Evaluating Earnings Quality, Part 2
What you'll learn
- LOS 11.gExplain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion.
- LOS 11.hEvaluate the earnings quality of a company.
When examining net income, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is known as mean reversion. (Mean reversion can be explained with basic principles of economics: the competitive marketplace corrects poor performance; thus, losses are eliminated as firms abandon negative value projects.
Conversely, capital is attracted to successful projects thereby increasing competition and lowering returns.)
Because of mean reversion, analysts should not expect extreme earnings (high or low) to continue indefinitely. When earnings are largely comprised of accruals, mean reversion will occur faster, and even more so when the accruals are largely discretionary.
Accounting systems require many estimates and rely on many subjective choices. These estimates and choices can be misused by managers to present misleading performance.
Two major contributors to earnings manipulation are:
1. Revenue recognition issues, and
2. Expense recognition issues (capitalization).
Revenue Recognition Issues
Revenue is the largest and most important element in the income statement. Subjectivity in revenue recognition practices makes revenue highly vulnerable to manipulation and therefore should be scrutinized by analysts. Analysts should not only concern themselves with quantity of revenue, but also with the quality of revenues (i.e., how those revenues were generated).
Revenues generated via deliberate channel stuffing or as a result of bill and hold arrangements should be considered spurious and inferior. Even (relatively) genuine revenues, when secured via the use of heavy discounting practices, come at the expense of deteriorating margins. 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.
Daniel Springs, Inc., (DSI) produces heavy duty automotive components. Financial results for DSI, as well as industry comparables, are shown in the following:
DSI selected financial data ($ 000s):
| 20X1 | 20X2 | 20X3 | |
|---|---|---|---|
| Sales | $12,117 | $13,112 | $14,766 |
| Accounts receivable | $1,272 | $1,573 | $2,363 |
Industry average:
| 20X1 | 20X2 | 20X3 | |
|---|---|---|---|
| DSO | 22.6 | 22.8 | 22.4 |
| Receivables turnover | 16.2 | 16.0 | 16.3 |
1. Compute DSI’s increase in revenue and receivables from 20x1 to 20x2 and from 20x2 to 20x3. Compare the change in revenues to the change in receivables.
2. Using end of year accounts receivables, comment on the trend in days’ sales outstanding (DSO) and receivables turnover for DSI and compare it to the industry average.
3. Comment on possible revenue recognition issues at DSI.
Solution
1. DSI’s revenues increased at a slower rate compared to the growth rate in receivables indicating potential problems with collections and low quality of receivables.
| 20X1 | 20X2 | 20X3 | |
|---|---|---|---|
| Change in sales | Not applicable | 8.2% | 12.6% |
| Change in receivables | Not applicable | 23.7% | 50.2% |
2. DSI’s days’ sales outstanding is increasing over time and is significantly higher than the industry average. The receivables turnover ratio for DSI is declining over time and is lower than industry average. Finally, the change in receivables as a proportion of revenues is positive and is increasing over time.
Sample calculations:
3. Based on all indicators, it appears that revenues at DSI are potentially of inferior quality. Analysts should be extremely skeptical about earnings quality of DSI.
Steps in the analysis of revenue recognition practices:
Step 1: Understand the basics. From the information disclosed, understand the revenue recognition practices followed by the company including relevant shipping terms, return policies, rebates, and the existence of multiple deliverables.
Step 2: Evaluate and question ageing receivables. Compare receivables metrics with those from the past and with the industry median.
Step 3: Cash versus accruals. Evaluate the proportion of earnings that are cash based versus accruals based.
Step 4: Compare financials with physical data provided by the company. For example, correlate sales with capacity utilization data.
Step 5: Evaluate revenue trends and compare with peers. Narrow down such analysis by segments.
Step 6: Check for related party transactions. For example, a company might artificially boost fourth quarter revenues by recognizing a large sale to an affiliated entity.
Expense Capitalization
One way to boost reported performance is to under report an operating expense by capitalizing it. Capitalizing an expense does however show up on the balance sheet as an asset and an analyst should be wary of unsupported changes in major asset categories. When the proportion of PP&E increases over time in common size balance sheets, analysts should question whether there is a systematic capitalization of expenses underway.
Steps in the analysis of expense recognition practices:
Step 1: Understand the basics. Understand the company’s cost capitalization policies based on information disclosed in the annual report. Also gather information about depreciation policies and how they compare with those of the company’s peers.
Step 2: Trend and comparative (peer) analysis. Evaluate changes in non current assets over time to see if there are any anomalies which could be explained by cost capitalization. Stable or improving profit margins coupled with a buildup of noncurrent assets would be a warning sign. Steady or rising revenue coupled with declining asset turnover ratios is another warning sign of cost capitalization.
Compare depreciation expense as a proportion of asset size over time and with peers. Finally compare capital expenditures to gross PP&E over time and with peers. Rising capital expenditures as a percentage of PP&E is another warning sign of cost capitalization.
Step 3: Check for related party transactions. An example of a problematic transaction would be if the company is shifting resources to a privately held company that is owned by senior managers. On the other hand, analysts should also watch for propping practices whereby profits from related entities temporarily prop up an ailing public company. (Managers might prop up a public company to preserve the option of misappropriating funds in the future.)