Reading Between the Lines of

Corporate Financial Reports: In Search

of Financial Misstatements Jacek Welc
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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 (eBook)

https://doi.org/10.1007/978-3-030-61041-8

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AG 2020
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 Preface

“There are more things in heaven and earth,

than are dreamed of…” by financial statement users
—William Shakespeare (paraphrased)

Corporate financial reports are involved in so many business and investment

activities that it is impossible to overestimate their relevance for managerial
decision-making. They are used by both corporate insiders (e.g. managers
of corporations), for instance in budgeting and performance evaluation, as
well as by external parties (e.g. stock market investors, creditors, suppliers
or governmental agencies) which are interested in an assessment of a given
company’s achievements and financial position. In fact, financial statements
constitute a primary source of information used in an examination of
corporate past results, but also in making investigations of a given entity’s
long-term perspectives, simulations of its future economic performance and
quantification of its business risk exposures.
However, even though corporate financial reports constitute an invaluable
source of information about an economic performance of companies, they
are far from being perfect. Multiple weaknesses of financial statements stem
from objective flaws of contemporary accounting methods (which always
entail rough simplifications of an often very complex business reality), as
well as from lacking immunity of corporate financial reporting to deliberate
manipulations and fraudulent acts. Consequently, reading, interpreting and
analyzing accounting numbers (e.g. when picking stocks or making credit risk

v
vi Preface

evaluation) should never be done mechanically and financial reports should

not be trusted blindly. While reading the lines of primary financial state-
ments (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 delib-
erate accounting manipulations, including aggressive and fraudulent finan-
cial 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 real-
life 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 finan-
cial statement analysis tools (such as profitability, liquidity and indebtedness
 Preface vii

ratios), although not absolutely essential, will be helpful in comprehending

the topics and problems discussed in this publication. Accordingly, those
readers who do not have any accounting background (and are not familiarized
with the three abovementioned primary financial statements), are suggested
to first learn the basics of accounting and corporate financial statements,
before reading this book. A good and clear coverage of the basic accounting
and financial statement analysis concepts may be found e.g. in the textbook
offered by Jill Collis (“Financial Accounting ”, Palgrave Macmillan, 2015).
The author’s business consulting practice has taught him that unskilled and
mechanical interpretation of data extracted from corporate financial reports
may be very hazardous and may result in very poor business and investment
decisions. Therefore, the content of this book is biased toward discussing
and illustrating the most typical problems and pitfalls associated with finan-
cial statement analysis. To the author’s knowledge, some of the issues dealt
with in this manuscript are overlooked by majority of other books on finan-
cial statement analysis (e.g. distortions caused by non-controlling interests or
manipulations of reported cash flows). This book also presents some analyt-
ical 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 corpo-
rate 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 appli-
cable 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 Jacek Welc

February 2020
 Contents

1 Most Common Distortions in a Financial Statement

Analysis Caused by Objective Weaknesses of Accounting
and Analytical Methods 1
1.1 Introduction 1
1.2 Undervaluation or Omission of Relevant Assets
on Balance Sheet 1
1.2.1 L’Oréal SA 2
1.2.2 AkzoNobel 4
1.2.3 Hudson’s Bay Company 5
1.3 Undervaluation or Omission of Relevant Liabilities
on Balance Sheet 6
1.3.1 Rental and Operating Lease Obligations 6
1.3.2 Contingent Liabilities of BP Plc 7
1.3.3 Contingent Liabilities of PG&E Corp 9
1.4 Inventory Write-Downs as an Imperfect Signal
of Problems with Excess or Obsolete Inventories 11
1.5 Distortions Caused by a Leeway in a Financial
Statement Presentation 14
1.5.1 Volkswagen and Daimler 15
1.5.2 Astaldi Group 19
1.6 Distortions of Turnover Ratios Caused by Seasonality,
Growth and Tax-Related Factors 20
1.6.1 Distortions Caused by Seasonality of Sales 21

ix
x Contents

1.6.2 Distortions Caused by Growth Rates of Sales 23

1.6.3 Distortions Caused by Changing Sales
Breakdown 25
Appendix 28
References 39

2 Other “Distortions” in a Financial Statement Analysis

Caused by Objective Weaknesses of Accounting
and Analytical Methods 41
2.1 Distortions Caused by Inventory Flow Methods 41
2.1.1 Incomparability of Results When Inventory
Prices Change 41
2.1.2 Distortions of FIFO-Based Profits When
Inventory Prices Change 43
2.1.3 Distortions of LIFO-Based Profits When
Inventory Turnover Changes 46
2.1.4 Conclusions 49
2.1.5 Distortions Caused by Noncontrolling
Interests 49
2.2 Distortions Caused by Changes in Accounting
Principles, Changes in Accounting Estimates
and Corrections of Accounting Errors 55
2.2.1 Incomparability of Results When
Accounting Principles Are Changed 55
2.2.2 Incomparability of Results When
Accounting Estimates Change 59
2.2.3 Incomparability of Results Caused
by Accounting Errors 62
2.3 Distortions Caused by Non-Mandatory Early
Adoption of New or Revised Accounting Standards 64
2.3.1 Boeing, General Dynamics, Lockheed
Martin and Raytheon 65
2.3.2 Kinaxis Inc. and Tieto Oyj 66
Appendix 68
References 75

3 Deliberate Accounting Manipulations: Introduction

and Revenue-Oriented Accounting Gimmicks 77
3.1 Quality of Earnings as One of the Major Problems
of Contemporary Accounting 77
 Contents xi

3.2 Links Between Earnings Manipulations and Balance

Sheet Distortions 80
3.3 Overstatement of Profits by Overstatement
of Revenues 84
3.3.1 Introduction 84
3.3.2 Overstatement of Profits by Premature
Recognition of Revenues Which Should Be
Deferred 84
3.3.3 Overstatement of Profits by Premature
Recognition of Revenues Which Are
Conditional on Future and Uncertain Events 86
3.3.4 Overstatement of Profits by Aggressive
Usage of Percentage-of-Completion Method
of Revenue Recognition 91
3.3.5 Overstatement of Profits by Artificial
Sale-and-Buy-Back Transactions 95
Appendix 99
References 100

4 Deliberate Accounting Manipulations: Expense-Oriented

Accounting Gimmicks and Intentional Profit
Understatements 103
4.1 Overstatement of Profits by Understatement
of Expenses 103
4.1.1 Overstatement of Profits by Understating
Write-Downs of Inventories and Receivables 103
4.1.2 Overstatement of Profits by Capitalizing
Excess Manufacturing Overheads
in Carrying Amount of Inventory 106
4.1.3 Overstatement of Profits by Aggressive
Capitalization of Costs in Carrying Amounts
of Operating Fixed Assets 109
4.1.4 Overstatement of Profits by Artificial
“Outsourcing” of R&D Projects 114
4.1.5 Overstatement of Profits by Delays
in Depreciating Fixed Assets 117
4.1.6 Overstatement of Profits by Understating
Provisions for Liabilities 119
4.2 Understatement of Profits by Overly Conservative
Accounting 122
xii Contents

4.2.1 Motivations for Profit Understatements 122

4.2.2 Four Approaches to Accounting 125
4.2.3 Real-Life Examples of (More or Less
Deliberate) Profit Understatements 129
Appendix 134
References 136

5 Evaluation of Financial Statement Reliability

and Comparability Based on Auditor’s Opinion,
Narrative Disclosures and Cash Flow Data 139
5.1 Introduction 139
5.2 Auditor’s Opinion 140
5.2.1 L’Oreal 141
5.2.2 Agrokor Group 142
5.2.3 LumX Group Limited 143
5.2.4 CenturyLink Inc. 143
5.2.5 Hanergy Thin Film Power Group Limited 145
5.2.6 Conclusions 147
5.3 Narrative Information Disclosed in Financial
Statements 148
5.3.1 OCZ Technology Group Inc. 148
5.3.2 Sino-Forest Corp. 152
5.3.3 AbbVie Inc. 153
5.3.4 Fresenius Group 157
5.3.5 Electronic Arts Inc. and Take-Two
Interactive Software Inc. 159
5.4 Discrepancies Between Operating Profits
and Operating Cash Flows 161
5.4.1 Toys “R” Us Inc. 162
5.4.2 21st Century Technology Plc 162
5.4.3 Pescanova Group 163
5.4.4 Carillion Plc 164
5.4.5 Cowell e Holdings Inc. 165
5.4.6 Conclusions 166
Appendix 167
References 167

6 Problems of Comparability and Reliability of Reported

Cash Flows 169
6.1 Introduction 169
 Contents xiii

6.2 Unreliability of Reported Cash Flows When Cash

Balances Themselves Are Falsified 169
6.2.1 China MediaExpress Holdings Inc. 170
6.2.2 Satyam Computer Services Limited 171
6.2.3 Patisserie Holdings Plc 172
6.2.4 Conclusions 173
6.3 Spurious Improvements in Operating Cash Flows
of Shrinking Businesses 173
6.3.1 Admiral Boats S.A. 174
6.3.2 Claire’s Stores Inc. 177
6.3.3 Cowell e Holdings Inc. 178
6.3.4 Conclusions 180
6.4 Distortions of Reported Cash Flows Caused
by Non-controlling Interests 180
6.4.1 Distorting Impact of Non-controlling
Interests on Reported Cash Flows 180
6.4.2 Real-Life Example of Rallye SA 183
6.5 Distortions of Reported Cash Flows Caused
by Capitalized Intangible Assets 189
6.6 Distortions of Reported Cash Flows Caused
by off-Balance Sheet Financing Schemes 192
6.7 Distortions of Reported Cash Flows Caused
by Customer Financing Schemes 196
6.8 Distortions of Reported Cash Flows Caused
by Business Combinations 198
6.8.1 Distorting Impact of Business Combinations
on Reported Cash Flows 198
6.8.2 Real-Life Example of Conviviality Plc 200
6.9 Example of Eroded Intercompany Comparability
of Reported Cash Flows 205
Appendix 210
References 215

7 Evaluation of Financial Statement Reliability

and Comparability Based on Quantitative Tools Other
Than Cash Flows: Primary Warning Signals 217
7.1 Introduction 217
7.2 Signal No 1: Discrepancies Between Revenue Growth
and Inventory Growth 218
7.2.1 Burberry Group Plc 219
xiv Contents

7.2.2 Pittards Plc 220

7.2.3 Toshiba Corp 221
7.2.4 Conclusions 222
7.3 Signal No 2: Discrepancies Between Revenue Growth
and Receivables Growth 223
7.3.1 Ingenta Plc 224
7.3.2 Aegan Marine Petroleum Network Inc 225
7.3.3 OCZ Technology Group Inc 226
7.3.4 Conclusions 227
7.4 Signal No 3: Discrepancies Between Growth
Rates of Revenues and Unbilled Receivables
from Long-Term Contracts 228
7.4.1 General Electric Co 229
7.4.2 Carillion Plc 232
7.4.3 Astaldi Group 234
7.4.4 Conclusions 235
7.5 Signal No 4: High or Fast Growing Share
of Intangibles in Total Assets 236
7.5.1 GateHouse Media Inc 237
7.5.2 OCZ Technology Group Inc 239
7.5.3 Starbreeze AB 244
7.5.4 Conclusions 246
7.6 Signal No 5: Systematically Falling Turnover
of Property, Plant and Equipment 247
7.6.1 Sino-Forest Corp 248
7.6.2 Icelandair Group 251
7.6.3 Jones Energy Inc 253
7.6.4 Conclusions 254
7.7 Signal No 6: Falling Ratio of Depreciation
and Amortization to Carrying Amount of Operating
Fixed Assets 254
7.7.1 Lufthansa Group 256
7.7.2 Netia S.A 257
7.7.3 Toshiba Corp 258
7.7.4 Conclusions 260
Appendix 260
References 264
 Contents xv

8 Evaluation of Financial Statement Reliability

and Comparability Based on Quantitative Tools Other
Than Cash Flows: Additional Warning Signals 267
8.1 Signal No 7: Changing Growth Rates of Deferred
Revenues 267
8.1.1 US Airways Group Inc. 268
8.1.2 GateHouse Media Inc. 269
8.1.3 Dart Group Plc 270
8.1.4 Conclusions 272
8.2 Signal No 8: Unusual Behavior of Provisions
for Future Costs and Liabilities 272
8.2.1 OCZ Technology Group Inc. 273
8.2.2 Nortel Networks Corp. 275
8.2.3 Takata Corp 277
8.2.4 Conclusions 278
8.3 Signal No 9: Discrepancies Between Accounting
Earnings and Taxable Income 279
8.3.1 GetBack S.A 279
8.3.2 General Electric Co. 282
8.3.3 Aventine Renewable Energy Holdings Inc. 284
8.4 Signal No 10: Related-Party Transactions 285
8.4.1 GetBack S.A. 285
8.4.2 Hanergy Thin Film Power Group Limited 287
8.4.3 Astaldi Group 289
8.5 Signal No 11: Suspected Behavior of Allowances
for Impairments of Inventories and Receivables 291
8.5.1 OCZ Technology Group Inc. 292
8.5.2 EServGlobal Ltd. 294
8.5.3 Delta Apparel Inc. 296
8.6 Signal No 12: Suddenly Changing Breakdown
of Inventories 298
8.6.1 Volkswagen Group 299
8.6.2 Nokia Corporation 300
8.6.3 Cowell e Holdings Inc. 301
8.7 Signal No 13: Other Significant and Unusual Trends 302
8.8 Importance of Investigating Combinations
of Warnings Signals 308
8.9 When Detecting Accounting Manipulations May Be
Difficult 310
xvi Contents

Appendix 312
References 318

9 Techniques of Increasing Comparability and Reliability

of Reported Accounting Numbers: Selected Simple Tools 321
9.1 Introduction 321
9.2 Adjustments for Differences in Inventory Accounting
Methods 322
9.3 Adjustments for off-Balance Sheet Liabilities 331
9.3.1 Introduction 331
9.3.2 Example of Southern Cross Healthcare 332
9.4 Adjustments for Capitalized Development Costs
and Other Intangible Assets 342
9.5 Adjustments for Differences in Depreciation Policies
Applied to Property, Plant and Equipment 352
Appendix 358
References 365

10 Techniques of Increasing Comparability and Reliability

of Reported Accounting Numbers: Some More Advanced
Tools 367
10.1 Introduction 367
10.2 Adjustments for Non-controlling Interests 367
10.3 Adjustments for Long-Term Contracts Accounted
for with the Use of the Percentage-of-Completion
Method 376
10.3.1 Complexities of Accounting for Long-Term
Contracts 376
10.3.2 Possible Profit Overstatements Caused
by Unprofitable Long-Term Contracts 377
10.3.3 Adjusting Reported Earnings for Contract
Assets and Liabilities 379
10.3.4 Real-Life Examples of Warnings Signals
Generated by “Invoiced Earnings” 383
10.4 Increasing Comparability and Reliability of Financial
Statement Numbers with the Use of Data on Current
and Deferred Income Taxes 389
10.4.1 Accounting (Book) Earnings vs. Taxable
Income 389
 Contents xvii

10.4.2 Increasing Financial Statement

Comparability and Reliability with the Use
of Income Tax Disclosures 396
Appendix 405
References 415

References 417

Index 425
 List of Charts

Chart 2.1 Hypothetical example of a group of companies (Source

Author) 49
Chart 3.1 Hypothetical non-manipulated income statement
and balance sheet (* including income taxes. Source
Author) 80
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) 81
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) 82

xix
xx List of Charts

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) 83
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) 182
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) 184
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) 358
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) 369
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) 406
 List of Examples

Example 1.1 Problem with excess inventories (followed by a collapse

of profitability) which does not require the inventory
write-down 12
Example 2.1 Impact of different inventory accounting methods
on comparability of financial results in a period
of rising inventory prices 42
Example 2.2 Distortions caused by FIFO in a time-series analysis
of results of a single company in periods of changing
inventory prices 44
Example 2.3 Distortions caused by “inventory digging” (or “LIFO
liquidation”) in periods of changing inventory prices 47
Example 3.1 Overstatement of profits by premature recognition
of revenues which should be deferred 85
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
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 90
Example 3.4 Overstatement of profits by aggressive usage
of percentage-of-completion method 93
Example 3.5 Overstatement of profits by artificial sale-and-buy-back
transactions of inventories 96
Example 4.1 Overstatement of profits by understating inventory
write-downs 104

xxi
xxii List of Examples

Example 4.2 Overstatement of profits by capitalizing (in inventory)

costs of unused capacity 108
Example 4.3 Overstatement of profits by aggressive capitalization
of routine maintenance costs in carrying amount
of fixed assets 110
Example 4.4 Overstatement of profits by artificial “outsourcing”
of R&D projects 115
Example 4.5 Overstatement of profits by artificial delays
in depreciating fixed assets 118
Example 4.6 Overstatement of profits by understatement
of a warranty provision 121
Example 4.7 Understatement of profits by overstating inventory
write-downs (alternation of Example 4.1) 128
Example 6.1 Distortions of reported cash flows caused
by non-controlling interests (NCI) 181
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) 190
Example 6.3 Overstatement of operating cash flows caused
by artificial “outsourcing” of R&D projects (extension
of Example 4.4 from Chapter 4) 191
Example 6.4 Overstatement of operating cash flows caused
by transfers of borrowed funds through unconsolidated
entities 193
Example 6.5 Overstatement of operating cash flows caused by loans
granted by a company to its customers 197
Example 6.6 Distortions of reported consolidated operating cash
flows caused by an acquisition of an inventory-intensive
subsidiary 199
Example 10.1 Application of the percentage-of-completion method 378
Example 10.2 An aggressive application of the percentage-
of-completion method for an unprofitable long-term
contract 380
Example 10.3 “Invoiced earnings” and their estimation with the use
of financial statement disclosures (based on data
presented in Example 10.2) 382
Example 10.4 Accounting for book-tax differences related
to depreciation 392
Example 10.5 Accounting for book-tax differences related to warranty
provisions 394
Example 10.6 Accounting for tax-loss carry-forwards 395
 List of Examples xxiii

Example 10.7 Reversing book-tax differences on the ground

of deferred tax disclosures (continuation of Example
10.4) 400
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