Assessing Earnings Quality at Nuware

Richard Hamilton
Mike Rakes
Brandon Sather
Theresa Sexton
 Nuware, Inc.
Consolidated Balance Sheets
as of January 31, 2003
2003 2002
Current Assets
Cash including available for sale investments of 59,716 and 35,076 $ 192,114 $ 55,609
Beneficial interest in securitized receivables
Accounts receivable, net adjusted reserve $ 291,618 $ 362,331
Inventory $ 277,002 $ 266,011
Prepaid expenses/other $ 56,179 $ 43,286
Total current assets $ 816,913 $ 727,237

Properties, Net $ 374,493 $ 370,262

Other noncurrent assets $ 49,411 $ 47,895

Total Assets $ 1,240,817 $ 1,145,394

Liabilities and Shareholder Equity

Current Liability
Current portion of long-term debt $ 393 $ 356
accounts payable $ 176,702 $ 129,076
gift cards, gift certificates and merchandise credits outstanding $ 117,495 $ 139,852
Accrued income tax payable $ 35,798 $ 29,738
Other accrued liabilities $ 192,348 $ 170,053
Total current liabilities $ 522,736 $ 469,075

Long-term debt $ 25,007 $ 25,356

other noncurrent liabilities $ 54,962 $ 43,265

Shareholder Equity
Common Stock, $0.10 par, 500,000,000 authorized, 100,883,000 issued $ 10,088 $ 10,088
Paid in capital $ 479,074 $ 440,190
Retained Earnings $ 298,816 $ 242,644

Cumulative other comprehensive income (loss) $ (11,210) $ (4,702)

Less: 10,045,000 and 7,362,000 common shares in treasury, at cost $ (138,656) $ (80,521)

Total liablities and Shareholder Equity $ 1,240,817 $ 1,145,395

Nuware allowance as a % of AR 3.09% 4.25%
RP allowance as a % of AR 4.49% 4.54%

Accounts Receivable Gross $ 305,326 $ 379,564

New Allowance $ 13,708 $ 17,233
Adjusted Accounts Receivable Net $ 291,618 $ 362,331

Remove beneficial interest in Securitized receivables 40538 34620

Remove beneficial interest from retained earnings 40538 34620
Move from Lifo to Fifo
Add to cost of sales 29500 35100
Add from inventory 29500 35100

Addback Advertising expenses 10200 8700

Addback Stock Compensation Expenses 1071 707

Back out Interest and investment income -9382 -5784

Add Adjust to tax reserve to RP Stuart -- 39% $ 1,648 $ 1,232

1. Provide a context for the concept of “earnings quality”

Earnings quality is a concept that covers multiple accounting concerns and

consists of two main elements. First, it touches on the idea that the
accounting is a fair representation of the firm’s performance.

For this first element, the idea of accounting being a fair representation of
the firm’s performance entails the removal of bias, especially management
bias, from the firm’s financials. Bias can occur via a manager’s optimism or a
manager’s incentive to report numbers pessimistically.

Whether or not a firm’s financials is a fair representation of its performance

is also difficult given the fact that there can be subjectivity in choosing
among accounting principles, not to mention the additional uncertainly that
arises because estimates are often used when applying these principles.

Second, earnings quality entails the idea that the information that’s provided
is relevant for forecasting the firm’s expected earnings and future financial
position.

2. Why is Harry Malone concerned about relying on Nuware’s

reported performance? If Nuware follows GAAP shouldn’t the
financial statements be reliable?

In this instance, Harry Malone is particularly concerned about relying on

Nuware’s reported performance given the in depth research done on R.P.
Stuart, his personal relationships with R.P. Stuart management, his belief in
the transparency of their reporting and the fact that though Nuware and R.P.
Stuart have virtually identical business models, R.P. Stuart struggled to
match last year’s profitability and Nuware increased its earnings by almost
20%.

Theoretically firms that follow GAAP should release reliable financial

statements. However, management still plays a significant role in deciding
how earnings will be stated. Despite the rules based system of GAAP, the
unique circumstances of individual businesses still allow for areas of gray.
There is room for deciding which accounting principle to apply and how to
estimate values when applying that estimate, be it an estimate of bad debt
expense, future costs of warranty programs or the fair value of financial
instruments, to name a few.
Moreover, as accounting scandals have proven, sometimes management
doesn’t make erroneous accounting representations because of uncertainty,
bias or estimates, but because they intend to deceive and they intentionally
misrepresent their firm’s financial position.

3. Assume the roles of Hereford and restate the company’s 2003

earnings as if the companies had used a similar accounting method
and assumptions. After such restatement, how do the earnings and
growth compare to R.P. Stuart?

The available for sale securities that Nuware lists as a current asset should
be backed out. Given that they are discussed in the footnotes as the only
financial instrument with a fair value different from the recorded value, this
leads one to believe that these securities are being held for an indefinite
period and should be classified as long terms assets at fair value, with any
cumulative gain or loss reported at fair value in the accumulated other
comprehensive income section of shareholder equity. This provides a much
better depiction of Nuware’s liquid assets in relation to R.P Stuart.

As the accounts receivable for Nuware decreased, Nuware reduced its

allowance for doubtful accounts, thereby estimating that more of its
receivables would be realizable. R.P. Stuart, in turn, kept its allowance
estimate steady. By adjusting the allowance, Nuware’s earnings are more in
line with the actual risk it bears on credit sales.

Although advertising is undertaken with the expectation that it will provide

value, whether it will or not is uncertain. Thus GAAP requires immediate
expensing of advertising costs. As such, advertising Costs that are
committed but not realized, i.e. $10.2MM and 8.7MM in 2003 and 2002,
respectively, must be expensed. This depicts expenses much more
realistically as between Nuware and Stuart.

Given that R.P. Stuart accounts for its stock compensation using the fair
value method it included stock compensation expense in its operating
income. As such, Nuware’s net income is more appropriately stated when
stock compensation expense of $1,071k and .707k is added back to
operating income.

Interest and investment income $9,382K $5,784k and $5,014K in 2003-

2001 should appropriately backed out given that their inclusion goes against
the second element of earnings quality, namely including information that’s
representative of a firm’s financial future. By backing out these peripheral
items, Nuware’s income from operations and ability to compete with R.P.
Stuart on an operations level is more accurately depicted.

For a lot of companies, cost of sales is the largest expense on the income
statement. Because LIFO tends to result in less variability in the gross
margin percentage over the business cycle, Nuware is better able to
accomplish income smoothing reporting using LIFO. As such, a LIFO
adjustment was made on the balance sheet (add 29.5MM and 35.1MM in
2003 & 2002) and a LIFO adjustment was made on the income statement by
adding 29.5MM and 35.1MM in 2003 and 2002 to the cost of sales.

4. Would you characterize the accounting discretion applied by

Nuware management as aggressive? In your opinion, has the
company been managing earnings?
Based on the analysis done in question three, we would characterize at least
some of the accounting discretion applied by Nuware as aggressive. There
are many examples that we will highlight again here. First, when the
Accounts Receivable are adjusted using the allowance used by RP, they
decrease from the stated balance by $1M in 2002 and $4.2M in 2003. This
would suggest that Nuware's method for calculating the allowance over
estimates what they actually will collect. Second, another indicator of
aggressive accounting is the way Nuware accounts for advertising expenses
- choosing to expense them in the period when the benefit is realized.
Advertising expenses are nearly impossible to tie directly to accounting
benefits, and this practice allows Nuware to move the expenses into a future
period as they see fit. This is evidence of earnings management on the part
of Nuware, and the data shows that adding these expenses back in 2002 and
2003 ($8.7M and $10.2M, respectively) significantly deflates the bottom line
income. Lastly, the Gross Profit Margin in each of the three years after
adjusting to RP's numbers drops between 1.7% - 2.1% which, again,
indicates that the accounting practices employed by Nuware were such that
the position of the company was over stated.

2003 2002 2001

Net Income $52,924.00 $39,565.00 $56,654.00
NI per DS $0.50 $0.38 $0.56
ROA 0.043 0.035 -- NI over Assets
ROE 0.067 0.057 -- NI over Equity
Tax Rate 39% 39% 39% Use RPs here
EPS Growth 0.33 -0.31 --
Sales Growth 0.027 0.061 -- Actual Sales are not adjusted
Gross Profit Margin 0.412 0.388 0.429