EVALUATING QUALITY OF FINANCIAL REPORTS Presenter’s name Presenter’s title dd Month yyyy

EVALUATING QUALITY OF FINANCIAL REPORTS

Presenter’s namePresenter’s titledd Month yyyy

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FINANCIAL REPORTING QUALITY AND EARNINGS QUALITY ARE INTERRELATED

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QUALITY SPECTRUM OF FINANCIAL REPORTS

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POTENTIAL PROBLEMS THAT AFFECT THE QUALITY OF FINANCIAL REPORTS

• Reported amounts and timing of recognition

• Classification

• Biased choices

• Fraud

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REPORTED AMOUNTS AND TIMING OF RECOGNITION: REVENUE

Aggressive, premature, and fictitious revenue

recognition

Overstated income

Overstated equity and overstated

net assets

Conservative revenue recognition

Understated income

Understated equity and understated

net assets

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REPORTED AMOUNTS AND TIMING OF RECOGNITION: EXPENSES

Understatement of bad debt expense

Overstatement of income

Overstated equity and overstated net receivables

Understatement of depreciation or amortization


Overstated equity and overstated net PPE

Understatement of interest or tax


Overstated equity and understated liability

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REPORTED AMOUNTS AND TIMING OF RECOGNITION: CASH FLOW

Defer payment of payables Increases operating cash flow for the period

Accelerate payments from customers

Increases operating cash flow for the period

Defer purchases of inventory Increases operating cash flow for the period

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CLASSIFICATION

– Reclassification of accounts receivable or inventory from current to long-term favorably affects company metrics, such as turnover ratios.

– Classification of revenue items as being derived from core, continuing operations favorably affects the apparent sustainability of revenues.

– Classification of expense items as non-operating favorably affects reported operating income.

– Classification of expense items and losses as non-recurring in non-GAAP/non-IFRS metrics favorably affects the apparent sustainability of profits.

– Classifications that result in items being reported in other comprehensive income can favorably affect comparability.

– Classification choices on the statement of cash flow can distort operating cash flows.

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ACCOUNTING WARNING SIGNS

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ACCOUNTING WARNING SIGNS (CONTINUED)

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EVALUATING THE QUALITY OF FINANCIAL REPORTS

– Understand company and industry

– Learn about management

– Identify important accounting areas

– Compare

– current year’s report with prior year’s report

– accounting policies with competitors’ policies

– ratios with competitors’ ratios

– Check for warning signs

– Review segment results

– Use quantitative predictors of misreporting

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QUANTITATIVE TOOL TO ASSESS THE LIKELIHOOD OF MISREPORTING—BENEISH MODEL

M-score = Score indicating probability of earnings manipulation• The following slides describe each input variable and provide an

explanation of why it is included. • Even if an analyst does not choose to use this particular model, it is

helpful to understand the input variables and their link with probable earnings manipulation.

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BENEISH MODEL: INPUT VARIABLES

• DSR (days sales receivable) = (Receivablest/Salest)/(Receivablest–1/Salest–1).

Changes in relationship between receivables and sales could indicate inappropriate revenue recognition.

• GMI (gross margin index) = Gross margint–1/Gross margint.

Deterioration in margins could predispose a company to manipulate earnings.

• AQI (asset quality index)= [1 – (PPEt + CAt)/TAt]/[1 – (PPEt–1 + CAt–1)/TAt–1], where PPE is property, plant, and equipment, CA is current assets, and TA is total assets.

Change in percentage of assets other than PP&E and current assets could indicate excessive expenditure capitalization.

• SGI (sales growth index) = Salest/Salest–1

Managing the perception of continuing growth and capital needs from actual growth could predispose a company to manipulate sales and earnings.

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BENEISH MODEL: INPUT VARIABLES CONTINUED

• DEPI (depreciation index) = Depreciation ratet–1/Depreciation ratet, where Depreciation rate = Depreciation/(Depreciation + PPE).

Declining depreciation rates could indicate understated depreciation as a means of manipulating earnings.

• SGAI (sales, general, and administrative expenses index) = (SGAt/Salest)/ (SGAt–1/Salest–1)

An increase in fixed SGA expenses suggests decreasing administrative and marketing efficiency, which could predispose a company to manipulate earnings.

• Accruals = (Income before extraordinary items – Cash from operations)/Total assets.

Higher accruals can indicate earnings manipulation.

• LEVI (leverage index) = Leveraget/Leveraget–1, where Leverage is calculated as debt to assets.

Increasing leverage could predispose a company to manipulate earnings.

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EARNINGS QUALITY

High Quality: • Sustainable• Returns ≥

Cost of capital

Low Quality: • Non-recurring• Returns <

Cost of capital

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INDICATORS OF EARNINGS QUALITY

• Recurring earnings

• Earnings persistence and related measures of accruals

• Beating benchmarks

• After-the fact confirmations of poor-quality earnings, such as enforcement actions and restatements

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NON-RECURRING EARNINGS: EXAMPLE

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How does the trend in Enron’s operating income compare with the trend in its income after other income and deductions?

Highly Variable

Smoothly Upward

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What items appear to be non-recurring as opposed to being a result of routine operations?

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CLASSIFICATION DECISIONS: EXAMPLES

• Borden, a food and chemicals company, misleadingly classified $146 million

of operating expenses as part of a special item (restructuring charges).• AmeriServe Food Distribution Inc., which declared bankruptcy only four months

after completing a $200 million junk bond issuance, classified substantial

operating expense as restructuring charges, which masked the company’s

serious financial underperformance.• Waste Management, which, in 1998, issued the then-largest restatement in

SEC history. It improperly inflated operating income by netting non-

operating gains from the sale of investments and discontinued

operations against unrelated operating expenses.• IBM classified intellectual property income as an offset to selling,

general, and administrative expenses. This classification resulted in an

understatement of operating expenses and thus an overstatement of core

earnings by $1.5 billion and $1.7 billion in 2001 and 2000, respectively.

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EARNINGS PERSISTENCE AND RELATED MEASURES OF ACCRUALS

• Earnings persistence

Earningst+1 = a + b1Earningst + e

• Relative persistence of cash flows and accruals

Earningst+1 = a + b1Cash flowt + b2Accrualst + e

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QUESTIONABLE EARNINGS QUALITY EXAMPLE: ALLOU HEALTH & BEAUTY CARE

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INCOME STATEMENT ONLY: QUESTION

Based on the income statement data, what is your evaluation of Allou’s performance over the period shown?

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INCOME STATEMENT ONLY: SOLUTION

Revenues grew each year, albeit more slowly in the latest year shown. Gross and operating margins declined somewhat, but have been fairly stable. Income from continuing operations was sharply lower in 2001. Net income was positive in each year.

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STATEMENT OF CASH FLOWS

Compare Allou’s income from continuing operations with operating cash flows. Interpret the amounts shown as adjustments to reconcile income from continuing operations to net cash used in operating activities.

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Allou reported positive income from continuing operations, but negative cash from operating activities in each of the three years shown. Persistent negative cash from operating activities is not sustainable for a going concern.

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The excerpt from Allou’s Statement of Cash Flows shows that accounts receivable and inventories increased each year. This increase can account for most of the difference between the company’s income from continuing operations and net cash used in operating activities. The company seems to be accumulating inventory and not collecting on its receivables.

Recall: The statement of cash flows, prepared using the indirect method, adjusts income to derive cash from operating activities. An increase in current assets is subtracted from the income number to derive cash from operating activities.

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MEAN REVERSION IN EARNINGS

• Mean reversion in earnings: Extreme levels of earnings, both high and low, tend to revert to normal levels over time.

• If earnings have a significant accruals component, it may hasten the earnings’ reversion to the mean.

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REVENUE RECOGNITION CASE: SUNBEAMSALES TRANSACTIONS THAT INFLATED REVENUES

• Included one-time disposals of product lines in sales without indicating the non-recurring aspect

• Induced customers to order more goods than they normally would through offers of discounts and other incentives, which had the effect of inflating current results by pulling future sales into the present. This practice is sometimes referred to as “channel stuffing.”

• Booked revenue and income from “sales” to a wholesaler who held the merchandise over the quarter’s end without accepting ownership risks, and then returned all the products to Sunbeam in the next quarter

• Engaged in “bill-and-hold” transactions in which revenue is recognized when the invoice is issued while the goods remain on the premises of the seller

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REVENUE RECOGNITION CASE: SUNBEAM(CONTINUED)

Information on Sunbeam’s Sales and Receivables, 1995–1997

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Information on Sunbeam’s Sales and Receivables, 1995–1997 and Pro Forma Information, 1997

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Comparison of Sunbeam and Industry Median, 1995–1997

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“The Company recognizes revenues from product sales principally at the time of shipment to customers. In limited circumstances, at the customer’s 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.”

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REVENUE RECOGNITION CASE: MICROSTRATEGY, INC.

“Revenue from product licensing arrangements is generally recognized after execution of a licensing agreement and shipment of the product, provided that no significant Company obligations remain and the resulting receivable is deemed collectible by management. . . . Services revenue, which includes training and consulting, is recognized at the time the service is performed. The Company defers and recognizes maintenance revenue ratably over the terms of the contract period, ranging from 12 to 36 months. (p. 49)

• Microstrategy’s multiple-element contracts involved both software licenses and services.

• Revenue on software licenses is recognized immediately.

• Revenue on services and on maintenance is recognized over time.

• Allocating a greater proportion of the sale price to the software license component increases the proportion that is recognized in income immediately.

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REVENUE RECOGNITION CASE: MICROSTRATEGY, INC. (CONTINUED)

MicroStrategy’s Revenue Mix by Quarters, 1Q1998–4Q1999

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COST CAPITALIZATION CASE: WORLDCOM CORP.

Common-Size Asset Portion of Balance Sheet for WorldCom, 1997–2001

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CASH FLOW QUALITY

– Corporate life cycle and industry profile affect cash flow and must be considered when analyzing the statement of cash flows.

– A startup company might be expected to have negative operating and investing cash flows, which would be funded from borrowing or from equity issuance (financing cash flows).

– In contrast, for established companies, high-quality cash flow would typically have most or all of the following characteristics:

– Positive OCF(operating cash flow)

– OCF derived from sustainable sources

– OCF adequate to cover capital expenditures, dividends, and debt repayments

– OCF with relatively low volatility (relative to industry participants).

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CLASSIFICATION SHIFTING: NAUTICA ENTERPRISES

AS REPORTED IN May 2000 for the fiscal year ending March 2000

Net earnings 46,163 Adjustments to reconcile net earnings to net cash provided by operating activities

Details omitted

Net cash provided by operating activities 62,685

Details omittedSale (purchase) of short-term investments 21,116 Net cash used in investing activities (12,450)

AS REPORTED IN May 2001 for fiscal years ending March 2001 2000Net earnings 46,103 46,163 Adjustments to reconcile net earnings to net cash provided by operating activities

Details omitted

Changes in operating assets and liabilitiesShort-term investments 28,445 21,116 Accounts receivable (17,935) (768)Inventories (24,142) (3,667)

Details omittedNet cash provided by operating activities

78,018

83,801

Net cash used in investing activities

(41,911)

(33,566)

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CLASSIFICATION SHIFTING: NAUTICA ENTERPRISES

AS REPORTED IN May 2000 for the fiscal year ending March 2000

Net earnings 46,163 Adjustments to reconcile net earnings to net cash provided by operating activities

Details omitted

Net cash provided by operating activities 62,685

Details omittedSale (purchase) of short-term investments 21,116 Net cash used in investing activities (12,450)

AS REPORTED IN May 2001 for fiscal years ending March 2001 2000Net earnings 46,103 46,163 Adjustments to reconcile net earnings to net cash provided by operating activities

Details omitted

Changes in operating assets and liabilitiesShort-term investments 28,445 21,116 Accounts receivable (17,935) (768)Inventories (24,142) (3,667)

Details omittedNet cash provided by operating activities

78,018

83,801

Net cash used in investing activities

(41,911)

(33,566)

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BALANCE SHEET QUALITY INDICATORS

• High financial reporting quality requires

– completeness,

– unbiased measurement, and

– clear presentation.

• High financial results quality (i.e., a strong balance sheet) requires

– optimal amount of leverage,

– adequate liquidity, and

– economically successful asset allocation.

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UNBIASED MEASUREMENT

• Understatement of impairment charges overstates profits on the income statement and also results in overstatement of the assets on the balance sheet.

– Inventory

– Property, plant, and equipment

– Goodwill

• Understatement of contra asset accounts overstates profits on the income statement and also results in overstatement of the assets on the balance sheet.

– Allowance for bad debt

– Deferred tax asset valuation allowance

• Assets and liabilities for which fair value is highly dependent on management estimates warrant scrutiny.

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OVERSTATED GOODWILL: SEALED AIR CORPORATION (SEE)

Excerpt from Sealed Air Corporation Balance Sheets ($ millions)

SEE’s total market cap was about $3,457 million in December 2011 and around $2,689 million when the Wall Street Journal article was written in August 2012.

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OVERSTATED GOODWILL: SEALED AIR CORPORATION (SEE)

Excerpt from Sealed Air Corporation Income Statements ($ millions)

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SOURCES OF INFORMATION ABOUT RISK

• Financial statements, including notes

– Ratios derived from financial statements

– Prediction models (e.g., bankruptcy, misreporting)

– Notes on contingencies and litigation

– Notes on actuarial risks associated with pensions and post-employment benefits

– Notes on credit risk, liquidity risk, and market risks that arise from the company’s financial instruments

• Audit opinion

• Discretionary change in auditor

• Management commentary

• Disclosures pertaining to specific events (e.g., capital raising, non-timely filing of financial reports, management changes, mergers and acquisitions)

• Financial press

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SOURCES OF INFORMATION ABOUT RISK: GROUPON

• The growth data, particularly coupled with specific disclosures in the IPO filing about management inexperience, are a warning sign of potential reporting risks.

• These reporting risks were observable many months before the company first disclosed its internal control weakness in March 2012.

It is absolutely ludicrous to think that Groupon is anywhere close to having an effective set of internal controls over financial reporting having done 17 acquisitions in a little over a year. When a company expands to 45 countries, grows merchants from 212 to 78,466, and expands its employee base from 37 to 9,625 in only two years, there is little doubt that internal controls are not working somewhere.

August 2011 accounting blog (Catanach and Ketz)

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SUMMARY

• Potential problems that affect the quality of financial reporting broadly include revenue and expense recognition on the income statement; classification on the statement of cash flows; and the recognition, classification, and measurement of assets and liabilities on the balance sheet.

• Typical steps involved in evaluating financial reporting quality include – an understanding of the company’s business and industry; – comparison of the financial statements in the current period and the previous

period;– evaluation of the company’s accounting policies compared with those of

other companies in the same industry; – financial ratio analysis; – examination of the statement of cash flows with particular focus on

differences between net income and operating cash flows; – perusal of risk disclosures; and – review of management compensation and insider transactions.

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Extended Example

SATYAM COMPUTER SERVICES

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EXAMPLE: SATYAM COMPUTER SERVICES

Satyam Computer Services Limited, an Indian information technology company, was founded in 1987 and grew rapidly by providing business process outsourcing (BPO) on a global basis. In 2007, its CEO, Ramalinga Raju, was named “Entrepreneur of the Year” by Ernst & Young, and in 2008, the World Council for Corporate Governance recognized the company for “global excellence in corporate accountability.”

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EXAMPLE: SATYAM COMPUTER SERVICES (CONTINUED)

In 2009, the CEO submitted a letter of resignation that outlined massive financial fraud at the company. The company’s decline was so rapid and significant that it came to be referred to as “India’s Enron.”

In late 2008, the World Bank terminated its relationship with the company after finding that Satyam gave kickbacks to bank staff and billed for services that were not provided. These initial revelations of wrongdoing had the effect of putting the company under increased scrutiny. Among other misconduct, the CEO eventually admitted that he created fictitious bank statements to inflate cash and to show interest income. The CEO also created fake salary accounts and took the money paid to those “employees.” The company’s head of internal auditing created fictitious customer accounts and invoices to inflate revenues.

Based on the information provided, characterize Satyam’s financial reports, with reference to the quality spectrum of financial reports.

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In 2009, the CEO submitted a letter of resignation that outlined a massive financial fraud at the company. The company’s decline was so rapid and significant that it came to be referred to as “India’s Enron.”


Explain each of the following misconducts with reference to the basic accounting equation: Transactions with World Bank; fictitious interest income; CEO’s embezzlement; fictitious revenue

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With reference to the basic accounting equation, transactions with the World Bank would…

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In 2009, the CEO submitted a letter of resignation that outlined a massive financial fraud at the company. The company’s decline was so rapid and significant that it came to be referred to as “India’s Enron.”In late 2008, the World Bank terminated its relationship with the company after finding that Satyam gave kickbacks to bank staff and billed for services that were not provided. These initial revelations of wrongdoing had the effect of putting the company under increased scrutiny. Among other misconduct, the CEO eventually admitted that he created fictitious bank statements to inflate cash and to show interest income. The CEO also created fake salary accounts and took the money paid to those “employees.” The company’s head of internal auditing created fictitious customer accounts and invoices to inflate revenues.

With reference to the basic accounting equation, Transactions with World Bank would…

• Billing for fictitious services: Increase an asset, such as

accounts receivable, and a revenue account, such as

service revenues.

Net effect: overstatement of income, net assets, and

equity.

• Kickbacks to the customer’s staff, if recorded: Increase

an expense account, such as commissions paid, and

increase a liability, such as commissions payable, or

decrease an asset, such as cash.

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With reference to the basic accounting equation, fictitious interest income would…

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With reference to the basic accounting equation, Fictitious interest income would…

• Fictitious interest income would result in

• overstated income;

• overstated assets, such as cash and

interest receivable; and

• overstated equity.

• These overstatements were hidden by

falsifying revenue and cash balances.

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With reference to the basic accounting equation, the CEO’s embezzlement would…

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With reference to the basic accounting equation, the CEO’s embezzlement would…

The embezzlement by creating fictitious

employees would increase an expense

account, such as wages and salaries, and

decrease the asset, cash.

The resulting understatement of income and

equity was offset by a real but fraudulent

decrease in cash, which was hidden by

falsifying revenue and cash balances.

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With reference to the basic accounting equation, fictitious revenue would…

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With reference to the basic accounting equation, Fictitious revenue would…

Fictitious revenues would result in

• overstated revenues and income;

• overstated assets, such as cash and accounts

receivable; and

• overstated equity.

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Based on the information provided, what documents were falsified to support the misconducts?

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Based on the information provided, what documents were falsified to support the misconducts?

Based on the information provided, the documents that were

falsified include

• invoices to the World Bank for services that were not provided,

• bank statements,

• employee records, and

• customer accounts and invoices.

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EVIDENCE FROM THE STATEMENT OF CASH FLOWS: SATYAM COMPUTER SERVICES

• An analyst “used a computer model to examine India’s 500 largest public companies for signs of accounting manipulation. He found that more than 20 percent of them were potentially engaged in aggressive accounting, but Satyam was not on the list. This is because the automated screens that analysts . . . use to pick up signs of fraud begin by searching for large discrepancies between reported earnings and cash flow. In Satyam’s case, the cash seemed to keep pace with profits.”

New York Times article (Kahn 2009)

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Excerpt from Satyam’s IFRS Consolidated Interim Cash Flow Statement ($ millions)

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Excerpt from Conference Call regarding Quarterly Results of Satyam, 18 July 2008

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ACCOUNTS RECEIVABLE: SATYAM COMPUTER SERVICES

Selected Annual Data on Accounts Receivable for Satyam, 2005–2008

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SATYAM COMPUTER SERVICES

Excerpt from Conference Call regarding Quarterly Results for Satyam,17 October 2008

Documents

EVALUATING QUALITY OF FINANCIAL REPORTS Presenter’s name Presenter’s title dd Month yyyy