earnings quality slides fsa

7/25/2019 Earnings Quality slides FSA

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Chapter 17: Earnings Quality

T1: Earnings Quality

T2: Earnings management

T3: Cash flow management (Yes)


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T1: Earnings quality

Earnings quality: The egree to whi!h earnings refle!t unerlying e!onomi! performan!e

Chara!teristi!s of high quality earnings:Transparent: "ery little or nothing is hien (full is!lo

sure)Protecting proprietary information is understood, hiding

other information is less understood

Clearly stated accounting principles as opposed to havi

ng them vaguely definedConsistent

Accounts for similar economic transactions in a similar

manner


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Earnings quality

Earnings quality means ifferent things to ifferent finan!ial statements users (!onte#tual):$egulators will refer to earnings that ahere to the rules

%n&estors will refer to earnings that are prei!ti&e of futu

re !ash flows'eners will refer to earnings that are !onser&ati&e


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T2: Earnings management

A company is going through the interview process inorder to hire a new chief financial officer. In the last in

terview session, each of 3 finalists is given the comp

any's financial data and asked, "hat are the net ear

nings!" applicants diligently compute the net earnings. #either of them gets the $o%. &he candidate who

lands the position answers the uestion %y replying,

"hat do you want them to %e!( )loud laugh*


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Earnings management

ew efinitions of earnings management (E)* purposeful inter&ention in the e#ternal finan!ial reporti

ng purpose+ with the intent of o,taining some pri&ate gain (-!hipper+ 1./.)

The !hoi!e ,y a manager of a!!ounting poli!ies (a!!rual

s)+ or real a!tions+ that affe!t earnings so as to a!hie&e some spe!ifi! reporte earnings o,0e!ti&e

ra!ti!es ,y whi!h earnings reports refle!t the esiresof management rather than the unerlying finan!ial perf

orman!e of the !ompany4 (*rthur 'e&itt+ former -EC Chairman)

*!!oringly+ E often unermines EQ


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Earnings management

*rthur 'e&itt the num,ers game4 famous spee!h (fo

rmer -EC Chairman+ 1../+ 5Y6 Center for 'aw 8usiness): This pro!ess (E) has e&ol&e o&er the years into what !an ,est

,e !hara!teri9e as a game among maret parti!ipants * game that+ if not aresse soon+ will ha&e a&erse !onsequen!es for *meri!a;s finan!ial reporting system * game that runs !ounter to the

&ery prin!iples ,ehin our maret;s strength an su!!ess4 %n!reasingly+ % ha&e ,e!ome !on!erne that the moti&ation to me

et >>


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The impa!t of earnings management

Can amage the per!ei&e qualityof reporte earnings$esulting in the ,elief that reporte earnings o not ref

le!t e!onomi! reality

This un!ertainty ultimately has the potential to unermine the effi!ient flow of !apital there,y amaging effi!ient !apital allo!ation

Post+nron, post+financial crisis- Investors reuire large

discounts or withdraw from the stock market

iuidity pro%lems


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Earnings management

'et?s not ,e 0ust negati&e 5oti!e that earnings management !an ,e goo (really+ YE*)/anagers possess private information, and can use earnin

gs management to convey this information

arnings smoothing to avoid unnecessary costly de%t covenant violation

0 was known for its earnings smoothing practices

nsure investors of ongoing growth


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%n!enti&es for earnings management

* E#ternal a!tors *nalyst ore!asts (,etter meet or ,eat it) @euristi! 8en!hmars (a tiny profit is way ,etter than a tiny l

oss) A Be!how et al (23) why earnings are Diny4


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*symmetry aroun was foun for:

Earnings relati&e to analysts? fore!astEarnings le&el

Earnings !hange

Be,t marets an !ontra!tual o,ligations (,etter not

&iolate e,t !o&enants) Competition (,etter !reate ,arriers to entry)

8 %nternal a!tors

otential mergers (ma#imi9e share pri!e to ,e use in a merger)

lanning an ,ugets (,etter meet the ,uget targets)


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C ersonal a!tors

F ersonal ,onuses (@ealy+ 1./G) a

%f earnings are a,o&e the ma#imum for a ,onus or far fro

m the minimum+ ,etter lower earnings this year%f % am within the ,onus range+ then ma#imi9e earnings

romotions an 0o, retention8etter loo an ama9ing CEH

8ig ,ath ,y new CEHs


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B oliti!al moti&ations (lower earnings)Buring tariff in&estigation Iones (1..1)


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Jeneral earnings management tools

*!!rualK,ase earnings managementChange a!!ounting poli!ies

lay with estimates

Boes not affe!t !ash flow

anagers !an ,e!ome &ery !reati&e when it !omes to earnings management

*n the Hs!ar for most !reati&e a!!ounting awar goes to>Ieff -illings (Enron?s CEH)


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$eal earnings management

$eal (transa!tionK,ase) earnings management

Change real ,usiness a!ti&itiesCut 456 and advertising7 offer discounts7

&ime deliveries

8verproduce

Channel stuffing

Aggressive discounts

@as an immeiate effe!t on !ash flows

-hortKterm ,enefit+ ,ut a net negati&e o&erall effe!t

&he soup story


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@ow to sa&e money on Draft Binner K time your gro!

ery shopping to the last ays of the perioLL or soup sales in gro!ery stores+ Chapman an -tee

n,urgh (211) showe that managers use aggressi&e pri!e is!ounts+ feature a&ertisements aisle i

splays towars the en of the quarterMyear* willingness to sa!rifi!e longKterm &alue to meet shortKter

m sales or earnings ,en!hmars

areting a!tions ,oost quarterly net in!ome ,y up to GN

@owe&er+ there is a pri!e to pay: the !ost in the following perio ,eing appro#imately 7GN of quarterly net in!ome

5othing illegal


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ore iffi!ult to un!o&erBoes not &iolate J** (the soup is!ounts)

@ar to prote!t in&estors

@ar to tell the moti&e: a legitimate ,usiness e!ision+ ora shortKterm E mo&e


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Choi!e of a!!ounting poli!y


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*!!ounting estimates

reparation of finan!ial statements requires intensi&e use of estimates

Estimates !an ,e neutral+ or>opportunisti! to show a esire out!ome

'oan loss pro&ision in ,ans6seful life of assets

ension assumptions

*sset impairments

Joowill writeKoffs*llowan!e for ou,tful a!!ounts (8om,arier+ 21=+ Q1 2

1G)


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*nalysis of quality of re&enues

$e&enue re!ognition poli!ies at Oynga?s arti!le

%n groups: Bis!uss the following:

1 Bes!ri,e what Oynga i

2


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rauulent earnings management


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i!rostrategy (0ust another e#ample)

8a!grounoune in 1./. ,y i!hael -aylor+ that was soon 0oine

,y -an0u 8ansal+ whi!h stuie with him at %T

The !ompany prou!e software for ata mining an ,usiness intelligen!e

%n 1..2+ the !ompany gaine its first ma0or !lient when itsigne a 1 million !ontra!t with !Bonal?s

$e&enues in!rease ,y 1N e&ery year ,etween 1.. an 1..P


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i!rostrategy

%n ar!h 2+ after a re&iew of its a!!ounting pra!ti!es+ i!ro-trategy announ!e that it woul restate its finan!ial results for pre!eing 2 years

This le to an -EC in&estigation+ an su,sequen

tly to a lawsuit against i!ro-trategy an !ertainof its offi!ials o&er frau was file


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i!rostrategy

E ra!ti!es: i!ro-trategy;s reporting failures were primarily the result of premature re&enue re!ognition"iolate a!!ounting rules in !ompli!ate transa!tions

i!ro-trategy ha esta,lishe a pattern of ha&ing top e#e!uti&es refrain from signing ma0or !ontra!ts until after the en of ea!h quarter Then they woul sign enough ofthem to ensure meeting re&enue targets

$e&enues were sha&e: 1... K G=m+ 1../ K 11m+ an 1

..7 K 1mAll 3 years turned from profita%le to losing money


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i!rostrategy

Consequen!es:

*fter it announ!e that it woul restate earnings for 3 years+ its sto! fell 3/N in 1 ay H&erall sto! pri!e roppe from a high of 333 per share to 33 per share

%n *pril 21+ the !ompany settle a !lassK a!tion suit all

eging frau arising from its a!!ounting pra!ti!es3 of its e#e!uti&es at the time of the restatement agree t

o frau in0un!tions an pai penalties of 3G+ ea!hThey also pai a !om,ine total of 1 in isgorgement

The !ompany agree to unertae !orporate go&ernan!e!hanges an implement a system of internal !ontrols

2ave an independent director reporting directly to the 1C )pr

e+18


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Earnings management hierar!hy

1 Choi!e of a!!ounting poli!ies

2 *ggressi&e a!!ounting estimates A a!!rual earnings management

3 -e!on ,est transa!tions K real earnings manageme

nt= rauulent transa!tions (J** &iolation)

=.


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%ni!ators of earnings quality

= Qualitati&erofita,le ,usiness moel

Effe!ti&e internal !ontrol systems -HR 32 == is!losure

Quality of the management team

-trong !orporate go&ernan!e

-pe!ial ,usiness e!isions ri&en to a!hie&e esire a!!ounting results (S of -Es+ *)


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%ni!ators of earnings quality

= Quantitati&e

$elation ,etween (a!!rualK,ase) net in!ome an (!ashK,ase) CH: are a!!ruals too ,ig

&he divergence, remem%er!

*!!ounting oli!y !hoi!es estimates

ersistentM sustaina,le earnings or 0ust oneKtime gainsro forma earning &ery ifferent from J** earnings

6o the reasons seem to make sense!

Earnings quality moels

These are only suggesti&e ini!ators


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*!!ruals

*!!ruals are funamental in a!!ounting

-u,0e!t to 0ugment an is!retion

The *!!rual *nomaly4 is!o&ere ,y $i!har -loan (1..P): You !an earn a,normal return ,y taing

a short position in the high a!!ruals firms an a long position on the low a!!rual firms*!!ruals are less persistent than !ash flow

%n&estors o not unerstan it


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Earnings management an fair &alue

@ow oes fair &alue a!!ounting affe!t earningsmanagement2 opposing ways

/ore earnings management %ecause >>>>>>>>>>>>

ess earnings management %ecause >>>>>>>>>>>>


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*!!ounting poli!y an estimation

Transparent a!!ounting poli!y is!losure

@ow &ague is it

Che! the re&enue re!ognition poli!y (footnotes)Boes it loo aggressi&e or !onser&ati&e

8a e,t allowan!e:


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Earnings persisten!e

%f earnings mostly !ome from firms? normal operati

ng ,usiness+ in general+ we shoul see a sta,le tren of earnings o&er years

easure earnings persisten!e

The resiuals from a firm spe!ifi! regression shoul ,e smallYou !an !he! on seasonal quarterly earnings

The closer to 1 is, the more persistence the earnings are

i t f i it


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ersisten!e of &arious items (sour!e: Be!how+22)


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-pe!ial ,usiness transa!tions

-E is use to stru!ture &ery !ompli!ate finan!ial transa!tions (Enron)

'eases: * !hange from !apital leases to operatingleases

$elateKparty transa!tions *!!ounts re!ei&a,le sale to ,ans aroun the en

of quarter to polish CH

*ll !an ,e ini!ati&e of low earnings quality


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8eneish?s earnings manipulation s!ore

K-!ore K=/= U .2 # B-$% U G2/ # J% U == # *Q% U /.2 # -J%U 11G # BE% K 172 # -J*% K 327 # '"J% U =P.7 # T*T*

Bays $e!ei&a,le %ne# (B-$%) (5et $e!ei&a,lestM -alest) M 5et $e!ei&a,lestK1M -

alestK1)

Jross argin %ne# (J%) V(-alestK1K CHJ-tK1) M -alestK1W M V(-alestK CHJ-t) M -ale

stW

*sset Quality %ne# (*Q%) V1 K (Current *ssetstU EtU -e!uritiest) M Total *ssetstW M V1 K ((Current *ssetstK1U EtK1U -e!uritiestK1) M Total *ssetstK1)W

-ales Jrowth %ne# (-J%) -alestM -alestK1Bepre!iation %ne# (BE%) (Bepre!iationtK1M (EtK1U Bepre!iationtK1)) M (Bepre!i

ationtM (EtU Bepre!iationt))

-J* E#pense %ne# (-J*%) (-J* E#pensetM -alest) M (-J* E#pensetK1M -alestK1)

'e&erage ine# ('"J%) V(Current 'ia,ilitiestU Total 'ong Term Be,tt) M Total *ss

etstW M V(Current 'ia,ilitiestK1U Total 'ong Term Be,ttK1) M Total *ssetstK1W

Total *!!ruals to Total *ssets (T*T*) (%n!ome from Continuing HperationstK C

ash lows from Hperationst) M Total *ssetst


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8eneish?s earnings manipulation s!ore

Ks!oreX K222 ini!ates noearnings manipulation

Ks!ore K222ini!ates earnings manipulation *ll &aria,les are !onstru!te from the finan!ial statem

ents (easy to !al!ulate) * shorter&ersion K-!ore:

K-!ore KPPG U /23 # B-$% U .P # J% U G.3 # *Q%U 717 # -J% U 17 # BE%

Eliminates the less signifi!ant parameters

rof 8eneish ,a!Kteste the moel against finan!ial r

eports release ,y !ompanies in 1./2K.2The K-!ore !orre!tly ientifie 7PN of the manipulations

17GN of falseKpositi&es were returne


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'et?s e&aluate Jroupon?s earnings quality

Jroupon?s K-!ore of 332G in 21

$estate earnings for 211-hares of Jroupon sun nearly 17N as in&estors rea!te

to a restatement of re&enue figures ,y the offers we,site as well as the !ompany?s amission of material wea

ness4 in its internal !ontrols (inan!ial Times+ *pril+ 2212)

Bo not 0ust apply it me!hani!allyBi&isions of ratios

Bollarama ha a high K-!ore+ ,ut ri&en ,y *$ that was minus!ule (all ratios)


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T3: Cash flow management

YE-L Cash flow !an also ,e manipulate> ,ut les

s -mart managers now that analystsMin&estors pay

attention to CH an now how to play the game

-ome of it is relate to !lassifi!ation within the statement of !ash flow

-ome is relate to real transa!tions

%t is all legal


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T3: Cash flow management


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-tret!h out paya,les

-low own the rate of payments to &enors to impr

o&e CHThis temporary in!rease in CH is unliely to ,e sustaina

,le

The e#tension of paya,les !an ,e ientifie ,y mon

itoring ays? sales in paya,les (B-)B- (Ening *MCHJ-) Z 3PG

Jeneral Ele!tri!: Bays? -ales aya,le

Year ening Be!31 23 22 21 2B- G31 G1G =77 =2

i ,l


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inan!e paya,les

* !ompany uses a thirKparty finan!ial institutio

n to pay the &enor in the !urrent perio+ with the !ompany then paying ,a! the ,an in a su,sequent perio

BelphiCorporation

"enors

JE CapitalCorp

Hperating !ashoutflow

inan!ing!ash outflow


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inan!e paya,les

*t the first quarterJE pai the amounts to Belphi?s &enor

Belphi in?t e#pan any !ash

= Then Belphi re!lassifie *M to shortKterm loans

* nonK!ash transa!tion= %n the su,sequent quarter

Belphi pai JE an the !ash outflow was a!!ounte for as a finan!ing a!ti&ity


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Capitali9ing normal operating e#penses

%t ,oosts operating !ash flow+ ,e!ause normal e#

penses (operating !ash outflows) get shifte to the in&esting se!tion as !apital e#penitures (in&esting !ash outflows)%n real life there are G shaes of grey


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The happy ening

B%Y earnings management A the %8 !ase

*fter the game:

earnings quality slides fsa

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