Reading Between the Lines of Corporate Financial Reports: In Search of Financial Misstatements 3030610403, 9783030610401

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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 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover illustration: Background image: santima.studio This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

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

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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

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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

1 1 1 2 4 5 6 6 7 9 11 14 15 19 20 21

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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

23 25 28 39

41 41 41 43 46 49 49

55 55 59 62 64 65 66 68 75 77 77

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

80 84 84

84

86

91 95 99 100

103 103 103

106

109 114 117 119 122

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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

122 125 129 134 136

139 139 140 141 142 143 143 145 147 148 148 152 153 157 159 161 162 162 163 164 165 166 167 167 169 169

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

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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

169 170 171 172 173 173 174 177 178 180 180 180 183 189 192 196 198 198 200 205 210 215

217 217 218 219

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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

220 221 222 223 224 225 226 227

228 229 232 234 235 236 237 239 244 246 247 248 251 253 254

254 256 257 258 260 260 264

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

267 267 268 269 270 272 272 273 275 277 278 279 279 282 284 285 285 287 289 291 292 294 296 298 299 300 301 302 308 310

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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

312 318 321 321 322 331 331 332 342 352 358 365

367 367 367

376 376 377 379 383

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

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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

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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

110 115 118 121 128 181

190

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)

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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

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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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 …

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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

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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 …

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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

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• 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),

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• 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)

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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)

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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,

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• 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 …

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• 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

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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*

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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.

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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.

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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)

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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:

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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)

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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*

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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)

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References Begley, T. (2013). The Real Costs of Corporate Credit Ratings (Working Paper No. 1230). Ross School of Business. Cahan, S. F., Chavis, B. M., & Elmendorf, R. G. (1997). Earnings Management of Chemical Firms in Response to Political Costs from Environmental Legislation. Journal of Accounting, Auditing & Finance, 12, 37–65. Cheng, Q., & Warfield, T. D. (2005). Equity Incentives and Earnings Management. The Accounting Review, 80, 441–476. Chi, J., & Gupta, M. (2009). Overvaluation and Earnings Management. Journal of Banking & Finance, 33, 1652–1663. Erickson, M., Hanlon, M., & Maydew, E. L. (2004). How Much Will Firms Pay for Earnings That Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings. The Accounting Review, 79, 387–408. Fan, Y., Thomas, W. B., & Yu, X. (2016). The Impact of Financial Covenants in Private Loan Contracts on Classification Shifting. SSRN Electronic Journal . https://ssrn.com/abstract=2675191. Giroux, G. (2004). Detecting Earnings Management. Hoboken: Wiley. Graham, J. R., Campbell, R. H., & Rajgopal, S. (2006). The Economic Implications of Corporate Financial Reporting. Financial Analysts Journal, 62, 27–39. Griffiths, I. (1990). Creative Accounting. How to Make Your Profits What You Want Them to Be. London: Unwin Hyman Limited. Holthausen, R. W., Larcker, D. F., & Sloan, R. G. (1995). Annual Bonus Schemes and the Manipulation of Earnings. Journal of Accounting and Economics, 19, 29– 74. Ketz, J. E. (2004). Hidden Financial Risk. Understanding Off-Balance Sheet Accounting. Hoboken: Wiley. Key, K. G. (1997). Political Cost Incentives for Earnings Management in the Cable Television Industry. Journal of Accounting and Economics, 23, 309–337. Kraft, T. (2012). Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Credit Spreads. The Accounting Review, 90, 641–674. Mackenzie, B., Coetsee, D., Njikizana, T., Chamboko, R., Colywas, B., & Hanekom, B. (2012). Interpretation and Application of International Financial Reporting Standards. Hoboken: Wiley. Naser, K. H. M. (1993). Creative Financial Accounting. Its Nature and Use. Hemel Hempstead: Prentice Hall. Revsine, L., Collins, D. W., & Johnson, W. B. (2002). Financial Reporting & Analysis. Upper Saddle River: Prentice Hall. Shah, S. Z. A., Butt, S., & Tariq, Y. B. (2011). Use or Abuse of Creative Accounting Techniques. International Journal of Trade, Economics and Finance, 6, 531–536. Stickney, C. P., Brown, P. R., & Wahlen, J. M. (2004). Financial Reporting and Statement Analysis. A Strategic Perspective. Mason: Thomson South-Western.

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Stlowy, H., & Breton, G. (2004). Accounts Manipulation: A Literature Review and Proposed Conceptual Framework. Review of Accounting & Finance, 3, 5–66. Whelan, C. (2004). The Impact of Earnings Management on the Value-Relevance of Earnings and Book Value: A Comparison of Short-term and Long-term Discretionary Accruals. A Dissertation Submitted to the Faculty of Business in Candidacy for the Degree of Doctor of Philosophy. Bond University, May 2004. Zack, G. M. (2009). Fair Value Accounting Fraud. New Global Risks & Detection Techniques. Hoboken: Wiley. Zhang, X. (2018). Do Firms Manage Their Credit Ratings? Evidence from RatingBased Contracts. Accounting Horizons, 32, 163–183.

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

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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 …

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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).

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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 …

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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:

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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

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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.

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• 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.

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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

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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

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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,

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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).

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• 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

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• 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

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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

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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

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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

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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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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

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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

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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.

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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

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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

References Badrinath, S. G., Gay, G. D., & Kale, J. R. (1989). Patterns of Institutional Investment, Prudence, and the Managerial ‘Safety-Net’ Hypothesis. Journal of Risk and Insurance, 56, 605–629. Barefield, R., & Comiskey, E. (1972). The Smoothing Hypothesis: An Alternative Test. The Accounting Review, 47, 291–298. Barnea, A., Ronen, J., & Sadan, S. (1975). The Implementation of Accounting Objectives—An Application to Extraordinary Items. The Accounting Review, 50, 58–68. Barth, M. E., Elliott, J. A., & Finn, M. W. (1999). Market Rewards Associated with Patterns of Increasing Earnings. Journal of Accounting Research, 37, 387–413. Beattie, V., Brown, S., Ewers, D., John, B., Manson, S., Thomas, D., et al. (1994). Extraordinary Items and Income Smoothing: A Positive Accounting Approach. Journal of Business Finance & Accounting, 21, 791–811. Beidleman, C. (1973). Income Smoothing: The Role of Management. The Accounting Review, 48, 653–667. Carlson, S. J., & Bathala, C. T. (1997). Ownership Differences and Firms’ Income Smoothing Behavior. Journal of Business Finance and Accounting, 24, 179–196. Dascher, P., & Malcolm, R. (1970). A Note on Income Smoothing in the Chemical Industry. Journal of Accounting Research, 8 (Autumn), 253–260. Feleaga, L., Dragomir, V., & Feleaga, N. (2010). National Accounting Culture and the Recognition of Provisions: An Application of the Prudence Principle. Crises et Nouvelles Problematiques de la Valeur, Nice. Francis, J., LaFond, R., Olsson, P. M., & Schipper, K. (2004). Costs of Equity and Earnings Attributes. The Accounting Review, 79, 967–1010. Fudenberg, D., & Tirole, J. (1995). A Theory of Income and Dividend Smoothing Based on Incumbency Rents. Journal of Political Economy, 103, 75–93. Graham, J. R., Campbell, R. H., & Rajgopal, S. (2006). The Economic Implications of Corporate Financial Reporting. Financial Analysts Journal, 62, 27–39.

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Gu, Z., & Zhao, J. Y. (2006). Information Precision and the Cost of Debt (Carnegie Mellon University Working Papers). Hunt, A., Moyer, S. E., & Shevlin, T. (2000). Earnings Volatility, Earnings Management, and Equity Value (University of Washington Working Papers). Jung, B., Soderstrom, N., & Yang, S. (2012). Earnings Smoothing Activities of Firms to Manage Credit Ratings. Contemporary Accounting Research, 30, 1–14. Li, S., & Richie, N. (2009). Income Smoothing and the Cost of Debt (Wilfrid Laurier University Working Papers). Myers, J., Myers, L., & Skinner, D. (2007). Earnings Momentum and Earnings Management. Journal of Accounting, Auditing & Finance, 22, 249–284. Penman, S. H., & Zhang, X.-J. (2002). Accounting Conservatism, the Quality of Earnings, and Stock Returns. The Accounting Review, 77, 237–264. Powell, L., Jubb, C., De Lange, P., & Langfield-Smith, K. (2005). The Distinction Between Aggressive Accounting and Financial Reporting Fraud: Perceptions of Auditors. AFAANZ Conference 2005. Previts, G. J., Bricker, R. J., Robinson, T. R., & Young, S. J. (1994). A Content Analysis of Sell-Side Financial Analyst Company Reports. Accounting Horizons, 8, 55–70. Rountree, B., Weston, J., & Allayannis, G. (2008). Do Investors Value Smooth Performance? Journal of Financial Economics, 90, 237–251. Suda, I., & Hanaeda, H. (2008). Nihon kigyo no zaimu hokoku: survey tyosa ni yoru bunseki (Corporate Financial Reporting Strategy: Survey Evidence from Japanese Firms). Securities Analysts Journal, 46, 51–69. Trueman, B., & Titman, S. (1988). An Explanation for Accounting Income Smoothing. Journal of Accounting Research, 26 (Supplement), 127–139. Wang, Z., & Williams, T. H. (1994). Accounting Income Smoothing and Stockholder Wealth. Journal of Applied Business Research, 10, 96–104.

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

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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

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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

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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 …

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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

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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

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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

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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.

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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.

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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.

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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

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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.

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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

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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

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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

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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.

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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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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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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

References Becker, C. L., DeFond, M. L., Jiambalvo, J., & Subramanyam, K. R. (1998). The Effect of Audit Quality on Earnings Management. Contemporary Accounting Research, 15, 1–24. Chan, K., Chan, L. K. C., Jegadeesh, N., & Lakonishok, J. (2006). Earnings Quality and Stock Returns. Journal of Business, 79, 1041–1082. Doris, L. (1950). Corporate Treasurer’s and Controller’s Handbook. New York: Prentice-Hall. Gray, I., & Manson, S. (2011). The Audit Process. Principles, Practice and Cases. Andover: South-Western Cengage Learnings. Hayes, R., Dassen, R., Schilder, A., & Wallage, P. (2005). Principles of Auditing. An Introduction to International Standards on Auditing. Harlow: Pearson Education. Howard, M. (2008). Accounting and Business Valuation Methods. How to Interpret Accounts. Oxford: Elsevier. Jackson, C. W. (2015). Detecting Accounting Fraud. Analysis and Ethics. Harlow: Pearson. Jones, M. (Ed.). (2011). Creative Accounting, Fraud and International Accounting Scandals. Chichester: Wiley.

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Lee, T., Ingram, R., & Howard, T. (1999). The Difference Between Earnings and Operating Cash Flow as an Indicator of Financial Reporting Fraud. Contemporary Accounting Research, 16, 749–786. Millichamp, A., & Taylor, J. (2008). Auditing. London: South-Western Cengage Learnings. O’Glove, T. L. (1987). Quality of Earnings. The Investor’s Guide to How Much Money a Company Is Really Making. New York: The Free Press. Sloan, R. G. (1996). Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings? Accounting Review, 71, 289–315. Vause, B. (2014). Guide to Analysing Companies. London: Profile Books. Xie, H. (2001). The Mispricing of Abnormal Accruals. Accounting Review, 76, 357– 373.

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

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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 …

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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

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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

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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

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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

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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

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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),

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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

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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.

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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.

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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

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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:

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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 …

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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

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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,

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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,

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– 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 …

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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

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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 …

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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

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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)

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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

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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 …

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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

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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).

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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

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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

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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

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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

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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

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(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).

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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

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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

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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.

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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

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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(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

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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

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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

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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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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

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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

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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

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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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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.

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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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– 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

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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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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.

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• 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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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

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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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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

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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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• 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

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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

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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 …

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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

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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

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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 …

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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)

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References Beneish, M. D. (1999). The Detection of Earnings Manipulation. Financial Analysts Journal, 55, 24–36. Dechow, P. M., Sloan, R. G., & Sweeney, A. (1996). Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC. Contemporary Accounting Research, 13, 1–36. Fairfield, P. M., Whisenant, J. S., & Yohn, T. L. (2003). Accrued Earnings and Growth: Implications for Future Profitability and Market Mispricing. The Accounting Review, 78, 353–371. Frank, M. Z., & Goyal, V. K. (2003). Capital Structure Decisions. AFA 2004 San Diego Meetings. Available at: http://ssrn.com/abstract=396020. Gilson, S. C., John, K., & Lang, L. H. P. (1990). Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default. Journal of Financial Economics, 27, 315–353. Jung, M., You, S., Chi, S., Yu, I., & Hwang, B. G. (2018). The Relationship Between Unbilled Accounts Receivable and Financial Performance of Construction Contractors. Sustainability, 10, 645–676. Khandani, B., Lozano, M., & Carty, L. (2001). Moody’s RiskCalc for Private Companies: The German Model . Moody’s Investors Service. Kwon, K. H., & Lee, N. (2019). Unbilled Receivables, Loss Allowances and Earnings Management. Academy of Accounting and Financial Studies Journal, 23, 1–11. Lev, B., Sarath, B., & Sougiannis, T. (2005). R&D Reporting Biases and Their Consequences. Contemporary Accounting Research, 22, 977–1026. Loughran, T., & McDonald, B. (2011). Barron’s Red Flags: Do They Actually Work? Journal of Behavioral Finance, 12, 90–97. Marquardt, C. A., & Wiedman, C. I. (2010). How Are Earnings Managed? An Examination of Specific Accruals. Contemporary Accounting Research, 21, 461– 491. Nelson, M. W., Elliott, J. A., & Tarpley, R. L. (2003). How Are Earnings Managed? Examples from Auditors. Accounting Horizons, 17, 17–35. Persons, O. (1995). Using Financial Statement Data to Identify Factors Associated with Fraudulent Financial Reporting. Journal of Applied Business Research, 11, 38–46. Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, I. (2005). Accrual Reliability, Earnings Persistence and Stock Prices. Journal of Accounting and Economics, 39, 437–485. Spathis, C., Doumpos, M., & Zopounidis, C. (2002). Detecting Falsified Financial Statements: A Comparative Study Using Multicriteria Analysis and Multivariate Statistical Techniques. The European Accounting Review, 11, 509–535. Teoh, S. H., Wong, T. J., & Rao, G. (1998). Are Accruals During Initial Public Offerings Opportunity? Review of Accounting Studies, 3, 175–208.

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Thomas, J. K., & Zhang, H. (2002). Inventory Changes and Future Returns. Review of Accounting Studies, 7, 163–187. Wright, G. B., & Cullinan, C. P. (2017). Corporation: The Case of the Standing Timber. Global Perspectives on Accounting Education, 14, 10–22.

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

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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 …

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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

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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 …

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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

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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

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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.

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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

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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.

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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

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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.

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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.

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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

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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.

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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

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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.

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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

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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.

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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,

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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

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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”

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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.

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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),

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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

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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

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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.

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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

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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

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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 …

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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

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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

303

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

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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).

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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

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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).

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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

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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

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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

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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

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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

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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

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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

References Caylor, M. (2009). Strategic Revenue Recognition to Achieve Earnings Benchmarks. Journal of Accounting and Public Policy, 29, 82–95. Chen, J. J., Xiao, X., & Cheng, P. (2011). Related Party Transactions as a Source of Earnings Management. Applied Financial Economics, 21, 165–181. Dechow, P. M., Ge, W., Larson, C. R., & Sloan, R. G. (2011). Predicting Material Accounting Misstatements. Contemporary Accounting Research, 28, 17–82. Hanlon, M. (2005). The Persistence and Pricing of Earnings, Accruals and Cash Flows When Firms Have Large Book-Tax Differences. The Accounting Review, 80, 137–166. Lee, H. A., & Choi, W. W. (2016). Allowance for Uncollectible Accounts as a Tool for Earnings Management: Evidence from South Korea. International Journal of Accounting & Information Management, 24, 162–184. Lev, B., & Nissim, D. (2004). Taxable Income, Future Earnings and Equity Values. The Accounting Review, 79, 1039–1074. McNichols, M., & Wilson, G. P. (1988). Evidence of Earnings Management from the Provision for Bad Debts. Journal of Accounting Research, 26, 1–31.

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Peek, E. (2004). The Use of Discretionary Provisions in Earnings Management: Evidence from the Netherlands. Journal of International Accounting Research, 3, 27–43. Philips, J., Pincus, M., & Rego, S. (2003). Earnings Management: New Evidence Based on the Deferred Tax Expense. The Accounting Review, 78, 491–522. Philips, J., Pincus, M., Rego, S., & Wan, H. (2004). Decomposing Changes in Deferred Tax Assets and Liabilities to Isolate Earnings Management Activities. The Journal of the American Taxation Association, 26, 43–66. Public Company Accounting Oversight Board (PCAOB). (2017). Auditing Standards of the Public Company Accounting Oversight Board (AS 2401: Consideration of Fraud in a Financial Statement Audit). Washington, DC: PCAOB. Sevin, S., & Schroeder, R. (2005). Earnings Management: Evidence from SFAS No. 142 Reporting. Managerial Auditing Journal, 20, 47–54. Suer, A. Z. (2014). The Recognition of Provisions: Evidence from BIST100 Nonfinancial Companies. Procedia Economics and Finance, 9, 391–401. Teoh, S. H., Wong, T. J., & Rao, G. (1998). Are Accruals During Initial Public Offerings Opportunity? Review of Accounting Studies, 3, 175–208. Weber, D. (2009). Do Analysts and Investors Fully Appreciate the Implications of Book-Tax Differences for Future Earnings? Contemporary Accounting Research, 26, 1175–1206. Wells, J. T. (2005). Principles of Fraud Examination. Hoboken: Wiley.

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

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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,

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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

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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

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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

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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

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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.

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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).

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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

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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.

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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

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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

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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.

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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

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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

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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

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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

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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)

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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

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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

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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

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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.

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• 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

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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.

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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

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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

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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

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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

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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).

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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

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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

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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

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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).

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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

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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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

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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

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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).

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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

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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

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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

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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

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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

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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

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• 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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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

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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:

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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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• 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

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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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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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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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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.

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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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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.

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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

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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

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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

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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

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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