9/1/18

Accounting
Analysis
- AVIJIT MALLIK, LECTURER, IBA,DU.

Agenda

u Why Accounting Analysis?

u Why Managers manage earnings?
u What conditions lead to earning management?
u How firms manage earnings?
u How to detect earning management? What are the potential red
flags?
u How to assess quality of disclosures?
u How to measure manipulation?

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Why Accounting Analysis?

u Quality of Reporting- the degree to which Financial statements data

are reliable
u Quality of Earnings- the degree to which Earnings are sustainable
What happens if both Quality of Reporting & Quality of Earning are
low?

Why do managers manage

earnings?
u Market Expectations
u Management compensations
u Career choices
u Debt covenants requirement
u To hide poor performance

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Conditions conducive to earnings

management
u Motives- meeting expectations, hiding poor performance etc.
u Opportunity- poor corporate governance, ineffective BoG or Poor
internal control
u Rationalization- justification
These three construct ‘FRAUD TRIANGLE’

How firms manage earnings?

u Revenue recognition policy:

Ø Channel stuffing
Ø Using FOB shipping point sales
Ø Using lower provision for bad debt
Ø Deferring any expense like warranty or servicing expenses
u Expense Provision:
Ø Showing lower depreciation by stretching life of an asset
Ø Changing inventory costing method

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How firms manage earnings?

Cont’d..
u Taking a bath- showing large write off or provision during
restructuring, recession, merger or change in management.
Example: IBM CEO Louis Gerstner, when took charge, wrote off a
huge cost ( $4 billion) during restructuring, part of which was future
expenses
u Cookie Jar Accounting: taking some present earnings to future to
smooth earnings
u Capitalizing Expenses: R & D expense, Brand development expense
u Dirty Surplus: Unrealized Gain or loss from foreign exchange,
securities available for sale, derivative instruments

What are the potential red flags?

§ Unexplained changes in accounting, especially when performance
is poor
§ Unexplained transactions that boost profits: asset sale or debt equity
swap
§ Unusual increases in accounts receivable in relation to sales
increase
§ unusual increases in inventories in relation to sales increases
§ An increasing gap between a firm’s reported income and its cash
flow from operating activities
§ Large fourth-quarter adjustments.
§ Qualified audit opinions or changes in independent auditors that
are not well justified
§ Related-party transactions or transactions between related entities

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Large 4th Quarter Adjustment- Exim Bank (2016-2017)

3rd Quarter EPS For Exim Bank Annual EPS For Exim Bank

How to assess the quality of

Disclosure?
u Does the company provide adequate disclosures to assess the firm’s
business strategy and its economic consequences?
u Do the footnotes adequately explain the key accounting policies
and assumptions and their logic?
u Does the firm adequately explain its current performance?
u If a firm is in multiple business segments, what is the quality of
segment disclosure?
u How forthcoming is the management with respect to bad news?

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Letter to shareholders by Square Textile:

Explaining Current Performance

How to measure manipulation?

u A popular Measure is ‘M- Score’ also known as manipulation ratio

M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI -
0.172*SGAI + 4.679*TATA - 0.327*LVGI
u A score greater than -2.22 (i.e. less negative than this) indicates a
strong likelihood of a firm being a manipulator.
u Does the Beneish M-Score work?
Beneish used all the companies in the database between 1982-1992. In
his out of sample tests, Beneish found that he could correctly identify
76% of manipulators, whilst only incorrectly identifying 17.5% of non-
manipulators.

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How to measure manipulation?

u The M score is based on a combination of the following eight different indices:
u DSRI = Days’ Sales in Receivables Index
Measured as the ratio of days’ sales in receivables in year t to year t-1. A large increase in DSR could be
indicative of revenue inflation.
u GMI = Gross Margin Index
Measured as the ratio of gross margin in year t-1 to gross margin in year t.
Gross margin has deteriorated when this index is above 1. A firm with poorer prospects is more likely
to manipulate earnings.
u AQI = Asset Quality Index
Asset quality is measured as the ratio of non-current assets other than plant, property and equipment to
total assets.
AQI is the ratio of asset quality in year t to year t-1.
u SGI = Sales Growth Index
Ratio of sales in year t to sales in year t-1. Sales growth is not itself a measure of manipulation. However,
growth companies are likely to find themselves under pressure to manipulate in order to keep up
appearances.

How to measure manipulation?

u DEPI = Depreciation Index
Measured as the ratio of the rate of depreciation in year t-1 to the corresponding rate in
year t.
u DEPI greater than 1 indicates that assets are being depreciated at a slower rate. This
suggests that the firm might be revising useful asset life assumptions upwards, or adopting a
new method that is income friendly.
u SGAI = Sales, General and Administrative expenses Index
The ratio of SGA expenses in year t relative to year t -1.
u LVGI = Leverage Index
The ratio of total debt to total assets in year t relative to yeat t-1.
An LVGI >1 indicates an increase in leverage
u TATA – Total Accruals to Total Assets
Total accruals calculated as the change in working capital accounts other than cash less
depreciation.

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How the M-Score predicted trouble

at Enron
u Calculating the M-Score for Enron between 1999 and 2000 gave a
figure of -0.55 – that indicated that Enron might be manipulating its
profits. This was proved to be the case in 2001.

M Score for Food and Allied Industry

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M Score for Food and Allied

Industry Cont’d..

u Source: Study by Ajaan Rahman Khan, Mohsina Akter (2017)

Analysts’ Implication: Sensitive

Areas prone to manipulation
INDUSTRY FLASHPOINTS
Banking Quality of Loan Loss Provision
COMPUTER HARDWARE Quality of warranty liability
COMPUTER SOFTWARE Marketability of product
TELCO Technological changes: Depreciation
expense or inventory value
TOBACCO Quality of estimated Health Liabilities
PHARMA Quality of R&D Expense
SUBSCRIBER SERVICES Development of Customer Base: Quality of
Capitalized Promotion Cost

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Analysts’ Implication

u Identify any questionable accounting choices or estimates

u Compare the depreciation rates, bad debt provision rates with
industry norms
u Assess the quality of earnings and ask if the earning is
sustainable
u Analyze carefully if the industry or company structure is too
complex
u Assess the corporate governance for Bangladeshi Firms.

uAny Questions ??

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