Section 6 Earnings quality

Transcription

1 Section 6 Earnings quality In the long run managements stressing accounting appearance over economic substance usually achieve little of either. --Warren Buffett 1

2 Learning objectives After studying this chapter, you will understand How accrual accounting can be used to affect the reported earnings How earnings management is different from fraud How the degree of earnings management can be measured by using accruals 2

3 Earnings quality and earnings management Earnings quality Higher quality earnings provide more information about the features of a firm s financial performance that are relevant to a specific decision made by a specific decisionmaker. -- Dechow et al. (2010, p. 344) Earnings management The choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective. -- Scott, W.R. (2015) 3

4 Why and how to manage earnings? Obviously, management has a strong incentive in the reported earnings Executive compensation Raising new capital for the firm Mergers and acquisitions Accounting policy choices Choosing specific accounting policies Discretionary accruals Note: fraudulent reporting is very rare, after all Real actions Influencing e.g. advertising, R&D spending, productions levels Manages both earnings and cash flows 4

5 Popular earnings management devices Working capital accruals A firm can borrow earnings from the next reporting period Big bath restructuring charges Excessive restructuring write-offs that overstate estimated charges for future expenditures Miscellaneous reserves for bad debts, loan losses etc. Reserve too much in good times and cut back on estimated charges, or even reverse previous charges, in bad times. A convenient income smoothing device. Intentional bias in estimates Premature or aggressive revenue recognition 5

6 Accounting errors and restatements Accounting errors and irregularities can occur for several reasons: Unintentional misapplication of GAAP, especially where judgment is required Intentional attempts to exploit the flexibility in GAAP Outright financial fraud Parties charged with discovering accounting errors and irregularities The company s internal audit staff and audit committee External auditors Authorities like FIVA or SEC 6

7 Accounting errors and restatements Once discovered, accounting errors and irregularities must be corrected and disclosed Errors are corrected by restating financial reports from prior periods afterwards Accounting restatements raise concerns on the over-all quality of financial statement information Obviously, investors dislike restatements 7

8 Example: Share price reaction to announced restatements 8

9 How to manage earnings via accruals? Consider the following simplified example: Cash flow from operations Less: Depreciations and amortizations -50 Add: Increase in accounts receivable +40 Add: Increase in inventory +100 Add: Decrease in accounts payable Earnings, as per income statement Change in working capital Total accruals

10 Example: Kone Corporation, 2013 Annual Report EBIT Accruals Note: Cash flow from operations is smaller than Operating income, that is, accruals reduce Operating income. 10

11 How to manage earnings via accruals? Reported earnings = Cash flow from operations ± Net accruals The iron law of accruals Accruals reverse in subsequent periods Net accruals can be decomposed into Discretionary accruals (earnings management) Non-discretionary accruals (reflects the growth and capital intensity of the firm) The key issue is: how to measure the non-discretionary part of accruals? 11

12 How to measure earnings management? Jones model (1991) Isolates the non-discretionary component of accruals: TA = α + β 1 REV + β 2 PPE + ε, where TA = Total accruals, REV = Change in sales, PPE = Fixed assets Residual ε is the measure of discretionary accruals Part of accruals that is NOT RELATED to the growth and capital intensity of the firm 12

13 Motives for earnings management: the bad side Management may use earnings management to avoid Negative stock price reaction that follows, if investors expectations are not met Reputational damage Negative concequences on executive compensation Management can achieve these goals by Avoiding reporting losses Meeting or beating analysts earnings forecasts Taking actions that influence the reported earnings 13

14 Motives for earnings management: the good side Managers may use earnings management as a vehicle for the communication of management s inside information to investors In this case, earnings management is useful from a financial reporting perspective Good earnings management occurs when Management knows that the long-term earnings prospects of the firm are better than the current non-managed earnings would imply Managament wants to improve the predictability of earnings by reporting a stream of smooth and growing earnings over time 14

15 Theory in practice: survey results A survey by Dichev, Graham, Harvey and Rajgopal (2013), Earnings Quality: Evidence from the Field Journal of Accounting and Economics (2013) A survey of 169 CFOs In-depth interviews of 12 CFOs and 2 standard setters US firms Topics addressed What drives earnings quality? How often are earnings intentionally misrepresented? What is the magnitude of the misrepresentation? Why misrepresent earnings? 15

16 Factors that Influence Earnings Quality 16

17 Misrepresentation of earnings 17

18 Misrepresent up or down? 18

19 Why misrepresent information? 19

20 Research evidence: Accruals anomaly Earnings contain cash-flow and accruals components Cash-flow component reflects the true firm performance Accruals component reflects the earnings management Implication for predicting future earnings Earnings are less likely persist in the future, if it is attributable primarily to the accrual components of current earnings Investors fixate on reported earnings and fail to recognize the higher/lower earnings persistence attributable to the cash-flow/accruals component of earnings Sloan (1996) reported this anomaly for the first time 20

21 Dechow et al. (2014), Accruals and other accounting anomalies Notes: The cumulative hedge portfolio returns to the accrual anomaly, BTM anomaly, and PEAD anomaly show the extent to which these trading strategies have generated returns over time. The accrual anomaly strategy 21 is implemented by buying the decile of firms with the lowest accruals and shorting the decile of firms with the greatest accruals.

22 Summary GAAP gives room for managerial discretion in financial reporting Earnings can be managed by using working capital accruals and other devices Research evidence shows that investors do not always recognize that earnings may be achieved by using accruals 22