Financial Statement Analysis and Security Valuation Stephen H. Penman

1. Financial Statement Analysisand Security ValuationStephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

2. The Quality of the Current Accounting Chapter 18

3. Chapter 18 Page 595 What you will learn in this chapter • Five questions to ask about the accounting qualityof a financial report • How to carry out an accounting quality analysis • The devices management can use to manipulate earnings • How to detect manipulated earnings • How an accounting quality analysis is combined with financial statement analysis and a red-flag analysis to discover the quality of earnings • How quality analysis is incorporated into forecasting Accounting quality analysis establishes the integrity of the accounting to be used in forecasting

4. Chapter 18 Pages 596-597 Five Questions AboutAccounting Quality • GAAP quality: is GAAP accounting deficient? • Audit quality: is the firm violating GAAP or committing outright fraud? • GAAP application quality: is the firm using GAAP accounting to manipulate reports? • Business timing quality: is the firm manipulating business to accommodate the accounting? Revenue timing Expenditure timing • Disclosure quality: are disclosures adequate to analyze the business? Disclosures that distinguish operating items from a financial items in the statements Disclosures that distinguish core operating profitability from unusual items Disclosures about the accounting used

5. Focus on the Quality of Earnings For valuation, the analyst forecasts future (residual) earnings using the current (residual) earnings as an indicator. So current (residual) earnings is of good quality if it is a good indicator of future earnings.

6. Chapter 18 Page 599 Figure 18-1 Accounting Quality Analysisis One Component of aQuality of Earnings Analysis • Quality of Earnings Analysis:

7. Chapter 18 Page 600 Detection of Low Quality Accounting: The Perspective • For valuation, the analyst wants to forecast future RNOA • If there is manipulation, current RNOA cannot be maintained in the future • RNOA0=OI0/NOA-1 and manipulation involves adjusting current operating income, OI0 • But OI=Free Cash Flow + DNOA • So a change in OI0 must also change NOA-1 by the same amount • So future RNOAt+1=OIt+1/NOAt must be reduced: • Denominator effect • Numerator effect

8. Chapter 18 Page 601 Two Directions for Manipulation • Borrowing income from the future • Increase in current revenue • Decrease in current expenses • Banking income for the future • Decrease current revenue • Increase current expenses Distinguish: • Conservative Accounting vs. • Liberal Accounting • Aggressive Accounting vs. • Big Bath Accounting Both increase current NOA Both reduce current NOA A matter of Accounting Policy A matter of short-term application of accounting that will reverse

9. Chapter 18 Page 602 Prelude to a Quality Analysis • Understand the business • Understand the accounting policy • Understand the business areas where accounting quality is most doubtful • Understand situations in which management are particularly tempted to manipulate

10. IndustryFlash Point • Banking Credit losses: quality of loan loss provisions • Computer hardware Technological change: quality of receivables and inventory • Computer software Market ability of products: quality of capitalized research and development • Retailing Credit losses: quality of net accounts receivable • Inventory obsolescence: quality of carrying values of inventory • Rebate programs: quantity of sales and estimated liabilities • Manufacturing Warranties: quality of warranty liabilities • Product liability: quality of estimated liabilities • Automobiles Overcapacity: quality of depreciation allowances • Telecommunications Technological change: quality of depreciation allowances • Equipment leasing Lease values: quality of carrying values for leases • Tobacco Liabilities for health effects of smoking: quality of estimated liabilities • Drugs R&D: quality of R&D expenditures • Product liability: quality of estimated liabilities • Airlines Frequent flier programs: estimated liabilities for travel awards • Real estate Property values: quality of carrying values for real property • Aircraft and ship Revenue recognition: quality of estimates under percentage of • manufacturing completion method and “program accounting” • Subscriber services Development of customer base: quality of capitalized promotion costs • Subscriptions paid in advance: quality of deferred revenue Flash Points: Accounting Areas where Manipulation is More Likely Chapter 18 Page 603 Box 18.1

11. Chapter 18 Page 604 Box 18.2 Flash Points: Institutional Situations WhereManipulation is More Likely • The firm is in the process of raising capital or renegotiating borrowing. Watch public offerings • Debt covenants are likely to be violated • A management change • An auditor change • Management rewards (like bonuses) are tied to earnings • A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all • Regulatory ratio requirements (like capital ratios for banks and insurance companies) are likely to be violated • Transactions are with related parties rather than at arm's length • Special events such as union negotiations and proxy fights • The firm is "in play" as a takeover target

12. Chapter 18 Page 604 Box 18.2 Flash Points: FinancialStatement Indicators that Manipulation is More Likely • A change in accounting principles or estimates • An earnings surprise • A drop in profitability after a period of good profitability • Constant sales or falling sales • Earnings growing faster than sales • Small or zero increases in profit margins (that might be a decrease without manipulation) • Small profits (that might be losses without manipulation) • Differences in expenses for tax reporting and financial reporting • Financial reports are used for other purposes, like tax reporting and union negotiations. • Accounting adjustments in the last quarter of the year

13. Chapter 18 Page 604 Table 18-1 IPOs and Manipulation

14. Chapter 18 Pages 606-607 Diagnostics to DetectManipulated Sales Net Sales = Cash from Sales + change in Net Accounts Receivable Diagnostic: Net Sales/ Cash from Sales Diagnostic: Net Sales/Net Accounts Receivable Diagnostic: Bad Debt Expense/Actual Credit Losses Diagnostic: Bad Debt Reserves/Accounts Receivable (Gross) Diagnostic: Bad Debt Expense/Sales Diagnostic: Sales Return Expense/Actual Sales Returns Diagnostic: Sales Return Reserves/Accounts Receivable (Gross) Diagnostic: Sales Return Expense/Sales Diagnostic: Warranty Expense/Actual Warranty Claims Diagnostic: Warranty Liabilities/Accounts Receivable (Gross) Diagnostic: Warranty Expense/Sales

15. Chapter 18 Page 606 Diagnostics to DetectManipulated Expenses • Investigate Changes in NOA with Normalized ATO OI = Free Cash Flow + D NOA “Hard” “Soft” So, D NOA is to be investigated: D NOA = Cash investment + new operating accruals “Hard” “Soft” Diagnostic: Restated OI/OI Restated OI = Free Cash Flow + D Sales/Normal ATO This works if Sales are not manipulated

16. Chapter 18 Page 609 Table 18-2 Diagnostics to DetectManipulated Expenses • Investigate Changes in ATO

17. Chapter 18 Pages 609-612 Diagnostics to DetectManipulated Expenses Investigate Line Items Directly • Challenge depreciation and amortization expense Diagnostic: Adjusted EBITDA=OI (before tax) + Depreciation Amortization – Normal Capital Expense Normal capital expense is approximated by the average capital expenditure over past years or normal depreciation and amortization for the level of sales, calculated from past (Depreciation + Amortization) / Sales ratios • Challenge depreciation and amortization and working capital accruals Diagnostic: CFO/OI Diagnostic: CFO/Average NOA Diagnostic: Accrual/D Sales • Challenge other components of expense that depends on estimates Diagnostic: Pension Expense/OI Diagnostic: Other Post-Employment Exp./SG&A Exp. Diagnostic: Operating Tax Expense/OI before Taxes

18. Chapter 18 Pages 613-614 Diagnostics to DetectManipulated Expenses Investigate Balance Sheet Line Items Directly • Particular suspects: • Assets whose carrying values are above their market values: these are likely impairment candidates • Assets whose carrying values and amortization rates are subject to estimate: intangible assets, goodwill, deferred tax assets (particularly their valuation allowances), non-typical capitalization of expenses such as start-up costs, advertising and promotion, product development, and software development costs • Estimated liabilities such as pension liabilities, other employment liabilities, warranties, deferred tax liabilities, deferred revenue, and estimated merger and restructuring costs • Off-balance-sheet liabilities such as guarantees, recourse for assigned receivables or debt, purchase commitments, and contingent liabilities for lawsuits and regulatory penalties • Environmental liabilities (for clean up of pollution)

19. Chapter 18 Page 613 Box 18.5 Use the Cash Flow Statement to Detect Abnormal Accruals Are the accruals in the cash from operations section justified by the sales for the period? • Compare changes in net accounts receivable with changes in sales for sales quality diagnostics • Compare changes in unearned revenue and warranty liabilities with changes in sales for sales quality diagnostics • Use the depreciation and amortization number for the adjusted EBITDA and depreciation diagnostics • Compare changes in prepaid expenses with changes in sales • Compare changes in accrued expenses with changes in sales • Use the deferred tax number for deferred tax diagnostics • Track restructuring charges and their reversals

20. Chapter 18 Page 616 Detecting Transaction Timing • Core Revenue Timing (Channel Stuffing) • Unexpected sales increases or decreases in the final quarter • Structuring of lease transactions to qualify as sales-type leases in lessors’ books • Core Expense Timing Diagnostic: R&D Expense/Sales Diagnostic: Advertising Expense/Sales Watch for temporary liquidation of hidden reserves for firms using conservative accounting (eg. LIFO dipping)

21. Chapter 18 Page 618 Detecting Organizational Manipulation • Off-Balance-Sheet Operations • R&D Partnerships • Pension Funds

22. Chapter 18 Page 619 Frustrations withDisclosure Quality • Consolidation accounting often makes the source of profitability hard to discover • Line of business and geographical segment reporting is often not detailed enough • Earnings in unconsolidated subsidiaries are hard to analyze. (Think of a firm that has all its earnings in subsidiaries in which it has less than 50% ownership: core profit margins are not transparent!) • Disclosure to reconcile free cash flow in the cash flow statement to free cash flow calculated (as OI - NOA) from the income statement and balance sheet. Some of the problems arise from uncertainty about items to be included in OI and NOA • Disclosures to calculate stock compensation expense are thin • Information is often not available to calculate losses on conversion of convertible claims into common equity • Details on selling, general and administrative expenses are often scarce

23. Chapter 18 Page 620 Figure 18.3 Abnormal Returns to Quality Analysis Source: R. Sloan, "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?" Accounting Review 71 (1996), p. 312.

24. Behavior of Earnings with High or Low Accrual Components Chapter 18 Page 621 Figure 18.4 Source: R. Sloan, "Do Stock Prices Fully Reflected Information in Accruals and Cash Flows About Future Earnings?" p. 301.