Earnings Quality: Reviewing Non-Accrual Items
Accounting is an art, not a science, and there is no certainty that extreme accrual amounts indicate that management is attempting to mislead investors about a company's true conditions. Recall that even managements that make honest and principled efforts to properly account for transactions may end up with inaccurate estimates. Further, extreme amounts of accruals may accurately reflect the conditions of the firm. For example, a small firm growing at a phenomenal rate could reasonably have large amounts of accounts receivable during this growth phase.
couring the company's financial reports for extreme accruals (either over or under the expected amount) is just one aspect of uncovering earnings manipulation. In order to increase the certainty regarding the nature of extreme accruals, the analyst should look into the character of the company's management. Some areas to explore are described below.
How do the firm's policies compare to industry norms?
Keep in mind that just because the firm's accounting is different from industry norms, doesn't mean it improperly reflects the economic condition of the firm. For example, a firm that reports warranty allowances lower than industry norms may actually have invested in a process that has fewer product failures than industry norms, which can likely be found out by rooting though the footnotes to the company's financial statements. (For more insight, read Footnotes: Start Reading The Fine Print and An Investor's Checklist To Financial Footnotes.)
Has management's judgment been realistic in the past?
Any indication that management has been biased when using its accounting discretion can be noted by:
- A history of one-time charges/special items (See, The One-Time Expense Warning to learn more.)
- Large fourth-quarter adjustments
- Repeated asset sales
- Any qualified audit opinions
Has the firm changed any of its policies or estimates? If so, why?
Using the warranty example from the previous section, if the firm has made significant investments to improve product quality, a reduction in warranty allowance may be justified.
Does the firm use a lot of financing mechanisms like partnerships and special-purpose entities or sell receivables with recourse?
When a firm creates a complex structure to facilitate a transaction, it could mean the mechanism was created to move liabilities off the balance sheet or hide investment losses. Furthermore, related-party transactions may lack the pricing objectivity of a market transaction and accounting estimates related to these transactions are likely to be more subjective and self-serving. A general rule of thumb is that the more entities the firm creates, the bigger the red flag. (For more on this, see Off-Balance-Sheet Entities: The Good, The Bad And The Ugly.)
How forthcoming has management been with reporting bad news?
How a person or entity handles the delivery of unflattering news about themselves is typically a good way to get a bead on his or her character. Do they adequately explain why the disappointing event occurred? Do they take responsibility and clearly articulate a strategy to rectify the situation?
Do you think the MD&A section in the annual report helps you understand the firm's current business environment and reasons for recent operating performance?
A management team concerned with good shareholder communication should use this section to link the period's financial performance to business conditions. For example, if gross profit fell in the period, was it due to price pressure, change in the sales mix to lower-margin product, or an increase in the cost of goods sold?
Do you think the footnotes to the financial statements explain the assumptions?
When accounting policies deviate from the industry norm or undergo a change, the footnotes should adequately describe why. Recall the warranty example above.
Does the insider buying/selling look unusually large or persistent relative to firm and industry history?
Management signals its degree of confidence in the when firm management team members buy or sell stock. While it can be argued that the signal given by stock sales is corrupted by factors such as the need to diversify wealth, unusually large sell transactions should still be noted and viewed negatively if there are other accrual and non-accrual evidence that suggests earnings manipulation. (To learn more, read Delving Into Insider Investments.)
Does the company have a governance body capable of monitoring management's choices?
Because there is a separation of ownership and control, corporate governance is a mechanism used to monitor management's choices to misuse its accounting judgment. There appears to be some evidence that, on average, larger boards tend to report higher-quality earnings than companies with small boards. Although evidence that the proportion of outside board members does not seem to matter, an independent audit committee does protect investors' interests, especially when a firm is in financial distress.
Audit and Non-Audit Fees
Are audit fees high? Is there a close relationship between the company and their auditor?
There appears to be a positive relationship between audit fees and the presence of high levels of accruals - higher audit fees lead to high accrual amounts. This relationship does not seem to be driven by deliberate auditor bias, but is a result of unconscious influence. In other words, auditors are not being bribed by higher audit fees, but close ties between parties creates a bias.
Does the company use an established accounting firm?
Prior to the Sarbanes-Oxley Act of 2002, a common allegation was that fees for non-audit services, such as valuation and appraisal or executive recruitment services, were an inducement to auditors to allow clients to get away with accounting misconduct. While definitive evidence is lacking, research in the area indicates that non-audit fee bribery is less likely in firms using Big Four accounting firms.
Heightened Periods of Pressure on Management
Could current economic conditions be putting managers in a difficult position?
The slowing of general or industry-specific economic conditions means fewer sales, more bad debts and more obsolete inventory. The decline in operating performance is amplified by the reversals of prior-period accruals based on recent experience, as the original accounting estimates were made under very different economic conditions. As the economy or industry slows down, managers may find it increasingly difficult to meet the earnings objectives set during the boom times.
Could current conditions within the company be putting managers in a difficult position?
Company-specific situations such as high market valuations, the length of time during which there have been no performance disappointments, involvement in merger and acquisition activity and issuance of debt or equity all appear to be correlated to higher accruals. Although there is no documented evidence that, on average, managers at high-accrual firms are deliberately manipulating earnings, there appears to be some relationship between high accruals and these high-pressure situations.
By gathering information from the qualitative statements made by management, one can gain a better understanding of their character. The analyst can then make inferences about how management exercises its flexibility under the accounting rules and how it handles specific accounting issues that are critical to the economics of the business. If the qualitative analysis results in a portrait of a management team with bad character, any extreme accrual amounts should be a red flag for likely earnings manipulation.
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