Earnings Analysis: Understanding Earnings Sustainability and Management, Study Guides, Projects, Research of Finance

Download Earnings Analysis: Understanding Earnings Sustainability and Management and more Study Guides, Projects, Research Finance in PDF only on Docsity! Financial Statem ent Analysis Management of Earnings Disclosure Earnings • Two key measures of the performance of a company are: – Earnings per share – Price earnings ratio • Both measure incorporate “earnings” from the Income Statement. To arrive at a suitable earnings figure to – Impairment losses on long-lived assets – Changes in estimates/accruals – Gains and losses from peripheral activities • In looking at the core “sustainable earnings” of a company the discontinued operations should be ignored. Extraordinary/Exceptional gains and losses • Those items presented as exceptional are items which, in the judgement of the company, need to be disclosed separately by virtue of their size or incidence in order to obtain a proper understanding of the financial information. • A judgement needs to be made as to the frequency. If infrequent earnings can be adjusted to exclude such amounts: Woolworths Note to the Accounts: Exceptional items Items that are material in size, unusual and infrequent in nature are presented as exceptional items in the income statement. The Directors are of the opinion that the separate recording of exceptional items provides helpful information about the Group’s underlying business performance. 7 performance of the company, or to influence contractual outcomes that depend on reported numbers.” Earnings Management OR "Creative accounting" "Window dressing" "Income smoothing" Ending up with a range of possible profits/losses Reasons why earnings disclosures might be managed • Bonus Contracts based on reported earnings • Maximise reporting of “good” news and minimise “bad news” • Smooth changes in earnings over time to reduce the perceived risk of the firm and its cost of capital • Minimise reported earnings to avoid: • government antitrust actions against the firm (USA) • upsetting the public post-privatisation • threat of windfall profits tax NHS & Earnings Management Abstract: “In this paper we review the financial reporting incentives associated with the requirement to breakeven for English NHS Trusts. We also investigate the distribution of reported income and estimate discretionary accruals thereby contributing to the limited literature on earnings management in not-for- profit hospitals. We find that Trust managers use discretion over accruals to report income within the target range around zero. … Our findings indicate that a precise and challenging financial breakeven target based on current cost residual income is associated with wide-spread use of discretionary accruals to an extent that weakens the accountability of NHS Accounting for Growth “The unpredictable economic conditions of the early 1990s had several peculiar side- effects. In addition to the spectacular collapse of a number of companies whose names have since passed into financial folklore, such as Polly Peck, BCCI and Maxwell Communications, a book about accounting techniques made the best-seller lists. The controversial publication of Terry Smith's Accounting for Growth in 1992 endorsed press allegations that the unpredictability of corporate failures could be attributed to accounting sleight of hand, and the heart of Mr Smith's analysis, the 'major companies' accounting health check', was an attempt to expose such practices. The head of UK company research at UBS Phillips & Drew, Mr Smith was identifying questionable accounting policy choices and their implications for investment performance, and his findings were considered to be a direct attack on some of the UK's largest and most politically powerful organisations. Phillips & Drew, who counted some of Mr Smith's victims among their largest clients, attempted to suppress the book, and his ultimate dismissal fuelled the explosion of publicity surrounding its publication.” Extracted from Accountancy May 1997 Terry Smith 2004 • Terry Smith in 1992 tried to explain the creative accounting dodges UK companies were using. It added impetus to the work of Sir David Tweedie, then of the Accounting Standards Board, who in 1990 had commenced his task of cleaning up UK financial reporting. • In 2004 Smith returned to the debate. He made it plain that Tweedie had done a tremendous job in clearing away the creative accounting of the early 1990s. But he said that the problem now is that companies have no need for creative accounting. The analysts, in effect, do it for them. • His view is that analysts now are so lazy and gullible that companies no longer have to be devious. "Analysts are sent the numbers in a press release, and none ever read a profit and loss account." Spin has taken over from creative accounting. (Financial Director 16 Jul 2004) Corporate Governance • In the 1991 the new Financial Reporting Council, the London Stock Exchange and the accountancy profession - with the backing of the government - set up the committee on the Financial Aspects of Corporate Governance. The Chairman, Sir Adrian Cadbury, and his committee started the corporate governance “movement”. • Corporate governance has been defined as: – …the system by which companies are directed and controlled. (Cadbury report, 1992; p. 15) • After Cadbury came Greenbury in the mid-90s, and the Hampel Committee 1998 and Turnbull in 1999. • By the end of the 90’s, headlines about UK scandals and corporate collapses were becoming a distant memory. • In July 2003, the Combined Code of Corporate Governance was published. The Code superseded the Combined Code 1998 and integrated the recommendations of the Turnbull, Higgs and Smith committees. There are two sections to the Code. – The first section deals with issues relating to the company such as the board and directors’ remuneration, – The second is devoted to institutional shareholders. This further enhances and • Financial Statement effects: – Profit variability – Cash Flow unchanged Capitalised Interest & True Interest Cover (measures the company's ability to cover interest payment:- -EBIT/Total Interest Charge in P&L account) Company (Property coys) Capitalised interest as a % of operating profit % Interest cover in P&L account x Interest cover taking capitalised interest into account X Broadwell Land 53.8 * 1.9 Citygrove 31.3 2.0 1.4 Kenntish Properties 57.6 * 1.7 Leading Leisure 53.5 2.5 1.1 Reliant 75.3 5.1 1.1 Rockfort 19.3 3.5 2.1 Rush & Tompkins 88.1 7.2 1.0 *Net interest receivable in the P&L account Extracted from Accounting for Growth by Terry Smith BAA and Depreciation Depreciation can be defined as the measure of the wearing out, consumption or other reduction in the useful life of a fixed asset arising from use, effluxion of time or obsolescence through technological or market changes. BAA: - useful economic life of assets changed over period: Years 1988 1989 1990 Terminal Lives 16 30 50 Runway Lives 23.5 40 100 In same period: Terminal 3 development - cost £110m Heathrow runway resurfacing - cost £11.5m Stanstead new terminal - cost £395m Glasgow Airport terminal - cost £47m Policy changes are often implemented before completion of major capital expenditure so effect not readily apparent. 22 Woolworths 2008 Chairman’s Statement “Against a difficult trading environment, we have managed substantial change across the Group as a whole. Profit before tax and exceptional items increased to £14.9m from £7.3m in the prior year. Adjusted profit (which is before tax, exceptional items, adjustment for fixed rental uplifts and amortisation of certain intangible assets) increased from £21.8 million to £28.3 million for the 52 weeks to 2 February 2008. We are pleased to report that the retail business returned to profitability this year. Whilst like-for-like sales were down 3.2 per cent, gross margin improved by 101 basis points and costs were contained below the rate of retail cost inflation. The business did benefit by £10.9 million (2007: £5.8 million) from the full year effect of relifing certain fixed assets; and from property profits, some £5.0 million higher than last year. Nonetheless, adjusted profit improved by £16.3 million to Asset sales • A pattern of gains suggests that the company's depreciation method is conservative, resulting in net carrying amounts for fixed assets below market values. • A pattern of losses would suggest that depreciation expense is understated and that fixed assets are overvalued on the balance sheet. • Gains and losses resulting from asset sales are considered by many analysts to be “nonrecurring” in nature and the inclusion of such gains in reported income lowers the “quality of earnings.” • Sale of significant portion of fixed assets is an indicator of change--in product line or production location. Industry specific earnings management • Banks:- bad debt provisions • High Tech companies:- potential for inventory losses as a result of technology change • Chemicals and pharmaceuticals:- product liability claims • Manufacturers:- warranty liabilities Distinguishing Between Fraud and Earnings Management (Dechow & Skinner (2000)) “Conservative” accounting “Neutral” earnings “Aggressive” accounting ACCOUNTING CHOICES Earnings management measures • Aggregate earnings management score developed by Leuz et al. that combines four different measures of earnings management; (Leuz, C., Nanda, D. and Wysocki, P. D. (2003) 'Earnings management and investor protection: An international comparison', Journal of Financial Economics) • Earnings persistence, an important indicator of earnings quality; (Penman, S. (2001). Financial Statement Analysis and Security Valuation , and Dechow, P. and Dichev, I. D. (2002) 'The quality of accruals and earnings: The role of accrual estimation errors', The Accounting Review) • Probability of earnings manipulation developed by Beneish. (Beneish, M. D. (1999) 'The detection of earnings manipulation', Financial Analysts Journal) The Business February 20, 2005 ANOTHER ROW ERUPTS OVER ONS CREATIVE ACCOUNTANCY BY: Allister Heath Gordon Brown, the UK chancellor, was embroiled in a mounting row over the independence of the Office for National Statistics (ONS) this weekend after renewed concerns about creative accounting in the public sector. Economists and pressure groups joined shadow Chancellor Oliver Letwin's campaign for greater independence for the ONS after a surprise reclassification of road repairs gave Brown a multi-billion pound accounting boost, making it less likely he would breach his Golden Rule. Instead of counting as current spending, which counts against the Golden Rule - which states Brown must only borrow to invest over the economic cycle - road repairs will be reclassified as capital spending, which doesn't count.