Assessing Earnings Quality

1. Assessing Earnings Quality

2. Many companies struggle to meet earnings expectations. Some of the more common causes of a decline in earnings quality are listed in this presentation.

3. Adopting Less Conservative Accounting Practices, such as... • Using longer depreciation lives. • Changing from accelerated to straight-line depreciation. • Using FIFO for inventory costing (assuming at least modest inflation).

4. One-time Transactions. • Sale of an office building. • Tax deals that give up future benefits to lower current tax rates.

5. Overly pessimistic impairment charges. • Some goodwill shouldn’t be written down frequently. Some should. • Of course, goodwill is not the only asset that could be written down.

6. Restructuring Charges. • Companies have been known to include costs in restructuring that should more correctly be allocated to future operations. • This is hard to detect, but watch for significant movement in “restructuring reserves.”

7. Pulling future earnings into the present. Accelerating shipments to customers (e.g., revenue recognition issues, “stuffing the channels, etc.) Watch for unusual build-up of accounts receivable.

8. Including profits from past periods into current period. An example would be reversing a reserve set up in a prior period.

9. Adopting new accounting standards. Companies who are early adopters of new accounting standards are often anxious to boost earnings.

10. Reduction of Managed Costs. • Research & Development • Maintenance Expense • Advertising Costs

11. Under-Reserving for the Future. • Bad debts • Warranty Obligations • Returns and Allowances

12. An increasing gap in time between… • …the recording of income and the receipt of cash. Watch for build-up in accounts receivable. • Remember to monitor the trade cycle!

13. Increasing Reliance on Earning Sources… • …that are not central to the company’s principal business activity and strategy. • Remember core competencies!

14. To Capitalize or Not to Capitalize? • Be leery of expenditures that were once expensed as incurred…but are now classified as an asset. • …sounds like World Com.

15. Easy to Compare to Earlier Periods? • Be leery of major acquisitions accompanied by inadequate disclosure. • This makes it difficult to measure and analyze sources of growth.

16. Adoption of a new strategy while using historical data to estimate… • reserves • income timing • expense recognition

17. Writing off investments soon after they are made… • …could be income smoothing, • …or could be (part of) “the big bath.” • …or could be, gulp, realistic!

18. An increasing level of financial leverage… • …suggests that future earnings are significantly more risky than in the past. • Don’t ignore DTL = DOL X DFL [% ∆ in Sales → % ∆ EPS]

19. When monitoring inventory levels… • …watch especially for build-up in finished goods. This could indicate marketing problems that aren’t [yet] reflected in current earnings. • Of course, monitor other inventory types also.

20. Now, what company situations are more likely to result in lowered earnings quality?

21. Significant Market Share When a company has achieved significant market share [growing more rapidly than the industry], it becomes increasingly difficult to maintain these levels of growth.

22. In a consolidating industry… …all of a sudden only the marginal companies are left. The question is, will acquisitions stop?

23. Accounting changes… Some companies have a history of using accounting decisions to achieve earnings expectations. Using the old adage, a tiger doesn’t change its stripes.

24. The auditors are fired… • CPAs don’t give up clients easily. • Could be indicative of auditors not going along with management’s attempt to lower earnings quality. • Or, perhaps the sound of shredders was too loud in the background!

25. The company has grown rapidly… • Internal controls are difficult to implement during rapid growth. • Poor or fraudulent business practices may be hard to detect…or discourage.

26. Sales, Profits and Cash Balances are Soaring! • …creative inventory shifting could be supplier financing to distributor. • …or, off-balance sheet customer financing arranged by distributor. • What happens when business slows down?

27. With thanks to… • Some of the concepts in this presentation were adapted from Merrill Lynch’s Quantitative Analysis Group. (Merrill Lynch’s Accounting Bulletins and Accounting UPDATES)

28. [Subliminal messages] • Studying finance is good. • Studying finance is good. • Studying finance is good. • Studying finance is good. • Finance: It’s not just for Saturday night studying anymore.