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

By Jacek Welc

This book provides a digestible step-by-step guide to reading corporate financial reports, drawing upon real-life case studies and examples of corporate collapses and accounting scandals, and applying practical tools to financial statement analysis. Appealing to a range of practitioners within corporate finance including investors, managers, and business analysts, this book is the first to specifically address the challenges facing those who are not professional accountants and auditors when examining corporate financial reports.

Corporate financial reports are used widely by managers, investors, creditors, and government agencies to examine company performance and evaluate potential risks. However, although seemingly an invaluable source of information for managerial decision-making, financial reports are often based on rough simplifications of a very complex reality. With no way of avoiding deliberate manipulations and fraudulent activity, these statements cannot be relied on completely when selecting stocks or evaluating credit risk, and therefore poor analysis can lead to potentially disastrous investment decisions.
The author suggests that in order to effectively interpret corporate financial reports, we must 'read between the lines' to accurately assess a company's economic performance and predict its long-term viability.

• Language: English
• Publisher: Palgrave Macmillan
• Release date: Nov 28, 2020
• ISBN: 9783030610418

Book preview

© The Author(s) 2020

J. WelcReading Between the Lines of Corporate Financial Reportshttps://doi.org/10.1007/978-3-030-61041-8_1

1. Most Common Distortions in a Financial Statement Analysis Caused by Objective Weaknesses of Accounting and Analytical Methods

Jacek Welc¹  

(1)

SRH Berlin University of Applied Sciences, Berlin, Germany

Jacek Welc

Email: [e-mail]

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 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 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).

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.

Table 1.1

Results of discontinued operations of AkzoNobel in fiscal years 2017 and 2018

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*2018 represents nine months

Source Annual report of AkzoNobel for fiscal year 2018

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 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.

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 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 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 pre-tax 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 pre-tax 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).

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