Chapter 17

1. Chapter 17 Analysis of the Quality of Financial Statements

2. Analysis of the Quality of Financial Statements

3. What you will learn from this chapter • Five questions to ask about the accounting quality of a financial report • How accounting methods and estimates determine the sustainability of earnings • The devices management can use to manipulate earnings • How to carry out an accounting quality analysis • How to develop diagnostics to detect manipulated earnings • How an accounting quality analysis is combined with financial statement analysis and red-flag analysis to discover the quality of earnings • How composite quality scoring works Accounting quality analysis establishes the integrity of the accounting to be used in forecasting

4. Five Questions About Accounting Quality • GAAP quality: is GAAP accounting deficient? • Audit quality: is the firm violating GAAP or committing outright fraud? • GAAP application quality: is the firm using GAAP accounting to manipulate reports? • Transaction quality: is the firm manipulating business to accommodate the accounting? • Transaction timing • Transaction structuring • Disclosure quality: are disclosures adequate to analyze the business? • Disclosures that distinguish operating items from a financial items in the statements • Disclosures that distinguish core operating profitability from unusual items • Disclosures about the accounting used

5. Detecting Income Shifting: The Accounting Leaves a Trail One trail: “Hard” “Soft” A further trail: Capitalization Quality Accrual Quality

6. Low Quality Accounting and RNOA For valuation, the analyst wants to forecast future RNOA. If there is manipulation, current RNOA cannot be maintained in the future. Manipulation has the following effects: • As RNOA0= OI0/NOA-1,manipulation involves adjusting current operating income, OI0 • But OI0 = Free Cash Flow0 + DNOA0 • So a change in OI0 must also change NOA0 by the same amount • So future RNOA1=OI1/NOA0 must be reduced: • Denominator effect • Numerator effect

7. How Accounting Manipulation Leaves a Trail in the Balance Sheet (1)

8. How Accounting Manipulation Leaves a Trail in the Balance Sheet (2)

9. How Accounting Manipulation Leaves a Trail in the Balance Sheet (3)

10. How Accounting Manipulation Leaves a Trail in the Balance Sheet (4)

11. Two Directions for Manipulation • Borrowing income from the future • Increase in current revenue • Decrease in current expenses • Banking income for the future • Decrease current revenue • Increase current expenses Distinguish: • Conservative Accounting vs. • Liberal Accounting • Aggressive Accounting vs. • Big Bath Accounting Both increase current NOA Both reduce current NOA A matter of Accounting Policy A matter of short-term application of accounting that will reverse

12. How Specific Balance Sheet Items are Managed to Increase Income

13. How Specific Balance Sheet Items are Managed to Increase Income (cont)

14. Prelude to a Quality Analysis • Understand the business • Understand the accounting policy • Understand the business areas where accounting quality is most doubtful • Understand situations in which management are particularly tempted to manipulate

15. Flash Points: Accounting Areas where Manipulation is More Likely • IndustryFlash Point • Banking Credit losses: quality of loan loss provisions • Computer hardware Technological change: quality of receivables and inventory • Computer software Market ability of products: quality of capitalized research and development • Revenue recognition: quality of receivables and deferred revenue • Retailing Credit losses: quality of net accounts receivable • Inventory obsolescence: quality of carrying values of inventory • Rebate programs: quantity of sales and estimated liabilities • Manufacturing Warranties: quality of warranty liabilities • Product liability: quality of estimated liabilities • Automobiles Overcapacity: quality of depreciation allowances • Telecommunications Technological change: quality of depreciation allowances • Equipment leasing Lease values: quality of carrying values for leases • Tobacco Liabilities for health effects of smoking: quality of estimated liabilities • Pharmaceuticals R&D: quality of R&D expenditures • Product liability: quality of estimated liabilities • Real estate Property values: quality of carrying values for real property • Aircraft and ship Revenue recognition: quality of estimates under percentage of • manufacturing completion method and “program accounting” • Subscriber services Development of customer base: quality of capitalized promotion costs • Subscriptions paid in advance: quality of deferred revenue

16. Flash Points: Institutional Situations where Manipulation is More Likely • The firm is in the process of raising capital or renegotiating borrowing. Watch public offerings • Debt covenants are likely to be violated • A management change • An auditor change • Management rewards (like bonuses) are tied to earnings • Management is repricing executive stock options • A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all • Regulatory ratio requirements (like capital ratios for banks and insurance companies) are likely to be violated • Transactions are with related parties rather than at arm's length • Special events such as union negotiations and proxy fights • The firm is "in play" as a takeover target • The firm engages in exotic arrangements (structured off-balance-sheet vehicles)

17. Flash Points: Financial Statement Indicators that Manipulation is More Likely • A change in accounting principles or estimates • An earnings surprise • A drop in profitability after a period of good profitability • Constant sales or falling sales • Earnings growing faster than sales • Very low earnings (that might be a loss without manipulation) • Small or zero increases in profit margins (that might be a decrease without manipulation) • A firm meets analysts’ earnings expectations, but just so. • Differences in expenses for tax reporting and financial reporting • Financial reports are used for other purposes, like tax reporting and union negotiations. • Accounting adjustments in the last quarter of the year

18. IPOs and Manipulation

19. Overview of Diagnostics to Detect Manipulation

20. Diagnostics to DetectManipulated Sales Net Sales = Cash from Sales + D Net Accounts Receivable + D Allowance for sales returns + D Unearned revenue - D Warranty liabilities Diagnostic: Net Sales/ Cash from Sales Diagnostic: Net Sales/Net Accounts Receivable Diagnostic: Bad Debt Expense/Actual Credit Losses Diagnostic: Bad Debt Reserves/Accounts Receivable (Gross) Diagnostic: Bad Debt Expense/Sales Diagnostic: Sales Return Expense/Actual Sales Returns Diagnostic: Sales Return Reserves/Accounts Receivable (Gross) Diagnostic: Sales Return Expense/Sales Diagnostic: Warranty Expense/Actual Warranty Claims Diagnostic: Warranty Liabilities/Accounts Receivable (Gross) Diagnostic: Warranty Expense/Sales

21. Red Flags: Revenue

22. Diagnostics to DetectManipulated Expenses • Investigate Changes in NOA with Normalized ATO OI = Free Cash Flow + D NOA “Hard” “Soft” So, D NOA is to be investigated: D NOA = Cash investment + new operating accruals “Hard” “Soft” Diagnostic: Restated OI/OI Restated OI = Free Cash Flow + D Sales/Normal ATO This works if sales are not manipulated

23. Red Flag: Unusual Growth in NOA

24. Diagnostics to DetectManipulated Expenses • Investigate Changes in ATO

25. Red Flags: Unusual Changes in ATO

26. Diagnostics to DetectManipulated Expenses • Investigate Line Items Directly • Challenge depreciation and amortization expense Diagnostic: Adjusted ebitda=OI (before tax) + Depreciation Amortization – Normal Capital Expense Normal capital expense is approximated by the average capital expenditure over past years or normal depreciation and amortization for the level of sales, calculated from past (Depreciation + Amortization) / Sales ratios

27. Red Flags: Depreciation and Amortization

28. Diagnostics to Detect Manipulated Expenses (Step 3 continued) • Challenge total accruals Diagnostic: CFO/OI Diagnostic: CFO/Average NOA • Challenge individual accruals Diagnostic: Accruals/D Sales

29. Red and Green Flags: Unusual Accruals

30. Diagnostics to Detect Manipulated Expenses (Step 3 continued) (d) Challenge expense components that depend on estimates Diagnostic: Pension expense/Total operating expense Diagnostic: Other post employment expense/ total operating expense See Chapter 12

31. Diagnostics to Detect Manipulated Expenses

32. Diagnostics to DetectManipulated Expenses • Investigate Balance Sheet Line Items Directly Particular suspects: • Assets whose carrying values are above their market values: these are likely impairment candidates • Assets whose carrying values and amortization rates are subject to estimate: intangible assets, goodwill, deferred tax assets (particularly their valuation allowances), non-typical capitalization of expenses such as start-up costs, advertising and promotion, product development, and software development costs • Assets recorded at estimated fair values • Estimated liabilities such as pension liabilities, other employment liabilities, warranties, deferred tax liabilities, deferred revenue, and estimated merger and restructuring costs • Off-balance-sheet liabilities such as guarantees, recourse for assigned receivables or debt, purchase commitments, and contingent liabilities for lawsuits and regulatory penalties • Environmental liabilities (for clean up of pollution)

33. Red Flag: Fair Value Accounting

34. The Cash Flow Statement is a Source of Information on Accruals

35. Detecting Transaction Timing • Core Revenue Timing (Channel Stuffing) • Unexpected sales increases or decreases in the final quarter • Structuring of lease transactions to qualify as sales-type leases in lessor’s books • Core Expense Timing Diagnostic: R&D Expense/Sales Diagnostic: Advertising Expense/Sales Watch for temporary liquidation of hidden reserves for firms using conservative accounting (eg. LIFO dipping) • Cherry picking for sales of securities • Releasing hidden reserves

36. Red Flag: Channel Stuffing

37. Red Flag: LIFO Dipping

38. Detecting Transaction Structuring • Related party transactions • Structuring sales-type leases • Grossing up commissions • Swapping inventory

39. A Red Flag: Transaction Structuring

40. Detecting Organizational Manipulation • Off-Balance-Sheet Operations • R&D Partnerships • Pension Funds • Special purpose entities

41. Frustrations with Disclosure Quality • Consolidation accounting often makes the source of profitability hard to discover • Line of business and geographical segment reporting is often not detailed enough • Earnings in unconsolidated subsidiaries are hard to analyze. (Think of a firm that has all its earnings in subsidiaries in which it has less than 50% ownership: core profit margins are not transparent!) • Disclosure to reconcile free cash flow in the cash flow statement to free cash flow calculated (as OI - NOA) from the income statement and balance sheet. Some of the problems arise from uncertainty about items to be included in OI and NOA • Disclosures to calculate stock compensation expense are thin • Information is often not available to calculate losses on conversion of convertible claims into common equity • Details on selling, general and administrative expenses are often scare

42. Composite Quality Scoring

43. Examples of Composite Scores

44. Detecting Sustainable RNOA with an S-Score S = Probability that RNOA will increase S = 0.5 indicates sustainable RNOA

45. Rewards to Sustainable Earnings Analysis Returns to portfolio that goes long on firms with high S-Scores and short on firms with low S-Scores