Understanding Earnings Quality. Patricia M. Dechow

Transcription

1 Understanding Earnings Quality Patricia M. Dechow

2 Defining Earnings Quality HIGH QUALITY EARNINGS Reflect the economics of the business Are sustainable (are a good indicator for the future) LOW QUALITY EARNINGS Do not reflect the economics of the business Have been manipulated/contain errors Are not sustainable (are a poor indicator for the future) Understanding the factors that cause earnings quality to differ is a key research area in accounting. Important for investing, auditing, SEC in monitoring and regulating, banks providing loans, etc.

3 Operationalizing Earnings Quality Concept of earnings persistence Earnings t+1 = α + βearnings t + ε β closer to 1 => earnings are more sustainable

4 Factors that Affect Earnings Quality Underlying Economics Industry Structure Earnings Quality Firm Structure and Investment Opportunities Stage of Life Cycle

5 Earnings Quality 1 Chris starts a business Cup and straw= 0.05 Lemon = 0.15 Sugar = 0.10 Total = 0.30

6 Earnings Quality 1 I will pay you $1.00 for that delicious cup of lemonade Cup and straw= 0.05 Lemons = 0.15 Sugar = 0.10 Total = 0.30

7 Earnings Quality I will pay you $1.00 for that delicious cup of lemonade That s perfect (my precious)! Cup and straw= 0.05 Lemons = 0.15 Sugar = 0.10 Total = 0.30

8 Chris earnings Revenue: Earnings Quality 1 Cup of Lemonade= $1.00 Expenses: Costs of goods sold = Earnings = 0.70 Cup and straw= 0.05 Lemons = 0.15 Sugar = 0.10 Total = 0.30

9 Earnings Quality Milli starts a business Cups and straws= 1.00 Lemons = 1.00 Box of sugar = 2.00 Total Costs = 4.00

10 Earnings Quality I will pay you $1.00 for that lemon sugar drink Cup and straws= 1.00 Lemons = 1.00 Box of sugar = 2.00 Total = 4.00

11 Earnings Quality I will pay you $1.00 for that lemon sugar drink TOMORROW Cup and straws= 1.00 Lemons = 1.00 Box of sugar = 2.00 Total = 4.00

12 Earnings Quality I will pay you $1.00 for that lemon sugar drink IT S A DEAL! TOMORROW Cup and straws= 1.00 Lemons = 1.00 Box of sugar = 2.00 Total = 4.00

13 Milli s Earnings (on a cash basis) Revenue: = 0 Expenses: = $ Cash earnings = Earnings Quality 2 Cup and straws= 1.00 Lemons = 1.00 Box of sugar = 2.00 Total = 4.00

14 Comparison of CASH FLOWS Chris Milli s Earnings = cash flows + accruals 0.70 = Earnings = cash flows + accruals 0.70 = $ $4.70 Similar transaction occurred but cash-based performance looks very different

15 Accrual Accounting THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT Focus on underlying economics

16 Earnings Quality Milli s Earnings: (Accrual basis) Revenue: Cup of Lemonade= $1.00 Expenses: Costs of good sold = 0.30 Earnings = 0.70 Cup and straws= Lemons = Box of sugar = Inventory = 4.00 SOLD = 0.30 Inventory = 3.70

17 Comparison of ACCRUAL EARNINGS Chris Milli s EARNINGS+ accruals 0.70 = Earnings = EARNINGS + accruals 0.70 = $ $4.70 Earnings on accrual basis makes businesses comparable

18 Reconciling Earnings to Cash Flows Chris Milli s Earnings = cash flows + accruals 0.70 = Earnings = cash flows + accruals 0.70 = $ $4.70 Earnings are the same even ACCRUALS though = cash flows are very different $

19 Quality Issues with Milli s accruals I will pay you $1.00 for that cup of lemonade TOMORROW 1.00 Accounts Receivable Sold Lemonade! Timely useful information Gandalf may disappear

20 Milli s accruals Inventory High inventory: Milli anticipates future sales! Obsolete inventory Nobody wants to buy lemonade

21 Comparison of Business Models Chris Milli s Has Cash!! Simple business Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong ACCRUALS = cash 1.00

22 Comparison of Earnings Quality Chris Milli s Earnings = cash flows + accruals 0.70 = Earnings = cash flows + accruals 0.70 = $ $4.70 ACCRUALS CAN BE FUZZY AND CONTAIN ERRORS CHRIS EARNINGS ARE HIGHER QUALITY THAN MILLI S ACCRUALS = cash 1.00

23 Operationalizing Earnings Quality Empirical evidence earnings persistence Earnings t+1 = α + βearnings t + ε Chris Milli s β > β

24 Operationalizing Earnings Quality Concept of earnings persistence Earnings t+1 = α + β 1 Cash flows t + β 2 Accruals t + ε β 1 > β 2

25 Understanding Earnings Quality EARNINGS = CASH FLOWS + ACCRUALS Earnings Quality research tries to disentangle Good Accruals that correctly reflect the business Bad Accruals that reflect errors, manipulation, and overinvestment

26 Factors that Affect Earnings Quality Underlying Economics Industry Structure Firm Structure and Investment Opportunities Earnings Quality Accrual Accounting System FASB/IFRS RULES Management Application of Rules Stage of Life Cycle Internal Controls Audit Quality Governance

27 FASB/IFRS RULES Philosophical Question: What is objective of accrual accounting?

28 FASB/IFRS RULES Philosophical Question: What is objective of accrual accounting? 1. Economic perspective: Investors care about firm value. The objective is to measure the value of assets and liabilities. 2. Performance evaluation Investors want to know what management did this period. The objective is to measure how much income was generated this period.

29 Economic Perspective Assets t Liabilities t = Shareholders Equity t Measure the value

30 Economic Perspective Assets t Liabilities t = Shareholders Equity t Measure the value Assets t+1 Liabilities t+1 = Shareholders Equity t+1 Measure the value

31 Economic Perspective Assets t Liabilities t = Shareholders Equity t Measure the value Value = Income Assets t+1 Liabilities t+1 = Shareholders Equity t+1 Measure the value

32 Economic Perspective Assets t Liabilities t = Shareholders Equity t Measure the value Value = Income Assets t+1 Liabilities t+1 = Shareholders Equity t+1 Measure the value Market Values Follow a Random Walk

33 Economic Perspective Assets t Liabilities t = Shareholders Equity t Measure the value Value = are transitory and unpredictable Assets t+1 Liabilities t+1 = Shareholders Equity t+1 Measure the value Market Values Follow a Random Walk

34 Operationalizing Earnings Quality Concept of earnings persistence Earnings t+1 = α + βearnings t + ε β = 0 Economic or Balance Sheet Perspective

35 Accounting Rules and Standards Balance Sheet Perspective Goodwill: Fair value no amortization Marketable securities: Fair Value Impairments of assets: Fair Value Capital Leases: Fair Value Deferred Revenue (Fair Value of Component) Debt Fair Value Securitization Fair value Inventory lower of market or cost

36 Accounting Rules and Standards Balance Sheet Perspective Goodwill: Fair value no amortization Marketable securities: Fair Value Impairments of assets: Fair Value Capital Leases: Fair Value Deferred Revenue (Fair Value of Component) Debt Fair Value Securitization Fair value Inventory lower of market or cost Transitory gains and losses muddies up earnings

37 FASB/IFRS RULES Philosophical Question: What is objective of accrual accounting? 1. Economic perspective: Investors care about firm value. The objective is to measure the value of assets and liabilities. 2. Performance evaluation (Income Statement perspective): Investors want to know what management did this period. The objective is to measure how much income was generated this period.

38 Performance Evaluation INCOME measures how much sustainable cash flows the managers generated Cash flows t-2 Cash flows t-1 Cash flows t+1 Cash flows t+2 CASH FLOWS t

39 Performance Evaluation INCOME measures how much sustainable cash flows the managers generated INCOME t Cash flows t-2 Cash flows t-1 Cash flows t+1 Cash flows t+2 CASH FLOWS t

40 Performance Evaluation INCOME measures how much sustainable cash flows the managers generated Cash Sales INCOME t Cash flows t-2 Cash Cash flows Expenses t-1 Cash flows t+1 Cash flows t+2 CASH FLOWS t

41 Performance Evaluation INCOME measures how much sustainable cash flows the managers generated Credit Sales Cash Sales INCOME t Cash flows t-2 Cash Cash flows Expenses t-1 Cash flows t+1 Cash flows t+2 CASH FLOWS t

42 Performance Evaluation INCOME measures how much sustainable cash flows the managers generated Cost of good sold Credit Sales Cash Sales INCOME t Cash flows t-2 Cash Cash flows Expenses t-1 Cash flows t+1 Cash flows t+2 CASH FLOWS t

43 Performance Evaluation INCOME measures how much sustainable cash flows the managers generated Cost of good sold Credit Sales INCOME t INCOME t+2 Cash Sales Cash flows t-2 Cash Cash flows Expenses t-1 Cash flows t+1 Cash flows t+2 CASH FLOWS t Deferred Revenues

44 Performance Evaluation INCOME measures how much sustainable cash flows the managers generated Cost of good sold Credit Sales INCOME t-1 INCOME t INCOME t+2 Cash Sales Cash flows t-2 Cash Cash flows Expenses t-1 Cash flows t+1 Cash flows t+2 Cash from previous credit Sales CASH FLOWS t Deferred Revenues

45 Performance Evaluation Accruals alter the timing of cash flow recognition in earnings To be identify firm performance INCOME t Cash flows t-2 Cash flows t-1 Cash flows t+1 Cash flows t+2 CASH FLOWS t

46 Performance Evaluation More Timely and Relevant INCOME t Cash flows t-2 Cash flows t-1 Cash flows t+1 Cash flows t+2 Assets = Spent cash in past DR: (capitalized cost) Liabilities = Received cash in past CR: (Deferred Revenue) CASH FLOWS t Assets = Receive cash in future DR: (Accounts Receivable) Liabilities = Spend cash in future CR: (Accounts payable) Balance Sheet s Role Keeps track of the cash allocation and reversals

47 Operationalizing Earnings Quality Concept of earnings persistence Earnings t+1 = α + βearnings t + ε Income Statement Perspective β => 1

48 FASB/IFRS RULES Income Statement Perspective Revenue Recognition: Does not allow the anticipation of future sales Cost of Goods Sold: match to revenue Depreciation: allocate over time Operating Leases: as paid Software: Capitalize when technological feasibility Deferred Revenue allocate over time

49 FASB/IFRS RULES Income Statement Perspective Mix of both Balance Sheet Perspective Revenue Recognition: Does not Goodwill: allow the Fair anticipation value no of amortization future sales Cost of Goods Sold: match to revenue Marketable securities: Fair Value Depreciation: allocate over timeimpairments of assets: Fair Value Operating Leases: as paid Capital Leases: Fair Value Software: Capitalize when technological Deferred feasibility Revenue (new rules) Deferred Revenue allocate over Impaired time Debt Fair Value Securitization Fair value

50 FASB/IFRS RULES Income Statement Perspective Mix of both Balance Sheet Perspective Revenue Recognition: Does not Goodwill: allow the Fair anticipation value no of amortization future sales Cost of Goods Sold: match to revenue Marketable securities: Fair Value Depreciation: allocate over timeimpairments of assets: Fair Value Operating Leases: as paid Capital Leases: Fair Value Software: Capitalize when technological Deferred feasibility Revenue (new rules) Deferred Revenue allocate over Impaired time Debt Fair Value Securitization Fair value Historical Costs on Balance sheet Transitory gains and losses go through income

51 Accounting Rules and Standards Income Statement Perspective Mix up both Balance Sheet Perspective Goodwill: Fair value Revenue Recognition: CONSERVATISM Marketable securities: Fair Value Cost of Goods Sold: matching Impairments of assets: Fair Value Depreciation: allocate over time Capital Leases: Fair Value Operating Leases: as paid Deferred Revenue (new rules) Software: Technological feasibility Impaired Debt Fair Value Deferred Revenue (old rules) Securitization Fair value Historical Costs on Balance sheet Transitory gains and losses go through income

52 Accounting Rules and Standards Income Statement Perspective Mix up both Balance Sheet Perspective Goodwill: Fair value Revenue Recognition: CONSERVATISM Marketable securities: Fair Value Cost of Goods Sold: matching Impairments of assets: Fair Value Depreciation: allocate over Use time CASH BASIS Capital Leases: Fair Value Operating Leases: as paid Expense R&D Deferred Revenue (new rules) Software: Technological Expense feasibility start up Impaired costs Debt Fair Value Deferred Revenue (old rules) Expense SG&A Securitization Fair value Historical Costs on Balance sheet Transitory gains and losses go through income

53 Accounting Rules and Standards Income Statement Perspective Mix up both Balance Sheet Perspective Goodwill: Fair value Revenue Recognition: CONSERVATISM Marketable securities: Fair Value Cost of Goods Sold: matching Impairments of assets: Fair Value Depreciation: allocate over CASH time BASIS Capital Leases: Fair Value Operating Leases: as paid Expense R&D Deferred Revenue (new rules) Software: Technological Expense feasibility start up Impaired costs Debt Fair Value Deferred Revenue (old rules) Expense SG&A Securitization Fair value Use Fair Values on the downside Historical Costs on But not on the upside Transitory gains and Balance sheet losses go through income

54 ACCRUAL ACCOUNTING TENSION Income Statement Perspective Balance Sheet Perspective

55 ACCRUAL ACCOUNTING TENSION Income Statement Perspective Balance Sheet Perspective Standard Setters Fund Managers Debt holders (in firms in Financial distress) Academics

56 ACCRUAL ACCOUNTING TENSION Income Statement Perspective Management Financial Analysts Investors Media Compensation consultants Auditors Balance Sheet Perspective Standard Setters Fund Managers Debt holders (in firms in Financial distress) Academics

57 Operationalizing Earnings Quality Concept of earnings persistence Earnings t+1 = α + βearnings t + ε Income Statement Perspective β > β Balance Sheet Perspective

58 Factors that Affect Earnings Quality Underlying Economics Industry Structure Firm Structure and Investment Opportunities Earnings Quality Accrual Accounting System FASB/IFRS RULES Management Application of Rules Stage of Life Cycle Internal Controls Audit Quality Governance

59 Consequence of moving accrual accounting to a balance sheet focus Declining association of stock returns with earnings Declining matching role of accruals Declining persistence of GAAP earnings

60 Matching implies a negative correlation between Cash flows and Accruals Low accruals Low cash flows (positive correlations) High accruals Low cash flows (negative correlations) Source: Dechow and Ge (2005)

61 Ranking on Accruals Correlation between Cash flows and Accruals Low accruals Low cash flows (positive correlations) High accruals Low cash flows (negative correlations) Income statement Role Matching: Low Cash flows Accruals indicate Large investments Source: Dechow and Ge (2005)

62 Ranking on Accruals Correlation between Cash flows and Accruals Low accruals Low cash flows (positive correlations) Balance Sheet role Distressed firms Low EARNINGS Taking write-offs (low accruals that are transitory High accruals Low cash flows (negative correlations) Income statement Role Matching: Low Cash flows Accruals indicate Large investments Source: Dechow and Ge (2005)

63 Ranking on Accruals Correlation between Cash flows and Accruals Low accruals Low cash flows (positive correlations) Balance Sheet role Distressed firms Low EARNINGS Taking write-offs (low accruals that are transitory Two types of firms have low cash flows Distressed firms taking write-offs (low accruals) Growth firms investing heavily (high accruals) High accruals Low cash flows (negative correlations) Income statement Role Matching: Low Cash flows Accruals indicate Large investments Source: Dechow and Ge (2005)

64 Matching role of accruals has declined Bushman Lerman and Zhang (2016)

65 Accruals Association with Cash Flows Newer cohorts (technology) do not have a negative association between cash flows and accruals Bushman Lerman and Zhang (2016)

66 Matching role of accruals has declined Bushman Lerman and Zhang (2016)

67

68 Good News: BB still Holds! (replication of Ball and Brown 1968 ) Data Price Residual Source: Dechow, Sloan, and Zha (2014)

69 Good news: Earnings Announcements Still Informative Volume Price Residual Source: Dechow, Sloan, and Zha (2014)

70 Earnings vs. cash flows association with stock returns over time Earnings CFO FCF Source: Dechow, Sloan, and Zha (2014)

71 Earnings vs. cash flows association with stock returns over time Non-GAAP Earnings Earnings CFO FCF Source: Dechow, Sloan, and Zha (2014)

72 Market Solution Declining association of stock returns with earnings Declining matching role of accruals Declining persistence of GAAP earnings Rise of management guidance Rising use of non-gaap performance metrics Rising emphasis by management on meeting analysts non-gaap EPS expectations

73 Factors that Affect Earnings Quality Underlying Economics Industry Structure Firm Structure and Investment Opportunities Earnings Quality Accrual Accounting System FASB/IFRS RULES Management Application of Rules Stage of Life Cycle Voluntary Disclosures Guidance Non-GAAP metrics to aid in understanding EQ Internal Controls Audit Quality Governance

74 ACCRUAL ACCOUNTING TENSION Income Statement Perspective Market s Solution Balance Sheet Perspective Management Standard Setters Financial Analysts Fund Managers Investors Voluntary Debt Disclosures holders (in firms in Financial distress) Media Guidance Academics Compensation consultants Non-GAAP metrics to Auditors aid in understanding EQ

75 Is the market solution good?

76 J. Michael Pearson, (started his reign as CEO and COB in 2008) Roll-up strategy: Grow by acquiring companies with existing drugs Cut R&D, layoff workers, increase the price of patented drugs 30 Acquisitions during tenure as CEO Strategy relies on easy access to capital markets to fund acquisitions

77 J. Michael Pearson, (started his reign as CEO and COB in 2008) Valeant consistently met analysts expectations 1 Beat Beat analysts EPS forecasts (26 times of 31 Quarters) Miss Analysts forecast of EPS 2015 Beat/Miss

78 J. Michael Pearson, (started his reign as CEO and COB in 2008) Strategy works: Stock Price increases 2000 percent: Price 30 Acquisitions during tenure as CEO By 2015 Pearson had nearly $3Billion in stock and options 50 0 Price

79 J. Michael Pearson, (started his reign as CEO and COB in 2008) Valeant consistently met analysts expectations 1 Beat Beat analysts EPS forecasts (26 times of 31 Quarters) How did they consistently beat? Miss Analysts forecast of EPS 2015 Beat/Miss Reported proforma EPS or cash EPS (excludes amortization of intangible assets such as drug patents, goodwill write-offs, layoff costs, acquisition costs, etc.)

80 Valeant s Reconciliation

81 J. Michael Pearson, CEO 'Going After' Valeant for predatory pricing But then, questions started being raised about sustainability and ethics of Valeant s strategy:

82 J. Michael Pearson, CEO Price tumbled today it is $15 Valeant was not a stock that created real economic growth But, was a Darling of Wall Street Met expectations Raised financing Positive stock price momentum High institutional ownership Strong analyst following 2008

83 Do firms manipulate to consistently meet expectations? Tools: Guidance Put in more effort Take real economic actions: real earnings management Massage accruals

84 Factors that Affect Earnings Quality Underlying Economics Industry Structure Firm Structure and Investment Opportunities Stage of Life Cycle Earnings Quality Voluntary Disclosures Guidance Non-GAAP metrics to aid in understanding EQ Accrual Accounting System FASB/IFRS RULES Management Application of Rules Internal Controls Audit Quality Governance

85 Percent of Manipulating firms consistently beat analysts expectations before and during the manipulation period % of firms that beat or meet analysts Earnings forecasts 100% 90% 80% 70% 60% 50% Before manipulation period Manipulation period After manipulation period Manipulators identified by SEC All AAERs Population Source: Chu, Dechow, Hui, and Wang (2018)

86 Manipulating firms have high accruals before and during manipulation period consistent with the use of more accounting flexibility Panel A: Working capital accruals. Manipulation period 8% Before manipulation period After manipulation period 6% 4% 2% 0% -2% -4% All AAERs Population

87 Implications Earnings quality and properties of accruals have changed over time: Balance sheet focus combined with conservatism fair values on the downside Conservatism cash basis - lack of capitalizing investment costs and so no creation of accruals in technology firms Rise of non-gaap earnings to solve these problems Continuing pressure on management to guide and meet expectations

88 What can we do?

89 What can we do? I

90 Project with Chad Larson and Bob Retesuk Earnings = Cash Flows + Accruals COMPUSTAT Earnings = CFO + WC Accruals + Depreciation + (FOPO) BIG DATA PROJECT Dechow, Larson, Retesuk (2018) For each firm-year on Compustat go to SEC filings find the Statement of Cash Flows and determine what is included in FOPO

91 Messy but manageable Data Analysis (Raw Line Item Data) 188,132 FOPO lines for 67,839 firm years (2.77 lines per firm year) Nearly 40,000 unique line item descriptions Over 2,000 unique ways to describe bad debt expense provision for doubtful accounts, provision for loan losses, provision for losses on accounts receivable, provision for bad debts, bad debt expense, allowance for doubtful accounts, provision for credit losses, provision for doubtful accounts receivable, provision for uncollectible accounts, provision for losses on receivables, provision for bad debt, provision for loan and lease losses, provision for uncollectible accounts receivable, provision for allowance for doubtful accounts, provision for doubtful receivables, bad debt provision,

92 Categorize into 32 different line items

93

94 Findings so far Many unusual and infrequent items are consistently reported by firms E.g., restructuring charges, gains and losses on MS Relate to specific industries (bad debts) Persistence and consistency are different aspects of EQ

95 OBJECTIVE OF DATA BASE GIVE RESEARCHERS THE DATA TO Better understand the details of specific accruals determine their characteristics Develop improved discretionary accrual models Develop industry level models Develop new approaches to thinking of EQ Provide new insights into understanding transitory components in earnings

96 Factors that Affect Earnings Quality Underlying Economics Industry Structure Firm Structure and Investment Opportunities Stage of Life Cycle Earnings Quality Big Data Analysis Unconventional approaches Voluntary Disclosures Guidance Non-GAAP metrics to aid in understanding EQ Accrual Accounting System FASB/IFRS RULES Management Application of Rules Internal Controls Audit Quality Governance

97 Factors that Affect Earnings Quality Underlying Economics Industry Structure Firm Structure and Investment Opportunities Stage of Life Cycle Earnings Quality Big Data Analysis Unconventional approaches Voluntary Disclosures Guidance Non-GAAP metrics to aid in understanding EQ Accrual Accounting System FASB/IFRS RULES Governance Structure Management Application of Rules Attitude at the top CEO/Executive team Overconfidence, Narcistic, competitive Incentive Compensation Internal Controls Audit Quality Governance

98 Factors that Affect Earnings Quality Underlying Economics Industry Structure Firm Structure and Investment Opportunities Stage of Life Cycle Influence of outside experts: lawyers compensation consultants Influence of taxes Earnings Quality Big Data Analysis Unconventional approaches Voluntary Disclosures Guidance Non-GAAP metrics to aid in understanding EQ Accrual Accounting System FASB/IFRS RULES Governance Structure Management Application of Rules Attitude at the top CEO/Executive team Overconfidence, Narcistic, competitive Incentive Compensation Internal Controls Audit Quality Governance

99 THANK YOU!