
possible aggressive application, whereby the estimated percentage of completion may be overstated, with a corresponding temporary overstatement of
reported revenues and profits (Nelson et al. 2003; Loughran and McDonald
2011; Kwon and Lee 2019). This typically is a result of either cost overruns
or overly optimistic forecasts of expected contract costs.
Usually there is at least one symptom visible in financial statements,
suggesting a possibility of an aggressive recognition of revenues and profits
from long-term contracts. This is a growth of unbilled receivables (i.e.
receivables originating from an application of the percentage-of-completion
method) exceeding growth of total revenues, particularly when recurring
several periods in a row (Jung et al. 2018). It must be noted, however,
that companies use variety of different labels for unbilled receivables (such
as “contract assets”, “long-term contract receivables”, etc.) and sometimes
they even include them within a broader classes of assets, such as “trade and
other receivables”. This means that a diligent reading of notes to financial
7 Evaluation of Financial Statement …
229
statements is often necessary when searching for assets related to long-term
contract.
7.4.1 General Electric Co
The first example illustrating an application of this warning signal is General
Electric Company (further in the text abbreviated to GE), whose selected
financial statement data are presented in Table 7.8.
As may be seen, in each year between 2014 and 2017 a carrying amount of
the company’s contract assets grew significantly faster than its total revenues.
Between 2014 and 2017 the contract assets rose cumulatively by as much as
70% (28.861 USD million vs. 16.960 USD million), while annual revenues
grew in the same time by mere 4,2% (122.092 USD million vs. 117.184
USD million). Clearly, such a long-term trend of ballooning contract assets
called for a detailed investigation of their nature and composition.
Table 7.9 contains an extract from GE’s annual report for fiscal year 2015,
which explains a nature of the company’s contract assets. As may be read,
this item of balance sheet includes unbilled receivable accounts (“revenues
earned in excess of billings”), related to the company’s long-term contracts.
Table 7.10, in turn, shows a composition of GE’s contract assets as at the end
of 2015, 2016 and 2017. From that table it may be concluded that a sizeable
increase in carrying amount of contract assets, observed between the end of
2015 and the end of 2017, was attributable to revenues in excess of billings
(i.e. unbilled receivables) and deferred inventory costs, since the other two
components of the GE’s contract assets stood almost flat across those periods.
Table 7.8 Selected financial statement data of General Electric Co. for fiscal years
2014–2017
*General Electric Co. uses term “Contract assets” for unbilled receivables related to
long-term contracts
Source Annual reports of General Electric Co. for fiscal years 2015–2017 and authorial
computations
230
J. Welc
Table 7.9 Extract from Note 9 to consolidated financial statements of General
Electric Co. for fiscal year 2015, explaining the substance of the company’s contract
assets
Note 9 (Contract assets and all other assets)
Contract assets reflect revenues earned in excess of billings on our long-term contracts to
construct technically complex equipment (such as gas power systems and aircra engines),
long-term product maintenance or extended warranty arrangements and other deferred
contract related costs. Long-term product maintenance amounts are presented net of
related billings in excess of revenues of $2,602 million and $2,329 million at December 31,
2015 and 2014, respecvely. Included in contract assets at December 31, 2015, is $1,979
million related to the Alstom acquision.
Source Annual report of General Electric Co. for fiscal year 2015
Table 7.10
2017
Composition of GE’s contract assets as at the end of fiscal years 2015–
Data in USD million
Total revenue in excess of billings
Deferred inventory costs
Nonrecurring engineering costs
Customer advances and other
Contract assets*
December 31, 2015
December 31, December
2016
31, 2017
15.991
2.328
18.611
3.349
22.111
3.839
1.790
2.185
1.814
1.048
1.018
1.097
21.156
25.162
28.861
*the sum of the components reported in millions may not equal the total amount
reported in millions due to rounding
Source Annual reports of General Electric Co. for fiscal years 2016 and 2017
Thus, it is advisable to dig deeper in the company’s annual reports, in search
of the causes of such a fast accumulation of its unbilled receivables. Table 7.11
offers another extracts from notes to the GE’s financial statements, explaining
briefly the reasons staying behind it.
Such narrative disclosures as those quoted in Table 7.11 should never be
downplayed, since they offer an information which is invaluable in evaluating quality and sustainability of reported corporate results. As may be read,
in two consecutive years (2016 and 2017) managers of General Electric Co.
changed their estimates of profitability of the company’s long-term contracts.
Their expectations (e.g. forecasted total project costs) were becoming more
and more optimistic, with resulting positive contributions of the revised
assumptions into the company’s reported earnings. Such repeated shifts in
managerial attitudes (toward more optimistic expectations), combined with
the company’s deteriorating revenues and margins, should have suggested
7 Evaluation of Financial Statement …
231
Table 7.11 Extracts from Note 9 to consolidated financial statements of General
Electric Co. for fiscal years 2016 and 2017, explaining the reasons staying behind
increases in carrying amounts of the company’s contract assets
Annual Report 2017: Note 9 (Contract assets)
Contract assets increased $3,699 million in 2017, which was primarily driven by a change in
esmated profitability of $2,131 million within our long-term product service agreements
within Power ($1,301 million), Transportaon ($361 million), Aviaon ($250 million) and Oil
& Gas ($288 million), and deferred inventory costs increased $490 million within Power
($397 million) and Oil & Gas ($121 million) due to the ming of revenue recognized for work
performed relave to the ming of billings and collecons.
Annual Report 2016: Note 9 (Contract assets and all other assets)
Contract assets increased $4,006 million in 2016, which was primarily driven by a change is
esmated profitability within our long-term product service agreements resulng in an
adjustment of $2,216 million, as well as an increase in deferred inventory costs.
Source Annual reports of General Electric Co. for fiscal years 2016 and 2017
a high dose of an analytical skepticism as regards a sustainability of the
company’s reported financial results.
Indeed, in 2018 the US Securities and Exchange Commission (SEC) initiated an probe aimed at reviewing the GE’s accounting policy applied to its
contract assets (unbilled revenues). The SEC’s interest has been focused on
checking whether General Electric Co. had been too aggressive in formulating (and then revising) its expectations of contract revenues and costs. In
light of the GE’s data discussed above (in particular a ballooning of carrying
amount of its contract assets, as compared to much more sluggish revenues),
such a probe undertaken by a regulatory body should come as no surprise to
any skillful reader of GE’s published financial reports.
In context of the General Electric’s data and narratives (discussed above)
it is important to note that the company’s multi-period and wide divergence
between a sluggish revenue growth and ballooning long-term contract assets
were followed not only by the US Securities and Exchange Commission’s
probe into the company’s accounting practices, but also by a collapse of its
earnings. In 2017 General Electric reported a pre-tax loss on continued operations, amounting to 8,8 USD billion (according to the company’s annual
report for 2017), which was restated in the annual report for 2018 downward, to 11,2 USD billion. However, not only the loss incurred in 2017 has
been restated, but also the company reported a loss of 20,1 USD billion for
fiscal year 2018. Accordingly, the warning signals discussed above preceded a
deep deterioration of General Electric’s profitability.
232
J. Welc
7.4.2 Carillion Plc
Carillion plc, currently a defunct British construction company, offers an
another interesting illustration of a relevance of tracking changes of unbilled
receivables (as compared to revenue growth) in evaluating sustainability of
earnings reported by firms involved in long-term contracts. The company’s
bankruptcy in 2017 constituted a shock to investors’ community. However,
the Carillion’s data presented in Table 7.12 suggest that warning signals about
the mounting imbalances in the company’s financial statements could be seen
as early as in 2012–2014.
It is important to note, when investigating the numbers presented in
Table 7.12, that unlike General Electric, Carillion plc has not reported its
unbilled receivables (which they labeled as “amounts owed by customers on
construction contracts”) as a separate line item in its balance sheet. Instead,
as might be seen in Table 7.13 and Table 7.14, the company included those
assets within a much broader class of “Trade and other receivables”. Therefore, unskillful reader of Carillion’s balance sheets could have overlooked an
existence of such contract assets. This confirms an importance of a careful
reading of notes to financial statements, when evaluating a quality of reported
earnings. Finally, in order to make sure that item labeled “amounts owed by
customers on construction contracts” is a synonym used by Carillion plc for
Table 7.12 Selected financial statement data of Carillion plc for fiscal years 2011–
2016 (rounded)
*Carillion plc used term “Group revenue” for net sales
**Carillion plc used term “Amounts owed by customers on construction contracts”
for unbilled receivables
Source Annual reports of Carillion plc for fiscal years 2012–2016 and authorial
computations
233
7 Evaluation of Financial Statement …
Table 7.13 Current assets of Carillion plc as at the end of fiscal years 2015 and 2016
December 31,
Data in GBP million
Note December 31, 2015
2016
Inventories
Trade and other receivables
15
17
64,3
1.270,8
78,8
1.664,0
Cash and cash equivalents
18
462,2
469,8
Derivave financial
26
14,6
46,4
1,2
10,8
1.813,1
2.269,8
Income tax receivable
Total current assets
Source Annual report of Carillion plc for fiscal year 2016
Table 7.14 Note 17 (Trade and other receivables) to financial statements of Carillion
plc for fiscal year 2016
December 31,
2015
December 31,
2016
Trade receivables
Amounts owed by customers on construcon contracts
253,1
386,8
229,5
614,5
Other receivables and prepayments
Data in GBP million
550,1
749,5
Amounts owed by joint ventures
59,6
59,9
Amounts owed under jointly controlled operaons
21,2
10,6
1.270,8
1.664,0
Total
Source Annual report of Carillion plc for fiscal year 2016
Table 7.15 Extract from Note 31 to financial statements of Carillion plc for fiscal
year 2016
Note 31 (AccounƟng esƟmates and judgments)
In determining the revenue and costs to be recognised each year for work done on
construc on contracts, es mates are made in rela on to the final out-turn on each contract.
[...] Management con nually reviews the es mated final out-turn on contracts and makes
adjustments where necessary. [...]
The amounts recognized based on the es mated and judgments noted above are included
within Amounts owed by customers on construc on contracts (£614.5) disclosed within
note 17 Trade and other receivables and represent management’s best es mate of the
outcome for the Group’s por olio of contracts and is subject to es ma on as discussed
above.
Source Annual report of Carillion plc for fiscal year 2016
234
J. Welc
unbilled receivables, Table 7.15 provides an extract from a narrative part of
the company’s annual report for 2016.
As might be clearly seen in Table 7.12, between 2011 and 2014 Carillion plc experienced a rather unbalanced growth of its unbilled receivables
(i.e. amounts owed by customers on construction contracts), which grew
cumulatively by as much as 36% (438 GBP million in 2014 vs. 322 GBP
million in 2011), as compared to a cumulative shrinkage of revenues by
almost 16% (3.494 GBP million in 2014 vs. 4.153 GBP million in 2011).
Obviously, such a stubborn adverse tendency should have been interpreted as
a serious warning signal. A seemingly positive break in this time-series came
in 2015, when the group’s reported revenues grew by more than 13%, while
a carrying amount of its unbilled receivables fell by almost 12%. However,
that improvement has turned out to be transitory only, since in 2016 (the
last fiscal year before the company’s financial default) the Carillion’s unbilled
receivables ballooned by almost 59% y/y, i.e. more than five times faster
than revenues, which rose by slightly over 11% y/y. Clearly, in light of such
skyrocketing values of Carillion’s unbilled receivables in 2016 (on the background of its much slower revenue growth), the company’s following troubles
should come as no surprise to any diligent analyst of its published financial
statements.
7.4.3 Astaldi Group
A final example confirming a relevance of examining trends in unbilled
receivables is Astaldi Group, the Italian construction company which filed
for bankruptcy in October 2018. Table 7.16 presents its revenues, pre-tax
earnings and amounts due from customers (which was a label used by the
company for its receivables stemming from long-term contracts), reported
for five consecutive years before the company’s collapse.
As may be seen, no concerns could have been raised between 2013 and
2015, since at that time the company’s revenues grew faster than its amounts
due from customers. However, a situation changed radically in the following
two years, when carrying amount of unbilled receivables rose several times
faster than revenues. Cumulatively, between 2015 and 2017 the Astaldi
Group’s annual net sales increased by 5,8% (i.e. from 2.730,0 EUR million
to 2.888,3 EUR million), while its amounts due from customers inflated by
as much as 37,1% (i.e. from 1.243,0 EUR million to 1.704,5 EUR million).
In light of such a wide gap between the observed changes of revenues and
unbilled receivables, the company’s financial collapse in 2018 should come
7 Evaluation of Financial Statement …
235
Table 7.16 Selected financial statement data of Astaldi Group for fiscal years 2013–
2017 (rounded)
Data in EUR million
Total operang
revenue
Data
Pre-tax profit
2013
2014
2015
2016
2017
2.381,4
2.540,4
2.730,0
2.851,8
2.888,3
130,0
130,7
111,5
129,1
−115,8
1.261,8
1.165,3
1.243,0
1.555,1
1.704,5
–
+6,7%
+7,5%
+4,5%
+1,3%
–
−7,6%
+6,7%
+25,1%
+9,6%
reported in
financial
statements
Amounts due from
customers*
Total operang
revenue
Growth y/y
Amounts due
from customers*
*Astaldi Group used term “Amounts due from customers” for its unbilled receivables
Source Annual reports of Astaldi Group for fiscal years 2014–2017 and authorial
computations
as no surprise to any diligent reader of the company’s financial statements,
published for prior years.
7.4.4 Conclusions
As might be seen, a watchful investigation of trends in unbilled receivables
(relative to revenues) should be deemed a crucial step in evaluating financial
results reported by firms involved in long-term contracts (accounted for with
the percentage-of-completion method). Any unbalanced increases in unbilled
receivables should be interpreted as symptoms of deteriorating reliability of
financial statements.
However, the discussion and examples presented in this section focus on
an asset side of long-term contracts only, i.e. on unbilled receivable accounts.
Meanwhile, an application of the percentage-of-completion method affects
also a right-hand side of balance sheet, through liabilities which reflect any
excesses of amounts collected from customers (e.g. from advance payments
for contracts) over revenues recognized on related long-term contracts.
Combining these two items of the balance sheet (reported on its opposite
236
J. Welc
sides) enables adjusting the reported earnings, by unwinding an estimated
impact of the percentage-of-completion method, as if a given firm books
revenues from its long-term contracts when they are invoiced. A procedure
and real-life examples of such analytical adjustments will be presented in
Sect. 10.3 of Chapter 10.
7.5
Signal No 4: High or Fast Growing Share
of Intangibles in Total Assets
Intangibles are considered By many financial analysts “soft assets”, due to
their lack of a physical substance. In comparison to “brick-and-mortar” assets
(e.g. properties, inventories or production machinery), intangibles are difficult to value and audit, which makes them particularly prone to accounting
manipulations. Moreover, even though many separately identifiable intangibles (such as brands or patents) may have very high market values, those
values may evaporate very quickly under adverse changes of market environment (Richardson et al. 2005). This risk is particularly high in case of
goodwill, discussed repeatedly in this book, which does not satisfy the criteria
for being treated as a separately identifiable asset. For instance, unlike copyrighted trademarks, software licenses or patents, goodwill cannot be separated
from a business as a whole, and then sold, rented or used as a loan collateral
(Frank and Goyal 2003). This means that a high or fast rising share of goodwill (but other intangibles as well) in total assets should always be deemed a
potential weakness of investigated financial statements.
Another risk of intangibles, from a perspective of financial statement reliability, stems from their accounting treatment (under both IFRS and US
GAAP). Namely, intangibles with indefinite useful lives (such as goodwill,
trademarks, newspaper titles, etc.) are not subject to scheduled amortization.
Instead, they are periodically tested for an impairment, with an application
of test procedures, which are themselves very subjective and prone to manipulations (e.g. discounted forecasted cash flows). Under such a treatment, as
long as no impairment of value is stated, a carrying amount of such intangibles stays intact from period to period, which implies a lack of any impact
of intangibles on reported operating expenses and profits. This, in turn,
may tempt some managers and accountants to deliberately overstate carrying
amounts of intangible assets, when such an opportunity appears (e.g. when
accounting for business combinations).
Indeed, some research studies found that companies which report their
intangibles aggressively tend to be overvalued (Lev et al. 2005). Therefore, a
7 Evaluation of Financial Statement …
237
suspiciously high or fast growing share of intangibles (including goodwill) in
total assets should be considered as a symptom of a possible deterioration of
a quality of reported earnings. An application of this analytical tool will be
illustrated with three real-life examples.
7.5.1 GateHouse Media Inc
GateHouse Media Inc., once one of the largest publishers of locally based
print and online media in the United States (as measured by a number of
daily publications), filed for bankruptcy in 2013. Media companies operate
in an intangible-intensive environment, which is often manifested in a high
share of intangibles in their total assets. A high amount of intangibles is not
in itself anything bad, as long as it does not become too high. Table 7.17
presents selected data of GateHouse Media Inc. for fiscal years between 2005
and 2009.
As might be seen, already in 2005 GateHouse Media Inc. had a very high
share (almost 84%) of intangibles in its total assets. In the following year
the company enjoyed a fast growth of revenues (almost 50% y/y), which
however was accompanied by even faster growth of intangibles (by about
70% y/y). The fast pace of growth (of both revenues as well as intangibles)
was continued in 2007. As a result, between the end of 2005 and 2007 a
carrying amount of the company’s intangibles rose by almost 1 USD billion
Table 7.17 Selected financial statement data of GateHouse Media Inc. for fiscal years
2005–2009
Source Annual reports of GateHouse Media Inc. for fiscal years 2006–2009 and
authorial computations
238
J. Welc
(from 533,8 USD million at the end of 2005 to over 1.510,6 USD million at
the end of 2007), while during the same time the company’s annual revenues
increased by approximately 370 USD million. Therefore, the company was
featured not only by a repeatedly very high share of intangibles in total
assets (hovering around 80% between 2005 and 2007), but also by a massive
capitalization of new intangible assets.
The growth of sales in 2006 was accompanied by an increase in the
company’s reported operating profit, which rose from 22,7 USD million
in 2005 to 31,2 USD million in 2006. However, in 2007 the continued
fast growth of revenues (which went up even more impressively than a year
before) did not drive the operating profit further upward, since the company
reported a deep operating loss amounting to 182,5 USD million. Even deeper
operating losses (with a total summed amount of over 1 USD billion) were
reported for the following two years.
Data presented in Table 7.17 show also that the operating losses reported
by GateHouse Media Inc. between 2007 and 2009 were entirely attributable
to its impairment charges (write-downs) of long-term assets. In each of
those three years a monetary amount of the impairment charges exceeded
an amount of the operating loss, which means that without those asset
write-downs the company would report positive operating earnings, within
a range between 27 USD million (in 2009) and 45 USD million (in 2007).
It is worthwhile, therefore, to review a composition of the asset impairments charged by the company between 2007 and 2009. This is shown in
Table 7.18.
As may be seen, a line item of the company’s income statement, which
constituted the heaviest burden on its reported operating results in all three
years between 2007 and 2009, was “Goodwill and mastheads impairment ”.
An accumulated three-year negative contribution of these charges into the
company’s earnings amounted to 989,7 USD million [= 225,8 + 488,5 +
275,3], and constituted over 80% of accumulated operating losses incurred
between 2007 and 2009. However, another heavy burden to the results
reported by GateHouse Media Inc. was “Impairment of long-lived assets”,
whose total negative contribution to the reported losses amounted to nearly
330 USD million [= 123,7 + 206,1] in 2008–2009. As might be concluded
from a narrative part of the company’s annual report for 2009, quoted
in Table 7.34 (in the appendix), this item also included large impairment
charges related to intangible assets of a very “soft” nature (which the company
labeled as “advertiser and subscriber relationships”). The impairment charge
related to advertiser and subscriber relationships (206,1 USD million in
2009), combined with the accumulated goodwill and mastheads impairments
7 Evaluation of Financial Statement …
239
Table 7.18 Operating cost breakdown of GateHouse Media Inc. in fiscal years 2007–
2009
Data in USD thousands
2007
2008
2009
Operang costs
309.633
382.333
335.602
Selling, general and administrave
154.406
186.409
165.160
57.092
69.913
55.752
Integraon and reorganizaon costs
7.490
7.113
2.029
Impairment of long-lived assets
1.553
123.717
206.089
Gain (−)/loss (+) on sale of assets
1.496
337
−418
225.820
488.543
275.310
Depreciaon and amorzaon
Goodwill and mastheads impairment
Source Annual report of GateHouse Media Inc. for fiscal year 2009
(989,7 USD million), constituted virtually the only factors responsible for
huge operating losses reported by GateHouse Media Inc. between 2007 and
2009.
The example of GateHouse Media Inc. constitutes a great real-life illustration of risks embedded in an unbalanced growth of intangible assets. In
each of four years between 2005 and 2008, i.e. even after its deep asset writedowns done in 2008, a share of intangible assets (including such extremely
“soft” and elusive items as relationships with advertisers and subscribers)
in the company’s total assets exceeded 70%. Furthermore, in each of those
years the carrying amount of intangibles exceeded the amount of annual
revenues by high margin. Clearly, such ballooning intangibles should be
always interpreted as a strong “red flag”.
7.5.2 OCZ Technology Group Inc
Another interesting illustration of an elusive nature of intangibles (particularly goodwill) is OCZ Technology Group Inc., a manufacturer of a
computer hardware (discussed already earlier in this book), who filed for
bankruptcy in 2013. Its selected accounting data, for fiscal years ending
February 29/28, 2011, 2012 and 2013, are presented in Table 7.19. It must
be noted that in its annual report for fiscal year ended February 28, 2013,
the company announced prior accounting manipulations and retrospectively
240
J. Welc
Table 7.19 Selected financial statement data of OCZ Technology Group Inc. for fiscal
years ending February 29/28, 2011–2013
*data reported in annual report of OCZ Technology Group Inc. for fiscal year ended
February 29, 2012
**data reported in annual report of OCZ Technology Group Inc. for fiscal year ended
February 28, 2013
Source Annual reports of OCZ Technology Group Inc. for fiscal years ended February
29/28, 2012 and 2013, and authorial computations
restated its financial results, reported in earlier reports. The period particularly
strongly affected by those restatements was the fiscal year ended February
29, 2012. Accordingly, the company’s accounting numbers for that very
period appear twice in Table 7.19, i.e. in their pre- and post-restatement
versions. The restatements of its past financial results affected multiple items
of income statement and balance sheet of OCZ Technology Group Inc, but
in the following discussion only restatements related to intangibles will be
addressed.
As may be observed in Table 7.19, at the end of fiscal year ended February
28, 2011, a share of the company’s intangibles in its total assets stood on a
rather inconspicuous level of slightly above 11%. In the following year this
ratio grew to above 19%, which itself may have not been considered a strong
warning signal. However, when assessing earnings quality, not only the share
of intangibles in total assets should be taken into consideration, but also their
composition and pace of growth, relative to sales. In 2012 the OCZ Technology’s revenues rose by impressive 92,4% y/y, while a carrying amount of
its intangibles grew from about 10 USD million to nearly 70 USD million.
That increase was mostly attributable to goodwill, whose carrying amount
increased from about 10 USD million to almost 61 USD million. Such a
sharp growth in goodwill (as well as other intangibles) typically stems from
7 Evaluation of Financial Statement …
241
major acquisitions of other businesses, and should always be investigated
diligently.
Stunningly, a goodwill of almost 61 USD million, as reported in the
annual report for fiscal year ended February 29, 2012, evaporated entirely
from the annual report published one year later. Simply speaking, given a
retrospective nature of its accounting restatements, the company admitted (in
2013) that at the end of its previous fiscal year a true value of goodwill was
zero, instead of 61 USD million. That goodwill impairment was one of the
major causes of a downward revision of previously reported loss from operations, from 11,9 USD million (as reported in the annual report for fiscal year
ended February 28, 2012) to nearly 120 USD million. It is interesting, therefore, to investigate what exactly happened. In particular, it is worthwhile to
check whether there were any visible symptoms of such an extreme fragility
of the company’s goodwill (which went up by over 50 USD million in fiscal
year ended February 28, 2012, only to be written off entirely one year later).
Table 7.20 contains an extract from Note 8 to consolidated financial statements of OCZ Technology Group Inc. for fiscal year ended February 28,
2013. As may be read, the new goodwill recognized during the previous
fiscal year stemmed from three takeovers (business combinations) of new
subsidiaries, named Indilinx, PLX and Sanrad. Later on, on the ground of
“the errors and related control weaknesses […], the significant operating losses
generated and reductions on its revenue forecasts”, the company concluded that
it was legitimate to write-off a whole carrying amount of goodwill to zero.
Of the three business combinations finalized by OCZ Technology Group
Inc. in its fiscal year 2012, the largest one (in terms of carrying amount of
goodwill recognized) was the takeover of Indilinx. Due to space limitations,
our further investigation of the OCZ Technology’s goodwill will be limited to
that single acquisition. Table 7.21 contains an extract from Note 4 to consolidated financial statements of OCZ Technology Group Inc. for fiscal year
ended February 29, 2012, offering valuable insights about that transaction.
As may be concluded from disclosures quoted in Table 7.21, the purchase
price paid (net of cash acquired), in order to gain a control over Indilinx,
amounted to 32,2 USD million. As a result of that takeover OCZ Technology Group Inc. recognized goodwill of 36,8 USD million. Consequently,
a fair value of identifiable net assets acquired (i.e. all non-goodwill assets,
including separately identifiable intangibles, less liabilities) was negative and
amounted to −4,6 USD million [= 32,2–36,8]. That was the amount by
which liabilities of the acquired subsidiary exceeded its assets (at alleged fair
values) on acquisition date. Clearly, paying over 32 USD million to acquire a
business with identifiable net assets of −4,6 USD million, although perhaps
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J. Welc
Table 7.20 Extract from Note 8 to consolidated financial statements of OCZ
Technology Group Inc. for fiscal year ended February 28, 2013, referring to
impairment of goodwill
Note 8 (Goodwill and Other Intangible Assets)
As of February 28/29, 2013 and 2012, the carrying amount of goodwill was zero. The
following is a summary of the goodwill ac vity for the year ended February 29, 2012
(restated, in thousands):
Goodwill
Balance as of February 28, 2011 ($)
Acquisi on of Indilinx
Acquisi on of PLX
$ 9,989
36,858
794
Acquisi on of Sanrad
14,211
Impairment
(61,852)
Balance as of February 29, 2012 ($)
-
[...]
The Company originally performed its annual impairment test of goodwill as of February 29,
2012, and determined [...] that its enterprise value exceeded the carrying value of its net
assets, and therefore no goodwill impairment existed. However, based upon the errors and
related control weaknesses [...], the significant opera ng losses generated and reduc ons
on its revenue forecasts, the Company reperformed its impairment test as of February 29,
2012. During step one of this reperformance, the Company reassessed the enterprise value
used in its impairment calcula on using a combina on of market-based metrics based upon
peer group metrics and discounted cash flow projec ons, and determined that the carrying
value of its assets exceeded its enterprise value. Therefore, the Company determined that
step two was required. [...]
In step two of the goodwill impairment test, with the assistance of a third party valua on
firm, the Company allocated the fair value of the repor ng unit to all of its assets and
liabili es as if the Company had been acquired in a business combina on and the es mated
fair value was the price paid to acquire the Company. The excess of the fair value of the
Company over the amount assigned to its assets and liabili es is the implied fair value of
goodwill. Based upon step two of the goodwill impairment calcula on that was
reperformed, the Company determined that goodwill had no implied fair value, and
therefore the Company recognized an impairment charge of $61.9 million in the fourth
quarter of fiscal 2012, represen ng a write-off of the en re amount of the Company’s
previously-recorded goodwill.
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
28, 2013
7 Evaluation of Financial Statement …
243
Table 7.21 Extract from Note 4 to financial statements of OCZ Technology Group
Inc. for fiscal year ended February 29, 2012, referring to its takeover of Indilinx Co.
Ltd.
Note 4 (AcquisiƟons)
Indilinx
On March 25, 2011, OCZ completed the acquisi on of 100% of the equity interests of
Indilinx Co., Ltd. (“Indilinx”), a privately-held company organized under the laws of the
Republic of Korea. [...]
The results of opera ons of Indilinx are included in OCZ’s Consolidated Statements of
Opera ons from March 25, 2011, the date of acquisi on. The following table summarizes
the alloca on of the purchase price based on the fair value of the assets acquired and the
liabili es assumed at the date of acquisi on:
(In thousands)
Cash acquired ($)
554
Other current assets
170
Fixed assets
431
Other tangible assets acquired
216
Intangible assets:
Exis ng technology
In-process technology
Customer lists and related rela onships
Trademarks and trade names
64
1,520
75
125
Goodwill
36,845
Total assets acquired
40,000
Loans payable
(4,381)
Accounts payable
(519)
Other accrued liabili es
(2,327)
Net assets acquired
32,773
Less: cash acquired
(554)
Net purchase price ($)
32,219
The purchase price set forth in the table above was allocated based on the fair value of the
tangible and intangible assets acquired, and liabili es assumed, as of March 25, 2011.
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
29, 2012
244
J. Welc
prospective and opening new business opportunities, must have been considered a hazardous investment (particularly in the industry exposed to high
technological risks).
The disclosures on assets and liabilities of the acquired company (Indilinx),
although very valuable, have a significant drawback. Namely, they offer only
a balance sheet information about the new subsidiary. Meanwhile, it was
possible that negative value of its non-goodwill net assets stemmed from its
past losses (incurred perhaps many years ago) and did not reflect its recent
profitability. Therefore, it is advisable to evaluate (if possible) also the income
statement numbers of the acquired business. Useful data, although unaudited,
limited in scope and often having a narrative form, may sometimes be found
in those notes to financial statements which disclose a so-called pro forma
financial information, such as Note 4 to OCZ Technology’s annual report,
quoted in Table 7.35 (in the appendix). As might be immediately concluded
from these disclosures, both acquired businesses (i.e. Indilinx and Sanrad),
mentioned by OCZ Technology Group Inc. in this part of Note 4, had a
very small scale of operations in the fiscal year ended February 29, 2012.
In the period between March 25, 2011 and February 29, 2012 (i.e. over
eleven months) Indilinx, whose acquisition boosted the carrying amount of
the OCZ Technology’s goodwill by as much as 36,8 USD million, obtained
revenues (net of intra-group transactions) of mere 2,8 USD million, and
incurred a net loss amounting to 4,9 USD million. Accordingly, this new
subsidiary contributed immaterially to the OCZ Technology’s revenues but
rather significantly to its reported net losses. With such results (negligible
sales and nonnegligible losses), combined with a negative fair value of net
assets, the acquired company may have been safely labeled as a start-up business. The very same may have been said about Sanrad, whose acquisition
boosted carrying amount of the OCZ Technology’s goodwill by 14,2 USD
million (according to disclosures quoted in Table 7.20).
Obviously, both business combinations closed by OCZ Technology in its
fiscal year 2012 could have been labeled as risky and pricey equity investments. In light of financial statement disclosures, easily available in the
company’s annual reports, it comes as no surprise that in the following period
the company had to restate its previously published results and to write-off
its goodwill down to zero.
7.5.3 Starbreeze AB
Starbreeze AB was a Swedish video game studio, which filed for bankruptcy
in December 2018. Its selected financial statement data are presented in
7 Evaluation of Financial Statement …
245
Table 7.22. As may be seen, between 2015 and 2017 Starbreeze spent huge
amounts of money on developing new games. Large parts of those expenditures have landed on the company’s balance sheet, as capitalized games and
technology development costs. Between the end of 2015 and the end of 2017
a carrying amount of this asset rose by as much as 527,9 SEK million (i.e.
from 114,9 SEK million to 642,8 SEK million), while at the same time the
company’s annual net sales did not exceed 370 SEK million.
Table 7.22 Selected financial statement data of Starbreeze AB for fiscal years 2015–
2017
Data in SEK million
2015
2016
2017
Net sales
218,4
345,5
361,4
42,9
56,5
−151,5
Capitalized games and technology
development costs
114,9
303,8
642,8
Total assets
568,1
2.148,9
2.459,2
Growth of net sales y/y
–
+58,2%
+4,6%
Growth of capitalized games and development costs y/y
–
+164,4%
+111,6%
Share of capitalized games and development costs in net
sales
52,6%
87,9%
177,9%
Share of capitalized games and development costs in
total assets
20,2%
14,1%
26,1%
Data
reported in
financial
statements
Opera ng profit/loss
Source Annual reports of Starbreeze AB for fiscal years 2016–2017 and authorial
computations
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J. Welc
As may be seen in a lower part of Table 7.22, in the investigated three-year
period the Starbreeze’s capitalized games and development costs rose much
faster (with triple digit growth rates) than sales. As a result, a share of this asset
in revenues increased from 52,6% in 2015 to almost 180% in 2017. Also, the
share of capitalized development costs in total assets grew from about 20%
in 2015 to over 26% two years later.
Such an intangible-intensive investment program has been aimed at
creating new game titles (and upgrading those already commercialized), but
apparently it failed, given the company’s insolvency announced in late 2018.
With the benefit of hindsight it may be concluded that a drainage of funds,
caused by such a huge growth of development expenditures (relative to the
company’s sales), was unsustainable. An elusive nature of intangible assets
created by such investments (probably with a significant share of games with
a work-in-progress status) meant that it was probably impossible to quickly
convert them back into cash (e.g. by selling them on the market), when
company lost financial liquidity. Anyway, from a financial statement user’s
perspective, the warning signals presented in Table 7.22 could have been
relied upon, since they correctly informed about an increasing risk of the
company’s upcoming financial troubles.
7.5.4 Conclusions
The examples of GateHouse Media Inc., OCZ Technology Group Inc. and
Starbreeze AB corroborate a relevance of rigorous investigation (involving
narrative disclosures) of capitalized intangible assets, when their carrying
amounts seem abnormally high or rise suspiciously sharply (or both). A “soft”
nature of most intangibles makes them very prone to manipulations and
vulnerable to changes in market conditions (Khandani et al. 2001). Indeed,
researchers found that values of intangible assets are particularly fragile in
bankruptcy (Gilson et al. 1990). Therefore, warning signals discussed above
should never be ignored.
Luckily, there are techniques of analytical adjustments, which allow corrections of corporate reported accounting data, by unwinding a capitalization of
intangible assets. These adjustments, which will be discussed with details in
Sect. 9.4 of Chapter 9, assume that expenditures on intangibles are expensed
as incurred (instead of being capitalized on balance sheet) and result in
obtaining corrected income statement, balance sheet and cash flow data,
which are much more conservative and comparable between companies.
7 Evaluation of Financial Statement …
7.6
247
Signal No 5: Systematically Falling Turnover
of Property, Plant and Equipment
Capital-intensive businesses (i.e. those which require large investments on
operating fixed assets, such as telecoms, airlines, hotels or power plants) tend
to be featured by a high share of property, plant and equipment in total assets.
Unlike short-term operating assets (e.g. inventories or receivables), which tie
up money temporarily and are expected to be converted back into cash in
a near future, capital expenditures on noncurrent assets have much longer
investment horizons. In case of many long-lived assets (particularly those with
very long useful lives, such as hotels or water supply pipelines) large lumpsum investment expenditures incurred in a given period may be expected to
generate economic returns across dozens of future years. Due to such a longterm horizon of fixed asset investments, they are generally prone to higher
uncertainty (in terms of expected returns) as compared to short-term assets.
A simple major metric, useful as a crude indicator of possible issues
regarding fixed operating assets, is their turnover ratio, meant as a quotient
of annual revenues to carrying amount of property, plant and equipment.
This ratio measures an intensity of utilization of corporate long-term operating assets and their revenue-generating capability. Similarly as in the case
of inventories and receivables, a systematic and prolonged (e.g. lasting several
years in a row) erosion of the fixed asset turnover usually results from one or
more of the following reasons:
• Market-related issues—a company has overinvested in its property, plant
and equipment (with resulting low rates of capacity utilization) or faces
more and more intense competitive pressures, which gradually reduce an
amount of revenues it is able to generate from its operating fixed assets
(however, at this point no impairment of fixed assets, meant as a fall of
their recoverable values below carrying amounts, is stated).
• Accounting-related issues—a company reports operating fixed assets at
overstated carrying amounts (i.e. above their recoverable values), for
instance as a result of:
– Inadequate write-downs of impaired long-lived assets (e.g. idle or obsolete production lines),
– Overly optimistic assumptions about useful lives of property, plant and
equipment (with a resulting understatement of periodic depreciation
charges),
– Aggressive capitalization of operating expenses (e.g. routine maintenance
costs) in carrying amounts of property, plant and equipment,
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J. Welc
– Inclusion of nonexistent (fictitious) items in carrying amount of property, plant and equipment.
• Intended extensions of a fixed asset base—a company repeatedly (across
several consecutive years) spends significant amounts of money on noncurrent operating assets, e.g. during an expansion into new markets (which
may require building new manufacturing plants or opening new warehouses and points of sale).
In case of the latter of the three factors, a fixed asset growth may exceed
revenue growth, with a resulting gradual erosion of fixed asset turnover, even
several years in a row (with no negative consequences for the company’s
profitability). For instance, this may be observed in case of unusually timeconsuming investment projects, such as building new nuclear power plant
(which may last more than ten years). However, if the turnover of operating fixed assets deteriorates systematically due to some market-related or
accounting-related issues, then such a tendency should be deemed a strong
warning signal, suggesting a possible deterioration of a given company’s profitability in the following periods (Teoh et al. 1998; Fairfield et al. 2003). A fall
of earnings, following periods of an unbalanced growth of carrying amounts
of long-lived assets, is often triggered by a “fire sale” of idle fixed assets (at
deeply discounted prices) or by write-downs of their carrying amounts (or
both). An application of the fixed asset turnover as a warning signal will be
illustrated by three real-life case studies.
7.6.1 Sino-Forest Corp
The first example, which illustrates accounting-related issues regarding
reporting for tangible fixed assets, is based on financial statement data of
Sino-Forest Corp. (which once claimed to be a leading commercial forest
plantation operator in China). Its business profile suggests a high share
of forest-related assets in total assets. Indeed, in its balance sheet at the
end of 2008 the company reported carrying amount of timber holdings
(as defined in Table 7.23) valued at 1.653,3 USD million, within its total
assets amounting to 2.603,9 USD million. Accordingly, the company’s timber
holdings constituted 63,5% of its total assets, as at the end of 2008.
However, as may be seen in Table 7.24, between the end of 2003 and the
end of 2008 the carrying amount of timber holdings grew cumulatively by
over 611% (from 232,5 USD million at the end of 2003 to 1.653,3 USD
million at the end of 2008), while at the same time the company’s annual
7 Evaluation of Financial Statement …
249
Table 7.23 Extract from Note 1 to financial statements of Sino-Forest Corp. for fiscal
year 2009, related to the company’s accounting for timber holdings
Source Annual report of Sino-Forest Corp. for fiscal year 2009
Table 7.24 Selected financial statement data of Sino-Forest Corp. for fiscal years
2003–2008
*Revenue/Timber holdings
Source Annual reports of Sino-Forest Corp. for fiscal years 2004–2008 and authorial
computations
revenues rose by 237,2% (from 267,5 USD million in 2003 to 896,0 USD
million in 2008). This resulted in a gradual deterioration of the company’s
timber assets turnover (meant as a quotient of annual revenues to carrying
amount of the timber holdings), which fell from 1,14 in 2003 to 0,54 in
2008.
Such a prolonged (six years long) trend of a steadily deteriorating
turnover of timber holdings, which constituted the company’s major revenuegenerating asset, should have been interpreted as a warning signal, suggesting
a possible presence of either some form of earnings manipulations (e.g. an
inclusion of nonexistent forests in the carrying amount of timber holdings
or an aggressive capitalization of planting and maintenance costs) or some
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J. Welc
market-related issues (e.g. falling sales prices of more mature wood plantations, relative to purchase costs of younger forests). Although in the following
two years (2009–2010) the turnover of timber holdings stopped falling and
stabilized in a range between 0,55 and 0,62, a monetary amount of these
operating assets continued growing faster than annual revenues. Between the
end of 2008 and the end of 2010 the carrying amount of reported timber
holdings went up by 1.469,2 USD million, while concurrently the company’s
annual revenues grew by 1.027,5 USD million.
The Sino-Forest’s “asset bubble” burst in 2011 with the following sequence
of events:
• In June 2011 Muddy Waters Research LLC, an investment and advisory
company, issued a report in which it alleged, among others, that SinoForest Corp. fraudulently overstated the value of its timber holdings. The
Sino-Forest’s stock price plummeted by over 70% in the course of the
following several days.
• In reaction, The Ontario Securities Commission (responsible for overseeing public companies listed on the Canadian equity markets) began its
investigation and in August 2011 it suspended trading of the Sino-Forest’s
shares.
• In the meantime, Sino-Forest Corp. launched its own internal audit of its
accounting documents.
• In November 2011 the Royal Canadian Mounted Police began its investigation, alleging that some of Sino-Forest’s managers may have been
involved in fraudulent activities.
• In November 2011 Sino-Forest Corp. announced that although its internal
investigation has not found any evidence of the accounting fraud, it was
unable to prove the existence of some of its forests (included in the carrying
amount of its reported noncurrent assets). Furthermore, the company’s
committee admitted that it was unable to value some of its timber holdings
and noted that many of them have been operated on the basis of informal
arrangements (instead of legal ownership).
• In December 2011 Sino-Forest Corp. announced that it would not be able
to settle its incoming interest payments.
• In January 2012 Sino-Forest Corp. admitted that its previously published
financial statements “should not be relied upon”.
• In March 2012 Sino-Forest Corp. filed for a bankruptcy protection to the
Toronto court.
7 Evaluation of Financial Statement …
251
• In May 2012 the Sino-Forest’s shares were delisted from the Toronto Stock
Exchange and in March 2013 they were canceled (with equity investors
receiving no consideration for the shares they held).
• At the end of 2013 the creditor-controlled successor company (to which
most of Sino-Forest’s assets have been transferred) announced that the
standing timber assets were worthless (Wright and Cullinan 2017).
A gloomy story of Sino-Forest Corp. should be treated as another evidence
confirming that even very simple and rough “red flags” (such as a steadily
deteriorating fixed asset turnover) should not be ignored. Even if very crude,
they often contain invaluable information. Any user of Sino-Forest’s financial statements, issued between 2003 and 2010, should have been warned by
such a stubborn long-term trend of eroding turnover of the company’s timber
holdings. As it turned out later on (at the end of 2013) these “assets” were
virtually worth nothing.
7.6.2 Icelandair Group
Another interesting illustration of the usefulness of fixed assets turnover as
the leading indicator of a likely deterioration of profitability is Icelandair
Group (an international airline headquartered in Reykjavik), whose selected
accounting data for fiscal years 2011–2018 are presented in Table 7.25. Since
financial results (particularly operating expenses) of airlines are very sensitive
to volatility of global oil prices, the Icelandair’s profits before aircraft fuel will
be investigated in a following discussion (in order to avoid likely distortions
brought about by shifting prices of jet fuel).
As may be seen, in each of the investigated eight years the company
increased its total revenues. However, while between 2011 and 2015 the
rising sales drove operating profits upward, in the following three years
a continued growth of revenues was accompanied by gradually shrinking
earnings. Between 2011 and 2015 not only the monetary amounts of operating income grew steadily, but also the company’s operating profitability
(measured by the ratio of operating profit before aircraft fuel to total
revenues) improved from year to year. In contrast, between 2015 and 2018
the company’s profitability fell from 32,2% to 16,0%, despite rising sales.
It may also be observed that between 2011 and 2014 the company
steadily increased its operating assets turnover, which grew from 2,86 to 3,49.
However, that trend reversed sharply in 2015, when turnover ratio fell from
3,49 to 2,72. In the following year a value of this metric continued falling
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J. Welc
Table 7.25 Selected financial statement data of Icelandair Group for fiscal years
2011–2018
*Operating profit (EBIT) + Aircraft fuel cost
**Icelandair Group uses term “Operating assets” for property, plant and equipment
***Total revenue/Operating assets
****EBIT before aircraft fuel/Total revenue
Source Annual reports of Icelandair Group for fiscal years 2012–2018 and authorial
computations
7 Evaluation of Financial Statement …
253
and then improved only marginally (to 2,24 in 2018, i.e. much below its
level observed between 2011 and 2015).
It may be concluded, therefore, that improvements in operating assets
turnover (observed between 2011 and 2014) were regularly followed by
increases in Icelandair’s operating profits (between 2012 and 2015). In
contrast, a sharp deterioration of the company’s assets turnover in 2015 (i.e.
when its operating profits were still in a rising trend) has turned out to be a
trustworthy leading indicator of an incoming turning point in the prior trend
of earnings (which started falling in 2016). Finally, a further erosion of the
operating assets turnover (between 2015 and 2017) was accompanied by a
continued deterioration of the company’s profitability.
7.6.3 Jones Energy Inc
Our final example in this section is Jones Energy Inc., an oil and gas company
engaged in the exploration, development, production and acquisition of oil
and natural gas properties in the United States. Its selected financial statement
data are presented in Table 7.26.
Table 7.26 Selected financial statement data of Jones Energy Inc. for fiscal years
2013–2018
*Revenues /Oil and gas properties
Source Annual reports of Jones Energy Inc. for fiscal years 2014–2018 and authorial
computations
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J. Welc
As may be seen, between 2013 and 2017 the company was featured by
very high carrying amounts of oil and gas properties, reported on its balance
sheet. In 2013 and 2014, when Jones Energy’s revenues stood on the highest
levels within the whole analyzed six-year period, its capitalized expenditures
on purchases and development of oil and gas properties were four to five
times higher than the company’s sales (which may be inferred from values
of turnover ratios, shown in the last row of Table 7.26). In the course of
the following two years, a carrying amount of these assets grew cumulatively
by 6,4% (i.e. from 1.638,9 USD million to 1.743,6 USD million), while
at the same time the company’s annual revenues contracted by as much as
66,4% (i.e. from 380,6 USD million to 127,8 USD million). As a result, the
turnover of oil and gas properties fell from 0,20–0,23 in 2013–2014 to as
low as 0,07 in 2016.
In light of such a dramatic erosion of the company’s turnover ratio,
combined with its already low value (below 0,25) across all years between
2013 and 2016, it is no wonder that in the following periods Jones Energy
had to write-down its oil and gas properties deeply. In 2017, when the
company’s prior trend of shrinking revenues reversed (with a growth of net
sales by almost 50% y/y), it booked an impairment of oil and gas properties
by 149,6 USD million. However, it turned out to be inadequate and in the
following year the company wrote down these assets again, this time by a
much larger amount of 1,3 USD billion. It did not protect Jones Energy Inc.
from a bankruptcy, which has been filed for in April 2019.
7.6.4 Conclusions
As clearly shown by the presented real-world examples of Sino-Forest Corp.,
Icelandair Group and Jones Energy Inc., both level as well as period-to-period
changes in fixed assets turnover are valuable not only as warning signals about
a possible accounting fraud, but are also useful in signaling a likely upcoming
insolvency and in early detection of turning points of profitability of capitalintensive businesses.
7.7
Signal No 6: Falling Ratio of Depreciation
and Amortization to Carrying Amount
of Operating Fixed Assets
The signal discussed in a preceding section (i.e. a systematically falling
turnover of property, plant and equipment) was related to fixed assets. As
7 Evaluation of Financial Statement …
255
was demonstrated, gradually decreasing value of that ratio usually signals
some inefficiencies, often followed by deteriorating margins and earnings.
However, an erosion of the fixed asset turnover may be attributable not
only to business-related factors, such as an overcapacity brought about by
prior over-investments, but also to some accounting issues. If at some point
a company suddenly extends its useful lives assumed for fixed assets, then
from this moment on they are depreciated with a slower pace (i.e. with lower
amounts of periodic depreciation charges). As a result, carrying amounts of
corporate long-term operating assets decrease with a slower pace too, which
affects their turnover ratio. Moreover, even if a company does not suddenly
shift its useful lives, but assumes them on overly optimistic (i.e. too long)
levels when they are recognized (i.e. when purchased or built), the turnover
ratio deteriorates gradually as well.
Accordingly, the turnover ratio is usually quite efficient in signaling some
issues related to operating fixed assets. However, an another metric useful
in investigating fixed assets is a quotient of depreciation and amortization
charges (in a given period) to carrying amount of depreciable and amortizable fixed assets (as at the end of the preceding period). When value of such
a ratio falls suddenly, it signals a likely recent extension of asset useful lives.
Even though such an accounting change may be unrelated to any fraud and
may be entirely legitimate (e.g. on the ground of a less intensive use of a given
company’s assets or due to overly pessimistic prior assumptions regarding
their useful lives), it always erodes inter-company and inter-temporal comparability of reported financial results. If, in turn, the value of this metric
falls gradually through several years, it is a symptom of overly optimistic
assumptions regarding the useful lives of property, plant and equipment. A
practical application of this ratio will be illustrated with the accounting data
of Lufthansa Group, Toshiba Corp. and Netia S.A.
When computing this ratio, a coherence between its numerator and
denominator must be ensured. Since depreciation and amortization expense
constitutes an input to the former, the latter should include only those
tangible and intangible fixed assets, which are subject to regular depreciation
and amortization charges. Accordingly, carrying amounts of the following
assets should be excluded from a number entered into the denominator:
• Land and other non-depreciable real-estate assets (e.g. investment properties), which may be included in carrying amount of property, plant and
equipment,
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J. Welc
• Intangible assets with indefinite useful lives (e.g. goodwill or trademarks),
which are periodically tested for an impairment (instead of being amortized).
7.7.1 Lufthansa Group
As was already discussed in Sect. 2.3 of Chapter 2, in its fiscal year 2014 the
Lufthansa’s reported earnings benefited from reduced depreciation charges,
which in turn stemmed from an adjustment of useful lives of its aircraftrelated assets. According to the company’s disclosures (included in its annual
report for 2014), those accounting adjustments were done in the previous
fiscal year (2013) and boosted earnings reported for 2013 and 2014 by 63
EUR million and 351 EUR million, respectively.
Let’s check how such a sudden change in an accounting estimate (which
under IFRS is applied prospectively only, with no revisions of previously
reported numbers) affected the Lufthansa’s ratio of depreciation and amortization expense to carrying amount of its depreciable and amortizable assets.
These data are presented in Table 7.27. As may be seen, between 2009
and 2012 the value of this metric presented moderate upward trend, rising
from 11,9 to 12,5%. However, in 2013 its value fell sharply and significantly, by almost one percentage point (to 11,6%). That was the year when
Table 7.27 Depreciation and amortization, on the background of depreciable and
amortizable fixed assets of Lufthansa Group, in fiscal years 2009–2015
Data in EUR million
2009
2010
2011
2012
2013
2014
2015
Deprecia on and
amor za on (D&A)
1.634
1.637
1.755
1.867
1.763
1.516
1.708
13.739
14.479
14.934
15.193
15.752
17.154
18.574
–
11,9%
12,1%
12,5%
11,6%
9,6%
10,0%
Depreciable and amor zable
fixed assets (FA)
D&A (t) / FA (t−1)*
*Depreciation and amortization in a given year/Carrying amount of depreciable and
amortizable (tangible and intangible) fixed assets as at the end of the previous year;
for instance, the ratio value for 2010 (i.e. 11,9%) is obtained by dividing D&A in
2010 (i.e. 1.637) by carrying amount of depreciable and amortizable fixed assets as
at the end of 2009 (i.e. 13.739)
Source Annual reports of Lufthansa Group for fiscal years 2010–2015 and authorial
computations
7 Evaluation of Financial Statement …
257
the company changed (i.e. lengthened) expected useful lives of its aircraft,
from twelve to twenty years (with a simultaneous reduction of the assumed
residual values of airplanes, from 15 to 5% of their initial carrying amounts).
However, that change boosted the Lufthansa’s earnings reported for 2013 by
“only” 63 EUR million, as compared to as much as 351 EUR of depreciation and amortization “savings” obtained in the next fiscal year. Accordingly,
in 2014 the value of the investigated ratio fell again and even more significantly than before (i.e. by two percentage points), to 9,6%. In 2015 it stood
at the lowered level, although somewhat higher than in 2014 (i.e. 10,0%).
To sum up, as a result of extending the aircraft useful lives in 2013, the
analyzed metric fell from 11,9–12,5% observed between 2010 and 2012, to
9,6–10,0% in 2014–2015.
Of course, Lufthansa Group did not hide the information about the
extension of its airplanes’ useful lives. Quite the reverse: that change of
its accounting estimates was described rather extensively in the company’s
annual reports for fiscal years 2013 and 2014. However, the numbers shown
in Table 7.27 teach that changes of the accounting assumptions, affecting
the Lufthansa’s depreciation and amortization expense, were signaled by a
very simple metric, based on the company’s primary financial statements (i.e.
before digging into narratives of its annual reports).
7.7.2 Netia S.A
The case of Netia S.A., a Polish media and telecommunication company
(listed on the Warsaw Stock Exchange), is somewhat similar to the example of
Lufthansa Group. Namely, in its fiscal year 2017 the company extended the
useful lives applied for a significant part of its operating fixed assets, including
intangibles (software) as well as property, plant and equipment (buildings,
telecommunication infrastructure and other devices). One year later (i.e. in
fiscal year 2018) the useful lives of some of the company’s long-term assets
were lengthened again. The result was a reduction of the depreciation and
amortization expense (two years in a row), which boosted the company’s earnings reported for both 2017 and 2018. Table 7.28 presents selected financial
statement data of Netia S.A., together with ratio of depreciation and amortization (in a given year) to carrying amount of tangible and intangible fixed
assets (as at the end of the previous year).
As may be seen, the value of the investigated ratio exceeded 21% in each
of the fiscal years between 2012 and 2016. However, in 2017 it fell sharply,
from 21,7 to 18,1% (i.e. by 3,6 percentage points). Since in the next fiscal
year the company extended the useful lives of its assets once again, the value
258
J. Welc
Table 7.28 Depreciation and amortization, on the background of depreciable and
amortizable fixed assets of Netia S.A., in fiscal years 2012–2018
Data in PLN million
2012
2013
2014
2015
2016
2017
2018
Depreciaon and
amorzaon (D&A)
482,5
440,0
424,0
421,1
401,2
311,6
279,9
Depreciable and amorzable
fixed assets (FA)
D&A (t) / FA (t−1)*
2.066,3 1.956,7 1.820,2 1.846,9 1.723,2 1.691,1 1.715,0
–
21,3%
21,7%
23,1%
21,7%
18,1%
16,6%
*Depreciation and amortization in a given year/Carrying amount of depreciable and
amortizable (tangible and intangible) fixed assets as at the end of the previous year;
for instance, the ratio value for 2013 (i.e. 21,3%) is obtained by dividing D&A in
2013 (i.e. 440,0) by carrying amount of depreciable and amortizable fixed assets as
at the end of 2012 (i.e. 2.066,3)
Source Annual reports of Netia S.A. for fiscal years 2013–2018 and authorial
computations
of the ratio continued falling in 2018, this time to 16,6%. Accordingly,
the Netia’s case seems to confirm the usefulness of examining relationships
between depreciation and amortization on one side, and carrying amounts
of fixed assets on the other side, in obtaining signals about likely changes of
useful lives of corporate long-term assets.
7.7.3 Toshiba Corp
The example of Toshiba Corp. differs from those of Lufthansa Group and
Netia S.A. While the latter cases dealt with one-off extensions of useful
lives of long-term assets, the former one illustrates multiple-year aggressive understatements of depreciation, amortization and impairment expenses
(with corresponding recurring overstatements of reported earnings).
In September 2015 the Toshiba’s directors publicly announced a detection
of the multiple-year accounting fraud, committed by the company’s previous
managers, in seven consecutive fiscal years (ending March 31) between 2008
and 2014. This led the new managers to a restatement of the Toshiba’s previously reported financial statements. Table 7.36 (in the appendix) presents
summarized impact of the restatement on the company’s earnings, cumulatively for the whole seven-year timeframe. As may be concluded from
these disclosures, the previously reported (fraudulently) pre-tax earnings,
7 Evaluation of Financial Statement …
259
amounting to 583,0 JPY billion (cumulatively), have been corrected downward to 358,2 JPY billion. As may be concluded from the lower part of
the table, out of the total amount of the correction (i.e. 224,8 JPY billion)
over one fifth [= 46,5 JPY billion / 224,8 JPY billion] was attributable to
“impairment and associated depreciation cost ”. This, in turn, reflected the
Toshiba’s prior multi-year overstatements of carrying amounts of fixed assets,
due to understating their depreciation, amortization and impairment charges.
Table 7.29 shows the Toshiba’s depreciation and amortization expenses, as
well as carrying amounts of its depreciable fixed assets (the sum of buildings,
machinery and equipment, due lacking disclosures on carrying amounts of
the company’s intangibles), as reported in its pre-restatement annual reports.
The lowest row of the table shows the Toshiba’s ratio of depreciation and
amortization (in a given year) to carrying amount of depreciable property,
plant and equipment (as at the end of the previous fiscal year).
As may be clearly seen in Table 7.29, in the investigated seven-year timeframe the Toshiba’s ratio of depreciation and amortization to depreciable
fixed assets showed an evident (almost monotonic) downward trend, falling
from 9,3% in fiscal year ended March 31, 2009, to as low as 6,2% five
years later. Obviously, such a stubborn long-term tendency should have been
interpreted as a strong warning signal, suggesting probable overstatements of
the company’s assets and earnings (confirmed in 2015 by the Toshiba’s new
managers).
Table 7.29 Depreciation and amortization, on the background of depreciable
property, plant and equipment of Toshiba Corp., in fiscal years 2008–2014
Fiscal years ending March 31
Data in JPY billion
Deprecia on and
amor za on (D&A)
Depreciable fixed assets (FA)
D&A (t) / FA (t−1)*
2008
2009
2010
2011
2012
2013
2014
380,2
349,8
299,0
259,6
249,6
218,7
186,4
3.758,5 3.695,3 3.525,4 3.327,0 3.073,0 3.030,3
3.105,5
-
9,3%
8,1%
7,4%
7,5%
7,1%
6,2%
*Depreciation and amortization in a given year/Carrying amount of depreciable fixed
assets as at the end of the previous year; for instance, the ratio value for 2009
(i.e. 9,3%) is obtained by dividing D&A in 2009 (i.e. 349,8) by carrying amount of
depreciable fixed assets as at the end of 2008 (i.e. 3.758,5)
Source Annual reports (before restatements) of Toshiba Corp. for fiscal years ended
March 31, 2009–2014, and authorial computations
260
J. Welc
7.7.4 Conclusions
As shown by the real-life examples of Lufthansa Group, Netia S.A. and
Toshiba Corp., suddenly or gradually falling relationship between depreciation and amortization expense on one side, and carrying amount of
operating fixed assets on the other side, should be treated as a warning signal.
Often such changes of that relationship reflect either one-time shifts in a
given company’s estimates of useful lives (which, even if legitimate, erode a
comparability of financial statements) or a multi-period string of profit overstatements, by means of overly optimistic assumptions regarding useful lives
of fixed assets.
Appendix
See Tables 7.30, 7.31, 7.32, 7.33, 7.34, 7.35, and 7.36.
Table 7.30 An inventory-related extract from annual report of Burberry Group plc
for fiscal year ended March 31, 2009
As Burberry aggressively reduced its inventory levels, this benefited sales, especially in the
final quarter of the year, albeit at lower gross margin.
Source Annual report of Burberry Group plc for fiscal year ended March 31, 2009
261
7 Evaluation of Financial Statement …
Table 7.31 Restatement of past income (loss) before income taxes of Toshiba Corp.,
for fiscal years (ended March 31) 2009–2012
Fiscal years ended March 31
Data in JPY billion
2009
2010
2011
2012
27,2
194,7
145,4
159,6
0,1
7,0
−7,9
−18,0
Recording of opera ng expenses in the
Visual Products business
−7,8
−6,5
12,7
−2,8
Component transac ons, etc. in the PC
business
−28,6
11,3
−22,3
−28,1
−4,4
−1,6
−10,3
−36,6
−3,8
−3,4
−7,3
−12,9
3,0
0,3
−48,9
13,7
−41,5
7,1
−84,0
−84,7
−14,3
201,8
61,4
74,9
(Before correcƟon)
Income (Loss) before income taxes
Percentage-of-comple on method
Valua on of inventory in the
Semiconductor business
Self-check, etc.
Impairment and associated deprecia on
cost
Total amount of correc on
(AŌer correcƟon) Income (Loss) before
income taxes
Source Toshiba Corporation. Notice on Restatement of Past Financial Results, Outline
of FY2014 Consolidated Business Results, Submission of 176th Annual Securities
Report and Outline of Recurrence Prevention Measures (September 7, 2015)
Table 7.32 Extract from the revised financial statements of Toshiba Corp., for fiscal
year ended March 31, 2012, regarding the company’s inventory-related restatements
RESTATEMENT OF PREVIOUSLY ISSUED CONSOLIDATED FINANCIAL STATEMENTS
Restatement for the accounƟng treatment in relaƟon to valuaƟon of inventory in the
Semiconductor Business
[…] it was found that in the Semiconductor Business, there were cases where valua on
losses for work-in-progress inventories and others were not recognized un l the me of
actual disposal of the inventories, and where the book values of term-end intermediate
products and term-end completed products were overstated […], and consequently cost of
goods sold was understated.
To correct these accoun ng treatments, the Company restated data in the consolidated
financial statements issued in the fiscal year ended March 31, 2010 and the following years.
Source Annual report of Toshiba Corp. (after retrospective restatement) for fiscal year
ended March 31, 2012
262
J. Welc
Table 7.33 Extract Form 6-K report, issued by Aegan Marine Petroleum Network
Inc. in June 2018 and addressing the results of the company’s internal investigation
regarding its receivable accounts and revenues
Based on the preliminary findings of the review, the Audit Commi ee believes that
approximately $200 million of accounts receivable on December 31, 2017 will need to be
wri en off. These amounts are currently due from four counterpar es and were reflected in
the Company’s financial statements as of December 31, 2017. There was approximately
$172 million as of December 31, 2016 and $85 million as of December 31, 2015 due from
these four counterpar es. The transac ons that gave rise to the accounts receivable (the
“Transac ons”) may have been, in full or in part, without economic substance and
improperly accounted for in contraven on of the Company’s normal policies and
procedures.
Source Form 6-K report issued by Aegan Marine Petroleum Network Inc. on June 4,
2018
Table 7.34 Extract from notes to consolidated financial statements of GateHouse
Media Inc. for fiscal year 2009, referring to impairment charges of long-lived assets
As part of the Company’s annual impairment assessment as of June 30, 2009 the Company
recorded an impairment charge related to goodwill of $245,974 and a newspaper masthead
impairment charge of $29,336. Due to reduc on in opera ng projec on within various
repor ng units, an impairment charge of $206,089 was recorded related to the Company’s
adver ser and subscriber rela onships as of June 30, 2009.
Source Annual report of GateHouse Media Inc. for fiscal year 2009
Table 7.35 Extract from Note 4 to financial statements of OCZ Technology Group Inc.
for fiscal year ended February 29, 2012, containing pro forma financial information
Note 4 (AcquisiƟons)
Pro Forma Financial Information
For the period from the acquisi on closing through February 29, 2012, Indilinx products
contributed revenue, excluding intercompany sales, of $2.8 million and a net opera ng loss
of $4.9. For the period from the acquisi on closing through February 29, 2012, Sanrad
reported a net opera ng loss of $0.4 million and contributed net revenue that was
insignificant.
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
29, 2012
7 Evaluation of Financial Statement …
263
Table 7.36 Restatement of past income before income taxes of Toshiba Corp. for
fiscal years (ending March 31) 2008–2014
Data in JPY billion
Before correcon: Income (Loss) before income taxes
(cumulave 2008–2014)
Percentage-of-compleon method
Recording of operang expenses in the Visual Products business
Fiscal years ending March 31, 2008–
2014
583,0
−47,9
−6,1
Component transacons, etc. in the PC business
−57,8
Valuaon of inventory in the Semiconductor business
−37,1
Self-check, etc.
−29,4
Impairment and associated depreciaon cost
−46,5
Total amount of correcon
−224,8
Aer correcon: Income (Loss) before income taxes
(cumulave 2008–2014)
358,2
Source Toshiba Corporation. Notice on Restatement of Past Financial Results, Outline
of FY2014 Consolidated Business Results, Submission of 176th Annual Securities
Report and Outline of Recurrence Prevention Measures (September 7, 2015)
264
J. Welc
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8
Evaluation of Financial Statement Reliability
and Comparability Based on Quantitative
Tools Other Than Cash Flows: Additional
Warning Signals
8.1
Signal No 7: Changing Growth Rates
of Deferred Revenues
Some businesses are featured by non-negligible share of deferred revenues
in total liabilities. Deferred revenues reflect amounts of money (coming
from sales sof products or services), that have been already collected from
customers, but in which case a revenue recognition (in income statement) is
postponed to future periods. The most common sources of deferred revenues
are:
• Prepayments received from customers for future deliveries of products or
services (for instance, cash inflows from sales of flight tickets by airlines,
where a full amount of revenue is collected on a booking date, i.e. months
or weeks ahead of a scheduled date of the booked flight).
• Sales of bundled products or services (also labeled as multiple arrangements), under one total price, where revenue recognition dates differ
between individual components of such a bundle (for example, an aircraft
manufacturer selling bundled aircraft, pilot’s trainings and two-year maintenance services).
Since deferred revenues are directly linked to customer orders, tracking
their period-to-period changes (particularly around their turning points) is
useful in detecting shifts in revenue (and income) trends. Growing carrying
amounts of deferred revenues are often a leading indicator of a likely growth
of sales in a near future, while shrinking deferred revenues (particularly when
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_8
267
268
J. Welc
sharply) usually reflect either falling backlog of customer orders (e.g. lowering
number of tickets sold by an airline) or a more aggressive accounting policy
(i.e. premature recognition of revenues from the sale of bundled services).
Using changes of deferred revenues in detecting turning points of revenue
trends will be exemplified with data of two American firms and one British
travel agency.
8.1.1 US Airways Group Inc.
The first example is US Airways Group Inc., whose total operating revenues
as well as air traffic liabilities (the term used by US Airways for their deferred
revenues from sold tickets) are presented in Table 8.1. Table 8.31 (in the
appendix), in turn, cites the company’s definition and accounting treatment
of its air traffic liabilities.
As may be read in Table 8.31, ticket sales for transportation that has not
yet been provided were initially deferred and recorded as air traffic liability on
balance sheet of US Airways Group. Afterward, as the transportation services
were rendered, respective amounts of the air traffic liabilities were transferred
from balance sheet to income statement (as operating revenues). However,
as must be noted, movements of carrying amounts of air traffic liabilities
were not entirely mechanical (i.e. resulting only from known prices of tickets
sold and flight dates), but were exposed to significant subjective judgments.
Table 8.1 Selected financial statement data of US Airways Group Inc. for fiscal years
2004–2013
*US Airways Group Inc. used term “Air traffic liability” for deferred revenues
Source Annual reports of US Airways Group for fiscal years 2005–2013 and authorial
computations
8 Evaluation of Financial Statement Reliability …
269
Those judgments related to, among others, estimates of future refunds and
ticket exchanges. Consequently, similarly to most other provisions, a presence of such estimates made the air traffic liabilities sensitive to often “soft”
assumptions.
As may be concluded from Table 8.1, double-digit period-to-period
changes in carrying amount of air traffic liabilities (deferred revenues) tended
to lead changes of US Airways Group’s total operating revenues. For instance,
between the end of 2004 and the end of 2005 the carrying amount of air
traffic liabilities more than tripled, which was followed by the three-digit
growth or revenues in 2006. Likewise, recurring increases of air traffic liabilities between the end of 2008 and the end of 2012 were followed by positive
changes of the annual revenues. In contrast, a sharp fall (by over 16% y/y) of
the carrying amount of air traffic liabilities in 2008 turned out to be a good
predictor of a revenue contraction (by almost 14% y/y) in 2009.
8.1.2 GateHouse Media Inc.
Another didactic example is GateHouse Media Inc. (a publisher of locally
based print and online media), whose selected accounting data are presented
in Table 8.2. Table 8.32 (in the appendix), in turn, cites the company’s
accounting policy toward a timing of revenue recognition.
As may be concluded from Table 8.32, some of the company’s revenues
were collected in advance, but recognized in its income statement in
Table 8.2 Selected financial statement data of GateHouse Media Inc. for fiscal years
2005–2012
Source Annual reports of GateHouse Media Inc. for fiscal years 2006–2012 and
authorial computations
270
J. Welc
the following periods, either on a straight-line basis (e.g. revenue from
subscribers) or at a given point in time (e.g. advertising revenue). Those
kinds of prepaid sales gave rise to deferred revenues on the company’s balance
sheet. As may be seen, between 2005 and 2012 changes of deferred revenues
turned out to serve as a useful leading indicator of future revenue growth.
Between 2005 and 2008 the fast progress of deferred revenues was repeatedly
followed by double-digit increases of annual revenues. In contrast, between
2008 and 2012 steadily falling carrying amounts of prepayments preceded
continued erosion of the company’s revenues. In particular, in 2008 a discrepancy between the positive growth of revenues (+18,1% y/y) and shrinking
deferred revenues (−4,7%) constituted a “watershed” between the period of
the company’s growth (until 2008) and its following contraction.
8.1.3 Dart Group Plc
A final example of usefulness of deferred revenue growth as a predictor of
future changes in net sales is Dart Group plc, a British travel agency. Similarly as in the airline industry, in the travel agency business tour services
are typically sold with advance payments, covering full amounts of final
prices charged on customers. However, in order to satisfy the matching principle of accounting, a recognition of such prepaid amounts (as revenue in
income statement) is postponed until when the prepaid tour service is actually
rendered. Consequently, between a customer’s booking of the tour (accompanied by his or her advance payment) and a time of the trip, an amount
collected by a tour agent is reported as deferred revenue on the right-hand
side of its balance sheet. Obviously, as demand for tours (and volume of
orders) rises, it is first reflected in increasing amounts of deferred revenues,
and only with some lag is followed by accelerating growth rates of net sales
in income statement. Likewise, if the industry faces economic slowdown or
recession (e.g. due to consumers’ negative sentiments and concerns about
their future jobs and incomes), the deferred revenues constitute a “barometer” which reflects such adverse conditions, ahead of an actual slowdown in
a given tour agent’s reported net sales. In light of a very cyclical nature of the
tourism industry, changes of deferred revenues are very useful in forecasting
net sales of many tour agents.
The revenues and deferred revenues of Dart Group plc, as well as their
respective growth rates, are presented in Table 8.3.
As may be seen, there seems the be a strong positive relationship between
growth of the company’s revenues in a given year and change in its deferred
8 Evaluation of Financial Statement Reliability …
271
Table 8.3 Selected financial statement data of Dart Group plc for fiscal years 2007–
2018
*Computed with the use of data for fiscal year 2006, not presented here
Source Annual reports of Dart Group plc for fiscal years 2004–2018 and authorial
computations
revenues in a preceding year (i.e. lagged by one period). Indeed, the coefficient of correlation between these two variables, between 2007 and 2018,
equals 0,71. Observation of the data shown in the table leads to the following
conclusions:
• An increase in deferred revenues by as much as 49,2% y/y in 2007 was
followed by an acceleration of the company’s growth rate of revenues, from
12,4% y/y in 2007 to 23,0% in 2008.
• A much slower growth of deferred revenue in 2008 and 2009 (9,1% and
negative 1,9%, respectively), was followed by a sharp slowdown of revenue
growth in 2009 and 2010 (2,3% and negative 1,1% y/y, respectively).
• In 2010–2013 the growth rates of deferred revenues accelerated to
27,7−58,5% y/y and led the above-average revenue growth rates (between
24,9% and 28,9% y/y) in 2011–2014.
• In 2014 and 2015 the deferred revenues grew somewhat slower (19–20%
y/y), which translated into lower increases in revenues (about 12% y/y) in
2015 and 2016.
• An acceleration of deferred revenue growth in 2016 and 2017 (to 32,2%
and 40,4%, respectively) again served as a reliable leading indicator of
272
J. Welc
the following accelerated revenue growth in 2017 and 2018 (23,0% and
38,3% y/y, respectively).
It may be safely concluded that period-to-period changes in Dart Group’s
deferred revenues constitute a very useful leading indicator of the company’s
future revenue growth. Between 2007 and 2018, all years featured by high
percentage increases (of more than 20% y/y) of deferred revenues were
invariably followed by revenue growth rates exceeding 20% y/y. In contrast,
slowdowns of deferred revenue growth to below 20% always preceded a
reduction of the company’s revenue growth to below 20%. Finally, the only
year with a negative change in carrying amount of the deferred revenues
(2009) was followed by the contraction of the company’s net sales (2010).
Obviously, if at any time in the future the Dart Group’s deferred revenues
shrink significantly, it should be treated as a strong “red flag”, signaling a very
likely upcoming contraction of its income statement’s top-line number.
8.1.4 Conclusions
As might be seen, in case of businesses with large advance payments from
customers, period-to-period changes in deferred revenues may be useful as
leading indicator of turning points of revenue trends (which usually also
mean turning points of earnings trends). However, as most other tools
discussed in this book, also this one should not be relied upon blindly. In
some circumstances short-term changes of customer behavior may distort
signals emitted by shifting deferred revenues. For instance, when airline
passengers expect rising ticket prices (e.g. as a result of growing global
oil prices), they may book flights with an unusually long advance, with a
resulting boost to deferred revenues that does not have to be followed by an
increase in a given airline’s sales revenues. Accordingly, an interpretation of
the deferred revenue trends should not be done in isolation from the changing
economic environment of an investigated business.
8.2
Signal No 8: Unusual Behavior of Provisions
for Future Costs and Liabilities
As was explained in the preceding chapters, estimating provisions (e.g. for
employee benefits, warranties, product returns, etc.) involves a huge load of
subjective judgments, often with a qualitative nature. Furthermore, as was
8 Evaluation of Financial Statement Reliability …
273
shown in Sect. 4.2.3 of Chapter 4, in some circumstances obtaining any reliable and unbiased estimates of provisions is not possible at all (for instance,
in case of provisions for litigation-related liabilities, whose final settlement
amount is unknown and will result from a future court verdict). Consequently, provisions constitute a class of financial statement items which is
particularly prone to manipulations (Peek 2004; Sevin and Schroeder 2005;
Suer 2014). Understated provisions (e.g. due to overly optimistic assumptions about likely product returns) imply understatement of current expenses
and overstatement of current profits. However, over-reserving (i.e. recognizing too large provisions, based on overly pessimistic assumptions), even
though depressing current earnings, may be equally misleading, since it
creates hidden reserves whose release in future periods helps in creating
an artificial impression of improving financial results. The former problem
will be illustrated with the example of OCZ Technology Group Inc., while
the latter one will be discussed with the use of accounting data of Nortel
Networks Corp. and Takata Corp.
8.2.1 OCZ Technology Group Inc.
Table 8.33 (in the appendix) cites the OCZ Technology Group’s accounting
policy toward warranty provisions. From its annual report for fiscal year
ended February 29, 2012, a financial statement reader could have learned
that the company had been offering warranties on certain products sold to
customers. However, no information could have been found about a length
of period for which those warranties stayed valid. Only in its annual report
for fiscal year ended February 28, 2013, the company informed that it
warranted its products for a period of three to five years. However, even
without knowing the warranty periods (when investigating the company’s
financial statements for fiscal year ended February 29, 2012), a skillful financial statement user could have found some warning signals suggesting a high
likelihood of under-reserving for the company’s warranty obligations. They
were hidden in Note 11 (Commitments and Contingencies) to the company’s
financial statements, quoted in Table 8.4.
As might be seen in Table 8.4, in each of the three periods the actually incurred warranty costs significantly exceeded the beginning balances
of warranty reserve. In fiscal years ending in February 2010, 2011 and
2012 a ratio of warranty costs incurred in a given period to the warranty
reserve as at the beginning of that period equaled 153% [=202/132], 375%
[=255/68] and 691% [=691/100], respectively. Accordingly, not only the
company’s warranty reserves were repeatedly understated, but a resulting gap
274
J. Welc
Table 8.4 Extract from Note 11 to financial statements of OCZ Technology Group
Inc. for fiscal year ended February 29, 2012, referring to the company’s warranty
provisions
February
28, 2010
February
28, 2011
February
29, 2012
Balance at beginning of period
132
68
100
Accrual for current period warranes
138
287
493
–
–
467
Data in USD thousands
Acquired warranty obligaon from Indilinx acquision
Acquired warranty obligaon from Sanrad acquision
–
–
55
Warranty costs incurred
–202
–255
–691
Balance at end of period
68
100
424
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
29, 2012
Table 8.5 Warranty provisions of OCZ Technology Group Inc. in relation to the
company’s annual sales revenues
Fiscal years ending
Data in USD thousands
Warranty provision—balance at end of period
Net revenues in a period
Warranty provision to net revenues
February 28,
2010
February 28,
2011
February 29,
2012
68
100
424
143.959
190.116
365.774
0,05%
0,05%
0,12%
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
29, 2012, and authorial computations
between the warranty costs incurred and warranty costs forecasted widened
steadily from period to period. It must be remembered, when interpreting
data shown in Table 8.4, that warranty reserves should take into account not
only warranty costs expected to be incurred in the nearest fiscal year, but also
estimated costs to be incurred in the following periods, during which the
company’s warranty obligations stay valid. As clearly seen in the presented
data, in its fiscal years 2010, 2011 and 2012 OCZ Technology Group Inc.
recognized warranty provisions much below its actual annual warranty costs,
even though the company warranted its products for periods of three to five
years (as might be read in the lower part of Table 8.33).
An additional symptom of inadequate warranty reserves recognized by
OCZ Technology Group was their relation to annual sales revenues, as
computed in Table 8.5. As may be seen, a ratio of the company’s warranty
provisions to its revenues stood at a very low level (less or close to one per
mil) across all three years.
8 Evaluation of Financial Statement Reliability …
275
Table 8.6 Extract from Note 9 to financial statements of OCZ Technology Group
Inc. for fiscal year ended February 28, 2013, referring to the company’s warranty
provisions
Years ended February 28/29
Data in USD thousands
Balance at beginning of period
Accrual for current period warranes
Warranty selements
Balance at end of period
2011
Restated
2012
Restated
2013
2.348
4.352
10.074
4.214
10.507
11.093
–2.210
–4.785
–9.394
4.352
10.074
11.773
Source Annual report of OCZ Technology Group Inc. for fiscal year ended February
28, 2013
In light of the above observations it is not surprising that in its annual
report for the following fiscal year (ended February 28, 2013), in which
the company restated its previously reported accounting numbers, warranty
provisions (and related expenses) constituted one of the materially corrected
areas. As may be seen in Table 8.6, according to the company’s revised
estimates, its warranty provisions as at the end of the fiscal years ending
in February 2011 and 2012 should have amounted to 4.352 USD thousands (instead of 100 USD thousands) and 10.074 USD million (instead
of 424 USD thousands), respectively. Obviously, such stunning prior understatements of the company’s warranty reserves significantly contributed to
inflating its operating results reported for previous periods.
8.2.2 Nortel Networks Corp.
While OCZ Technology Group Inc. exemplifies the problems resulting from
understated provisions, Nortel Networks Corp. offers an interesting illustration of distortions brought about by deliberately overstated reserves. Table 8.7
presents the company’s financial results for fiscal years 2001 and 2002, as
reported in its annual reports for 2002 and 2003.
As may be seen, in its annual report for fiscal year 2002 Nortel Networks
Corp. reported two-year operating losses (summed for 2001 and 2002),
amounting to 30.567 USD million [=26.763 + 3.804]. A very significant
contributor to those losses were special charges, with their total two-year
amount of 18.079 USD million, of which 12.716 USD million [=12.121 +
595] being attributable to goodwill impairment, while the remaining 5.363
USD million [=3.660 + 1.703] being attributable to other special charges. A
breakdown of the company’s other special charges (amounting to 3.660 USD
276
J. Welc
Table 8.7 Selected financial statement data of Nortel Networks Corp. for fiscal years
2001 and 2002
Data in USD million
Data as reported in
annual report for
fiscal year 2002
Data as reported in
annual report for
fiscal year 2003
2001
2002
2001
2002
17.511
10.560
18.900
11.008
Gross profit
3.344
3.607
4.288
3.905
Selling, general and administrave expense
5.911
2.675
6.111
2.553
Research and development expense
3.224
2.230
3.116
2.083
15
–
15
–
Revenues
In-process research and development expense
Amorzaon of intangibles
Acquired technology
Goodwill
Stock opon compensaon
807
157
806
157
4.148
–
4.058
–
109
91
248
110
Special charges
Goodwill impairment
12.121
595
11.426
595
Other special charges
3.660
1.703
3.390
1.500
112
–40
138
–21
–26.763
–3.804
–25.020
–3.072
Gain (–)/loss (+) on sale of businesses
Operang loss
Source Annual reports of Nortel Networks Corp. for fiscal years 2002 and 2003
Table 8.8 Extract from Note 6 (Special charges) to financial statements of Nortel
Networks Corp. for fiscal years 2002 and 2003
Data in USD million
Reported in annual
report for 2002
2001
2002
2001
2002
Workforce reducon
1.361
926
1.216
820
Contract selement and lease costs
883
228
789
233
Plant and equipment write-downs
970
433
941
420
39
89
37
–
407
27
407
27
3.660
1.703
3.390
1.500
Other
Intangible asset impairments
Total other special charges
Reported in annual
report for 2003
Source Annual reports of Nortel Networks Corp. for fiscal years 2002 and 2003
million and 1.703 USD million in 2001 and 2002, respectively) could have
been found in Note 6 to the company’s financial statements for fiscal year
2002. An extract from that note is shown in Table 8.8.
8 Evaluation of Financial Statement Reliability …
277
As may be seen, total other special charges recognized by Nortel Networks
Corp. in 2001 and 2002 included provisions for expected restructuringdriven cash outflows (e.g. costs of workforce reduction or contract settlement
and lease costs) as well as asset write-downs. Although financial statement
users usually have no possibility (without an access to the investigated
company’s internal documents) to verify a reasonableness of assumptions
underlying estimates of asset write-downs and expected restructuring costs, it
should be borne in mind that such income statement items may be intentionally based on overly pessimistic managerial judgments, particularly in periods
of adverse economic conditions (when market tolerance for deep losses tends
to be higher than in “normal” times). The early 2000s was exactly such a
period (with a recession in most developed economies), which could have
created a temptation to write down some assets to below their true realizable
values. The obtained “cookie jar reserves” could have been released in the
future (with positive contribution to reported earnings), which would help
in generating an impression of improving financial results.
Data disclosed in the last two columns of Table 8.8 point out that Nortel
Networks Corp. exaggerated its other special charges, reported in its annual
report for fiscal year 2002. The restated other special charges for 2001–2002
amount to a total of 4.890 USD million [=3.390 + 1.500], as compared
to previously reported 5.363 USD million [=3.660 + 1.703]. Whether a
resulting difference of 473 USD million reflected an objective and legitimate change of underlying assumptions (or resulted from intentional prior
understatement of earnings) can rarely be stated with certainty on the basis of
financial statement disclosures only. However, in the case of Nortel Networks
Corp. the evidence of its deliberate earnings manipulation may be found
in the announcement issued by US Securities and Exchange Commission,
quoted in Table 8.34 (in the appendix). As may be read in that announcement, the SEC’s report corroborated an intentional understatement of results
published by Nortel Networks Corp. for fiscal year 2002 (“improperly maintaining over $400 million in excess reserves”), aimed at inflating the company’s
results reported for 2003 (by releasing “approximately $500 million in excess
reserves to boost its earnings and fabricate a return to profitability”).
8.2.3 Takata Corp
Another interesting case illustrating sometimes capricious nature of corporate
provisions is Takata Corp., which was discussed in Sect. 4.2.3 of Chapter 4.
As might be remembered from that discussion, Takata’s warranty provisions
were allegedly estimated on the basis of its historical experience, combined
278
J. Welc
with changing economic conditions, which made those reserves sensitive to
multiple subjective judgments. In its annual reports the company admitted
that changes in warranty reserves constituted one of the major causes of
the observed discrepancies between its accounting profits and operating cash
flows. A combination of the relevance of those provisions for the company’s
income and their vulnerability to multiple subjective judgments always justifies a thorough evaluation of possible contributions of this expense item into
reported earnings.
The data presented in Table 4.7 (in the appendix) and Table 4.4, discussed
in Chapter 4, confirmed a huge impact of changing warranty reserves on
the Takata’s reported income. In 2015 it reported a pre-tax loss of 18,0
JPY billion, which to a large extent was attributable to an increase in
warranty provisions by 17,0 JPY billion. In contrast, in the following year the
company’s reported income before tax improved to a negative 4,8 JPY billion,
but it benefited from by a reduction of the warranty reserve balance by as
much as 30,2 JPY billion. Accordingly, if Takata’s warranty provisions stayed
intact in the investigated periods, in 2015 and 2016 it would report losses
amounting to 1,0 JPY million and 35,0 JPY million, respectively (with an
implied deep deterioration, instead of improvement, of the company’s pre-tax
earnings).
As was also shown in Sect. 4.2.3 of Chapter 4, in 2016 Takata Corp.
dramatically reduced its ratio of warranty reserves to annual net sales. In the
two preceding years this metric stood within a range between 10,5% and
11,7%, while in 2016 it fell sharply, to mere 5,6%. A combination of a relatively high share of warranty reserves in net sales in 2014 and 2015, with their
sharp decrease in 2016, suggests that some overly pessimistic assumptions
regarding warranty expenses could have been applied in those earlier years. If
that was the case, then the company’s results reported for 2014–2015 could
have been materially understated, with the following profit overstatement (as
a result of a reversal of the excessive warranty reserves) in 2016.
8.2.4 Conclusions
The real-world examples discussed in this part of the chapter stress an importance of a watchful analysis of any major changes of corporate provisions.
Both understatements as well as overstatements of accounting reserves may
seriously erode reliability and comparability of reported corporate results. A
huge load of qualitative and subjective assumptions, underlying estimates of
most provisions, makes them particularly prone to deliberate manipulations.
8 Evaluation of Financial Statement Reliability …
279
Therefore, it pays to be watchful and critical when analyzing financial reports
of firms with significant impact of provisions on reported earnings.
8.3
Signal No 9: Discrepancies Between
Accounting Earnings and Taxable Income
It must be always kept in mind, when investigating published financial statements, that corporate taxable income is not the same as corporate pre-tax
earnings (reported in income statement) and both items may deviate significantly from each other, particularly in a short run. A more detailed discussion
of book-tax differences (and an illustration of their usefulness in a comparative financial statement analysis) will constitute a content of Sect. 10.4 of
Chapter 10. In this section, in turn, a simple analytical tool for an assessment of general earnings quality, based on discrepancies between accounting
earnings and taxable income, will be demonstrated.
Poor reliability of reported pre-tax earnings is often signaled by their suspiciously large (and increasing from period to period) excess over the same
company’s taxable income. When financial statements become less and less
reliable (e.g. because of an application of some aggressive accounting techniques), it is often signaled by a widening positive gap between reported
accounting earnings and taxable income. Therefore, an unusually large and/or
gradually widening discrepancy between these two numbers should always be
diligently investigated.
The usefulness of book-tax accounting discrepancies in warning against
a doubtful quality of reported earnings has been confirmed by multiple
empirical studies (Philips et al. 2003, 2004; Lev and Nissim 2004; Hanlon
2005; Weber 2009). It is also corroborated by real-life examples of GetBack
S.A., General Electric Co. and Aventine Renewable Energy Holdings Inc.,
presented below.
8.3.1 GetBack S.A
GetBack S.A. is a Polish financial services company, specialized in the
management of corporate receivables. It collapsed suddenly and filed for
bankruptcy in early 2018. Its main business activity boiled down to acquiring
portfolios of problematic receivables (mostly owed to banks, but also to
various nonfinancial firms) at discounted prices, and then collecting them
on its own account, similarly as in factoring transactions.
280
J. Welc
GetBack S.A. got listed on the Warsaw Stock Exchange in 2017. After
its listing it seemed to become one of the shining stars of the Polish capital
market, with a seemingly impressive profitability and growth. It was also
covered by multiple stock analysts and brokerage houses, who seemed to
blindly trust the company’s published accounting numbers (given a number
of positive stock recommendations it received). However, few months after a
sudden collapse of GetBack’s financial results (followed by its bankruptcy)
the Polish Financial Supervision Authority issued an announcement, in
which it informed a financial community in Poland about the massive
accounting fraud committed by GetBack’s senior managers. In its fraudulent
scheme the company repeatedly engaged in the sale-and-buy-back transactions with several unconsolidated (but obviously “friendly”) entities, aimed at
inflating the company’s reported earnings and getting rid of its toxic assets
(sub-standard receivables) from balance sheet.
A thorough investigation of GetBack’s financial statements (both published
in its stock issue prospectus, as well as later on in the company’s interim
financial reports) led to multiple warning signals, which should have not been
overlooked by any skillful analyst. One of these “red flags”, related to fastwidening discrepancies between GetBack’s reported pre-tax earnings and its
taxable income, generated a particularly strong alarming sound. The selected
accounting data, related to the company’s book-tax divergences, are presented
in Table 8.9.
As may be seen, between the beginning of 2016 and the end of June 2017
the company’s reported cumulative pre-tax earnings amounted to over 280
Table 8.9 Pre-tax accounting earnings (as reported in income statement) and
estimated taxable income of GetBack S.A. in fiscal year 2016 and the first half of
fiscal year 2017
Data in PLN thousand
Consolidated pre-tax earnings*
(1) Current income tax
2016
First half
of 2017
191.176
89.715
230
0
(2) Increase in capitalized tax-loss carry-forwards**
6.706
22.018
(3) Current tax—tax losses in the period [= (1) – (2)]
–6.476
–22.018
–34.084
–115.884
(4) Esmated taxable income [= (3)/19%]***
*As reported in the company’s consolidated income statements
**As reported in the company’s balance sheet and notes to financial statements
***Statutory corporate income tax rate in Poland equals 19%
Source Stock Issue Prospectus and interim financial reports of GetBack S.A. (published
in Polish only) and authorial computations
8 Evaluation of Financial Statement Reliability …
281
PLN million [=191,2 PLN million + 89,7 PLN million]. However, it paid
no current income taxes in the first half of 2017, and merely 230 PLN thousand in the whole preceding fiscal year. At the same time in its consolidated
balance sheet GetBack S.A. reported fast growing deferred tax assets, related
to its tax-loss carry-forwards (i.e. reflecting prior tax losses, which will be
available as tax shields to reduce future tax burdens). A carrying amount of
those capitalized tax-loss carry-forwards grew by 6,7 PLN million in 2016
and by another 22,0 PLN million in the first half of 2017. It is worth noting
that a positive (even if marginally) current income tax in 2016, combined
with ballooning tax-loss carry-forwards, resulted from the fact that corporate
income taxes in Poland are settled on an individual company level (and not on
a group of companies level). In other words, while some companies within
GetBack’ group earned positive taxable income (implying non-zero current
income taxes), the others incurred tax losses at the same time.
Disclosures presented in Table 8.9 may be used to estimate the company’s
total consolidated taxable income. Differences between current income taxes
and tax-loss carry-forwards constitute a basis for such estimates. As may be
seen in the table, in the GetBack’s case such differences amounted to −6.476
PLN thousand [=230−6.706] and −22.018 PLN thousand [=0−22.018], in
2016 and the first half of 2017, respectively.
Since current income taxes and tax-loss carry-forwards are recognized
in financial statements on the basis of statutory income tax rate (which
equals 19% in Poland), the GetBack’s total income tax losses may be estimated by dividing the amounts computed above (i.e. −6.476 PLN thousand
and −22.018 PLN thousand) by the company’s statutory tax rate of 19%.
Such calculations generate estimates of income tax losses, incurred in the
whole 2016 and the first half of 2017, amounting to 34.084 PLN thousand
[=−6.476 PLN thousand/19%] and 115.884 PLN thousand [=−22.018
PLN thousand/19%], respectively.
According to these estimates, between the beginning of 2016 and the
end of June 2017 GetBack S.A. incurred cumulative consolidated income
tax losses, amounting to approximately 150,0 PLN million [=34,1 PLN
million + 115,9 PLN million]. For the same eighteen-month period the
company reported in its income statement as much as 280,9 PLN million
[=191,2 PLN million + 89,7 PLN million] of cumulative consolidated pretax earnings. Accordingly, the estimated gap between the company’s reported
pre-tax earnings and its total taxable income amounted to over 430,0 PLN
million [=280,9 PLN million−(−150,0 PLN million)]. Obviously, such a
wide book-tax divergence should have cast any financial statement user’s
doubt on reliability of GetBack’s reported consolidated financial results.
282
J. Welc
GetBack S.A. is an example confirming that many companies, which delve
into aggressive or fraudulent accounting practices, apply such techniques of
earnings manipulations which do not entail a necessity of paying increased
income taxes. In GetBack’s case it could have meant arranging such roundtrip transactions (sale-and-buy-back of portfolios of receivables) which were
not reported to tax authorities or involved unconsolidated related entities
which qualified for some special (preferential) tax treatments. Nevertheless,
the company’s huge and ballooning discrepancies between accounting earnings and taxable income generated very strong warning signals regarding its
fraudulent financial reporting.
8.3.2 General Electric Co.
As was shown earlier in this book, between 2014 and 2017 the General
Electric’s contract assets (which is a label used by the company for its longterm contracts, accounted for with the use of the percentage-of-completion
method) grew significantly faster than sales. An accumulation of those assets
on the company’s balance sheet was so sizeable that it even provoked the
US Securities and Exchange Commission to probe General Electric Co. for
its accounting practices. As was illustrated, continuous multi-period divergences between growth rates of GE’s contract assets and revenues constituted
a reliable warning signal about a likely collapse of the company’s reported
earnings.
However, an another “red flag” which should have cast doubt on sustainability of the General Electric’s reported profits was the company’s negative
tax rate in 2016. As may be seen in Table 8.10, between 2011 and 2013
the company’s effective income tax rate (based on its current income tax and
earnings from continuing operations before income taxes) hovered within a
range between 21,2% and 29,5%. In the following year it fell to 16,1–17,2%
(depending on whether the computation is based on data from the annual
report for 2014, or on the revised data issued in the annual report for 2016),
before suddenly skyrocketing to almost 75% in 2015. The causes of such a
sharp increase in the company’s effective tax rate in 2015 are explained in
Table 8.35 (in the appendix). As may be concluded from those narratives,
in 2015 a large part of the General Electric’s total current tax of 6.103 USD
million was attributable to a one-off income tax payable (amounting to 3.548
USD million), related to the repatriation of the company’s assets between its
various tax jurisdictions. Without such an extraordinary boost its total current
tax would amount to 2.555 USD million [=6.103 USD million–3.548 USD
million] and the company’s adjusted effective tax rate, stripped out from
8 Evaluation of Financial Statement Reliability …
283
Table 8.10 Pre-tax earnings (on continued operations) and current income taxes of
General Electric Co. for fiscal years 2011–2016
Data in USD million
2011
2012
2013
2014
2015
2016
Data from annual reports for fiscal years 2013 and 2014
Current income tax
5.949
3.686
3.971
2.958
–
–
Earnings from connuing operaons
before income taxes
20.159
17.381
16.151
17.229
–
–
Effecve income tax rate*
29,5%
21,2%
24,6%
17,2%
–
–
Data from annual report for fiscal year 2016**
Current income tax
–
–
–
1.655
6.103
–1.278
Earnings from connuing operaons
before income taxes
–
–
–
10.263
8.186
9.030
Effecve income tax rate*
–
–
–
16,1%
74,6%
–14,2%
*Current income tax/Earnings from continuing operation before income taxes
**After the revision of previously published results for discontinued operations
Source Annual reports of General Electric Co. for fiscal years 2012–2016 and authorial
computations
that one-off factor, would equal 31,2% [=2.555 USD million/8.186 USD
million]. Accordingly, it may be concluded that between 2011 and 2015
the General Electric’s effective income tax rate, adjusted for one-off factor
present in the company’s results reported for 2015, was consistently positive
and moved within a range between 16,1% and 31,2%. However, it changed
dramatically in the following year.
As may be seen in Table 8.10, in 2016 the company’s current income tax
fell below zero, for the first time within the whole investigated six-year timeframe. Despite reporting positive and growing earnings before income taxes
(amounting to 9,0 USD billion), General Electric reported a negative consolidated current income tax, amounting to −1.278 USD million. This means
that in spite of its positive and rising accounting profits, the company probably incurred a consolidated tax loss in 2016. Therefore, an implied negative
tax rate of −14,2% should have been interpreted as a reflection of the fastwidening gap between the company’s book earnings and taxable income,
suggesting a low sustainability of the former. In light of this, the consolidated losses reported by the company for 2017 and 2018 should have come
as no surprise to any diligent reader of its prior financial statements.
284
J. Welc
8.3.3 Aventine Renewable Energy Holdings Inc.
Our final case study in this section is based on data published by Aventine Renewable Energy Holdings Inc., a US-based maker of corn ethanol,
which filed for bankruptcy in April 2009. Its selected accounting numbers
are presented in Table 8.11.
As may be seen, between 2004 and 2006 the Aventine’s effective income
tax rate wandered within a range between 31,8% and 38,1%, with an arithmetic mean of 35,9% (near the company’s statutory tax rate of 35,0%).
However, in the following year the ratio fell alarmingly, to as low as 17,3%. In
that period the Aventine’s income before income taxes shrank by 61,5% y/y
(from 86,5 USD million to 33,3 USD million), but such a deep reduction
of the company’s effective tax rate (i.e. a fall from 37,8% to 17,3%) suggests
an even sharper contraction of the company’s taxable income.
Indeed, the estimated taxable income, computed in a similar way as for
GetBack S.A., shrank by as much as 82,4% y/y (i.e. from 93,6 USD million
to 16,4 USD million) in fiscal year 2007. Furthermore, a gap between the
estimated taxable income and the reported pre-tax earnings, which in the
preceding three years hovered within a range ±9%, extended sharply to −
50,7%. Such a sudden and wide rift between the Aventine’s accounting earnings and its taxable income constituted a trustful leading indicator of the
upcoming huge losses, reported for 2008 and 2009 (and accompanied by the
company’s bankruptcy filing).
Table 8.11 Pre-tax earnings and current income taxes of Aventine Renewable Energy
Holdings Inc. for fiscal years 2004–2009
Data in USD thousand
2004
2005
2006
2007
2008
Current income taxes
18.182
16.218
Income before income taxes
47.678
50.989
2009
32.754
5.749
−10.616
−6.193
86.586
33.322
−55.798
−55.216
Effecve income tax rate*
38,1%
31,8%
37,8%
17,3%
N/A
N/A
Esmated taxable income**
51.949
46.337
93.583
16.426
−30.331
−17.694
9,0%
−9,1%
8,1%
−50,7%
−
−
Difference between esmated
taxable income and reported
income before income taxes
*Current income tax/Income before income taxes
**Current income taxes/Statutory income tax rate of 35%
Source Annual reports of Aventine Renewable Energy Holdings Inc. for fiscal years
2005–2009 and authorial computations
8 Evaluation of Financial Statement Reliability …
8.4
285
Signal No 10: Related-Party Transactions
Related-party transactions are deals between a given company and some other
entities or persons, related to it either personally (e.g. by family relationships)
or by some other links, such as equity interests, borrowings, etc. A classical
example of the former is purchases of some goods or services by a company
from vendors which have family ties with its top managers (e.g. when the
vendor is a privately held firm owned by a spouse of a given company’s CEO).
An example of the latter is a rental of an office space by a company from its
parent entity.
Transactions between an entity and its related parties are not inherently bad. They may benefit the company if their terms and conditions
are favorable to it (provided that these favorable terms are not aimed at
deliberately overstating earnings) or when the company may obtain from
them some nonfinancial benefits, unavailable in deals with unrelated entities (e.g. a participation in its parent entity’s technological know-how).
However, related-party transactions also open a room for earnings manipulations, particularly when they are arranged artificially only to inflate the
involved company’s reported profits (Wells 2005; Chen et al. 2011). A disastrous impact of such fictitious deals on reliability of financial statements has
already been demonstrated in Sect. 3.3.5 of Chapter 3 and Sect. 4.1.4 of
Chapter 4. Indeed, the US-based Public Company Accounting Oversight
Board (PCAOB) considers significant related-party transactions, particularly
when they are suspiciously complex or unusual in nature, as one of the
key symptoms of likely accounting fraud (PCAOB 2017). As will be shown
below, such warnings are entirely legitimate.
8.4.1 GetBack S.A.
As explained in the preceding section, GetBack S.A. is a Polish firm (listed on
the Warsaw Stock Exchange), whose former managers committed a massive
accounting fraud, followed by the company’s bankruptcy. This fraud was
based on a series of round-trip transactions (sale-and-buy-back of portfolios of receivables) between the company and its related but unconsolidated
parties. As was concluded, those artificial transactions have been arranged in
a way which brought about huge and fast-widening divergences between the
company’s reported accounting earnings and its taxable income. However,
equally curious and striking warning signals could have been obtained from
an observation of progress of the company’s related-party transactions, as
shown in Table 8.12.
286
J. Welc
Table 8.12 Related-party transactions and total operating revenues of GetBack S.A.
between fiscal years 2015 and 2017
Data in PLN million
Operang revenues, including:
Revaluaon of receivables porolio
Operang revenues without porolio revaluaon
Revenues from related pares, including:
Revenues from associated enes
2015
2016
First
half of
2017
206.673
422.671
337.592
4.658
56.426
34.162
202.015
366.245
303.430
46.156
83.035
438.841
7.734
57.967
202.495
Revenues from other related pares
38.422
25.068
236.346
Share of revenues from related pares in total
operang revenues (without porolio revaluaon)
22,8%
22,7% 144,6%
Source Stock Issue Prospectus and interim financial reports of GetBack S.A. (published
in Polish only) and authorial computations
GetBack’s revenues consisted mainly of revenues from collections of
purchased receivable accounts and revenues from managing (on behalf of
other entities) portfolios of receivables. An element of the former, in turn,
was a noncash periodic revaluation (allowed by IFRS) of fair values of
the company’s receivables. The following discussion will be based on the
company’s revenues stripped out from these accounting revaluations.
Any analyst, evaluating the accounting numbers presented in Table 8.12,
should pose the following question: how was it possible that in the first half
of 2017 a total amount of GetBack’s revenues from related parties exceeded
the company’s total consolidated revenues (without portfolio revaluation) by
as much as 44,6% (438,8 PLN million vs. 303,4 PLN million). Logically, if
sales to any customer contribute to total revenues, then arithmetically their
share in total revenues should never exceed 100%. The only conceivable way,
whereby revenues from any entity may surpass total net sales, is recognizing
the former at an amount which constitutes a difference between the value for
which the assets have been sold and their carrying amount (a cost of sales) on
a sale date. In other words, such a revenue measurement means that net sales
include a gross profit on a sale, instead of separately reporting revenues and
cost of sales.
If related-party transactions have a fictitious nature, i.e. are intended to
artificially inflate the company’s earnings and/or to remove some toxic assets
from its balance sheet, then their recognition in net sales at gross profit may
be aimed at hiding them. If total revenues include only gross profits generated
on such fabricated deals (which are often arranged at abnormally high prices),
then their monetary contribution to net sales is subdued. In other words,
8 Evaluation of Financial Statement Reliability …
287
an inclusion in sales of only the gross profits “earned” on such transactions
implies their “dilution” within the whole revenues, whereby they may be less
visible and detectable.
A dramatic and sharp increase in the share of related-party transactions in
GetBack’s total revenues (from below 23% in 2015–2016 to over 144% in
the first half of 2017) should have been interpreted as a severe warning signal,
indicating a low (and fast deteriorating) reliability of accounting earnings
reported by the company. In this light the company’s later default, combined
with a detection of its accounting fraud, comes as no surprise.
8.4.2 Hanergy Thin Film Power Group Limited
Another educative example of an importance of investigating the relatedparty transactions is offered by Hanergy Thin Power Group Limited,
discussed already in Sect. 5.2 of Chapter 5. As may be remembered, the
auditor’s qualified opinion on the company’s financial statements for fiscal
year 2015 was based on the scope of its transactions with related entities,
including its affiliates and a parent company. The auditors were unable to
obtain sufficient appropriate evidence about a recoverability of the company’s
trade receivables, stemming from those transactions. In light of the significant share of trade receivables in Hanergy’s current and total assets (as at the
end of 2015), such qualifications cast a doubt on a general reliability of the
company’s financial statements.
The opinion of the Hanergy’s auditors only strengthens the arguments
about dangers of significant related-party transactions. However, that adverse
opinion was issued after any financial statement users could have found
out about extremely high contribution of sales to related entities into the
Hanergy’s consolidated revenues and earnings.
Table 8.13 Selected accounting numbers of Hanergy Thin Power Group Limited for
fiscal years 2012–2015
Data in HK$ million
Revenue
2012
2013
2014
2015
2.756,5
3.274,4
9.615,0
2.814,7
Cost of sales
789,5
608,8
4.110,4
1.441,4
Gross profit
1.967,0
2.665,6
5.504,6
1.373,2
Profit before tax
1.666,2
2.328,3
4.186,7
−12.087,4
Profit for the year
1.316,2
2.069,0
3.203,6
−12.233,5
Source Annual reports of Hanergy Thin Power Group Limited for fiscal years 2013–
2015
288
J. Welc
Table 8.13 shows the company’s selected accounting numbers for fiscal
years 2012–2015. As may be seen, between 2012 and 2014 Hanergy Thin
Power Group Limited reported fast growing revenues and earnings. It also
allegedly enjoyed impressive gross margins on sales (meant as a quotient of
gross profit and revenue), particularly in 2012 and 2013, when this ratio
equaled 71,4% [=1.967,0/2.756,5] and 81,4% [=2.665,6/3.274,4], respectively. As a result, its reported net profit more than doubled between 2012
and 2014. Unfortunately (to some investors in the company’s shares), the
Hanergy’s results collapsed in 2015, when its revenues shrank by over 70%
y/y and its profit for the year plummeted to a deeply negative amount.
For watchful analysts and investors a seeming success story of Hanergy
Thin Power Group Limited should have seemed suspected since at least 2012.
As may be seen in Table 8.14, in both 2012 as well as 2013 sales of the
company’s turnkey production lines to its related parties (Hanergy Affiliates)
made up almost 100% of its total revenues. In other words, the company had
no customers other than its related entities (including its parent company).
Furthermore, according to disclosures shown in Table 8.15, not only an
extremely high volume of the Hanergy’s transactions with its related entities
should have cast doubt on reliability of the company’s financial statements,
but also a sluggish pace of collecting the resulting receivable accounts. As may
be seen, at the end of 2012 all its receivables were past due and constituted
28,4% of the company’s annual revenues [=782,3/2.756,5]. In the following
year a monetary amount of the overdue (but not impaired) accounts rose to
2.082,5 HKD [=1.014,6 + 1.067,9], which made up as much as 63,6%
Table 8.14 Extract from Note 34 (Related-party transactions) to the consolidated
financial statements of Hanergy Thin Power Group Limited for fiscal year 2013
Note 34: Related-party transacons
(a) In addion to the transacons and balances detailed elsewhere in these
consolidated financial statements, the Group had the following material
transacons with Hanergy Affiliates during the year.
HK$’000
Manufacturing of turnkey producon lines
Rental expense
Equipment lease expense
Technology usage fee expense
Purchase of photovoltaic modules
Sales of spare parts
Provision of research and development service
and the right to use patented technology
2013
2012
3,243,704
4,849
20,682
29,597
1,896,573
3,970
2,756,463
2,744
16,473
28,761
30,721
−
−
−
Source Annual report of Hanergy Thin Power Group Limited for fiscal year 2013
8 Evaluation of Financial Statement Reliability …
289
Table 8.15 Extracts from Note 20 (Trade and other receivables) to consolidated
financial statements of Hanergy Thin Power Group Limited for fiscal year 2013
Note 20: Trade and other receivables
The Group’s gross amount due from customers for contract work was related to contracts
with the Hanergy Affiliates.
[…]
Account receivables from customers are mainly related to contracts with the Hanergy
Affiliates […]. […] the credit period ranges from 0 days to 10 days during the year.
[…]
The aging analysis of the trade receivables that are not individually nor collecvely
considered to be impaired is as follows:
HK$’000
221.214
2012
−
Less than 3 months past due
1.014.630
782.321
6 months to 1 year past due
1.067.890
−
2.303.734
782.321
Neither past due nor impaired
2013
Source Annual report of Hanergy Thin Power Group Limited for fiscal year 2013
[=2.082,5/3.274,4] of the company’s net sales recognized in that period.
Moreover, an average collection time lengthened significantly, since at the
end of 2013 the accounts past due by more than half a year constituted as
much as 46,4% [=1.067,9/2.303,7] of total receivables, while at the end of
the preceding year no accounts with such long delays were reported.
To summarize, a volume of the related-party transactions entered into
by Hanergy Thin Power Group Limited in both 2012 and 2013 should
have been interpreted as very risky from a point of view of sustainability
of its seemingly impressive results. The following collapse (in 2015) of the
company’s revenues and earnings, combined with the adverse auditor’s review
of its financial statements, constitute an unequivocal proof of relevance of
assessing the related-party transactions watchfully.
8.4.3 Astaldi Group
The final example in this section is based on the accounting data of Astaldi
Group, the Italian construction company which filed for a bankruptcy in
October 2018. As was shown in Sect. 7.4 of Chapter 7, in several years
prior to the company’s default its unbilled receivables (stemming from an
application of the percentage-of-completion method of accounting for longterm contract) emitted a warning signal. However, equally severe “red flags”
290
J. Welc
could have been noted in relation to the company’s transactions with related
entities.
As may be seen in Table 8.16, between 2013 and 2016 the Astaldi’s total
revenues and operating profits showed uninterrupted, almost straight-line
rising trends. Only in the following year its revenue growth slowed down
and operating earnings shrank by 76% y/y (i.e. from 317,0 EUR million to
76,3 EUR million). However, the contraction of profits in fiscal year 2017
constituted only a prologue to Astaldi’s following straits, culminated in its
bankruptcy filing.
The following conclusions, regarding fiscal years 2013–2016, could have
also been inferred from an investigation of data presented in Table 8.16:
• Between 2013 and 2016 the revenues from unrelated parties grew cumulatively by 9,1% (i.e. from 2.076,1 EUR million to 2.264,5 EUR million),
while at the same time an amount of sales to related entities increased by
as much as 71,1% (i.e. from 432,3 EUR million to 739,7 EUR million),
with a resulting increase of the contribution of the related parties to total
revenues from 17,2% to 24,6%.
• While receivables from unrelated parties fell by 8,2% between 2013 and
2016 (i.e. from 2.172,2 EUR million to 1.993,8 EUR million), despite
the growth of revenues from unrelated parties by 9,1%, the receivables
from related entities ballooned by as much as 453,6% (i.e. from 51,5 EUR
million to 285,1 EUR million).
Table 8.16
Selected accounting numbers of Astaldi Group for fiscal years 2013–2017
Data in EUR million
2013
2014
2015
2016
2017
Total operang revenue
2.508,4
2.652,6
2.854,9
3.004,2
3.060,7
of which from unrelated pares
2.076,1
2.126,8
2.189,6
2.264,5
2.478,9
of which from related pares
432,3
525,8
665,3
739,7
581,8
Operang profit
234,1
269,6
276,2
317,0
76,3
Total receivable accounts*
2.223,7
2.068,3
1.936,0
2.278,9
2.181,4
of which from unrelated pares
2.172,2
1.940,8
1.805,3
1.993,8
1.841,5
51,5
127,5
130,7
285,1
339,9
Growth of unrelated-party revenues
−
+2,4%
+3,0%
+3,4%
+9,5%
Growth of related-party revenues
−
+21,6%
+26,5%
+11,2%
−21,3%
Growth of unrelated-party receivables
−
−10,7%
−7,0%
10,4%
−7,6%
Growth of related-party receivables
−
+147,6%
+2,5%
+118,1%
+19,2%
of which from related pares
*Receivables from customers + Trade receivables
Source Annual reports of Astaldi Group for fiscal years 2014–2017 and authorial
computations
8 Evaluation of Financial Statement Reliability …
291
Accordingly, it could have been concluded that the Astaldi’s related-party
transactions not only constituted a more and more material part of its total
revenues recognized between 2013 and 2016, but also that they grew in a
rather unbalanced way, from a perspective of cash flow generation. While
the company’s receivables from unrelated parties changed more or less in
tune with their underlying revenues (perhaps with an exception of fiscal year
2016), the growth rate of receivables from related entities (453,6% cumulatively between 2013 and 2016) was over sixfold faster than the pace of growth
of revenues from those entities (71,1%, cumulatively).
To sum up, it may be concluded that the fast growing amounts of sales to
related parties entailed a rising pressure on the Astaldi’s operating cash flows,
which probably contributed (at least to some extent) to its financial troubles
in 2018.
8.5
Signal No 11: Suspected Behavior
of Allowances for Impairments
of Inventories and Receivables
As was explained in Sect. 4.1.1 of Chapter 4, carrying amounts of inventories
and receivables in balance sheet should not exceed their respective recoverable values. Accordingly, when inventories or receivables become impaired
(i.e. when their recoverable values fall below current book values), then their
carrying amounts should be written down, with an amount of the writedown reported as an expense in income statement. In contrast, reversals of
prior write-downs of inventories and receivables are recognized as gains in the
income statement (usually as part of other operating income). Consequently,
period-to-period changes in allowances for impaired noncash current assets
affect corporate reported earnings, opening a room for accounting manipulations (McNichols and Wilson 1988; Teoh et al. 1998; Caylor 2009; Lee and
Choi 2016).
As was already demonstrated in Sect. 4.1.1 of Chapter 4, understating
write-downs of inventories and receivable accounts constitutes one of the
common techniques of aggressive accounting, resulting in inflated reported
profits. However, also illegitimate and overly optimistic reversals of prior
impairment charges may be used in overstating accounting earnings. In
light of a huge load of subjective (and often difficult to verify) judgments,
combined with multiple unobservable inputs and estimates, movements
of inventory and receivable write-downs (and their impact on reported
accounting numbers) should always be diligently scrutinized.
292
J. Welc
As will be exemplified by the following case studies of OCZ Technology
Group Inc., eServGlobal Ltd. and Delta Apparel Inc., any unusual behavior
of impairment allowances should be considered a “red flag”. A classical
warning signal here comes from a combination of the following trends
(occurring concurrently):
• A year-over-year increase in a gross amount (i.e. before impairment
charges) of a given balance sheet item (inventories or receivable accounts),
with its pace exceeding a growth of revenues, particularly if the former is
rising fast while the latter is slowing or contracting,
• A significant and/or sudden reduction of a percentage share of an amount
of accumulated impairment allowances in a given account’s (i.e. inventories
or receivables) gross value.
Since the amounts of allowances for impaired current assets are rarely
disclosed on a face of balance sheet, they usually have to be extracted from
respective notes to financial statements.
8.5.1 OCZ Technology Group Inc.
The first case study presented in this section is based on accounting numbers
of OCZ Technology Group, discussed several times in the preceding sections
of this book. The company’s selected data are shown in Table 8.17.
As may be seen, in each of the investigated years the OCZ Technology
Group’s sales grew fast. Cumulatively, between fiscal years 2010 and 2012
the company’s revenues increased by 154% (i.e. from 144,0 USD million
to 365,8 USD million). However, at the same time both main elements of
its working capital rose even faster. A cumulative increase in gross inventory
amounted to as much as 955,0% (i.e. from 10,6 USD million to 111,8 USD
million), while at the same time the company’s gross receivables increased
by 240,5% (i.e. from 23,2 USD million to 79,0 USD million). In other
words, in the investigated periods OCZ Technology Group seemed to be
quite aggressive in using its working capital to boost sales and earnings.
Such a fast growth of gross inventories and receivables, particularly in fiscal
year ended February 29, 2012 (when both items grew with triple-digit rates),
called for an increased prudence in estimating their respective impairment
allowances. However, contrary to this, OCZ Technology Group reduced its
ratios of write-downs to gross amounts. The company’s optimism seemed
particularly striking in case of its inventory reserve, which stood virtually
intact (i.e. was raised from 3.146 USD thousand to 3.184 USD thousand),
293
8 Evaluation of Financial Statement Reliability …
Table 8.17 Inventory reserves and allowances for doubtful accounts of OCZ
Technology Group Inc., on the background of the company’s revenue, inventory and
receivables growth
Fiscal years ending
Data in USD thousands
February 28,
2010
February 28,
2011
February 29,
2012
143.959
190.116
365.774
9.846
22.798
108.664
20.380
31.687
72.543
765
3.146
3.184
2.853
2.881
6.416
Inventory, gross*
10.611
25.944
111.848
Accounts receivables, gross**
23.233
34.568
78.959
Growth of net revenue y/y
−
+32,1%
+92,4%
Growth of gross inventory y/y
−
+144,5%
+331,1%
Net revenue
Inventory, net
Accounts receivable, net
Inventory reserve
Allowance for doubul accounts, sales
returns and other allowances
Growth of gross receivables y/y
Inventory reserve/gross inventory
Allowance for doubul accounts/gross
receivables
−
+48,8%
+128,4%
7,2%
12,1%
2,9%
12,3%
8,3%
8,1%
*Inventory, net + Inventory reserve
**Accounts receivable, net + Allowance for doubtful accounts, sales returns and
other allowances
Source Annual reports of OCZ Technology Group Inc. for fiscal years ended February
28, 2011, and February 29, 2012, and authorial computations
despite an observed increase in a gross inventory value by as much as 331,1%
y/y (compared to a revenue growth of 92,4% y/y). As a result, a ratio of
inventory reserve to gross inventory fell dramatically, from 12,1% to as low
as 2,9%. In the case of receivables the company was somewhat more conservative, increasing a monetary amount of its allowance for doubtful accounts
from 2.881 USD thousand to 6.416 USD thousand. However, in light of
fast growing gross receivable accounts (+128,4% y/y) it meant a reduction of
a share of bad-debt allowances in gross receivables, from 8,3% to 8,1% (after
falling from 12,3% to 8,3% one year earlier).
To sum up, despite ballooning gross values of inventories and receivables,
OCZ Technology Group reduced its ratios of impairment allowances to gross
amounts of both accounts. In fiscal year ended February 29, 2012, that
reduction was particularly striking and alarming in case of the company’s
inventories, whose gross amount grew more than three times faster than
net sales. As was confirmed one year later (in annual report for fiscal year
ended February 28, 2013, in which the company revised its previously
294
J. Welc
published accounting numbers), such an optimism in estimating impairment allowances was decisively illegitimate. As it has turned out, retrospective
adjustments of carrying amounts of inventories and receivables constituted
the most significant elements of the OCZ Technology Group’s restatements
of its prior financial statements.
8.5.2 EServGlobal Ltd.
Another educative example is offered by eServGlobal Ltd., the Australian
IT company, specialized in developing and commercializing mobile financial
technology (e.g. platforms for online transfers of money). Since the company
operates in a B2B (business-to-business) environment, its trade receivables
have a significant share in its total consolidated assets.
As may be seen in Table 8.18, in its fiscal year ended October 31, 2013,
eServGlobal’s net sales rose by over 10% y/y. At the same time its gross trade
receivables shrank by 7,6% y/y. Accordingly, relative changes of receivables
and revenues did not call for any concern at that time. In spite of this, the
company seemed quite conservative and increased its share of allowance for
doubtful debts in gross trade receivables from 9,2% to 10,0%. However,
opposite relationships were observed in the following year, when eServGlobal’s net sales stagnated (with a reported growth of 0,8% y/y), while
its gross receivables ballooned by as much as 68,3% y/y. Despite skyrocketing value of its receivables, the company reduced not only its ratio of
Table 8.18 Allowance for doubtful receivable accounts of eServGlobal Ltd., on the
background of the company’s net sales and receivables growth
Fiscal years ending
Data in AUD thousands
October
31, 2012
October
31, 2013
October
31, 2014
October
31, 2015
October
31, 2016
28.070
31.003
31.261
25.866
21.577
8.791
8.049
14.160
11.515
4.982
892
894
890
5.514
3.733
9.683
8.943
15.050
17.029
8.715
Growth of revenue y/y
−
10,4%
0,8%
−17,3%
−16,6%
Growth of gross receivables y/y
−
−7,6%
68,3%
13,1%
−48,8%
9,2%
10,0%
5,9%
32,4%
42,8%
Revenue
Trade receivables, net
Allowance for doubul debts
Trade receivables, gross*
Allowance for doubul debts/gross
trade receivables
*Trade receivables, net + Allowance for doubtful debts
Source Annual reports of eServGlobal Ltd. for fiscal years ended October 31, 2013–
2016, and authorial computations
8 Evaluation of Financial Statement Reliability …
295
allowances to gross amount (from 10,0% to 5,9%) but even a monetary value
of its bad-debt reserve (which fell from 894 AUD thousand to 890 AUD
thousand).
Obviously, such an optimism as regards collectability of the company’s
receivables seemed illegitimate, given their huge growth contrasting with
stagnating sales. However, it seemed even more alarming in light of the
data shown in Table 8.19, which presents an aging structure of the eServGlobal’s unimpaired receivables. As may be seen, at the end of October 2014
the company’s past due but not impaired accounts constituted 53,1% of
carrying amount of its total receivables. This was significantly less than 79,1%
observed one year before. However, its breakdown by age classes deteriorated,
since the accounts past due by more than 120 days increased to almost 3,5
AUD million, from 1,6 AUD million as at the end of October 2013. As a
result, at the end of the fiscal year 2014 these long-overdue accounts constituted as much as 24,5% [=3.469 AUD thousand/14.160 AUD thousand]
of total net receivables, compared to 20,0% [=1.608 AUD thousand/8.049
AUD thousand] one year earlier. When combined with a huge accumulation of total gross receivables, it suggested increasing (instead of reducing
from 894 AUD thousand to 890 AUD thousand) the monetary amount of
bad-debt allowance.
An under-reserving for past due receivables, as at the end of October 2014,
was corroborated one year later, when the company had to dramatically boost
its allowance for doubtful debts (from 890 AUD thousand to as much as 5,5
AUD million). However, even such a huge increase in this reserve (which at
Table 8.19 Aging structure of past due but not impaired receivables of eServGlobal
Ltd
Fiscal years ending
Data in AUD thousands
October
31, 2012
October
31, 2013
October
31, 2014
October
31, 2015
October
31, 2016
By up to 30 days
640
1.200
30–90 days
410
1.055
2.523
934
1.119
1.505
1.350
90–120 days
371
128
2.503
22
1
1.129
6
1.608
3.469
4.995
405
Aging of past due but non impaired
120+ days
Total past due but non impaired
2.550
6.366
7.519
7.280
1.658
Total past due but not
29,0%
79,1%
53,1%
63,2%
33,3%
impaired/Total trade receivables,
t
Source Annual reports of eServGlobal Ltd. for fiscal years ended October 31, 2013–
2016, and authorial computations
296
J. Welc
Table 8.20 Revenue and profit before tax of eServGlobal Ltd. for fiscal years 2012–
2016
Fiscal years ending
Data in USD thousands
Revenue
Profit/loss before tax
October
31, 2012
October
31, 2013
October
31, 2014
October
31, 2015
October
31, 2016
28.070
31.003
31.261
25.866
21.577
−15.402
4.495
28.009
−28.893
−14.031
Source Annual reports of eServGlobal Ltd. for fiscal years ended October 31, 2013–
2016
the end of October 2015 rose to almost one-third of the total gross receivables) was insufficient to protect the company’s receivable turnover against
deteriorating further. As may be seen in Table 8.18, in fiscal year 2015 the
eServGlobal’s gross receivables grew again (this time by 13,1% y/y), despite
a double-digit contraction of the company’s revenues. Only in the following
year its gross amount of receivable accounts fell deeper than net sales (which,
in turn, shrank again).
In light of the trends in revenues, gross receivables and allowances for
bad-debts, observed in fiscal years 2012–2014, a following reversal of the
company’s revenue growth (which turned negative, as shown in Table 8.20),
combined with its deep reported losses, should come as no surprise.
8.5.3 Delta Apparel Inc.
The final example presented in this section deals with inventories of Delta
Apparel Inc., a manufacturer of clothing.
As may be seen in Table 8.21, in the first three of the five investigated
periods the company was able to lift its net sales significantly, without any
simultaneous increase in carrying amount of its inventories. Cumulatively,
its revenues grew at that time by almost one-third (i.e. from 322,0 USD
million to 424,4 USD million), while its inventories (at net amounts) were
reduced by 6,5% (i.e. from 124,7 USD million to 116,6 USD million).
Consequently, no alarming trends could have been observed in relation to
the Delta Apparel’s inventories. In spite of that, in its fiscal year ended July
3, 2010, the company prudently increased its inventory reserve to 3,2% of
gross inventories, from a zero value in prior two years.
However, a situation reversed in the following period, when a continued
double-digit growth of revenues (+12,0% y/y) was accompanied by an almost
three times faster increase in gross inventories. Despite that, in its fiscal year
ended July 2, 2011, managers of Delta Apparel Inc. reduced their estimate
8 Evaluation of Financial Statement Reliability …
297
Table 8.21 Inventory reserves of Delta Apparel Inc., on the background of the
company’s net sales and inventory growth
Fiscal years ending
Data in USD million
June 28,
2008
June 27,
2009
July 3,
2010
July 2,
2011
June 30,
2012
Net sales
322,0
355,2
424,4
475,2
489,9
Inventories, net
124,7
125,9
116,6
159,2
161,6
−
−
3,8
3,7
5,2
124,7
125,9
120,4
162,9
166,8
Growth of net revenue y/y
−
+10,3%
+19,5%
+12,0%
+3,1%
Growth of gross inventory y/y
−
+1,0%
−4,4%
+35,3%
+2,4%
0,0%
0,0%
3,2%
2,3%
3,1%
Inventory reserve
Inventories, gross*
Inventory reserve/gross inventory
*Inventory, net + Inventory reserve
Source Annual reports of Delta Apparel Inc. for fiscal years ended June 27, 2009, July
2, 2011 and June 30, 2012, and authorial computations
Table 8.22 Selected income statement numbers of Delta Apparel Inc. for fiscal years
2008–2012
Fiscal years ending
Data in USD million
Net sales
Gross profit
Operang income
Gross margin on sales*
Operang profitability**
June 28,
2008
June 27,
2009
July 3,
2010
July 2,
2011
June 30,
2012
322,0
355,2
424,4
475,2
489,9
64,7
76,4
100,8
116,2
83,7
4,9
12,1
20,2
25,3
−6,2
20,1%
21,5%
23,8%
24,5%
17,1%
1,5%
3,4%
4,8%
5,3%
−1,3%
*Gross profit/Net sales
**Operating income/Net sales
Source Annual reports of Delta Apparel Inc. for fiscal years ended June 27, 2009, July
2, 2011 and June 30, 2012, and authorial computations
of inventory reserve, not only on a percentage basis (from 3,2% to 2,3% of
gross inventories) but also in terms of its monetary amount (from 3,8 USD
million to 3,7 USD million).
Such an under-reserving for a possible impairment of stockpiling inventories negatively affected the Delta Apparel’s results reported for the following
fiscal year. As may be read in Table 8.36 (in the appendix), the company had
to write down its inventories by as much as 16,2 USD million. As shown
in Table 8.22, that erosion of inventory value materially contributed to the
company’s operating loss of 6,2 USD million, incurred in its fiscal year ended
June 30, 2012.
298
8.6
J. Welc
Signal No 12: Suddenly Changing
Breakdown of Inventories
In case of manufacturing firms, particularly those which report significant
amounts of inventories, valuable leading signals may be generated not only
by changes in carrying amounts of total inventories (relative to sales), but
also from sudden shifts in an inventory breakdown. Observation of empirical data teaches that often turning points of trends of revenues and profits
(particularly when the former’s growth so far showed a relatively fast pace,
e.g. as compared to competitors) coincide with the following simultaneous
(and related to each other) patterns:
• Increase in finished goods inventories much faster than growth of sales.
• Reduction in carrying amounts of raw materials (and similar manufacturing inputs, such as components, spare parts, etc.).
A simultaneity of these two patterns is entirely logical when implications
of a fast changing demand are taken into consideration. Sudden contractions
of demand for company’s products or services, either due to external forces
(e.g. unforeseen recession) or some internal factors (e.g. sharply deteriorating
competitiveness), often result in stockpiling inventories of finished goods,
which are more and more difficult to sell. The accumulation of finished
goods, in turn, stems from the company’s prior production plans, which have
been based on earlier (higher) levels of demand. A resulting deterioration of
inventory turnover lasts for some time, until the company’s managers reduce
its output volume commensurately with a depressed demand level. At the
same time, however, the managers (with all their detailed insider’s information about the company’s falling backlog of orders) cut their purchases of
production inputs, such as raw materials or components, in tune with their
lowered planned output volumes.
Consequently, at turning points of revenue trends inventories of raw materials and finished goods often change in opposite directions. While the former
start falling immediately, as a result of a managerial reaction to expected
reduced levels of sales and output, the latter accumulates for some time (since
a company continues turning its work in progress inventories into finished
goods, at prior output rates, planned before the demand’s contraction).
As will be demonstrated by three real-life examples (Volkswagen Group,
Nokia Corporation and Cowell e Holdings Inc.), such a stockpiling of
finished goods at a turning point of a revenue trend tends to be followed not
only by negative growth rates of revenues, but also by eroding gross margin
299
8 Evaluation of Financial Statement Reliability …
on sales. The latter, in turn, is often driven by sell-offs of excess inventories
at discounted prices.
8.6.1 Volkswagen Group
Table 8.23 presents selected financial statement data of Volkswagen Group,
for its fiscal years 2005–2009. The following conclusions may be inferred
from their investigation:
• Between 2005 and 2007 carrying amounts of the company’s inventories of
raw materials and finished goods changed with differing rates, but always
in the same direction (both fell in 2006 and then grew in the following
year).
• However, directions of their changes diverged dramatically in 2008, when
the amount of raw materials shrank by almost 10% y/y, while the carrying
amount of finished goods rose by as much as over 35% y/y/(several times
faster than sales).
• The wide discrepancy between changes of raw materials and finished
goods, observed in 2008, preceded the Volkswagen Group’s contraction
Table 8.23 Selected accounting numbers of Volkswagen Group for fiscal years 2005–
2009
Data in EUR million
2005
2006
2007
2008
2009
Sales revenue
93.996
104.875
108.897
113.808
105.187
Gross profit
12.263
13.855
16.294
17.196
13.579
2.538
2.009
6.151
6.333
1.855
12.643
12.463
14.031
17.816
14.124
2.163
2.061
2.225
2.009
2.030
9.100
9.050
10.425
14.099
10.417
Operang profit
Inventories, including:
Raw materials, consumables
and supplies
Finished goods and purchased
merchandise*
Other inventories**
Growth of sales y/y
Gross margin on sales***
1.380
1.352
1.381
1.708
1.677
−
+11,6%
+3,8%
+4,5%
−7,6%
12,9%
13,0%
13,2%
15,0%
15,1%
Change of raw materials
−
−4,7%
+8,0%
−9,7%
+1,0%
Change of finished goods
−
−0,5%
+15,2%
+35,2%
−26,1%
*Including current leased assets
**Including work in progress
***Gross profit/Sales revenue
Source Annual reports of Volkswagen Group for fiscal years 2006–2009 and authorial
computations
300
J. Welc
of revenues (by 7,6% in 2009, after several consecutive years of growth),
profits and gross margin on sales (which in 2009 fell to its lowest level
within the whole investigated five-year timeframe).
As may be seen, in 2008 opposite directions of changes of Volkswagen
Group’s raw materials and finished goods (with a reduction of the former,
accompanied by a huge growth of the latter) should have been considered
as a leading indicator of an upcoming erosion of the company’s revenues,
margins and earnings.
8.6.2 Nokia Corporation
Similar patterns to those discussed above in relation to Volkswagen Group
could have been observed in the case of Nokia Corporation. As may be
seen in Table 8.24, between 2005 and 2007 the company’s inventories of
raw materials and finished goods changed in tune with each other (with
both experiencing small declines in 2006, followed by huge increases in
the next year). However, after several years of double-digit growth rates, in
2008 Nokia’s sales stagnated, in combination with a significant reduction (by
over 12% y/y) of the company’s supplies of raw materials and a continued
(although at much slower pace) accumulation of its inventories of finished
goods.
Table 8.24
2009
Selected accounting numbers of Nokia Corporation for fiscal years 2005–
Data in EUR million
2005
2006
2007
2008
2009
Net sales
34.191
41.121
51.058
50.710
40.984
Gross profit
11.982
13.379
17.277
17.373
13.264
Operang profit
4.639
5.488
7.985
4.966
1.197
Inventories, including:
1.668
1.554
2.876
2.533
1.865
Raw materials, supplies and other
361
360
591
519
409
Finished goods
622
594
1.225
1.270
775
Work in progress
685
600
1.060
744
681
−19,2%
Growth of sales y/y
−
+20,3%
+24,2%
−0,7%
35,0%
32,5%
33,8%
34,3%
32,4%
Change of raw materials
−
−0,3%
+64,2%
−12,2%
−21,2%
Change of finished goods
–
−4,5%
+106,2%
+3,7%
−39,0%
Gross margin on sales*
*Gross profit/Net sales
Source Annual reports of Nokia Corporation for fiscal years 2006–2009 and authorial
computations
8 Evaluation of Financial Statement Reliability …
301
As may be inferred from the last two columns of Table 8.24, an observed
divergence between growth rates of Nokia’s raw materials and finished goods
(with a contraction of the former accompanied by a continued increase in
carrying amount of the latter) was an accurate predictor of the following
contraction of the company’s net sales, reported earnings and gross margin
on sales (which all fell in 2009).
8.6.3 Cowell e Holdings Inc.
The final case study examined in this section is Cowell e Holdings Inc., one
of the major suppliers of front camera modules (components of smartphones)
to Apple Inc. The company’s selected financial statement data are presented
in Table 8.25.
The analysis of these accounting numbers leads to the following conclusions:
• Between 2013 and 2015, when the company’s revenues continued their
growth, its inventories of raw materials were gradually falling (cumulatively
by 14,5%, i.e. from 29,6 USD million to 25,3 USD million), while at the
same time a carrying amount of its finished goods rose dramatically (rising
cumulatively by as much as three-fold, i.e. from 17,9 USD million to 71,5
USD million). Accordingly, such an unusually long divergence between
Table 8.25 Selected accounting numbers of Cowell e Holdings Inc. for fiscal years
2013–2018
Data in USD million
2013
2014
2015
2016
2017
2018
Revenue
813,9
886,5
980,2
914,6
740,7
535,9
Gross profit
103,2
112,1
136,9
76,1
74,2
52,3
Profit from operaons
69,0
70,7
78,6
35,4
31,1
14,3
Inventories, including:
55,0
66,0
101,3
60,0
107,4
66,7
Raw materials
29,6
27,2
25,3
21,2
19,4
11,3
Finished goods
17,9
32,2
71,5
23,7
60,8
47,1
7,5
6,6
4,5
15,1
27,2
8,3
Growth of revenue y/y
–
+8,9%
+10,6%
−6,7%
−19,0%
−27,6%
Gross margin on sales*
Work in progress
12,7%
12,6%
14,0%
8,3%
10,0%
9,8%
Change of raw materials
–
−8,1%
−7,0%
−16,2%
−8,5%
−41,8%
Change of finished goods
–
+79,9%
+122,0%
−66,9%
+156,5%
−22,5%
*Gross profit/Revenue
Source Annual reports of Cowell e Holdings Inc. for fiscal years 2014–2018 and
authorial computations
302
J. Welc
declining raw materials and stockpiling finished goods should have been
interpreted as a strong “red flag”.
• A combination of falling raw materials and accumulating finished goods,
observed between 2013 and 2015, was an accurate predictor of the
following reversal of the company’s revenue trend (marked by a decline
by 6,7% y/y in 2016), combined with a deep erosion of its gross margin
on sales (which fell from 12,6–14,0% recorded between 2013 and 2015,
to as low as 8,3% in 2016).
• In 2016 the company reduced carrying amounts of both raw materials
and finished goods, which was however followed by their another divergence observed again in 2017 (when raw materials continued falling, while
finished goods stockpiled dramatically).
• Similarly as before, diverging growth rates of both examined classes of
inventories served as a reliable leading indicator of the upcoming plummeting of the company’s revenues (which shrank by almost 28% y/y in
2018) and earnings (which contracted for a third year in a row).
The example of Cowell e Holdings Inc. confirms an importance of spotting any material shifts in an inventory breakdown of inventory-intensive
manufacturing businesses. Significant discrepancies between changes of raw
materials (when they fall) and finished goods (particularly if they grow
conspicuously fast) should be always treated as “red flags”, which increase a
likelihood of an upcoming reversal of a given company’s revenue and earnings
trends.
8.7
Signal No 13: Other Significant
and Unusual Trends
Analytical tools discussed so far in Chapters 7 and 8 focused on concrete and
specified items of corporate financial statements, such as inventories, receivables, deferred revenues, provisions or taxes. However, when investigating
financial reports it is very important to diligently watch for any items which
show unusual or conspicuous behavior. Such items, particularly when hidden
behind obscure labels (e.g. “other operating assets”), may contain very relevant information for an earnings quality analysis. This issue will be illustrated
with selected accounting data of Folli Follie Group (a Greek firm operating
in a jewelry industry), presented in Table 8.26.
As may be seen, between 2015 and 2017 the Folli Follie’s revenues grew
steadily, by 12,1% y/y in 2016 and 6,1% y/y in 2017. Even though its cost of
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8 Evaluation of Financial Statement Reliability …
Table 8.26 Selected financial statement data of Folli Follie Group for fiscal years
2015–2017
Data in EUR million
2015
2016
2017
1.193,0
1.337,3
1.419,3
Cost of goods sold
611,8
725,0
785,5
Operang income
238,5
262,3
260,6
Inventories
490,3
586,0
635,0
Trade receivables
585,9
654,7
664,0
Other current assets**
235,2
230,0
350,1
Cash & cash equivalents
245,5
328,2
446,3
Trade and other payables
133,5
140,9
139,1
Turnover (Net sales)*
Data
reported in
financial
statements
Cash flows from operang acvies
Growth y/y
57,9
140,1
−21,0
Turnover (Net sales)*
–
12,1%
6,1%
Cost of goods
–
18,5%
8,3%
Operang income
–
10,0%
−0,6%
Inventories
–
19,5%
8,4%
Trade receivables
–
11,7%
1,4%
Other current assets**
–
−2,2%
52,2%
Cash & cash equivalents
–
33,7%
36,0%
Trade and other payables
–
5,5%
−1,3%
*Folli Follie Group used term “Turnover” for net sales
**Including derivatives and other financial assets at fair value through profit, which
the company reported under separate line items of its balance sheet
Source Annual reports of Folli Follie Group for fiscal years 2016–2017 and authorial
computations
goods sold grew faster than sales, the operating income increased by 10,0%
in 2016 and stayed virtually intact in the following period. All in all, for
all three years the company reported rather stable operating profits, within
a range between 238 EUR million and 262 EUR million a year. However,
in June 2018 Greek authorities probed Folli Follie for suspected accounting
irregularities (with the trading of its shares being suspended by the Athens
Stock Exchange) and in the following month the company had to resort to a
pre-bankruptcy protection procedure. With a benefit of hindsight, it is educative to check what warning signals could have been detected in the company’s
financial results reported for 2015–2017.
First of all, the company’s operating cash flows, after showing an impressive
increase (by over 140% y/y) in 2016, plummeted to a negative level in the
following year. This obviously should have been interpreted as a “red flag”.
However, in the short-run negative operating cash flows themselves do not
304
J. Welc
automatically imply an immediate insolvency. For instance, a fast growing
company with a healthy business model could have been investing intensively
in new inventories, to put them on shelves in its new points of sales (with
a temporary negative contribution of inventory growth into operating cash
flows). Alternatively, it could have significantly increased a share of wholesale
operations (as compared to retail) in its sales breakdown, with a resulting
boost to receivable accounts. Finally, in order to negotiate more favorable
terms of supplies (e.g. lower purchase prices) a firm could have accelerated
payments to its vendors, with a resulting reduction in payable accounts. All
such undertakings could have temporarily pushed the company’s operating
cash flows to much below its accounting earnings. Thus, before mechanically
interpreting the Folli Follie’s 2017 negative cash flows as a warning signal, it
is recommendable to investigate a composition of those cash flows.
Given the stated stability of the company’s operating income (which stood
almost intact between 2016 and 2017), a sharp collapse of its operating cash
flows must have been caused by some other factors, e.g. changes in working
capital. As may be seen in Table 8.26, between 2016 and 2017 a balance of
the company’s trade and other payables fell by mere 1,8 EUR million (i.e.
from 140,9 EUR million to 139,1 EUR million), which means that repayments of payables could have not been blamed for draining the company’s
money. Accordingly, it is likely that increases in inventories or receivables have
eroded cash. Indeed, the inventories rose by 49 EUR million (from 586 EUR
million to 635 EUR million), while a balance of receivable accounts grew
by 9,3 EUR million (from 654,7 EUR million to 664 EUR million), with
a total negative contribution of both items amounting to 58 EUR million.
However, as may be seen in Table 8.26, the company’s other current assets
increased particularly strongly (by over 120 EUR million) between the end
of 2016 and the end of 2017. It is worth noting that these assets rose by over
52% y/y, as compared to a revenue growth of 6,1% and increases in inventories and receivables by 8,4% and 1,4%, respectively. Clearly, with such a
huge increase (in monetary as well as percentage terms) the other current
assets deserve a closer examination.
Table 8.37 (in the appendix) presents a composition of the Folli Follie’s
other current assets (after excluding derivatives and other financial assets at
fair value through profit, which the company reported under separate line
items of its balance sheet), as at the end of 2016 and 2017. As may be seen,
between these two reporting dates the company’s total other current assets
went up by 117,4 EUR million (i.e. from 213,1 EUR million to 330,5 EUR
million), with the largest contribution of advances to suppliers (which grew
from 130,7 EUR million to 224,1 EUR million).
8 Evaluation of Financial Statement Reliability …
305
Interestingly, in a narrative part of Note 10 to its financial statements
Folli Follie Group offered some description of its advances to suppliers,
cited in Table 8.38 (in the appendix). According to that explanation, the
advances to suppliers relate to suppliers of merchandise (inventory) as well
as to vendors of “equipment […] to be established in […] points of sales”.
First of all, even though a breakdown of the whole amount of advances to
suppliers is not disclosed anywhere in the company’s financial statements, an
inclusion of any equipment-related prepayments within current assets seems
strange, since these advances correspond to investments on long-term assets
(not the current ones). Second, a narrative explanation of a nature of the Folli
Follie’s advances to suppliers seems quite obscure, since the company uses,
but not defines, such terms as “reliable performance” or “privilege discounts”.
It may be only guessed, based on these narratives, that in return for such
large advance payments the company has been offered non-negligible price
discounts. Although it could have been economically justified, some other
questions arise.
Deferred payment terms offered by suppliers result in trade payables,
reported on a right-hand side of balance sheet. In contrast, advances to
suppliers are short-term assets, reported on its left-hand side. Since both
correspond to the company’s settlements with the same class of stakeholders
(suppliers) and result from similar types of transactions (purchases of operating assets), trends of operating payables should be analyzed net of advances
to suppliers (if significant). Table 8.27 presents a computation of the Folli
Follie’s net payables (i.e. trade and other payables less advances to suppliers),
together with their turnover (in days), within a five-year timeframe between
2013 and 2017.
Table 8.27 Calculation of Folli Follie’s turnover of net trade payables between fiscal
years 2013 and 2017
Data in EUR million
2013
2014
2015
2016
2017
Trade and other payables
120,3
181,9
133,5
140,9
139,1
224,1
Advances to suppliers
73,5
69,1
89,7
130,7
Net payables*
46,8
112,8
43,8
10,2
–85,0
440,6
496,3
611,8
725,0
785,5
38,8
83,0
26,1
5,1
–39,5
Cost of goods sold
Turnover of net payables (in days)**
*Trade and other payables—Advances to suppliers
**=(Net payables/Cost of goods) × 365
Source Annual reports of Folli Follie Group for fiscal years 2014–2017 and authorial
computations
306
J. Welc
As may be seen, at the end of 2013 the company’s net payables amounted
to 46,8 EUR million. During 2014 they rose to 112,8 EUR million (due
to a combination of increase in trade payables and reduction of advances to
suppliers), but across all the following periods they fell steadily, to a negative amount of −85 EUR million, as at the end of 2017. While between the
end of 2015 and 2017 the gross carrying amount of trade and other payables
stood rather still (within a narrow range between 133 and 141 EUR million),
the prepayments to suppliers grew monotonically. Between 2014 and 2017
gross trade payables contracted by as much as 42,8 EUR million [=139,1–
181,9], but at the same time the balance of advance payments rose by as
much as 155,0 EUR million [=224,1–69,1]. No wonder that in the investigated period (particularly near its end) changes in net payables contributed
so negatively to the Folli Follie’s operating cash flows.
Interesting (even if simplistic) observations stem also from changes of a
computed turnover of payables. While between 2013 and 2015 the company
settled its payments to suppliers after one to three months, on average, in
the following two years this statistic fell dramatically, to as low as almost
minus forty days in fiscal year 2017. According to these estimates, in 2017
the company must have prepaid (instead of benefiting from deferred payment
terms) for its supplies, with the average advance time of more than one
month.
Obviously, the observed behavior of the Folli Follie’s net payables (i.e.
payables after taking into account advances to suppliers, which were hidden
within other current assets), particularly their negative amount as at the end
of 2017, deserves being labeled as unusual. When interpreting data shown
in Table 8.27 any financial statement user should have concluded that something must have been going wrong, either with the company’s relations with
suppliers (who perhaps knew much more about the company’s upcoming
insolvency than any user of Folli Folie’s financial statements) or with the
company’s financial reporting.
Since advances to suppliers are nonrefundable prepayments for goods
ordered from them, some financial analysts would argue that these accounts
should be used in adjusting inventories upward, rather than correcting trade
payables downward. If such an inventory adjustment approach is followed,
then in 2016 and 2017 the company’s inventory changes (on the background
of its revenue growth) would look as shown in Table 8.28.
As may be clearly seen, in both investigated years the growth of adjusted
inventories (i.e. including advances to suppliers) exceeded the company’s sales
growth by much wider margins than in the case of unadjusted (reported)
inventories. According to data presented earlier in Table 8.26, in 2016 and
8 Evaluation of Financial Statement Reliability …
307
Table 8.28 Growth of Folli Follie’s sales and adjusted inventories* between fiscal
years 2015 and 2017
Data in EUR million
2015
2016
2017
Inventories (as reported)
490,3
586,0
635,0
89,7
130,7
224,1
580,0
716,7
859,1
1.193,0
1.337,3
1.419,3
Growth of turnover (Net sales)**
–
12,1%
6,1%
Growth of inventories, including advances to suppliers
–
23,6%
19,9%
Advances to suppliers
Inventories including advances to suppliers*
Turnover (Net sales)**
*Inventories (as reported) + Advances to suppliers
**Folli Follie Group used term “Turnover” for net sales
Source Annual reports of Folli Follie Group for fiscal years 2016–2017 and authorial
computations
2017 the company’s reported inventories grew by 19,5% y/y and 8,4% y/y,
that is about 7,7 and 2,2 percentage points, respectively, above the sales
growth. However, adjusted inventories grew much more, particularly in 2017,
when their carrying amount rose over three times faster than sales.
In light of the above discussion it must be concluded that the majority of
financial statement ratios (such as profitability or liquidity ratios), as well as
warning signals discussed earlier in this chapter (as well as in the previous
one), would have probably understated the risks of financial troubles faced
by Folli Follie Group. According to the data shown in Tables 8.26, 8.27 and
8.28:
• In 2016 and 2017 the company’s reported inventories grew faster than
sales, but a gap between those growth rates did not exceed eight percentage
points (and narrowed significantly in 2017).
• In both 2016 and 2017 the company’s trade receivables grew slower than
net sales, which obviously would not call for any concern.
• In both 2016 and 2017 the changes in trade payables (as reported on
the face of balance sheet) showed nonsignificant period-to-period changes,
which would not call for any concern.
• In both years, however, the company’s net trade payables, i.e. reported
payables less advances to suppliers, showed a fast falling trend (to a negative amount at the end of 2017), despite a continued growth of costs of
goods sold.
• In both years inventories, adjusted upward for advances to suppliers,
showed a fast growth (two or three times faster than sales).
308
J. Welc
The example of Folli Follie Group teaches that earnings quality indicators
(similarly as most other analytical tools), discussed earlier in Chapters 7 and
8, should not be calculated and interpreted mechanically, since they are not
free from their own weaknesses. None of those warning signals should be
used in isolation from other information disclosed (often deeply in notes) in
corporate financial statements. If any material items of financial statements
behave unusually or conspicuously (like advances to suppliers in case of Folli
Follie Group), they should be investigated thoroughly.
8.8
Importance of Investigating Combinations
of Warnings Signals
When evaluating reliability and comparability of corporate financial results it
is important to pay attention to combinations of various indicators (instead
of interpreting them in isolation from each other), since often multiple
accounts are manipulated at the same time (Dechow et al. 2011). When
multiple warning signals (instead of just one or two) suggest some likely
operating problems and/or accounting irregularities, their combined informativeness rises dramatically. Usually a collapse of a given firm’s reported
earnings, following their material prior misstatements, is very dramatic when
preceded by noticeable imbalances observed in multiple areas of accounting.
This will be illustrated with the example of AgFeed Industries Inc., a Chinese
agricultural company which was listed on the New York Stock Exchange.
As may be read in Table 8.39 (in the appendix), which contains an extract
from one of the US Securities and Exchange Commission’s press releases,
the managers of AgFeed Industries Inc. committed a multiyear large-scale
accounting fraud between 2008 and 2011. That fraudulent scheme included
inflating revenues by means of fictitious sales transactions (with the use of
fake invoices) as well as overstating inventories by reporting nonexistent hogs.
As may be seen in Table 8.29, between 2008 and 2010 the company
reported double-digit growth rates of revenues. However, at the same time
its income from operations was steadily declining. Moreover, in both 2008
and 2009 the AgFeed’s cash flows lagged behind its reported accounting earnings, with a gap widening from period to period. The first warning signal was
therefore generated by the company’s cash flows from operations, which in
2008 and 2009 constituted 74,9% [=18,5 USD million/24,7 USD million]
and 33,3% [=3,9 USD million/11,7 USD million] of its operating income,
respectively.
8 Evaluation of Financial Statement Reliability …
309
Table 8.29 Selected financial statement data of AgFeed Industries Inc. for fiscal years
2008–2010
Data in USD million
2008
2009
2010
143,7
173,2
243,6
Income from operaons
24,7
11,7
−40,4
Net cash provided by operang
acvies
18,5
3,9
−10,0
Net revenue
Data
reported in
financial
statements
Growth y/y
Accounts receivable
9,5
14,4
21,9
Inventory
20,6
23,8
84,6
Property and equipment
31,7
34,6
66,0
Net revenue
—
+20,5%
+40,6%
Accounts receivable
—
+51,6%
+52,1%
Inventory
—
+15,5%
+255,5%
Property and equipment
—
+9,1%
+90,8%
Source Annual reports of AgFeed Industries Inc. for fiscal years 2009–2010 and
authorial computations
The further investigation reveals that between 2008 and 2010 the
company’s receivable accounts rose relatively fast, with their cumulative
growth of 130,5% (i.e. from 9,5 USD million to 21,9 USD million),
compared to a cumulative increase in annual revenues by 69,5% (i.e. from
143,7 USD million to 243,6 USD million). Also, in 2010 the company’s
inventories (which changed in an inconspicuous way before) ballooned by
over 250% y/y. Accordingly, in 2010 both components of the AgFeed’s
working capital (i.e. receivables and inventories) grew incommensurately with
its revenues.
However, as may also be seen in Table 8.29, in 2010 the carrying amount
of the company’s property, plant and equipment (PP&E) rose by over 90%,
which entailed a deterioration of its PP&E’s turnover ratio from 5,00 [=173,2
USD million/34,6 USD million] in 2009 to 3,69 [=243,6 USD million/66,0
USD million] in the following year. Accordingly, it seemed that all three
major classes of the company’s operating assets (i.e. receivables, inventories
and tangible fixed assets) showed aggressive growth rates in its fiscal year
2010.
However, not only increases of the AgFeet’s operating assets should have
attracted a diligent analyst’s skepticism, but also a sharp shift in a breakdown of the company’s inventories. As shown in Table 8.30, in 2008 and
2009 the share of hogs in total inventories stood within a relatively narrow
range, between 65,7% and 69,4%. In the following year, however, a carrying
amount of this item grew over four-fold (i.e. from 15,7 USD million to 71,5
USD million), with a resulting increase of its share in total inventories to
310
J. Welc
Table 8.30 Breakdown of the AgFeed’s inventories between fiscal years 2008 and
2010
Data in USD thousand
Raw material
2008
2009
2010
5.625,1
7.639,0
12.146,2
Work in process
103,3
84,5
160,0
Finished goods—feed
575,1
460,3
810,8
Hogs
14.325,4
15.651,6
71.462,8
Total
20.628,9
23.835,4
84.579,8
69,4%
65,7%
84,5%
Share of hogs in total inventories
Source Annual reports of AgFeed Industries Inc. for fiscal years 2009–2010 and
authorial computations
almost 85%. Such a material change in the inventory breakdown, manifested
in an increase of the share of hogs by nearly twenty percentage points, should
have cast doubt on reliability of carrying amount of this class of the company’s
assets.
As the case study of AgFeed Industries shows, tracking multiple indicators
of earnings quality increases an accuracy of the obtained research findings. On
an individual basis, these indicators may sometimes be misleading, since they
serve only as crude symptoms (not proofs) of some likely issues. However,
when more than one or two analytical tools generate alarming signals, then
a likelihood of some real underlying (even if hidden) problems increases
exponentially.
8.9
When Detecting Accounting Manipulations
May Be Difficult
All analytical tools discussed in the preceding sections are useful in evaluating reliability of reported financial numbers. As has been illustrated with
the use of real-life data, these tools often generate warning signals, which
precede negative events, such as a company’s bankruptcy or a collapse of its
earnings. However, their usefulness does not mean their infallibility, since in
some situations such simple tools are unable to generate sufficiently strong
warning signals. Sometimes it is impossible (or almost impossible) to detect
accounting manipulations without an access to corporate internal documents.
One of the examples of such circumstances is a falsification of reported cash
and cash equivalents, which will be illustrated with real-life data of Redcentric
plc.
8 Evaluation of Financial Statement Reliability …
311
Redcentric plc is a British IT company, listed on the London Stock
Exchange. In November 2016 its stock price collapsed by over 60%, in reaction to its public announcement of a detection of “misstated accounting
balances”, leading to a significant downward revision of its financial results
reported earlier for fiscal year ended March 31, 2016. Table 8.40 (in the
appendix) compares selected numbers, reported by the company for that fiscal
year, in its two consecutive annual reports: in the annual report for fiscal year
ended March 31, 2016 (i.e. including the accounting misstatements) and
in the annual report published one year later (i.e. after a revision of previously reported numbers). For comparative purposes the unrevised data for
fiscal year ended March 31, 2015, are also presented. Table 8.41 (also in the
appendix), in turn, contains extracts from Note 28 to the Redcentric’s consolidated financial statements for fiscal year ended March 31, 2017, explaining
its revisions of previously reported accounting numbers (for fiscal year ended
March 31, 2016).
As might be seen in Table 8.40, the revisions of its previously published
numbers have affected all three Redcentric’s primary financial statements.
In income statement, revenues reported for fiscal year ended March 31,
2016, have been reduced by several percentage points, while much more
dramatic impact has been observed in the case of profits, which turned from
significantly positive to negative values (on both the operating as well as
the after-tax level). Strikingly, operating cash flows, which in the previously
published annual report showed seemingly positive trend (rising slightly and
staying on the level almost twice as high as the accrual-based operating profit),
turned out to be negative after the revision. In balance sheet, most asset values
have been corrected downward (with a particularly striking impact on cash
and short-term deposits), although carrying amount of intangibles has been
raised. Finally, on a right-hand side of the Redcentric’s balance sheet its total
equity has been reduced significantly, while carrying amount of overdraftrelated financial obligations has been revised from zero to almost four GBP
million.
Table 8.41 (in the appendix) explains major factors responsible for such
material revisions of financial results reported by Redcentric plc for its fiscal
year ended March 31, 2016. The following conclusions may be inferred from
combining narratives quoted in this table with the numbers disclosed in
Table 8.40:
• The overstatement of Redcentric’s earnings, reported for its fiscal year
ended March 31, 2016, resulted from both its inflated sales (due to premature revenue recognition), as well as from significant understatement of
cost of sales.
312
J. Welc
• The most material revisions affected cash and cash equivalents, whose real
value as at the end of March 2016 was zero (instead of 8,5 GBP million,
as reported in the annual report for fiscal year ended March 31, 2016),
while at the same time the company’s overdrafts have been dramatically
understated, with their zero carrying amount (instead of their real value of
almost 4,0 GBP million).
• Significant overstatement of the Redcentric’s cash balances (by almost 8,5
GBP million), combined with the deep understatement of the company’s
overdraft-related obligations (by almost 4,0 GBP million), resulted not
only in inflated and unreliable earnings and operating cash flows, but also
in an understated value of the company’s reported net debt (and major
credit risk metrics, such as debt-to-EBITDA).
• Other revisions had predominantly presentational character and less material individual amounts (e.g. reclassifying some items of property, plant and
equipment to inventories and intangibles).
To sum up, among multiple misstated numbers in the Redcentric’s financial statements for fiscal year ended March 31, 2016, cash-related items
(including both cash balances on an asset side of the balance sheet, as well as
overdraft-related liabilities on its right-hand side) have been the most materially distorted ones. This, in turn, dramatically eroded a reliability of the
company’s reported operating cash flows (which themselves have been hugely
inflated, as a result of misstated net cash balances) in informing about the
quality of the company’s published results. Although an analysis of noncash
accounting items could have emitted some warning signals (e.g. a high share
of intangibles in total assets or fast growing receivables, which outpaced
revenues significantly), they were generally unrelated to the core problem,
which lied in the inflated cash balances and understated net debt.
This example shows that in some circumstances basic tools applicable in
assessing financial statement reliability are not entirely reliable themselves.
This is valid also for cash flows, which are falsely deemed by many financial
statement users as immune to manipulations. As demonstrated here, when
reported cash balances are inflated, then cash flow statement loses its credibility, while at the same time the other indicators may generate warning
signals which may not be strong enough to be treated as really alarming.
Appendix
See Tables 8.31, 8.32, 8.33, 8.34, 8.35, 8.36, 8.37, 8.38, 8.39, 8.40, and
8.41.
8 Evaluation of Financial Statement Reliability …
313
Table 8.31 Extract from Note 1 to financial statements of US Airways Group Inc. for
fiscal year 2012, related to the company’s revenue recognition policy
Note 1 (Basis of presentation and summary of significant accounting policies)
Revenue recognition (Passenger Revenue)
Passenger revenue is recognized when transportation is provided. Ticket sales for
transportation that has not yet been provided are initially deferred and recorded as air
traffic liability on the consolidated balance sheets. The air traffic liability represents
tickets sold for future travel dates and estimated future refunds and exchanges of
tickets sold for past travel dates. The majority of tickets sold are nonrefundable. A
small percentage of tickets, some of which are partially used tickets, expire unused.
Due to complex pricing structures, refund and exchange policies, and interline
agreements with other airlines, certain amounts are recognized in revenue using
estimates regarding both the timing of the revenue recognition and the amount of
revenue to be recognized. These estimates are generally based on the analysis of the
Company’s historical data. [...] Estimated future refunds and exchanges included in
the air traffic liability are routinely evaluated based on subsequent activity to validate
the accuracy of the Company’s estimates. [...]
Source Annual report of US Airways Group Inc. for fiscal year 2012
Table 8.32 Extract from Note 1 to financial statements of GateHouse Media Inc. for
fiscal year 2012, related to the company’s revenue recognition policy
Note 1 (Description of business, basis of presentation and summary of significant
accounting policies)
Revenue recognition
Circulation revenue from subscribers is billed to customers at the beginning of the
subscription period and is recognized on a straight-line basis over the term of the
related subscription. Circulation revenue from single copy sales is recognized at the
time of sale. Advertising revenue is recognized upon publication of the advertisement.
Revenue for commercial printing is recognized upon delivery. Directory revenue is
recognized on a straight-line basis over the period in which the corresponding
directory is distributed.
Source Annual report of GateHouse Media Inc. for fiscal year 2012
314
J. Welc
Table 8.33 Extracts from notes to financial statements of OCZ Technology Group
Inc. for fiscal years ending February 28/29, 2012 and 2013, explaining the company’s
accounting policy toward warranty provisions
Annual Report for Fiscal Year Ended February 29, 2012:
Product warranties
We offer our customers warranties on certain products sold to them. These warranties
typically provide for the replacement of its products if they are found to be faulty
within a specified period. Concurrent with the sale of products, a provision for
estimated warranty expenses is recorded with a corresponding increase in cost of
goods sold. The provision is adjusted periodically based on historical and anticipated
experience. Actual expense of replacing faulty products under warranty, including
parts and labor, are charged to this provision when incurred.
Annual Report for Fiscal Year Ended February 28, 2013
Product warranties
The Company generally warrants its products for a period of three to five years.
Concurrent with the period when product revenue is recognized, a provision is
recorded for the estimated warranty obligation to provide for the replacement of
products or account credits for products that are found to be faulty within the
warranty period. The obligation is adjusted periodically based on historical and
anticipated experience.
Source Annual reports of OCZ Technology Group Inc. for fiscal years ended February
29, 2012 and February 28, 2013
8 Evaluation of Financial Statement Reliability …
315
Table 8.34 Extract from the U.S. Securities and Exchange Commission’s
announcement of findings of the investigation of accounting manipulations
in Nortel Networks Corp
U.S. Securities and Exchange Commission
Litigation Release No. 20333/October 15, 2007
Accounting and Auditing Enforcement Release No. 2740/October 15, 2007
SEC vs. Nortel Networks Corporation and Nortel Networks Limited,
Civil Action No. 07-CV-8851 (S.D.N.Y.)
Nortel Networks Pays $35 Million to Settle Financial Fraud Charges
[…]
The complaint […] alleges that Nortel had improperly established, and was
improperly maintaining, over $400 million in excess reserves by the time it
announced its fiscal year 2002 financial results. According to the complaint, these
reserve manipulations erased Nortel’s fourth- quarter 2002 pro forma profit and
allowed it to report a loss instead so that Nortel would not show a profit earlier than it
had previously forecast to the market. The complaint alleges that in the first and
second quarters of 2003, Nortel improperly released approximately $500 million in
excess reserves to boost its earnings and fabricate a return to profitability. These
efforts turned Nortel’s first quarter 2003 loss into a reported profit under U.S. GAAP,
and largely erased its second quarter loss while generating a pro forma profit.
According to the complaint, in both quarters Nortel’s inflated earnings allowed it to
pay tens of millions of dollars in so-called “return to profitability” bonuses, largely to
a select group of senior managers.
[…]
Source U.S. Securities and Exchange Commission
Table 8.35 Extract from Note 14 (Income taxes) to consolidated financial statements
of General Electric Co. for fiscal year 2016, explaining causes of its unusually high
income tax rate in fiscal year 2015
Note 14: Income taxes
The GE Capital Exit Plan
In conjunction with the GE Capital Exit Plan, GE Capital significantly reduced its
non-U.S. assets while continuing to operate appropriately capitalized non-U.S.
businesses with substantial assets related to GE Capital’s vertical financing
businesses, including Energy Financial Services, GECAS and Healthcare Equipment
Finance. As a result of the GE Capital Exit Plan, GE Capital recognized a tax expense
of $6,327 million in continuing operations during 2015. This primarily consisted of
$3,548 million of tax expense related to the repatriation of excess foreign cash and the
write-off of deferred tax assets of $2,779 million that will no longer be supported
under this plan.
Source Annual report of General Electric Co. for fiscal year 2016
316
J. Welc
Table 8.36 Extract from Note 2 (Significant accounting policies) to consolidated
financial statements of Delta Apparel Inc. for fiscal year ended June 30, 2012,
explaining the company’s inventory write-down
Note 2: Significant accounting policies
Inventories: […]
During the second quarter of fiscal year 2012, we recorded a $16.2 million lower of
cost or market write-down on the inventory […]. The estimation of the total writedown involves management judgments and assumptions including assumptions
regarding future selling price forecasts, the allocation of raw materials between
business units, the estimated costs to complete, disposal costs and a normal profit
margin. The inventory and yarn firm purchase commitments associated with this
inventory write-down was sold during our fiscal year 2012.
Source Annual report of Delta Apparel Inc. for fiscal year ended June 30, 2012
Table 8.37 Extract from Note 10 (Trade receivables and other current assets)
to financial statements of Folli Follie Group for fiscal year 2017, including the
composition of the company’s other current assets*
Data in EUR million**
Trade receivables (customers via credit
Short-term loan claims
Receivables from public sector
Advances to suppliers
Personnel advances
Purchases under settlement
Other receivables
Prepaid expenses
Accrued income
Total other current assets*
31.12.2016
31.12.2017
18,2
3,6
8,0
130,7
0,1
2,3
40,3
9,6
0,2
20,5
58,6
6,0
224,1
0,2
2,2
13,3
5,5
0,2
213,1
330,5
*Excluding derivatives and other financial assets at fair value through profit, which
the company reported under separate line items of its balance sheet
**Sum of the components reported in millions may not equal the total amount
reported in millions due to rounding
Source Annual report of Folli Follie Group for fiscal year 2017
Table 8.38 Extract from Note 10 (Trade receivables and other current assets) to
financial statements of Folli Follie Group for fiscal year 2017, referring to its advances
to suppliers
Note 10 (Trade receivables and other current assets)
The account “Advances to suppliers” primarily refers to advances given to production
units towards the “reliable performance” commitment, the competitive prices of large
annual orders and the assurance of privilege discounts when it comes to inventories
and the acquisition of the equipment to be established in subsidiaries’ points of sales
within the region of South Eastern Asia.
Source Annual report of Folli Follie Group for fiscal year 2017
8 Evaluation of Financial Statement Reliability …
317
Table 8.39 Extract from the U.S. Securities and Exchange Commission’s press release
regarding the accounting fraud committed by managers of AgFeed Industries Inc
Source U.S. Securities and Exchange Commission’s Press Release dated March 11, 2014
(“SEC Charges Animal Feed Company and Top Executives in China and U.S. With
Accounting Fraud”)
Table 8.40 Selected financial statement data of Redcentric plc, reported for fiscal
years ended March 31, 2015 and 2016, in its two consecutive annual reports
*Including accounting errors
**Revised to adjust for the past accounting errors
Source Annual reports of Redcentric plc for fiscal years ended March 31, 2016, and
March 31, 2017
318
J. Welc
Table 8.41 Extract from Note 28 (Error restatement) to financial statements of
Redcentric plc for the fiscal year ended March 31, 2017
Certain assets of the Group recognized as PPE were identified as relating to
inventory. Accordingly these assets were reclassified from PPE to inventory (2016:
£497k).
Certain amounts relating to accrued income and trade receivables were identified as
being irrecoverable. As a result further provisions against receivables balances were
recognized and other balances were adjusted against revenue. Overall, this reduced
trade and other receivable balances (2016: £1,555k).
Certain customer receipts were recognized in advance of the date of the clearing of
associated cash receipts. This resulted in an overstatement of cash and cash
equivalents and an understatement of net debt (2016: £8,242k).
In addition, certain cash payments relating to trade creditors were recorded in the
wrong period, resulting in an overstatement of cash and cash equivalents and an
understatement of net debt (2016: £4,240k).
Certain costs relating to the year ended 31 March 2016 and 31 March 2015 had not
been recorded as liabilities at the relevant period end. This resulted in an
understatement of trade creditor and accrual balances (2016: £3,193k), along with
associated cost of sales and operating expenses balances. […]
Certain assets of the Group relating to capitalized software were identified to have
been recognized as part of property, plant and equipment instead of as an intangible
asset. Accordingly management have reclassified these assets from PPE to intangible
assets (2016: £2.242k).
Source Annual report of Redcentric plc for fiscal year ended March 31, 2017
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Deferred Tax Assets and Liabilities to Isolate Earnings Management Activities.
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142 Reporting. Managerial Auditing Journal, 20, 47–54.
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9
Techniques of Increasing Comparability
and Reliability of Reported Accounting
Numbers: Selected Simple Tools
9.1
Introduction
As was shown in the previous chapters, there are many factors which may
dramatically reduce reliability and comparability of reported corporate financial data, including reported cash flows. Some of those factors are entirely
objective and unrelated to anyone’s deliberate manipulations (i.e. they stem
from weaknesses of accounting methods themselves, which always offer only
an imprecise simplification of a complex economic reality), while in other
circumstances distortions or biases of reported numbers may result from
an intentional application of some techniques of aggressive or fraudulent
accounting.
Fortunately, many (but of course not all) of those accounting distortions
may be dealt with and corrected (Pratt 2001; Moody’s Investor Service 2010;
Kraft 2012), with the use of analytical adjustments presented in this chapter,
as well as in the following one. An application of most of the techniques
discussed below (as well as in Chapter 10) requires data from primary financial statements as well as an information which is typically dispersed across
various notes to financial statements. Sometimes those techniques call also
for financial reports of other firms (than the one being investigated), which
means that not always their application will be easy. However, in those
circumstances when an analyst has all the needed information at his or her
disposal, the techniques presented below may offer an invaluable enrichment
of inferences derived from a financial statement analysis.
The first of the techniques presented in this chapter is aimed at increasing
a comparability of financial numbers reported by firms which use different
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_9
321
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J. Welc
inventory accounting methods (i.e. FIFO vs. LIFO vs. weighted-average). In
the next section the corrections of distortions caused by off-balance sheet
liabilities (related to rental and operating lease contracts) will be presented.
The chapter closes with the section that deals with problems brought about
by capitalized development costs (and other intangible assets). Additional
(and somewhat more sophisticated) useful techniques of adjusting reported
accounting numbers will be demonstrated in Chapter 10.
9.2
Adjustments for Differences in Inventory
Accounting Methods
As was shown in Sect. 2.1 of Chapter 2, differences in methods applied by
various firms for inventory accounting (FIFO, LIFO or weighted-average)
may dramatically erode a comparability of their reported results, particularly
in periods featured by significant changes of inventory prices (Helfert 1997).
However, in some circumstances the analytical adjustments are possible.
These adjustments convert the cost of goods sold (abbreviated further to
CoGS) from FIFO or weighted-average method to LIFO, on the basis of
inflation indexes. In this section an application of such an adjustment technique will be illustrated with the use of financial statement data of three firms
operating in metal trade and processing industry: Reliance Steel & Aluminum
Co., Klöckner & Co. and Worthington Industries Inc. Their names will be
abbreviated further to Reliance, Klöckner and Worthington, respectively.
Table 9.17 (in the appendix) contains descriptions of business profiles of
those three companies, extracted from their annual reports for fiscal year
2016. As may be read, all three firms function in a broadly defined metal
trade and processing industry, with wide portfolios of products and services
offered. While Reliance and Klöckner may be described as independent operators of metals service centers, which distribute their products and services to
multiple industries, Worthington seems to be a more specialized manufacturer of metal-based industrial goods. However, their common denominator
is a focus on processing metals bought from metal suppliers. In other words,
all three firms purchase metals from other companies (e.g. steel smelters),
instead of producing them on their own. This implies a likely exposure of
their financial results to changing global prices of steel and other metals (as
their major production inputs). And if those firms apply different inventory
accounting methods, their reported results may lose comparability in periods
of rising or falling metal prices. Thus, before making any comparative analysis
of the accounting numbers reported by Reliance, Klöckner and Worthington,
9 Techniques of Increasing Comparability …
323
it is advisable to check if the comparability of their accounting numbers may
be distorted by differences in applied inventory accounting methods.
Table 9.18 (in the appendix) contains extracts from annual reports of
Reliance, Klöckner and Worthington for fiscal year 2016, referring to
their accounting policies applied to inventories. As may be immediately
concluded, all three firms apply different inventory accounting methods.
While Reliance Steel & Aluminum values its inventories with last-in-firstout (LIFO) method, Worthington Industries applies first-in-first-out (FIFO)
approach. In contrast, Klöckner reports its inventories on the basis of their
average prices. Obviously, such intercompany differences in the accounting
methods may dramatically erode the comparability of reported numbers,
in those periods when metal prices change significantly. In this context it
is worth noting that Reliance Steel & Aluminum states outright that its
LIFO-based accounting for inventories is subject to the volatility of inventory prices. Worthington Industries, in turn, admits that in its 2015 fiscal year
it had to make a write-down of carrying amounts of inventory (to reflect a
decline in market steel prices), even though it applies a FIFO-based approach,
under which year-end carrying amounts of inventories lie relatively closer
(as compared to LIFO and weighted-average methods) to their replacement
costs. It confirms an importance of an analytical due diligence addressing
inventories when investigating financial results of such inventory-intensive
businesses.
Now when we know for sure that the comparability of financial results
reported by Reliance, Klöckner and Worthington may be seriously eroded in
periods of volatile metal prices, it is legitimate to assess a likely impact of such
volatility on their accounting numbers. However, one serious issue emerges
here. It relates to a selection of a metal price inflation index suitable for each
of these three firms. The problem is that although all of them operate in a
broadly defined metal trade and processing industry, their sales breakdowns
by product categories may differ significantly. As might be read in Table 9.17
(in the appendix), Reliance Steel & Aluminum distributes “a full line of […]
metal products, including alloy, aluminum, brass, copper, carbon steel, stainless
steel, titanium and specialty steel products”. Klöckner, in turn, describes itself
as “one of the world’s largest […] distributors of steel and metal products and one
of the leading steel service center companies”. Finally, Worthington claims to
be “focused on value-added steel processing and manufactured metal products”.
Obviously, all three firms may have completely different shares of various
metals (e.g. steel, iron, aluminum, etc.) in their sales structures. Theoretically, an assessment of an impact of changing metal prices on their reported
324
J. Welc
financial results should be based on inflation indexes tailored to sales breakdowns of individual businesses. However, it is rarely viable in practice, due
to a lack of detailed data about exact sales breakdowns of the investigated
firms. Consequently, a simplified approach must be followed, based on some
“one-fits-all” inflation index applicable to all three firms. However, a question
still remains on which of the metal price indexes should be chosen for further
analysis. Fortunately, this issue is not always as problematic as it may seem.
Chart 9.1 (in the appendix) visualizes the following five metal-related inflation indexes in the period between January 2009 and January 2017 (based on
data published by the Federal Reserve Bank of St. Louis):
• PPICMM—Producer Price Index by Commodity Metals and Metal Products: Primary Nonferrous Metals,
• WPU10—Producer Price Index by Commodity for Metal and Metal
Products,
• WPU101—Producer Price Index by Commodity for Metals and Metal
Products: Iron and Steel,
• WPU101707—Producer Price Index by Commodity for Metals and Metal
Products: Cold Rolled Steel Sheet and Strip,
• WPU10250105—Producer Price Index by Commodity for Metals and
Metal Products: Aluminum Sheet and Strip.
As may be clearly seen, all five metal price indexes showed significant
volatility in the ten-year timeframe covered by the chart (particularly around
2009–2010). However, they also showed strong co-movements, confirmed
in Table 9.19 (in the appendix), where it may be seen that all correlation
coefficients between pairs of individual metal price indexes were positive and
exceeded 0,80.
In light of the data presented on Chart 9.1 as well as in Table 9.19, it seems
legitimate to conclude that the five analyzed inflation indexes contain similar
information about metal price tendencies. Strong positive long-term correlations between those indexes justify selecting one of them as a proxy for general
price tendencies in the metal industry. Accordingly, for further analysis the
producer price index for iron and steel (WPU101) has been chosen.
Table 9.1 presents values of two accounting ratios, affected by inventory
price changes, computed for the investigated firms in a ten-year period. The
values of these two metrics will be interpreted on the background of metal
price inflation data. However, before proceeding further, it must be noted that
in the case of Reliance and Kloeckner, annual reports cover periods ending
December 31, while Worthington’s fiscal years cover twelve-month periods
9 Techniques of Increasing Comparability …
325
Table 9.1 Gross margin on sales* and inventory turnover (in days)** of Reliance
Steel & Aluminum, Klöckner and Worthington Industries between fiscal years 2008
and 2017
Reliance Steel & Aluminum Co. (LIFO method used in inventory accounƟng)
Data for annual periods years
ending December 31
2008 2009 2010 2011
2012 2013
2014 2015 2016 2017
Gross margin on sales*
24,8
%
26,3
%
25,1
%
24,4
%
26,1
%
26,0
%
25,1
%
27,2
%
30,1
%
28,7
%
Inventory turnover (days)**
71,5
67,1
66,4
72,0
74,5
82,3
81,7
77,0
92,9
90,9
Metal price infla on y/y
(WPU101)***
−8,8
%
7,3
%
16,6
%
7,0 −11,1
%
%
4,4
%
−6,6
%
−22,
2%
18,3
%
6,3
%
Klöckner & Co. (weighted-average method used in inventory accounƟng)
Data for annual periods ending
December 31
2008 2009 2010 2011
2012 2013
2014 2015 2016 2017
Gross margin on sales*
20,3
%
16,7
%
21,9
%
18,5
%
17,4
%
18,6
%
19,4
%
19,2
%
22,9
%
20,9
%
Inventory turnover (days)**
67,9
64,8
80,8
86,0
75,0
82,1
91,8
67,4
83,2
81,1
Metal price infla on y/y
(WPU101)***
−8,8
%
7,3
%
16,6
%
7,0 −11,1
%
%
4,4
%
−6,6
%
−22,
2%
18,3
%
6,3
%
Worthington Industries Inc. (FIFO method used in inventory accounƟng)
Data for annual periods ending
May 31
Gross margin on sales*
Inventory turnover (days)**
Metal price infla on y/y
(WPU101)***
2009 2010 2011 2012
2013 2014
2015 2016 2017 2018
6,6
%
14,4
%
14,6
%
13,1
%
15,2
%
15,7
%
13,7
%
16,1
%
17,8
%
15,7
%
40,3
79,9
64,9
66,6
58,8
56,8
46,9
49,2
52,1
54,9
−39,8
%
36,5
%
9,8
%
−6,8
%
−7,0
%
4,7
%
−13,9
%
−3,4
%
10,6
%
13,5
%
*(Sales revenues—Cost of goods sold)/Sales revenues ** (Inventory at the end of
period/Cost of goods sold in the period) × 365
**For Reliance and Klöckner the inflation indexes for periods from December to
December have been used, while for Worthington the inflation indexes for periods
from May to May have been used
Source Annual reports of individual companies (for various fiscal years) and authorial
computations
326
J. Welc
ending May 31. To ensure coherence and reliability of the analysis, the inflation indexes covering twelve-month periods from December to December
will be used for Reliance and Kloeckner, while Worthington’s ratios will be
investigated on the background of inflation data for annual periods from May
to May.
In this context one issue deserves an explanation. In the first period,
the Worthington’s metal price deflation (−39,8%) was much deeper than
in the case of its two “peers” (−8,8%). In contrast, in the following
period the former’s inflation (36,5%) significantly exceeded the pace of price
increase faced by Reliance and Klöckner (7,3%). That was caused by a time
coincidence of Worthington’s fiscal year-end (May) with a bottom of the
metal prices, which started rebounding in May 2009 (as might be seen on
Chart 9.1).
Table 9.2 presents some statistical measures computed on the ground of the
data presented in Table 9.1. These are correlations, calculated separately for
each of the three companies (on the ground of their annual data), between
metal price inflation on one side and gross margin and inventory turnover
on the other side. The table also shows coefficients of variation of both
investigated financial statement ratios.
As may be seen in Table 9.2, in the investigated ten-year timeframe
Worthington experienced a much wider variability of gross margin on
sales as well as inventory turnover, as compared to both “peers”. Also, the
Worthington’s values of both ratios showed much stronger positive correlations with changes of metal prices. In this context it is worth noting that
Reliance Steel & Aluminum, who uses LIFO method for its inventory, shows
the lowest correlations between changes of metal prices and both accounting
Table 9.2 Coefficients of variation of gross margin on sales and inventory turnover
of Reliance Steel & Aluminum, Klöckner and Worthington Industries, as well as
correlations of gross margin on sales and inventory turnover with metal price
inflation
Coeĸcients of variaƟon
Company (inventory accounƟng
method)
CorrelaƟons between
metal price inflaƟon and
Gross
margin on
sales
Inventory
turnover (in
days)
Gross
margin on
sales
Inventory
turnover
(in days)
Reliance (LIFO)
6,9%
11,9%
0,24
0,15
Klöckner (weighted-average)
9,9%
11,4%
0,46
0,39
21,0%
19,8%
0,70
0,78
Worthington (FIFO)
Source Authorial computations based on data presented in Table 9.1
9 Techniques of Increasing Comparability …
327
ratios. Klöckner’s correlations, in turn, have values between those obtained
for its “peers”, which is consistent with the company’s inventory accounting,
based on the weighted-average method.
Weak correlations between the Reliance’s LIFO-based ratios and changes of
metal prices are entirely logical. Likewise, relatively strong statistical relationships between the Worthington’s ratios and metal prices are fully consistent
with its FIFO-based accounting. This is because:
• Under the LIFO method, in periods of rising/falling inventory prices,
rising/falling cost of goods sold (based on the most recent inventory prices)
matches with growing/falling sales prices and revenues (which reflect recent
trends in input prices), with resulting margins being relatively weakly
affected by inventory price inflation,
• Under the LIFO method, in periods of rising/falling inventory prices,
rising/falling cost of goods sold (based on the most recent inventory prices)
does not correlate with carrying amounts of inventories, which are based
on input prices observed many months or even years ago,
• Under the FIFO method, in periods of rising/falling inventory prices,
reported margins tend to artificially rise/fall, due to a timing mismatch
between growing/falling sales prices and revenues (which already reflect
recent trends in input prices) and cost of goods sold (which is still based
on inventory prices observed several periods before), with a resulting
significant positive correlation between input prices and reported margins,
• Under the FIFO method, in periods of rising/falling inventory prices,
inventory turnover (in days) tends to artificially lengthen/shorten, due
to a timing mismatch between rising/falling carrying amount of inventory (which reflects recent trends in input prices) and cost of goods sold
(which is still based on inventory prices observed several periods before),
with a resulting significant positive correlation between input prices and
inventory turnover (in days).
Accordingly, the Worthington’s strong positive correlations (and the
Reliance’s weak ones) should not be surprising. They are to a large extent
attributable to distortions brought about by timing mismatches observed
under FIFO method, which result in artificially changing values of gross
margin on sales and inventory turnover (in periods of changing inventory prices). In this context, the Klöckner’s moderate correlations (stronger
than for Reliance but weaker than for Worthington), which are based on
accounting data obtained with the use of the weighted-average method,
should come as no surprise as well.
328
J. Welc
These conclusions are also consistent with what could be observed in the
Worthington’s data for individual years, presented in Table 9.1. As might be
seen, the company’s fiscal year with the deepest metal price deflation (2009)
was also featured by the lowest gross margin on sales. In fact, that was the
only period within the whole ten-year timeframe with a single-digit margin.
However, in the following year the strong rebound of metal prices (which
grew by 36,5%) boosted the company’s margin up to 14,4%.
The discussed FIFO-driven distortions of cost of goods sold may dramatically erode a comparability of financial results reported by various firms
(which use different inventory accounting methods), in periods of significantly changing inventory prices. Fortunately, the cost of goods sold reported
under FIFO and weighted-average method may be easily converted to a
LIFO-based cost, with the following formulas (White et al. 2003):
• For cost of goods sold reported under FIFO method:
CoGS(LIFO) = CoGS(FIFO) + [BI(FIFO) × i),
where:
CoGS(LIFO)—cost of goods sold under LIFO method,
CoGS(FIFO)—cost of goods sold under FIFO method,
BI(FIFO)—inventory at the beginning of period under FIFO method,
i—inventory price inflation in a period.
• For cost of goods sold reported under weighted-average method:
i
,
CoGS(LIFO) = CoGS(WA) + BI(WA) ×
2
where:
CoGS(WA)—cost of goods sold under weighted-average method,
BI(WA)—inventory at the beginning of period under weighted-average
method.
When applying the above formulas one must keep in mind that they offer
only approximations of actual LIFO-based costs, i.e. they do not produce
numbers which precisely match to those which would have been reported if
a given company uses LIFO (instead of FIFO or weighted-average method).
9 Techniques of Increasing Comparability …
329
Nevertheless, these simple equations are very useful in improving an intercompany comparability of reported financial results, provided that correct
and reliable inventory price inflation data are available. An application of
these formulas will be exemplified with the data shown in Table 9.1, for the
first two years (which were featured by an unusual volatility of metal prices).
Table 9.3 presents the Klöckner’s and Worthington’s reported data as well
as their adjustments to LIFO-based costs of goods sold. Table 9.4, in turn,
compares margins of all three investigated firms.
As may be seen in Table 9.4, in both investigated periods Worthington
underperformed its “peers” in terms of gross margin on sales, based on
the reported data. However, in its fiscal year ended May 31, 2010, the
company seemed to achieve an impressive improvement of profitability,
with its gross margin rising more than two-folds (as compared to only a
Table 9.3 Adjustments of Klöckner’s and Worthington’s costs of goods sold (CoGS)
and gross margins on sales** from weighted-average and FIFO methods (respectively)
to LIFO
Klöckner (data in EUR
million, for fiscal years ended
December 31)
Worthington (data in USD
million, for fiscal years ended
May 31)
2008
2009
2009
2010
Reported sales revenues
6.750
3.860
2.631
1.943
Reported CoGS*
5.383
3.216
2.457
1.663
956
1.001
593
271
Inventory price infla on
−8,8%
7,3%
−39,8%
36,5%
5.341
3.253
2.221
1.762
CoGS converted to LIFO
= 5.383 +
[956 x
(−8,8%/2)]
= 3.216 +
[1.001 x
(7,3%/2)]
= 2.457 +
[593 x
(−39,8%)]
= 1.663 +
[271 x
(36,5%)]
20,3%
16,7%
6,6%
14,4%
Reported beginning inventory*
Gross margin on sales
based on reported data
=
=
=
=
(6.750−5.383) (3.860−3.216) (2.631−2.457) (1.943−1.663)
/ 6.750
/ 3.860
/ 2.631
/ 1.943
20,9%
Gross margin on sales
based on adjusted data
15,7%
15,6%
9,3%
=
=
=
=
(6.750−5.341) (3.860−3.253) (2.631−2.221) (1.943−1.762)
/ 6.750
/ 3.860
/ 2.631
/ 1.943
*Under weighted-average method in Klöckner’s case and under FIFO method in
Worthington’s case
**(Sales revenues—Cost of goods sold)/Sales revenues
Source Authorial computations based on annual reports of individual companies
330
J. Welc
Table 9.4 Comparison of gross margin on sales* of Reliance Steel & Aluminum,
Klöckner and Worthington Industries
RaƟos computed on the
basis of reported data
RaƟos computed on the
basis of adjusted data**
2008***
2009***
2008***
2009***
Reliance (LIFO)
24,8%
26,3%
24,8%
26,3%
Klöckner (weighted-average)
20,3%
16,7%
20,9%
15,7%
6,6%
14,4%
15,6%
9,3%
Worthington (FIFO)
*(Sales revenues—Cost of goods sold)/Sales revenues
**After converting costs of goods sold reported by Klöckner and Worthington from
the weighted-average method and FIFO, respectively, to LIFO
***Fiscal years ending December 31 of a given year in the case of Reliance and
Klöckner, and fiscal years ending May 31 of the following year in the case of
Worthington
Source Authorial computations based on data presented in Table 9.1 and Table 9.3
modest improvement reported by Reliance and significant deterioration experienced by Klöckner). However, when looking at the adjusted numbers, the
whole improvement evaporates. Now when the computed ratios may be
deemed more comparable (i.e. corrected for distortions caused by intercompany differences in inventory accounting methods), not only the company’s
profitability shrinks instead of growing, but also a scope of this deterioration (minus 6,3 percentage points) is deeper than in the case of Klöckner
(minus 5,1 percentage points). It seems to be a confirmation of an importance of adjustments discussed in this section in comparative analyses of those
inventory-intensive companies, which operate in an environment featured by
volatile prices.
However, adjustments presented in this section are also useful in timeseries studies of financial results reported by a single firm, particularly in
making trend or volatility analysis. Table 9.20 (in the appendix) presents
the Worthington’s reported and adjusted (from FIFO to LIFO) operating
profit, together with its variability, in the whole ten-year timeframe. As may
be clearly seen, the company’s profits reported on a FIFO basis seem to be
much more volatile than on a LIFO basis. And we know that these are the
profits of the same company for the same years, which means that a difference
between the two coefficients of variation is entirely attributable to accounting
issues (i.e. FIFO vs. LIFO methods), and not to any fundamental economic
factors. Nevertheless, the company appears seemingly riskier (i.e. having more
volatile earnings) when it uses FIFO for its inventory accounting.
9 Techniques of Increasing Comparability …
331
When applying the adjustment technique presented in this section, one
should be aware of its weaknesses. First, it is often problematic to obtain reliable data about inflation indexes suitable for inventory of a given company.
It is generally easier to find data about price tendencies of broader classes of
similar goods (e.g. general construction materials, metals, industrial chemicals, etc.) as compared to more narrowly defined specialized inventories. For
instance, when analyzing manufacturers of ceramic tiles it may be difficult to
obtain data about price changes of specific granulates or paints, used exclusively in a ceramic tiles industry. In such circumstances some broader inflation
indexes must be used as proxies, which reduces an accuracy of adjustments of
costs of goods sold.
Moreover, the presented adjustment technique is far from perfect even
when narrow inflation indexes are available and reliable, due to lacking data
on inventory and sales breakdowns of individual businesses. All three companies investigated in this section operate in the metal trade and processing
industry. Each of them distributes various metals, such as steel, aluminum,
iron, titanium and others. However, shares of each of those metals in sales
breakdowns of individual firms are usually unknown to external analysts,
since it is not mandatory to disclose such a detailed information in financial
reports. If a given firm sells (or processes) several different types of inventories,
then a weighted-average of individual inflation indexes for those inventories
should be treated as a “customized” inflation index representative for its cost
of goods sold. However, the weights of individual inputs are unknown to
a financial statement user, which means that by necessity some simplified
approaches must be adopted (like the one used in this section, based on an
inflation index for a broad category of iron and steel). Such a simplification
always erodes a precision of the obtained adjustments.
9.3
Adjustments for off-Balance Sheet
Liabilities
9.3.1 Introduction
Off-balance sheet financial obligations (e.g. operating leases or rentals), if
significant, may dramatically distort values of many financial statement ratios,
particularly such risk metrics as indebtedness and liquidity ratios (but also
metrics based on operating profit and cash flows). This happens because
under most accounting standards (with an exception of IFRS since 2019)
those obligations are not included within financial liabilities disclosed on
332
J. Welc
balance sheet (Jackson 2006). Instead, future scheduled repayments of those
liabilities are reported only in notes to financial statements. However, on the
ground of those note disclosures an analyst may adjust numbers reported
in primary financial statements, in order to get a more reliable picture of
an investigated company’s financial standing (Standard and Poor’s 2007).
A procedure of such an adjustment of the reported numbers (and ratios)
will be illustrated in this section with a real-life example of Southern Cross
Healthcare Group PLC.
Before proceeding further, it is important to note that since 2019 the International Financial Reporting Standards require an inclusion of operating lease
and similar commitments (e.g. non-cancellable rental contracts) in balance
sheet. Accordingly, under IFRS those kinds of obligations are no longer
treated as off-balance sheet liabilities (which means that no longer the adjustments discussed in this section are needed for companies reporting under
IFRS). However, most other accounting standards (including US GAAP) still
treat operating and rental obligations as off-balance sheet items. Therefore,
intercompany comparisons may be seriously flawed when based on crude
(unadjusted) numbers, particularly in comparative studies of global capitalintensive firms, whose results are reported under various accounting standards
(e.g. airlines, hotels or telecoms). In such instances an analyst should adjust
reported numbers of those firms, whose lease and rental obligations are kept
off-balance sheet, with the use of techniques presented in this section.
9.3.2 Example of Southern Cross Healthcare
Southern Cross Healthcare was a British provider of health and social care
services, which is rendered through its care centers (mostly dedicated to
elderly people). The company’s capital-intensive operations entailed huge
investments in fixed assets (particularly real-estate properties where individual
care centers functioned), which were mostly financed through operating
leases. The company’s rapid and financially unbalanced growth led it to
serious financial troubles in 2011 and finally to its bankruptcy, which was
declared in 2012. Table 9.21 (in the appendix) presents selected data extracted
from financial statements of Southern Cross Healthcare for fiscal year ending
September 30, 2010.
As may be seen in Table 9.21, in the fiscal year under investigation
Southern Cross Healthcare incurred an operating loss as well as a loss before
taxation. As expected, given a capital-intensive nature of its operations, the
company’s assets consisted mostly of noncurrent ones. From a right-hand side
of its balance sheet it may be also concluded that those assets were mostly
9 Techniques of Increasing Comparability …
333
financed with debts (with carrying amount of equity constituting only about
12% of carrying amount of total assets). However, despite its operating loss
the company was able to generate positive operating cash flows, although on
the level which was too low to cover the combined investing and financing
outflows (with a resulting negative total cash flows).
However, if the company had significant off-balance sheet liabilities, then
many of those financial statement items may have been seriously understated
or overstated. In particular, the following distortions of reported numbers are
typically brought about by off-balance sheet obligations:
• Operating profit is understated, since it is burdened by the entire
amounts of annual operating lease and rental payments, while part of those
payments reflect embedded interest expense and should be treated as a
finance cost (rather than the operating one).
• Finance costs are understated, since they do not include an interest
expense which is embedded in operating lease and rental payments (and
as such it is treated as an operating expense).
• Noncurrent assets are understated, because they do not include those
operating assets, which a company uses under either lease or rental
contracts (instead of owning them).
• Current liabilities and noncurrent liabilities are understated, because
they do not include real financial commitments (future payments) stemming from operating lease and rental contracts.
• Operating cash flows are understated, since they are burdened by
operating lease and rental payments, while the whole amounts of those
payments should be treated as finance cash outflows (not the operating
ones).
• Financing cash flows are overstated, because they do not include operating lease and rental payments.
Table 9.5 contains an extract from Note 30 (on lease-related financial commitments) to consolidated financial statements of Southern Cross
Healthcare for fiscal year 2010. As may be seen, at the end of September 2010
a total nominal amount of all future operating lease payments amounted
to 5.776,3 GBP million, while at the same time a carrying amount of the
company’s total liabilities reported on its balance sheet amounted to 384,5
GBP million [= current liabilities of 96,6 + noncurrent liabilities of 287,9].
Obviously, such a huge load of non-cancellable off-balance sheet financial
commitments may have devastated relevance, reliability and comparability of
the numbers reported by the company in its primary financial statements.
334
J. Welc
Table 9.5 Total financial commitments under non-cancellable operating leases of
Southern Cross Healthcare, as at the end of September 2009 and September 2010
(from Note 30 to the company’s consolidated financial statements)
In GBP million
Within one year
Within one to five years
September 30, 2009
September 27, 2010
246,6
250,4
986,4
1.001,6
Over five years
4.694,2
4.524,3
Total
5.927,2
5.776,3
Source Annual report of Southern Cross Healthcare for fiscal year ended September
30, 2010
Thus, it was legitimate to correct those reported numbers for distortions
brought about by the lease-related obligations.
As may be seen in Table 9.5, at the end of September 2010 the sum of
all future lease-related payments to be incurred by Southern Cross Healthcare amounted to 5.776,3 GBP million. However, that was their nominal
amount, which did not take into account a time value of money. Meanwhile, long-term liabilities are reported in a balance sheet at their discounted
values. Consequently, the company’s liabilities reported in its balance sheet
cannot be adjusted simply by adding to them the sum of nominal (undiscounted) amounts of all future operating lease payments (as reported in the
note). Instead, those future payments should be first discounted (to reflect the
time value of money as well as the company’s credit risk) and only then their
discounted values should be summed. However, to do such a discounting an
appropriate discount rate must be determined first. One of the approaches
is to apply an average interest rate charged by the company’s creditors on its
bank borrowings. If the company provides an information about its cost of
debt in notes to its financial statements, then such disclosures may be very
useful (otherwise, the discount rate must be estimated with an application of
some analytical techniques).
Table 9.22 (in the appendix) contains an extract from Note 22 (on financial instruments) to consolidated financial statements of Southern Cross
Healthcare for 2010. As may be concluded from those disclosures, at the
end of September 2010 bank loans borrowed by Southern Cross Healthcare
had interest rates which exceeded the UK bank base rates by about 2,75–
3,25% (depending on terms and conditions of individual loan agreements).
Accordingly, it seems legitimate to assume that the company’s average bank
loan premium (i.e. a difference between a loan’s nominal interest rate and the
bank base rate) equaled about 3,0% at that time. However, in its financial
9 Techniques of Increasing Comparability …
335
statements the company has not disclosed any information about what types
of bank base rates constituted a basis for its floating rate financial liabilities.
It may be assumed, given the company’s location and its functional currency
(GBP), that those were LIBOR rates with varying maturities (depending on
maturities of the company’s individual loans). For our further analysis let’s
assume that a legitimate proxy for “UK bank base rates” is 12-month GBP
LIBOR, which at the end of 2010 stood at about 1,5%. With this information we can obtain an estimate of the company’s average cost of debt of about
4,5% (= the assumed average bank loan margin of 3,0% plus the assumed
LIBOR rate of 1,5%). This rate will be used in discounting the company’s
financial commitments under its non-cancellable operating leases.
Another step in our analysis, before we proceed to discounting all future
operating lease payments, is to assume a probable pattern of those payments
(e.g. their fixed or diminishing annual amounts). It could be seen in Table 9.5
that the annual payment in the next fiscal year was expected to amount to
250 GBP million (after rounding to an integer), while the sum of annual
payments in the following four periods (i.e. from the second to the fifth year)
was expected to amount to about one billion of GBP (i.e. about 250 GBP
million annually). Consequently, it seems safe to assume that the amounts
of the annual operating lease payments would stay intact in the future and
would amount to approximately 250 GBP million in each year (until the year
when all outstanding liabilities are repaid).
With all this information we may now proceed to discounting the future
operating lease payment of Southern Cross Healthcare, in order to obtain
their discounted value, as at the end of September 2010. Those computations are presented in Table 9.6. According to these data, the operating lease
commitments of Southern Cross Healthcare (as at the end of September
2010) would be fully repaid in 2034. While the nominal amount of all
those future payments summed to 5.776,3 GBP million, its discounted value
(with the assumed discount rate of 4,5%) equaled 3.546,8 GBP million. This
discounted value of the company’s off-balance sheet liabilities can be now
added to its liabilities disclosed in the balance sheet for the end of September
2010.
However, the total discounted amount includes both current and noncurrent part, and should be split accordingly. This breakdown may be done as
follows:
• An annual payment assumed for the next fiscal year amounts to 250 GBP
million, which consists of a principal amount (which should be added to
the company’s current liabilities as at the end of September 2010) as well
336
J. Welc
Table 9.6 Discounted value of non-cancellable operating lease commitments of
Southern Cross Healthcare, as at the end of September 2010
*The number for the last year reflects a residual amount, remaining to be paid in
that period after all the preceding annual payments are taken into account (i.e. it
is a difference between 5.776,3 and the sum of all annual payments between 2011
and 2033)
** = annual operating lease payment in a given year × cumulative discount factor
for that year
Source Annual report of Southern Cross Healthcare for fiscal year ended September
30, 2010, and authorial computations
9 Techniques of Increasing Comparability …
337
as an embedded interest cost (which should be accrued in the course of the
next fiscal year, instead of being treated as liability at the end of September
2010),
• The discounted value of all future operating lease payments amounts to
3.546,8 GBP million (as at the end of September 2010), which combined
with the assumed interest rate of 4,5% implies an estimated interest cost
(to be paid in the next fiscal year) amounting to 159,6 GBP million [=
3.546,8 × 4,5%],
• If the total annual payment in the next fiscal year amounts to 250,0 GBP
million, while the estimated interest cost in the same period amounts to
159,6 GBP million, then the estimated current portion of a principle
amount (which is a current liability to be capitalized on the balance sheet)
equals 90,4 GBP million [= 250,0−159,6],
• If the total discounted amount of all future operating lease obligations
amounts to 3.546,8 GBP million, while its estimated current part equals
90,4 GBP million, then the estimated noncurrent portion of the principle
amount (which is a noncurrent liability to be capitalized on the balance
sheet) equals 3.456,4 GBP million [= 3.546,8−90,4].
Accordingly, our adjustments for the off-balance sheet liabilities of
Southern Cross Healthcare (as at the end of September 2010) will increase the
company’s current liabilities by 90,4 GBP million and its noncurrent liabilities by 3.456,4 GBP million. However, if total liabilities are adjusted upward,
then total equity and liabilities no longer equal total assets. Consequently,
some other adjustments are needed, to restore an equality of both sides of
balance sheet. This will be done by capitalizing noncurrent assets which the
company used under its operating lease contracts (and which in its financial statements were treated as off-balance sheet assets). There are at least two
ways to do so.
One of the two approaches (more justified on theoretical grounds but very
subjective and problematic in practice) assumes that a pattern of depreciation of fixed assets used under operating lease may differ from a schedule
of payments of lease obligations related to those assets. In other words,
it assumes that useful lives and depreciation methods (e.g. straight-line vs.
accelerated), appropriate for the leased assets, may have nothing to do with
contracted lease payment schedules. Consequently, an application of this
approach to lease adjustment implies treating lease obligations (which are
discounted in a way illustrated above) differently from related lease-financed
assets (in which case the assumptions regarding useful lives, residual values
and depreciation methods must be taken). A major problem of this approach
338
J. Welc
lies in a lack of any information (apart from a very general one) about
nature, location, age and exploitation conditions of the assets used under
lease contracts. Without such an information the depreciation assumptions
cannot be based on any reasonable grounds (instead, they must be based
on subjective assumptions), particularly when leased assets have a totally
different nature from those which are owned and reported on the face of
balance sheet.
An alternative approach is much simpler, and although not theoretically
sound, it has a benefit of much lower sensitivity to subjective judgments.
This approach involves a rough assumption, according to which the carrying
amount of leased assets does not deviate from a discounted value of future
lease payments (which also implies an implicit assumption that leased assets
are depreciated in tune with payments of lease obligations). This approach
will be followed further in this section. Accordingly, as at the end of
September 2010 the carrying amount of assets used by Southern Cross
Healthcare under operating lease contracts equals 3.546,8 GBP million. By
this very amount the assets reported on the company’s balance sheet will be
adjusted upward.
So far we have gone through all computations needed to adjust the
company’s balance sheet for its off-balance sheet liabilities, as at the end of
September 2010. However, as was explained before, for a diligent financial
statement analysis the company’s income statement and cash flow statement
(for fiscal year ended September 30, 2010) should be adjusted as well. To
this end we need to split the annual operating lease payment of 246,6 GBP
million (the amount paid in fiscal year 2010, according to the information
presented in Table 9.5), which in the company’s reported income statement
was entirely treated as an operating cost, into its principal amount (which
according to our assumptions will serve as a proxy for a depreciation charge
and an element of operating costs) and an interest expense (which will be
transferred from reported operating costs to finance costs).
To make this breakdown we need to replicate the discounting procedure
(the same as presented in Table 9.6), but for the end of September 2009.
In those computations, presented in Table 9.7, a similar assumption of fixed
amounts of annual payments (but amounting to 246,6 GBP million, instead
of 250,0 GBP million) has been taken. According to those data, while the
nominal amount of all future operating lease payments stood at 5.927,2
GBP million (as at the end of September 2009), its discounted value (with
the assumed discount rate of 4,5%) equaled 3.577,7 GBP million. With
the assumed interest rate of 4,5% it meant that the estimated amount of
interest cost (embedded in the whole annual payment of 246,6 GBP million)
9 Techniques of Increasing Comparability …
339
Table 9.7 Discounted value of non-cancellable operating lease commitments of
Southern Cross Healthcare as at the end of September 2009
*The number for the last year reflects a residual amount, remaining to be paid in
that period after all the preceding annual payments are taken into account (i.e. it
is a difference between 5.927,2 and the sum of all annual payments between 2010
and 2033)
** = annual operating lease payment in a given year × cumulative discount factor
for that year
Source Annual report of Southern Cross Healthcare for fiscal year ended September
30, 2010, and authorial computations
340
J. Welc
amounted to 161,0 GBP million [= 3.577,7 × 4,5%]. This amount will be
subtracted from the company’s reported operating costs and transferred to its
finance costs (to eliminate a distortion stemming from an inclusion of the
embedded interest costs in the company’s operating expenses).
Finally, we have to obtain the amounts of adjustments of the company’s
reported cash flows. This is very simple, since the whole amount of leaserelated payments done in fiscal year ended September 30, 2010 (i.e. 246,6
GBP billion, according to the data presented in Table 9.5) should be treated
as a financing cash outflow, instead of an operating one. This is because that
amount included both a principal amount of a financial obligation as well as
the related interest costs (and both items constitute financing cash flows).
Now when all amounts of financial statement adjustments have been
obtained, we may proceed to revising the reported numbers presented in
Table 9.21 (in the appendix). This is done in Table 9.8.
As may be seen, our lease-related adjustments have a dramatic impact
on financial numbers reported by Southern Cross Healthcare in its primary
financial statements for fiscal year ending September 30, 2010. First, the
company’s reported operating loss turns into an operating profit, as a result
of transferring lease-driven interest costs from operating expenses to finance
costs. Second, noncurrent assets rise more than ten-folds, due to a capitalization of previously unrecognized leased long-term assets. Third, on a
right-hand side of balance sheet the value of lease-adjusted total liabilities
is more than ten times higher than its reported carrying amount. Finally, the
company appears to have generated much higher operating cash flows, which
were offset by much more deeply negative financing cash outflows (as a result
of transferring all lease-related payments from the operating cash flows to the
financing ones).
In a final step of our analysis we may now compare values of selected
financial ratios, as computed on the ground of both reported as well as leaseadjusted numbers. Only two financial risk metrics (indebtedness ratio and
current liquidity ratio) will be compared here, but it must be kept in mind
that most other ratios of profitability, financial risk and turnover are also
distorted by off-balance sheet liabilities. Table 9.9 confirms a significance of
an impact of off-balance sheet liabilities on financial risk metrics of Southern
Cross Healthcare, as at the end of September 2010.
As may be seen, at the end of the investigated period the company was
heavily loaded with debt, with its raw (unadjusted) indebtedness ratio of more
than 88%. Its financial risk exposure, stemming from its high indebtedness,
was magnified by a rather low value of raw current liquidity ratio (much
below unity). However, both metrics look even more dramatic when they are
9 Techniques of Increasing Comparability …
341
Table 9.8 Adjustment of reported financial statement numbers of Southern Cross
Healthcare (for fiscal year ended September 30, 2010) for the company’s off-balance
sheet liabilities
In GBP million
Financial statement
Item
Reported amounts
Consolidated income statement
Revenue
Opera ng
Finance
Finance
Loss before
Noncurrent
assets
Current
Consolidated balance sheet
TOTAL
ASSETS
958,6
−44,1
−3,7
Commentary on the
Adjusted adjusted amounts
amounts
958,6
116,9 =−44,1 + 161,0 (interest
−164,7 =−3,7−161,0 (interest
0,4
0,4
−47,4
−47,4
366,2
3.913,0
70,2
70,2
436,4
Total
51,9
Current
96,6
= 366,2 + 3.546,8
(capitalized off-balance
= 436,4 + 3.546,8
3.983,2 (capitalized off-balance
sheet assets)
Noncurrent
287,9
51,9
187,0 = 96,6 + 90,4
3.744,3 = 287,9 + 3.4564
TOTAL
436,4
3.983,2 = 436,4 + 3.546,8
= 29,7 + 246,6
(opera ng lease
276,3
payments transferred to
FCF)
Opera ng
cash flows
(OCF)
29,7
Inves ng
cash flows
Consolidated cash flow statement (ICF)
−3,9
−3,9
Financing
cash flows
(FCF)
−56,4
−303,0
TOTAL
−30,6
−30,6
=−56,4−246,6
(opera ng lease
payments transferred
from OCF)
Source Annual report of Southern Cross Healthcare for fiscal year ended September
30, 2010, and authorial computations
342
J. Welc
Table 9.9 Raw vs. lease-adjusted values of selected financial risk ratios of Southern
Cross Healthcare (as at the end of fiscal year ended September 30, 2010)
RaƟos based on
Financial risk raƟo
Formula applied
(Noncurrent liabili es +
Indebtedness ra o Current liabili es)/Total
assets
Current liquidity
ra o
Current assets/Current
liabili es
Reported amounts
Adjusted amounts
88,1%
98,7%
= (96,6 + 287,9) /
436,4
= (187,0 + 3.744,3) /
3.983,2
0,73
0,38
= 70,2 / 96,6
= 70,2 / 187,0
Source Annual report of Southern Cross Healthcare for fiscal year ended September
30, 2010, and authorial computations
based on lease-adjusted numbers. Now it turns out that virtually all of the
company’s assets (almost 99%), including owned as well as leased ones, have
been financed from debt, while its liquid (current) assets have been able to
cover only about 38% of its short-term liabilities. No wonder that Southern
Cross Healthcare fell into troubles and filed for bankruptcy in the following
periods.
9.4
Adjustments for Capitalized Development
Costs and Other Intangible Assets
Accounting for intangible assets, including capitalized research and development (R&D) costs, may pose serious issues of comparability and reliability
of reported financial statements (Lev 2003; Zhang and Zhang 2007; Wyatt
2008). For instance, reading the narrative notes to financial statements of
nine global car manufacturers, disclosed in their annual reports for fiscal year
2008, leads to the following conclusions:
• Companies that reported their results under IFRS (Volkswagen, BMW,
Daimler, Fiat, PSA Peugeot-Citroen, Renault) expensed research costs and
capitalized development costs, while firms reporting (in 2008) under other
accounting standards (Ford, Honda, Toyota) expensed all their research
and development expenditures as incurred.
• There were significant accounting policy differences not only between
companies reporting under two different accounting standards (IFRS and
US GAAP), but also between individual companies reporting under IFRS.
9 Techniques of Increasing Comparability …
343
• While majority of firms reporting under IFRS capitalized both direct
and indirect development expenditures (Volkswagen, BMW, Daimler,
Renault), there were companies which claimed to capitalize only direct
development costs and to expense development overheads (PSA PeugeotCitroen).
• Companies differed significantly in terms of their stated amortization
periods of capitalized development expenditures:
– while BMW Group seemed to apply quite uniform amortization period
to all its R&D projects (“generally seven years”), Daimler assumed much
wider range of expected product life cycles (“2 to 10 years”),
– while most companies amortized their capitalized development costs
through periods no longer than ten years (Volkswagen Group, Daimler,
Fiat Group, PSA Peugeot Citroen), there were some which claimed to
set the maximum amortization periods at seven years (Renault).
Obviously, such a wide variety of approaches toward the accounting for
R&D expenditures may seriously erode an intercompany comparability of
reported accounting numbers (even between firms which apply the same set
of accounting standards). Also, a considerable leeway and huge load of subjective judgments (which are difficult to verify, e.g. by auditors), embedded in
IAS 38 (Intangible assets), entail a wide spectrum of techniques whereby
firms may manipulate their reported assets and earnings, e.g. by aggressively
misclassifying their individual R&D projects into those still in a research and
those already in a development phase. Moreover, as was shown in Sect. 4.1.4
of Chapter 4 and in Sect. 6.5 of Chapter 6, accounting for intangible assets
as well as some possible arrangements related to those assets (e.g. an artificial “outsourcing” of R&D activities to non-consolidated related parties) may
distort not only income statement and balance sheet data, but may also ruin
comparability and reliability of reported cash flows (by overstating operating
cash flows and understating investing cash flows). Therefore, in a comparative
financial statement analysis, particularly of intangible-intensive businesses, it
is always important to identify possible intangibles-driven distortions, and to
correct the reported numbers for them (if possible).
Fortunately, there exist simple analytical techniques which are helpful in
eliminating (or at least subduing) the problems with comparability and reliability of reported financial numbers, brought about by intangible assets. An
application of those techniques will be illustrated with the use of reported
data of Toyota Motor Corporation and Volkswagen Group.
Table 9.23 (in the appendix) quotes the explanations of accounting policies
applied by both firms to their research and development expenditures. As may
344
J. Welc
Table 9.10 Selected financial statement data and accounting ratios of Toyota and
Volkswagen Group for fiscal years 2007 and 2008
Data from reported financial
statements
Revenues
Opera ng income (EBIT)
Toyota
(data in JPY million)
Volkswagen (data in EUR
million)
2007
2008
2007
2008
23.948
26.289
108.897
113.808
2.239
2.270
6.151
6.333
Net earnings
1.484
1.526
4.122
4.688
Total assets
32.575
32.458
145.357
167.919
Total equity
11.836
11.870
31.938
37.388
Total liabili es
20.739
20.588
113.419
130.531
Opera ng cash flows (OCF)
3.238
2.982
15.662
10.799
Opera ng profit growth y/y
–
1,4%
–
3,0%
Net earnings growth y/y
–
2,8%
–
13,7%
Opera ng profitability = EBIT /
Revenues
9,3%
8,6%
5,6%
5,6%
Net profitability
= Net earnings / Revenues
6,2%
5,8%
3,8%
4,1%
OCF to total liabili es
15,6%
14,5%
13,8%
8,3%
Indebtedness = Total
liabili es/Total assets
63,7%
63,4%
78,0%
77,7%
Source Annual reports of individual companies for fiscal year 2008 and authorial
computations
be read, Toyota (which in 2008 applied US GAAP) treated all amounts spent
on its R&D as period costs, i.e. it expensed them as incurred. Consequently,
there were no assets recognized on its balance sheet, stemming from its past
expenditures on R&D. If there are no R&D-driven assets, then there are
no issues of R&D-distortions of reported numbers (e.g. related to a subjectivity of borderlines between research and development phases or subjectivity
of estimates of useful lives of capitalized development costs). In contrast, in
accordance to IAS 38, Volkswagen Group expensed all its research costs, while
capitalizing (as intangible assets) its development expenditures, which were
afterward amortized using the straight-line method. Clearly, given the R&Dintensive nature of the car industry, such differences in accounting approaches
toward research and development costs may have dramatically eroded a
comparability of financial statement data reported by both competitors.
9 Techniques of Increasing Comparability …
345
Table 9.10 presents selected financial statement data, extracted from
annual reports of both firms for fiscal year 2008, as well as several financial statement ratios, computed on the basis of those reported numbers. As
may be seen, as compared to Toyota, in 2008 Volkswagen Group reported
slightly faster pace of growth of operating profit (3,0% y/y vs. 1,4% y/y)
and significantly faster growth of consolidated net earnings (13,7% y/y vs.
2,8% y/y). In both periods the VW’s operating profitability lagged behind
that reported by Toyota, but stood stable between 2007 and 2008 (while
Toyota’s profitability fell in the same period). Likewise, although the VW’s net
profitability was lower than the Toyota’s one, the former improved it slightly
in 2008, while the latter reported a shrinking net margin. In both years
Toyota enjoyed better financial risk metrics than its German rival, having
higher and more stable coverage of total liabilities by operating cash flows, as
well as total indebtedness (unadjusted for off-balance sheet liabilities) lower
by about 14,5 percentage points. To sum up, although in both years Volkswagen Group appeared to have lower profitability and higher financial risks,
it seemed to be capable of delivering stronger growth of earnings (particularly
on the bottom-line level) and more stable margins.
However, we know that all the above comparisons may have been seriously distorted by different accounting policies applied by both firms to their
research and development expenditures (i.e. an expensing of all R&D costs
by Toyota and a capitalization of development expenditures by Volkswagen).
Therefore, it is justified to compare not only their ratios computed on the
basis of raw (reported) data, but also after adjusting those data for those
accounting differences. Theoretically, two alternative approaches are available
here:
• Adjustment of Toyota’s reported numbers by capitalizing (and then amortizing) its development expenditures (so that the Toyota’s adjusted data
look as if it applies the same IFRS-based principles as Volkswagen Group),
• Adjustment of VW’s reported numbers by expensing all its R&D expenditures (so that the VW’s adjusted data look as if it applies the same US
GAAP-based principles as Toyota Motor Corporation).
The first of the two approaches is difficult to be applied in practice, since
it calls for splitting all of Toyota’s R&D expenditures into their research and
development parts (while the company does not disclose such breakdowns).
Furthermore, such an artificial capitalization of Toyota’s development costs
would entail a necessity to take multiple subjective assumptions, regarding
useful lives of its capitalized development costs. For these reasons, it is more
346
J. Welc
practical and more objective to follow the second approach, i.e. adjusting the
VW’s data so that they look as if the company expenses both research and
development costs as incurred (instead of expensing the research costs while
capitalizing the development ones).
As we know from our previous discussion, a capitalization of development
costs erodes a comparability of all three primary financial statements, with
the following line items being particularly affected:
• Operating profit and pre-tax earnings, which are both overstated (as
compared to when all R&D expenditures are expensed as incurred) in
those periods when amounts of capitalized development costs exceed an
amount of amortization of previously capitalized development costs (while
being understated in those periods, when the amortization of development
costs exceeds the amount of new development costs capitalized).
• After-tax earnings, which are overstated (understated) in tune with an
overstatement (understatement) of the operating profit and pre-tax earnings.
• Total assets and long-term assets, which are overstated due to non-zero
carrying amounts of capitalized development costs (which do not appear at
all on balance sheets of those firms that expense all their R&D expenditures
as incurred).
• Total liabilities and long-term liabilities (provisions), which are overstated by an amount of deferred tax provisions, resulting from temporary
book-tax differences, brought about by a different treatment of development costs for financial reporting and for tax purposes).
• Total shareholder’s equity, which is overstated as a result of an overstatement of assets (by an amount that exceeds the amount of overstatement of
liabilities).
• Operating cash flows, which are overstated by treating development
expenditures as investments in intangible assets (i.e. investing cash
outflows), instead of being treated as operating expenses.
• Investing cash flows, which are understated as a result of an overstatement
of operating cash flows.
As regards the overstatement of reported liabilities, it results from temporary book-tax differences (explained with more details in Sect. 10.4 of
Chapter 10) related to capitalized development costs. In most tax jurisdictions, in a tax accounting all R&D expenditures may be expensed (i.e. may
be tax deductible) as incurred. Consequently, if development costs are capitalized for financial reporting purposes, while being expensed as incurred for tax
9 Techniques of Increasing Comparability …
347
purposes, then a temporary book-tax difference emerges, for which a deferred
tax provision is recognized as part of a given company’s liabilities. Thus, when
adjusting reported income statement and balance sheet for the capitalized
development costs (by writing them off, as if they have been expensed as
incurred not only for tax purposes, but for financial reporting as well), we will
need to eliminate the provision for deferred taxes, recognized by a company
before, in relation to its capitalized development costs.
Table 9.11 presents adjustment formulas which are to be used to remove
the distortions listed above. As may be seen, only limited information is
needed to process all these adjustments. These are data on gross amounts of
capitalized development costs (i.e. capitalized development expenditures at
cost, before any amortization) and carrying amounts of capitalized development costs, which are mandatorily disclosed in notes to financial statements.
Table 9.11 Formulas for adjusting income statement, balance sheet and cash flow
statement for capitalized development costs
Financial statement items
Income
statement
Way of adjustment
Opera ng profit
and pre-tax
earnings
Subtract from reported profits an amount equal to a difference
between carrying amounts of capitalized development costs (i.e.
the difference between net amount at the end of a given period
and net amount at the end of the previous period)
Net (a er-tax)
earnings
Subtract from reported earnings the amount of the adjustment
computed for opera ng and pre-tax profit, lowered by an
amount resul ng from a company’s statutory income tax rate
Subtract from reported assets a carrying amount of capitalized
Total assets and
development costs (both at the end of a given period as well as
long-term assets
at the end of the previous period)
Balance
sheet
Cash flow
statement
Total liabili es
and long-term
liabili es
Subtract from reported liabili es an amount of the adjustment
computed for total assets, mul plied by a company’s statutory
income tax rate
Shareholder’s
equity
Subtract from reported equity an amount equal to a difference
between the amount of adjustment computed for total assets
and the amount of adjustment computed for total liabili es
Opera ng cash
flows (OCF)
Subtract from reported OCF an amount equal to a difference
between gross amounts (i.e. at cost) of capitalized development
costs (i.e. the difference between gross amount at the end of a
period and gross amount at the end of the previous period)
Inves ng cash
flows (ICF)
Add to reported ICF the amount of the adjustment computed for
opera ng cash flows
Source Author
348
J. Welc
Table 9.24 (in the appendix) contains data on gross values and carrying
amounts of the Volkswagen Group’s intangible assets, as at the end of its
fiscal years 2006, 2007 and 2008.
As may be seen in Table 9.24, in its note the company breaks down its
total intangibles into five classes, of which two correspond to the capitalized
development costs. They reflect capitalized costs related to products and technologies which are either still under development or already in use. In both
cases the gross values (i.e. at cost) increased systematically between the end of
2006 and the end of 2008. However, a different pattern may be discerned in
the case of their carrying amounts, which fell in 2007 (meaning that in that
year the amounts of amortization exceeded the amounts of new capitalized
costs), but rose in 2008 (meaning that in that year the company capitalized
more than it amortized from its previously capitalized costs).
From a perspective of our financial statement adjustments, there is no
difference in an economic substance between both classes of capitalized development costs, reported separately in the VW’s note (i.e. between costs related
to products under development and costs related to products currently in
use). Therefore, for our further analysis we can sum the amounts reported by
Volkswagen Group for these two classes of intangibles, as shown in the upper
part of Table 9.12. The same table presents the amounts of adjustments of
individual financial statement items, computed in accordance to the formulas
presented in Table 9.11. Income tax rate assumptions, used in computations
presented in Table 9.12, are based on the VW’s disclosures in Note 10 to its
Annual Report 2008, according to which its income tax rate equaled 38,3%
in 2007 and 29,5% in 2008.
Now when we have all the amounts of adjustments (computed and
presented in Table 9.12), we may proceed to revising the VW’s reported
numbers, as shown in Table 9.13.
Finally, we may compute the adjusted values of the VW’s financial statement ratios (based on revised accounting data from the last two columns of
Table 9.13 as inputs), and compare them to both the VW’s pre-adjustment
ratios as well as to the Toyota’s ratios. This comparison is presented
in Table 9.14. As may be seen, our restatements of the VW’s reported
accounting numbers for its capitalized development costs have a significant
impact on values of some of the investigated metrics. The company’s operating profit, which seemed to grow by 3% y/y when based on the raw
numbers, now shows a decline by more than 27% y/y. An impact of our
adjustments is even more striking in the case of net earnings growth, which
turned from a double-digit rate of almost 14% y/y (on an unadjusted basis)
to a contraction by almost 18% y/y. Also, the VW’s profitability ratios no
9 Techniques of Increasing Comparability …
349
Table 9.12 Data on capitalized development costs of Volkswagen Group (as at the
end of fiscal years 2006, 2007 and 2008) as well as the amounts of adjustment’s of
the VW’s reported financial statement numbers for fiscal years 2007 and 2008
EUR million
2006
2007
2008
Capitalized development costs
at cost (gross amounts)*
12.018
12.408
14.164
= 1.872 + 10.146
= 1.938 + 10.470
= 2.665 + 11.499
Capitalized development costs
at carrying amounts*
6.500
6.082
7.617
= 1.759 + 4.741
= 1.709 + 4.373
= 2.426 + 5.191
418
−1.535
=−(7.617−6.082)
Amounts of adjustments to the VW’s reported numbers**
Amount of adjustment of
reported opera ng profit
–
Amount of adjustment of
reported net earnings***
–
= 418 x
(1 − 38,3%)
−1.082
= −1.535 x
(1 − 29,5%)
Amount of adjustment of
reported total assets
–
−6.082
−7.617
Amount of adjustment of
eported total liabili es***
–
−2.129
= −6.082 x 38,3%
−2.666
= −7.617 x 29,5%
Amount of adjustment of
reported shareholder’s equity
–
−3.953
= − (6.082 − 2.129)
−4.951
= − (7.617 − 2.666)
Amount of adjustment of
reported opera ng cash flows
–
−390
= − (12.408 −
12.018)
−1.756
= − (14.164 −
12.408)
Amount of adjustment of
reported inves ng cash flows
–
390
1.756
=−(6.082−6.500)
258
*Numbers computed on the basis of the reported data presented in Table 9.24 (in
the appendix)
**Numbers computed with the use of formulas presented in Table 9.11
***Income tax rates of 38,3% and 29,5% have been applied for fiscal years 2007 and
2008, respectively (according to Note 10 to the VW’s financial statements for fiscal
year 2008)
Source Annual reports of Volkswagen Group for fiscal years 2007–2008 and authorial
computations
longer present any prior stability. Instead, they deteriorate visibly between
2007 and 2008. Finally, the coverage of liabilities by operating cash flows
is now lower than before, while total indebtedness turns out to be higher
(although the impact of our adjustments on these two financial risk metrics
is rather modest).
350
J. Welc
Table 9.13 Adjustments of reported financial statement numbers of Volkswagen
Group (for fiscal years 2007 and 2008) for the company’s capitalized development
costs
Data in EUR million
Reported numbers*
Adjusted numbers**
2007
2008
2007
2008
108.897
113.808
108.897
113.808
Opera ng income
6.151
6.333
Net earnings
4.122
4.688
Total assets
145.357
167.919
Total liabili es
113.419
130.531
Total equity
31.938
37.388
Opera ng cash flows
15.662
10.799
Revenues
6.569
4.798
= 6.151 + 418
= 6.333 − 1.535
4.380
3.606
= 4.122 + 258
= 4.688 −1.082
139.275
160.302
= 145.357 −6.082 = 167.919 −7.617
111.290
127.865
= 113.419 −2.129 = 130.531 −2.666
27.985
32.437
= 31.938 −3.953
= 37.388 −4.951
15.272
9.043
= 15.662 −390
= 10.799 −1.756
*as presented in Table 9.10
**numbers computed with the use of data presented in Table 9.12
Source Annual reports of Volkswagen Group for fiscal years 2007–2008 and authorial
computations
Our earlier comparison of the unadjusted ratios computed for both car
manufacturers let us to conclude that in both years Volkswagen Group
appeared to have lower profitability and higher financial risks (as compared to
Toyota), but they seemed to be partially compensated by the company’s capability of delivering stronger earnings growth and apparently stable margins.
Now it is clear that a seemingly superior growth and stability of the VW’s
earnings was a purely accounting phenomena, i.e. it was caused by different
accounting policies applied by both forms to their R&D expenditures. A
comparison of ratios adjusted for the VW’s capitalized development costs
clearly shows that in the investigated periods Toyota not only enjoyed higher
margins and safer values of financial risk metrics, but also outperformed
its German rival in terms of the earnings growth (which in 2008 stayed
marginally positive, in contrast to the VW’s contracting profits).
When applying the adjustment techniques illustrated above it is important to remember about possible differences in strategies of various firms
351
9 Techniques of Increasing Comparability …
Table 9.14 Selected raw and adjusted ratios of Toyota and Volkswagen Group for
fiscal years 2007 and 2008
Toyota
2007
2008
Volkswagen
2007
2008
RaƟos computed on the basis of unadjusted (reported) accounƟng numbers
Opera ng profit growth y/y
– 1,4%
–
3,0%
Net earnings growth y/y
– 2,8%
–
13,7%
Opera ng profitability
= EBIT / Revenues
9,3% 8,6%
5,6%
5,6%
Net profitability
= Net earnings / Revenues
6,2% 5,8%
3,8%
4,1%
15,6% 14,5%
13,8%
8,3%
63,7% 63,4%
78,0%
77,7%
OCF to total liabili es
Indebtedness
= Total liabili es/Total assets
RaƟos aŌer adjusƟng the VW’s accounƟng numbers for its capitalized development costs
Opera ng profit growth y/y
– 1,4%
–
−27,0%
Net earnings growth y/y
– 2,8%
–
−17,7%
Opera ng profitability
= EBIT / Revenues
9,3% 8,6%
6,0%
4,2%
Net profitability
= Net earnings / Revenues
6,2% 5,8%
4,0%
3,2%
15,6% 14,5%
13,7%
7,1%
63,7% 63,4%
79,9%
79,8%
OCF to total liabili es
Indebtedness = Total
liabili es/Total assets
Source Annual reports of individual companies for fiscal years 2007–2008 and
authorial computations
toward their R&D projects. Some companies prefer to conduct their R&D
activities internally (e.g. in their own laboratories), while others decide to
subcontract them to external entities. Also, as was shown in Sect. 4.1.4 of
Chapter 4, an artificial “outsourcing” of R&D projects constitutes one of
the techniques of aggressive accounting, whereby not only development costs
may be capitalized but also the research expenditures. Regardless of the underlying motivations, subcontracted R&D expenditures land as intangible assets
in balance sheet, instead of being expensed as incurred. This, in turn, erodes
a comparability of financial results reported by firms with different R&D
strategies (“in house” vs. subcontracting), even if they apply the same set of
accounting standards. In such circumstances it may be legitimate to apply
the adjustment techniques presented in this section not only to internally
352
J. Welc
generated capitalized development costs, but also to R&D projects purchased
from other entities (and recognized in the balance sheet as patents, licenses,
product formulas, etc.).
However, like most other techniques of a financial statement analysis, the
adjustments discussed in this section are prone to their own weaknesses. In
particular, they tend to penalize innovative firms that devote relatively large
funds (as compared to their competitors) to R&D projects. When comparing
businesses operating in R&D-intensive industries, on the ground of their
financial numbers corrected for capitalized development costs, companies
which aggressively cut their R&D expenditures may seem to outperform
others in terms of profitability. However, such an apparent supremacy may
be very short-lived, if pace of innovation constitutes one of key factors of
a strategic competitive advantage in a particular business. In such circumstances, myopic savings on R&D, which boost profitability temporarily, may
jeopardize the company’s perspectives (or even sustainability) in the long run.
Therefore, the techniques presented in this section should always be applied
with care.
9.5
Adjustments for Differences
in Depreciation Policies Applied
to Property, Plant and Equipment
For many businesses, particularly those which operate in capital-intensive
industries, one of the major cost items is depreciation of property, plant
and equipment. However, even firms which function in the same industry
(and use similar productive assets) may differ significantly in terms of
their accounting policies applied to long-term operating assets. While some
companies may apply a straight-line depreciation (where depreciation charges
have a fixed cost characteristics), others may select a natural method of
depreciating fixed assets (whereby depreciation charges turn into a variable
expense). Also, useful lives of long-term assets must be estimated, which
entails significant subjective judgments. Finally, some firms may assume positive and material residual values of their depreciable assets (which may help
reducing periodic depreciation charges), while others may claim that their
fixed assets are worth nothing at the end of their useful lives. It is worth
noting that similar issues of comparability apply to amortizable intangible
assets (e.g. capitalized development costs, licenses, databases, etc.).
A load of depreciation-related and amortization-related subjective judgments may dramatically erode a comparability of accounting numbers
9 Techniques of Increasing Comparability …
353
reported by various companies, even if they operate in the same industry
(and even if they apply the same set of accounting standards). Therefore, in
comparative analyses of financial results it is often legitimate to adjust the
numbers reported by various firms, by reversing intercompany differences in
accounting policies applied to their depreciable and amortizable fixed assets.
A simple technique of such an adjustment will be illustrated in this section,
with the use of data of three regional low-cost airlines: easyJet, Regional
Express and WestJet.
Table 9.25 (in the appendix) contains an extract from annual report of
easyJet for fiscal year 2010, relating to the company’s accounting policy
applied to its aircraft-related assets. As may be read, in its fiscal year 2010
easyJet depreciated those assets on a straight-line basis, with some non-zero
residual values (undisclosed). It is worth noting that the company applied the
same useful live to each aircraft it owned (23 years), as well as the same useful
live to each spare part (14 years).
The aircraft-related accounting principles of easyJet differed significantly
from the policy adopted by Regional Express, which is referenced to in
Table 9.26 (in the appendix). As may be concluded from those disclosures,
the company’s aircrafts were depreciated on a basis of their assumed usability,
as measured by an expected time of service (in terms of number of hours
of flights), instead of on a time basis. However, in relation to its engines,
Regional Express applied a straight-line method, with a fixed ten-year useful
live assumed (for each engine used).
Finally, Table 9.27 (in the appendix) contains an extract from annual
report of WestJet airlines, which summarizes the company’s approach toward
depreciating its aircraft-related assets. According to those disclosures, the
WestJet’s aircrafts were depreciated on a basis of their assumed usability, as
measured by an expected number of cycles flown. Therefore, the company’s
policy of aircraft depreciation, which was based on the actual usage (instead
of a passage of time), seems to be quite similar to that applied by Regional
Express (and different from easyJet’s straight-line approach). However, it is
worth noting that a depreciation driver used by WestJet differed in nature
from the one applied by Regional Express. While the latter connected its
depreciation to an actual time spent by a given aircraft in the air, the former
anchored its depreciation charges to the number of flights (which seems to
ignore any differences in duration of flights on various routes). As regards
spare engines and parts, WestJet applied a policy of straight-line depreciation,
similarly to easyJet and Regional Express. However, its useful live assumed
for those assets (20 years) was much longer than in the case of its two “peers”
(who depreciated those spares between 10 years and 14 years).
354
J. Welc
To sum up, it is legitimate to conclude that all three airlines differed
significantly in their approaches to depreciating aircraft-related fixed assets.
As regards the aircrafts themselves, easyJet depreciated them on a straightline basis, while its two “peers” adopted depreciation methods based on an
actual exploitation of a given machine (however, the cost drivers which they
applied differed too). Furthermore, even though all three companies depreciated spare engines and parts on a straight-line basis, their assumed useful
lives of those assets differed significantly (from ten to twenty years). Finally,
all three firms depreciated their aircraft-related assets down to their assumed
non-zero residual values, which implies likely differences in residual values
assumptions. All in all, it is likely that a comparability of financial results
reported by easyJet, Regional Express and WestJet could have been eroded by
their diverse depreciation policies. Consequently, for comparative purposes it
is justified to adjust their reported numbers, by reversing those intercompany
accounting differences.
A goal of such an adjustment is to estimate hypothetical financial results
of each of those three firms, as if they apply the same depreciation policy and
assumptions. The simplest way to do so is to take a following set of analytical
assumptions:
• Each company applies a straight-line method of depreciation, with zero
residual values.
• Each company assumes the same useful lives to depreciate its aircraftrelated assets.
A good starting point is an estimation of each company’s average useful live
(in number of years), on the ground of a numerical information disclosed
in notes to financial statements. According to Note 8 (Property, plant and
equipment) to easyJet’s annual report for fiscal year ended September 30,
2010, the annual depreciation of the company’s aircraft-related assets in that
period amounted to 69,2 GBP million, while on September 30, 2009 (i.e. at
the beginning of that fiscal year) the value of those assets at their initial costs
(i.e. their gross value) amounted to 1.747,1 GBP million. The straight-line
method of depreciation means that a simplified estimate of an average useful
live may be computed by dividing the annual depreciation of assets by their
initial (cost) value, which yields 25,2 years [= 1.747,1/69,2].
Similar computations may be replicated for the other two carriers.
However, they do not apply the straight-line depreciation method (instead,
they link their depreciation charges to an actual usage of assets), which means
that the obtained results should be interpreted with some caution. According
9 Techniques of Increasing Comparability …
355
to Note 9 (Property, plant and equipment) to annual report of Regional
Express for its financial year ended June 30, 2010, the annual depreciation of the company’s aircraft-related assets in that period amounted to 6,4
AUD million (including aircraft depreciation of 5,9 AUD million and engine
depreciation of 0,5 AUD million), while on June 30, 2009 (i.e. at the beginning of that fiscal year) the value of those assets at their initial costs amounted
to 115,5 AUD million (including the aircraft at cost of 108,0 AUD million
and the engines at cost of 7,5 AUD million). If the straight-line method of
depreciation is assumed (with zero residual values), then dividing an annual
depreciation in a period by an initial value of assets at the beginning of that
period results in a simplified estimate of the average useful live of 18,0 years
[= 115,5/6,4].
Finally, we may obtain similar estimates for WestJet airlines. However, in
its financial reports the company did not disclose any information about the
annual depreciation of its aircraft-related assets. Consequently, those depreciation charges must be estimated on the ground of the note disclosures on
accumulated depreciation. According to Note 5 (Property and equipment) to
WestJet’s annual report for 2010, at the end of 2010 the accumulated depreciation of the company’s aircraft-related assets amounted to 651,2 CAD million
(including depreciation of aircraft of 623,0 CAD million and depreciation of
spare engines and parts of 28,2 CAD million), while at the end of 2009
the combined accumulated depreciation of aircraft, spare engines and parts
amounted to 537,9 CAD million. A difference between these two amounts
yields the estimate of the annual depreciation of the aircraft-related assets
in fiscal year 2010, which equals 113,3 CAD million [= 651,2−537,9].
According to the same note to WestJet’s annual report for 2010, at the end of
2009 the value of the company’s aircraft-related assets, at their initial costs,
amounted to 2.557,6 CAD million (including aircraft at cost of 2.457,0
CAD million and spare engines and parts at cost of 100,6 CAD million).
If the straight-line method of depreciation is assumed (with zero residual
values), then dividing the annual depreciation by the initial value of assets
at the beginning of the period results in a simplified estimate of the average
useful live of 22,6 years [= 2.557,6/113,3].
To sum up, our simplified estimates of the average useful lives of aircraftrelated assets are 25,2 years for easyJet, 18,0 years for Regional Express and
22,6 years for WestJet. The arithmetic mean of these three estimates equals
21,9 years, so it may be assumed that 22 years (after rounding) may serve as
a crude proxy for the most likely useful life of a typical aircraft-related asset
(used in average conditions). With this assumption the adjusted amounts of
annual depreciation charges may be computed, as shown in Table 9.15. As
356
J. Welc
Table 9.15 Adjustments of annual depreciation charges and annual operating
profits of easyJet, Regional Express and WestJet
easyJet (data
in GBP
million)*
Aircra -related assets at cost, at the beginning
of the fiscal year
Reported deprecia on of aircra -related assets
in the fiscal year
Regional
Express (data WestJet (data
in AUD
in CAD
million)**
million)***
1.747,1
115,5
2.557,6
69,2
6,4
113,3
Assumed useful life of aircra -related assets
Hypothe cal annual straight-line deprecia on
(with 22 years of useful life
and zero residual value)
Adjustment of operaƟng profit
for intercompany diīerences
in depreciaƟon of aircraŌ-related assets
22 years
79,4
= 1.747,1 /
22 years
−10,2
= 69,2 −79,4
5,3
= 115,5 /
22 years
116,3
= 2.557,6 /
22 years
+1,1
−3,0
= 6,4 −5,3 = 113,3 −116,3
*Data for fiscal year ended September 30, 2010
**Data for fiscal year ended June 30, 2010
***Data for fiscal year ended December 31, 2010
Source Annual reports of individual companies for fiscal year 2010 and authorial
computations
may be seen, annual depreciation charge for Regional Express is to be adjusted
downward (by 1,1 AUD million), with a resulting increase of its adjusted
operating profit and adjusted operating margin (as shown in Table 9.16). In
contrast, annual depreciation charges of easyJet and WestJet are to be revised
upward (by 10,2 GBP million and 3,0 CAD million, respectively), with
resulting reductions of their adjusted operating profits and adjusted operating
margins.
As may be seen in Table 9.16, on the ground of the reported (unadjusted)
financial numbers Regional Express seemed to outperform both “peers”, with
its double-digit operating margin. In contrast, easyJet seemed to be the least
profitable of all three firms. However, after reading notes to financial statements of all three companies (particularly descriptions of their depreciation
policies), one might have wondered to what extent those differences in profitability stemmed from real fundamental factors. In other words, one could
have supposed that perhaps the apparent outperformance of Regional Express
could have been caused by its relatively optimistic (or even aggressive) depreciation assumptions, while easyJet’s inferior margins could have resulted from
its more conservative accounting policy. However, profitability ratios based
on the corrected and more comparable numbers eliminate such doubts. Now
9 Techniques of Increasing Comparability …
357
Table 9.16 Raw and depreciation-adjusted operating margins of easyJet, Regional
Express and WestJet in their respective fiscal years 2010
Regional
easyJet
Express WestJet (data
(data in GBP (data in AUD
in CAD
million)*
million)***
million)**
Reported annual revenues
2.973,1
223,6
2.609,3
Reported annual opera ng profit
173,6
26,0
247,6
Adjusted annual opera ng profit
163,4
= 173,6 −10,2
27,1
= 26,0 + 1,1
244,6
= 247,6 −3,0
OperaƟng profitability based on reported
numbers
OperaƟng profitability based on adjusted
numbers
5,8%
11,6%
9,5%
= 173,6 /
2.973,1
= 26,0 /
223,6
= 247,6 /
2.609,3
5,5%
12,1%
9,4%
= 163,4 /
2.973,1
= 27,1 /
223,6
= 244,6 /
2.609,3
*Data for fiscal year ended September 30, 2010
**Data for fiscal year ended June 30, 2010
***Data for fiscal year ended December 31, 2010
Source Annual reports of individual companies for fiscal year 2010 and authorial
computations
the most profitable airline appears even more profitable, while the adjusted
margins of both its “peers” are slightly lower than their counterparts based
on the reported numbers. Accordingly, the presented adjustments for intercompany differences in accounting policies helped in validating the findings
regarding differences in margins earned by the investigated three airlines.
When applying the adjustment technique exemplified in this section, one
must be aware of its limitations, which are common for all such “one-fits-all”
approaches. In computations presented above the same average useful live
(of 22 years) and the straight-line depreciation method have been assumed
for all airplanes of all three airlines. Although such an assumption wipes out
possible distortions stemming from subjective judgments, it may have no relationship with a business reality. It may be entirely legitimate to depreciate
some assets relatively fast, if they are utilized with an above-average intensity
(e.g. at a full capacity in harsh climate conditions), while identical assets used
in different conditions may deserve longer useful lives. Also, various assets
serving similar purposes (e.g. various models of a passenger car) may differ in
terms of their quality and durability. It may be entirely legitimate to assume
a relatively long useful live for a modern premium-quality machine, while
accelerating depreciation of its cheaper and less durable version. With such
358
J. Welc
differences in actual useful lives of various items of property, plant and equipment, the “one-fits-all” approach presented here may tend to penalize firms
that invest in high-quality assets (which deserve longer depreciation periods)
while favoring those who use their cheaper and less durable equivalents.
Appendix
See Chart 9.1 and Tables 9.17, 9.18, 9.19, 9.20, 9.21, 9.22, 9.23, 9.24, 9.25,
9.26, 9.27.
Chart 9.1 Five inflation indexes (expressed as percent changes in prices, year over
year) for metal and metal products, in the period between January 2009 and
January 2017 (Abbreviations of price indexes used: PPICMM—Producer Price Index
by Commodity Metals and Metal Products: Primary Nonferrous Metals, WPU10—
Producer Price Index by Commodity for Metal and Metal Products, WPU101—
Producer Price Index by Commodity for Metals and Metal Products: Iron and
Steel, WPU101707—Producer Price Index by Commodity for Metals and Metal Products: Cold Rolled Steel Sheet and Strip, WPU10250105—Producer Price Index by
Commodity for Metals and Metal Products: Aluminum Sheet and Strip. Source
Authorial computations based on data published by Federal Reserve Bank of St.
Louis)
9 Techniques of Increasing Comparability …
359
Table 9.17 Descriptions of core business activities of Reliance Steel & Aluminum,
Klöckner and Worthington Industries (extracted from their annual reports for fiscal
year 2016)
RELIANCE STEEL & ALUMINUM
We are the largest metals service center company in North America (U.S. and
Canada). Our network of metals service centers operates more than 300 locations in
39 states in the U.S. and in 12 other countries […]. Through this network, we provide
metals processing services and distribute a full line of more than 100,000 metal
products, including alloy, aluminum, brass, copper, carbon steel, stainless steel,
titanium and specialty steel products, to more than 125,000 customers in a broad
range of industries. […] Many of our metals service centers process and distribute
only specialty metals.
KLÖCKNER
Klöckner & Co SE is one of the world’s largest producer-independent distributors of
steel and metal products and one of the leading steel service center companies. We act
as a connecting link between steel producers and consumers. As we are not tied to
any particular steel producer, customers benefit from our centrally coordinated
procurement and wide range of national and international sourcing options from over
50 main suppliers worldwide. […] Spanning 13 countries, our global network
provides customers with local access to some 190 distribution and service locations.
[…] Concentrated mainly in construction as well as the machinery and mechanical
engineering industries, our customer base comprises around 130,000 mostly small to
medium-sized steel and metal consumers. In addition, we supply intermediate
products for the automotive, shipbuilding and consumer goods industries.
WORTHINGTON
Founded in 1955, Worthington is primarily a diversified metals manufacturing
company, focused on value-added steel processing and manufactured metal products.
Our manufactured metal products include: pressure cylinders for liquefied petroleum
gas (“LPG”), compressed natural gas (“CNG”), oxygen, refrigerant and other
industrial gas storage; hand torches and filled hand torch cylinders; propane-filled
camping cylinders; helium-filled balloon kits; steel and fiberglass tanks and
processing equipment primarily for the oil and gas industry; cryogenic pressure
vessels for liquefied natural gas (“LNG”) and other gas storage applications;
engineered cabs and operator stations and cab components; and, through our joint
ventures, suspension grid systems for concealed and lay-in panel ceilings; laser
welded blanks; light gauge steel framing for commercial and residential construction;
and current and past model automotive service stampings. […]
Source Annual reports of individual companies for fiscal year 2016
360
J. Welc
Table 9.18 Inventory accounting methods used by Reliance Steel & Aluminum,
Klöckner and Worthington Industries
RELIANCE STEEL & ALUMINUM
The majority of our inventory is valued using the last-in, first-out (“LIFO”) method,
which is not in excess of market. Under this method, older costs are included in
inventory, which may be higher or lower than current costs. This method of valuation
is subject to year-to-year fluctuations in cost of materials sold, which is influenced by
the inflation or deflation within the metals industry as well as fluctuations in our
product mix and on-hand inventory levels.
KLÖCKNER
Inventories are measured at the lower of cost and net realizable value. […]
Measurement is normally on a monthly moving average basis. In certain cases, cost is
assigned by specific identification of individual costs.
WORTHINGTON
Inventories are valued at the lower of cost or market. Cost is determined using the
first-in, first-out method for all inventories. […] Due to a decline in steel prices in the
fiscal year ended May 31, 2015 (“fiscal 2015”), the replacement cost of our inventory
was lower than what was reflected in our records on May 31, 2015. Accordingly, we
recorded a lower of cost or market adjustment of $ 1,716,000 on May 31, 2015 to
reflect this lower value. The entire amount related to our Steel Processing operating
segment and was recorded in cost of goods sold.
Source Annual reports of individual companies for fiscal year 2016
Table 9.19 Correlation coefficients between five inflation indexes (as shown on
Chart 8.1) for metal and metal products, in the period between January 2009 and
January 2017
PPICM
M
WPU10
WPU101
WPU101 WPU102
707
50105
PPICMM
1,00
WPU10
0,91
1,00
WPU101
0,83
0,97
1,00
WPU101707
0,85
0,96
0,97
1,00
WPU10250105
0,91
0,93
0,88
0,88
1,00
Abbreviations of price indexes used
PPICMM—Producer Price Index by Commodity Metals and Metal Products: Primary
Nonferrous Metals
WPU10—Producer Price Index by Commodity for Metal and Metal Products
WPU101—Producer Price Index by Commodity for Metals and Metal Products: Iron
and Steel
WPU101707—Producer Price Index by Commodity for Metals and Metal Products:
Cold Rolled Steel Sheet and Strip
WPU10250105—Producer Price Index by Commodity for Metals and Metal Products:
Aluminum Sheet and Strip
Source Authorial computations based on data published by Federal Reserve Bank of
St. Louis
9 Techniques of Increasing Comparability …
361
Table 9.20 The reported and adjusted (from FIFO to LIFO) operating profit of
Worthington Industries in fiscal years 2009–2018
Fiscal years
ending May 31
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Coefficient of
variation
Reported (FIFObased) operating
profit
Adjusted operating
profit*
−175
61
22
124
102
129
136
61
122
213
142
−77
88
127
157
119
118
135
179
94
120,0%
70,7%
*After converting cost of goods sold from its FIFO to LIFO basis
Source Annual reports of Worthington Industries Inc. and authorial computations
Table 9.21 Selected financial statement data of Southern Cross Healthcare for fiscal
year ended September 30, 2010
Financial
Item
In GBP million
t t
t
Revenue
958,6
Consolidated
income statement
Consolidated
balance sheet
Consolidated cash
flow statement
Operating loss
Finance costs
Finance income
Loss before taxation
Noncurrent assets
Current assets
TOTAL ASSETS
Total equity
Current liabilities
Noncurrent liabilities
TOTAL EQUITY AND
Operating cash flows
Investing cash flows
Financing cash flows
TOTAL CASH FLOWS
−44,1
−3,7
0,4
−47,4
366,2
70,2
436,4
51,9
96,6
287,9
436,4
29,7
−3,9
−56,4
−30,6
Source Annual report of Southern Cross Healthcare for fiscal year ended September
30, 2010
362
J. Welc
Table 9.22 Average cost of debt of Southern Cross Healthcare, as at the end of
September 2010 (from Note 30 to the company’s consolidated financial statements)
Note 22: Financial instruments
The floating rate financial liabilities comprised:
Sterling denominated bank borrowings and overdrafts that bear interest at rates
between 2,75% and 3,25% above UK bank base rates.
Source Annual report of Southern Cross Healthcare for fiscal year ended September
30, 2010
Table 9.23 Description of accounting policies related to research and development
expenditures of Volkswagen Group and Toyota Motor Corporation
VOLKSWAGEN GROUP
In accordance with IAS 38, research costs are recognized as expenses when incurred.
Development costs for future series products and other internally generated intangible
assets are capitalized at cost, provided manufacture of the products is likely to bring
the Volkswagen Group an economic benefit. If the criteria for recognition as assets
are not met, the expenses are recognized in the income statement in the year in which
they are incurred.
Capitalized development costs include all direct and indirect costs that are directly
attributable to the development process. Borrowing costs are not capitalized. The
costs are amortized using the straight-line method from the start of production over
the expected life cycle of the models or powertrains developed—generally between
five and ten years.
TOYOTA MOTOR CORPORATION
Research and development costs are expensed as incurred […].
Source Annual reports of individual companies for fiscal year 2008
9 Techniques of Increasing Comparability …
363
Table 9.24 Gross values and carrying amounts of Volkswagen Group’s intangible
assets, as at the end of fiscal years 2006, 2007 and 2008 (extracted from notes to the
company’s consolidated financial statements for fiscal years 2007 and 2008)
Concession
Capitaliz
s,
ed
industrial
Capitalized
develop
and
costs for
Other
Goodwi
ment
In EUR million
similar
products
intangib Total
ll
costs for
rights, and
under
le assets
products
licenses in
development
currentl
such rights
y in use
and assets
Cost
13.56
Balance on Dec 31, 2006
63
195
1.872
10.146
1.286
2
14.04
Balance on Dec 31, 2007
67
201
1.938
10.470
1.370
6
19.98
Balance on Dec 31, 2008
89
2.771
2.665
11.499
2.959
3
Amortization and
impairment
Balance on Dec 31, 2006
57
–
113
5.405
794 6.369
Balance on Dec 31, 2007
61
–
229
6.097
829 7.216
Balance on Dec 31, 2008
77
–
239
6.308
1.068 7.692
Balance on Dec 31, 2006
6
195
1.759
4.741
492 7.193
Balance on Dec 31, 2007
6
201
1.709
4.373
Balance on Dec 31, 2008
12
2.771
2.426
5.191
541 6.830
12.29
1.891
1
Carrying amount
Source Annual reports of Volkswagen Group for fiscal years 2007 and 2008
Table 9.25 Accounting policy applied by easyJet to its aircraft-related fixed assets
Property, plant and equipment
Property, plant and equipment is stated at cost less accumulated depreciation.
Depreciation is calculated to write off the cost, less estimated residual value, of assets
on a straight-line basis over their expected useful lives. Expected useful lives are
reviewed annually.
Aircraft
Aircraft spares
Aircraft improvements
Aircraft—prepaid maintenance
Expected useful live
23 years
14 years
3–7 years
3–10 years
The cost of new aircraft comprises the invoices price of the aircraft from the supplier
less the estimated value of other assets received by easyJet for nil consideration.
Source Annual report of easyJet plc for fiscal year ended September 30, 2010
364
J. Welc
Table 9.26 Accounting policy applied by Regional Express to its aircraft-related fixed
assets
Property, plant and equipment
Land and buildings, plant and equipment, leasehold improvements and equipment
under finance lease are stated at cost less accumulated depreciation and impairment.
Cost includes expenditure that is directly attributable to the acquisition of the item.
[…] Depreciation is calculated on a straight-line basis so as to write off the net cost of
each asset over its expected useful life to its estimated residual value. […]
The rates applied are as follows:
Aircraft
Engines
15,000 to 60,000 hours
10 years
The estimated useful lives, residual values and depreciation method are reviewed at
the end of each annual reporting period […].
Source Annual report of Regional Express for fiscal year ended June 30, 2010
Table 9.27
Accounting policy applied by WestJet to its aircraft-related fixed assets
Property and equipment
Property and equipment is stated at cost and depreciated to its estimated residual
value. […]
Asset class
Aircraft, net of estimated residual value
Live satellite television included in
aircraft
Spare engines and parts, net of estimated
residual value
Basis
Cycles
Rate
Cycles flown
Straight-line
10 years/terms of
lease
Straight-line 20 years
Aircraft are depreciated over a range of 30,000 to 50,000 cycles. One cycle is defined
as one flight, counted by the aircraft leaving the ground and landing. Estimated
residual values of the Corporation’s aircraft range between $4,000 and $6,000.
Source Annual report of WestJet for fiscal year ended December 31, 2010
9 Techniques of Increasing Comparability …
365
References
Helfert, E. A. (1997). Techniques of Financial Analysis. A Practical Guide to Managing
and Measuring Business Performance. Chicago: Irwin.
Jackson, C. W. (2006). Business Fairy Tales. Grim Realities of Fictitious Financial
Reporting. Mason: Thomson.
Kraft, T. (2012). Rating Agency Adjustments to GAAP Financial Statements and
Their Effect on Ratings and Credit Spreads. The Accounting Review, 90, 641–674.
Lev, B. (2003, September). Remarks on the Measurement, Valuation, and Reporting
on Intangible Assets. FRBNY Economic Policy Review, 9, 17–22.
Moody’s Investor Service: Moody’s Approach to Global Standard Adjustments in
the Analysis of Financial Statements for Non-financial Corporations. December
21, 2010.
Pratt, S. P. (2001). The Market Approach to Valuing Businesses. New York: Wiley.
Standard & Poor’s RatingsDirect: Standard & Poor’s Encyclopedia of Analytical
Adjustments for Corporate Entities. July 9, 2007.
White, G. I., Sondhi, A. C., & Fried, D. (2003). The Analysis and Use of Financial
Statements. Hoboken: Wiley.
Wyatt, A. (2008). What Financial and Non-financial Information on Intangibles Is
Value-Relevant? A Review of the Evidence. Accounting and Business Research, 38,
217–256.
Zhang, I., & Zhang, Y. (2007). Accounting Discretion and Purchase Price Allocation
After Acquisitions (HKUST Business School Research Paper No. 07-04). Hong
Kong.
10
Techniques of Increasing Comparability
and Reliability of Reported Accounting
Numbers: Some More Advanced Tools
10.1 Introduction
The first section of this chapter presents analytical adjustments aimed at mitigating the distortions stemming from significant non-controlling interests.
Then, adjustments for the effects of long-term contracts (accounted for with
the percentage-of-completion method) will be demonstrated. The chapter
closes with an illustration of an analytical technique aimed at increasing
data comparability on the ground of financial statement disclosures related
to deferred tax assets and deferred tax liabilities.
10.2 Adjustments for Non-controlling Interests
As was illustrated in Sect. 2.2 of Chapter 2, as well as in Sect. 6.4 of
Chapter 6, non-controlling interests (sometimes also labeled as minority
interests), when material, may dramatically distort comparability, reliability
and relevance of consolidated financial statements. This is because the full
consolidation of financial statements, under both IFRS and US GAAP,
entails summations of full amounts of individual line items of stand-alone
financial statements of a parent company and all its subsidiaries (adjusted
for the effects of intragroup transactions, if any), regardless of the parent’s
actual share in equities of its controlled entities. Consequently, even though
the parent company is entitled to participate in less than 100% of economic
benefits generated by its non-wholly owned subsidiaries, it includes entire
© The Author(s) 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8_10
367
368
J. Welc
amounts of their profits, net assets and cash flows in its consolidated financial
statements.
However, in some circumstances analytical adjustments to published
consolidated accounting numbers may be done, in order to reflect the lessthan-full share of a given parent company in the economic benefits generated
by its non-wholly owned subsidiaries. This is possible (with some limitations) when separate financial statements of the parent and its subsidiaries are
available to a financial statement user. In such cases the reported numbers,
prepared under the principles of full consolidation, may be converted into
proportionally consolidated statements, by adjusting the reported data for
shares of non-controlling interests (further abbreviated as NCI) in the
subsidiaries’ equities. Such adjustments will be illustrated by real-life example
of Asseco Group, the Polish company listed on the Warsaw Stock Exchange
and one of the largest IT businesses in Europe.
Asseco Group consists of dozens of companies, headquartered and operating in various parts of the world. Most of them have significant noncontrolling interests and are not listed on any stock exchanges. However,
several of the Asseco’s subsidiaries are public, which means that their separate
financial statements are easily available. Adjustments of the Asseco’s consolidated financial numbers will be illustrated with the use of data of two of its
public subsidiaries: Formula Systems (1985) Ltd. and Sapiens International
Corporation N.V. Their names will be abbreviated as Formula and Sapiens,
respectively.
The parent company in Asseco Group (Asseco Poland S.A.) is headquartered in Poland and listed on the Warsaw Stock Exchange. Therefore, its
functional currency, in which it reports its consolidated financial results,
is Polish zloty (PLN). Formula Systems (1985) Ltd. is the Asseco’s direct
subsidiary, headquartered in Israel but listed on the NASDAQ market of the
New York Stock Exchange. Sapiens, in turn, is Formula’s direct subsidiary,
also headquartered in Israel and also listed on the NASDAQ. Consequently, Sapiens is indirectly controlled by Asseco. As listed companies, both
Asseco’s subsidiaries publish their annual reports, with USD as their reporting
currency. Equity relationships between these three firms, valid as at the end
of 2016, are depicted on Chart 10.1.
As may be seen, Asseco Poland S.A. claimed to control Formula Systems
(1985) Ltd., despite holding a minority (less than 50%) share in its shareholder’s equity. Table 10.13 (in the appendix) contains an extract from
notes to consolidated financial statements of Asseco Group for fiscal year
2016, explaining the arguments for treating the Asseco’s minority interest in
Formula as the controlling one. As may be read, a control of Asseco Poland
10 Techniques of Increasing Comparability …
369
Asseco Poland S.A.
Share in equity of 46,33%
(46,33% at the end of 2015)
Formula Systems (1985) Ltd.
Share in equity of 48,85%
(49,13% at the end of 2015)
Sapiens Interna onal Corpora on N.V.
Chart 10.1 Equity relationships between Asseco Poland S.A., Formula Systems (1985)
Ltd. and Sapiens International Corporation N.V. (as at the end of fiscal year 2016)
(Source Annual reports of Asseco Poland S.A., Formula Systems (1985) Ltd. and
Sapiens International Corporation N.V. for fiscal year 2016)
over Formula was stated on the ground of the shareholders’ agreement, in
which another minority shareholder (who also served as the Formula’s CEO)
granted to Asseco his authorization for the exercise of his voting rights. Effectively, at the end of both 2015 and 2016 Asseco was able to control Formula
despite holding less than 50% interest in its equity. It is worth noting, that
the authorization granted to Asseco, although irrevocable, was valid for twelve
months (which means that in case it is not extended in the future, Asseco
could have lost its control over Formula, even without any change in its share
in Formula’s equity). Evidently, maintenance of Asseco’s control over its direct
subsidiary was heavily vulnerable to a future state of affairs between Asseco
and Formula’s CEO (as one of Formula’s minority shareholders).
Factors used as arguments for treating Sapiens International Corporation
N.V. as the Formula’s direct subsidiary (and effectively as an entity indirectly
controlled by Asseco Poland) seem even more sensitive to future state of
affairs between the subsidiary’s shareholders. Table 10.14 (in the appendix)
contains an extract from notes to consolidated financial statements of Asseco
Group for fiscal year 2016, explaining the arguments for treating its minority
interest in Sapiens as the controlling one. According to those explanations,
the control of Formula over Sapiens (and indirectly the control of Asseco
over Sapiens) was concluded on the ground of observed past inactivity of
Sapiens’s shareholders, meant as their nonattendance at shareholder meetings.
As a result, at the end of 2016 Asseco claimed to enjoy a so-called de facto
control over Sapiens, despite owning less than 50% share in its equity (as well
as less than half of the total voting rights). It is clear that such a conclusion,
even though entirely allowed under IFRS, was based on an extrapolation of
the past inactivity of the subsidiary’s minority shareholders into the future.
370
J. Welc
Consequently, maintenance of the Asseco’s control over Sapiens was vulnerable to future behavior of the subsidiary’s shareholders (which was rather out
of the Asseco’s control).
To sum up, at the end of fiscal years 2015 and 2016 Asseco Poland claimed
to control Formula Systems, despite holding less than 50% of its shares, by
means of the voting agreement between Asseco and one of the other Formula’s
shareholders. Formula, in turn, was claimed to enjoy the de facto control
over Sapiens (despite holding a minority interest in its equity), owing to
the alleged inactivity and dispersion of its other shareholders. Consequently,
Asseco Poland was concluded to have control over both Formula Systems and
Sapiens International.
All this means that in its consolidated financial statements for fiscal years
2015 and 2016, Asseco Poland included full amounts of individual line items
of financial statements of both of its subsidiaries (according to principles of
the full consolidation under IFRS), despite being entitled to the following
shares in economic benefits generated by those firms:
• Formula Systems: 46,33% in both 2015 and 2016,
• Sapiens International: 22,76% [= 46,33% × 49,13%] in 2015 and
22,63% [= 46,33% × 48,85%] in 2016.
It is worth noting that the Asseco’s effective share in the economic benefits generated by Sapiens International was less than 23% in both 2015
and 2016. However, according to the IFRS, Asseco was required to consolidate the full amounts of its subsidiary’s revenues, expenses, assets, liabilities
and cash flows. Obviously, if only scope of operations of Sapiens International (as well as Formula Systems) implied their significant contributions
to the consolidated results of the whole Asseco Group, it would entail en
erosion of reliability and comparability of those consolidated numbers. In
such a circumstance it is legitimate to adjust the reported numbers, as if the
proportional consolidation method is applied.
Selected numbers extracted from consolidated financial statements of all
three companies are presented in Table 10.15 (in the appendix). However,
Formula and Sapiens report their results in USD, while Asseco Poland’s
functional currency is PLN. This means that on consolidation the results
of both subsidiaries are first converted from USD to PLN, and only then
added to the results of other entities included in Asseco Group. Consequently, before making any analytical adjustments, we have to first convert
the reported numbers, as presented in Table 10.15, into PLN-denominated
ones. Such conversion will be done with the use of currency rates presented
10 Techniques of Increasing Comparability …
371
in Table 10.16 (in the appendix). The converted (PLN-denominated) results
are shown in Table 10.1.
As may be seen, a significant share of non-controlling interests (NCI)
in equities of Asseco’s subsidiaries is reflected in a high share of NCI in
the company’s consolidated earnings and equity. Likewise, minority share of
Formula Systems in the equity of Sapiens is reflected in a high share of NCI
in Formula’s consolidated earnings and equity. In contrast, results of Sapiens
are not distorted by any material non-controlling interests.
Table 10.1 Selected accounting numbers extracted from consolidated financial
statements of Asseco Group, Formula Systems (1985) Ltd. and Sapiens International
Corporation N.V. for fiscal years 2015 and 2016 (as presented in Table 10.15), after
their conversion from USD to PLN
*Data converted from USD to PLN, based on currency rates presented in Table 10.16
(in the appendix)
**Operating profit + Depreciation and amortization
***Non-controlling interests
Source Annual reports of Asseco Poland S.A., Formula Systems (1985) Ltd. and Sapiens
International Corporation N.V. for fiscal year 2016 and authorial computations
372
J. Welc
The next step in our analysis is to adjust the selected consolidated numbers
reported by Asseco Group for the NCI’s shares in financial results reported
by its controlled entities. In other words, the fully consolidated numbers
will be transformed, so that only actual shares of Asseco Poland in the
economic benefits generated by its non-wholly owned subsidiaries are taken
into account. The adjustments will cover those financial statement items,
which are needed to compute the following financial risk metrics:
• Coverage of total liabilities by EBITDA (i.e. EBITDA divided by total
liabilities),
• Total indebtedness ratio (i.e. total liabilities divided by total assets),
• Current liquidity ratio (i.e. current assets divided by current liabilities).
In the final step of our analysis the ratios listed above will be used to evaluate a scope of a distorting impact of non-controlling interests on usefulness
and reliability of these accounting-based metrics. However, before proceeding
to any adjustments, a very important distinction between consolidated earnings, assets and liabilities must be recalled. Liabilities owed by subsidiaries are
payable in full (regardless of a parent’s share in its subsidiary’s equity), while
only that portion of the non-wholly owned subsidiary’s assets and profits may
be considered attributable to the parent (as one of the subsidiary’s shareholders), which is proportional to its share in the subsidiary’s equity (and
which on liquidation would be left available to all subsidiary’s shareholders
after all the subsidiary’s creditors are satisfied). In other words, from a parent’s
perspective a full amount of its subsidiary’s liabilities should be treated as
the parent’s debts, in a sense that they must be repaid first in case of the
subsidiary’s liquidation (before any transfers to shareholders are done), while
less-than-full amounts of subsidiary’s assets and profits (i.e. only amounts
which correspond to the parent’s share in the subsidiary’s equity) may be
treated as the parent’s ones. Consequently, adjustments for non-controlling
interests must be done to reported consolidated assets and profits, while
reported consolidated liabilities should be left intact.
When adjusting the reported consolidated numbers for non-controlling
interests, a bottom-up approach must be applied. Results of subsidiaries
on the lowest level within a group structure must be revised first. Then,
the adjusted numbers of those low-level subsidiaries are used to restate the
numbers reported by higher level controlled entities. Finally, consolidated
data of the parent company itself are to be corrected. This means that in
the Asseco’s case we need to first adjust the consolidated numbers reported
by Formula Systems (for its less-than-full share in Sapien’s equity), and only
10 Techniques of Increasing Comparability …
373
then the consolidated numbers of the whole Asseco Group may be revised
(on the ground of the Formula’s adjusted data).
Table 10.2 presents adjustments of selected consolidated numbers of
Formula Systems (converted from USD to PLN, as shown in Table 10.1), for
the NCI’s share in the equity of Sapiens International. Table 10.3, in turn,
presents revisions of consolidated data reported by Asseco Group, for the
NCI’s shares in equities of Formula Systems and Sapiens International. The
percentages applied in the last columns of both tables reflect the NCI’s shares
in the shareholders’ equity of Sapiens International and Formula Systems.
As may be seen in Table 10.3, the Asseco’s consolidated EBITDA,
corrected for the NCI’s shares in equities of its subsidiaries, appears to be
lower by 18–20% than the company’s raw (reported) consolidated EBITDA.
The effects of the adjustments are even more material in the case of consolidated current assets, whose revised amounts are lower than the reported ones
by about 26–30%.
Finally, Table 10.4 presents values of three financial risk metrics, computed
for Asseco Group, on the ground of its raw (reported) and revised consolidated numbers. As may be seen, in case of all three investigated ratios there
are noticeable differences between their raw and adjusted values. Ratios based
on the reported numbers suggested that the company enjoyed a rather safe
coverage of its debts by EBITDA (slightly above a threshold of 25%), low
indebtedness (below 35%) and high liquidity (much above its safety threshold
of 1,20). However, after correcting all three ratios for non-controlling interests, a less favorable picture emerges, with the debt coverage below 25% and
the current liquidity only marginally above its assumed threshold of 1,20.
It must be noted that the adjustment techniques demonstrated in this
section have some severe limitations (similarly as most other methods
presented in this book). First of all, while profits or losses from any transactions between a parent and its subsidiaries are eliminated from the former’s
consolidated financial statements (these are so-called consolidation adjustments for intragroup transactions), their effects are not removed from
the subsidiaries’ financial statements (except for the effects of transactions
between a given subsidiary and its own subsidiaries). This is because from
the subsidiary’s perspective they constitute “outside” transactions, i.e. deals
with entities which are not part of that particular subsidiary’s own group of
companies. Consequently, if transactions between a parent company and its
non-wholly owned subsidiaries are material in amounts, the analytical adjustments presented in this section may be severely distorted by profits or losses
resulting from such intragroup transactions (and may not be accurate).
374
J. Welc
Table 10.2 Adjustments of selected accounting numbers (converted from USD to
PLN) reported by Formula Systems, for non-controlling interests in the equity of
Sapiens International (with the NCI’s share in Sapiens’ equity of 50,87% and 51,15%
in 2015 and 2016, respectively)
*Data reported by Sapiens (after their conversion from USD to PLN) are presented in
Table 10.1
Source Annual reports of Asseco Poland S.A., Formula Systems (1985) Ltd. and Sapiens
International Corporation N.V. for fiscal year 2016 and authorial computations
10 Techniques of Increasing Comparability …
375
Table 10.3 Adjustments of selected accounting numbers of Asseco Group, for noncontrolling interests in the equity of Formula Systems (with the NCI’s share in
Formula’s equity of 53,67% in both fiscal years 2015 and 2016)
Data from
consolidated
statements of Asseco
Group
Income
statement
data
EBITDA
Current
assets
Reported data (in
PLN million)
2015
1.007,7
4.257,1
2016
1.069,5
4.331,8
Data adjusted for
NCI (in PLN Way of calculation
million)* of data adjusted
for NCI*
2015
2016
826,5
2016: = [reported
profit of 1.069,5 −
(53,67%
Formula’s adjusted
EBITDA of 406,6]
851,3
2015: = [reported
profit of 1.007,7 −
(53,67%
Formula’s adjusted
EBITDA of 337,7]
3.128,6
2016: = [reported
assets of 4.331,8 −
(53,67%
Formula’s adjusted
current assets of
2.391,4]
3.048,3
2015: = [reported
assets of 4.257,1 −
(53,67%
Formula’s adjusted
current assets of
2.102,6]
Balance
sheet
data
Total
assets
12.057,5
12.791,2
9.770,8
10.040,4
Current
liabilities
2.384,6
2.495,9
2.384,6
2.495,9
Total
liabilities
3.729,6
4.120,6
3.729,6
2016: = [reported
assets of 12.791,2
− (53,67%
Formula’s adjusted
total assets of
5.125,4]
2015: = [reported
assets of 12.057,5
− (53,67%
Formula’s adjusted
total assets of
4.260,6]
Numbers stay
intact (since the
subsidiary’s
liabilities are
payable in their full
4.120,6 amounts,
regardless of the
NCI’s share in its
equity)
*Data of Formula Systems, adjusted for the NCI’s share in the equity of Sapiens
International, are presented in Table 10.2
Source Annual reports of Asseco Poland S.A., Formula Systems (1985) Ltd. and Sapiens
International Corporation N.V. for fiscal year 2016 and authorial computations
376
J. Welc
Table 10.4 Selected financial risk ratios of Asseco Group in fiscal years 2015 and
2016, computed on the basis of the company’s reported and adjusted consolidated
accounting numbers*
Ratio
Coverage of total
liabilities by EBITDA
(EBITDA/total liabilities)
Total indebtedness (total
liabilities/total assets)
Current liquidity (current
assets/current liabilities)
Ratios based on reported
numbers
Ratios based on adjusted
numbers*
2015
2016
2015
2016
27,0%
26,0%
22,2%
20,7%
=
1.007,7/3.72
9,6
=
1.069,5/4.12
0,6
=
826,5/3.729,
6
=
851,3/4.120,
6
30,9%
32,2%
38,2%
41,0%
=
3.729,6/12.0
57,5
=
4.120,6/12.7
91,2
=
3.729,6/9.77
0,8
=
4.120,6/10.0
40,4
1,79
1,74
1,31
1,22
=
4.257,1/2.38
4,6
=
4.331,8/2.49
5,9
=
3.128,6/2.38
4,6
=
3.048,3/2.49
5,9
*After adjusting reported consolidated EBITDA, total assets and current assets for the
shares of non-controlling interests in equities of the Asseco’s subsidiaries (Formula
Systems and Sapiens International)
Source Annual reports of Asseco Poland S.A., Formula Systems (1985) Ltd. and Sapiens
International Corporation N.V. for fiscal year 2016 and authorial computations
10.3 Adjustments for Long-Term Contracts
Accounted for with the Use
of the Percentage-of-Completion Method
10.3.1 Complexities of Accounting for Long-Term
Contracts
Long-term contracts (e.g. for construction, shipbuilding, customized heavy
machinery, etc.) pose special challenges to accounting. Because of the time
needed to complete them, deferring recognition of revenue and profit until a
completion of a given contract would result in an income statement reflecting
not a fair view of an activity of a company during the period, but rather the
results relating to contracts which have been completed by the end of that
period (Lewis and Pendrill 2004). Therefore, the percentage-of-completion
method is applied in case of most long-term contracts.
The percentage-of-completion method permits a company to recognize
revenue in proportion to the amount of work completed, rather than in line
with its billings (Fridson and Alvarez 2002). The most commonly applied
10 Techniques of Increasing Comparability …
377
approach is to record part of the estimated total profit based on the ratio of
costs incurred to date to the expected total contract costs (Subramanyam and
Wild 2009). Therefore, as was shown in Sect. 3.3.4 of Chapter 3, even though
the percentage-of-completion method may have been well-intentioned (on
the ground of a matching principle of accounting), it may cause undesirable
consequences, since it relies on often subjective (and prone to manipulations)
estimates of future costs and future events (Schilit 2002). Consequently,
this accounting method may overstate revenue and profits if expenditures
made are recognized before they contribute to completed work, e.g. when
the costs of raw materials or advance payments to subcontractors are taken
into account in a determination of work completed (White et al. 2003).
While long-term contracts frequently provide that the seller may bill the
purchaser at pre-specified intervals (e.g. when some project milestones are
reached), under the percentage-of-completion method companies recognize
revenues and gross profits based on the progress of the construction, accumulating the construction costs plus gross profit earned to date in an asset
account (e.g. inventory or receivables, depending on an accounting policy
applied by a given form), while the progress billings in a contra asset account
(Kieso et al. 2010).
Accordingly, a balance sheet presentation of long-term contracts shows as
an asset, labelled as e.g. “Contract assets” or “Amounts due from customers” or
similarly, the net amount of:
• total costs incurred to date,
• plus attributable profits (or less foreseeable losses),
• less any progress billings to the customer,
while for any contracts in which case the above amount is negative, it is
shown as a liability, labeled as e.g. “Contract liabilities” or “Amounts due to
customers” or similarly (Elliott and Elliott 2011).
An application of the percentage-of-completion method is illustrated in
Example 10.1.
10.3.2 Possible Profit Overstatements Caused
by Unprofitable Long-Term Contracts
As was explained in Sect. 3.3.4 of Chapter 3, unprofitable long-term
contracts, when accounted for inappropriately, may bring about serious
overstatements of reported earnings. This is particularly dangerous when a
company faces unexpected cost overruns, with no or limited possibility of
378
J. Welc
Example 10.1
Application of the percentage-of-completion method
At the end of 2018 a construction company entered a contract with its customer, for
building a nuclear power plant. The contracted revenue amounts to 12.000 EUR million,
while the expected total contract costs amount to 10.000 EUR million. The total construction
work is expected to take four years (and is going to begin in 2019).
During the four years of the contract work its costs looked as follows:
Amounts in EUR million
(1) Contract costs incurred to date
(2) Expected future costs to be incurred
(3) Expected total costs of the contract
2019
1.000
9.000
10.000
2020
4.000
6.000
10.000
2021
9.000
1.000
10.000
2022
10.000
–
10.000
Percentage-of-completion [= (1)/(3)]
10,0%
40,0%
90,0%
100,0%
With the contract’s percentage-of-completion, estimated above, the company’s income
statement would look as follows:
Amounts in EUR million
Cumulative contract revenue
2019
2020
2021
2022
1.200
= 10,0%
4.800
= 40,0%
10.800
= 90,0%
12.000
= 100,0%
12.000
12.000
12.000
12.000
Revenue recognized in a period
1.200
3.600
6.000
1.200
Contract costs incurred to date
1.000
4.000
9.000
10.000
Contract costs recognized in a period
1.000
3.000
5.000
1.000
200
600
1.000
200
Gross profit recognized on the contract
The above pattern of a revenue and profit recognition (based on the percentage-ofcompletion method) usually does not coincide with the pattern of customer invoicing
(billing). Suppose that during the work on the contract the company invoiced its customer as
follows:
Amounts in EUR million
Contract revenues billed in a period
Contract revenues billed to date
2019
1.500
1.500
2020
3.000
4.500
2021
4.000
8.500
2022
3.500
12.000
Combining the percentage-of-completion method with the customer invoicing (billing)
results in the following amounts being recognized in the company’s balance sheet:
Amounts in EUR million
2019
2020
2021
2022
Contract costs incurred to date
1.000
4.000
9.000
10.000
Cumulative gross profit recognized
200
800
1.800
2.000
Cumulative contract revenue recognized
1.200
4.800
10.800
12.000
Contract revenues billed to date
1.500
4.500
8.500
12.000
0
300
2.300
0
−300
0
0
0
Contract assets*
Contract liabilities**
*Recognized when cumulative contract revenue recognized with the percentage-ofcompletion method exceeds cumulative amounts Invoiced (billed)
**Recognized when cumulative billings exceed cumulative contract revenue
recognized
Source Author
10 Techniques of Increasing Comparability …
379
passing its inflated expenses on to its customer. Although accounting standards require recognizing losses on long-term contracts immediately when
they become probable, dishonest managers may temporarily inflate reported
profits before completion of a given contract’s work. It is not uncommon that
only at the very end of a given contract the losses incurred on it are reported
in income statement (which is often too late to avoid a company’s insolvency).
Example 10.2 illustrates an impact of such an aggressive application of the
percentage-of-completion method on reported financial results.
As illustrated by Example 10.2 (as well as by the example discussed in
Sect. 3.3.4 of Chapter 3), such an aggressive application of the percentage-ofcompletion method for unprofitable long-term contracts results in significant
profit overstatements, followed by a collapse of the company’s earnings.
However, as will be demonstrated in the remaining part of this section, it is
often signalled beforehand, by a rising discrepancy between a given company’s
reported earnings and its profits adjusted for the percentage-of-completion
method (hereafter termed as “invoiced earnings”).
10.3.3 Adjusting Reported Earnings for Contract Assets
and Liabilities
As was shown in Sect. 7.4 of Chapter 7, an unbalanced growth (i.e.
significantly faster than sales) of carrying amount of unbilled receivables
constitutes one of the indicators of a deteriorating earnings quality of businesses engaged in long-term contracts (accounted for with the use of the
percentage-of-completion method). However, that simple approach to evaluating sustainability of corporate earnings focused on a single side of a balance
sheet only (i.e. unbilled receivables), completely ignoring its opposite side
(liabilities), which also includes some items related to long-term contracts.
Therefore, in this part of the chapter an alternative and more detailed analytical approach will be presented, based on an estimation of a given company’s
“invoiced earnings”.
The “invoiced earnings” may be estimated for any reporting period, on the
ground of a given company’s income statement, balance sheet and selected
notes to financial statements, and with the use of the following analytical
procedure:
• STEP 1: Compute a company’s net contract assets/liabilities balance, as
a difference between its contract assets (unbilled receivables) and contract
liabilities (amounts which represent excesses of billings over contract costs),
as at the beginning and the end of an investigated reporting period.
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Example 10.2 An aggressive application of the percentage-of-completion method
for an unprofitable long-term contract
At the end of 2018 a construcon company entered a contract with its customer, for
building a nuclear power plant. The contracted revenue amounted to 12.000 EUR million,
while the inially expected total contract costs amounted to 10.000 EUR million. The total
construcon work took four years (and began in 2019).
In the third year of its work on the contract the company suffered from significant cost
overruns, which boosted the total contract costs to 13.000 EUR million (with a resulng loss
on the contract, amounng to 1.000 EUR million). However, in spite of it, in 2021 the
company did not update its contract cost budget (from 10.000 EUR million to 13.000 EUR
million), deferring a recognion of the loss unl the compleon of the contract (in 2022).
The total contract costs looked as follows:
Amounts in EUR million
(1) Contract costs incurred to date
(2) Expected future costs to be incurred*
(3) Expected total costs of the contract
2019
1.000
9.000
10.000
2020
4.000
6.000
10.000
2021
9.000
1.000
10.000
2022
13.000
–
13.000
Percentage-of-compleon [= (1)/(3)]
10,0%
40,0%
90,0%
100,0%
*Without updating them upwards in 2021, for the cost overrun amounting to 3.000
EUR million
With the contract’s percentage-of-compleon, esmated above, the company’s income
statement looked as follows:
Amounts in EUR million
Cumulave contract revenue
2019
2020
1.200
= 10,0%
4.800
= 40,0%
2021
2022
10.800
= 90,0%
12.000
12.000
= 100,0%
12.000
12.000
12.000
Revenue recognized in a period
1.200
3.600
6.000
1.200
Contract costs incurred to date
1.000
4.000
9.000
13.000
Contract costs recognized in a period
1.000
3.000
5.000
4.000
200
600
1.000
−2.800
Gross profit recognized on the contract
As may be seen, the total loss on the contract amounted to 1.000 EUR million [= 200 + 600 +
1.000−2.800]. However, due to its aggressive approach to the percentage-of-compleon
method, the company overstated its earnings reported for 2021 (by delaying a recognion
of its cost overrun), with the following deep loss reported for 2022.
Suppose that during the work on the contract the company invoiced its customer as follows
(with the same ming and amounts as in Example 10.1):
Amounts in EUR million
Contract revenues billed in the period
Contract revenues billed to date
2019
1.500
1.500
2020
3.000
4.500
2021
4.000
8.500
2022
3.500
12.000
Combining the percentage-of-compleon method with the customer invoicing (billing)
results in the following amounts being recognized in the company’s balance sheet:
Amounts in EUR million
2019
2020
2021
2022
Contract costs incurred to date
1.000
4.000
9.000
13.000
200
800
1.800
−1.000
Cumulave contract revenue recognized
1.200
4.800
10.800
12.000
Contract revenues billed to date
1.500
4.500
8.500
12.000
0
300
2.300
0
−300
0
0
0
Cumulave gross profit recognized
Contract assets*
Contract liabilies**
*Recognized when cumulative contract revenue recognized with the percentage-ofcompletion method exceeds cumulative amounts Invoiced (billed)
**Recognized when cumulative billings exceed cumulative contract revenue
recognized
Source Author
10 Techniques of Increasing Comparability …
381
• STEP 2: Compute a change of the net contract assets/liabilities, between
the beginning and the end of the investigated reporting period.
• STEP 3: Subtract the amount computed in STEP 2 from the company’s
reported earnings (gross profit or operating income or pre-tax earnings), to
obtain the estimate of its “invoiced earnings”.
Such an approach effectively eliminates effects of the percentage-ofcompletion method from a given company’s income statement. In other
words, the “invoiced earnings” constitute a difference between corporate
revenues invoiced in a period (i.e. total revenues without the unbilled ones)
and its contract costs incurred in that period. This is shown in Example 10.3,
which is a continuation of Example 10.2.
As may be seen, in 2019 the examined hypothetical company invoiced
its contract customer for 1.500 EUR million, incurring at the same time
the contract costs amounting to 1.000 EUR million. Accordingly, its excess
of billed revenues over incurred expenses (i.e. the “invoiced earnings”)
amounted to 500 EUR million. However, as was shown in Example 10.2,
under the percentage-of-completion method the revenues recognized for
the same period amounted to 1.200 EUR million, resulting in a reported
accounting profit of 200 EUR million (i.e. 300 EUR million less than
the “invoiced earnings”). In contrast, in 2021, when the company suffered
from the cost overrun, its contract costs incurred amounted to 5.000 EUR
million, while its customer was invoiced for 4.000 EUR million. Consequently, in 2021 the company incurred the “invoiced loss” of 1.000 EUR
million. However, under the percentage-of-completion method (misapplied
here, since the company aggressively overstated its estimate of the stage of
completion and avoided recording the contract loss) the company reported
the accounting profit amounting to 1.000 EUR million. As a result, in 2021
a positive difference between reported income and “invoiced earnings” (or
rather “invoiced loss”) amounted to 2.000 EUR million.
Before exemplifying the usefulness of the “invoiced earnings” in a financial
statement analysis, it is important to emphasize that this item is not reported
anywhere in corporate financial reports. However, it can be estimated with
the use of the three-step procedure described above, on the ground of income
statement, balance sheet and note disclosures. An application of this procedure, based on fictitious data presented in Example 10.2, is presented in
the lower part of Example 10.3. As may be seen, starting with earnings
reported in the income statement (e.g. gross profit or operating income or
pre-tax earnings), and adjusting them for period-to-period changes in net
contract assets/liabilities (which, in turn, may be extracted either from the
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J. Welc
Example 10.3 “Invoiced earnings” and their estimation with the use of financial
statement disclosures (based on data presented in Example 10.2)
Suppose that the hypothetical company, discussed in Example 10.2, recognizes its contract
revenues only when billed (invoiced), while expensing all contract expenditures when
incurred. With such an accounting policy its income statement would look as follows:
Amounts in EUR million
Contract revenues billed in the period
Contract costs recognized in the period
“Invoiced earnings” in the period
2019
1.500
1.000
2020
3.000
3.000
2021
4.000
5.000
2022
3.500
4.000
500
0
−1.000
−500
As may be seen, with such an approach the company would report a gross profit amounting
to 500 EUR million in 2019 (when its billed revenues of 1.500 EUR million exceeded its
incurred contract costs of 1.000 EUR million), followed by a zero profit in 2020 and by
significant losses (totaling 1.500 EUR million) reported in the last two years. In the first two
periods the cumulative “invoiced earnings” of 500 EUR million are lower than the
cumulative 800 EUR million [= 200 + 600] of profits reported under the percentage-ofcompletion method, but this difference would not be alarming. However, in 2021 the
increasing reported profit under the percentage-of-completion method (growing from 600
EUR million to 1.000 EUR million) contrasts stunningly with the deeply negative “invoiced
earnings” (i.e. the loss of 1.000 EUR million). Accordingly, a comparison of the company’s
reported profit and “invoiced earnings” would generate a significant warning signal in 2021.
Although the “invoiced earnings” are not disclosed in corporate reports, they may be
estimated, based on a given firm’s data from income statement, balance sheet and notes to
financial statements. In the case of the hypothetical company discussed here this
computation would look as follows:
Amounts in EUR million
2019
2020
2021
2022
(1) Reported earnings*
200
600
1.000
−2.800
0
−300
−300
300
0
300
2.300
0
2.300
0
0
0
−300
= −300
–0
600
= 300
− (−300)
2.000
= 2.300
− 300
−2.300
− 2.300
500
= 200
−(−300)
0
= 600
− 600
−1.000
= 1.000
− 2.000
−500
= −2.800
− (−2.300)
(2) Contract assets**
(3) Contract liabilities**
(4) Net contract assets/liabilities [= (2) − (3)]
(5) Change in net contract assets/liabilities***
(6) Invoiced (adjusted) earnings [= (1) − (5)]
=0
*Based on the percentage-of-completion method
**Disclosed either on a face of balance sheet or in notes
***With a zero opening value at the beginning of 2019
Source Author
balance sheet or from respective notes), results in obtaining an estimate of
the “invoiced earnings”. For the hypothetical company examined here, these
estimates perfectly reconcile with its true “invoiced earnings”, as displayed in
the upper part of Example 10.3.
Analytical usefulness of the “invoiced earnings” lies in their signaling capabilities as regards a reliability of a reported accounting income (based on the
10 Techniques of Increasing Comparability …
383
percentage-of-completion method). If a positive difference between the latter
and the former rises conspicuously from period-to-period (particularly when
fast-growing reported profits are accompanied by falling and already negative
“invoiced earnings”), an increased dose of skepticism is advisable in relation
to the reported earnings.
As may be observed in the lower part of Example 10.3, in the case of the
investigated aggressive company the difference between its reported profits
and invoiced (adjusted) earnings turned from minus 300 EUR million in
2019 [= 200 EUR million − 500 EUR million], to the positive amount
of 600 EUR million in the following year [= 600 EUR million − 0 EUR
million] and as much as 2.000 EUR million in 2021 [= 1.000 EUR million
− (−1.000 EUR million)]. Additionally, in 2021, which is a period of material cost overrun incorrectly accounted for with the percentage-of-completion
method, the company’s reported income grew by two thirds (i.e. from 600
EUR million to 1.000 EUR million), while at the same time its “invoiced
earnings” plummeted, from zero to the loss of 1.000 EUR million. Such
divergence constitutes a strong “red flag”, whose relevance is confirmed here
by the deep accounting loss (amounting to 2.800 EUR million) reported
for 2022. In the following sub-section the usefulness of this warning signal
will be exemplified further, based on real-life data of two now-bankrupt
construction companies.
However, one caveat should be mentioned here, regarding an interpretation of the estimated “invoiced earnings”. Namely, it must be kept in mind
that they do not constitute a proxy for actual accounting earnings which
would be reported under a completed contract method, in which case revenue
and profit is deferred until the very end of a given contract (instead of being
recognized based on billed revenues and incurred expenses). Instead, the
“invoiced earnings” measure hypothetical profits (or losses) which would be
reported if a firm applied very simplistic accounting principles, under which
all contract revenues are recognized when billed, while all contract costs are
expensed as incurred.
10.3.4 Real-Life Examples of Warnings Signals
Generated by “Invoiced Earnings”
In this subsection the real-life case studies of two construction businesses,
namely Astaldi Group and Carillion plc, will be presented. The former was
the Italian firm which operated internationally and filed for bankruptcy in
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late 2018. The latter, in turn, was the British contractor that collapsed financially in late 2017. Both have been already discussed and investigated in
earlier chapters of this book.
10.3.4.1 Astaldi Group
Astaldi Group collapsed financially in 2018. Therefore, a following discussion
and analysis will be based on its financial statements published until 2017. As
may be read in the upper part of Table 10.17 (in the appendix), consistently
with most other firms operating in its industry the company reported its
construction contracts based on its estimates of the stage of completion of the
contract activity (i.e. with the use of the percentage-of-completion method).
Astaldi Group stated also that it recognized any losses on the contracts
entirely in the year in which the loss became “reasonably foreseeable”. Further
in those extracts it may be read that the Astaldi’s construction contracts, in
which case the work in progress exceeded the amounts of progress billings,
were reported as assets under “Amounts due from customers”. In contrast, any
contracts featured by the excess of billings and advance payments over the
contract work in progress were treated as liabilities, labeled as “Amounts due
to customers”. Accordingly, the former represented the amounts of contract
assets (unbilled receivables), while the latter reflected the company’s contract
liabilities.
The left part of Table 10.5 presents the Astaldi Group’s profit before taxation (as reported in its income statement), as well as its amounts due from
and to customers (as reported on the face of the company’s balance sheet),
for fiscal years 2011–2017. As may be seen, between 2011 and 2016 the
company’s annual pre-tax earnings seemed relatively stable (hovering within a
range between 111,5 EUR million and 130,7 EUR million), and only it 2017
they collapsed to a loss of 115,8 EUR million. Since such a deep and sudden
accounting loss (following a string of consistently stable profits) constitutes a
strong warning signal itself, the following discussion and analysis will focus
on data for the preceding years (i.e. 2011–2016), i.e. when the company was
allegedly profitable.
The right part of Table 10.5 contains an estimation of the Astaldi
Group’s “invoiced earnings” (i.e. adjusted pre-tax earnings). A comparison
of the numbers shown in the second and the last column of the table (i.e.
profit before taxation and adjusted pre-tax earnings) leads to the following
conclusions:
10 Techniques of Increasing Comparability …
385
Table 10.5 Reported profits, contract assets (“Amounts due from customers”),
contract liabilities (“Amounts due to customers”) and “invoiced earnings” of Astaldi
Group in fiscal years 2011–2017 (data in EUR million)
*Label used by Astaldi Group for its contract assets (unbilled receivables)
**Label used by Astaldi Group for its contract liabilities (excess of billings over
contract costs)
***= Amounts due from customers − Amounts due to customers
****= Profit before taxation − Change in net contract assets/liabilities
Source Annual reports of Astaldi Group for fiscal years 2012–2017 and authorial
computations
• Between 2012 and 2014 the company’s very stable reported profits before
taxation (within a very narrow range around 130,0 EUR million) were
accompanied by steadily rising “invoiced earnings”, which grew from 89,5
EUR million in 2012 to 140,4 EUR million (107,4% of the reported
profit) in 2014.
• In the following year these patterns suddenly broke out, since a moderate
contraction of the company’s reported pre-tax income, by 14,7% y/y (i.e.
from 130,7 EUR million to 111,5 EUR million), was accompanied by a
collapse of its “invoiced earnings”, which fell from a positive value of 140,4
EUR million to a loss amounting to 144,6 EUR million.
• A huge divergence between the reported and adjusted earnings was
repeated in 2016, when a seeming improvement in the company’s profit
before taxation (i.e. its increase from 111,5 EUR million to 129,1 EUR
million) contrasted with the “invoiced loss”, amounting to over 100,0 EUR
million.
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J. Welc
• Finally, in 2017 the company reported a pre-tax loss, amounting to 115,8
EUR million, which was still accompanied by a much deeper adjusted loss
of almost 240,0 EUR million.
Accordingly, a strong warning signal, suggesting a poor and deteriorating
quality of the Astaldi Group’s reported earnings, was generated as early as
in 2015, when the company’s positive pre-tax profit deviated sharply from
its “invoiced earnings”. Similarly adverse relationship between these two
items was observed in the next fiscal year. Therefore, it may be concluded
that the Astaldi Group’s “invoiced earnings” (and their very material deviations from reported profits) constituted a reliable leading indicator of the
company’s upcoming deep losses reported for fiscal year 2017, followed by
its bankruptcy filling in 2018.
Finally, Table 10.18 (in the appendix) seems to corroborate the usefulness of the “invoiced earnings” as a leading indicator, by comparing them to
the Astaldi Group’s reported operating cash flows, in four fiscal years prior
to the company’s default. As may be seen, although in 2015 (when Astaldi
Group reported only a moderate erosion of its profit before taxation) the
company’s operating cash flows fell by as much as 55,5% y/y (i.e. from 273,4
EUR million to 121,5 EUR million), their contraction was not as dramatic
and striking, as in the case of the “invoiced earnings” (which collapsed from
a positive value of 140,4 EUR million to a loss amounting to 144,6 EUR
million).
10.3.4.2 Carillion Plc
Carillion plc defaulted in late 2017. As may be read in the upper part of
Table 10.19 (in the appendix), its revenues and costs were recognized “by
reference to the degree of completion of each contract, as measured by the proportion of total costs at the balance sheet date to the estimated total cost of the
contract ” (if only the outcome of a given construction contract could have
been estimated reliably). Contracts, in which case “costs incurred plus recognized profits less recognized losses” exceeded progress billings, were reported
“as amounts owed by customers on construction contracts within trade and other
receivables”. In contrast, contracts for which “progress billings exceed costs
incurred plus recognized profits less recognized losses”, were included in trade
and other payables (and labeled as “amounts owed to customers on construction
contracts”).
The left part of Table 10.6 presents the Carillion’s annual profits before
taxation (as reported in its income statement), its amounts owed by customers
10 Techniques of Increasing Comparability …
387
Table 10.6 Reported profits, contract assets (“Amounts owed by customers on
construction contracts”), contract liabilities (“Amounts owed to customers on
construction contracts”) and “invoiced earnings” of Carillion plc in fiscal years
2008–2016 (data in GBP million)
*Label used by Carillion plc for its contract assets (unbilled receivables)
**Label used by Carillion plc for its contract liabilities (excess of billings over contract
costs)
***= Amounts owed by customers on construction contracts − Amounts owed to
customers on construction contracts
****= Profit before taxation − Change in net contract assets/liabilities
Source Annual reports of Carillion plc for fiscal years 2009–2016 and authorial
computations
on construction contracts (included within the company’s trade and other
receivables) and the amounts owed to customers on construction contracts
(included within trade and other payables). As may be seen, in every period
within the whole investigated nine-year timeframe the Carillion’s reported
pre-tax earnings exceeded 100 GBP million, with over 140 GBP million
reported for each of the last three years. However, as was already shown
in Sect. 7.4 of Chapter 7, in several years prior to the company’s collapse
(particularly in 2016), its unbilled receivable accounts grew suspiciously fast.
Moreover, as clearly depicted in Table 10.6, between 2011 and 2016 the
company’s amounts owed to customers (i.e. progress billings and advance
payments) showed a distinctive and monotonically falling trend. Accordingly,
even these crude data disclosed in the company’s financial reports should have
cast doubt on sustainability of its reported earnings.
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J. Welc
The right part of Table 10.6 contains an estimation of the Carillion’s
“invoiced earnings”. A comparison of the numbers shown in the second and
the last column of the table leads to the following conclusions:
• In each of the seven years between 2009 and 2015 the company’s “invoiced
earnings” stood positive, even if only marginally on some occasions (in
2013).
• However, while between 2007 and 2011 the Carillion’s adjusted earnings
consistently exceeded its reported income, the relationship reversed afterwards, with the “invoiced earnings” lagging behind the pre-tax profit in
four out of five years between 2012 and 2016.
• A particularly alarming signal occurred in fiscal year 2016, when the Carillion’s reported pre-tax income contracted only moderately (i.e. from 155,1
GBP million to 146,7 GBP million), while concurrently its adjusted pretax earnings dived from their positive values, observed between 2009 and
2015, to a deep loss (amounting to 86,4 GBP million).
Chart 10.2 (in the appendix) displays divergences between Carillion’s
“invoiced earnings” and its reported profit before taxation (which by definition are the same as changes in net contract assets/liabilities, but with the
opposite sign), within the whole investigated eight-year timeframe. As may be
clearly seen, a visual inspection of these data should have immediately called
for an increased skepticism, as regards sustainability of the Carillion’s financial results (and the company itself ), reported for its fiscal year 2016. While
in the preceding eight years the deviations of the “invoice earnings” from the
reported numbers fell within a range between −110,5 GBP million and +
96,1 GBP million, in 2016 the gap suddenly widened to a whopping 233,1
GBP million.
Finally, similarly as in the case of Astaldi Group, Table 10.20 (in the
appendix) seems to confirm the usefulness of the “invoiced earnings” as a
leading indicator of the upcoming financial troubles. As may be seen, while
the Carillion’s operating cash flows shrank systematically between 2014 and
2016, their erosion in the last fiscal year before the company’s default was
not as spectacular as in the case of the “invoiced earnings”. While in 2016 a
contraction of the Carillion’s pre-tax earnings by 5,4% y/y (i.e. from 155,1
GBP million to 146,7 GBP million) was accompanied by a decrease in its
operating cash flows by 4,0% y/y (i.e. from 120,3 GBP million to 115,5 GBP
million), the company’s income adjusted for its contract assets and contract
liabilities plummeted much more alarmingly.
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389
10.4 Increasing Comparability and Reliability
of Financial Statement Numbers
with the Use of Data on Current
and Deferred Income Taxes
10.4.1 Accounting (Book) Earnings vs. Taxable Income
Corporate income tax reported in an income statement includes two related
(but different in nature) items: current income tax and deferred income tax.
This is so because companies use different accounting principles for financial reporting (for which they apply e.g. International Financial Reporting
Standards or US GAAP) and for income tax purposes (for which firms apply
tax regulations effective in a given tax jurisdiction). Consequently, corporate
taxable income may materially deviate from profit before tax (also termed
as book earnings or accounting earnings) presented in the income statement. In other words, reported pre-tax earnings do not constitute a basis
for calculating and settling corporate income taxes. It may even happen that
a given company incurs a tax-loss, while reporting positive pre-tax earnings
(or, alternatively, it may incur a pre-tax loss while having positive taxable
income).
Discrepancies between taxable income and book earnings may be classified
as:
• either permanent differences,
• or temporary differences.
Temporary book-tax differences constitute a basis for estimating deferred
income tax, as shown in the income statement (which is a purely accounting
number and as such it has no any relation to actual income taxes paid).
However, book-tax differences (and resulting deferred taxes) appear not
only in a company’s income statement, but also in its balance sheet, where
deferred tax assets and deferred tax provisions (liabilities) are recognized.
Deferred tax assets typically contain the following broad tax-related
categories of assets:
• Expected future economic benefits stemming from prior temporary booktax differences, expected to reverse in the future.
• Expected future economic benefits related to tax-loss carry-forwards,
resulting from past tax losses, expected to be tax-deductible in the future.
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J. Welc
Many tax regulations allow past tax losses to be carried forward and to
be deducted from future taxable income (creating a kind of a future “tax
shield”). Such tax-loss carry-forwards may be either indefinite or valid for a
limited number of years. They create a deductible temporary difference and
may be considered an economic asset (reflecting expected economic benefits
from future “tax shields”). This is why such expected future tax savings may
be treated as deferred tax assets.
In contrast to deferred tax assets, deferred tax provisions (or deferred tax
liabilities) reflect future income taxes payable, resulting from past temporary
book-tax differences, expected to reverse in the future.
According to IFRS, deferred tax assets must be recognized for all
deductible temporary differences and the carry-forwards of tax-losses, but
only to the extent that it is probable that future taxable profits will be available, against which the temporary differences can be utilized. In assessing a
likelihood that tax-losses will be utilized, an entity should consider whether:
• future budgets indicate that there will be sufficient taxable income derived
in the foreseeable future,
• the losses arise from causes that are unlikely to recur in the foreseeable
future,
• actions can be taken to create taxable amounts in the future,
• there are existing contracts or sales backlogs that will produce taxable
amounts,
• there are new developments of favorable opportunities likely to give rise to
taxable amounts,
• there is a strong history of earnings other than those giving rise to the loss,
and the loss was an aberration and not a continuing condition.
IAS 12 (Income taxes) requires an entity to account for the tax consequences of transactions and other events in the same way that it accounts
for the transactions and other events themselves. For transactions and other
events recognized outside profit or loss (e.g. directly in equity), any related
tax effects are also recognized outside profit or loss. Thus, deferred tax assets
and liabilities may result from temporary differences already reflected in
an income statement (e.g. depreciation), but also from book-tax differences
which may impact earnings only in the future (e.g. from an upward revaluation of assets, credited directly to equity). Deferred tax assets and liabilities
can be offset only if a legally enforceable right to offset current amount exists.
10 Techniques of Increasing Comparability …
391
When statutory tax rates change, the recognized deferred tax assets and liabilities (also those recognized in prior periods) must be adjusted (updated) to
reflect the new expected tax rates.
The reporting for book-tax differences related to depreciation is illustrated
in Example 10.4.
While Example 10.4 illustrated the mechanics of accounting for deferred
tax provisions, reporting for book-tax differences which create deferred tax
assets is illustrated in Example 10.5.
Finally, Example 10.6 illustrates reporting for tax-loss carry-forwards.
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J. Welc
Example 10.4
Accounting for book-tax differences related to depreciation
A company purchased a fixed asset for 12.000 EUR at the end of 2006. Since the beginning of
2007 the asset is rented to another entity. The annual rental income amounts to 4.000 EUR.
The company prepares two separate financial reports:
• one for its shareholders and other stakeholders (e.g. creditors), under IFRS,
• one for income tax purposes.
For accounting purposes the company assumed six-year straight-line depreciation with zero
residual value. In contrast, for tax purposes it assumed four-year straight-line depreciation
(the shortest permitted by tax regulations) with zero residual value. The income tax rate
equals 19%.
The company’s revenues, depreciation, profits and taxes payable, in fiscal years 2007–2012,
look as follows:
Amounts in EUR
1) Revenues
2) Book depreciation (6 years)
3) Tax depreciation (4 years)
4) Pre-tax earnings [= (1) − (2)]
5) Taxable income [= (1) − (3)]
Current income tax (19% of
taxable income)
2007
4.000
2.000
3.000
2.000
1.000
2008
4.000
2.000
3.000
2.000
1.000
2009
4.000
2.000
3.000
2.000
1.000
2010
4.000
2.000
3.000
2.000
1.000
2011
4.000
2.000
0
2.000
4.000
2012
4.000
2.000
0
2.000
4.000
190
190
190
190
760
760
If the company reports current income tax only (with no any reflection of its
depreciation−related temporary book-tax differences in deferred income tax), then its
income statement would look as follows:
Amounts in EUR
(1) Revenues
(2) Pre-tax earnings
(3) Income tax (only current)
(4) Net earnings
Effective tax rate [= (3)/(2)]
2007
4.000
2.000
190
1.810
9,5%
2008
4.000
2.000
190
1.810
9,5%
2009
4.000
2.000
190
1.810
9,5%
2010
4.000
2.000
190
1.810
9,5%
2011
4.000
2.000
760
1.240
38,0%
2012
4.000
2.000
760
1.240
38,0%
As may be seen, in such circumstances the income tax reported (and paid) would suddenly
jump upwards (fourfold!) in fiscal year 2011, after the asset becomes fully depreciated for tax
purposes. It would entail a fall of previously stable net earnings, by almost one third (without
any change in the company’s economic environment). Clearly, such income tax reporting
would be misleading for financial statement users. Therefore, in order to reflect the future
increase of the effective tax burdens (beginning in 2011), in the preceding fiscal years (2007–
2010) the deferred tax provisions are recognized, as presented below.
As may be seen in the following tables (below), the book-tax differences resulting from
differing depreciation schedules (for accounting and tax purposes) accumulate until 2010 (i.e.
until the asset becomes fully depreciated for tax purposes), and afterwards they reverse
(until the asset becomes fully depreciated for accounting purposes, i.e. until the end of
2012). Such book-tax differences result in positive deferred taxed reported in income
statement in 2007–2010 (to reflect steadily accumulating provisions for future increased tax
(continued)
393
10 Techniques of Increasing Comparability …
Example 10.4 (continued)
payments) as well as accumulating deferred tax provisions reported in a balance sheet.
However, since 2011 onwards the taxable income exceeds the accounting profit (in contrast
to 2007–2010) and as a result the deferred taxes reported in the income statement become
negative. Accordingly, the previously accumulated deferred tax provisions begin to reverse.
Amounts in EUR
2007
2008
2009
2010
2011
2012
Pre-tax earnings minus taxable income
1.000
1.000
1.000
1.000
−2.000
−2.000
10.000
8.000
6.000
4.000
2.000
0
9.000
6.000
3.000
0
0
0
1.000
2.000
3.000
4.000
2.000
0
190
190
190
190
−380
−380
190
380
570
760
380
0
Book value of an asset
Tax value of an asset
Book-tax difference of the asset's
value
Deferred tax for the period
(income statement)
Deferred tax provision (balance sheet)
The company’s income statement, which includes both current and deferred income taxes,
looks as follows:
Amounts in EUR
(1) Revenues
(2) Pre-tax earnings
(3) Income tax, including:
Current income tax
Deferred income tax
(4) Net earnings
Effective tax rate [= (3)/(2)]
2007
4.000
2.000
380
190
190
1.620
19,0%
2008
4.000
2.000
380
190
190
1.620
19,0%
2009
4.000
2.000
380
190
190
1.620
19,0%
2010
4.000
2.000
380
190
190
1.620
19,0%
2011
4.000
2.000
380
760
−380
1.620
19,0%
2012
4.000
2.000
380
760
−380
1.620
19,0%
Under such an approach, the total reported income tax is identical for each year, but its
breakdown shifts between two sub-periods: 2007–2010 and 2011–2012.
Source Author
394
J. Welc
Example 10.5
Accounting for book-tax differences related to warranty provisions
A company manufactures and sells electronic devices. It launched its operaons in 2007 and
grew fast between fiscal years 2007 and 2010. The company grants to its customers a
twelve-month warranty for its products. From its past experience it knows that warranty
expense, which must be incurred aer sales, equals 4% (on average) of revenues from the
sale of products.
The company prepares two separate financial reports:
• one for its shareholders and other stakeholders (e.g. creditors), under IFRS,
• one for income tax purposes.
For financial reporng purposes the warranty expense (provision) is recorded when it
becomes probable (i.e. when products are sold). In contrast, for tax purposes the warranty
expense becomes tax-deducble when it is actually paid (i.e. when warranty services are
rendered). The income tax rate equals 19%.
The computaons presented below are based on a simplifying assumpon, according to
which the company’s managers and accountants are accurate in forecasng its future
warranty-related expenditures. For instance, the warranty expense amounng to 400 EUR
and recognized in the income statement in 2007 is followed by the actual warranty
expenditure, equaling exactly 400 EUR, in the following period.
Under such condions the company’s booking entries look as follows:
Amounts in EUR
(1) Revenues
(2) Warranty expense in income statement
(equaling 4% of sales revenues in a period)
(3) Warranty expense for tax purposes
(4) Book-tax difference related to the warranty
expense
Recognion of the warranty expense provision
Reversal of the previously recognized provision
(5) Warranty provision at the end of a period
Warranty-related deferred tax assets (in balance
sheet), as at the end of a period [= 19% × (5)]
Warranty-related deferred tax, reported in
income statement [= 19% × (4)]
2007
10.000
2008
12.500
2009
20.000
2010
25.000
400
500
800
1.000
0
400
500
800
−400
−100
−300
−200
400
–
400
500
−400
500
800
−500
800
1.000
−800
1.000
76
95
152
190
−76
−19
−57
−38
As may be seen, a growth of scale of the company’s operaons (as measured by its
revenues) is reflected in a gradual increase in its deferred tax assets related to its product
warranes (because, with growing sales, the increasing number of products is returned to
be repaired, even though their percentage share in total sales stays intact, at 4%).
Source Author
10 Techniques of Increasing Comparability …
Example 10.6
Accounting for tax-loss carry-forwards
A company manufactures and sells electronic devices. It launches its operaons in 2007 and
grew between fiscal years 2007 and 2010. In 2007 it operated below its break-even point
(i.e. it incurred a loss), but in the following years it reached a posive profitability. Suppose,
for simplicity, that the company’s accounng pre-tax earnings are equal to its taxable
income throughout the whole period (thus, its only deferred taxes relate to tax-loss carryforwards). The company’s income tax rate equals 19%.
Income tax regulaons, effecve in a country where the company operates, state that:
• Tax-loss incurred in a period is deducble from future posive taxable income
(creang an income tax shield).
• A maximum amount of 50% of the past income tax-loss may be deducted from the
future taxable income in any single fiscal year.
The company’s revenues, expenses and pre-tax earnings look as follows:
Amounts in EUR
Revenues
Total expenses
Pre-tax earnings
2007
10.000
15.000
−5.000
2008
20.000
16.000
4.000
2009
25.000
20.000
5.000
2010
25.000
20.000
5.000
Under such circumstances the calculaon of current income tax expense looks as follows:
Amounts in EUR
(1) Statutory tax rate
(2) Tax profit/loss in a given period*
(3) Tax shield from past tax-losses**
(4) Taxable profit adjusted for a tax shield
[=(2) – (3)]
Current income tax [= (1) × (4)]
2007
19%
−5.000
0
2008
19%
4.000
−2.500
2009
19%
5.000
−2.500
2010
19%
5.000
0
0
1.500
2.500
5.000
0
285
475
950
*It is assumed for simplicity that the company’s accounting pre-tax earnings are equal
to its taxable income throughout the whole period, except for its tax-loss carryforwards
**50% of the tax loss incurred in fiscal year 2007
The income tax-loss incurred in fiscal year 2007 may lower future taxes payable. Due to this,
it is treated as an asset (expected to bring future economic benefits). However, it should be
capitalized (as deferred tax asset) only if the expected future economic benefits are
probable.
Amounts in EUR
(1) Revenues
(2) Pre-tax earnings
(3) Income tax, including:
Current income tax
Deferred income tax
(4) Net earnings
Deferred tax asset (balance sheet)
Current tax/Pre-tax earnings
2007
10.000
−5.000
−950
0
−950*
−4.050
950*
0,0%
2008
20.000
4.000
760
285
475
3.240
475
7,1%
2009
25.000
5.000
950
475
475
4.050
0
9,5%
2010
25.000
5.000
950
950
0
4.050
0
19,0%
*= tax rate (19%) × income tax loss which may be deducted from future taxable
income
Thanks to the deferred tax asset (resulng from past tax-loss) the company’s income taxes
paid in 2008–2009 are lower than taxes computed for those years on the ground of its pretax earnings. Only in 2010 (when the deferred tax asset from past losses is fully ulized) the
effecve income tax rate converges with a statutory rate (as shown above).
Source Author
395
396
J. Welc
10.4.2 Increasing Financial Statement Comparability
and Reliability with the Use of Income Tax
Disclosures
Financial statement disclosures about current and deferred income taxes
(particularly detailed data disclosed deeply in notes to financial statements)
are useful in a financial statement analysis, since they enable increasing
reliability and intercompany comparability of accounting numbers. Comparability and reliability of financial results may be improved by adjusting the
numbers reported in financial reports, by eliminating or reducing a distorting
impact of some subjective judgments (e.g. in such areas as useful lives of
PP&E, capitalization and amortization of intangibles, write downs of inventories and receivables). The reason is that although companies may use wide
ranges of assumptions for financial reporting, they usually strictly follow more
conservative and rigid income tax rules (Phillips et al. 2003).
For example, two firms which use similar machinery may differ significantly in terms of their assumed useful lives and salvage values (e.g. one
company may depreciate its assets through four years, while another one may
assume six-years useful lives), but they tend to depreciate such assets for tax
purposes as fast as possible (i.e. using the shortest permitted tax depreciation period). Consequently, even though their depreciation charges reported
in income statements may differ materially (even if they utilize very similar
assets), it is likely that they apply more comparable (or at least less subjective) depreciation schedules for tax purposes. Even if their tax depreciation
schedules are not the same (e.g. when both companies utilize similar assets,
but located in different tax jurisdictions), their tax depreciation charges will
usually be much more immune to subjective judgments (since they are based
on tax regulations).
Income tax disclosures are also useful in evaluating financial statement
reliability (Phillips et al. 2004). When companies manipulate reported earnings (by applying some “creative accounting” techniques), they usually bias
those earnings upwards. However, even if they do so, they are still interested in paying as low taxes as possible. Thus, when reported profits are
overstated (by an aggressive accounting), they often entail a widening
positive gap between reported accounting earnings and a taxable income
(which may be detected by means of income tax disclosures). Such diverging
book-tax differences constitute a strong “red flag” about the possible aggressive accounting (Philips et al. 2003; Lev and Nissim 2004; Hanlon 2005;
Weber 2009).
10 Techniques of Increasing Comparability …
397
An application of analytical techniques, aimed at increasing data comparability and based on income tax disclosures, will be illustrated with a real-life
example of the car industry. Suppose that Your task is to compare a pre-tax
profitability, as measured by a quotient of pre-tax earnings and sales revenues,
of three German car manufacturers (BMW, Daimler and VW) in fiscal year
2009. Table 10.7 presents selected numbers, extracted from consolidated
income statements of the investigated firms, as well as their “raw” pre-tax
profitability ratios (i.e. unadjusted for any differences in accounting principles
and assumptions applied by those firms).
Clearly, on the ground of these “raw” data, Volkswagen Group appears as
the most profitable of all three firms. In particular, its profitability seems to
be much better than that presented by Daimler (with a difference of more
than four percentage points). Generally speaking, there could have existed
two broad groups of factors responsible for such differences:
• Business reasons, reflecting true differences in the economic efficiency of
individual firms.
• Accounting reasons, reflecting distorting effects of multiple accounting
assumptions (including subjective judgments) taken by those companies
in the process of financial statement preparation.
Even if those three firms had identical real financial results (which, of
course, was not possible in practice), their reported numbers could have
still differed significantly. Typically, the following accounting-related factors
(among others) can distort an intercompany comparability of financial
results:
Table 10.7 Pre-tax profitability of three car manufacturers in fiscal year 2009
(computations based on unadjusted income statement data, as reported in their
consolidated financial statements for fiscal year 2009)
*Profit before tax/Sales revenues
Source Annual reports of individual companies for fiscal year 2009 and authorial
computations
398
J. Welc
• Accounting for intangible assets − firms can apply varying assumptions regarding capitalization and amortization of development costs (e.g.
varying amortization schedules).
• Accounting for property, plant and equipment—firms may apply varying
depreciation schedules and may take different assumptions about salvage
values of fixed assets.
• Accounting for receivables and inventories—firms may be more or less
prudent when estimating their realizable values.
• Warranty provisions (or provisions for product returns)—firms may be
more or less optimistic about probable future outflows of cash on warranty
repairs of their goods returned by customers.
Table 10.21 (in the appendix) contains the annual report extracts on
accounting policies applied by three car manufacturers toward capitalized
development expenditures. As may be read, the companies differ significantly
in terms of their amortization schedules applied to capitalized development
costs. While BMW claims to generally apply a single useful live for all
its R&D projects (seven years), VW seems to use more flexible rates (five
to seven years) and Daimler applies the widest range (two to ten years).
Clearly, such accounting differences may significantly erode a comparability
of financial results reported by these car manufacturers.
Table 10.8, in turn, contains extracts on accounting policies applied by the
same three firms toward depreciation of their operating tangible fixed assets.
Table 10.8 Accounting policies applied to selected classes of property, plant and
equipment by BMW Group, Daimler and Volkswagen Group
BMW GROUP
Systematic depreciation is based on the following useful lives […]:
in years
Plant and machinery
Other equipment, factory and office equipment
5 to 10
3 to 10
DAIMLER
Property, plant and equipment are depreciated over the following useful lives:
Technical equipment and machinery
6 to 26 years
Other equipment, factory and office equipment
2 to 30 years
VOLKSWAGEN GROUP
Depreciation is based mainly on the following useful lives:
Technical equipment and machinery
Other equipment, operating and office equipment, including
special tools
Source Annual reports of individual companies for fiscal year 2009
Useful live
6 to 12 years
3 to 15 years
10 Techniques of Increasing Comparability …
399
Similarly as in the case of intangibles, the companies differ significantly in
terms of their depreciation policies. BMW seems to apply relatively short
useful lives and relatively narrow ranges. In contrast, Daimler applies much
longer maximum useful lives. VW’s assumptions lie in between.
To sum up:
• All three car manufacturers seem to differ significantly in terms of the
amortization schedules applied to their capitalized development costs.
• All three firms seem to differ significantly in terms of the depreciation
schedules (useful lives) applied to their operating tangible fixed assets.
Such intercompany differences in accounting assumptions result from a
significant leeway offered by accounting standards (as well as from multiple
subjective judgments necessary to be taken in the process of financial statement preparation). These differences may dramatically distort findings of
a comparative financial statement analysis, since the reported amortization
and depreciation expenses, and as a result also reported earnings and assets,
are affected by the subjective assumptions taken by individual companies.
However, it is likely that these firms apply more similar and comparable
amortization and depreciation schedules for tax purposes, and that they
expense development costs and PP&E as soon as possible (to minimize
income tax burdens). Thus, an analyst may try to increase the comparability
of their financial results, by reversing some of the temporary book-tax differences (on the ground of deferred tax disclosures hidden in notes to financial
statements). To this end, the analytical approach presented in Example 10.7
(which is an extension of Example 10.4 presented earlier in the chapter) may
be applied.
A real-life example of an application of the proposed analytical procedure
will be based on consolidated financial statement data reported by BMW
Group, Daimler and Volkswagen Group for fiscal year 2009. In this example
we will try to reduce the intercompany differences in accounting policies
applied to intangible and tangible fixed assets.
Let’s begin with the numbers extracted from BMW’s note on deferred
tax assets and deferred tax liabilities, as disclosed in the company’s consolidated financial statements for fiscal year 2009. These data are presented in
Table 10.22 (in the appendix). As may be concluded from these data, for its
deferred tax reporting BMW splits its operating long-term assets into three
subcategories: intangibles, PP&E (property, plant and equipment) and leased
products (which are probably BMW’s products, still owned by the company
400
J. Welc
Example 10.7 Reversing book-tax differences on the ground of deferred tax
disclosures (continuation of Example 10.4)
The temporary book-tax differences related to values of assets and liabilies give rise to
differed tax assets and deferred tax liabilies. Based on the numerical data presented in
Example 10.4 one may see that:
• The book-tax difference in asset’s value amounted to: 1.000 EUR in 2007, 2.000 EUR
in 2008 and 3.000 EUR in 2009 (thus, it widened steadily in the course of those
years).
• The reason was a connuing (in those three years) excess of the asset’s tax
depreciaon (3.000 EUR annually) over its book depreciaon (2.000 EUR annually).
• The widening gap between the asset’s book and tax values gave rise to deferred tax
liability (amounng to 190 EUR in 2007, 380 EUR in 2008 and 570 EUR in 2009),
computed as the tax rate (19%) mulplied by the book-tax difference.
• When the asset becomes fully depreciated for tax purposes, while sll being
depreciable for book purposes (fiscal years 2011–2012 in this case), the related
deferred tax asset start reversing (because now the book depreciaon exceeds the
tax depreciaon).
• Thus, period-to-period changes in deferred tax assets and deferred tax liabilies,
related to some broad category of assets (e.g. intangibles or PP&E), enable
reversing the underlying book-tax differences (and adjusng the reported financial
statement numbers to their tax accounng equivalents).
In Example 10.4 the reversal for fiscal year 2009 would look as follows:
Amounts in EUR
(1) Reported pre-tax accounng earnings for 2009:
(2) Deferred tax liability at the end of 2009:
(3) Deferred tax liability at the end of 2008:
(4) Change in deferred tax liability [= (2) − (3)]
(5) Tax rate applied in compung deferred taxes
(6) Reversal of book-tax difference [=−(4)/(5)]*
(7) Adjusted pre-tax earnings [= (1) + (6)]
2009
2.000
570
380
190
19%
−1.000 = −(190/19%)
1.000 = 2.000 − 1.000
*The reversal has a negative sign here, because the growing deferred tax liabilities
reflect the fact that book depreciation is lower than tax depreciation (i.e. the
accounting earnings exceed the taxable income); if the book-tax differences give rise
to deferred tax assets (i.e. when taxable income exceeds accounting earnings), the
reversal would have a positive sign (to adjust the reported earnings upwards)
In a more general case (i.e. when both deferred tax assets as well as deferred tax liabilies
exist, for a broad category of assets) the following procedure should be applied (based on
ficous data).
(1) Reported pre-tax accounng earnings in Period t:
(2) Deferred tax assets at the end of Period t:
(3) Deferred tax assets at the end of Period t−1:
(4) Deferred tax liabilies at the end of Period t:
(5) Deferred tax liabilies at the end of Period t−1:
(6) Change in net deferred tax posion [= ((2) −(4)) −
((3)−(5))]*
(7) Tax rate applied by a company in compung deferred taxes
(8) Reversal of book-tax differences [= (6)/(7)]
(9) Adjusted pre-tax earnings [= (1) + (8)]
2.000
600
400
300
200
100
20%
500 = 100/20%
2.500 = 2.000 + 500
*Only those changes in deferred tax assets and liabilities should be taken into account
which affect an income statement; any changes affecting equity directly (e.g. resulting
from an upward revaluation of PP&E or from accounting for business combinations)
should be omitted, if possible
Source Author
10 Techniques of Increasing Comparability …
401
but used by its customers under lease contracts). Table 10.9 contains a
calculation of the amount of BMW’s adjustment for book-tax temporary
differences, related to its tangible and intangible fixed assets. As may be seen,
BMW’s total net deferred tax assets, related to intangible and tangible assets,
fell in 2009 (from −5.515 EUR million to −5.699 EUR million). It implies
a negative (downward) adjustment of the company’s pre-tax profit reported
for fiscal year 2009.
Table 10.23 and Table 10.24 (both in the appendix) present the data
extracted from Daimler’s note on deferred tax assets and deferred tax liabilities, as disclosed in the company’s consolidated financial statements for fiscal
year 2009. As may be seen, for reporting deferred tax assets Daimler splits its
tangible and intangible long-term assets into three subcategories: intangibles,
PP&E and leased equipment. However, for reporting deferred tax liabilities
Daimler splits its tangible and intangible assets into four subcategories (with
capitalized development costs constituting a subcategory separate from other
intangibles).
Table 10.9 Calculation of the amount of BMW’s adjustment for book-tax temporary
differences, related to its tangible and intangible fixed assets (based on data
disclosed in Table 10.22)
Net deferred tax assets/liabilities* related to (in EUR
million):
2008
2009
(1) Intangible assets
−1.540
= 1 − 1.541
−1.489
= 1 − 1.490
(2) Property, plant and equipment
−411
= 43 − 454
−372
= 38 − 410
−3.564
= 573 − 4.137
−3.838
= 443 − 4.281
−5.515
−5.699
(3) Leased products
(4) Total net deferred tax position [= (1) +
(2) + (3)]
Change in total net deferred tax position
−184
Income tax rate applied by a company**
30,2%
Impact of book-tax temporary differences,
related to intangibles and PP&E, on profit before tax
−609
=−184/30,2%
*Deferred tax assets − deferred tax liabilities
**The company’s effective tax rate in Germany, according to narrative disclosures
provided in its note on income taxes (it must be kept in mind that the actual income
tax rate differs between various locations of the company’s international facilities,
which may distort the above estimates)
Source Annual report of BMW Group for fiscal year 2009 and authorial computations
402
J. Welc
Table 10.10 presents a calculation of the amount of Daimler’s adjustment
for book-tax temporary differences, related to its tangible and intangible fixed
assets. As may be seen, unlike in BMW’s case, Daimler’s total net deferred tax
assets, related to its intangible and tangible assets, rose in 2009. It implies a
positive (upward) correction of the company’s pre-tax profit reported for fiscal
year 2009.
Finally, Table 10.25 (in the appendix) presents the data extracted from
Volkswagen Group’s note on deferred tax assets and deferred tax liabilities,
while Table 10.11 contains the calculation of the amount of VW’s adjustment
for book-tax temporary differences, related to its tangible and intangible fixed
assets. As may be seen, in contrast to BMW and Daimler, for its deferred
tax reporting Volkswagen Group splits its tangible and intangible fixed assets
into only two subcategories. Similarly as for BMW, the company’s total net
Table 10.10 Calculation of the amount of Daimler’s adjustment for book-tax
temporary differences related to its tangible and intangible fixed assets (based on
data disclosed in Tables 10.23 and 10.24)
Net deferred tax assets/liabilities* related to (in EUR
million):
(1) Development costs
2008
2009
−1.406
= 0 − 1.406
−1.598
= 0 − 1.598
32
17
= 120 − 88
= 84 − 67
(3) Property, plant and equipment
−680
= 559 − 1.239
−353
= 646 − 999
(4) Equipment on operating leases
−2.822
= 953 − 3.775
−2.500
= 659 − 3.159
−4.876
−4.434
(2) Other intangible assets
(5) Total net deferred tax position [= (1) +
(2) + (3) + (4)]
Change in total net deferred tax position
442
Income tax rate applied by a company**
29,825%
Impact of book-tax temporary differences, related to
intangibles and PP&E, on profit before tax
1.482
= 442/29,825%
*Deferred tax assets − deferred tax liabilities
**The company’s effective tax rate in Germany, according to narrative disclosures
provided in its note on income taxes (it must be kept in mind that the actual income
tax rate differs between various locations of the company’s international facilities,
which may distort the above estimates)
Source Annual report of Daimler Group for fiscal year 2009 and authorial
computations
10 Techniques of Increasing Comparability …
403
Table 10.11 Calculation of the amount of Volkswagen Group’s adjustment for booktax temporary differences, related to its tangible and intangible fixed assets (based
on data disclosed in Table 10.25)
Net deferred tax assets/liabilies* related to (in EUR
million):
(1) Intangible assets
(2) Property, plant and equipment, and leasing and
rental assets
(3) Total net deferred tax posion [= (1) +
(2)]
2008
2009
−2.036
= 235 − 2.271
−2.191
= 197 − 2.388
1.394
1.119
= 4.123 − 2.729
= 3.699 − 2.580
−642
−1.072
Change in total net deferred tax posion
−430
Income tax rate applied by a company**
29,5%
Impact of book-tax temporary differences, related to
intangibles and PP&E, on profit before tax
−1.458
= −430/29,5%
*Deferred tax assets − deferred tax liabilities
**The company’s effective tax rate in Germany, according to narrative disclosures
provided in its note on income taxes (it must be kept in mind that the actual income
tax rate differs between various locations of the company’s international facilities,
which may distort the above estimates)
Source Annual report of Volkswagen Group for fiscal year 2009 and authorial
computations
deferred tax assets, related to intangible and tangible assets, fell in 2009. It
implies a negative (downward) adjustment of the VW’s pre-tax profit reported
for fiscal year 2009.
Now when we have computed all three amounts of the book-tax adjustments (for all three firms), we can proceed to restating their respective
earnings reported for fiscal year 2009. These analytical adjustments are
presented in Table 10.12.
As may be seen, the corrected profitability of BMW and Volkswagen is
lower than their respective “raw” profitability. In contrast, Daimler’s restated
results look better than its “raw” numbers. A difference between the profitability of Daimler and Volkswagen, which exceeds four percentage points
when based on their reported data, shrinks to less than one percentage point,
when based on our more comparable adjusted numbers.
The following general conclusions may be inferred from Table 10.12:
• Intercompany differences in pre-tax margins, based on the adjusted
numbers, are narrower than those based on “raw” (reported) data.
404
J. Welc
Table 10.12 Comparison of “raw” and adjusted (for book-tax differences related
to tangible and intangible fixed assets) profitability ratios of the three-car
manufacturers in fiscal year 2009
In EUR million
BMW
Daimler
Volkswagen
Sales revenues
50.681
78.924
105.187
413
−609
(from
Table 10.9)
−2.298
+1.482
(from
Table 10.10)
1.261
−1.458
(from
Table 10.11)
−196
= 413 − 609
−816
= −2.298 + 1.482
−197
= 1.261 − 1.458
Pre-tax profitability based on
reported numbers*
0,8%
−2,9%
1,2%
Pre-tax profitability based on
adjusted numbers**
−0,4%
−1,0%
−0,2%
“Raw” profit before tax (as reported)
Amount of adjustment for book-tax
differences
Adjusted profit before tax
*“Raw” profit before tax/Sales revenues
**Adjusted profit before tax/Sales revenues
Source Annual reports of individual companies for fiscal year 2009 and authorial
computations
• The reason is that these three companies probably differ much more in
terms of their subjective accounting judgments, applied in accounting for
their tangible and intangible assets, than they do in their approaches to
compute taxable income.
• On the ground of the “raw” data, Daimler emerged as the only company
with a negative profitability, while after adjusting the numbers it turns out
that all three competitors presented negative revised pre-tax earnings in
fiscal year 2009.
• Although Daimler was still (after our book-tax adjustments) the firm with
the lowest profitability in 2009, its distance to both competitors (particularly to Volkswagen) shrinks significantly, from more than four percentage
points to less than one percentage point.
• Thus, now the “good” company (Volkswagen) seems not to be as good as
before, while the “bad” one (Daimler) is no longer that bad.
When applying the techniques presented in this section one must
remember about several possible distortions of the obtained adjusted
numbers. First, corporate deferred tax assets and deferred tax liabilities may
change from period-to-period not only in relation to revenues and expenses,
but also as a result of takeovers of other companies. When one company
obtains a control over another one (which becomes its new subsidiary), it
10 Techniques of Increasing Comparability …
405
starts consolidating net assets of the acquired entity, including its deferred
tax assets and deferred tax liabilities. In such circumstances carrying amounts
of deferred taxes reported in consolidated balance sheet may change dramatically, but with no any relationships with differences between taxable income
and pre-tax accounting profit (earned by a company in that period).
Second, deferred tax assets and deferred tax liabilities may change from
period-to-period due to downward or upward revaluations of carrying
amounts of some assets and liabilities, charged directly to shareholder’s equity
(i.e. without recognizing them as gains or losses in income statement). The
examples are upward revaluations of property, plant and equipment under
IFRS (allowed under a so-called revaluation model) or fair value adjustments of available-for-sale financial assets. In such cases carrying amounts
of deferred taxes may change independently from differences between taxable
income and pre-tax accounting profit.
Finally, the adjustments discussed in this section are sensitive to assumptions about corporate tax rates. In the above calculations the effective tax rates
of parent companies have been used as proxies for tax rates applicable to all
their fixed assets. However, all three car manufacturers are global corporations, with manufacturing facilities spread across many countries and many
tax jurisdictions. Consequently, individual items of their fixed assets, located
in different countries, have different applicable income tax rates. As a result,
deferred tax assets and deferred tax liabilities related to those geographically
dispersed assets are recognized on the basis of multiple effective tax rates (and
not just a single rate of the parent company). However, detailed data on
location of individual corporate assets are usually not disclosed in published
financial statements. Therefore, a simplified approach must be applied, based
on a single tax rate (of the parent company) for all consolidated assets. Obviously, such simplification may erode an accuracy of book-tax adjustments in
case of businesses operating in multiple tax jurisdictions.
Appendix
See Chart 10.2 and Tables 10.13, 10.14, 10.15, 10.16, 10.17, 10.18, 10.19,
10.20, 10.21, 10.22, 10.23, 10.24, and 10.25.
406
J. Welc
Chart 10.2 Differences between Carillion’s “invoiced earnings” and its reported
profit before taxation (in GBP million), based on data presented in Table 10.6 (Source
Annual reports of Carillion plc for fiscal years 2009–2016 and authorial computations)
Table 10.13
Asseco’s justification of treating Formula Systems as its controlled entity
Consolidation of entities in which the Group holds less than 50% of voting right
The Parent Company maintains control over Formula Systems (1985) Ltd. despite
holding less than 50% of its shares, because Mr. Guy Bernstein, CEO of Formula
Systems, granted an irrevocable authorization for the exercise of voting rights with
respect to all of his shares by Mr. Marek Panek, Member of the Management Board
of Asseco Poland S.A., or another Member of the Management Board of Asseco
Poland S.A. acting in his place. Such authorization was issued in 2015, and on
November 3, 2016 it was extended for the next 12 months. Pursuant to this
authorization, when exercising voting rights attached to all shares held by Mr.
Bernstein, Mr. Marek Panek is obligated to vote as recommended by the Management
Board of Asseco Poland S.A.
Source Annual report of Asseco Group for fiscal year 2016
10 Techniques of Increasing Comparability …
Table 10.14
entity
407
Asseco’s justification of treating Sapiens International as its controlled
Consolidation of entities in which the Group holds less than 50% of voting right
In the case of Sapiens International Corporation NV (hereinafter “Sapiens”), the
conclusion regarding the existence of control […], in line with IFRS 10, was made
considering the following factors:
1. Governing bodies of Sapiens:
[…]
2. Shareholder structure of Sapiens:
•
the company’s shareholder structure is dispersed because, apart from Formula
Systems, just one shareholder holds more than 5% of voting rights at the
general meeting (5.36% of votes), and the next major shareholder holds
approx. 4.86% of votes;
•
there is no evidence that any shareholders have or had any agreement for
common voting at the general meeting;
•
over the last four years (i.e. 2013–2016), the company’s general meetings
were attended by shareholders representing in aggregate between 70% and
77% of total voting rights. This means that the level of activity of the
company’s shareholders is relatively moderate or low. Bearing in mind that
Formula presently holds approx. 48.85% of total voting rights, the attendance
from shareholders would have to be higher than 95% in order to deprive
Formula of an absolute majority of votes at the general meeting. The
Management believes that achieving such high attendances seems unlikely.
With regard to the above, the Group has determined that Formula Systems, despite
the lack of an absolute majority of shares in Sapiens during the year 2016, has still
been able to influence the appointment of directors at Sapiens, and therefore may
affect the directions of development as well as current business operations of that
company. Therefore, Formula has power over the company of Sapiens and is able to
use that power to affect the amount of generated returns […].
Source Annual report of Asseco Group for fiscal year 2016
408
J. Welc
Table 10.15 Selected accounting numbers extracted from consolidated financial
statements of Asseco Group, Formula Systems (1985) Ltd. and Sapiens International
Corporation N.V. for fiscal years 2015 and 2016
*Data extracted from consolidated cash flow statements
**Operating profit + Depreciation and amortization
***Noncontrolling interests
Source Annual reports of Asseco Poland S.A., Formula Systems (1985) Ltd. and Sapiens
International Corporation N.V. for fiscal year 2016
Table 10.16 Currency rates used in converting financial results of Formula Systems
and Sapiens International from USD into PLN
USD/PLN rate:
2015
2016
Average rate in the year*
3,7730
3,9435
Rate at the end of the year**
3,9011
4,1793
*Currency rates used in converting income statement data
**Currency rates used in converting balance sheet data
Source National Bank of Poland
10 Techniques of Increasing Comparability …
409
Table 10.17 Extract from notes to consolidated financial statements of Astaldi
Group for 2017, describing the company’s accounting policy regarding its long-term
contracts
Contract work in progress
Construction contracts are recognized based on the consideration received or
receivable with reasonable certainty in relation to the stage of completion of the
contract activity, using the percentage of completion method, based on the costs to
cost model.
[…]
If the completion of a contract is expected to generate a loss, this is entirely
recognized in the year in which it is reasonably foreseeable.
When the outcome of a construction contract cannot be estimated reliably, contract
work in progress is recognized on the basis of the contract costs incurred that it is
probable will be recoverable, without recognizing any profit or loss.
[…]
Contract work in progress is recognized net of any allowance for impairment and/or
provisions for expected losses to complete, progress billing and advances.
Progress billings are amounts billed for work performed on a contract and are
recognized as a reduction in amounts due from customers, with any surplus
recognized as a liability. On the other hand, billed advances have a financial nature
and, therefore, do not affect revenue. As such, they are recognized as a liability since
they are amounts received before the related work is performed. However, they are
progressively reduced, usually under contractual arrangements, as a balancing entry
to the relevant progress billings.
If the provisions for expected losses to complete exceed the amount recognized as an
asset for the relevant contract, the negative difference is shown under Amounts due to
customers.
These analyses are carried out on a contract-by-contract basis: should the difference
be positive (due to contract work in progress being higher than the amount of
progress billings), it is classified as an asset under “Amounts due from customers”; on
the other hand, should the difference be negative, it is classified as a liability under
“Amounts due to customers”.
Source Annual report of Astaldi Group for fiscal year 2017
410
J. Welc
Table 10.18 Reported profits, operating cash flows and “invoiced earnings” of
Astaldi Group in fiscal years 2014–2017 (data in EUR million)
Data in EUR million
Data reported in income
statement and cash flow statement
Year
Profit before
taxation
Adjusted
pre-tax
Cash flow from
earnings****
operating
activities*
273,4
140,4
2014
130,7
2015
111,5
121,5
−144,6
2016
129,1
9,0
−101,5
2017
−115,8
−116,1
−237,3
*While Astaldi Group also reported “Net cash flows used in operating activities”,
lower than “Cash flows from operating activities”, for comparative purposes the
latter one is disclosed in the table, since the former included interest and dividends
received and paid, which in the Author’s opinion deserve to be treated as investing
and financing cash flows (due to their economic substance)
Source Annual reports of Astaldi Group for fiscal years 2015–2017 and authorial
computations
10 Techniques of Increasing Comparability …
411
Table 10.19 Extract from notes to consolidated financial statements of Carillion plc
for fiscal year 2016, describing the company’s accounting policy regarding its longterm contracts
Construction contracts
When the outcome of a construction contract can be estimated reliably, contract
revenue and costs are recognized by reference to the degree of completion of each
contract, as measured by the proportion of total costs at the balance sheet date to the
estimated total cost of the contract.
[…]
When the outcome of a construction contract cannot be estimated reliably, contract
revenue is recognized to the extent of contract costs incurred where it is probable
those costs will be recoverable.
The principal estimation technique used by the Group in attributing profit on
contracts to a particular period is the preparation of forecasts on a contract by contract
basis. These focus on revenues and costs to complete and enable an assessment to be
made of the final out-turn of each contract. Consistent contract review procedures are
in place in respect of contract forecasting.
When it is probable that total contract costs will exceed total contract revenue, the
expected loss is recognized immediately. Contract costs are recognized as expenses in
the period in which they are incurred.
When costs incurred plus recognized profits less recognized losses exceed progress
billings, the balance is shown as amounts owed by customers on construction
contracts within trade and other receivables. Where progress billings exceed costs
incurred plus recognized profits less recognized losses, the balance is shown as
amounts owed to customers on construction contracts within trade and other payables.
Source Annual report of Carillion plc for fiscal year 2016
412
J. Welc
Table 10.20 Reported profits, operating cash flows and “invoiced earnings” of
Carillion plc in fiscal years 2013–2016 (data in GBP million)
Data in GBP million
Year
2013
Data reported in income
statement and cash flow
statement
Cash generated
Profit before
from
taxation
operations*
110,6
−62,2
Adjusted
pre-tax
earnings**
0,1
2014
142,6
156,0
73,2
2015
155,1
120,3
185,4
2016
146,7
115,5
−86,4
*While Carillion plc also reported “Net cash flows from operating activities”, lower
than “Cash generated from operations”, for comparative purposes the latter one is
disclosed in the table, since the former included financial income received, financial
expense paid and acquisition-related cost, which in the Author’s opinion deserve to
be treated as investing and financing cash flows (due to their economic substance)
**As computed in Table 10.6
Source Annual reports of Carillion plc for fiscal years 2014–2016 and authorial
computations
Table 10.21 Accounting policies applied to capitalized development costs by BMW
Group, Daimler and Volkswagen Group
BMW GROUP
Capitalized development costs are amortized on a systematic basis, following the
commencement of production, over the estimated product life which is generally
seven years. [emphasis added]
DAIMLER
Capitalized development costs include all direct costs and allocable overheads and are
amortized over the expected product life cycle (2 to 10 years). [emphasis added]
VOLKSWAGEN GROUP
Capitalized development costs include all direct and indirect costs that are directly
attributable to the development process. […] The costs are amortized using the
straight-line method from the start of production over the expected life cycle of the
models or powertrains developed—generally between five and ten years. [emphasis
added]
Source Annual reports of individual companies for fiscal year 2009
10 Techniques of Increasing Comparability …
413
Table 10.22 Deferred tax assets and deferred tax liabilities of BMW Group, as at
the end of fiscal years 2008 and 2009 (data extracted from Note 15 to BMW’s
consolidated financial statements for fiscal year 2009)
In EUR million
Intangible assets
Property, plant and
Leased products
Investments
Other current assets
Tax loss carry-forwards
Provisions
Liabilities
Consolidations
Valuation allowance
Netting
Deferred taxes
Deferred tax assets
2008
2009
1
1
43
38
573
443
3
5
1.796
2.175
1.438
1.838
1.197
1.388
2.945
3.316
1.736
1.564
9.732
10.768
−513
−550
−8.353
−8.952
866
1.266
Deferred tax liabilities
2008
2009
1.541
1.490
454
410
4.137
4.281
5
8
3.196
3.559
–
–
75
47
1.296
1.444
406
482
11.110
11.721
–
–
−8.353
−8.952
2.757
2.769
Source Annual report of BMW Group for fiscal year 2009
Table 10.23 Deferred tax assets of Daimler Group, as at the end of fiscal years 2008
and 2009 (data extracted from Note 8 to Daimler’s consolidated financial statements
for fiscal year 2009)
In EUR million
Intangible assets
Property, plant and equipment
Equipment on operating leases
Inventories
Investments accounted for using the equity method
Receivables from financial services
Other financial assets
Tax loss and tax credit carry-forwards
Provisions for pensions and similar obligations
Other provisions
Liabilities
Deferred income
Other
Valuation allowance
Deferred tax assets
Source Annual report of Daimler Group for fiscal year 2009
Deferred tax assets
2008
120
559
953
701
2.357
89
3.622
3.703
610
1.729
1.351
552
49
16.395
−3.510
2009
84
646
659
562
15
117
3.324
5.770
620
1.874
882
751
74
15.378
−3.096
12.885
12.282
414
J. Welc
Table 10.24 Deferred tax liabilities of Daimler Group, as at the end of 2008 and
2009 (data extracted from Note 8 to Daimler’s consolidated financial statement for
fiscal year 2009)
Deferred tax liabilities
In EUR million
Development costs
Other intangible assets
Property, plant and equipment
Equipment on operating leases
Inventories
Receivables from financial services
Other financial assets
Other assets
Provisions for pensions and similar obligations
Other provisions
Taxes on undistributed earnings of non-German
Other
Deferred tax liabilities
2008
1.406
88
1.239
3.775
140
1.403
158
522
2.640
193
48
170
2009
1.598
67
999
3.159
132
805
110
257
2.851
264
46
270
11.782
10.558
Source Annual report of Daimler Group for fiscal year 2009
Table 10.25 Deferred tax assets and deferred tax liabilities of Volkswagen Group,
as at the end of fiscal years 2008 and 2009 (data extracted from Note 10 to VW’s
consolidated financial statement for fiscal year 2009)
In EUR million
Intangible assets
Property, plant and equipment, and
leasing and rental assets
Noncurrent financial assets
Inventories
Receivables and other assets
Other current assets
Pension provisions
Other provisions
Liabilities
Tax loss carry-forwards
Valuation allowances on deferred tax
Gross value
Deferred tax assets
Deferred tax
liabilities
2008
2009
2008
2009
235
197
2.271
2.388
4.123
3.699
2.729
2.580
1.059
335
822
129
1.050
2.723
1.657
663
–
756
304
622
82
1.303
2.885
1.309
929
–
2
321
7.103
41
8
530
499
–
–
4
324
5.931
20
3
61
245
–
–
12.796
12.084
13.504
11.558
Source Annual report of Volkswagen Group for fiscal year 2009
10 Techniques of Increasing Comparability …
415
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Index
A
AbbVie 153–157
accounting fraud 148, 152, 163,
169, 171, 172, 250, 254, 258,
280, 285, 287, 308
accounting gimmicks 77, 79, 82, 84,
103, 139, 140, 169
accounting scandals 79, 148
Admiral Boats 174, 175, 180
Aegan Marine Petroleum Network
225, 226
affiliates 146, 147, 287
after-tax earnings 52, 80, 161
AgFeed Industries 308–310
aggressive accounting 80, 110, 120,
122, 125, 127, 169, 268, 279,
291, 351, 396
Agrokor Group 142
AkzoNobel 2, 4–6
amortization 2, 58, 114, 115,
161–166, 171, 172, 177, 178,
192, 236, 239, 254–260, 343,
346–348, 352, 371, 396, 398,
399
Apple 165, 301
Asseco Group 368–373, 375, 376
associates 14–16
Astaldi Group 14, 19, 20, 234, 235,
289, 290, 383–386, 388
Athens Stock Exchange 303
auditor 12, 79, 80, 95, 113, 127,
140–148, 166, 217, 287, 289
auditor’s opinion 147, 148
Aventine Renewable Energy
Holdings 279, 284
B
bankruptcy 9, 10, 122, 129, 142,
148, 162–164, 173, 174, 177,
178, 183, 217, 226, 232, 234,
237, 239, 244, 246, 250, 254,
279, 280, 284, 285, 289, 290,
303, 310, 332, 342, 383, 386
big-bath reserves 123
BMW 205–210, 342, 343, 397–399,
401–404
Boeing 64–66
© The Editor(s) (if applicable) and The Author(s), under exclusive
license to Springer Nature Switzerland AG 2020
J. Welc, Reading Between the Lines of Corporate Financial Reports,
https://doi.org/10.1007/978-3-030-61041-8
425
426
Index
book-tax differences 279, 346,
389–392, 394, 396, 399, 400,
404
book value 5, 55, 161
BP 7, 8
Burberry Group 219, 223
business combinations 3, 198, 200,
202, 204, 236, 241, 244, 400
current assets 52–54, 78, 158, 173,
174, 233, 243, 291, 292,
303–306, 333, 337, 340,
371–376
current liabilities 52–54, 158, 189,
333, 335, 337, 372, 376
current liquidity ratio 52, 158, 340
D
C
Canadian GAAP 56–58
capacity utilization 59, 106, 107,
247
capitalized development costs 246,
322, 342–352, 398, 399, 401
Carillion 164, 165, 232–234, 383,
386–388
cash balances 169–173, 189, 312
cash flow statement vi, 55, 84, 139,
169, 170, 172, 173, 183, 189,
196, 200–202, 204–206, 218,
312, 338, 347
Casino Group 184–188
CenturyLink 143–146
21st Century Technology 162, 163
China MediaExpress Holdings 170,
171, 173
Chrysler 17, 51–54
Claire’s Stores 177, 180
conservative accounting 121–123,
125, 127, 129, 132, 134, 356
consolidated earnings 5, 183, 371,
372
contingent liabilities 6, 7, 9
Conviviality 198, 200–204
costs of goods sold 11, 13, 44, 47,
307, 329–331
Cowell e Holdings 165, 166,
178–180, 298, 301, 302
creative accounting 221, 396
credit ratings 78
credit risk v, 7, 122, 224, 312, 334
Daimler 14–19, 342, 343, 397–399,
401–404
Dart Group 270–272
deferred revenues 84, 267–272, 302
deferred tax assets 143, 281, 367,
389–391, 394, 399–405
deferred tax provisions 346, 389–392
Delta Apparel 292, 296, 297
depreciation 56–58, 60, 61, 106,
110, 113, 117, 118, 161, 247,
254–260, 337, 338, 352–357,
390–392, 396, 398–400
derivatives 14, 17, 303, 304
development costs 3, 114, 155, 156,
159–161, 192, 206, 209, 245,
246, 343–347, 349, 351, 398,
399
double entry principle 81
E
earnings before interest and taxes 15,
18
earnings manipulations 77, 79, 80,
122, 139, 153, 249, 282, 285
earnings quality 80, 174, 180, 240,
279, 302, 308, 310, 379
easyJet 353–357
EBITDA 78, 146, 161–166,
170–172, 174, 177–180, 312,
371–376
Electronic Arts 159–161
equity-accounted investments 14–16,
18–20
Index
equity and liabilities 81, 337
eServGlobal 292, 294–296
Exito Colombia 184–187
427
GetBack 279–282, 284–287
goodwill 2, 143–146, 199, 236–242,
244, 256, 275
Google 124
F
fair value 17, 143, 145, 146, 156,
241–244, 303, 304, 405
Fiat 51–54, 205, 207, 210, 342, 343
fictitious revenues 81, 82
financial statement comparability 59,
68, 396
financial statement consolidation
157
financial statement reliability 83,
127, 132, 139, 140, 148, 172,
236, 267, 312, 396
financing cash flows 181, 195, 340
first-in-first-out (FIFO) 41, 323
fixed assets 56, 109, 110, 113, 114,
117, 118, 127, 181, 189,
190, 192, 217, 247, 248,
251, 254–260, 309, 332, 337,
352–354, 398, 399, 401–405
Folli Follie Group 302, 303, 305,
307, 308
Ford Motor 62, 63, 206–208
Formula Systems 368–376
Frankfurt Stock Exchange 158
fraudulent accounting 83, 127, 282,
321
Fresenius Group 157–159
Fresenius Medical Care 157–159
Fresenius SE & Co. KGaA 157–159
full consolidation method 52, 183,
192
G
GateHouse Media 237–239, 246,
269
General Dynamics 64–66
General Electric 79, 229–232, 279,
282, 283
H
H&M 11, 13, 26
Hanergy Holding 146, 147
Hanergy Thin Film Power Group
145, 147, 287
historical cost 2, 3, 218
Honda 342
Hudson’s Bay 2, 5, 6
I
Icelandair Group 251, 252, 254
IFRS vii, 3, 7, 14, 17, 41, 55–58,
66, 67, 77, 78, 114, 117, 140,
142, 144, 183, 192, 206, 236,
256, 286, 331, 332, 342, 343,
345, 367, 369, 370, 390, 392,
394, 405
impairment charges 11, 130,
144–146, 174, 238, 259, 291,
292
impairment test 144, 155, 242
income smoothing 78, 106, 123,
129
income tax expense 51, 395
indebtedness ratio 5, 9, 10, 67, 78,
193, 195, 340, 372
Indilinx 241–244, 274
inflating revenues 82, 84, 308
Ingenta 224, 225
intangible assets 2, 3, 114, 142, 155,
160, 189, 190, 206, 236, 238,
239, 243, 246, 322, 342–344,
346, 348, 351, 352, 398, 401,
402, 404
interest costs 14, 15, 117, 181, 182,
195, 340
428
Index
International Financial Reporting
Standards vii, 55, 56, 59, 66,
141, 144, 189, 332, 389
International Monetary Fund 59
inventories 11–13, 21, 23, 25,
42–44, 46–49, 55, 86, 95,
96, 103–107, 109, 126–129,
150, 161, 173, 174, 176–182,
198–201, 203, 217–223, 236,
247, 291–293, 296–302, 304,
306–310, 312, 323, 327, 331,
396, 398
inventory digging 46, 47, 49
inventory turnover 11, 13, 14, 42,
44, 46, 47, 49, 176, 298,
325–327
inventory write-down 12, 104, 105,
130
investing cash flows 189–192, 196,
200, 206–208, 343, 349
invoiced earnings 379, 381–388
J
long-term contracts vii, 91, 92,
228–230, 232, 234, 235, 282,
367, 376, 377, 379
Longtop Financial Technologies 79
L’Oréal 2, 3
Lufthansa 27, 28, 59–61, 255–258,
260
LumX Group 143, 144
M
many inventories 12
margin on sales 11, 13, 44, 45,
174–176, 220, 297, 299–302,
325–330
market value 2, 3, 96, 104, 105,
128, 149, 150
matching principle 43, 84, 86, 270,
377
Matthew Clark 203, 205
Mesa Air Group 129, 131, 132
Microsoft 124
minority interests 367
Monsanto 79
Jones Energy 253, 254
N
K
Kinaxis 64, 66, 67
Klöckner & Co. 322, 325
L
last-in-first-out (LIFO) 41, 323
liabilities and provisions 81, 82, 119,
122
LIFO liquidation 46, 47, 49
liquidity vi, 6, 8, 52–54, 78, 125,
158, 162, 163, 173, 219, 224,
246, 307, 331, 340, 372, 373,
376
Lockheed Martin 64–66
London Stock Exchange 162, 200,
311
NASDAQ 368
net assets 4, 5, 55, 147, 152, 158,
161, 183, 185, 203, 241, 242,
244, 368, 405
net earnings 4, 50, 51, 55, 58, 63,
80, 81, 183, 193, 345, 348,
349, 392
Netia 255, 257, 258, 260
net income 62, 63
net realizable value 11
New York Stock Exchange 170, 225,
308, 368
Nokia 298, 300, 301
non-controlling interests vii, 49–52,
54, 55, 157–159, 180–189,
367, 368, 371–376
Nortel Networks 273, 275–277
Index
O
OCZ Technology 79, 148–152,
157, 226, 227, 239–244, 246,
273–275, 292, 293
off-balance sheet liabilities 6, 78,
195, 322, 331–333, 335, 337,
338, 340, 341, 345
operating cash flows 133, 161–166,
169–180, 182–187, 189–193,
195–210, 278, 291, 303, 304,
306, 311, 312, 333, 340, 343,
345–347, 349, 386, 388
operating earnings 154, 162, 238,
290
operating income 5, 14, 15, 20, 131,
162, 173, 226, 251, 291, 303,
304, 308, 381
operating loss 11, 113, 129, 144,
175, 220, 238, 297, 332, 340
operating profit 12, 14–20, 50, 61,
66, 130, 145, 158, 162, 163,
174, 181, 182, 238, 251, 311,
330, 331, 340, 345, 346, 348,
349, 356, 357
outsourcing 114, 115, 191, 192,
343, 351
overstated assets 83
overstated equity 82
overstatement of profits 84, 106,
125, 132
429
premature recognition of revenues
84–88, 90
pre-tax earnings 16, 17, 117, 133,
134, 221, 234, 258, 278–281,
284, 346, 347, 381, 384, 385,
387–389, 395, 397, 400, 404
pre-tax profit 84, 85, 87, 88, 110,
115, 118, 190, 191, 235
price-to-earnings 63, 161
product returns 87, 119, 127,
149–152, 272, 398
profitability vi, 12, 15, 18, 43, 44,
77, 78, 123, 124, 129, 131,
146, 154, 155, 163, 165,
219, 224, 230, 231, 244,
248, 251–254, 277, 280, 297,
307, 329, 340, 344, 345, 348,
350–352, 356, 357, 395, 397,
403, 404
profit before income taxes 62
property, plant and equipment 109,
127, 142, 193, 247, 248, 252,
254, 255, 257, 259, 309, 312,
352, 358, 398, 399, 405
provision 7, 8, 10, 119–121,
129–134, 147, 150, 221, 274,
347, 392, 394
PSA Peugeot-Citroen 342, 343
Puda Coal 79
R
P
parent company 50–54, 146,
157–159, 181, 186, 198, 201,
287, 288, 367, 368, 372, 373,
405
Patisserie Holdings 170, 172, 173
percentage-of-completion method
91, 92, 153, 221, 228, 235,
282, 289, 367, 376–384
Pescanova 163, 164
PG&E 9, 10
Pittards 129, 130, 220, 221, 223
R&D 14, 114, 115, 154–156, 161,
191, 192, 342–346, 350–352,
398
Rallye 183–189
Raytheon 64–66
receivable accounts 21, 22, 24, 27,
81, 106, 127, 150, 152, 173,
175, 176, 179, 196–198,
223–229, 235, 286, 288,
290–294, 296, 304, 309, 387
receivable turnover 21, 24, 296
recoverable amount 5, 103, 104, 144
430
Index
Redcentric 173, 310–312
Regional Express 353–357
related-party transactions 146,
285–287, 289, 291
Reliance Steel & Aluminum 322,
323, 325, 326, 330
Renault 342, 343
research and development 78, 155,
156, 190, 206, 276, 288, 342,
343, 345
reserves 78, 106, 122–125, 131–134,
151, 273–275, 277, 278, 293,
297
restatement 62, 63, 148, 150, 152,
221, 222, 240, 258, 259
revaluation 286, 390, 400, 405
revenue recognition 65, 86, 90, 91,
151–153, 223, 227, 228, 267,
269, 311
round-trip transactions 95, 96, 163,
282, 285
282, 283, 289, 352, 379, 387,
388
sustainable earnings 139
T
Takata 129, 132–134, 273, 277, 278
Take-Two Interactive Software 159,
160
taxable income 49, 279–285, 389,
390, 392, 395, 396, 400, 404,
405
tax-loss carry-forwards 280, 281,
389–391, 395
Tesco 79
Tieto Oyj 64, 66–68
Toronto Stock Exchange 251
Toshiba 79, 221–223, 255, 258–260
Total GPA Brazil 185–187
Toyota 342–345, 348, 350, 351
Toys “R” Us 162
trademark 2, 154
turnover ratios 20–25, 27, 28, 254
S
sale-and-buy-back 95, 96, 280, 282,
285
Sapiens International 368–371,
373–376
Satyam Computer Services 170, 171,
173
seasonality 18, 21, 23
Securities and Exchange Commission
171, 231, 277, 282, 308
shareholder’s equity 50, 53, 55, 80,
183, 195, 205, 346, 349, 368,
405
Sino-Forest 152, 153, 157, 248–251,
254
software development costs 159, 160
Southern Cross Healthcare 332–342
Starbreeze 244–246
Stemcentrx 155, 156
sustainability vi, 124, 139, 140, 148,
166, 173, 180, 224, 230, 232,
U
unbilled receivable 228, 229, 235,
387
unused capacity 107, 109
US Airways Group 268, 269
useful lives 3, 60, 61, 110, 114, 115,
127, 236, 247, 255–258, 260,
337, 344, 345, 352, 354, 355,
357, 396, 398, 399
US GAAP vii, 3, 14, 41, 65, 77,
159, 161, 183, 192, 206, 236,
332, 342, 344, 345, 367, 389
V
Volkswagen 14–19, 205, 207, 208,
210, 298–300, 342–345,
348–351, 397–399, 402–404
Index
W
warning signal 148, 163, 171, 182,
219, 222, 224, 225, 229,
234, 240, 248, 249, 259, 260,
282, 287, 289, 292, 304, 308,
382–384, 386
warranty provisions 119, 274, 398
warranty reserves 133, 134, 274, 278
Warsaw Stock Exchange 257, 280,
285, 368
431
weighted-average method 43, 55, 56,
322, 325, 327–330
WestJet 56–59, 353–357
working capital 23, 27, 156, 174,
180, 198, 200–205, 292, 304,
309
Worthington Industries 322, 323,
325, 326, 330
write-down 11, 95, 96, 104, 109,
113, 126, 128, 130, 145, 149,
221, 291, 323