Earnings &

Financial
Reporting Quality

Bistrova Julia
 2

What is common between these

companies?
 3

One of recent “cooking books” examples

-86%
 4

Accounting Discretions

Preparation of Financial Statements involves a lot of assumptions:

 Revenue recognition;
 Depreciation choices;
 Inventory choices;
 Choices related to goodwill and other Fixed assets;
 Pension choices;
 Financial asset/liability valuation;
 Stock option expense estimates.
What accounts are managed most?
 6

Motivation for Earnings Manipulation

 Boost stock price

.. Cheaper to raise new financing, acquire other firms
.. Boost value of stock option grant/insider trade
 Meet analysts’ forecasts
.. Keeps interest in the stock high (affects liquidity)
.. Reputation of management
 Contractual incentives
.. Earnings based bonuses
.. Debt covenants, unions, etc.
What Types of Companies are Most Likely to
Use Shenanigans?
 Companies with a weak control environment
- No independent members
- Lack of competent/independent auditor
- Inadequate internal audit function
 Management facing extreme competitive
pressure or known or suspected of having
questionable character
 Small fast-growth
 Newly-public companies
 Privately held companies
 8

Situation when Creative Accounting is Most

Likely

 Earnings short of market expectation

 Firm preparing for IPO
 Earnings above minimum for incentive compensation
 Firm close to violating debt covenant
 Earnings trend above/below what management
believes is a sustainable trend
 Earnings volatility induced by a series of non-recurring
items
 A change has taken place in top management
 9

PO Analysis on Baltic Market - Profitability

Profitability Capital Profitability

Clear decline in profitability in post PO years, but clear improvement

after 2 years of listing
Brno, Economics and Management 2011
 10

PO Analysis on Baltic Market - Earnings Quality

One year before the offering Level of accruals is highest

most companies seem to use before the offering is made,
creative accounting practices while it declines sharply as
as indicated by large amount company is listed on
of companies having high net exchange.
income at low cash flows.
Brno, Economics and Management 2011
 11

Annual Profit Growth

US companies annual earnings growth

Source: AllianceBernstein
Disciplining Management

Int.audit

Ext.audit

Sarbanes-
Oxley Act2002
Lawyers

Regulators General market

scrutiny
Basic tools to evaluate plausibility of financial results of the
company:

1. Net and operating income dynamics;

2. Return on capital ratios;
3. Economic value added;
4. Comparison of net income and operating cash flow;
5. Accruals;
6. Creative accounting practices detection.
Accruals component

Accrual-basis accounting – revenue/expense is recorded when there is

legal obligation created (e.g. when goods are shipped) regardless of
whether there was an exchange of cash.

Accounts on a balance sheet that represent liabilities and non-

cash-based assets used in accrual-based accounting. These
accounts include, among many others, accounts payable,
accounts receivable, goodwill, future tax liability and future interest
expense.
Accruals

1. Accruals = (∆Current Assets-∆Current Liab.-Depreciation =

(∆Acconts Receivable+∆Inventories+∆Other CA)-(∆PPE+∆Other
CL )-Depreciation)/Assets;

2. Balance sheet based accruals = (NOAt - NOAt-1) / ((NOAt +

NOAt-1)/2)
Net Operating Assets = (Assets - Cash)-(Liabilities – Total Debt)

3. Cash flow statement based accruals = (NIt - CFOt - CFIt) / ((NOAt

+ NOAt-1)/2)
Task – Coca-Cola B/S Accruals
Task – Coca-Cola CF Accruals
Accruals vs. SEC supervision
Accruals of CEE Companies according to
Corporate Governance quartile
10.0%
Balance sheet based
accruals
5.0% Cash flow statement
based accruals

0.0%
1 2 3 4
-5.0%

-10.0%

-15.0% Quartile number

2007 2008 2009 2010

C/F Accruals 0.46% 0.05% -1.07% -0.84%
B/S Accruals 3.82% 12.50% -4.72% -0.20%
Detection of Creative Accounting Practices

1. Recording revenue too soon

2. Recording bogus revenue
3. Boosting income with one-time gains
4. Shifting current expenses to a later or earlier
period
5. Failing to disclose all liabilities
6. Shifting current income to a later period
7. Shifting future expenses into the current period
1. Recording revenue too soon
 Shipping goods before sale is finalized
 Recording revenue when important
uncertainties exist
 Recording revenue when future services are still
due
Warning signs: large increases in AR, large
decreases in unearned revenues
2. Recording bogus revenue

 Recording income in exchange for similar assets

 Recording refunds from suppliers as revenue
 Using bogus estimates on interim financial reports

Warning signs: large increases in AR, large

decreases in unearned revenues

Inflated earnings with bogus accounting

entries from ‘corporate unallocated
revenue accounts’
3. Boosting income with one-time gains

 Boosting profits by selling undervalued assets

 Boosting profits by retiring debt
 Failing to segregate non-recurring activities

Warning signs: inconsistency in the reported operating income

(check income statement)
 24

Possible creative accounting practices

Case from Baltic Equity Market – A/S Baltika
A/S Baltika

∆operating profit +83%; excl. other operating profit ∆operating profit -30%
 25

Possible creative accounting practices

Case from European Equity Market – Telefon AB L.M.Ericsson
3Q 2007 Annual Report 2006

Share price declined by 27% a day when

Ericsson reported 3Q results;

Inflated operating profit in 3Q 2006 (by EUR 3

bn) by other investments and operation.
4. Shifting current expenses to a later or
earlier period
 Improperly capitalizing costs
 Depreciating or amortizing costs too slowly
 Failing to write off worthless assets

Warning signs: track growth in noncurrent assets; check depreciation

rates and its change; check for inventory built-ups

Underreported ‘line costs’ by capitalizing

them

In 2001 showed 1.4 bn USD profit, rather

than a loss
5. Shifting future expenses into the current
period

 Accelerating discretionary into the

current period
 Writing off future years’ depreciation and
amortization during the current year
Vodafone made a £14.9bn ($27.9bn)
loss last year - a record for a UK firm -
after it admitted some of its assets were
worth less that it thought.It incurred
one-off costs of more than £23.5bn
after revaluing its German business
Mannesmann, which it bought in 2000
for £112bn ($183bn at the time).
6. Shifting current income to a later period

 Creating reserves and releasing them into

income in a later period
7. Failing to disclose all liabilities

 Reporting revenue when cash is received in

advance of providing services
 Failing to accrue expected or contingent
liabilities
 Failing to disclose all material commitments and
contingencies
 Engaging in transactions to keep debt off books
Special purpose entities to hide debt

Warning signs: check for leasing obligations,

SPE/SPVs;
Wal-Mart Example
Total obligations under capital leases 3798 mn USD, of which 285
mn USD was due within1year.
8. Cash Flow Statement Issues

1. Classification issues

2. Omitted investing and financing activities

Homework
 Calculate and evaluate CF and B/S Accruals; Net Income
vs. Cash Flow

 Check and evaluate CEO compensation;

 Check and evaluate Audit Committee/BoD

Independence;

 Check other warning signs of low quality earnings;

 Make a SHORT presentation with conclusions and

intepretations