ACC 411
Financial Statement Analysis
Winter 2017
4) To recognize the red flags that serve as useful screens for potential
cases of earnings management.
Such incentives to manage earnings may be especially strong when the firm is
planning to sell shares to the market, as in an initial public offering or via a
secondary stock offering, if the firm has yet to report a profit, or when the firm is
or has been performing poorly.
Professor Charles E. Wasley 3
Factors Influencing Accounting
Quality
(At least) 3 factors influence the quality of a firms financial statement (i.e.,
accounting) numbers.
1) Noise from GAAP (IFRS) accounting rules.
The fit between GAAP (IFRS) and the nature of a firms business activities and its
economic environment is not perfect and may introduce noise into the financial
statements when managers attempt to use the financial statements to report on the
firms performance.
2) Management forecast errors (i.e., honest mistakes):
Managers cannot perfectly forecast future events so some of their estimates will turn
out to be wrong (e.g., rates of uncollectible A/R, warranty rates, useful lives etc.).
3) Managers strategic choice of GAAP (IFRS) (i.e., managerial opportunism):
As discussed below, managers incentives to choose accounting policies that are
biased, that is, designed to put a positive spin on the firms results and financial
position.
Such incentives include debt covenants, compensation contracts, corporate control contests,
tax and regulatory considerations, capital market and stakeholder considerations, as well as
competitive industry considerations.
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What is Earnings Management?
Note that earnings management takes place within the confines of GAAP (IFRS) where
managers are strategic and sometimes aggressive/opportunistic in their choice of
accounting policies and financial reporting decisions.
Earnings management is not fraud. When managers commit fraud they havent been
applying GAAP (IFRS) aggressively or strategically, they were not following GAAP at all.
Because, many earnings management practices dont impact a firms actual cash flows.
Examples include changing useful lives or manipulating bad debt or warranty accruals.
These actions are of concern, but less so than earnings management practices that affect cash flows.
On the other hand, some earnings management practices affect the firms cash flows and such
actions are of more concern than those above.
Examples include cutting R&D and/or advertising, selling appreciated assets to recognize one-time
gains that are taxable.
A key reason to be concerned about earnings management is that when earnings are managed, it
is more difficult for financial statement users like us to get a true picture of a firms real underlying
economic performance, and it is that performance that we are interested in.
As a result, financial statement users like us have to be concerned about earnings management
and develop ways to identify when earnings management may be occurring and how to unravel it.
In this course we cover a number of techniques that are useful in detecting earnings management
and undoing it.
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What Does Earnings Management
Signal?
The graph on the following slide depicts the functional form of a typical earnings-based
bonus plan for top executives (i.e., CEOs and CFOs).
The performance measure on the x-axis is usually accounting earnings or something that is
a function of accounting earnings like return on equity.
The way the bonus works is quite simple. Below a lower bound of the performance measure
called the performance threshold there is no bonus. Once the performance measure
reaches the performance threshold the bonus increases in the performance measure.
Once the performance measure hits an upper bound, the bonus is capped.
The key area in the graph is the incentive zone because it is in this area that increases in
the performance measure (e.g., earnings) have the greatest effect on executives bonuses.
Describe the incentives managers have to manage earnings upward or downward when they
are below the performance threshold; in the incentive zone; and above the upper bound of
the bonus cap.
4) Overvaluation of Assets:
A/R, inventory and investments (etc.) are carried at valuations above
realizable amounts.
For example, the allowance for doubtful accounts might be too small or
management may postpone a write-down of obsolete inventory. The
postponement of an inventory write-down boosts current earnings, while
future earnings will be reduced when the inventory account is adjusted.
Maybe after the current management is gone (retired).
5) Undervaluation of Liabilities:
For example, warranty liabilities are too low. Current earnings are
increased as a result, while the earnings of future years will be reduced
when the liabilities are later increased as needed.
Read the accounting policies footnote in the firms annual report and compare
it to the previous year too identify any (subtle) changes. Think about why?
Professor Charles E. Wasley 14
Detecting Earnings Management Using a
Scientific Approach: A Model of Earnings
Management/Manipulation
Beneish (1999) developed a model to identify the financial characteristics of firms
likely to have engaged in earnings manipulation/management.
The model was developed using firms subject to SEC enforcement actions and
involved identifying the characteristics (e.g., various financial ratios) of firms likely
to have manipulated/managed earnings.
In the model, the value of y is as follows (the following slides define and
describe the variables used in the model):
The statistical model used is a probit model which converts the value of y into
a probability based on the standardized normal distribution (the command
NORMSDIST in Excel, when applied to a particular value of y, converts it to the
appropriate probability).
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The Variables in the Model:
Calculation and Economic Intuition
1) Days Sales in Receivables Index (DSRI): Is the ratio of A/R to Sales at the end of the current year to
the same ratio of the preceding year. A large increase in A/R as a percentage of Sales may indicate an
over-statement of A/R and Sales in the current year to boost earnings. Such an increase might result
from channel-stuffing or from liberalizing credit terms to boost sales. Thus, a higher value implies a
higher probability of earnings manipulation, so the coefficient on this variable should be positive.
2) Gross Margin Index (GMI): Is the ratio of gross profit (Sales-CGS) to Sales last year to that for the
current year. A decline in the gross margin percentage will result in an index greater than 1.0 and firms
with weaker profitability this year are more likely to engage in earnings manipulation. As a result, a
higher value implies a higher probability of earnings manipulation, so the coefficient on this variable
should be positive.
3) Asset Quality Index (AQI): Asset quality refers to the proportion of total assets composed of assets
other than current assets, PP&E and investments in securities. The remaining assets include intangibles
and other assets whose future benefits are less certain. The asset quality index equals the proportion of
these lower-quality assets in the current year relative to the preceding year. An increase in the
proportion suggests an increased effort to capitalize and defer costs the firm should have expensed. As
a result, a higher value implies a higher probability of earnings manipulation, so the coefficient on this
variable should be positive.
4) Sales Growth Index (SGI): Is the ratio of Sales for the current year to Sales of the preceding year.
While growth in Sales does not necessarily imply manipulation, growing firms usually rely on external
financing more than mature firms and the need for financing might motivate managers to manipulate
sales (as well as earnings). As a result, a higher value implies a higher probability of earnings
manipulation, so the coefficient on this variable should be positive.
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The Variables in the Model:
Calculation and Economic Intuition
5) Depreciation Index (DEPI): Is depreciation expense as a percentage of Net PP&E before
depreciation for the preceding year relative to the same percentage for the current year. A ratio
greater than 1.0 indicates that the firm has slowed the rate of depreciation (perhaps by lengthening
useful lives), thereby increasing earnings. Thus, a higher value implies a higher probability of
earnings manipulation, so the coefficient on this variable should be positive.
6) Selling and Administrative Expense Index (SAI): Is the ratio of SG&A to Sales for the current year
to the same percentage for the preceding year. An index less than 1.0 suggests the firm may be
manipulating earnings by capitalizing various costs instead of expensing them. As a result, a lower
value implies a higher probability of earnings manipulation, so the coefficient on this variable should
be negative.
7) Leverage Index (LVGI): Is the proportion of total financing composed of current liabilities and long-
term debt for the current year relative to the same proportion for the preceding year. An increase in
the proportion of debt likely subjects a firm to a greater risk of violating debt covenants and the need
to manipulate earnings to avoid any violation. As a result, a higher value implies a higher probability
of earnings manipulation, so the coefficient on this variable should be positive.
8) Total Accruals to Total Assets (TA_TA): Total accruals is the difference between income from
continuing operations and cash flow from operations. This variable is an indicator of the extent to
which earnings results from accruals instead of cash flows. A large excess in income from continuing
operations over cash flow from operations indicates that accruals are playing a large part in
measuring income, and accruals can be manipulated much easier than cash flows. Thus, a higher
value implies a higher probability of earnings manipulation, so the coefficient on this variable should
be positive. Professor Charles E. Wasley 17
The Earnings Manipulation
Model
Under the model the value of y is as follows (as noted above we convert
the y into a probability based on the standardized normal distribution by
using the command NORMSDIST in Excel):
The signs of all the coefficients (except leverage) are consistent with our
discussion/predictions on the prior slides.
A Type I error involves failing to identify a firm as an earnings manipulator when it turns
out to be one. A Type II error involves identifying a firm as an earnings manipulator when
it turns out not to be one.
Usually Type I errors are more costly to investors than Type II errors. The key issue here is
that the cutoff probability depends on the investors/analysts view of the relative cost of
Type I and Type II errors. That is, how much more costly is it to classify an actual earnings
manipulator as a non-manipulator than to classify an actual non-manipulator as a
manipulator?
A Type I error can result in an investor losing all of the investment in a firm when the manipulation
comes to light.
Misclassifying an actual non-manipulator results in the investor losing the return that would have
been earned on that investment.
Anything unusual?
DAYS' SALES IN RECEIVABLES INDEX 0.97072 1.08611 1.10220 1.18797 1.05124 0.99999 1.18493 0.98809
GROSS MARGIN INDEX 1.00022 1.00595 1.01467 1.00545 0.97389 0.99284 0.98325 0.98477
ASSET QUALITY INDEX 0.96106 0.96600 1.16805 0.98131 1.02227 1.01126 1.06825 0.89326
SALES GROWTH INDEX 1.01631 1.04959 1.05846 1.03373 1.00948 1.07223 1.08225 1.11620
DEPRECIATION INDEX 0.97061 0.99390 0.98000 0.98847 1.00663 0.93018 0.94963 0.96834
SALES, GENERAL AND ADMINISTRATIVE INDEX 1.01419 0.99314 0.98732 0.98732 1.01835 1.01957 1.02584 1.02694
LEVERAGE INDEX 0.99782 0.98582 0.99800 1.05027 0.98043 0.97938 1.02769 0.95737
TOTAL ACCRUALS TO TOTAL ASSETS -0.03604 -0.04256 -0.04413 -0.04585 -0.06925 -0.06065 -0.04757 -0.05308
THE VALUE OF "y" IS: -2.681 -2.561 -2.464 -2.511 -2.749 -2.703 -2.459 -2.681
EARNINGS MANIPULATION PROBABILITY IS: 0.548% 0.751% 0.959% 0.852% 0.456% 0.517% 0.970% 0.549%
CUTOFF
COST OF TYPE I ERROR RELATIVE TO TYPE II ERROR: PROBABILITY
10:1 6.85%
20:1 3.76%
30:1 3.76%
DAYS' SALES IN RECEIVABLES INDEX 0.00000 0.00000 0.92915 0.85664 0.85631 0.97929 1.22073 0.96694 0.99497
GROSS MARGIN INDEX 1.05031 1.01558 1.02071 1.01350 0.98248 1.00755 0.99669 1.04596 0.00000
ASSET QUALITY INDEX 1.39219 1.03858 0.88570 1.28067 0.90684 0.57363 1.25919 0.59518 0.89073
SALES GROWTH INDEX 0.99038 1.04918 1.03673 1.03111 1.00630 1.02495 1.06517 1.13056 1.12342
DEPRECIATION INDEX 0.98724 1.04305 1.10926 0.98047 0.89349 0.97303 1.01294 1.05608 1.00835
SALES, GENERAL AND ADMINISTRATIVE INDEX 1.04092 1.00772 1.01019 0.99883 1.00325 0.99753 1.00361 0.93727 1.01625
LEVERAGE INDEX 0.96324 0.99549 1.02271 0.98935 0.93534 1.05137 1.13953 0.99132 1.00050
TOTAL ACCRUALS TO TOTAL ASSETS -0.10319 -0.04850 -0.05379 -0.05379 -0.07619 -0.05024 -0.02864 -0.05556 -0.05838
THE VALUE OF "y" IS: -3.702 -3.554 -2.795 -2.713 -3.001 -2.899 -2.294 -2.773 -3.221
EARNINGS MANIPULATION PROBABILITY IS: 0.021% 0.036% 0.401% 0.502% 0.221% 0.298% 1.435% 0.427% 0.111%
CUTOFF
COST OF TYPE I ERROR RELATIVE TO TYPE II ERROR: PROBABILITY
10:1 6.85%
20:1 3.76%
To see the effect, recalculate the probability of earnings manipulation (note, I gave you
the formula in the table) after inserting 0.0 for the Days Receivable Index. The probability
of earnings manipulation will drop to 0.347% (which is trivial).
While you may have been tempted to focus on the Sales Growth Index of 2.39864, that
would have been a bit misguided, because virtually all of Amazons sales are made in
cash, and we are concerned with credit (not cash) sales being used to manage earnings.
This was a good example to study because it reminds us that we have to be careful about
mechanically applying models and/or calculating ratios, etc., given the underlying
economics of a firms business model.
Professor Charles E. Wasley 26
Summary