Assessing Earnings
Quality
Many companies struggle
to meet earnings
expectations.
Some of the more common
causes of a decline in earnings
quality are listed in this
presentation.
Adopting Less
Conservative Accounting
Practices, such as...
• Using longer depreciation lives.
• Changing from accelerated to
straight-line depreciation.
• Using FIFO for inventory costing
(assuming at least modest inflation).
One-time Transactions.
• Sale of an office building.
• Tax deals that give up future
benefits to lower current tax
rates.
Overly pessimistic
impairment charges.
• Some goodwill shouldn’t be
written down frequently. Some
should.
• Of course, goodwill is not the
only asset that could be written
down.
Restructuring Charges.
• Companies have been known to
include costs in restructuring
that should more correctly be
allocated to future operations.
• This is hard to detect, but
watch for significant movement
in “restructuring reserves.”
Pulling future earnings
into the present.
Accelerating shipments to
customers (e.g., revenue
recognition issues, “stuffing the
channels, etc.) Watch for
unusual build-up of accounts
receivable.
Including profits from past
periods into current
period.
An example would be reversing
a reserve set up in a prior
period.
Adopting new
accounting standards.
Companies who are early
adopters of new accounting
standards are often anxious to
boost earnings.
Reduction of Managed
Costs.
• Research & Development
• Maintenance Expense
• Advertising Costs
Under-Reserving for the
Future.
• Bad debts
• Warranty Obligations
• Returns and Allowances
An increasing gap in
time between…
• …the recording of income and
the receipt of cash. Watch for
build-up in accounts receivable.
• Remember to monitor the trade
cycle!
Increasing Reliance on
Earning Sources…
• …that are not central to the
company’s principal business
activity and strategy.
• Remember core competencies!
To Capitalize or Not to
Capitalize?
• Be leery of expenditures that
were once expensed as
incurred…but are now classified
as an asset.
• …sounds like World Com.
Easy to Compare to
Earlier Periods?
• Be leery of major acquisitions
accompanied by inadequate
disclosure.
• This makes it difficult to
measure and analyze sources of
growth.
Adoption of a new strategy
while using historical data
to estimate…
• reserves
• income timing
• expense recognition
Writing off investments
soon after they are made…
• …could be income smoothing,
• …or could be (part of) “the big
bath.”
• …or could be, gulp, realistic!
An increasing level of
financial leverage…
• …suggests that future earnings
are significantly more risky
than in the past.
• Don’t ignore DTL = DOL X DFL
[% ∆ in Sales → % ∆ EPS]
When monitoring
inventory levels…
• …watch especially for build-up in
finished goods. This could
indicate marketing problems
that aren’t [yet] reflected in
current earnings.
• Of course, monitor other
inventory types also.
Now, what company
situations are more
likely to result in
lowered earnings
quality?
Significant Market Share
When a company has achieved
significant market share
[growing more rapidly than the
industry], it becomes
increasingly difficult to
maintain these levels of growth.
In a consolidating
industry…
…all of a sudden only the
marginal companies are left.
The question is, will
acquisitions stop?
Accounting changes…
Some companies have a history
of using accounting decisions
to achieve earnings
expectations.
Using the old adage, a tiger
doesn’t change its stripes.
The auditors are fired…
• CPAs don’t give up clients easily.
• Could be indicative of auditors not
going along with management’s
attempt to lower earnings quality.
• Or, perhaps the sound of shredders
was too loud in the background!
The company has grown
rapidly…
• Internal controls are difficult to
implement during rapid growth.
• Poor or fraudulent business
practices may be hard to
detect…or discourage.
Sales, Profits and Cash
Balances are Soaring!
• …creative inventory shifting
could be supplier financing to
distributor.
• …or, off-balance sheet customer
financing arranged by
distributor.
• What happens when business
slows down?
With thanks to…
• Some of the concepts in this
presentation were adapted from
Merrill Lynch’s Quantitative
Analysis Group. (Merrill Lynch’s
Accounting Bulletins and
Accounting UPDATES)
[Subliminal messages]
•
•
•
•
Studying
Studying
Studying
Studying
finance
finance
finance
finance
is
is
is
is
good.
good.
good.
good.
• Finance: It’s not just for
Saturday night studying
anymore.