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    Accounting Analysis Final

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    Sarwar Iqbal
    This document discusses accounting analysis and earnings management. It covers: 1) Why managers may manage earnings to meet expectations, compensation targets, or debt covenants. 2) Conditions like opportunities and rationalizations that can lead to earnings management according to the fraud triangle. 3) Common earnings management techniques like revenue recognition changes, expense management, and cookie jar reserves. 4) Ways to detect earnings management through red flags and metrics like the Beneish M-Score model.

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    © All Rights Reserved
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    Accounting Analysis Final

    Uploaded by

    Sarwar Iqbal
    53 views10 pages
    This document discusses accounting analysis and earnings management. It covers: 1) Why managers may manage earnings to meet expectations, compensation targets, or debt covenants. 2) Conditions like opportunities and rationalizations that can lead to earnings management according to the fraud triangle. 3) Common earnings management techniques like revenue recognition changes, expense management, and cookie jar reserves. 4) Ways to detect earnings management through red flags and metrics like the Beneish M-Score model.

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    This document discusses accounting analysis and earnings management. It covers: 1) Why managers may manage earnings to meet expectations, compensation targets, or debt covenants. 2) Conditions like opportunities and rationalizations that can lead to earnings management according to the fraud triangle. 3) Common earnings management techniques like revenue recognition changes, expense management, and cookie jar reserves. 4) Ways to detect earnings management through red flags and metrics like the Beneish M-Score model.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    53 views10 pages

    Accounting Analysis Final

    Uploaded by

    Sarwar Iqbal
    This document discusses accounting analysis and earnings management. It covers: 1) Why managers may manage earnings to meet expectations, compensation targets, or debt covenants. 2) Conditions like opportunities and rationalizations that can lead to earnings management according to the fraud triangle. 3) Common earnings management techniques like revenue recognition changes, expense management, and cookie jar reserves. 4) Ways to detect earnings management through red flags and metrics like the Beneish M-Score model.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 10

    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?

    1
    9/1/18

    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

    2
    9/1/18

    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

    3
    9/1/18

    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

    4
    9/1/18

    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?

    5
    9/1/18

    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.

    6
    9/1/18

    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.

    7
    9/1/18

    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

    8
    9/1/18

    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

    9
    9/1/18

    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 ??

    10

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