Chapter 17: Earnings Quality

T1: Earnings Quality

T2: Earnings management
T3: Cash flow management (Yes)

T1: Earnings quality

Earnings quality: The degree to which earnings r
eflect underlying economic performance
Characteristics of high quality earnings:
Transparent: Very little or nothing is hidden (full disclo
sure)
Protecting proprietary information is understood, hiding
other information is less understood
Clearly stated accounting principles as opposed to havi
ng them vaguely defined
Consistent
Accounts for similar economic transactions in a similar
manner
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Earnings quality
Earnings quality means different things to differe
nt financial statements users (contextual):
Regulators will refer to earnings that adhere to the rules
Investors will refer to earnings that are predictive of futu
re cash flows
Lenders will refer to earnings that are conservative

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T2: Earnings management

A company is going through the interview process in
order to hire a new chief financial officer. In the last in
terview session, each of 3 finalists is given the comp
any's financial data and asked, "What are the net ear
nings?" 2 applicants diligently compute the net earni
ngs. Neither of them gets the job. The candidate who
lands the position answers the question by replying,
"What do you want them to be? (loud laugh)

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Earnings management
Few definitions of earnings management (EM)
A purposeful intervention in the external financial reporti
ng purpose, with the intent of obtaining some private gai
n (Schipper, 1989)
The choice by a manager of accounting policies (accrual
s), or real actions, that affect earnings so as to achieve s
ome specific reported earnings objective
Practices by which earnings reports reflect the desires
of management rather than the underlying financial perf
ormance of the company. (Arthur Levitt, former SEC Ch
airman)

Accordingly, EM often undermines EQ

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Earnings management
Arthur Levitt the numbers game famous speech (fo
rmer SEC Chairman, 1998, NYU Center for Law & Business):
This process (EM) has evolved over the years into what can best
be characterized as a game among market participants. A game th
at, if not addressed soon, will have adverse consequences for Am
erica's financial reporting system. A game that runs counter to the
very principles behind our market's strength and success.
Increasingly, I have become concerned that the motivation to me
et Wall Street earnings expectations may be overriding common s
ense business practices. Too many corporate managers, auditors,
and analysts are participants in a game of nods and winks. In the
zeal to satisfy consensus earnings estimates and project a smoot
h earnings path, wishful thinking may be winning the day over fait
hful representation.

And 4 years later

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The impact of earnings management

Can damage the perceived quality of reported ear
nings
Resulting in the belief that reported earnings do not ref
lect economic reality
This uncertainty ultimately has the potential to underm
ine the efficient flow of capital thereby damaging effici
ent capital allocation
Post-Enron, post-financial crisis: Investors require large
discounts or withdraw from the stock market
Liquidity problems

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Earnings management
Lets not be just negative. Notice that earnings m
anagement can be good (really, YEA)
Managers possess private information, and can use earnin
gs management to convey this information
Earnings smoothing to avoid unnecessary costly debt c
ovenant violation
GE was known for its earnings smoothing practices
Ensure investors of ongoing growth

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Incentives for earnings management

A.

External Factors

Analyst Forecasts (better meet or beat it)

Heuristic Benchmarks (a tiny profit is way better than a tiny l
oss) Dechow et al. (2003) why earnings are Kinky?

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Incentives for earnings management

Asymmetry around 0 was found for:
Earnings relative to analysts forecast
Earnings level
Earnings change

Debt markets and contractual obligations (better not

violate debt covenants)
Competition (better create barriers to entry)
B. Internal Factors
Potential mergers (maximize share price to be used i
n a merger)
Planning and budgets (better meet the budget target
s)
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Incentives for earnings management

C. Personal Factors
Personal bonuses (Healy, 1985)

If earnings are above the maximum for a bonus or far fro

m the minimum, better lower earnings this year.
If I am within the bonus range, then maximize earnings

Promotions and job retention

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Better look an amazing CEO

Big bath by new CEOs

Incentives for earnings management

D. Political motivations (lower earnings)
During tariff investigation Jones (1991)
When under investigation for monopoly practices Cahan
(1992)
So regulator does not intervene
Think Hydro Quebec

Same incentives regarding revenues where applicable

Benchmarks
Bonus

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General earnings management tools

Accrual-based earnings management
Change accounting policies
Play with estimates
Does not affect cash flow

Managers can become very creative when it com

es to earnings management
And the Oscar for most creative accounting awa
rd goes to..Jeff Skillings (Enrons CEO)

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Real earnings management

Real (transaction-based) earnings management
Change real business activities
Cut R&D and advertising; offer discounts;
Time deliveries

Overproduce
Channel stuffing
Aggressive discounts
Has an immediate effect on cash flows
Short-term benefit, but a net negative overall effect
The soup story

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Real earnings management

How to save money on Kraft Dinner - time your groc
ery shopping to the last days of the period!!
For soup sales in grocery stores, Chapman and Stee
nburgh (2011) showed that managers used aggressi
ve price discounts, feature advertisements & aisle di
splays towards the end of the quarter/year
A willingness to sacrifice long-term value to meet short-ter
m sales or earnings benchmarks
Marketing actions boost quarterly net income by up to 5%
However, there is a price to pay: the cost in the following p
eriod being approximately 7.5% of quarterly net income.
Nothing illegal
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Real earnings management

More difficult to uncover
Does not violate GAAP (the soup discounts)
Hard to protect investors
Hard to tell the motive: a legitimate business decision, or
a short-term EM move

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Choice of accounting policy

When presented with alternatives, firms will likely
choose the accounting policy that will make them
look best (a beauty contest)
Inventory valuation using LIFO in the U.S.
Revenue recognition policy

Accounting policies must be disclosed by firms

But firms can use general terms in the notes
Should be the same year after year
Research found that investors adjust for LIFO vs. FIFO
PE(LIFO firms) > PE(FIFO firms)

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Accounting estimates
Preparation of financial statements requires intens
ive use of estimates
Estimates can be neutral, or.opportunistic to sho
w a desired outcome
Loan loss provision in banks
Useful life of assets
Pension assumptions
Asset impairments
Goodwill write-offs
Allowance for doubtful accounts (Bombardier, 2014, Q1 20
15)

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Analysis of quality of revenues

Revenue recognition policies at Zyngas article
In groups: Discuss the following:
1.
2.
3.
4.
5.

Describe what Zynga did

What is the accounting term to describe it?
Did they violate the accounting rules?
What is the accounting treatment?
How can you learn about such things? (EA Q3, 2013, p.3
0)

6. What might be the reasons for the change?

Try to think of more than 1 reason

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Fraudulent earnings management

When managing earnings in a way that violates
GAAP, it becomes fraudulent
Most fraudulent transactions involve collusion of
at least two people
We start innocent: The route is legitimate accrua
l-based EM first, then real EM, and eventually fra
udulent EM
Lehman Brothers, ZZZZ Best
From week 2, remember?

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Microstrategy (just another example)

Background
Founded in 1989 by Michael Saylor, that was soon joined
by Sanju Bansal, which studied with him at MIT
The company produced software for data mining and bu
siness intelligence
In 1992, the company gained its first major client when it
signed a $10 million contract with McDonalds
Revenues increased by 100% every year between 1990 a
nd 1996
Went public in 1998. On its first day of trading, the stock
price doubled

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Microstrategy
In March 2000, after a review of its accounting pr
actices, MicroStrategy announced that it would r
estate its financial results for preceding 2 years
This led to an SEC investigation, and subsequen
tly to a lawsuit against MicroStrategy and certain
of its officials over fraud was filed

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Microstrategy
EM Practices: MicroStrategy's reporting failures w
ere primarily the result of premature revenue recog
nition
Violated accounting rules in complicated transactions
MicroStrategy had established a pattern of having top ex
ecutives refrain from signing major contracts until after t
he end of each quarter. Then they would sign enough of
them to ensure meeting revenue targets.
Revenues were shaved: 1999 - $54m, 1998 - $11m, and 1
997 - $1m
All 3 years turned from profitable to losing money

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Microstrategy
Consequences:
After it announced that it would restate earnings for 3 ye
ars, its stock fell 38% in 1 day. Overall stock price dropp
ed from a high of $333 per share to $33 per share.
In April 2001, the company settled a class- action suit all
eging fraud arising from its accounting practices.
3 of its executives at the time of the restatement agreed t
o fraud injunctions and paid penalties of $350,000 each.
They also paid a combined total of $10M in disgorgemen
t
The company agreed to undertake corporate governance
changes and implement a system of internal controls
Have an independent director reporting directly to the SEC (pr
e-SOX)
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Earnings management hierarchy

1. Choice of accounting policies
2. Aggressive accounting estimates accrual earning
s management
3. Second best transactions - real earnings manageme
nt
4. Fraudulent transactions (GAAP violation)

. We start young and innocent and then move alon

g the slippery slope

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Indicators of earnings quality

Qualitative
Profitable business model?
Effective internal control systems? SOX 302 & 404 discl
osure
Quality of the management team
Strong corporate governance
Special business decisions driven to achieve desired a
ccounting results (# of SPEs, M&A)

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Indicators of earnings quality

Quantitative
Relation between (accrual-based) net income and (cashbased) CFO: are accruals too big?
The divergence, remember?

Accounting Policy choices & estimates

Persistent/ sustainable earnings or just one-time gains?
Pro forma earning very different from GAAP earnings
Do the reasons seem to make sense?

Earnings quality models

These are only suggestive indicators

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Accruals
Accruals are fundamental in accounting
Subject to judgment and discretion
The Accrual Anomaly discovered by Richard Slo
an (1996): You can earn abnormal return by taking
a short position in the high accruals firms and a lo
ng position on the low accrual firms
Accruals are less persistent than cash flow
Investors do not understand it

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Earnings management and fair value

How does fair value accounting affect earnings
management?
2 opposing ways
More earnings management because ____________
Less earnings management because ____________

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Accounting policy and estimation

Transparent accounting policy disclosure
How vague is it?

Check the revenue recognition policy (footnotes)

Does it look aggressive or conservative?

Bad debt allowance:

What is the trend? Too small? Too large?

Contingent liabilities:
How fast do they recognize them as losses?
When lawsuits are settled, are amounts similar to the acc
rued amounts? Did they accrue for anything before the fi
nal ruling? Starbucks 2013

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Earnings persistence
If earnings mostly come from firms normal operati
ng business, in general, we should see a stable tre
nd of earnings over years
Measure earnings persistence
The residuals from a firm specific regression shoul
d be small
You can check on seasonal quarterly earnings

The closer to 1 is, the more persistence the earni

ngs are

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Persistence of various items (source: Dechow,20

02)

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Special business transactions

SPE is used to structure very complicated financia
l transactions (Enron)
Leases: A change from capital leases to operating
leases
Related-party transactions
Accounts receivable sale to banks around the end
of quarter to polish CFO

All can be indicative of low earnings quality

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Beneishs earnings manipulation score

M-Score = -4.840 + 0.920 x DSRI + 0.528 x GMI + 0.404 x AQI + 0.892 x SGI
+ 0.115 x DEPI - 0.172 x SGAI - 0.327 x LVGI + 4.697 x TATA

Days Receivable Index (DSRI) = (Net Receivablest / Salest) / Net Receivablest-1 / S

alest-1)
Gross Margin Index (GMI) = [(Salest-1 - COGSt-1) / Salest-1] / [(Salest - COGSt) / Sale
st]
Asset Quality Index (AQI) = [1 - (Current Assetst + PP&Et + Securitiest) / Total Ass
etst] / [1 - ((Current Assetst-1 + PP&Et-1 + Securitiest-1) / Total Assetst-1)]
Sales Growth Index (SGI) = Salest / Salest-1
Depreciation Index (DEPI) = (Depreciationt-1/ (PP&Et-1 + Depreciationt-1)) / (Depreci
ationt / (PP&Et + Depreciationt))
SG&A Expense Index (SGAI) = (SG&A Expenset / Salest) / (SG&A Expenset-1 / Sal
est-1)
Leverage index (LVGI) = [(Current Liabilitiest + Total Long Term Debtt) / Total Ass
etst] / [(Current Liabilitiest-1 + Total Long Term Debtt-1) / Total Assetst-1]
Total Accruals to Total Assets (TATA) = (Income from Continuing Operationst - C
ash
Flows from Operationst) / Total Assetst
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Beneishs earnings manipulation score

M-score<= -2.22 indicates no earnings manipulation
M-score> -2.22 indicates earnings manipulation
All variables are constructed from the financial statem
ents (easy to calculate)
A shorter version M-Score:
M-Score = -6.065 + 0.823 x DSRI + 0.906 x GMI + 0.593 x AQI
+ 0.717 x SGI + 0.107 x DEPI
Eliminates the less significant parameters

Prof. Beneish back-tested the model against financial r

eports released by companies in 1982-92.
The M-Score correctly identified 76% of the manipulations
17.5% of false-positives were returned

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Lets evaluate Groupons earnings quality

Groupons M-Score of 33.25 in 2010
Restated earnings for 2011
Shares of Groupon sunk nearly 17% as investors reacte
d to a restatement of revenue figures by the offers webs
ite as well as the companys admission of material wea
kness in its internal controls. (Financial Times, April, 2
2012)

Do not just apply it mechanically

Divisions of ratios
Dollarama had a high M-Score, but driven by AR that wa
s minuscule (all ratios)

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T3: Cash flow management

YES! Cash flow can also be manipulated but les
s
Smart managers know that analysts/investors pay
attention to CFO and know how to play the game
Some of it is related to classification within the sta
tement of cash flow
Some is related to real transactions
It is all legal

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T3: Cash flow management

Whether you have the cash as cash equivalent or short-t
erm marketable securities will affect classifications
Operating lease vs. capital lease will affect the various pa
rts of the SCF
Securitization of AR in the end of the reporting period will
affect CFO
Customer acquisition costs (Shell Games article)
Speed-up cash collections and window-dress CFO
Blackberry Q3 2014, remember?

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Stretch out payables

Slow down the rate of payments to vendors to impr
ove CFO
This temporary increase in CFO is unlikely to be sustaina
ble

The extension of payables can be identified by mon

itoring days sales in payables (DSP)
DSP = (Ending AP/COGS) * 365
General Electric: Days Sales Payable

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Year ending Dec.31

2003

2002

2001

2000

DSP

53.1

51.5

47.7

40.2

Finance payables
A company uses a third-party financial institutio
n to pay the vendor in the current period, with th
e company then paying back the bank in a subse
quent period
Financing
cash outflow

Delphi
Corporation

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GE Capital
Corp.

Vendors
Operating cash
outflow

Finance payables
At the first quarter
GE paid the amounts to Delphis vendor
Delphi didnt expand any cash

Then Delphi reclassified A/P to short-term loans

A non-cash transaction

In the subsequent quarter

Delphi paid GE and the cash outflow was accounted f
or as a financing activity

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Capitalizing normal operating expenses

It boosts operating cash flow, because normal ex
penses (operating cash outflows) get shifted to th
e investing section as capital expenditures (invest
ing cash outflows)
In real life there are 50 shades of grey
We will later see opposite lease classification incenti
ves

Worldcom capitalized $5B of expenses

This was not grey, simply GAAP violation!
Not only because of CFO motive

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The happy ending

DIY earnings management the IBM case
After the game: Why should we even care about
earnings quality? How should it affect your analy
sis?

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