Appendix 3a A Guide to Earnings Quality

Appendix 3a A Guide to Earnings Quality
Copyright © 2016 Pearson Education, Inc.

Appendix 3A: A Guide to Earnings Quality
The earnings statement encompasses a number of areas that provide management with opportunities for influencing the outcome of reported earnings: Accounting choices, estimates, and judgments Changes in accounting methods and assumptions Discretionary expenditures Nonrecurring transactions Nonoperating gains and losses Revenue and expense recognitions that do not match cash flow Copyright © 2016 Pearson Education, Inc.

Financial statement analysts should consider qualitative and quantitative components of earnings. Quality of information on the balance sheet and statement of cash flows is equally important. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Premature Revenue Recognition
Revenue should not be recognized until there is evidence that a true sale has taken place. Delivery of products has occurred. Services have been rendered. Price has been determined. Collection is expected. Many firms record revenues before these conditions have been met. Copyright © 2016 Pearson Education, Inc.

A firm’s revenue recognition policy can be found in financial statement notes. The analyst can use the notes to determine whether any changes have been made to the policy and reasons for and impact of the changes. Copyright © 2016 Pearson Education, Inc.

Analyzing the relationship among sales, accounts receivable, and inventory can signal red flags. Fourth-quarter spikes in revenue may indicate premature revenue recognition. Copyright © 2016 Pearson Education, Inc.

Diebold Inc. was charged for manipulating its earnings from at least 2002 through 2007. Diebold Inc. used the “bill-and-hold” technique (pre-delivery revenue recognition) to recognize revenue prematurely when the necessary criteria of a bill-and-hold transaction had not been met. Diebold Inc. also manipulated reserves and accruals, improperly delayed and capitalized expenses, and wrote up the value of inventory. Copyright © 2016 Pearson Education, Inc.

In 2007, Dell Inc. admitted to financial statement manipulations that included premature revenue recognition. As a result financial statements for the years through 2006 were restated. Revenues were overstated to meet quarterly performance goals. Restatement in fiscal 2005 caused a reduction in revenue for software sales in the amount of $105 million. Copyright © 2016 Pearson Education, Inc.

Prior to 2001, Computer Associates used a strategy, referred to as the “35-day month practice” to inflate revenues by keeping the accounting books open longer than the end of the quarter. $2.2 billion of revenue was prematurely recorded. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts Volume of credit sales Firm’s customer base and past experience with customers Firm’s credit policies and collection practices Economic conditions Changes in any of the above factors Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts Underestimating bad debt expense will boost net income. Overestimating the allowance account can provide firms with an opportunity for a later correction that will ultimately boost net income. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts There should be a consistent relationship between the rate of change in sales, accounts receivable, and the allowance for doubtful accounts. Companies should offer clear explanations of their accounts receivable and allowance for doubtful accounts in their notes if there are significant and abnormal changes to the accounts. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts In 2007, Seagate Technology had an increase in the allowance account despite a decrease in accounts receivable. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts Seagate Technology explains this change in the notes. Seagate Technology terminated its distributor relationships with eSys and ceased shipments of its products to eSys. eSys was the largest distributor of Seagate products. Seagate Technology recorded $40 million of allowance for doubtful accounts. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts Seagate Technology is pursuing collection on all amounts owed by eSys, which will be recorded in the period received. Seagate Technology will continue to pursue any claims that may be assertable against eSys. Seagate Technology has commenced legal proceedings against eSys and its chief executive officer. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts Many times, companies offer no explanation of questionable changes. Logitech International S.S. offers no explanation for the volatility in charges to bad debt expense or write-offs of accounts receivable. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Allowance for Doubtful Accounts Proctor & Gamble Company no longer includes information on the balance sheet, in the notes, or in a valuation schedule to indicate the company even has an allowance for doubtful accounts. With over $5.3 billion in 2010 of accounts receivable it is unlikely that the firm has no bad debt. The quality of reported earnings is affected negatively by the lack of disclosure. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Price Versus Volume Change
If a company’s sales are changing, it is important to determine whether the change is a result of price, volume, or both. Information regarding the reasons for change in sales is covered in a firm’s Management Discussion and Analysis. To relate changes in sales to the reasons for changes, use sales data from the income statement and the volume/price discussion from the Management Discussion and Analysis. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Sales or Revenues – Real Versus Nominal Growth
A related issue is whether sales are growing in “real” as well as “nominal” terms. Change in sales in nominal terms can be calculated from figures reported on the income statement. An adjustment of the reported sales figure with the Consumer Price Index (CPI) will enable the analyst to make a comparison of the changes in real and nominal terms. Copyright © 2016 Pearson Education, Inc.

Sales, when adjusted for general inflation, grew at a rate of 8.51%, which means nominal sales growth has kept pace with the general rate of inflation. Nominal sales increased 10.11% while the CPI increased only 1.48%. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Cost of Goods Sold – Cost Flow Assumption for Inventory During periods of inflation LIFO produces lower earnings than FIFO or average cost. During volatile periods or periods of falling prices, LIFO produces higher earnings than FIFO or average cost. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Cost of Goods Sold – Cost Flow Assumption for Inventory LIFO produces higher-quality earnings than FIFO or average cost. The inventory accounting system used by the company is described in the note to the financial statements that details accounting policies or the note discussing inventory. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Cost of Goods Sold – Base LIFO Layer Liquidations
Occurs when LIFO is being used the firm sells more goods than purchased during an accounting period companies are shrinking rather than increasing inventories Copyright © 2016 Pearson Education, Inc.

Using the Checklist Cost of Goods Sold – Base LIFO Layer Liquidations
Reduces the quality of earnings Increase in operating profit due to inventory reductions Copyright © 2016 Pearson Education, Inc.

Using the Checklist Cost of Goods Sold – Loss Recognitions on Write-Downs of Inventories The principle of conservatism in accounting requires that firms carry inventory in the accounting records at the lower of cost or market. Market generally is determined by the cost to replace or reproduce the inventory but should not exceed the net realizable amount the company could generate from selling the item. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Cost of Goods Sold – Loss Recognitions on Write-Downs of Inventories The amount of the write-down will affect comparability, thus quality, of the profit margins. When the write-down of inventory is included in the cost of goods sold, the gross profit margin is affected in the year of the write-down. Significant write-downs of inventory are relatively infrequent. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Cost of Goods Sold – Loss Recognitions on Write-Downs of Inventories In comparing gross profit margins between periods, the analyst should be aware of the impact on the margin that occurs from such write-downs. Sometimes companies may write down the value of inventories every year. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Operating Expenses – Discretionary Expenses
A company can increase earnings by reducing variable operating expenses in a number of areas: repair and maintenance of capital assets research and development advertising and marketing Copyright © 2016 Pearson Education, Inc.

If discretionary expenses are reduced primarily to benefit the current year’s reported earnings, the long-run impact on operating profit may be detrimental. The analyst should review the trends of discretionary expenses and compare them with the firm’s volume of activity and level of capital investment. Copyright © 2016 Pearson Education, Inc.

Amounts of discretionary expenditures are disclosed in the financial statements and notes. Advertising expenses are usually detailed in the summary of significant accounting policies note. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Operating Expenses – Depreciation
The straight-line method of depreciation is used by most companies for reporting purposes. It produces a smoother earnings stream and higher earnings in the early years of the depreciation period. It is lower in quality in most cases, because it does not reflect the economic reality of product usefulness. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Operating Expenses – Depreciation
Companies that misclassify operating expenses as capital expenditures have created poor quality of financial reporting. Recording an amount that should be deducted in its entirety in one year as a capital expenditure results in the expense being depreciated over several years. Comparing companies is difficult when each firm chooses different depreciation methods and/or different lives for their long-lived assets. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Operating Expenses – Asset Impairment
The write-down of asset values affects the comparability and the quality of financial data. The reasons for write-downs is presented in the notes to the financial statements. Firms also write down the carrying cost of property, plant, and equipment and intangible assets when there is a permanent impairment in value and when certain investments in marketable equity securities are carried at market value. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Operating Expenses – Reserves
Allowance for doubtful accounts Product warranty Restructuring Sales returns Environmental obligations. Copyright © 2016 Pearson Education, Inc.

Accrual accounting requires companies to estimate and accrue obligations for items that may be paid in future periods but should be accrued in the current period. The creation and use of reserve accounts is required to properly match revenues and expenses. Copyright © 2016 Pearson Education, Inc.

The abuse of reserve accounts has been an ongoing issue. Cookie-jar accounting occurs when companies create or use reserve accounts for the purpose of setting aside funds in good years by over-reserving and the reducing or reversing charges to the reserve accounts in poor years. “Big bath” charges are enormous write- offs taken by companies to clean up their balance sheets. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Operating Expenses – In-Process Research and Development In-process research and development charges are one-time charges taken at the time of an acquisition. Charge amounts are part of the acquisition price that the acquiring company determines are not yet viable research and development. These charges can be written off immediately under current accounting rules. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Operating Expenses – In-Process Research and Development Any revenue gains from the research in the future will cause higher earnings that have not been matched to the expenses that created them. Companies can write off significant amounts of research and development the year of an acquisition in order to boost earnings in later years. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Gains (Losses) from Sales of Assets When a company sells a capital asset, the gain or loss is included in net income for the period. The sale of a major asset is sometimes made to increase earnings and/or to generate needed cash during a period when the firm is performing poorly. Such transactions are not part of the normal operations of the firm and should be excluded from net income when considering future operating potential of the company. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Gains (Losses) from Sales of Assets The following table found in the Goodyear Tire & Rubber Company’s 2013 Form 10-K illustrates nonoperating revenues and expenses: Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Interest Income
Nonoperating in nature except for certain types of firms such as financial institutions Results primarily from short-term temporary investments in marketable securities to earn a return on cash not immediately needed in the business Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Interest Income
In the assessment of earnings quality, the analyst should be alert to the materiality and variability in the amount of interest income. Interest income is disclosed on the face of the income statement or in notes to the financial statements. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Equity Income
Use of the equity method to account for investments in unconsolidated subsidiaries permits the investor to recognize as investment income the investor’s percentage ownership share of the investee’s reported income rather than recognizing income only to the extent of cash dividends actually received. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Income Taxes
The provision for income tax expense on the income statement differs from the tax actually paid. When assessing the net earnings number, it is important to differentiate between increases and decreases to net earnings caused by tax events. Copyright © 2016 Pearson Education, Inc.

A significant change in the effective tax rate may be a one-time nonrecurring item. Included in the income tax notes to the financial statements is a reconciliation of the U.S. federal statutory tax rate to the company’s effective tax rate. Copyright © 2016 Pearson Education, Inc.

When projecting future earnings, the analyst must consider whether the firm will need to repatriate funds in the future. The analyst should also stay abreast of changes in tax laws that would eliminate current benefits of leaving earnings overseas. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Discontinued Operations Discontinued operations should be excluded in considering future earnings. Two items are recorded if the discontinued operations have been sold: the gain or loss from operations of the division up to the time of sale, net of tax the gain or loss as a result of the sale, net of tax Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Discontinued Operations The footnote disclosure from Zebra Technologies 2013 Form 10-K for discontinued operations is as follows: Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Discontinued Operations It would be appropriate to deduct the net earnings on discontinued operations in in all three years from net earnings for comparative purposes. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Nonoperating Revenue and Expense – Extraordinary Items Gains and losses that are both unusual and infrequent Shown separately, net of tax, on the income statement Rare to see on an earnings statement The gain or loss should be eliminated from earnings when evaluating a firm’s future earnings potential. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Other Issues – Material Changes in Number of Shares Outstanding The number of common stock shares outstanding and earnings per share can change materially from one accounting period to the next. These changes result from such transactions as treasury stock purchases and the purchase and retirement of a firm’s own common stock. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Other Issues – Material Changes in Number of Shares Outstanding The reasons for repurchase of common stock should be determined if possible. It is important to consider whether a firm is spending scarce resources to merely increase earnings per share. Copyright © 2016 Pearson Education, Inc.

Using the Checklist Other Issues – Operating Earnings, a.k.a. Core Earnings, Pro Forma Earnings, or EBITDA Operating earnings is an important figure for assessing ongoing potential of a firm. Some companies have created their own operating profit numbers and tried to convince users that these figures are the ones to focus on instead of the GAAP-based amounts. These “company created” numbers go by a variety names such as core earnings, pro forma earnings, or EBITDA. Copyright © 2016 Pearson Education, Inc.

Using the Checklist What Are the Real Earnings?
Each individual user of financial statements should adjust the earnings figure to reflect what that particular user believes is relevant to the decision at hand. Based on the checklist, Exhibit 3A.2 shows the items that should be considered as adjustments to earnings. Copyright © 2016 Pearson Education, Inc.

Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2016 Pearson Education, Inc.

Appendix 3a A Guide to Earnings Quality

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