Business Analysis and Valuation

Dr. Aprajita Pandey

BITS Pilani Department of Economics and Finance
Pilani Campus
 BITS Pilani
Pilani Campus

Earnings Management
 Earnings Quality

• Refers to the probability of earnings trends continuing and the extent to

which earnings could represent distributable cash. Earnings are said to
be of high quality if they can be distributed in cash, they are derived
primarily from continuing operations and the methods used in
measuring profit are conservative.
• In contrast, earnings are said to be of low quality if they have only a
small percentage of distributable cash, are derived from non-operating
sources, and are computed using liberal accounting methods.

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 How a company’s earnings quality may be
affected??
• Choice of accounting policies.
• Changes in accounting methods.
• Changes in accounting estimates.
• Non-operating and non-recurring items.
• Discontinued operations and
• Prior period errors.

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 Examples of Accounting policy choices in areas in which
management exercises significant discretion and judgment

Revenue Recognition Determining when a sale occurred or a service was provided.

Allocating fair value to the multiple elements of goods and services to be
provided.
Estimating percentage of completion in construction contracts.
Inventories Specific identification, first-in, first-out, and weighted-average cost
Estimating net realizable value

Property, plant and equipment Cost of acquisition

Revaluation
Depreciation Estimating and revising useful life and residual value
Straight-line, written-down value, production units and sum-of-the years’-
digit methods
Asset impairment Estimating future cash flows
Estimating cost of capital
Financial assets Determining fair value
Classifying financial investments as hold to collect or hold to collect and
sell
Estimating credit losses
Operating investments Determining control, significant influence and joint control
Leases Classifying a lease as an operating or a finance lease
Determining incremental borrowing rate
Estimating residual value
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 Earning Quality and cash flow

• Earnings that are in cash are of high quality. If the gap between earnings and cash
flow is low, the earnings are rapidly converted into cash.
• Cash flow to earnings ratio = Net cash from operating activities/ Profit.
• High volatility from one period to another would raise questions about earnings
quality.

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 Earnings Quality and Growth

• Firms that grow by frequent acquisitions are more prone to trouble. Acquisitions are
often over valued. Failed acquisitions leave behind a debris of goodwill impairment
loss. Again, firms that enjoy stratospheric growth rates are brought down to earth
sooner than later as competition catches up. Further, the earnings of start-up firms are
completely unpredictable, since such firms swing from high hopes to great despair on
a daily basis.

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 Advanced Profitability Analysis: Focus on
Operations
• Operating Profit
• Since interest expense and non-operating items are determined by factors that have
little to do with the efficiency of management of assets, analysts calculate a return
measure based on the net operating profit after tax (NOPAT). For this purpose, we
consider only revenues from sales and cost of operations and exclude non-operating
incomes and exceptional items and non-operating expenses, interest expense.

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 Earnings Management

• Earnings management is using judgment and discretion available in generally

accepted accounting principles or making operating decisions in order to produce a
pre-determined effect on the financial statements.
• We consider three types of earnings Management
• Managing accruals
• Managing real earnings
• Perpetrating fraud.

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 Accrual based Earnings Management

• Accrual accounting requires managers to make critical financial reporting decisions,

such as estimating useful lives of property, plant and equipment, determining fair
value, selecting depreciation methods, testing for impairment, estimating credit losses
debts, and reckoning pension liability.
• Earnings management may either
• Increase income, increase assets, decrease liabilities or
• Decrease Income, decrease assets, increase liabilities

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 Increase Income, Increase assets, Decrease
Liabilities
• Companies want to appear successful before a public issue of equity or debt. So we
would expect them to report a higher profit. They may raise the useful lives of assets,
lower the allowance for credit losses, recognize revenue for goods sent to distributors
but not yet sold, and switch from WAC to FIFO during inflation.
• Similar pressures exist when they have overshot analyst expectations or are facing
scrutiny for anti-competitive activities.

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 Decrease Income, Decrease Assets, Increase
Liabilities
• Companies want to minimize their income tax expense, especially if they have to
pay MAT. So we would expect them to report a lower profit. They may reduce the
useful lives of assets, increase the allowance for credit losses, delay recognizing
revenue from goods already sold, or switch from FIFO to WAC during inflation.
Similar pressure exists when they have overshot analyst expectations or are facing
scrutiny for anti-competitive activities.

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 Real Earnings Management

• In real earnings management managers manipulate earnings by modifying operating

decisions.
• Reducing discretionary expenditures (A consumer goods company may defer an advertisement campaign to the next
quarter in order to improve the current quarter earnings)
• Offering price discounts to boost sales (Prices re reduced towards the end of the reporting period)
• Selling surplus assets at a gain (Surplus land and buildings may be sold in order to realize gains)
• Offering generous credit terms (Customers may be induced in to buying more because of easier and cheaper credit)
• Overproduction (Increasing output reduces fixed overhead per unit and lowers cost of goods sold)
• Delaying Plant commissioning
• Deferring capital expenditure
• Deferring planned maintenance.

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 Fraud

• Fraudulent financial reporting is an extreme form of earnings management. Unlike

AEM and REM, fraud involves altering the facts. Fraud is the last resort of
beleaguered managers who have exhausted possibilities for AEM and REM. Since it
is illegal, it must not be attempted.
• Defer recognition of revenue earned in the remaining days of the quarter to the next quarter.
• Fake sales and receivables
• Present unearned revenue as revenue.
• Delay delivery of goods to the next quarter.

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