Chapter 18 - Analysis of the Quality of Financial Statements

CHAPTER EIGHTEEN

Analysis of the Quality of Financial Statements

Stephen H. Penman

The web page for Chapter 18 runs under the following headings:

What this Chapter is Doing

Why a Quality Analysis is Important

Comprehensive Quality Analysis

The Key Point to Appreciate

The Key Diagnostic

Some Perspective on the Quality of GAAP Accounting

Fair Value Accounting

Composite Quality Scores

Earnings Quality by Dechow and Schrand

Earnings Quality by Francis, Olsson, and Schipper

Quality of Financial Statements During the Bubble

Earnings Prediction

Financial Statement Analysis and the Prediction of Stock Returns

Readers’ Corner

What this Chapter is Doing

This chapter lays out an approach to assessing the quality of the accounting in financial statements. The approach is a structured one that ensures that all aspects of the financial statements are covered. The output is a series of diagnostics that can indicate possible quality problems.

Much of the analysis in Part Two of the book bears on the issue of earnings quality (see the section below on “Comprehensive Quality Analysis”), so this Chapter is really a capping off of material that precedes it.

18-1 Chapter 18 - Analysis of the Quality of Financial Statements

Why a Quality Analysis is Important

Current financial statements are the basis for forecasting future financial statements (in the pro forma analysis of Part Three of the book) from which valuations are made. Clearly, reliance on poor quality financial statements leads to poor quality pro formas and poor valuations. Further, when accounting issues surface for a firm, the stock price typically takes a big hit. The analyst tries to avoid taking that hit by a diligent appraisal of the quality of the accounting statements. More proactively, the analyst who anticipates emerging accounting problems can profit from that prediction (by shorting the stock).

Comprehensive Quality Analysis

If you reflect on the material covered in the book to this point, you will appreciate that much of that material – particularly the analysis in Part Two – is concerned with defining quality accounting numbers to use in equity valuation:

1. The choice of accrual accounting valuation models in Part I was based on the observation that the cash accounting implied by Discounted Cash Flow Analysis is not “good quality” accounting for valuation purposes. That is, free cash flow is not a good measure of value added because it treats investment as a outflow of value. The closing section of Chapter 17 titled, The Quality of Cash Accounting and Discounted Cash Flow Analysis comes back to this theme. General Electric consistently generates negative free cash flow, as does Home Depot and Starbucks, but these are valuable companies. Of course, accrual accounting, with its reliance on estimates to correct the problems with cash flows, can also be poor quality – and thus the need for accrual-based valuations to be supported by a sound analysis of the quality of the accrual accounting.

2. The analysis of the equity statement (in Chapter 9) is designed to identity comprehensive income, a better quality number than net income because it includes dirty-surplus items missing from net income. Further, the identification of “hidden dirty-surplus items” recognizes gains and losses – such as the loss from employee stock options -- that are omitted by (poor quality) GAAP accounting.

3. The separation of net operating assets (NOA) from net financial obligations (NFO) in balance sheet reformulations (Chapter 10) distinguishes assets and liabilities that are well-measured (typically the NFO) from those that are not (the NOA). We made good use of this distinction in valuation (in Chapter 14) by recognizing that, for the well-measured NFO, the valuation is complete in the balance sheet so pro forma analysis is not required. Of course we always challenge the quality of balance sheet measures so that, even if marketable equity securities are marked to market in the balance sheet, we do incorporate that market value in a valuation if we feel that the market value is a bubble price.

4. The separation of operating income form financing income in reformulated income statements (Chapter 10) distinguished types of income that have different implications for valuation and thus can be seen as having different quality. So, if the NFO are at market value in the balance sheet, the net financing expense component of earnings is ignored.

5. The distinction between core income and non-core income (Chapter 13) is a distinction between types of income that have different implications for the future and thus are different quality. Income from pension assets must not be confused with core income from sales, for example. Chapter 13, indeed, is a prelude to the quality analysis in Chapter 18. With its discussion of restructuring charges and their bleed-backs, it introduces the notion of shifting income between periods with accrual estimates. The IMB case (M13.3) is a good introduction to Chapter 18.

6. The analysis of leverage in Chapter 14 is designed to distinguish earnings growth that comes for operations (and is important to valuation) from growth that comes from borrowing (which the investor should not pay for).

The Accounting Quality Watch at the end of a number of preceding chapters summarized the quality issues you have run into prior to this chapter. This chapter provides the capstone to the quality analysis of the earlier chapters.

The Key Point to Appreciate

Here’s the key point to appreciate in an analysis of earnings quality: Accrual accounting is a set of rules that determine in which period earnings are to be recognized; with some discretion allowed, accrual accounting can shift income between periods. Current income can be increased (with accounting methods) only by reducing future income (thus “borrowing from the future”.) Decreasing current income (with accounting methods) has the consequence of increasing future income (“saving for the future”). With the forecasting of future income in mind (for valuation), current income must therefore be tested if it is to be relied on as an indicator of future income.

The Key Diagnostic

Because net financial expenses (NFE) are usually well measured, earnings quality analysis focuses on operating income (OI). From earlier in the book (Chapter 8), we know that the following relation always holds:

OI = Free cash flow – ΔNOA

Free cash flow is a relatively “hard” number – although one must be attentive to firms timing cash flows (see Chapter 10). The change in net operating assets, ΔNOA is the relatively soft number so is the primary number to be analyzed. Much of Chapter 17 is designed to do this. Note that

ΔNOA = Investment + operating accruals

So, ΔNOA and any manipulation of operating income comes from two sources:

(i) Misclassification of investments (capitalization policy) (ii) Accrual estimates.

The expression for operating income (OI) here shows that, any manipulation of income must leave a trail in the balance sheet through the amount of ΔNOA. Following that trail – to changes in accounts receivable, accrued expenses, deferred revenues, etc. – is the exercise of a sound quality analysis. Many of the quality diagnostics in Chapter 18 amount to defining the trail to be followed to challenge the ΔNOA (and thus the operating income) reported for a period.

Some Perspective in the Quality of GAAP Accounting

After reading Chapter 18, you might get the impression that GAAP accrual accounting has a lot of quality problems. The financial scandals on the early 2000s reinforce that impression. GAAP accounting has a number of deficiencies, most of which have been highlighted in this book. But we must have a sense of perspective. While remaining skeptical about the accounting in financial reports, we must remember that accrual accounting, in principle, serves the valuation analyst well. It might be worthwhile, at this point, to go back to Chapters 2 and 4 where the basic principles of accrual accounting – and particularly its positive features – are emphasized.

Let’s try to weigh the “good” and “bad” features of GAAP accounting. First, some problems with GAAP accounting, most of which are covered earlier in the book.

Problematic Features of GAAP

1. The accounting for the shareholders’ equity statement is poor. In particular, gains and losses are not recognized when shares are issued or repurchased at a price different from market value. This results in hidden gains and losses (mostly losses) when warrants, convertible bonds, convertible preferred stock, put and call options, and employee stock options are involved. (Chapter 9)

2. GAAP’s emphasis on Net Income and EPS and the reporting of Other Comprehensive Income in the equity statement can obscure the profitability picture. For example, firms can “cherry pick” realized gains into Net Income while reporting unrealized losses in the equity statement.

3. As a consequence of the poor accounting for claims that are contingent on a firm’s stock price, contingent liabilities are omitted from the balance sheet. For example, the value of the option overhang that is important to valuation is omitted. (Chapter 14 has the remedy)

4. Gains on pension assets are netted to operating costs in the income statement, distorting margins. (Chapter 13)

5. The cash flow statement does not make a clean distinction between cash from operating/investment activities and cash from financing activities. (Chapter 11)

6. If securities markets are inefficient, mark-to-mark accounting can introduce bubble gains into the financial statements. (Chapter 13)

7. Liabilities are omitted from the balance sheet, in particular operating leases, obligations with respect to special entities, and the option overhang. (Chapter 20)

8. The lack of disclosure can be frustrating to the analyst. Here are some observations, along with some recommendations:

 The US income statement is a disgrace. Often it is reduced to a few lines.

 There is little detail on S G & A expense. This item is typically 20 percent of sales, but there is little breakdown on the multitude of sins that it covers. Firms even credit gains from asset sales to S G & A. It would seem a simple matter to report executive compensation, gains on pension fund assets (distinguished from service costs), gains and losses from asset sales, and reversals of restructuring charges (to name a few) as separate lines on the face on the income statement. With before-tax operating profit margins typically less than 12 percent of sales, an investor’s request to report any expense greater than 2 percent of sales -- along with more sensitive lesser items such executive, director and auditor compensation -- seems reasonable.

 An analysis of net revenue, a reconciliation of gross revenue to net revenue, and a breakdown of booked and deferred revenue is needed.

 Transitory items need to be clearly displayed on the income statement, so the reader can get an understanding of core operating earnings.

 The obscurity introduced by consolidations is troubling. The reader cannot get a clear picture of how assets and liabilities are structured – through joint ventures, alliances, special entities, R&D partnerships and other “networking” relationships. Transparency can be improved with

organizational diagrams, disaggregated reporting, and proportionate presentations, for example.

 A presentation of how current earnings are affected by changes in estimates in prior periods is needed. This table would include amounts bled back to earnings from reversals of restructuring charges, dipping into cookie jar reserves, reducing deferred tax asset allowances, and bad debt and loan loss experience relative to prior estimates.

 Also needed is a discussion of accruals for which there is particular uncertainty and a ranking of accrual estimates by their perceived uncertainty, giving the reader a better sense of what numbers are “hard” and “soft” and a better appreciation of the likelihood that earnings will be sustainable.

 Include a “quality of earnings statement” by management, supplemented by a statement of significant uncertainties by auditors.

Desirable Features of GAAP

As we have emphasized in this book, the basic features of GAAP are desirable from the equity analysts’ point of view:

1. With the exception of fair value accounting for securities and some financial assets, equity prices are not in the financial statements. This suits the analyst, for she wishes to use the accounting to challenge stock prices so does not want the accounting to reflect those prices. During the technology boom of the 1990s, commentators who justified high stock prices relative to book values assailed accounting for not recognizing the intangible assets. One saw calculations where analysts measured the value of intangibles as the difference between the value of tangible assets (with some premium applied) and (bubble) market values for the whole firm. With the exceptions noted above, GAAP does not make this mistake; GAAP does not bring prices into financial statements. Quality accounting recognizes that market prices are inherently speculative, for they are based on beliefs about the future.

2. Revenue recognition and matching. Shareholders buy future earnings and thus speculate as to what those earnings might be when they buy shares. But sound accounting understands that the shareholder is best served if you don’t mix what you know with speculation about what you don’t know. This restatement of the reliability criterion, embraced under the FASB’s Conceptual Framework, is also a maxim of fundamental investing.

Accounting recognizes that a firm adds value for shareholders only if it gets customers and receives more value from customers than is given up in servicing customers. Shareholder value is added in the stock market, but the source of that added value is value added from the firm’s trading with customers in product markets and suppliers in the input markets. It is this source of value that the shareholder wants to understand: how much was earned this period from trading with customers and suppliers? The investor uses this hard information, uncontaminated by speculative information, to speculate on the firm’s ability to generate earnings from customers in the future. Revenue recognition and matching, the hallmark of the traditional financial reporting model, implements these ideas. See Chapter 2.

Regrettably, the principle has been abused in practice. Excessive write-downs, merger charges, cookie jar reserving, front-end revenue recognition, and under- or over-estimating of allowances for credit losses, warranties, and deferred tax assets (to name a few) – with the associated intertemporal shifting of earnings – are failures in applying basic accounting, not a failure of principle. Auditing and corporate governance institutions sometimes do not enforce unbiased revenue recognition and matching.

The move to more “fair value accounting” -- currently under discussion among standard setters – should proceed with care, particularly for non-financial institutions. The danger is that we lose the information from revenue realization and matching and substitute (possibly bubble) market prices or biased and imprecise fair value estimates. Historical cost accounting provides information (about the profitability of trading with customers) to inform about prices. Fair value accounting often gets the information from prices, so may destroy the ability to inform about prices.

3. Accrual accounting is, in principle, good accounting for equity analysis. This accounting does, of course, invite some speculation in the estimation of accruals that are needed to match revenues with expenses. This is the tension in earnings measurement: quality earnings require accruals, but accruals are estimates that can be poor quality. Auditors and directors are a check (ideally), but some expenses – like amortization and depreciation – are intrinsically hard to measure. For some costs, there may be no accounting solution. Expensing R&D expenditures, for example, results in (gross) mismatching. But to capitalize and amortize may just introduce arbitrary amortizations into the matching. The reliability criterion overrides. Be it as it may, accounting quality is the less for the inability to measure.

4. Speculation about intangible assets in not allowed in GAAP. The traditional financial reporting model was assailed during the late 1990’s bubble for not recognizing the value of intangible assets, particularly “knowledge assets.” No one knows what the value of a knowledge asset is (or even precisely what it is!). One suspects that commentators were imputing these assets from bubble prices. Recognizing the value of these assets in the balance sheets would be pure speculation, and subsequent fuzzy amortization of a fuzzy number would destroy information in matching. Do we really want to entertain the idea that Dell Corporation should recognize the value of its supply chain, its direct-to-customer strategy, its culture and organization on its balance sheet – and then amortize these assets to income? Or do we want to relegate such notion to fantasy, ill- conceived ideas of a bubble mentality? Do we rather not want to stick to the notions of revenue recognition and matching so that the value of such assets is recognized when a firm gets a customer and the associated expenses are also recognized to get a measure of value added – accrual earnings -- from these assets? After all, we have managed to analyze and value Dell quite well in this book (in examples, exercises and cases) using historical cost/revenue recognition accounting. And we found that Coca Cola lent itself to a simple valuation (in Box 15.4 in Chapter 15) without recognizing its brand value on the balance sheet.

Financial statements actually do report on knowledge assets, not in balance sheets, but (eventually) in income statements. Knowledge assets have value because they lead to earnings from customers. Earnings are reported, but only as customers are booked. Accounting confirms whether investor’s speculation about the value of knowledge assets is justified, but does not engage in the speculation.

Chapter 9 of S. Penman, Accounting for Value, also provides a critique of GAAP accounting from the perspective of the fundamental investor.

Fair Value Accounting

Fair value accounting involves marking assets and liabilities to “fair value.” It is applied to a limited number of assets and liabilities, mainly financial assets, derivatives, and trading and available-for-sale securities. However, firms have a “fair value option” to fair value a wider range of assets and liabilities under FASB Statement 159 in the U.S. and IAS 39 under IFRS.

FASB Statement 157 provides guidance for measuring fair value, distinguishing Level 1 fair values (where market prices in liquid markets indicate fair value), Level 2 (where prices for the specific asset don’t exist but can be inferred from other market data), and Level 3 where the firm has to estimate market prices. In all cases the market price, or the estimate market price, is the prices at which the firm could sell the asset or pay to be relieved of the liability (so-called exit value).

Level 3 fair values clearly pose a quality problem: estimates contain error and can be biased. The issues rose in the credit crisis of 2008-09 when banks had to estimate fair values of assets (like collateralized debt obligations) that earlier had traded in liquid market which then dried up. Any observed traded prices were suspect as “depressed prices” or “fire-sale prices” that did not (some say) represent value to the banks holding them. Clearly fair values come with a huge product warning label in this case.

But Level 1 fair values also pose a problem. First, traded prices may be bubble prices. Indeed, some claimed that the 2008-09 credit crisis was due to banks booking fair value profits as real estate price and the assets derived from them went up in a real estate bubble. The higher profits and resultant higher bank capital reserves induced more bad lending against fake value in real estate, leading to the crash. Remember our warning, form as far back as Chapter 1, about putting prices in the financial statements. Second, exit value is not necessarily value to the enterprise: the value as which a bank can sell mortgage loans – what someone else would pay – is not the value to the bank from working with its own customers to get through their credit difficulties and pay back the loan. More so it the market price is a depressed price.

So, in a quality analysis, challenge fair values on the balance sheet and fair value gains and losses reported in comprehensive income.

These and other issues are addressed in the following CEASA White Paper:

Principles for the Application of Fair Value Accounting, at http://www4.gsb.columbia.edu/ceasa/research/papers/white_papers

Also see a CEASA paper by Doron Nissim on fair value accounting in the banking industry: http://www4.gsb.columbia.edu/ceasa/events/news/item/7636/Occasional+paper+on+f air+value+policy+in+the+banking+industry+is+now+available+online

Chapter 8 of S. Penman, Accounting for Value, also provides a critique of fair value accounting from the perspective of the fundamental investor.

Composite Quality Scores

Chapter 18 provides quite a few quality diagnostics, and some of them tell the same story. One can combine measures into a single quality score that summarizes the information that a set of financial statement measures convey as a whole. The following papers contain examples.

Piotroski, J. 2000. Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Journal of Accounting Research 38 (Supplement): 1-41.

This paper calculates a score that distinguishes financial well being among firms with low price-to-book ratios.

Penman, S., and X. Zhang. 2004. Modeling sustainable earnings and P/E ratios with financial statement analysis. Download the document at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=318967

This paper weights a variety of measures to derive one composite score, an “S score” or “sustainable earnings score” that ranges from zero to one. See the text.

S. Penman and X. Zhang, “Modeling Sustainable Earnings and P/E Ratios with Financial Statement Analysis” at

Beneish, M. 1999. The Detection of Earnings Manipulation. Financial Analysts Journal 55(5): 24-36.

This paper calculates a score that gives an indication of earnings manipulation.

Chapter 20 also gives examples of composite scoring – to indicate the probability of default or bankruptcy.

Earnings Quality by Dechow and Schrand

For a broad ranging coverage of earnings quality, see

P. Dechow and C. Schrand, Earnings Quality. CFA Institute, 2005.

Earnings Quality by Francis, Olsson, and Schipper

For another survey of research in this area, go to

J. Francis, P. Olsson, and K. Schipper, Earnings Quality, Foundations and Trends in Accounting at

http://www.nowpublishers.com/product.aspx?product=ACC&doi=1400000004

Quality of Financial Statements During the Bubble

The following paper discusses accounting quality issues that arose in the late 1990’s bubble:

Penman, S., “The Quality of Financial Statements: Perspectives from the Recent Stock Market Bubble,” Accounting Horizons (Supplement 2003), 77-96. The paper can be downloaded at: