CB 3041

Financial Statement Analysis

Lecture 6
Accounting Quality and Earnings
Management
 Learning Objectives
 Describe the concept of quality of accounting
information and the characteristics of balance
sheet quality and earnings quality.
 Discuss the steps in analyzing earnings.
 Define earnings management and understand
conditions under which managers more likely
to engage in it.
 Understand different types of earnings
management techniques used by managers
 Accounting Quality
• Accounting information should be fair complete
representation of firm’s economic performance,
position, and risk.


 high-quality accounting information maximizes

economic content and minimizes measurement error
and bias.
 Accounting Quality
• Accounting information should provide relevant
information for forecasting future earnings and
cash flows.
 high-quality accounting provide information about
the extent to which current earnings will persist into
the future.
 high accounting quality helps the analyst assess
current period performance, forecast future earnings
and cash flows, and value the firm’s shares.
 Accounting Quality

Are earnings persistence and predictability

sufficient to indicate that earnings are of
“high quality”?
 Consider Company X’s Earnings
Company X’s quarterly earnings per share (actual and consensus forecast)

 High-quality earnings in 1998-2000?

 High-quality earnings in 2001?
 What is the name of the company?
Quality in Financial Statements and Disclosures
 A high-quality balance sheet portrays, at a
point in time:
 The economic resources that the firm can
reasonably expect to generate future economic
benefits (assets)
 The claims on those resources (liabilities and
owners’ equity)
 When the resource inflows and outflows will be
realized (i.e., proper current and noncurrent
classifications)
Quality in Financial Statements and Disclosures
 A high-quality statement of cash flows:
 Summarizes all the cash flow implications of
the firm’s performance and changes in the
firm’s financial position over a period of time
 Appropriately classifies cash flows into
operating, investing, and financing activities in
sufficient detail
 Reports significant noncash investing and
financing activities in an accompanying note
Quality in Financial Statements and Disclosures
 A high-quality income statement includes:
 All revenues the firm earned during the period and
can reasonably expect to collect
 The costs of all resources the firm consumed in the
production process to generate revenues
 The costs of all resources the firm consumed during
the period that do not relate directly to revenues but
are incurred to run the business (such as fixed
administrative costs and interest expenses)
 The effects of any gains or losses during the period
 Accruals for economic resources the firm generated
or consumed during the period, even though the
related cash flows occur in a prior or later period
 Achieving Quality
 Managers should make accounting choices
and determine appropriate estimates
within GAAP or IFRS based on the firms’
underlying economic circumstances,
including conditions in their industry,
competitive strategy, and technology.
 Achieving Quality
 Accounting standard setters establish
principles to provide firms with guidance
and rules for measuring and reporting
economic effects of their activities,
performance, and financial position in
order to achieve high-quality accounting.
 Achieving Quality
 An analyst might adjust reported amounts
to enhance the accounting quality before
using them to assess operating
performance, financial position, or risk.
 High Quality Leads to the Ability to
Assess Earnings Persistence over Time
 A key quality of financial accounting
information is the extent to which it measures
and reports current earnings that are likely to
persist into the future versus earnings that are
transitory.
 High accounting quality helps the analyst assess
current period performance, forecast future
earnings and cash flows, and value the firm’s
shares.
 High Quality Leads to the Ability to
Assess Earnings Persistence over Time
 Managers have a strong incentive to produce
high-quality earnings.
 Voluntary management disclosures are high
quality if managers are unbiased and as accurate
as possible with respect to identifying one-time
items and in making direct forecasts.
Earnings Quality vs Balance Sheet Quality
 Accounting quality is a property of all financial
statements, and it is useful to distinguish
between the concept of earnings quality (an
income statement concept) and the concept of
balance sheet quality.
Earnings Quality vs Balance Sheet Quality
• High-quality earnings allows
 accurate assessment of current performance and a
foundation for predicting future performance

• Earnings quality is low if earnings

 includes revenues the firm did not earn during the
period or may not be able to collect.
 understates or fails to include expenses or losses of
the period.
 misclassifies or disguises key income items.
Earnings Quality vs Balance Sheet Quality
• High-quality balance sheet allows
 accurate assessment of key descriptions of risk:
liquidity, financial flexibility, and solvency
• Balance sheet quality is low if
 assets or liabilities are mismeasured.
 assets or liabilities are omitted.
 the timing of resource flows are incorrect.
 the components of equity are misrepresented.
Earnings Quality vs Balance Sheet Quality
• High-quality accounting for assets and liabilities usually
creates high-quality income measurement
 Because income statement amounts reflect changes
in the measurement and recognition of assets and
liabilities
• Sometimes, an accounting choice intended to create a
high-quality income statement can reduce the quality of
the balance sheet
 E.g., LIFO vs. FIFO
 Earnings Management
• Academic Literature defines earnings management:
• “occurs when managers use judgment in financial reporting in
structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the
company or to influence contractual outcomes that depend on reported
accounting numbers.”
(Healy and Wahlen 1999)

• Earnings management :
• Viewed as a purposeful and deliberate intervention of financial
reporting
• Techniques include not only accounting methods but also non-
accounting methods, for example structuring transactions etc.
 Earnings Management
• Detecting earnings management is difficult because
• managers can exercise judgment in financial reporting in many
ways.
• earnings management is often intended to create the appearance of
fundamental economic growth (for example, increasing sales and
earnings).
• “If one cannot prove intent, it is hard to distinguish between earnings
management and the legitimate exercise of accounting discretion.”
(Dechow and Skinner 2000)

•Is earnings management a fraud?

 Earnings Management vs. Fraud
• Earnings management may include:
• Choices that are fraudulent
• Choices that are aggressive (but within IFRS) with managerial intent
• Very hard to prove intent if this is the case
 Incentives of Earnings Management
• Managers may engage in earnings management if choices
and estimates benefit them personally or if doing so leads
to benefits for the firm and its stakeholders.

• Do managers have incentives to manage earnings upward

or downward?
 Incentives of Earnings Management
• Manager might manage earnings upward
• to increase the manager’s compensation under compensation
contracts based on earnings or stock prices.
• to increase stock prices by meeting or beating the earnings target,
and to maintain a smooth earnings time-series to make the firm to
appear less risky.
• to enhance job security by influencing the outcomes of transactions
that affect corporate control, such as proxy fights and takeovers.
• to obtain debt financing at a lower cost by appearing more profitable
or less risky, or avoid violation of debt covenants.
• to increase stock prices when engaging in initial public and seasoned
equity offerings and using firm shares in acquisitions.
• to increase stock prices prior to a sale of their personal ownership
interests (insider selling) in order to maximize gains from the sale.
 Incentives of Earnings Management
• Manager might manage earnings downward
• to discourage entry into the industry by potential competitors.
• to reduce the probability of antitrust actions against the firm or
other regulatory interventions or political interference related to
tax issues, and import relief.
• to suppress stock prices and thus yield favorable terms when
taking a company private.
• to decrease share prices prior to managers’ insider share purchases
in order to maximize manager gains from future share sales.
• to appear to be less profitable when negotiating wages with labor
union.
• to create opportunities to report higher earnings in future periods.
 Incentives of Earnings Management
• Do managers have incentives to manage earnings upward
or downward?
• Both. CFOs interviewed believe 60% (40%) of EM in
income-increasing (decreasing).
• From an investor’s perspective, which approach is a
more serious concern?
Incentives of Earnings Management

Dichev et al. 2013

 Thresholds when Managing Earnings
• Companies manage earnings to meet/exceed specific
thresholds.
• Reporting positive profits (to avoid reporting losses).
• Meeting or beating prior period earnings (to avoid
earnings decreases).
• Meeting or beating the market’s expectations, i.e.
consensus analysts’ forecasts (to avoid earnings
disappointments, avoid negative earnings surprises).
 Thresholds when Managing Earnings
• Which threshold is more important for managers?
• Prior to the mid-1990s, managers seek to avoid reporting losses
more than to avoid negative earnings surprises or earnings
decreases.
• Since the mid-1990s, managers seek to avoid negative earnings
surprises more than to avoid losses or earnings decreases.
• Since the mid-1990s, investors unambiguously reward (penalize)
firms for reporting earnings meeting (missing) analysts’ estimates
more than for meeting (missing) the other two thresholds.

• Why analyst forecasts became more important threshold?

• Increased media coverage given to analyst forecasts
• More analyst following
• More firms covered by analysts
• Increases in both the accuracy and precision of analyst forecasts
Histogram of Analyst Forecast Errors

Evidence of
earnings
management?

Analyst Forecast Error = Actual EPS –

Forecasted EPS
 Example of “Serial” MBE
• HealthSouth Corp. matched analysts’ expectations for 48
consecutive quarters through mid-1998.
• Was this unerring track record attributable to predictable operations and
acceptable income-smoothing techniques? Hindsight showed it was not.

• “Creative” accounting:
• In 2003, a forensic audit concluded that HealthSouth’s cumulative earnings were
overstated by anywhere from $3.8 billion to $4.6 billion.
• The audit identified fraudulent transactions, including improper accounting for
reserves, executive bonuses, and related-party transactions.
• In 1996, Scrushy allegedly instructed the company’s senior officers and
accountants to falsify company earnings reports in order to meet investor
expectations and control the price of the company’s stock.
• In certain fiscal years, the company’s income was overstated by as much as 4,700
percent.
• 15 HealthSouth accounting and finance executives pled guilty by the end of 2003.
 Types of Earnings Management
• Earnings management can be classified into two broad categories:
1. Accrual-Based Earnings Management
• Involves (accounting) choices that try to “obscure” or “mask” true
economic performance.
• May violate US GAAP/IFRS or be within US GAAP/IFRS.
• E.g., fictitious or premature revenue recognition, changing depreciation
assumptions, etc.

2. Real Earnings Management

• Involves changing underlying operations in an effort to boost current
period earnings.
• Involves taking actions that deviate from the first best practice.
• E.g., cutting prices in an effort to accelerate sales, cutting R&D,
delaying desirable investments, and selling fixed assets to affect gains
and losses.
 Types of Earnings Management
• Accrual-Based vs. Real Earnings Management:
• Evidence that accrual-based earnings management increased
steadily from 1987 until the passage of the Sarbanes Oxley Act
(SOX) in 2002, followed by a significant decline after SOX.
• In contrast, the level of real earnings management activities
declined prior to SOX and increased significantly after SOX.
• Firms apparently switched from accrual-based to real earnings
management methods after SOX, possibly because these
techniques, while more costly, are harder to detect.
 Earnings Management Techniques
• Technique 1: Inflate Revenue
• Recognize fictitious revenue (nonexistent sale or service
transaction).
• Recognize revenue prematurely (legitimate sale or service
transaction in a period prior to that called for by GAAP):
• Before customer acceptance
• Before service has been rendered
• When customer pays in advance

• Take advantage of flexibility when using estimates:

• Collectibility (allowance for doubtful accounts)
• Allowance for sales returns & allowances
• Percentage of completion accounting
 Example of Fictitious Revenue
ComROAD AG (Munich-based navigation systems manufacturer)
Preliminary findings from a special audit of years 1998 through 2000, 23 April
2002
The public accounting firm Rödl & Partner – which ComROAD AG’s Board of Directors
engaged to perform a special audit – has provided the following preliminary findings
concerning ComROAD AG’s revenues generated from a subsidiary, VT Electronics Ltd.,
Hong Kong, during the 1998 through 2000 financial years:
According to Rödl & Partner’s findings, 63% or TDM 2,860 of total revenues of TDM 4,567
for the year ending 12/31/1998 reported in the financial statements were earned through VT
Electronics Ltd. In 1999, out of the total revenues of TDM 20,019 reported in the financial
statements for the year ending 12/31/1999, 86% or TDM 17,180 were earned through VT
Electronics. According to Rödl & Partner’s current knowledge, in 2000, out of the total
revenues of TDM 85,803 reported in the financial statements for the year ending 12/31/2000,
97% or TDM 83,264 of total revenues were earned through VT Electronics Ltd.

Rödl & Partner points out that they could not find any basis that actual
revenues were realized with this firm or that this company actually existed at
any point in time.
Example of Fictitious Revenue
 Example of Premature Revenue Recognition
The “35-Day” Month
Computer Associates International, Inc. (8-K filed on April 26, 2004)
The Audit Committee’s investigation found accounting irregularities that led
to material misstatements of the Company’s financial reports for fiscal years
2000 and 2001, and prior periods. The Audit Committee believes that several
factors contributed to the improper recognition of revenue in these periods,
including a practice of holding the financial period open after the end of
the fiscal quarters, providing customers with contracts with preprinted
signature dates, late countersignatures by Company personnel,
backdating of contracts, and not having sufficient controls to ensure the
proper accounting under SOP 97-2. In addition, the Audit Committee found
that certain former executives and other personnel were engaged in the
practice of “cleaning up” contracts by, among other things, removing fax
time stamps before providing agreements to the outside auditors. These
same executives and personnel also misled the Company’s outside counsel,
the Audit Committee and its counsel and accounting advisers regarding these
accounting practices.
Example of Premature Revenue Recognition
The “35-Day” Month
• According to SEC and FBI investigation:
• The scheme began in 1998, possibly earlier, and continued through
September 2000.
• In all, the company prematurely reported $3.3 billion in revenue
from 363 software contracts.
 During the four quarters of fiscal year 2000, for example, the practice
improperly inflated revenues by 25%, 53%, 46% and 22%,
respectively.
• The goal was to meet or beat per-share earnings estimates of Wall
Street analysts, a key to keeping a company’s stock price rising.
 2000, Q2: the company reported $557 million in revenue beyond the
$1.05 billion it could properly claim. The company thus reported $0.60
in EPS, beating the consensus Wall Street forecast of $0.59. Without
the padded revenue, earnings would have been $0.05 per share.
 Example of Premature Revenue Recognition
Channel Stuffing
Channel stuffing refers to shipments of goods to distributors who are
encouraged to overbuy under short-term offers of deep discounts.
Bristol Myers Squibb Co., 2002 10-K.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
The Company experienced a substantial buildup of wholesaler inventories in its U.S.
pharmaceuticals business over several years, primarily in 2000 and 2001. This buildup was
primarily due to sales incentives offered by the Company to its wholesalers. These
incentives were generally offered towards the end of a quarter in order to incentivize
wholesalers to purchase products in an amount sufficient to meet the Company’s
quarterly sales projections established by the Company’s senior management. In April
2002, the Company disclosed this substantial buildup, and developed and subsequently
undertook a plan to work down in an orderly fashion these wholesaler inventory levels.
In late October 2002, based on further review and consideration of the previously disclosed
buildup of wholesaler inventories in the Company’s U.S. pharmaceuticals business and the
incentives offered to certain wholesalers, and on advice from the Company’s independent
auditors, PricewaterhouseCoopers LLP, the Company determined that it was required to
restate its sales and earnings to correct errors in timing of revenue recognition for
certain sales to certain U.S. pharmaceuticals wholesalers.
Example of Premature Revenue Recognition
Bill-and-Hold Transaction
Bill-and-hold transaction refers to a transaction in which the sales
agreement stipulates that goods that have been sold are not shipped to
buyer but rather being warehoused by seller, awaiting buyer
instructions.
Sunbeam Corp., 1997 10-K, footnote 1:

The Company recognizes revenues from product sales principally at the time
of shipment to customers. In limited circumstances, at the customers’ request
the Company may sell seasonal product on a bill and hold basis provided that
the goods are completed, packaged and ready for shipment, such goods are
segregated and the risks of ownership and legal title have passed to the
customer. The amount of such bill and hold sales at December 29, 1997 was
approximately 3% of consolidated revenues.
 Signs of Premature Revenue Recognition
• Large and volatile amounts of uncollectible accounts
receivable.
• Unusually large amounts of returned goods.
• Excessive warranty expenditures.
• A significant increase in days accounts receivable are
outstanding.
 Example of Evaluating the Integrity of
Revenue (Recognition) Using Ratio Analysis
Sunbeam Corp., Selected Account Balances 1994-1997 (retrieved from 10-Ks):
1994 1995 1996 1997
Sales Revenue ($) n/a 1,016,883 984,236 1,168,182
Accounts Receivable, net ($) 214,222 216,195 213,438 295,550

AR Turnover, in days* n/a 77.2 79.7 79.5

AR Turnover, in days** n/a 77.6 79.2 92.3
* approximated as: {365 / [Sales Revenue / Average Accounts Receivable]}

** approximated as: {365 / [Sales Revenue / Ending Balance of Accounts Receivable]}

Example of Evaluating the Integrity of Revenue
Sunbeam Corp.
 The reporting of these bill-and-hold sales was a new revenue
reporting strategy.
 In August 1998, Sunbeam’s audit committee determined that the
company would be required to restate its 1997 financial
statements, reducing reported net sales by $95 million and
reducing reported net income by $71 million.
o The review identified many accounting issues, including
revenue improperly recognized (principally “bill and hold”
sales).
 Example of Evaluating the Integrity of
Revenue (Recognition) Using Ratio Analysis
Cisco Systems Inc., 2002 10-K.
July 26, July 27,
CONSOLIDATED BALANCE SHEETS (In millions, except par value) 2003 2002
ASSETS
Current assets:
Cash and cash equivalents
$ 3,925 $ 9,484
Short-term investments
4,560 3,172
Accounts receivable, net of allowance for doubtful accounts
of $183 at July 26, 2003 and $335 at July 27, 2002 1,351 1,105
Inventories 873 880
Deferred tax assets 1,975 2,030
Lease receivables, net 163 239
Prepaid expenses and other current assets 568 523
Total current assets 13,415 17,433
Investments 12,167 8,800
Property and equipment, net 3,721 4,102
Goodwill 4,043 3,565
Purchased intangible assets, net 556 797
Lease receivables, net 60 39
Other assets 3,145 3,059
TOTAL ASSETS $ 37,107 $ 37,795

(Allowance for Doubtful Accounts / Accounts Receivable, gross): 335

2002:
(1,105  335)
0.232

183 0.119
2003:
(1,351  183)
 Earnings Management Techniques
• Technique 2: Reduce Reported Expenses
• Take advantage of flexibility when using estimates
• E.g., depreciation expense: increase useful life or salvage value
• Change accounting methods
• E.g., switch from LIFO to FIFO
• Postpone expense recognition
• Capitalize and amortize instead of expensing immediately
• Delay asset impairments or write-offs
• Classification shifting
• Misclassify items within the income statement
• E.g., recognizing operating expenses as part of special items
• Misclassify items across time
• E.g., overestimating restructuring charges in one period, leading
to recognizing restructuring credits in a future period
 What about WorldCom?
• First quarter of 2002:
• “The company has $2.3 billion in cash, which translates into a $20.50 book
value per share, And you have to pay only $2 for this gem!”
• Third quarter of 2002:
• WorldCom made a $3.8 billion reclassification from assets to expenses.
• WorldCom capitalized line cost expenses (monthly “rent” paid for the use
of communications networks and systems) instead of expensing them.
• This inflated profits and cash flow from operations.
• $11 billion of fraudulent transactions are eventually uncovered.
• In July 2002, the company declares bankruptcy.
FUTURE
ASSET
BENEFITS
Line cost expenses
NO FUTURE
EXPENSE BENEFITS
 Consequences
• In March 2004, WorldCom restates profits downward by
$74.4 billion.

• Shares fell to $0.06, losing 90% of its value.

• Five executives indicted for fraud, four plead guilty.
• CEO and CFO both sentenced to lengthy prison terms.
• Largest bankruptcy in the U.S. at that time, far bigger than Enron.
• Could you have predicted it?
 Examples of Classification Shifting
• Borden, Inc.:
• In 1992, classified $192 million of marketing expenses as part of a
restructuring charge when it should have been included in S, G & A
expenses.
• 40% of the $642 million restructuring charge turned out to be routine
operating expenses.
• SmarTalk, Inc.:
• Reported net income of $478,000 in its quarterly report for the third
quarter of 1997, whereas the company had losses that period.
• SmarTalk hid the losses by improperly capitalizing ordinary operating
expenses (the expenses were improperly treated as an asset).
• Waste Management, Inc.:
• In 1996, recorded approximately $85 million of gains from sales of
discontinued operations as part of continuing operations, netting these
one-time below-the-line gains against current period operating expenses.
 INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note D: ACQUISITIONS / DIVESTITURES

DIVESTITURES

During 1999, the company completed the sale of its Global Network business
to AT&T for 4,991 million. More than 5,300 IBM employees joined AT&T as a
result of these sales of operations in 71 countries.
During 1999, the company recognized a pre-tax gain of $4,057 million
($2,495 million after tax, or $1.33 per diluted common share).
The net gain reflects dispositions of plant, rental machines and other property
of $410 million, other assets of $182 million and contractual obligations of
$342 million. The gain was recorded as a reduction of Selling, general and
administrative expense in the Consolidated Statement of Earnings.
 INTERNATIONAL BUSINESS MACHINES CORPORATION and Subsidiary Companies
CONSOLIDATED STATEMENT OF EARNINGS
(in millions)
FOR THE YEAR ENDED DECEMBER 31: NOTES 2000 1999 1998
================================================================ ==================
Revenue:
Hardware $ 37,777 $ 37,888 $ 36,096
Global Services 33,152 32,172 28,916
Software 12,598 12,662 11,863
Global Financing 3,465 3,137 2,877
Enterprise Investments/Other 1,404 1,689 1,915
--------------------------------------------------------------------------------------------------------------------------------------------
Total revenue 88,396 87,548 81,667
--------------------------------------------------------------------------------------------------------------------------------------------
Cost:
Hardware 27,038 27,591 24,653
Global Services 24,309 23,304 21,125
Software 2,283 2,240 2,260
Global Financing J 1,595 1,446 1,494
Enterprise Investments/Other 747 1,038 1,263
--------------------------------------------------------------------------------------------------------------------------------------------
Total cost 55,972 55,619 50,795
--------------------------------------------------------------------------------------------------------------------------------------------
Gross profit 32,424 31,929 30,872
--------------------------------------------------------------------------------------------------------------------------------------------
Expense: Operating
Selling, general and administrative P 15,639 14,729 16,662 Income
Research, development and engineering R 5,151 5,273 5,046 2000: 11,634
Other income (617) (557) (589) 1999: 11,927
Interest expense J&K 717 727 713 1998: 9,164
---------------------------------------------------------------------------------------------------------------------------------------------
Total expense 20,890 20,172 21,832
---------------------------------------------------------------------------------------------------------------------------------------------
Income before income taxes 11,534 11,757 9,040
Provision for income taxes O 3,441 4,045 2,712
---------------------------------------------------------------------------------------------------------------------------------------------
Net income 8,093 7,712 6,328
================================================================ ===================
 Earnings Management Techniques
• Technique 3: Take a “Big-Bath”
• Results: reduce current earnings and boost future earnings.
• Common methods for recognizing large “one-time” charges (e.g.,
restructuring charges, asset impairments, etc.)

• Include other operating expenses or future operating expenses

• Overestimate related expenses (“cookie jar” reserves) and
reverse part of the charge in future periods

• Decide to recognize other large expenses/charges/losses (e.g.,

asset impairments or write-offs) in same period
 Big Baths Using Restructuring Charges
• Restructuring “reversals” recorded to
• Beat analysts’ forecasts
• Avoid reporting net losses
• Avoid earnings declines
• Example:
• McCormick used a restructuring credit to post a 5.7% earnings increase
for1995 Q1, when its earnings would otherwise have declined slightly.
• The company recognized a restructuring charge of $46.3 million for 1994
Q4 to close two plants, sell its frozen-food unit and cut employment 7%.
• But in 1995 Q1, the company reversed $2.3 million of that charge, which
increased that quarter’s bottom line—without mentioning it in its earnings
announcement.
• That restructuring “credit” was not disclosed until a month later when the
company filed its quarterly report to the SEC.
 Big Baths Using Restructuring Charges
• Underlying issue:
• The market tends to react enthusiastically to large corporate write-
offs, such as restructuring charges.
• Views:
• Buffett argued that the size and timing of restructuring charges are
“dictated by the cynical proposition that Wall Street will not mind if
earnings fall short by $5 per share in a given quarter, just as long as this
deficiency ensures that quarterly earnings in the future will consistently
exceed expectations by five cents per share.”

• Robert S. Miller, Chairman of Waste Management, Inc.:

“Somebody woke up to the fact that if you take something as a
restructuring charge, investors will forgive you immediately.”
 “Cookie Jars”
• Estimated vacation pay liability is:
• Accrued (expense and related liability are recognized) as an employee works.
• Must be estimated because not all employees take all their vacation time.
• Reduced when cash is paid because employee is using vacation time.
• SEC lawsuit against Xerox Corp. accused of having defrauded investors:
• In 1993, Xerox changed its vacation policy by limiting the amount of accrued
vacation an employee could earn. This policy change resulted in an over-
accrual of vacation pay of approximately $120 million.
• Beginning in 1994 and continuing through 1997, Xerox systematically and
improperly released the over-accrual at a rate of $7.5 million per quarter
($30 million per year).
• Xerox created a “cookie jar” in which the company dipped to inflate income
by $30M every year!
 Early Warning Signs of Abusive EM
• Include:
• Cash flows that are not correlated with earnings (CFO vs. NI)
• Receivables that are not correlated with revenues (AR vs. Sales)
• Allowances for uncollectible accounts that are not correlated with
receivables (Allowance vs. AR gross)
• Reserves that are not correlated with balance sheet items
• Acquisitions with no apparent business purpose
• Earnings that consistently and precisely meet analysts’ expectations
• Deviations from industry norms or performance
Source: Dichev et al. 2013
 Analyzing Earnings
• Two-Step Process:
 Identify source(s) of earnings:
• Identify income statement items (e.g., revenues,
expenses, gains, losses) that contribute the most to the
firm’s earnings.
• Determine which factors drive changes in earnings.
Best case scenario: increases in sales revenue drive
increases in operating income, which drive increases in
income from continuing operations (and net income).
 Assess earnings “quality”:
• Evaluate extent to which reported earnings reflects economic
reality or is a product of manipulation by management.
 Identify Sources of Earnings
• Objective: Identify source(s) of earnings and sources of
improvement (or deterioration) in earnings.

• Approach: Determine which factors contribute the most to

earnings levels and changes.
• Determine factors for each main line items in the income
statement.
• Sales: level and change.
• Gross margin: level and change, from Sales or COGS?
• Profit from operations: level and change, from gross margin or
operating expenses?
• Profit before tax : level and change, Special items? Operating income
or nonoperating income? Income from continuing operations,
discontinued operations?
• Net income: level and change.
 Assess Earnings Quality
• General characteristics of earnings of “high quality”:
• Generated by the firm’s core (operating) activities.
• Generated by recurring items.
• Related to cash items, not noncash items generated by accrual
accounting.

• Why are these criteria important for investors?

• To predict future earnings.
• To determine the likelihood of a future negative earnings surprise.
• To value the firm.
 Assess Earnings Quality
• Evaluation of earnings quality involves two steps:
• Quantitative Analysis
• Identify questionable numbers and patterns in reported data.
• Identify discrepancies between net income and cash flow from
operations.

• Qualitative Analysis
• Determine cause of issues identified by the quantitative analysis.
• Determine whether issues due to earnings manipulation.
• Evaluate accounting choices.
• Evaluate conservatism/aggressiveness of accounting choices.
• Conclude on likelihood that earnings are manipulated (inflated or
understated).
• Conclude on likelihood that earnings reflect economic reality.
 Assess Earnings Quality
Quantitative Analysis
• “Tips” to identify discrepancies between net income and
cash flow from operations (CFO):
• Calculate ratio of net income / CFO.
• Values ≈ 1.0: Indicate earnings are likely to be of high quality.
• Values > 1.0: Indicate substantial portion of net income is from
noncash and/or nonoperating items.
• Values < 1.0: Consistent with: (1) Noncash and/or nonoperating
charges reducing net income, and/or (2) CFO is overstated.
• Volatility in this ratio over time cause for concern.
 Assess Earnings Quality
Quantitative Analysis
• “Tips” to identify discrepancies between net income and
cash flow from operations (CFO):
• Compare direction and rates of change of net income vs. CFO:
• Should be in the same direction and change at similar rates.
• A large discrepancy is a red flag, esp. if net income is
increasing while CFO is decreasing.
• Discrepancies reveal the need for further investigation.
 Assess Earnings Quality
Quantitative Analysis
• “Tips” to identify discrepancies between net income and
cash flow from operations (CFO):
• Analyzing patterns in accruals : (NI –OCF) / Avg. Total Assets
• Compare accruals over time and with peers.
 Assess Earnings Quality
Quantitative Analysis
• Beneish Manipulation Index
• The 12-factor model relies on a combination of financial statement
items and changes in stock prices for a firm’s shares
• The 8-factor model uses only financial statement items
• M-score (y) = – 4.840 + 0.920⨯DSRI + 0.528⨯GMI + 0.404⨯AQI

+ 0.892⨯SGI + 0.115⨯DEPI – 0.172⨯SAI

– 0.327⨯LVGI + 4.670 ⨯ TATA
• Positive coefficients increase M-score and the probability of earnings
manipulation.
• M-score (y) can be converted into a probability using a standardized
normal distribution. (in Excel, NORMSDIST function will do this)
 Assess Earnings Quality
Quantitative Analysis
• Cutoff probability that signals earnings manipulation
• A Type I error involves failing to identify a firm as an income
manipulator when it turns out to be one.
• A Type II error involves identifying a firm as an income manipulator
when it turns out not to be one.
• A Type I error is more costly to the investor than a Type II error.

Cost of Type I Error Relative to Type II Cutoff

Error M-Score or
Probability
10:1 -1.49, 6.85%
20:1 -1.78, 3.76%
40:1 or higher -1.89, 2.94%
 Beneish Manipulation Index
• Days’ Sales in Receivables Index (DSRI)
•
• A large increase in this index might indicate an overstatement of
accounts receivable and sales during the current year to boost
earnings. Such an increase also might result from a change in the
firm’s credit policy (for example, liberalizing credit terms).
• Gross Margin Index (GMI)
•
• A decline in the gross margin percentage will result in an index
greater than 1.0. Firms with weaker profitability this year are more
likely to engage in earnings manipulation.
 Beneish Manipulation Index
• Asset Quality Index (AQI)
•
• The remaining assets include intangibles for which future benefits
are less certain, which are potentially lower-quality assets. An
increase in the proportion might suggest an increased effort to
capitalize and defer costs the firm should have expensed.
• Sales Growth Index (SGI)
•
• Growth does not necessarily imply manipulation. However,
growing firms usually rely on external financing. The need for
low-cost external financing might motivate managers to
manipulate earnings. Growing companies are often young and tend
to have less-developed governance to monitor managers’
manipulation.
 Beneish Manipulation Index
• Depreciation Index (DEPI)
•
• A ratio greater than 1.0 indicates that the firm has slowed the rate of
depreciation, perhaps by lengthening depreciable lives, thereby
increasing earnings.
• Selling and Administrative Expense Index (SAI)
•
• An increase in SG&A might indicate increased marketing expenses
that would lead to increased sales in future. Firms not able to sustain
the sales engage in earnings manipulation. Alternatively, the index
greater than 1.0 suggests that the firm has expensed various costs
instead of capitalizing them. Firms attempting to manipulate earnings
would defer costs, and the index value would be less than 1.0. The
coefficient on this variable is negative.
 Beneish Manipulation Index
• Leverage Index (LVGI)
•
• An increase in debt will result in a greater risk of violating debt
covenants and the need to manipulate earnings to avoid the
violation. Alternatively, a decrease in debt may suggest decreased
ability to borrow and the need to engage in manipulation to portray
a healthier firm. The coefficient on this variable is negative.
• Total Accruals to Total Assets (TATA)
•
• A large excess of income from continuing operations over cash
flow from operations indicates that accruals play a large part in
measuring income. Accruals can serve as a means of manipulating
earnings.
 Beneish Manipulation Index
Sunbeam Corporation
 Sunbeam manufactures countertop kitchen appliances and
barbecue grills.
 Its sales growth and profitability slowed considerably in the
mid-1990s, and the firm experienced market price declines
for its stock.
 The firm hired Al Dunlap in mid-1996 as CEO. Known as
“Chainsaw Al,” he had developed a reputation for cutting
costs and strategically redirecting troubled companies.
Dunlap laid off half the workforce, closed or consolidated
more than half of Sunbeam’s factories, and divested several
businesses in 1996 and 1997.
 Beneish Manipulation Index
Sunbeam Corporation
 The reported results for 1997 showed significant
improvement over 1996. Sales increased 18.7%, while gross
margin increased from 8.5% to 28.3%. The stock price more
than doubled between the announcement of Dunlap’s hiring
in mid-1996 and the end of 1997.
 In first quarter of 1998, Sunbeam reported a net loss for the
quarter, a surprise to analysts and the stock market.
 Close scrutiny by analysts and the media suggested that
Sunbeam might have manipulated earnings in 1997.
 Beneish Manipulation Index
Sunbeam Corporation
 The SEC instituted a formal investigation into this
possibility in mid-1997.
 Sunbeam responded in October 1998 by restating its
financial statements from the fourth quarter of 1996 to the
first quarter of 1998.
 The restatements revealed that Sunbeam had engaged in
various actions that boosted earnings for 1997.
 Beneish Manipulation Index
Sunbeam Corporation
 The actions included the following:
 Sunbeam instituted “early buy” and “bill and hold” programs in
1997 to encourage retailers to purchase inventory from Sunbeam
during the last few months of 1997. Sunbeam did not adequately
provide for returns and canceled transactions, resulting in an
overstatement of sales and net income for 1997.
 Sunbeam overstated a restructuring charge in the fourth quarter of
1996 for expenses that should have appeared on the income
statement for 1997.
 Sunbeam understated bad debt expense for 1997.
 Beneish Manipulation Index
Sunbeam Corporation

M-score and the probability level falls

well below the cutoff points.
Under the assumption of a 40:1 Type I to Type
II cost relation, Sunbeam is a manipulator
 Who Discovered the Enron Fraud?
In early 2001, Jim Chanos, who runs Kynikos Associates, a
highly regarded firm specialized in short selling said publicly
that “no one could explain how Enron actually made
money.”
• Pointed out:
• Enron had completed transactions with related parties that were run
by a senior officer of Enron (conflict of interest).
• Cash flow from operations seemed to bear little relationship to
reported earnings.
• Operating margin had plunged from around 5% in early 2000 to
under 2% by early 2001.
• CEO Skilling was aggressively selling shares—hardly the behavior
of someone who believes his stock is correctly priced.
 Is Enron Overpriced?
Fortune - March 5, 2001

 Enron was trading at about 55 times trailing (past) earnings.

• Fortune pointed out that Enron’s financial statements were nearly

impenetrable.
• “To skeptics, the lack of clarity raises a red flag about Enron’s pricey
stock… the inability to get behind the numbers combined with ever higher
expectations for the company may increase the chance of a nasty surprise.
Enron is an earnings-at-risk story”…
• “At the least, these sorts of hard-to-predict earnings are usually assigned a
lower multiple... In 1999 its cash flow from operations fell from $1.6
billion the previous year to $1.2 billion. In the first nine months of 2000,
the company generated just $100 million in cash. (In fact, cash flow
would have been negative if not for the $410 million in tax breaks it
received from employees’ exercising their options)”…

• In October 2001, the Enron meltdown began…

 Quick Check Question 1
Earnings quality relates to the:

a. Balance sheet
b. Statement of cash flows
c. Income statement
d. Manager’s discussion and analysis (MD&A)
 Quick Check Question 2
Which of the following is least likely to be a
motivation to overreport net income?

a. Meet earnings expectations.

b. Negotiate labor union contracts.
c. Remain in compliance with bond covenants.
 Quick Check Question 3
Which of the following is most likely an example
of accounting fraud?

a. Using aggressive pension assumptions.

b. Booking revenue from a fictitious customer.
c. Selecting an acceptable depreciation method that
misrepresents the economics of the transaction.
 Quick Check Question 4
If revenue is recognized too early, the balance
sheet quality is impaired by an:

a. Understatement of expenses
b. Overstatement of liabilities
c. Understatement of liabilities
d. Understatement of revenues
 Quick Check Question 5
Which of the following actions is least likely to
immediately increase earnings?

a. Selling more inventory than is purchased or produced.

b. Lowering the salvage value od depreciable assets.
c. Recognizing revenue before fulfilling all the terms of a
sale.