Financial statements: a futile endeavour?

It’s a lot easier to identify problems in hindsight when one knows what went wrong than to appreciate the risk in real-time.

By Cormac Lucey

About once a year, I dine with three friends from my training days. As you can imagine, the discussion is always high-powered and elevated. Well, some of the time it is. At our last dinner, I asked a question of someone who works in a senior position at AIB Group: how many people does he think there are on planet earth that have completely read and comprehended the most recent AIB annual report? We reckoned the answer might be about 10 people, at least half of them connected to AIB.

I fear that more and more work is spent preparing and auditing financial statements as fewer and fewer people read and comprehend them. Increasingly, people working on financial statements must feel like those at ground control in David Bowie’s ‘Space Oddity’ as they wonder whether anyone is listening to their signals. As a personal investor, I am increasingly concerned that, in reading financial statements, there may be some detail whose importance I have failed to appreciate. Recent events at Datalex provide a cautionary tale.

A cautionary tale

Between summer 2017 and January of this year, the company’s share price gradually lost value (from about €4 to €2.50). On 15 January, the company made an abrupt announcement that “the board has revised its guidance for adjusted EBITDA for FY 2018 and now expects to report an adjusted EBITDA loss in the range of -$4m to -$1m”. This was shocking, as the company had generated an EBITDA of $13.6 million in 2017 and $11.6 million the year before. The share price fell to €1.

The directors commented that “a substantial element of the revised guidance reflects changes in the timing of recognition by the Group of certain contracted revenue. Most of this revenue, not recognised in 2018, will be recognised in 2019 and 2020”. A later company statement in March declared that an external review by PwC had “identified significant accounting irregularities during the period as the underlying cause for the Group’s overstatement of revenues, noting material weaknesses in the internal control environment; the Group’s accounting process in this area has been largely manual…”

Other signs

I wondered whether the auditors had missed something. The 2017 annual report suggests they didn’t. First, EY had correctly identified revenue recognition as the largest audit risk. Second, they had “communicated to the audit committee that the revenue recognition and Accrued Income process for professional services projects is manual”. Third, they had reported that “the Group’s largest project increased significantly during the year and, as a result, there was a heightened degree of subjectivity applied by management in determining an appropriate percentage of completion calculation for this project”.

It would have been very easy for a reader of the 2017 financials to pass over these comments without appreciating their eventual significance. Were there other signs that might have raised attention? 

If revenue was being overstated, we would expect receivables to grow disproportionately. That is indeed what happened. At the end of 2016, Datalex’s trade receivables (including accrued income) amounted to 87 days of sales. By December 2017, this had grown to 114 days. That substantial rise was entirely due to an increase in the balance owed by “Customer A”.

On top of that, some 31.12.2017 accrued income was recorded as a non-current asset, something that hadn’t occurred the previous year. Recording income that the firm doesn’t expect to receive for more than 12 months raises questions.

It’s a lot easier to identify these matters in hindsight, when one knows what went wrong, than to conclude in real-time that they represented an important signal, rather than mere noise.

Cormac Lucey FCA is an economic commentator and lecturer at Chartered Accountants Ireland.