Earnings Quality Issues
and Financial Ratio
Analysis
Framework for Analysis
1. Establish the objectives
– Input
• Analyst’s perspective (evaluate a debt or equity
investment, or establish a credit rating)
• Needs communicated by client or supervisor
• Institutional guidelines
– Output
• Purpose statement and specific questions to be
answered
• Nature and content of final report
• Timetable and budget
Framework for Analysis
2. Data collection
– Input
• Financial statements
• Communication with management, suppliers,
customers, and competitors
– Output
• Organized financial information
Framework for Analysis
3. Processing the data from Step 2
– Output
• Adjusted financial statements
• Common-size statements
• Ratios
• Forecasts
4. Analyzing the data from Steps 2 & 3
– Output
• Results of analysis
Framework for Analysis
5. Develop and communicate conclusions
– Input
• Results from analysis using report guidelines
– Output
• Recommendations
6. Follow-up
– Input
• Periodically update information
– Output
• Update analysis and recommendations
Understand What
You Are Looking At
• Awareness of the type of disclosure:
1. Prepared according to GAAP
2. Pro forma information
• Earnings disclosures: what earnings are being
disclosed?
1. Transitory items
2. Permanent items
Earnings Measures
• EBITDA
Used as a proxy for operating cash
flow but ignores tax, interest, and
working capital changes
• EBT
• Operating
income
• Income from
continuing
operations
Excludes tax effects
Profits from operating activities EBIT
Income after unusual or infrequent
items and tax, but before
extraordinary items and
discontinued operations
Earnings Measures
• Net income
• Pro forma
income
Income after all items below and
above the line have been
included
The firm’s own measure of
“operational earnings”—removes
what management considers to
be transitory items (view with
suspicion)
IFRS SELF-TEST QUESTION
Which of the following is not reported in an income statement
under IFRS?
a. Discontinued operations.
b. Extraordinary items.
c. Cost of goods sold.
d. Income tax.
IFRS SELF-TEST QUESTION
Which of the following is not reported in an income statement
under IFRS?
a. Discontinued operations.
b. Extraordinary items.
c. Cost of goods sold.
d. Income tax.
Read the Fine Print
• Don’t just view the financial statements
– MDA
– Footnotes
Most of the detailed
explanations can be
found here
• Includes information on significant items,
accounting policies, estimates, and judgements
(and changes to them)
• incomprehensible footnotes or MDA = Warning
sign
Be Skeptical
• If the firm’s results are consistently better than
industry averages or the economy
• If so, look for:
1. Competitive advantage (a positive)
2. Earnings management (a negative)
• Studies suggest mean earnings grow at the
same rate as GDP
• Very small percent of companies exceed median
growth for a significant period
Check for Cash Flow
• Operating cash flow is less easy to manipulate than earnings
• Point: In the long-run, the growth rates of NI and CFO should be
similar
– Look at the quality of income ratio = Net CFO/Net income. A ratio near 1
is good.
– Quality of income deteriorates prior to bankruptcy
• Problem: In the short-run, the growth rates may differ
significantly because of:
– Seasonality
– Cyclicality
Okay
– Life cycle
– Firm-specific factors
– Earnings manipulation
Problem
Understand the Risks
• Business risk:
sales volatility
operating leverage
• Financial risk: Capital structure
• More specific risk disclosed in 10K filing:
– Interest rate risk
– Currency risk
– Collectability of AR
– Price risk of inputs (raw materials, etc.)
– Contingencies
Evaluating Financial Reporting
Quality
Two bases for preparing
accounting statements
• Cash flow basis
– Transactions recorded when cash is paid or received
– cash payment reduces net income in year of investment
especially for long term investments
• Accruals basis
– Revenues and expenses triggered by the earnings process
– Revenues—increase in net assets
– Expenses—decreases in net assets
– Long term investments are capitalized and expensed over the
life of the asset
Accrual vs. Cash Accounting
• Cash flow basis
– No subjectivity
– Easy to verify
• Accruals basis
– Subjective measurement
– Better indication of “true” value creating activities
– More timely and relevant information for decision
making (e.g., recording of sales on credit = future cash
flow owed by customer)
– Potential earnings management
Knowledge check
A manufacturing firm purchases equipment for use in its
operations. With regard to recording the purchase using the
cash basis versus the accrual basis of accounting, which of
the following statements is most appropriate?
A. With the cash basis, revenues and expenses relating to
the equipment are generally recognized in different periods.
B. With the cash basis, revenues and expenses relating to
the equipment are generally recognized in the same period.
C. With the accrual basis, the cost of the equipment is
allocated to the cash flow statements over the asset's life.
Knowledge check
A manufacturing firm purchases equipment for use in its
operations. With regard to recording the purchase using the
cash basis versus the accrual basis of accounting, which of
the following statements is most appropriate?
A. With the cash basis, revenues and expenses relating to
the equipment are generally recognized in different periods.
B. With the cash basis, revenues and expenses relating to
the equipment are generally recognized in the same period.
C. With the accrual basis, the cost of the equipment is
allocated to the cash flow statements over the asset's life.
Accruals
Accruals are created from
1. Unearned (deferred) revenue
– Payment is received before providing goods or
services
– Increases assets and liabilities
2. Accrued revenue
– Revenue has been earned but not yet collected
– Increases assets and equity
Creating Accruals (continued)
3. Deferred expenses
– Costs that benefit future periods
– Increases asset
4. Accrued expense
– Expenses incurred but not yet paid
– Increases liabilities and decreases equity
Earnings Persistence
Earnings persistence is the durability of earnings.
• Why do we care about earnings persistence?
– Tells us how continuous those earnings will be in the future.
• Earnings can be measured using either accruals or cash basis
• Accrual earnings is less persistent than cash earnings.
– Because accruals tend to mean revert due to:
• Strategic manipulation
• Unintentional errors
• Analysts should assign lower weight to accruals-based
earnings as compared to cash earnings while forecasting
future earnings
• Price multiple for cash earnings would be higher than
accruals-based earnings multiples.
Mean Reversion
• Empirical observation: earnings at extreme levels revert to
normal over time
Logic:
Excess returns (economic profit)
New industry entrants
Increased competition
Margins reduce
• Earnings = cash flow and accrual components
Earnings comprised of accruals → lower future earnings
and cash flows
The greater the accrual component of earnings, the faster
reversion occurs
Manipulation Incentives
“Earnings
Game”
Strategic manipulation of earnings is due primarily to the
following:
Capital markets:
• Meet or exceed current expectations
– Manipulation of reported earnings
• Manage expectations going forward
– Using communication with analysts to move
consensus sell-side forecasts
Pattern of forecast errors:
• Initial forecasts optimistic
• Later forecasts pessimistic
– Positive earnings surprises on announcement of results
Manipulation Incentives
Remuneration contracts
• Bonus payments
• Stock options
Debt covenants
• Avoid technical defaults
• Interest costs tied to financial performance
Financing
• Prior to issuing of debt or equity (“window dressing”)
Disciplining Mechanisms
•
•
•
•
•
•
External auditors
Internal audit, audit committee
Management certification
Lawyers—class action lawsuits
Regulators
General market scrutiny
Earnings Quality
Quality = persistence/sustainability
• EQ refers to the ability of a firm’s reported earnings to predict
its future earnings.
• Reported earnings are affected by many factors including
aggressive vs. conservative choices:
– S/L vs. accelerated deprecation
– Accrual choices – requiring some judgement.
• These accruals naturally self correct over time:
• Insufficient depreciation expense → higher impairment
charge
• Insufficient bad debt provision → higher future bad
debt write offs
Measuring Earnings Quality
Earnings have a cash flow component and an accrual
component
Aggregate accruals =
Accrual
Cash
based –
earnings
earnings
Aggregate accruals can be measured using either a:
• Balance sheet approach
• Cash flow statement approach
There is an inverse relationship between
accruals and earnings quality
Balance Sheet Based Accruals
Accruals
ratio
=
Aggregate accruals
(NOAt + NOAt–1) / 2
*Also includes cash equivalents and marketable securities
Net operating
assets (NOA)
Aggregate accruals
=
(Total assets –
cash*)
–
(Total liabilities –
total debt)
=
NOAt
–
NOAt–1
Balance Sheet Accruals Example
Use the following data to calculate the accruals ratio:
2009
2008
Cash
$8,800 $8,000
Receivables
14,000 12,000
Inventory
16,800 16,000
PP&E
55,200 52,000
$94,800 $88,000
Payables
Short-term debt
Long-term debt
Capital stock
Retained earnings
$7,040 $6,400
10,576 9,600
60,000 60,000
9,200 8,000
7,984 4,000
$94,800 $88,000
Net Operating Assets
Total assets
Cash
Operating assets
2009
$94,800
(8,800)
$86,000
2008
$88,000
(8,000)
$80,000
Total liabilities
Short-term debt
Long-term debt
Operating liabilities
$77,616
(10,576)
(60,000)
$7,040
$76,000
(9,600)
(60,000)
$6,400
Net operating assets
$78,960
$73,600
Balance Sheet Based Accruals –
Solution
Aggregate accruals
Accruals
ratio
=
$78,960 – $73,600
= $5,360
$5,360
=
($78,960 + $73,600) / 2
= 7.0%
Cash Flow Based Accruals
Aggregate accruals
=
NI – (CFOt + CFIt)
Issue—different treatment of finance costs and
dividends under IAS and U.S. GAAP
Interest Paid: IFRS –O or F; US GAAP – F
Dividend Paid: IFRS – O or F; Div R – O or I
US GAAP – F; Div R - O
Accruals
ratio
Aggregate accruals
=
(NOAt + NOAt–1) / 2
Income Statement
Revenues
Cost of goods sold
Depreciation
SG&A
Interest
Taxes
Net income
2009
$ 76,000
(48,000)
(6,000)
(4,000)
(4,800)
(5,760)
$7,440
Cash Flow Statement
Net income
Depreciation
Increase receivables
Increase inventory
Increase payables
CFO
CFI
CFF
Change in cash
2009
$7,440
6,000
(2,000)
(800)
640
$11,280
(9,200)
(1,280)
$800
Free Cash Flow (FCF)
•
•
•
•
FCF is cash available for discretionary uses
Frequently used to value firms
FCFF = CFO + Int (1 – T) – FCInv
FCFE = CFO – FCInv + Net debt increase
Cash Flow Based Accruals – Solution
Aggregate accruals
Accruals
ratio
=
$7,440 – ($11,280 –
$9,200)
= $5,360
$5,360
=
($78,960 + $73,600) / 2
B/S and cash flow accruals can differ because of:
Non-cash acquisitions
Currency translation
Inconsistent classification between B/S and cash flow
= 7.0%
Aggregate Accruals Effectiveness
The accruals ratio has been shown to be effective in identifying
earnings quality issues
For example:
1. Companies restating earnings had highest aggregate
accruals (Richardson, Tuna, Wu (2002)):
Impact was a market value decline of 10% following
restatement
2. Aggregate accruals = leading indicator of SEC enforcement
actions (Richardson, Sloan, Soliman, Tuna (2006))
Observation was that accruals peak 2 years prior to
enforcement action
Common Accounting Issues
Revenue Recognition
Range of problems:
1. Recognition of sale before completion of earnings process
2. Recognition of sale without assurance of payment
Estimates:
Credit sales
Deferred/unearned revenue
Warranty provisions
Sales returns
Accelerating Revenue
Range of problems:
1. Recognition of sale before completion of earnings process
(assessing the completion date)
2. Lowering credit standards
3. Cut-off issues (moving sales between periods)
Warning signs:
Large ↑ AR
Bundled products
Large ↓ Unearned
Management vested options ITM
Revenue
Pressure to meet earnings forecasts
Disproportionate
Raising additional finance
revenue in last ¼
Accelerating Revenue
Recognizing revenue too early:
1. Bill-and-hold sales
2. Lessor use of sales type lease
3. Recording sales prior to acceptance by customer (sales of
equipment prior to installation)
4. Incorrectly using percent-of-completion method for longterm contracts
Ratio Detection
↑ Sales to cash
collected from
customers
Days sales
outstanding
Sales
=
Revenue – Δ AR + Δ deferred
revenue
365
=
AR T/O
Sales
Avg AR
Classification of Nonrecurring or
Nonoperating Revenue as Operating
Range of problems:
• Investment income
• Divestiture of non-current assets
• NB. No accrual or deferral reversal in later periods
Warning signs:
• Temporary inconsistency of items included within definition
of operating income
Expense Recognition – Understating
Expenses
Range of problems:
1. Discretion over depreciation and amortization
2. Impairment recognition
3. Application of lower of cost and fair value rules
Warning signs:
Δ of methods or lives – depreciation (disclosed in
footnotes)
Conference calls – additional information
LIFO liquidations
365
DOH =
Inventory obsolescence
Inv T/O
Expense Recognition – Deferring
Expenses
Range of problems:
• Capitalization of operating expenses
Warning signs:
• ↑ Net non-current assets (B/S broad measure accruals)
• Consider asset growth in the context of expected sales and
margin growth
• Software development costs – discretion
Classification of Operating Expenses as
Nonrecurring or Non-Operating
Range of problems:
• Incorrect classification reduces COGS or SG&A
Warning signs:
• Company has genuine special items that can be
piggybacked
• Changes in operating profit margin or gross margin
accompanied by spikes in special items
Big Bath Provisions
Range of problems:
1. Impairments – future I/S improvements via ↓ depreciation
2. Restructuring or impairment charges reversed in
subsequent periods
3. Use of high or low bad debt reserves out of line with peers
Cash Flow Statement Issues
Classification issues:
• Definition of cash and cash equivalents
• Marketable liquid investments may be CFI
• Solution: Operating cash flows = CFO + CFI
Omitted investing and financing activities:
• Non-cash acquisitions (e.g., acquiring PP&E with seller provided
financing)
Solution: utilize B/S based measure of aggregate accruals
• Operating leases
Solution: capitalize
Off-Balance-Sheet Liabilities
Range of problems:
• Assets and liabilities avoiding recognition:
– Operating leases
– Sale of AR with recourse
– Take or pay/through put agreements
– Equity accounted SPVs
Warning signs:
Firms following U.S. GAAP must report future cash flow
obligations of operating leases – analyst should discount to
PV and restate balance sheet
Balance Sheet Goodwill
Goodwill:
1. FMV adjustments on acquisition
2. Future impairments
Warning signs:
Goodwill reported and not impaired for companies where
market cap < book value
Fair Value Reporting
• IASB and FASB move to embrace fair value accounting
• Issues:
– Some assets have readily identified fair values
• Listed equity
– Some assets don’t have readily identified fair values
(assets with no actively traded secondary markets)
• Unlisted equity
• Specialized equipment
– Valuation models = discretionary inputs
Foundation Concepts
• Note: Many of the “adjustments” mentioned in
this topic review are discussed elsewhere in the
curriculum
• The point of this topic review is to “put it all
together” (i.e., to detail how to take the
individual adjustments and restate the financial
statements) before calculating ratios
Knowledge check
An analyst finds return on equity (ROE) a good measure of management performance and
wants to compare two firms: Firm A and Firm B. Firm A reports net income of $3.2 million and
has a ROE of 18. Firm B reports income of $16 million and has an ROE of 16.
A review of the notes to the financial statements for Firm A, shows that the earnings include a
loss from smelting operations of $400,000 and that the firm has exited this business. In
addition, the firm sold the smelting equipment and had a gain on the sale of $300,000.
A similar review of the notes for Firm B discloses that the $16 million in net income includes
$2.6 million gain on the sale of no longer needed office property. Assume that the tax rate for
both firms is 36%, and that the notes describe pretax amounts.
Which of the following is closest to the "normalized" ROE for Firm A and for Firm B,
respectively?
A. 16.0 and 18.0.
B. 18.4 and 14.3.
C. 17.1 and 16.9.
Knowledge check
An analyst finds return on equity (ROE) a good measure of management performance and
wants to compare two firms: Firm A and Firm B. Firm A reports net income of $3.2 million and
has a ROE of 18. Firm B reports income of $16 million and has an ROE of 16.
A review of the notes to the financial statements for Firm A, shows that the earnings include a
loss from smelting operations of $400,000 and that the firm has exited this business. In
addition, the firm sold the smelting equipment and had a gain on the sale of $300,000.
A similar review of the notes for Firm B discloses that the $16 million in net income includes
$2.6 million gain on the sale of no longer needed office property. Assume that the tax rate for
both firms is 36%, and that the notes describe pretax amounts.
Which of the following is closest to the "normalized" ROE for Firm A and for Firm B,
respectively?
A. 16.0 and 18.0.
B. 18.4 and 14.3.
C. 17.1 and 16.9.