|
Quality of Earnings and Accounting Practices
Many firms will make accounting choices that present their financial statements in the
best possible light. The different choices that firms can make give rise to the comparabil-
ity problems we have discussed. As a result, earnings statements for different companies
may be more or less rosy presentations of true economic earnings—sustainable cash flow
that can be paid to shareholders without impairing the firm’s productive capacity. Analysts
commonly evaluate the quality of earnings reported by a firm. This concept refers to the
realism and conservatism of the earnings number, in other words, the extent to which we
might expect the reported level of earnings to be sustained.
Examples of the types of factors that influence quality of earnings are:
•
Allowance for bad debt. Most firms sell goods using trade credit and must make
an allowance for bad debt. An unrealistically low allowance reduces the quality of
reported earnings.
•
Nonrecurring items. Some items that affect earnings should not be expected to
recur regularly. These include asset sales, effects of accounting changes, effects of
exchange rate movements, or unusual investment income. For example, in years
with large stock market returns, some firms enjoy large capital gains on securities
held. These contribute to that year’s earnings, but should not be expected to repeat
regularly. They would be considered a “low-quality” component of earnings.
Similarly, investment gains in corporate pension plans generated large but one-off
contributions to reported earnings.
•
Earnings smoothing. In 2003, Freddie Mac was the subject of an accounting
scandal, when it emerged that it had improperly reclassified mortgages held in
its portfolio in an attempt to reduce its current earnings. Why would it take such
actions? Because later, if earnings turned down, Freddie could “release” earnings
by reversing these transactions, and thereby create the appearance of steady
earnings growth. Indeed, almost until its sudden collapse in 2008, Freddie Mac’s
nickname on Wall Street was “Steady Freddie.” Similarly, in the four quarters
ending in October 2012, the four largest U.S. banks released $18.2 billion in
reserves, which accounted for nearly one-quarter of their pretax income.
7
Such
“earnings” are clearly not sustainable over the long-term and therefore must be
considered low quality.
•
Revenue recognition. Under GAAP accounting, a firm is allowed to recognize a
sale before it is paid. This is why firms have accounts receivable. But sometimes
it can be hard to know when to recognize sales. For example, suppose a
computer firm signs a contract to provide products and services over a 5-year
period. Should the projected revenue be booked immediately or spread out over
5 years? A more extreme version of this problem is called “channel stuffing,”
7
Michael Rapoport, “Bank Profit Spigot to Draw Scrutiny,” The Wall Street Journal, October 11, 2012.
bod61671_ch19_635-677.indd 662
bod61671_ch19_635-677.indd 662
7/17/13 4:13 PM
7/17/13 4:13 PM
Final PDF to printer
C H A P T E R
1 9
Financial
Statement
Analysis
663
in which firms “sell” large quantities of goods to customers, but give them the
right to later either refuse delivery or return the product. The revenue from the
“sale” is booked now, but the likely returns are not recognized until they occur
(in a future accounting period). Hewlett-Packard argued in 2012 that it was led
to overpay for its acquisition of Autonomy Corp. when Autonomy artificially
enhanced its financial performance using channel stuffing. For example,
Autonomy apparently sold software valued at over £4 billion to Tikit Group; it
booked the entire deal as revenue but would not be paid until Tikit actually sold
software to its clients.
8
Thus, several years’ worth of only tentative future sales
was recognized in 2010.
If you see accounts receivable increasing far faster than sales, or becoming a
larger percentage of total assets, beware of these practices. Given the wide latitude
firms have in how they recognize revenue, many analysts choose instead to concen-
trate on cash flow, which is far harder for a company to manipulate.
•
Off-balance-sheet assets and liabilities. Suppose that one firm guarantees the
outstanding debt of another firm, perhaps a firm in which it has an ownership
stake. That obligation ought to be disclosed as a contingent liability, because it
may require payments down the road. But these obligations may not be reported
as part of the firm’s outstanding debt. Similarly, leasing may be used to manage
off-balance-sheet assets and liabilities. Airlines, for example, may show no
aircraft on their balance sheets but have long-term leases that are virtually
equivalent to debt-financed ownership. However, if the leases are treated as
operating rather than capital leases, they may appear only as footnotes to the
financial statements.
Do'stlaringiz bilan baham: | 
