Accounting Analysis - AVIJIT MALLIK, ASSISTANT PROFESSOR, IBA,DU. Agenda Why Accounting Analysis? Why Managers manage earnings? What conditions lead to earning management? How firms manage earnings? How to detect earning management? What are the potential red flags? How to assess quality of disclosures? How to measure manipulation? Why Accounting Analysis? Quality of Reporting- the degree to which Financial statements data are reliable Quality of Earnings- the degree to which Earnings are sustainable What happens if both Quality of Reporting & Quality of Earning are low? Why do managers manage earnings? Market Expectations Management compensations Career choices Debt covenants requirement To hide poor performance Conditions conducive to earnings management Motives- meeting expectations, hiding poor performance etc. Opportunity- poor corporate governance, ineffective BoG or Poor internal control Rationalization- justification These three construct ‘FRAUD TRIANGLE’ How firms manage earnings? Revenue recognition policy: Channel stuffing or channel loading Using FOB shipping point sales Using lower provision for bad debt Deferring any expense like warranty or servicing expenses Expense Provision: Showing lower depreciation by stretching life of an asset Changing inventory costing method How firms manage earnings? Cont’d.. Taking a bath- showing large write off or provision during restructuring, recession, merger or change in management. Example: IBM CEO Louis Gerstner, when took charge, wrote off a huge cost ( $4 billion) during restructuring, part of which was future expenses Cookie Jar Accounting: taking some present earnings to future to smooth earnings Capitalizing Expenses: R & D expense, Brand development expense Dirty Surplus: Unrealized Gain or loss from foreign exchange, securities available for sale, derivative instruments What are the potential red flags? Unexplained changes in accounting, especially when performance is poor Unexplained transactions that boost profits: asset sale or debt equity swap Unusual increases in accounts receivable in relation to sales increase unusual increases in inventories in relation to sales increases An increasing gap between a firm’s reported income and its cash flow from operating activities Large fourth-quarter adjustments. Qualified audit opinions or changes in independent auditors that are not well justified Related-party transactions or transactions between related entities Large 4th Quarter Adjustment- Exim Bank (2016-2017) 3rd Quarter EPS For Exim Bank Annual EPS For Exim Bank How to assess the quality of Disclosure? Does the company provide adequate disclosures to assess the firm’s business strategy and its economic consequences? Do the footnotes adequately explain the key accounting policies and assumptions and their logic? Does the firm adequately explain its current performance? If a firm is in multiple business segments, what is the quality of segment disclosure? How forthcoming is the management with respect to bad news? Letter to shareholders by Square Textile: Explaining Current Performance How to measure manipulation? A popular Measure is ‘M- Score’ also known as manipulation ratio M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI 0.172*SGAI + 4.679*TATA - 0.327*LVGI A score greater than -2.22 (i.e. less negative than this) indicates a strong likelihood of a firm being a manipulator. Does the Beneish M-Score work? Beneish used all the companies in the database between 1982-1992. In his out of sample tests, Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of nonmanipulators. How to measure manipulation? The M score is based on a combination of the following eight different indices: DSRI = Days’ Sales in Receivables Index Measured as the ratio of days’ sales in receivables in year t to year t-1. A large increase in DSR could be indicative of revenue inflation. GMI = Gross Margin Index Measured as the ratio of gross margin in year t-1 to gross margin in year t. Gross margin has deteriorated when this index is above 1. A firm with poorer prospects is more to manipulate earnings. likely AQI = Asset Quality Index Asset quality is measured as the ratio of non-current assets other than plant, property and equipment to total assets. AQI is the ratio of asset quality in year t to year t-1. SGI = Sales Growth Index Ratio of sales in year t to sales in year t-1. Sales growth is not itself a measure of manipulation. However, growth companies are likely to find themselves under pressure to manipulate in order to keep up appearances. How to measure manipulation? DEPI = Depreciation Index Measured as the ratio of the rate of depreciation in year t-1 to the corresponding rate in year t. DEPI greater than 1 indicates that assets are being depreciated at a slower rate. This suggests that the firm might be revising useful asset life assumptions upwards, or adopting a new method that is income friendly. SGAI = Sales, General and Administrative expenses Index The ratio of SGA expenses in year t relative to year t -1. LVGI = Leverage Index The ratio of total debt to total assets in year t relative to yeat t-1. An LVGI >1 indicates an increase in leverage TATA – Total Accruals to Total Assets Total accruals calculated as the change in working capital accounts other than cash less depreciation. How the M-Score predicted trouble at Enron Calculating the M-Score for Enron between 1999 and 2000 gave a figure of -0.55 – that indicated that Enron might be manipulating its profits. This was proved to be the case in 2001. M Score for Food and Allied Industry M Score for Food and Allied Industry Cont’d.. Source: Study by Ajaan Rahman Khan, Mohsina Akter (2017) Analysts’ Implication: Sensitive Areas prone to manipulation INDUSTRY FLASHPOINTS Banking Quality of Loan Loss Provision COMPUTER HARDWARE Quality of warranty liability COMPUTER SOFTWARE Marketability of product TELCO Technological changes: Depreciation expense or inventory value TOBACCO Quality of estimated Health Liabilities PHARMA Quality of R&D Expense SUBSCRIBER SERVICES Development of Customer Base: Quality of Capitalized Promotion Cost Analysts’ Implication Identify any questionable accounting choices or estimates Compare the depreciation rates, bad debt provision rates with industry norms Assess the quality of earnings and ask if the earning is sustainable Analyze carefully if the industry or company structure is too complex Assess the corporate governance for Bangladeshi Firms. Any Questions ??
