Summary
This particular section sheds light on the measures used to assess the quality of financial reporting. The framework looks at a company's risk and success factors. The quality of the analysis depends on the inputs put into it. In addition, the quality of the measures used to assess financial reporting varies between companies, and can also be different for a single company for a period of time. Measures that are based on inventory suit retail businesses, measures that are based on depreciation suit capital intensive companies, and measures that are based on off balance sheet reporting are best suited to financial institutions. It is common for companies to hide the use of discretion during periods of growth. One very useful measure for ascertaining the quality of a company is through the sector neutralizing method. The method works by subtracting the mean or median ratio for a given sector group from a given company's ratio are very useful in finding whether a company has high or low quality financial reporting. Combining this analysis with information on how a company has changed is an effective measure of countering heterogeneity. Company's can change in a number of ways. For instance, a company can grow by acquiring another company, or become the part of a different company's portfolio. Keeping in mind such changes is necessary as it allows fair comparisons to be made. Ratio analysis should use standardized financial data so that company performance can be measured accurately. Understanding the link between primary financial statements is also necessary. For instance, problems with revenue or expenses in the income statement will have an effect on the assets side of the balance sheet. To keep matters simple, we have only included expenses and revenues.
4.1 Revenue Recognition Issues
Revenue recognition issues such as mis-stating revenue, recognizing revenue early, or classifying non operating income or gains as a result of operating activities can make a company's financial performance look better than it actually is. Below are the major types of revenue recognition issues.
4.1.1 Revenue Mis-statement
Revenue can either be overstated or understated. Understating revenue makes a company's performance look worse than what it is, while overstating revenue can make a company's performance seem better than what it is.
4.1.1.1 The Range of Problems
Although revenue accounting seems easy, it is tough to make mistakes in it. Accrual accounting sates that revenue has to be recognized when the good or service has reached the final customer. Total revenue in a fiscal year is equal to the cash collected from customers plus the increase in net accounts receivables less the increase in unearned revenue. Unearned revenue (advance received in return for the provision of a good or service) is a subject where the most mistakes are made, as companies have to do a lot of guesswork when it comes to collectables. Unearned revenue leads to the reported revenue being different to the revenue earned in cash.
4.1.1.2 Warning Signs
Issues with reported revenue can be best checked by looking at a balance sheet associated with revenue. Major changes in these accounts are a major cause for concern. Similarly, large increases in accounts receivable show are a sign of low quality revenue. Companies with earning increased due to an increase in accounts receivable have lower rates of returns.
4.1.2 Accelerating Revenue
There are also issues with when a sale is first made. Deciding which fiscal year the revenue should be recognized in is an issue.
4.1.2.1 The Range of Problems
Revenue is recognized when a good is delivered to a customer or when a service is performed. Sales people, faced with the stress of meeting internal sales targets, often move sales from one period to the current fiscal year. The process is fine as long as the revenue has been generated. However, some companies find it hard to assess the revenue generation process, and therefore end up recognizing a sales from another period in the current year. Revenue is often accelerated by companies who sell items such as computer software.
4.1.2.2 Warning Signs
Analysts should be careful about revenue reporting practices when
- Management has a portion of vested options in money
- The company is trying to meet analyst forecasts
- The company is looking to raise finance
These factors act as incentives to revenue acceleration.
Revenue acceleration warning signs are similar to the signs when revenue is overstated. Accounts receivables (credit sales increase, while credit quality goes down) change by a large amount, while unearned revenue accounts decrease( management aggressively delivers goods and services in the current fiscal year).
Microstrategy presents an example for this case. Microstrategy announced that it would restate its earnings for the year 2000. The company accelerated recognized revenue by transferring legitimate future sales orders in the current fiscal period. The process ended up increasing revenue while sending stock prices up. However, investors soon realized that the company had recognized revenue early, and corrections were made quickly.
Acceleration of revenue recognition can be found out by analyzing the revenue to cash ratio. The ratio should be stable normally. However, when there are large changes in the ratio, then there is a possibility of acceleration of revenue recognition.
4.1.3 Classification of Nonrecurring or Nonoperating Revenue as Operating Revenue
Operating income figures as considered by investors as the most informative when it comes to assessing the performance of a company.
4.1.3.1. The Range of Problems
Operating income numbers are focused on the most in capital markets. Items outside the core operating activity are not as important in assessing the long term cash flow generation capability of a company. A retail sector company might have to state everything about financial assets. However, these statements are not reflective of a company's core operating activity. The key for analysts is to separate operating activities from non operating activities. The classification of items as operating income rather than non operating income is not about net income reported under accepted accounting principles. Instead, the issue relates to the earnings number generally provided to capital markets. This is often called "earnings before bad stuff".
4.1.3.2 Warning Signs
Inconsistency with respect to included revenues and expenses can be a sign of reporting nonrecurring items into operating income.
4.2 Expense Recognition Issues
Having discussed revenue recognition issues, let's now have a look at expense recognition issues. Issues include:
- Understating expenses
- Deferring expenses
- Reporting ordinary expenses as non operating or non recurring.
4.2.1 Understating Expenses
Understating expenses can lead to income being overstated. In this section, we will consider issues in regards to costs.
4.2.1.1 The Range of Problems
In this section, we will consider selling, general and administrative expenses(SG&A), and the Cost of Goods Sold(COGS). The classical expense account includes depreciation and amortization, and is reported as part of SG&A and COGS on the income statement. Companies have to ascertain capital costs associated with noncurrent assets, and then depreciate accordingly. Depreciation itself is based on many assumptions such as the useful life on an asset.
The COGS account also includes a lot of discretion. Accrual accounting only expenses costs with inventory when it is sold. For companies with a large inventory though, this presents a challenge.
4.2.1.2 Warning Signs
Financial statements include a lot of information about depreciation and amortization. Companies should therefore be clear in the methods they use (for e.g. Straight line). Depreciation rates relative to the value of assets can be compared to the rates of other companies as well. Financial information can be provided with other information companies provide during conferences to obtain a better picture. Ford Motor Company proves as a good example of this scenario. Ford reported net income of $266 million at the end of the quarter 30 September 2004 compared to a loss of $25 million for the quarter ended 30 September 2003. The financial services arm of Ford was the reason the company had increased profitability figures. The unit reported an increase of net income from $1.031 billion for Q3,2003 to $1.425 billion for Q3,2004. Revenues fell from $6.499 billion to $6.198 billion, but depreciation decreased from $2.072 billion to $1.570 billion. The attendees of the conference were quck to pick up the figures, and noted that the positive changes in financial performance was down to lease residual value improvements. This allowed Ford to report a profit rather than a loss. The examples illustrates that financial statements alone are not proof enough for a company's performance, and that valuable data can be earned through conference calls.
Quality issues with inventory reporting can be tracked by monitoring changes in the inventory balance. Inventory buildup is a sign that a company is trying to meet consumer demand. However, in most cases, inventory builds up due to the company failing to manage its inventory properly. A days inventory outstanding ratio can be used to judge the quality of a company's inventory. The ratio is net inventory divided by cost of goods sold x 365. The ratio explains how quickly a company can turn its inventory in to revenue. Management should therefore always be asked as to why they let the inventory buildup in the first place.
4.2.2 Deferring Expenses
Apart from understating expenses, companies also shift expenses of one period to another.
4.2.1.1 The Range of Problems
One of the worst cases of accounting abuse is when costs are capitalized when they should be expensed. Since companies have a lot of discretion when it comes to the capitalization of costs, this malpractice is common.
4.2.2.2 Warning Signs
The simplest way to check errors in the capitalization of costs is to track growth in noncurrent assets. The broad measures of accruals described in Section 2 will flag companies that have experienced significant growth in their net operating assets. This growth is usually associated with lower future performance. However, not all companies that grow perform poorly in the future. Therefore, it is necessary to identify the growth rate at which a company is growing so that it can be assessed whether future performance will be lowered or not.
Example 4
Expense Recognition for an Information Service Provider
Thomson Corporation of Canada is one of the world's leading information services providers. Software providers are allowed to capitalize costs associated with software development and then amortize these costs over a period in which the product is expected to be sold. Here is Thompson's income statement for the year ended 31 December 2006:
2005/2006
Revenues: 6173/6641
Cost of sales, selling, marketing, general and administrative expenses: (4351)/ (4702)
Depreciation: (414)/ (439)
Amortization: (236)/ (242)
Operating Profit: 1172/1258
Net other income: (28)/ (1)
Net interest expense and other financing costs: (221)/(221)
Income Taxes: (261)/ (119)
Earnings from continuing operations: 662/919
Earnings from discontinued operations, net of tax: 272/201
Net Earnings: 934/1120
Dividends Declared on preference shares: (4)/(5)
Earnings attributable to common shares: 930/1115
Earnings per common share
Basic and diluted earnings per common share
Basic and diluted earnings per common share: $1.42/ $1.73
Note 1: Summary of Significant Accounting Policies
Computer Software
Capitalized Software for internal use
Certain costs incurred in connection with the development of software to be used internally are capitalized once a project has progressed beyond a conceptual, preliminary stage to that of application development. Costs which qualify for capitalization include both internal and external costs, but are limited to those that are directly related to the specific project. The capitalized amounts, net of accumulated amortization, are included in Computer Software net in the consolidated balance sheet. These costs are amortized over their useful lives, which range from three to ten years. The amortization expense is included in Depreciated in the consolidated statement of earnings.
Capitalized Software to be marketed
In connection with the development of software that is intended to be marketed to consumers, certain costs are capitalized once technological feasibility of the product is established and a market for the product has been identified. The capitalization amounts, net of accumulated amortization, are also included in Computer Software net in the consolidated balance sheet. The capitalized amounts are amortized over the expected period of benefit, not to exceed three years, and this amortization expense is included in Cost of Sales, selling, marketing, and administrative expenses in the consolidated statement of earnings.
The amortization charge for internal use computer software in 2006 was $241 million, (224 million in 2005) and is included in deprecation in the consolidated statement of earnings. The amortization charge for software intended to be marketed was $25 million ($21 million in 2005) and is included in cost of sales, selling, marketing, general and administrative expenses in the consolidated statement of earnings.
Solution to #1
The total balance for capitalized computer software increased from $568 in 2005 to $647 in 2006, a difference of $79. This is the amount by which computer software costs exceeded the amount recognized as an expense on the income statement.
Solution to #2
Operating profit would have been $1179. The effective tax rate for 2006 is 11.5%. Net income would be reduced by $79 adjusted for tax=$70, so the adjusted earnings from continuing operations =$849. Earnings from continuing operations were overstated by 8.2%.
Solution to #3
Software development costs would typically be expensed as part of research and development, or in Thompsons case as part of cost of sales. With such treatment, software development costs affect (reduce) cash flow from operating activities. By contrast, capitalized software costs are amortized to expense over time. The initial expenditure is recorded as a cash flow from investing activities. Amortization of the capitalized amount is added back to net income when calculating cash flow from operating activities. In effect, capitalizing software costs reclassifies them from an operating cash flow to an investing cash flow, and then allocates that amount to amortization expense over time.
Solution to #4
EBITDA ignores the costs related to software development by adding amortization back to operating income. Unless either the initial capitalized amount or the subsequent amortization is deducted, investors are effectively ignoring a software company's software development costs altogether in evaluating the company. As software companies must develop software in order to stay competitive, evaluating a company on the basis of EBITDA ignores a critical component of expense.
4.2.3 Classification of Ordinary Expenses as Nonrecurring or Non Operating
This issue deals with the problem of masking a decline in performance by reclassifying operating expenses.
4.2.3.1 The Range of Problems
There is an incentive for management of companies to reclassify some operating expenses as non operating. The item would normally be classified under SG&A or COGS. These items are reported separately on the income statement.
4.2.3.2 Warning Signs
One way to track this behavior is by using the ratio of Sales- COGS- SGA/ Sales. Analysts should compute year to year changes in the core operating margin and look for spikes in the incidence of negative special items for companies that have experienced an increase in this margin.
Example 5
Core Operating Margin Warning Sign
Canada based Nova chemicals manufacturers and markets plastics and chemicals. Here is the company's income statement:
2006/2005/2004
Revenue: 6519,5616,5270
Feedstock and Operating costs: 5663,4906,4378
Depreciation and Amortization: 299,290,297
Selling, general and Administrative: 201,199,274
A $15 million change was recorded related to the accrual of total expected severance costs for Chesapeake, Virginia Polystyrene Plant, which was shut down in 2006. To date, $3 million has been paid to employees.
NOVA's plant, property, and equipment balance declined from $3626 in 2005 to $2719 in 2005. Net Operating assets were $3088 in 2005 and $2349 in 2006.
Solution to #1:
Core operating margins, when calculated for NOVA were 10.0%,9.1%, and 11.1% in 2006, 2005, and 2004 respectively. When calculated using all operating items other than the restructuring change, core operating margins were 4.7%,3% and 5.2% which is directionally similar.
Solution to #2:
The balance sheet based accruals ratio is equal to the change in NOA/AVERAGE NOA. In NOVA's case, the figure is -27.2%.
Solution to #3:
Yes, the large accrual ratio suggests that a major portion of NOVA's income was due to discretionary items. The increase in core operating margin from 2005 to 2006, combined with a large special item in 2006, fits McVay's warning sign that the company may be classifying ordinary operating expenses as non operating or non recurring. This is an indication of the opportunistic use of expense classification by NOVA. Therefore, the numbers reported for NOVA should be viewed carefully and with some doubt in mind.
Example #6
The Classification of Expenses
Matsushita Electric Industrial Co., Ltd of the Panasonic fame, is one of the world's leading manufacturer of consumer , business, and other electronic products. The company also manufactures a large range of components. Below are Matsushita's income statements for the year ended 31 March.
As shown, Matsushita includes a line other deductions, which would be understood to be non operating items because it appears below items such as other income and other expenses. Without further examination, analysts may be inclined to treat this item as non operating or non recurring. However, the deductions amount to a high percentage of pre-tax income (as high as 70% in 2005) and revenue (2% in 2005). Clearly, the distinction is worth further analysis. Here are some additional notes:
4, Investments in Advances to, and Transactions with Associated Companies
During the years ended March 31 2006, 2005, the company incurred a write down of 30681 million Yen and 2883 million Yen, respectively, for other than temporary impairment of investments and advances in associated companies.
5, Investment in Securities
During the years ended 31 March 2007,2006,2005, the company incurred a write down of 939 million Yen, 458 million Yen, and 2661 million Yen, respectively, for other than temporary impairment of available for sale securities, mainly reflecting the aggravated market condition of certain industries in Japan.
7, Long Lived Assets
The company periodically reviews the recorded value of its long lived assets to determine if the future cash flows to be derived from these assets will be sufficient to recover the remaining recorded asset values.
8, Goodwill and other Intangible Assets
The Company recognized an impairment loss of 27299 million Yen during the fiscal year 2007 related to goodwill of a mobile communication subsidiary. The impairment is due to an decrease in the estimated fair value of the reporting unit caused by decreased profit expectations and the intensification of competition in a domestic market which was unforeseeable in the prior year.
The Company recognized an impairment loss of 3197 million Yen during the fiscal year 2007 related to the goodwill of JVC due primarily to profit performance in JVC's consumer electronics business being lower than the company's expectations.
The Company recognized an impairment loss of 50050 million Yen during the fiscal year 2006 related to the goodwill of a mobile communication subsidiary. This impairment is due to a decrease in the estimated fair value of the reporting unit caused by decreased profit expectation and the closure of certain businesses in Europe and Asia.
(15) Restructuring Changes
The Company has provided early retirement programs to those employees voluntarily leaving the company. The accrued early retirement programs are recognized when the employees accept the offer and the amount can be reasonably estimated. Expenses associated with the closure and integration of locations include amounts such as moving expense and facilities and costs to terminate leasing contracts incurred at domestic and overseas manufacturing plants and sales offices. An analysis of the accrued restructuring changes for the years ended 31 March 2007, 2006, and 2005, are as follows:
2007/2006/2005
Balance at the start of the year: 1335/3407/-
New Charges:19574/48975/110568
Cash Payments: (10889)/(51047)/(107161)
Balance at the end of the year:10020/1335/3407
