Evaluation of Earnings Quality

We analyze companies’ earnings to understand the earnings quality, i.e., the persistence and sustainability of earnings. Many accounting policies demand estimations and rely on subjective decisions. Some managers take advantage of this and indulge in creative accounting to report misleading performance. There are two main ways for earnings manipulation top take place:

• Improper revenue recognition.
• Improper expense recognition (capitalization).

Improper Revenue Recognition

Most misreporting occurs in revenue recognition, as revenue is the most significant single figure on the income statement and arguably the most crucial. There exists discretion in revenue recognition policies, and this calls for analysts to analyze revenues exhaustively. Analysts should not only focus on the quantity of revenue, but also with the quality of revenues (i.e., how those revenues were generated). Sales transactions that can inflate earnings include:

Channel stuffing: This is the practice of inducing customers to order more goods than they typically would through offering favorable discounts and generous return policies. This pulls future sales into the present, which implies that receivables increase faster than revenue. An increasing proportion of receivables to revenue means that a lesser proportion of sales have been collected. The decrease in collection of sales is an indication that the customers’ ability to repay has deteriorated.

Bill-and-hold practices: Here, the goods remain on the seller’s premises even though revenue has been recognized when the invoice is issued. This increases days’ sales outstanding (DSO) over time, which is an indication of poor revenue quality.

Example: Evaluating Earnings Quality

ABC Ltd. is a hypothetical consumer goods company in Canada. Relevant annual data on ABC Ltd.’s financial reports from 2016 through 2018, as well as industry comparable, are shown below:

$$ \textbf{ABC Ltd. Selected Annual Data} $$

$$\small{\begin{array}{l|r|r|r} {}& \textbf{2016} & \textbf{2017} & \textbf{2018}\\ \hline{}& \textbf{(CA\$ millions)} & \textbf{(CA\$ millions)} & \textbf{(CA\$ millions)}\\ \hline\text{Sales} & 13,396 & 14,391 & 16,045\\ \hline\text{Accounts receivable} & 2,551 & 2,852 & 3,642\\ \hline\textbf{Industry Mean}&{}&{}&{}\\ \hline\text{Days’ sales outstanding (DSO)} & 53.81 & 51.34 & 46.85\\ \hline\text{Receivables turnover} & 11.95 & 12.75 & 14.41\\  \end{array}}$$

Question 1: Calculate the increase in ABC’s revenue and receivables for the three years and compare the change in revenues to the change in receivables.

Solution

$$\begin{array}{l|r|r|r} {}& \textbf{2016} & \textbf{2017} & \textbf{2018}\\ \hline\text{Change in sales} & – & 7.43\% & 11.49\%\\ \hline\text{Change in accounts receivable} & – & 11.80\% & 27.70\%\\  \end{array}$$

ABC’s receivables growth outstripped revenue growth, suggesting a decline in the collection of sales and reduced quality accounts receivable. Analysts should pay close attention to ABC’s notes to explore this further.

Question 2: Using ABC’s selected annual data above, comment on the trend of DSO and receivables turnover for ABC Ltd. and compare it to the industry mean.

Solution

$$\small{\begin{array}{l|r|r|r} {}& \textbf{2016} & \textbf{2017} & \textbf{2018}\\ \hline\text{Receivables/Revenue (sales)} & 19.04\% & 19.82\% & 22.70\%\\ \hline\text{Change in receivables/Revenue (sales)} & 0 & 4.07\% & 14.54\%\\ \hline{}&{} &{} &{}\\ \hline\text{Days’ sales outstanding (DSO)} & 69.51 & 72.34 & 82.85\\ \hline\text{Receivables turnover} & 5.25 & 5.05 & 4.41\\  \end{array}}$$

$$\text{Number of days’ sales outstanding (DSO)}=\frac{\text{Accounts receivable}}{\text{Revenue}} \times 365$$

$$\text{Accounts receivable turnover}= \frac{365}{\text{The number of days’ sales outstanding (DSO)}}$$

ABC’s number of days’ sales outstanding (DSO) is increasing, suggesting that receivables are not paid on a timely basis or misreported revenues. Additionally, ABC’s DSO is significantly higher than the industry mean. Receivable turnover refers to the number of times receivables are converted into cash each year. ABC’s turnover ratio is declining over time and is lower relative to the industry mean. This indicates inefficient cash collection. Finally, the change in the proportion of receivables to revenues is positive and increasing over time.

Question 3: Comment on potential revenue recognition issues at ABC Ltd.

Solution

Based on the above indicators, ABC Ltd.’s revenues are potential of poor quality. Analysts should, therefore, exhaustively analyze ABC’s revenue.

When analyzing a company’s quality of revenues, the following steps are essential:

Step 1. Begin with the Basics

From the most recent annual report, it is essential to fully understand the company’s revenue recognition policies in the first step. These policies include the shipping terms, return policies, rebates, and the presence of multiple-element contracts.

Step 2. Evaluate and Seek Reasons for Ageing Receivables

Compare the trend in the company’s DSO or receivables turnover and that of similar competitors over a relevant time frame.

Step 3. Compare Cash and Accruals

An analyst should compare the company’s proportion of accounts receivable to revenues with that of competitors or industry average over relevant time frames

Step 4. Compare with Real World

The analyst should relate revenues to the company’s reported non-financial data to determine if the revenue trends are sensible. Additionally, analysts should compare relevant revenue-per-unit measures with industry measures.

Step 5. Analyze Revenue Trends and Composition

Trend analysis of relationships between kinds of revenue recognized and the relationship between overall revenue and accounts receivable over time and in comparison with peers can lead analysts to ask questions of the managers.

Step 6. Relationships

Check whether there are revenues recognized from private entities by a publicly owned entity. Managers can use this as an incentive to cover obsolete or damaged inventory while overstating revenues.

Improper Expense Recognition (Capitalization)

Managers can use capitalization to avoid expense recognition. This boosts the reported performance by underreporting the operating expense. However, for an operating expense to be under-reported, an offsetting increase in the balance sheet of another account must exist. An analyst should be cautious of unsupported changes in significant asset categories. For example, an increase in the percentage of property, plant, and equipment to total assets is a warning sign. Therefore, analysts should consider reviewing if the company has changed its strategy or anything else to justify such an increase.

Steps in analyzing expense recognition policies are as follows:

Step 1. Begin with the Basics

Understand the cost capitalization practices fully, as disclosed in the most recent annual report. Besides, the analyst should collect information concerning depreciation policies and how they compare with the industry measures or the company’s competitors.

Step 2. Perform Trend Analysis

Analyze non-current assets for quarter-to-quarter and year-to-year changes to see if there are any anomalies. These unusual cost increases could be explained by improper cost capitalization. Constant or improving profit margins, which might be as a result of the unusual buildup of non-current assets, would be an improper capitalization of “line costs.” Additionally, steady or rising revenue, coupled with decreasing asset turnover ratios, is a warning sign of improper cost capitalization.

Compute and compare depreciation (or amortization) expense as a proportion of asset base over time and with the company’s competitors. Finally, compare capital expenditures to gross Property, Plant, and Equipment over time and with competitors or industry measures. Increasing capital expenditures as a proportion of property, plant, and equipment is an indicator of improper cost capitalization.

Step 3. Relationships

Analysts should pay close attention to a public company that transacts with a private entity owned by senior officers or shareholders. Transactions might occur at unfavorable prices to transfer wealth from the public company to the private entity. These inappropriate transfers can be through compensation, direct loans, or guarantees and are referred to as tunneling.

Furthermore, analysts should check for propping practices. Here, the private entity could transfer resources to the public company to ensure that it is economically viable and hence, maintain the option to misappropriate or to participate in future profits.

Question

A research analyst at XYZ Ltd., an investment company, has been assigned to investigate the earnings quality of Jupiter Ltd. The analyst reviews last year’s financial assets for Jupiter Ltd. and examines the effects of two potential misstatements. The analyst concludes that Jupiter improperly reported $75 million of revenue and improperly capitalized $100 million of its cost of revenue. He then estimates the effect of these two misstatements on net income, assuming a tax rate of 30%.

After adjusting the Jupiter Ltd. income statement for the two possible misstatements, the decline in net income is closest to:

     A. $52.5 million.

     B. $122.5 million.

     C. $175 million.

Solution

The correct answer is B.

Adjusting the revenue misstatement would result in lower revenue by $75 million. Similarly, adjusting the cost of revenue misstatement would result in a higher cost of revenue by $100 million. The pre-tax income decreased by $175 million. Applying a tax rate of 30%, the reduction in net income would be:

$$175\times (1 – 0.30) = \text{\$122.5 million}$$

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (h) Evaluate the earnings quality of a company.