Right let's get started. So thanks for joining today's webinar on forensic accounting. Before we dive into materials that we're going to be using for this webinar a quick introduction to me. My name is Deborah Taylor. I'm a trainer at Financial Edge, where I've been teaching for about six years now. And before I joined Financial Edge, my background is I spent nearly 10 years working in equity research where I was an accounting and valuation analyst at Barclays. And specifically in that role, I spent a huge amount of time digging into financial statements, looking for anomalies in accounting and potential investment ideas for clients. For example, hedge funds who are looking for interesting opportunities. So, my background lends itself to a bit of forensic accounting. I'm gonna share some of my expertise on that with you guys today. Right? Let me share my screen. Just as we get started, I would encourage you to access the materials, that have been provided to you. We're gonna be doing some exercises. This is definitely not a session where you can just sit back and, do nothing. I'm gonna ask you guys to to do some activities. Obviously you won't be able to share your responses with me, but it does help to make sure that you are following the content. And as we go through, if you've got any questions, we do have a question and answer box. So please do submit your questions as we are going through the materials.

Right? Let's start talking about forensic accounting, which sounds pretty hardcore, particularly for a Friday. But the reality is this is really a core analyst skill. What do I mean by that? Well, let's say for example, if you work in research, either on the sell side or the buy side, it's critical that you can spot early signs that maybe a company is underperforming or maybe you're doing due diligence for an m and a deal or a private equity transaction. You really need to spot any concerns around that targets, underlying performance. And then finally, what about if you work in credit? Maybe you are running some analysis on a company that you're potentially going to be lending to you. You definitely want to be able to spot any red flags around a company's performance. And that's really what we are trying to get to grips with today. How can we build a little framework for identifying signs of company distress? With that in mind, it's worth just doing a little bit of myth busting. I think we have to reign in our enthusia enthusiasm slightly when it comes to forensic accounting work. Some of it might be quite enlightening in terms of the volume of work that's needed. So let's just bust a few myths around forensic accounting, at least the stuff that we are going to be doing. The first myth is that we are always looking for evidence of fraud or that we can accurately predict corporate collapse. The reality is that most of the time that's not the case. We are looking for much more subtle clues around a company's underlying performance. We are really looking for evidence of bias in a company's financial statements, and that bias helps the company to conceal poor performance. Now, that's not always as extreme as a corporate fraud, and it doesn't always mean that a company's about to go bust within the next 12 months. But as analysts being able to spot the early signs that companies may be not doing as well as everyone else thinks is really valuable.

The next myth is that we need really detailed knowledge of all the accounting rules, because that helps us to spot areas of non-compliance. This is definitely not a checkbox exercise. Yeah, and we definitely don't need to know all the accounting rules. The reality is we need to know the high risk areas. We need to know the soft areas and the accounting because this is where the bias is likely to arise. These are the areas where there are levers that the management team of a company can pull, maybe if they want to massage how they communicate their performance. And we are gonna focus on those soft areas in this session.

The third myth is that we need to read the financial statements cover to cover. 'cause that helps us to spot all the accounting red flags. Believe me when I say I've never sat down and read a set of financial statements cover to cover, it's not only incredibly boring, but it makes it very difficult to see the wood from the trees. We want to use a much more risk focused and targeted approach. And so what we are gonna do is we're gonna use things like ratios and focus on key aspects of a company financial statements. In our efforts, it may well be that we then have to drill down and do some more detailed analysis and review of detailed footnotes, but the starting point is usually quite high level high. So that's how we are going to approach things. But let's dive in and find out what those soft areas that we are gonna cover today. We only have an hour. But so we are gonna just kind of dip our toes into the waters of some of these soft areas. And there are three areas where in my view, companies have these levers that they can pull to massage how they communicate their performance. The first of these applies only to public companies, and that is the communication of non-GAAP numbers. Okay? And we'll go into a bit more detail about what we mean by non-GAAP and why this is a soft area. But that applies only to public companies going round in a anti-clockwise direction. Estimated numbers. That's the next area. You might think to yourself, well, hang on a second. The numbers in financial statements are not estimates, but that's really not the case. There's plenty of areas where management have to make judgment in how numbers are recorded. And so those areas are inherently soft. And we are gonna focus on not only some of the areas where management make key judgements, but also some of the symptoms that we see when aggressive estimates are used. And the final area is classifying cash flows. It's an often used phrase that profits well, cash is backed, profit is fiction. And that assumes that therefore cash cannot be manipulated by companies. The reality is that's not true. Companies have some discretion in how they present cash flows, particularly in how they classify their cash flows in the cash flow statement. Some of that is really about how they structure the transactions because that then also influences how those transactions are presented. So kind of bringing all of these three areas together, if we spot that there is bias and at least one of these areas, then we have a major red flag. Now today, we're not gonna have time to go into lots of case studies to demonstrate these. But the materials that you've been given access to have lots of case studies in them. And I'd encourage you after the webinar to go into those materials and have a look at the case studies. And I think it would surprise you how many times we actually have red flags in more than one of these areas. So where we've got an intersection of those where we've got a red flag in two or three of those, that definitely gives us more confidence that there is really something concerning in the numbers that may be management are not wanting to make clear in their financial results. Okay, so that is soft areas of accounting. Now we're gonna go through all three of these today, but we're gonna spend a little bit more time on the estimated numbers just because we are a little bit tighter on time, than we would normally spend on forensic accounting. So we're gonna spend a good chunk of the time focusing on estimated numbers. But let's start off with non-GAAP, and just spend a few minutes talking about if we are looking at public company, why we might want to challenge those non-gap numbers. What do we mean by non-GAAP? That's the first thing, right? Well, non-GAAP is basically KPIs, that are used by management in their press release and often in analyst presentations. And they can be referred to with lots of different descriptors. They can describe their earnings as adjusted underlying core earnings, trading earnings. And even pro forma can be a form of non-GAAP numbers. Now, the critical thing that links all of these, however they're described, is that non-GAAP metrics are not covered by accounting rules management define their own KPIs. They include those KPIs each year in their results and in their analyst presentations. But that does mean that they have flexibility in how those numbers are calculated. They're not strictly audited numbers, okay? So we have to have a little bit more skepticism in how we analyze them. And in particularly, in particular, I would encourage you to scrutinize the adjustments that management make. Now, hopefully for us, the regulations both under in Europe and in the US require some kind of reconciliation between GAAP. That's the numbers on the face of the financial statements and non-GAAP numbers. So we get to see the adjustments that management make and I would really encourage you guys to scrutinize those adjustments. But also maybe just look at key ratios like for example, the proportion of non-GAAP to gap earnings. That gives you an idea of how much those adjustments are contributing to non-GAAP earnings, right? Let's have a look at the sorts of adjustments that management make, and I broadly categorize them into these four buckets. And we're gonna start off on the right hand side of this slide. And the first type of adjustment that management make is usually to exclude volatile items. That can be things like transaction gains and losses, FX gains and losses items which move around each year and maybe help maybe create a bit of noise in the numbers. So it's helpful to be able to exclude those from underlying earnings metrics. And therefore, indeed, when management do make these sorts of adjustments, we usually relatively relaxed about them. Obviously we have to remember that companies with large amounts of volatile items, that does increase the risk of the company. But for a perspective of measuring or understanding underlying performance, they're not very predictive. Moving along, the next items that tend to get adjusted for are m and a items. For example, adding back amortization of m and a intangibles, or even excluding acquisition costs. And again, I have some sympathy with these adjustments because actually it's not very predictive. Amortization of M&A intangibles tends to unwind over a few years. And acquisition costs, they don't recur. So actually excluding those, I think generally makes sense, but as we move to the left, we start to get a little bit more concerned. The next category is excluding non-recurring items. That's things like restructuring costs, litigation costs, or even asset impairments. Now, if they are truly non-recurring items, then no problem with management making those sorts of adjustments. But we do have to be careful because there are lots of examples of companies making adjustments to, for, for items that they deemed to be non-recurring, which actually do recur each year. An example might be a pharmaceuticals company, which adds back litigation costs, you know, which in an industry where litigation is generally quite high, we might consider that a certain proportion of those costs are actually operational costs of you know, being in that industry. So a little bit of caution when we are looking at non-recurring items. The box on the left though, that's the ones where we have to be really on red alert. And those are adjustments the management make to really adjust the accounting where they deem that the existing accounting rules that gap maybe don't communicate fully their performance, but we have to remember that the accounting standards are set with a great deal of collaboration with companies and experts. And so we really have to question whether management could do a better job of coming up with accounting rules and examples of the sorts of adjustments which we are particularly concerned about. Adding back anything that's non-cash, for example, stock option costs. And also where the presentation has changed, for example, joint venture and associate profits, those are equity method income items being added in to their operating profits. In general, we would view, those sorts of profits as non-core and therefore we wouldn't want to include them in underlying business performance. So we can kind of think of this being a spectrum of adjustments. So when we scrutinize that reconciliation, we can say to ourselves, well, the items on the right, they're generally low risk. But if we see many more adjustments on the left hand side, as in particular things like adding back stock option costs or other non-cash recurring items, we would definitely, view that as a red flag around understanding a company's performance. With that in mind, let's have a go at an example reconciliation. This is a company based on a real one, a company's reconciliation of reported operating profit to their underlying EBIT. And we've got two years worth of data here, and we are going to try and identify any adjustments which we would have concerns about. And you can see we've got four numbers on the screen. I want you to spend 10 seconds looking at this reconciliation, and then we'll go through and identify what those four concerns might be. So I'll just pause for 10 seconds.

Okay, let's have a look. Let's see what's concerning about this particular

And in fact, before I even dive into any specific numbers, I would just highlight we've got a bit of a concerning trend, which is that we have operating profit for the company going down between 2017 and 2018 whereas the underlying EBIT is trending the other way. So already we would have some concerns that that the adjustments are being made to reverse the trend, which is the earnings are falling. Okay? So we should already be on red alert that there are some levers being paused by management.

So the first thing is to highlight that we've got restructuring costs, which they can definitely be non-recurring, but in this particular example, it appears to be that they are non re that they are actually recurring items. So we really have to ask ourselves, are they really valid to be excluded? But also this is clearly a signal the company is you know, if it's repeatedly having to restructure, there is some potential concern about the underlying business performance.

Next, we have gains from asset disposal not being referenced in the reconciliation, but we have the costs associated with asset disposal being added back. So we have to be a bit careful about cherry picking. It's often the case that management will add back non-recurring costs, but then, not make an adjustment for non-recurring income items. The third item, pension costs, pension service costs a little bit like stock option costs, non-cash operational costs. Those are definitely recurring. They're part of compensation. If a company is making pledges around the pension benefits in the same way that it's offering stock options, those are recurring staff costs. Even if they aren't cash, they definitely have monetary value to an employee. We often in the financial services industry talk about our total comp for a reason. So, added back that definitely raises a red flag.

And then finally they've got that classic where profits from associates are being added in to their underlying ebit that just gives a nice boost to their underlying EBIT. But generally we would assume that those are non-core income items and therefore not something for inclusion in underlying EBIT. So those are the sort of red flags that come in that reconciliation. So remember the key things here to look to the adjustments and secondly, to look at the trend around underlying EBIT versus the reported number. And finally, a nice ratio for you to use when you're just kind of looking for these red flags initially is to look at the ratio of non-GAAP to GAAP earnings.

Okay? So that is non-GAAP. Just before we draw a line under this topic, you may have heard about Thomas Cook, a UK company.

They did report their own non-GAAP earnings metric, their underlying EBIT, regularly through to 2018. You can see the historical time series here, the dark green is their underlying EBIT and the gray blocks, the reported figure, that's the GAAP earnings numbers. And we can see that 2015 through to 2017, there was a great deal of difference. So the percentage there is a percentage uplift to get from reported to underlying, and then in 2018 it rocketed. So that underlying EBIT was 158%, uh, of the operating profit figure. And definitely that was a red flag. Thomas Cook went into liquidation just 10 months after publishing its 2018 annual report. Now, it wasn't just about the nature of the adjustments that would've given this one away. They did also make a number of, uh, adjustments. The actual nature of the adjustments were very concerning. So they had lots of operational adjustments in particularly in that final year in 2018. So scrutinizing that reconciliation can be a really good starting point. Now, we said at the beginning there are three soft areas of the accounting. We've looked at a relatively high level at non-GAAP. Now let's move on to a slightly meaty topic, which is the topic of estimated numbers. How can management stretch the truth when it comes to estimates in their financial statements? Now, we are gonna look at four key areas here, and these in my mind, are the four key areas that I have seen companies try to stretch the truth around their performance. Okay? And I think this therefore gives us quite good coverage of the sorts of issues that you'll come across. But also critically, it does help us to identify the sorts of symptoms we get, when estimates are being used to massage a company's performance. Now, some of these topics are gonna be specific to certain industries, okay? So for example, contract revenue and profit recognition. That's clearly gonna be relevant to companies in industries with contracts. So we're thinking here about services construction and even particularly long cycle industrials. Okay? So if you're thinking, well, hang on a second, that's not relevant to any of the industries that I look at. Well, maybe inventory is gonna be more up your street inventory valuation. There is gonna be some judgment around that. And that in particular is relevant for consumer businesses that staples in particular and also industrials. So inventory valuation for some slightly different sectors. The final two topics are however, completely sector agnostic provisions, the use of provisions, how that can be used to massage earnings. Every single sector it's a potential risk for. And a final One, slightly more complex topic is accounting for M&A and the softness that can result from m and a accounting. So as it says on the slide, these numbers are gonna be highly subjective and therefore could be subject to management bias. So where does the bias arise? I'm gonna talk you through each issue, but we're also gonna do some workouts here. So really helpful if you can get your workout file to hand and you can work out work through those with me.

Let's start off with contract revenue and profit recognition. So the issue we have here is how revenues and profits are gonna be recognized in different accounting periods where you've got long-term contracts. Now the example we are gonna use is a multi-year contract, but it could equally apply where you've got multi quarter contracts as well. Now the critical thing here is that the accounting standards, and if you are looking at companies under IFRS, it's IFRS 15. If you're looking at US companies, it's a ASC 606. The rules are relatively uniform under IFRS and US GAAP. But the key thing is that for long-term contracts, the, for the most part, revenue is recognized on what we refer to as a cost to cost basis. What that means is that costs incurred during a product are gonna drive revenue and profit recognition, and that's costs incurred relative to total estimated contract cost. Okay? And that is gonna be absolutely critical. And before we do anything else, let's dive into our workout file and have a look at how cost of cost accounting works. I'd like you to go to the estimates tab of your workout file. And here we've got an example contract. So workout one, a company has entered into a three year contract with a customer for a fixed fee of 100 management estimates that estimates that total contract costs will be 80. We're asked to calculate the contract revenues and profits throughout the three years, given the information below on the actual costs incurred. Then we're asked to see how revenues and profits change if there are cost overruns in year three. And those overruns are 10. Let's start off with the initial inputs. We have a revenue, a fixed fee contract, remember, and that's 100 and management estimates that total costs will be 80. So right at the initial points, contract profits are expected to to be 20.

Okay, now how are those profits? And also the related revenues gonna be spread over the three years. Remember, we're gonna use cost to cost accounting here. So what we're gonna do is we're gonna take the proportion of costs incurred each year, and we are gonna spread the revenues based on the proportion of costs relative to total contract costs. Now you can see here we've got contract costs of 20 in year one 50 in year two and 20 in year three, sorry should say, should say 10 in year three, apologies. So that gives us 80 of total contract costs. That's what's been expected upfront by management. So let's take our contract costs 20, we're gonna divide that sorry, we're gonna multiply that, sorry, by our contract revenue of 100. And we're gonna lock that sell reference. And I'm gonna divide that by total contract costs. So effectively what we're saying is we've incurred one quarter of the total contract costs in year one. So we're gonna recognize one quarter of the contract revenue that gives us revenue of 25. We then deduct the costs incurred from the revenue, and that gives us profit recognized in year one of five.

So that's year one, we can roll forward these calculations. Year two, we get a jump in the amount of revenue recognized. That's simply because we've also got a jump in the amount of contract costs incurred. And again, contract profit is just the difference between revenue and costs. So, so far, so straightforward. Now let's calculate year three's numbers. Now, this time I'm gonna do something slightly different. I'm gonna acknowledge that this is a fixed fee contract. So the revenue that can be recognized in year three is simply the total revenues under the fixed fee arrangements, less revenues recognized in previous years.

And again, profits is just a difference between our revenue and our costs. So that is the profile of revenue and profit recognition if everything goes according to plan, all good. But the question asks us, how do revenues and profits change? If there are cost overruns of 10 in year three, that means that contract costs in year three are actually going to be 20. What happens? Ah, things have gone horribly wrong. We are no longer recognizing a profit in year three, we're recognizing a contract loss. But why? Well, the reason is simply because we've recognized revenues too early that forced us to recognize profits too early in actual, in reality, um, we, we've management have overestimated the contract profits and therefore that's led to too much revenue of profit being recognized early on in the contract. We then effectively have to reverse out some of the profits previously recognized.

So this means that if management's are aggressive around their estimates of contract costs, this can help them to report exaggerated revenues and profits in the early years of the contract. And in fact, in year three, when things go bad, well we'll have a contract impairment and maybe we can just highlight that as a non-recurring item in our non-GAAP earnings. So it gets excluded from underlying earnings anyway. So what we're going to see in terms of the symptoms of this, well, we're gonna see elevated margins because we've got too much profit being recognized in the early years profit that never fully materializes, at least in terms of the margin level. But then also in the balance sheet, we're gonna have high levels of accrued income what we now refer to as contract assets in our working capital.

And in the cash flow statement, we are going to see low levels of cash conversion because effectively we're gonna have a working capital build in the balance sheet. Let's have a look at how we can document that. Now, I'm gonna put together just in a blank spreadsheet, I refer to this as my symptom tracker. Okay? This is the symptoms of aggressive long-term contract accounting. So what do we see in the income statement? Well, we see elevated, oops, we see elevated margins.

Okay? So too much profit are being recognized, which elevates our margins. Then we see in the balance sheet where we see high levels or elevated levels of contract assets. Remember that's just a new way we describe accrued income.

In the cash flow statements, we see low cash conversion. Effectively, we've got profits being recognized, which are never gonna convert to cash. I've also got a little column here for the non-GAAP reconciliation. Well, as I've mentioned, if a company's recognizing contract impairments, we're probably gonna see those adjustments later in the contract life because they'll describe them as being non-recurring. So there we have our symptoms for long-term contracts where there's aggressive revenue recognition. These are the places that we can spot it in our financial statements, and we're gonna keep coming back to this symptom tracker because it'll be interesting to see if the symptoms are similar across lots of the different items that we look at. Let's go back to our slides.

So the next area, as I mentioned, is inventory valuation. Now, why are there estimates in relation to inventory valuation? Well, the key thing is how overheads are allocated to inventory. So inventory has to be recorded at the lower of cost and the net selling price, but cost, what does that mean? What's involved in producing a unit of product? Well, that includes direct costs, but also an allocation of manufacturing overheads. And how are those overheads allocated? Well, most companies or many companies use what we refer to as activity based costing. Some sometimes abbreviated to A, B, C. It's as easy as a B, C to estimate your inventory. What that means is the overheads allocated on the basis of the number of units produced each period, not the units sold, the units produced. Let's have a look at how those numbers, can work in practice. So workout two, we've got an example of a company which produces 100 units of inventory during the year. We're told that direct costs for the inventory production are three per unit and production overheads are 200. We're asked to calculate the cost of goods sold for the year and the inventory balance at the end of the year if 80 of those units are sold. Now below that narrative, we've got some data, which has just taken from that question. We've got the 200 of overheads that need to be allocated, the direct, direct costs per unit of three. And we've got, I'm gonna put that as 100, sorry, 100 of units being produced and 80 of units being sold, right? So now let's calculate the cost per unit during that year. The direct costs, well, we know, we've been told that those direct costs are three per unit, but we know that the overheads incurred in the year of 200, they were involved in producing 100 units of inventory. So we're gonna take the overheads of 200, divide it by the number of units produced, and that gives us the allocation per unit of two. So that means the total cost per unit of inventory is five. Okay? So each unit of inventory initially goes into the inventory balance at five each, and then when that unit is sold, that's gonna go into the cost of goods sold at five as well. So let's work out the cost of goods sold for that inventory during the year 80 of those units are sold. So we're gonna take the units sold of 80, multiply it by the cost per unit. So the cost of goods sold is 400. Okay? What about the inventory balance at the end of the year? How much inventory do they have left? Well, we know that we started with a hundred units being produced. We know that eight of those units were sold. If we multiply that by the cost per unit, that means our inventory balance at the end of the year, those 20 units are worth 100. So that is the process of allocating overheads to, each unit of inventory. But where are the estimates? How can management pull the levers around those estimates? Well, let's see what happens if there is an increase in the number of units produced. Let's say instead the number of units produced is 150. What's gonna happen to our cost of goods sold? Our cost of goods sold have gone down. They've gone down from 400 to just under 350. And of course the inventory balance has gone up because we've got more units unsold.

So this is an issue because by ramping up their inventory, they've managed to reduce their cost of goods sold. And this is gonna flatter their performance. In particular, it's gonna elevate their margins in the income statement, but we're also gonna have elevated levels of inventory in the balance sheet.

In terms of the cashflow statement, well, we're gonna have lower cash conversion because that inventory build is gonna create a drag on our working capital in our cashflow statement. And what about the non-GAAP rec? Well, in the non-GAAP rec, eventually we're gonna end up with some inventory, inventory impairments, because actually some of this inventory which is a, you know, maybe overproduced may not be sold. So let's go back to our symptom tracker. So we had a reduction, our cost of goods sold, and therefore elevated margins. In the balance sheet, we've got elevated inventory.

So again, elevated working capital in the cash flow statement. Again, we're gonna have lower cash conversion. And in our non-GAAP reconciliation, we're gonna have inventory impairments.

So some quite similar symptoms being displayed, even though they are quite different issues.

Let's go back to our slides.

So the next area we're gonna look at is provisions. So provision balances. Well, where's the risk here? So provisions are recognized by companies as soon as they anticipate a probable cash outflow in the future, okay? And that results in expense being recognized in the income statement, but that provision, what if it's never, what if it's never utilized? What if the cashflow never occurs? Well, the cashflow, if it never occurs, well that means the provision is released, it's reversed, which means we then have the opposite effect. We have an income item in the income statement. So we can think of provisions as a bit of a cookie jar that management can store them away in good years and then release them in lean years to help massage how performance is communicated. So let's have a look at our workout just to kind of demonstrate that. Go to our workout file here we have workout free.

And here we have a company which has generated 100 of revenue and incurred 70 of costs in years one to three. Three at the end of year one management decides to recognize a restructuring provision of five. This provision is then released during year three, and we're asked to calculate the company's operating profit in years one to three. Now, important during those years, we have revenue flat 100 costs are flat and 70 in each year. However, we're gonna include within our operating profits some restructuring costs because we know the provision is created in year one. Now I'm gonna show costs as a positive number. So I'm gonna take my provisions balance of five in year one, deduct the prior year provisions balance, and that gives me a cost of five, which goes into my operating profit. So let's calculate my operating profit, and we can see that's 25 in the second year, we actually have our operating profits going up to 30. And that's because the provision is still there in the balance sheet. No change, no income, no expense associated with that. But the prior year did have that restructuring expense going through. So we now have a small increase in our operating profit in year two. What happens in year three? Well, that's the year that the provision is released. And remember that's an income item. And so what that does is it gives a nice sweet boost to profits. And what we now have, instead of flat operating profits, we have a nice year on year growth in profits and that cookie jar being utilized by management. So remember this is sector agnostic. Any sector can use provisions and therefore we do need to be really on red alert. Now, what sorts of symptoms do we get when companies are using provisions to boost their earnings? Well, clearly what we're gonna have in the year that the earnings are released, we're gonna have elevated margins. We've got some profits being generated which are gonna enhance. Profits don't have any impact on revenues at all. So that's gonna elevate our margins. What about the balance sheet? Well, what we're gonna have in previous years, we're gonna have elevated provisions, but then in the year that provisions of release, we have falling provisions in the balance sheet. Okay? And then the third thing, what about cash conversion? Well, provision releases are a non-cash source of earnings and therefore that's definitely gonna lower our cash conversion. Finally, what about the non-GAAP reconciliation? Well, it may well be that in the years that the provision is created, that's treated as an exceptional, but I think there's a big question mark as to whether a provision release will be highlighted by management in their non-GAAP adjustments. And in fact, it's specifically one I came across years ago when I was analyzing a company in the aerospace and defense sector in the UK. And, there was one company that repeatedly was releasing provisions over a number of years and that helped conceal really poor underlying business performance. And we spotted that specifically because of cash conversion. So let's have a look. What are we gonna have in the income statement? Elevated margins in the balance sheet, we're gonna have falling provisions. So instead of elevated assets, we've got falling liabilities, cash flow statement, we're gonna have low cash conversion and non-GAAP. I think possibly we'll have provision releases but I wouldn't bet any money on it. Okay, so that's our third item onto our fourth and final estimates area, which is accounting for M&A. A little bit trickier this one. And we will, as part of our workouts, do a little bit of recap and consolidation accounting. But why are there estimates associated with M&A? Well, remember back to your consolidation, accounting, training. We have to estimate the fair values of the target balance sheet and also the purchase price. Now you might say to yourself, those are factual, but there's definite estimates being made when we're working out how much is being paid, for a company, particularly if there are earnouts, there has to be an estimate of what the eventual payment is going to be and estimates are gonna be made in terms of targets balance sheet, there may well be items like inventory, long-term contracts, revisions, all the things that we've just looked at sitting in the targets balance sheet. And therefore the acquisition companies management might say, well, we disagree with the estimates previously made by management. So those are the risk areas. Let's have a look at those in terms of a worked example.

And we have out full, okay, let's have a look at the question. We are told that company A acquires 100% of the equity of company B on the last day of their financial year. The purchase consideration of is 50 of equity and five in contingent consideration, we're gonna calculate the consolidated balance sheet at the date of acquisition and the consolidated operating profit in the year after the acquisition. And then we'll look at an additional scenario where how's the numbers change if company B'S inventory has stepped down, and also if the earnout target is missed.

Let's start off with a very quick bit of revision on consolidation. Company A is acquiring company B. How do you produce the consolidated balance sheet at acquisition? Well, we have our transaction effects that we need to put through, and that involves, first of all, zeroing out the targets equity. So we're gonna remove that 40 from the consolidation because it's been acquired, as part of the acquisition. Then we put through the purchase consideration and we're told that the purchase consideration is 50 of equity, new equity being issued, and also five in contingent considerations. That's basically a promise of future payment, which is estimated, uh, at the point of acquisition. And importantly, I know you can't see this on the screen, that contingent consideration relates to an earnout.

Okay, so there we have our purchase consideration. And finally, goodwill. Goodwill difference between the purchase price and the value of shareholders equity. So we take the 55 total purchase consideration, we're gonna add to that, the negative equity, and that gives us goodwill of 15, right? Let's now produce the consolidated numbers or the combo numbers as is described on this spreadsheet.

So we add together the acquirer and the targets assets. We put through those transaction effects, and I'm gonna add together to give total assets of 1,115.

I'm now gonna do the same for the liabilities and equity. And we can see few. Our balance sheet does balance, so we know we've done the consolidation correctly. But this was just a very straightforward kind of review of accounting and we're gonna come back to this calculation very shortly. Now, let's do the same for the income statement. And this is in the year after acquisition. So company A has owned company B throughout the year. So in terms of consolidating these numbers, this is super straightforward. We are just gonna add company A's and Company B's revenues costs, and that's gonna give us the combined operating profit for this business of 65. So far, so simple right now let's revisit the scenarios we're asked, asked to consider. In the question it says, how do these numbers change? If Company B'S inventory is stepped down by five at acquisition, what does that mean? Well, effectively company a's management have come along and said, well, company B'S inventory, we think it's worth less than is in their balance sheet, and we're gonna reduce the value of that by five in the acquisition adjustments. So we're gonna take the current assets of company B and we're gonna reduce those by five. So I'm gonna put an adjustment here into my Goodwill column. At the same time, we're basically saying, well, we've paid 55 as the purchase price, but if we step down the assets of the target, we're also stepping down the target's equity. So that means we are also going to have to step up the target's goodwill. So that means we are gonna create goodwill of 20. So by doing that step down, we're then stepping up goodwill, which is no great loss to the acquirer. They don't worry too much if they end up creating a bit of extra goodwill as part of the acquisition adjustments. But why might it be beneficial to them to step down the targets inventory or any other working capital items? Well, let's have a look at the adjustments that we are making, the INF effect on the income statement. Let's assume that that inventory that's been step bound by five is then sold in the year after acquisition. Well, what's gonna happen to our cost of goods sold? Well, co company B'S, costs of goods sold, which were previously anticipated as 10, they're gonna be lower because the cost of their inventory is lower. So we're gonna lower their cost of goods sold by five. And what does that do? By update my calculations, of course, that elevates the reported profits in the year after acquisition. Just when the company needs to be able to justify that it was a good acquisition, they have eked out some extra margin. So again, we're gonna enhance our margins as a result of that acquisition accounting adjustment. But we're also asked to consider what happens if the earnout target is missed. So here we've assumed acquisition that the earnout was gonna result in a pay out of five, but let's say the target company, company B has underperformed during the subsequent year, we don't have to pay that five effectively. We have a provision which is gonna be released, okay? And typically we're gonna release that through SG&A and therefore we're gonna take that five, reduce our SG&A by five. And again, what happens to our profits post-acquisition? They go up. But the worrying thing is that those post-acquisition profits go up. They've been boosted by that release, but the reality is that that release is a result of an earnout target being missed and therefore company B's performance is not what was anticipated. So in actual fact, what we should be focusing on is the fact that company B is now underperforming.

So let's just step back from that again, let's think about how we'll see these symptoms in our financial statements. Well, we've got elevated profits, we're gonna have elevated margins in the income statement. What about the balance sheet? Well, we're gonna have elevated levels of goodwill because we've got very aggressive assumptions or estimates being used in both the purchase price and also the step downs on the targets balance sheet. What about cash conversion? Well, in the year after acquisition, we've got a provision release, which we know lowers cash conversion, but also we've got inventory, uh, being included in cost of goods sold at below. Really what the ongoing cost is. So new inventory that's being purchased will be at a much higher cost and therefore we're gonna have low cash conversion. So let's get back to our symptom tracker. We are gonna have, again, elevated margins. We are gonna have elevated levels of goodwill and we're gonna have low cash conversion, quite possibly. We may well see, particularly with an earnout target being missed. It may well lead to goodwill impairments.

So these are the places that we're gonna be looking for all of these symptoms of aggressiveness around the use of estimates. So really helpful to actually start off with not looking for these individual accounting issues. Start off with looking for these symptoms. When we pick up a set of financial statements, do we have elevated margins in the income statement? Do we have some of these elevated items in the balance sheet? Do we have critically low cash conversion in the cash flow statement? Or at least some evidence of these issues within things like working capital and provision movements in the cash flow statement? Right? Let's go back to our slides. That was a lot to digest, a lot to get through. Important to remember, basically estimates are essentially accruals, okay? And accrual is effectively an estimate number. So we are really gonna focus our efforts when we are doing forensic analysis on the reconciliation of profits to cash flows, particularly those operating cash flows in relation to these items. Okay? So it's a useful tool, cash flow statement. It's often one of the first places I go to after I've looked at the income statement. I generally go straight to cash flow statement to look for these red flags. Have a go at that yourself. Now I'm gonna give you 10 seconds again to have a look at an example reconciliation of profits to cash flows. We've got some information on investing cash flows as well, just in case it's useful to you, right? Let's have a look at what those items are. I gave you a few seconds just to try and identify the issues. You've got four numbers on the screen, which gives us a clue. There's four items. Well, first of all, you should immediately have spotted contract impairment losses, which is indicative that previously management may have been aggressive around revenue recognition or simply that they have poor cost control when it comes to their long-term contracts. So that's the first thing. Secondly, we've also got high levels or growing levels of receivables effectively as receivables will include contract assets. So in conjunction with the contract asset impairments, well, that is really the double whammy in terms of indicative of, re aggressive revenue recognition on long-term contracts.

Thirdly, we've got decreases in provisions. Now that could be provisions being Utilized, okay, but it could also be indicative of provisions being released. So we'd really want to go to the footnotes then to see, well, why those provisions decreasing? Is it utilization or is it indeed a release that provides a boost to earnings? And fourthly, well, we have got an acquisition in this company highlighted in the investing cash flows. It's important to note that this acquisition, it closed just prior to the 2018 year end. So there's no evidence that it's already having an impact on things like margins, As a result of maybe acquisition adjustments or earnouts. So it's something we're gonna watch out for in the future. Okay? But, just one thing that's really useful to note is that the power of the cash flow is so strong because it's not distorted by acquisitions in the sense that sometimes we look at the relationship between the balance sheet and the income statement as an indicator that relationship breaks down when there's an acquisition because you might have an acquisition where there's a significant increase in the balance sheet. If an acquisition closes just before year end and you haven't got the same effect in the income statement, whereas the cash flow statement and the income statement, they're both flow statements, and so they're both affected to the same extent by an acquisition. And so even in years where you've got an acquisition, you can still trust on the power of cash conversion for helping reveal any red flags, right? So that is estimates, okay? There is an example company in your workout file. There's a case study activity. Again, it's another UK company. Make no apologies for the fact that my background is as a UK analyst. So lots of examples from UK companies. Capita was a company that during 2013 to 2015, their accrued income as a percentage of total revenues started to increase. And there also their accrued income in the balance sheet relative to trade receivables was growing. And in 2016, they issued a series of profit warnings and then had to announce a rights issue due to a subtle change in revenue accounting rules which basically meant that they weren't able to pay dividends for a a fair while. So it can be a useful a useful way of identifying red flags, looking at the cash flow statement, looking, using that d dive deep into the footnotes around things like accrued income. If you're looking at a long term contract business, looking at inventory footnotes, if you're looking at inventory, business and provisions for any companies really where you have concerns around their cash conversion. So that is a case example. The final topic, we only have a few minutes for this we'll just touch on this. We mentioned it right at the beginning, which is where there Is bias or potential for bias in the cashflow statement. Now, the choices that management tend to have is two key choices that I'm gonna highlight. One is in relation to cost capitalization, which of course as we all know, takes cash, flows, cash outflows out the operating cashflow section and puts 'em in the investing cash flows. Now, under IFRS, we have a particular choice around R&D

because IFRS allows capitalization of development costs, but even in the US you have the opportunity to capitalize software development. Now, these two areas, sorry, these two areas in particular, apologies, I would focus on because remember that the underlying costs which are being capitalized are ongoing costs of the business. So staff costs. So effectively, if you're capitalizing development costs under IFRS or software development costs under either US GAAP or IFRS, you are generally capitalizing staff costs. They're being sucked outta opex and put into CapEx. Okay? What does that do? Well, of course it elevates your margins because you are removing CapEx. Yeah, in particular, you are elevating your EBITDA margins because it never then hits your earnings metric. But also in the balance sheet, what have you got? We'll have elevated levels of P&PE, but also you'll be in a cash flow statement, albeit not in the operating cash flow conversion. But if you were to use, for example, free cash flow conversion, you would see at lower levels because you've got higher levels of CapEx. Okay? So again, if we go to our symptom tracker, we have elevated margins, we have elevated PP&E or CapEx spend. We have low cash conversion, but this is at the free cash flow level. And ultimately in the non-gap reconciliation later on, you may well see PP&E impairments, but it may well be that you don't see that for a fair while. So all of those symptoms that we saw earlier when it comes to use estimates are still relevant when it comes to things like capital overcapitalizing costs. Okay? There is one further issue with cashflow cash flows I want to highlight.

And that is to do with the use of supply chain financing. Now, supply chain financing is where companies take financing cash inflows and have the ability to drop them into operating cash flows. Now, the common names for this are for example, these of factoring and reverse factoring, which are incredibly common. For example, in our main teaching for graduate programs, we use the beverages industry. We look at Coca-Cola, Pepsi, Coke, Dr. Pepper. All of these companies at some point in the last few years have been using supply chain financing. Let's have a look at the accounting for that and in fact how it works and why. It's gonna be worth spending time looking for. This traditional factoring is where companies supply goods. Let's say a company supplied goods to their customer on standard payment terms, maybe 30 days, but they want the cash flow sooner than that. They don't wanna work 30, wait 30 days. What they do is they assign that invoice to the bank, effectively, the bank buys the debt and they give the cash straight to the company. So instead of waiting 30 days, maybe the company gets payment after 10 days, okay? However, that payment is net of a fee because effectively this is a cash advance by the bank. Then what happens at 30 days? Then of course the customer's ready to pay, but instead of paying the company, they pay the bank. Okay? So effectively this is off balance sheet finance because the company's borrowing from the bank until the customer pays after 30 days. The problem is how is it accounted for? Well, it's not accounted for as a loan instead, well, the interest, the fee is treated as interest, okay? The fees are treated as a finance cost, but in their balance sheet, it's as if the cash has been received from the customer, it's settlement of an invoice. So it comes in as a working capital inflow in the cashflow statement. What about reverse factoring? Well, it's kind of the same thing, but instead of using it being involved in the customer, instead it relies on the supplier. So here we have a company that's bought some goods from its supplier and the supplier has maybe supplied that on standard payment terms. So let's assume again, it's 30 days, but the company doesn't wanna pay after 30 days. The company wants to maybe pay after 60 days and the supplier isn't open to renegotiation of payment terms. Well, what the company do can do is it can assign the invoice to the bank and the bank pays its invoice to the supplier on their behalf.

So that's paid after 30 days by the bank. Then the company maybe after 60 days, pays the bank in full. And again, there's an extra fee being paid because the bank has effectively made a payment on their behalf. And so that payment, after 60 days helps the company because it's extended their payment days. But there is a fee associated. And again, the cashflow associated with that. When that cashflow occurs, it's like treated as a working capital cashflow and the fees are treated as an interest cost. We have to watch out for this because there's not great disclosure around the use of either factoring or reverse factoring. We tend to look to the narrative in the financial statements, but really the clues are going to be found looking at things like the cashflow statement. Again, looking for working capital inflows, which is really quite unusual over an extended period of time. And also elevated levels of interest costs, particularly relative to the amount of on balance sheet finance. So those are the critical areas I would look for in terms of cashflow classification. So what we have here, I'm gonna skip a few slides. The three areas we've looked at, non-GAAP numbers, estimated numbers, classifying cash flows. We can think of looking at the quality of all of these, looking at things like the reconciliation of non-GAAP, looking at the cashflow statement, looking at the footnotes, around things like interest costs to identify off balance sheet finance. And that gives you your forensic accounting toolkit. Lots covered in this session. We probably ran out, run over very slightly, so apologies for that. You are provided with a full workout file with lots of case study examples. Take your time going through those examples. They really reinforce some of the content that we've just covered today. I noticed that no one's answered any q and a during this session. I'll keep the Q&A box and the webinar open for just another minute in case you've got any final questions before I close the room. But the final thing for me to say other than answering any final questions is a big thank you for joining me on this Friday. I hope you've enjoyed the session. I hope you've all learned something and have a wonderful rest of the day and a wonderful weekend.