12.2-12.3: Evaluating Earnings Quality Flashcards
Steps in evaluating the quality of financial reports:
Step 1: Understand the company,
Step 2: Understand management
Step 3: Identify material areas of accounting that are vulnerable to subjectivity.
Step 4: Make cross-sectional and time series comparisons of financial statements and important ratios.
Step 5: Check for warning signs as discussed previously.
Step 6: For firms in multiple lines of business or for multinational firms, check for shifting of profits or revenues to a specific part of the business that the firm wants to highlight.
Step 7: Use quantitative tools to evaluate the likelihood of misreporting.
The Beneish Model
The Beneish model is a probit regression model that estimates the probability of earnings manipulation using eight independent variables.
Beneish Model Formula
M-score = –4.84 + 0.920 (DSRI) + 0.528 (GMI) + 0.404 (AQI) + 0.892 (SGI) + 0.115 (DEPI) − 0.172 (SGAI) + 4.679 (Accruals) − 0.327 (LEVI)
Beneish Model intrepretation
M-score > –1.78 (i.e., less negative) indicates a higher-than-acceptable probability of earnings manipulation.
Limitations of the Beneish Model
- Relies on accounting data, which may not reflect economic reality. - - - managers become aware of the use of specific quantitative tools, they may begin to game the measures used.
Altman Model
Altman’s Z-score model was developed to assess the probability that a firm will file for bankruptcy.
Altman Model intrepretation
higher Z-score is better (less likelihood of bankruptcy).
One limitation of the Altman model
single-period static model and, hence, does not capture the change in key variables over time.
High-quality earnings are characterized by two elements:
Sustainable: high-quality earnings tend to persist in the future.
Adequate: high-quality earnings cover the company’s cost of capital.
Sustainable or persistent earnings
earnings that are expected to recur in the future.
One way to gauge earnings persistence is to use a regression model such as:
Accruals regression model
Explain mean reversion in earnings
earnings at extreme levels tend to revert back to normal levels over time
When earnings are largely comprised of accruals, mean reversion will occur faster—and even more so when the accruals are largely discretionary.
Two major contributors to earnings manipulation are:
Revenue recognition issues and;
Expense recognition issues (capitalization).
Revenue Recognition Issues
Revenues generated via deliberate channel-stuffing or as a result of bill-and-hold arrangements should be considered spurious and inferior.
A higher growth rate of receivables relative to the growth rate of revenues is a red flag.
Similarly, an increasing days’ sales outstanding (DSO) over time is an indication of poor revenue quality.
Expense recognition issues (capitalization).
One way to boost reported performance is to under-report an operating expense by capitalizing it.
Indicators of Cash Flow Quality
High-quality cash flow is characterized by positive OCF that is derived from sustainable sources and is adequate to cover capital expenditures, dividends, and debt repayments.
Evaluation of the statement of cash flows (and more importantly cash flow from operating activities) entails:
Checking for any unusual items or items that have not shown up in prior years.
Checking revenue quality.
Checking for strategic provisioning.
High-quality financial balance sheet reporting
completeness, unbiased measurement, and clarity of presentation.
Completeness of a balance sheet
compromised by the existence of off-balance-sheet liabilities such as purchase agreements structured as take-or-pay contracts
Describe sources of information about risk.
Financial statements.
Auditor’s report.
Notes to financial statements.
Disclosures about contingent liabilities include a description of the liability, as well as estimated amounts and timing of the payments.
Management Discussion and Analysis (MD&A).
SEC Form ‘NT’.
Financial press.
