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ChapterEighteenMcGraw-Hill/IrwinCopyright©2013byTheMcGraw-HillCompanies,Inc.Allrightsreserved.
Chapter18Preparedby:StephenH.Penman–ColumbiaUniversityWithcontributionsbyNirYehuda–NorthwesternUniversityMingcherngDeng–UniversityofMinnesotaPeterD.EastonandGregoryA.Sommers–NotreDameandSouthernMethodistUniversitiesLuisPalencia–UniversityofNavarra,IESEBusinessSchool18-2
WhatYouWillLearnfromthisChapterHowaccountingmethodsandestimatesaffectthesustainabilityofearningsWhat“qualityofearnings”means.TheaccountingdevicesthatmanagementcanusetomanipulateearningsHowfirmcantimetransactionstodeterminetheirearningsWhatdisclosurequalitymeansSituationswhereaccountingmanipulationismorelikelyWhychangeinnetoperatingassetsisthefocusofaqualityanalysisHowdiagnosticsaredevelopedtodetectmanipulationinfinancialstatementsHowqualityscoringworks18-3
TheBigPictureforthisChapterAccountingqualityanalysisestablishestheintegrityoftheaccountingusedforforecastingHowincomeshiftingworks:AccountingmethodscanbeappliedtoborrowincomefromthefuturepushincomefromthepresenttothefutureBut,thisincomeshiftingleavesatrailthatcanbefollowedbythequalityanalyst18-4
FiveQuestionsAboutAccountingQualityGAAPquality:isGAAPaccountingdeficient?Auditquality:isthefirmviolatingGAAPorcommittingoutrightfraud?GAAPapplicationquality:isthefirmusingGAAPaccountingtomanipulatereports?Transactionquality:isthefirmmanipulatingbusinesstoaccommodatetheaccounting?TransactiontimingTransactionstructuringDisclosurequality:aredisclosuresadequatetoanalyzethebusiness?DisclosuresthatdistinguishoperatingitemsfromafinancialitemsinthestatementsDisclosuresthatdistinguishcoreoperatingprofitabilityfromunusualitemsDisclosuresabouttheaccountingused18-5
DetectingIncomeShifting:TheAccountingLeavesaTrailOnetrail:“Hard”“Soft”Afurthertrail:CapitalizationQualityAccrualQuality18-6
LowQualityAccountingandRNOAForvaluation,theanalystwantstoforecastfutureRNOA.Ifthereismanipulation,currentRNOAcannotbemaintainedinthefuture.Manipulationhasthefollowingeffects:AsRNOA0=OI0/NOA-1,manipulationinvolvesadjustingcurrentoperatingincome,OI0ButOI0=FreeCashFlow0+DNOA0“Hard”“Soft”SoachangeinOI0mustalsochangeNOA0bythesameamountSofutureRNOA1=OI1/NOA0mustbereduced:DenominatoreffectNumeratoreffect18-7
HowAccountingManipulationLeavesaTrailintheBalanceSheet(1)18-8
HowAccountingManipulationLeavesaTrailintheBalanceSheet(2)TheCaseofNoGrowthwithIncomeShifting18-9
HowAccountingManipulationLeavesaTrailintheBalanceSheet(3)TheCaseofGrowthwithNoIncomeShifting18-10
HowAccountingManipulationLeavesaTrailintheBalanceSheet(4)TheCaseofGrowthwithIncomeShifting18-11
TwoDirectionsforManipulationBorrowingincomefromthefutureIncreaseincurrentrevenueDecreaseincurrentexpensesBankingincomeforthefutureDecreasecurrentrevenueIncreasecurrentexpensesDistinguish:ConservativeAccountingvs.LiberalAccountingAggressiveAccountingvs.BigBathAccountingBothincreasecurrentNOABothreducecurrentNOAAmatterofAccountingPolicyAmatterofshort-termapplicationofaccountingthatwillreverse18-12
HowSpecificBalanceSheetItemsareManagedtoIncreaseIncome18-13
HowSpecificBalanceSheetItemsareManagedtoIncreaseIncome(cont)18-14
PreludetoaQualityAnalysisUnderstandthebusinessUnderstandtheaccountingpolicyUnderstandthebusinessareaswhereaccountingqualityismostdoubtfulUnderstandsituationsinwhichmanagementareparticularlytemptedtomanipulate18-15
FlashPoints:AccountingAreaswhereManipulationisMoreLikelyIndustryFlashPointBankingCreditlosses:qualityofloanlossprovisionsComputerhardwareTechnologicalchange:qualityofreceivablesandinventoryComputersoftwareMarketabilityofproducts:qualityofcapitalizedresearchanddevelopmentRevenuerecognition:qualityofreceivablesanddeferredrevenueRetailingCreditlosses:qualityofnetaccountsreceivableInventoryobsolescence:qualityofcarryingvaluesofinventoryRebateprograms:quantityofsalesandestimatedliabilitiesManufacturingWarranties:qualityofwarrantyliabilitiesProductliability:qualityofestimatedliabilitiesAutomobilesOvercapacity:qualityofdepreciationallowancesTelecommunicationsTechnologicalchange:qualityofdepreciationallowances18-16
FlashPoints:AccountingAreaswhereManipulationisMoreLikelyIndustryFlashPointEquipmentleasingLeasevalues:qualityofcarryingvaluesforleasesTobaccoLiabilitiesforhealtheffectsofsmoking:qualityofestimatedliabilitiesPharmaceuticalsR&D:qualityofR&DexpendituresProductliability:qualityofestimatedliabilitiesRealestatePropertyvalues:qualityofcarryingvaluesforrealpropertyAircraftandshipRevenuerecognition:qualityofestimatesunderpercentageofmanufacturingcompletionmethodand“programaccounting”SubscriberservicesDevelopmentofcustomerbase:qualityofcapitalizedpromotioncostsSubscriptionspaidinadvance:qualityofdeferredrevenue18-17
FlashPoints:InstitutionalSituationswhereManipulationisMoreLikelyThefirmisintheprocessofraisingcapitalorrenegotiatingborrowing.WatchpublicofferingsDebtcovenantsarelikelytobeviolatedAmanagementchangeAnauditorchangeManagementrewards(likebonuses)aretiedtoearningsManagementisrepricingexecutivestockoptionsAweakgovernancestructure:insidemanagementdominatetheboard;thereisaweakauditcommitteeornoneatallRegulatoryratiorequirements(likecapitalratiosforbanksandinsurancecompanies)arelikelytobeviolatedTransactionsarewithrelatedpartiesratherthanatarm"slengthSpecialeventssuchasunionnegotiationsandproxyfightsThefirmis"inplay"asatakeovertargetThefirmengagesinexoticarrangements(structuredoff-balance-sheetvehicles)18-18
AchangeinaccountingprinciplesorestimatesAnearningssurpriseAdropinprofitabilityafteraperiodofgoodprofitabilityConstantsalesorfallingsalesEarningsgrowingfasterthansalesVerylowearnings(thatmightbealosswithoutmanipulation)Smallorzeroincreasesinprofitmargins(thatmightbeadecreasewithoutmanipulation)Afirmmeetsanalysts’earningsexpectations,butjustso.DifferencesinexpensesfortaxreportingandfinancialreportingFinancialreportsareusedforotherpurposes,liketaxreportingandunionnegotiations.AccountingadjustmentsinthelastquarteroftheyearFlashPoints:FinancialStatementIndicatorsthatManipulationisMoreLikely18-19
IPOsandManipulation18-20
OverviewofDiagnosticstoDetectManipulation18-21
DiagnosticstoDetectManipulatedSalesNetSales=CashfromSales+DNetAccountsReceivable+DAllowanceforsalesreturns+DUnearnedrevenueDiagnostic:NetSales/CashfromSalesDiagnostic:NetSales/NetAccountsReceivableDiagnostic:BadDebtExpense/ActualCreditLossesDiagnostic:BadDebtReserves/AccountsReceivable(Gross)Diagnostic:BadDebtExpense/SalesDiagnostic:Netsales/AllowanceforreturnsDiagnostic:Netsales/unearnedrevenue18-22
RedFlags:Revenue18-23
RedFlags:Revenue(continued)18-24
DiagnosticstoDetectManipulatedSalesNetSales=CashfromSales+DNetAccountsReceivableDiagnostic:SalesReturnExpense/ActualSalesReturnsDiagnostic:SalesReturnReserves/AccountsReceivable(Gross)Diagnostic:SalesReturnExpense/SalesDiagnostic:WarrantyExpense/ActualWarrantyClaimsDiagnostic:WarrantyLiabilities/AccountsReceivable(Gross)Diagnostic:WarrantyExpense/Sales18-25
DiagnosticstoDetectManipulatedExpensesInvestigateChangesinNOAwithNormalizedATOOI=FreeCashFlow+DNOA“Hard”“Soft”So,DNOAistobeinvestigated:DNOA=Cashinvestment+newoperatingaccruals“Hard”“Soft”Diagnostic:RestatedOI/OIRestatedOI=FreeCashFlow+DSales/NormalATOThisworksifsalesarenotmanipulated18-26
RedFlag:UnusualGrowthinNOA18-27
DiagnosticstoDetectManipulatedExpensesInvestigateChangesinATO18-28
RedFlags:UnusualChangesinATO18-29
DiagnosticstoDetectManipulatedExpensesInvestigateLineItemsDirectlyChallengedepreciationandamortizationexpenseDiagnostic:Adjustedebitda=OI(beforetax)+DepreciationAmortization–NormalCapitalExpenseNormalcapitalexpenseisapproximatedbytheaveragecapitalexpenditureoverpastyearsornormaldepreciationandamortizationforthelevelofsales,calculatedfrompast(Depreciation+Amortization)/Salesratios18-30
RedFlags:DepreciationandAmortization18-31
DiagnosticstoDetectManipulatedExpensesChallengetotalaccrualsDiagnostic:CFO/OIDiagnostic:CFO/AverageNOAChallengeindividualaccrualsDiagnostic:Accruals/DSales(Step3continued)18-32
RedandGreenFlags:UnusualAccrualsARedFlag.SharedMedicalSystems,asupplierofinformationsystemstohospitalsandphysicians,reportedearningsof$18.3millioninitsfirstquarterof1999,almostunchangedfromthepreviousquarter.Howeverrevenuesdeclinedfrom$339.3millionto$287.1million.Levelorincreasingearningsondecliningsalesalwayswavesaredflag.Thecashflowstatementrevealedfurtherones:Accruedexpensesdeclinedfrom$86.5millionto$61.5millionandtheamountofcomputersoftwarecapitalizedinthebalancesheetincreasedfrom$75.7millionto81.1million.Manipulationorlegitimatebusiness?Well,earningssignificantlyincreasedthroughoutthenextyear,onrisingrevenues,soareversalwasnotapparent.AGreenFlag.MicrosoftCorporationwritessoftwarecontractswithmultipledeliverablesanddefersasignificantportionoftherevenueonthesecontracts.Attheendofits2005fiscalyear,deferredrevenuesstoodat$9.17billionor23.0percentofsales.Theprospectofthefirmbleedingthisdeferredrevenuebackintoincomeisreal,sotheanalysthasMicrosoftonawatch.In2005,thecashflowstatementrevealsthatMicrosoftadded$12.5billiontodeferredrevenueandtransferred$11.3ofdeferredrevenuetorevenuetotheincomestatement.Thereisnosignofanexcessivebleedback.18-33
RedandGreenFlags:UnusualAccruals(continued)ARedFlag.CiscoSystemsreportedrevenueof$4,816millionforitssecondquarterof2002upfromthe$4,448millionintheprecedingquarterandexceedingprojections.Itlookedliketherevenuedecline,fromthe$6,000millionperquarterin2001,wasover.However,thefirmpointedoutthat,forthefirsttime,deferredrevenuehadreversed:Thefirmhadrecognizedanunusuallylargeamountofrevenueonconditionalshipmentsfrompriorperiods.18-34
DiagnosticstoDetectManipulatedExpenses(Step3continued)(d)ChallengeexpensecomponentsthatdependonestimatesDiagnostic:Pensionexpense/TotaloperatingexpenseDiagnostic:Otherpostemploymentexpense/Totaloperatingexpense18-35
DiagnosticstoDetectManipulatedExpenses18-36
DiagnosticstoDetectManipulatedExpensesInvestigateBalanceSheetLineItemsDirectlyParticularsuspects:Assetswhosecarryingvaluesareabovetheirmarketvalues:thesearelikelyimpairmentcandidatesAssetswhosecarryingvaluesandamortizationratesaresubjecttoestimate:intangibleassets,goodwill,deferredtaxassets(particularlytheirvaluationallowances),non-typicalcapitalizationofexpensessuchasstart-upcosts,advertisingandpromotion,productdevelopment,andsoftwaredevelopmentcostsAssetsrecordedatestimatedfairvaluesEstimatedliabilitiessuchaspensionliabilities,otheremploymentliabilities,warranties,deferredtaxliabilities,deferredrevenue,andestimatedmergerandrestructuringcostsOff-balance-sheetliabilitiessuchasguarantees,recourseforassignedreceivablesordebt,purchasecommitments,andcontingentliabilitiesforlawsuitsandregulatorypenaltiesEnvironmentalliabilities(forcleanupofpollution)ObligationstoSpecialPurposeEntitiesEstimatedliabilities,suchaswarrantyliabilities18-37
RedFlag:FairValueAccounting18-38
TheCashFlowStatementisaSourceofInformationonAccruals18-39
DetectingTransactionTimingCoreRevenueTiming(ChannelStuffing)UnexpectedsalesincreasesordecreasesinthefinalquarterStructuringofleasetransactionstoqualifyassales-typeleasesinlessor’sbooksCoreExpenseTimingDiagnostic:R&DExpense/SalesDiagnostic:AdvertisingExpense/SalesWatchfortemporaryliquidationofhiddenreservesforfirmsusingconservativeaccounting(eg.LIFOdipping)CherrypickingforsalesofsecuritiesReleasinghiddenreserves18-40
RedFlag:ChannelStuffing18-41
RedFlag:LIFODipping18-42
DetectingTransactionStructuringRelatedpartytransactionsStructuringsales-typeleasesGrossingupcommissionsSwappinginventory18-43
ARedFlag:TransactionStructuring18-44
DetectingOrganizationalManipulationOff-Balance-SheetOperationsR&DPartnershipsPensionFundsSpecialpurposeentities18-45
FrustrationswithDisclosureQualityConsolidationaccountingoftenmakesthesourceofprofitabilityhardtodiscoverLineofbusinessandgeographicalsegmentreportingisoftennotdetailedenoughEarningsinunconsolidatedsubsidiariesarehardtoanalyze.(Thinkofafirmthathasallitsearningsinsubsidiariesinwhichithaslessthan50%ownership:coreprofitmarginsarenottransparent!)Disclosuretoreconcilefreecashflowinthecashflowstatementtofreecashflowcalculated(asOI-NOA)fromtheincomestatementandbalancesheet.SomeoftheproblemsarisefromuncertaintyaboutitemstobeincludedinOIandNOADisclosurestocalculatestockcompensationexpensearethinInformationisoftennotavailabletocalculatelossesonconversionofconvertibleclaimsintocommonequityDetailsonselling,generalandadministrativeexpensesareoftenscare18-46
CompositeQualityScoring18-47
ExamplesofCompositeScores18-48
DetectingSustainableRNOAwithanS-ScoreS=ProbabilitythatRNOAwillincreaseS=0.5indicatessustainableRNOA18-49
RewardstoSustainableEarningsAnalysisReturnstoportfoliothatgoeslongonfirmswithhighS-ScoresandshortonfirmswithlowS-Scores18-50
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