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11-1-2005 Earnings Quality: It's Time to Measure and Report Jodi L. Gissel Marquette University, [email protected]

Don Giacomino Marquette University, [email protected]

Michael D. Akers Marquette University, [email protected]

Published version. The CPA Journal, Vol. 75, No. 11 (November 2005). Permalink. Reprinted from The PC A Journal, November 2005, © 2005, with permission from the New York State Society of Certified Public . The uthora of this document, Jodi L. Gissel, published under the name Jodi L. Bellovary at the time of publication. Earnings Quality: It's Time to Measure and Report Jodi L Bellovary; Don E Giacomino; Michael D Akers The CPA Journal; Nov 2005; 75, 11; ABI/INFORM Global pg. 32

AC COUN TING & A U DITI NG

Earnings Quality: It's Time to Measure and Report

By Jodi L. Bellovwy, Don E. and the extent to which it can predict and Information," Accoullting Horizons 17 Giacomino, and Michael D. Akers anticipate future eamings. (Supplement), 2003]. Penman ["The Quality of Financial Statements: arnings quality is an important Earnings Quality Defined Perspectives from the Recent Stock Market aspect of evaluating an entity' s A variety of earnings-quality definitions Bubble ," A ccounting Horizons 17 E tinancial health, yet in vestors, cred­ exist. Teets ["Quality of Earnings: An (S upplement), 2003] indicates that quality itors, and other users often overlook it. Earnings quality refers to the ability of reported earnings to reflect the company's true earnings, as well as the usefulness of reported earnings to predict future earnings. Earnings quality also refers to the stability, persistence, and lack of vwiability in reported eamings. The evaluation of earnings is often difficult, because companies highli ght a variety of eamings figures: , operating earn­ ings, net income, and pro forma earnings. In addition, companies often calculate these figures differently. The income state­ ment alone is not useful in predicting futu re earnings. The SEC and the investing public are demanding greater assurance about the quality of earnings. Analysts need a more suitable basis for earnings estimates. Credit rating agencies are under increased sc ruti­ ny of their ratings by the SEC. Such comfort level and informati on are not provided in the report or the finan­ Introduction to the Issues in Accounting of earnings is based on the quality of for­ cial statements. Only 27% of finance exec­ Education," Issues in Accounting ward earnings as well as current reported utives recently surveyed by CFO "feel Education, 17 (4), 2002] states that earnings. Schipper and Vincent ["Earnings 'very confident' about the quality and com­ "some consider quality of earnings to Quality," Accounting Horizons 17 pleteness of information available about encompass the underlying economic per­ (Supplement), 2003] define earnings public companies" ["It's Better (and formance of a firm , as well as the account­ quality as "the extent to which reported Worse) Than You Think," by D. Durfee ing standards that report on that underly­ earnings faithfully represent Hicksian May 3, 2004]. ing phenomenon; others consider quality income," which includes "the change in net There are a variety of definitions and of earnings to refer o nl y to how well economic other than from transac­ models for assessing earnings quality. accounting earnings convey infonnation tions with owners." The authors have proposed a uniform, inde­ about the underlying phenomenon." Pratt Using various definitions of earnings pendent definition of quality of earnings defines earnings quality as "the extent to quality, researchers and analysts have devel­ that allows for the development of an which net income reported on the income oped several models. The Sidebar sum­ Earnings Quality Assessment (EQA) statement differs from true earnings" [in F. mw·izes eight models for measuring earn­ model. The proposed EQA model evalu­ Hodge, "Investors' Perceptions of EWllings ings quality. The models are used for very ates the degree to which a company 's Quality, Auditor Independence, and the naITOW, specific purposes. While the crite­ repot1S its true eWllings Usefulness of Audited Financial ria used in these definitions and models

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Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CFRA ERP FER L-T ML RJ s&P UBS

Criteria

Pension fund x x

(Continues on page 34)

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Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. overlap, none provide a comprehensive Framework is to assist investors in mak­ and items, as well as one­ view of earnings quality. For example, the ing investment decisions, which includes time items, accounting changes, acquisi­ primary purpose of the Center for Financial predicting future earnings. The Conceptual tions, and discontinued operations. The Research and Analysis (CRFA), s model is Framework refers not only to the reliabil­ model also assesses the stability, or lack to uncover methods of earnings man ipula­ ity (or truthfulness) of financial statements, thereof, of a company, which leads to a tion. Of the eight models discussed, on ly but also to the relevance and predictive more complete understanding of its future the Lev-Thiagarajan and Empirical ability of information presented in finan­ earnings potential. Research Partners models have been empir­ cial statements. The authors' detinition of The criteria were drawn from the eight ically tested for evidence of usefulness relat­ quality of earnings draws from Pratt's models discussed, including the 10 criteria ed to quality of earnings. Lev a nd and Penman' s definitions. The authors overlapping two or more models. The EQA Thiagarajan's findings confirm that their define earnings quality as the ability of evaluator assigns a point value ranging hom fundamental (earnings) quality score corre­ reported earnings to reflect the company's I to 5 for each of the 20 criteria, with a pos­ lates to earnings persistence and growth, true earnings and to help predict future sible total of 100 points. A score of 1 indi­ and that subsequent growth is higher in high earnings. They consider earnings stability, cates a negative effect on earnings quality, quality-scoring groups. Empirical Research persistence, and lack of vari ability to be and a score of 5 indicates a very positive Partners' model is ba~ed in part on method­ key. As Beaver indicates: "current earnings effect on earnings quality. EQA scores, then, ology developed and tested by Piotroski, are useful for predicting future earnings ... can range from 20 to 100. Similar to the whose findings indicate a positive rela­ [and] future earnings are an indicator of grading methods for bond ratings, grades tionship between scores ba~ed on the model future dividend-payi ng ability" (in M. are a<;signed based on the following scale: and future profitability. Bauman, " A Review of Fundamental 85-100 points = A, 69-84 points = AB, Exhihit 1 summarizes the criteria consid­ Analysis Research in Accounting," Journal 53-68 points = B, 35- 51 points = BC, and ered in each of the eight models for mea­ (~f Accounting Literature 15 , 1996). 20--34 points = C. While the EQA evalua­ suring earnings quality. Of the 51 crite­ tor needs to use professional judgment in riaJmeasurement~ used in the eight models, Earnings Quality Assessment (EGA) assigning scores to each of the criteria, the only eight (acquisitions; flow from oper­ The authors propose an Earnings Quality guidelines in Exhibit 2 are recommended. ations/net income; employee stock options; Assessment (EQA) that provides an inde­ operating earnings; pension fund expenses; pendent measure of the quality of a com­ Auditors Should Perform the Earnings R&D spending; share buyback/issuance; and pany's reported earnings. The EQA con­ Quality Assessment tax-rate percentage) are common to two sists of a model that uses 20 criteria that Responsibility for completion of the models, and only two (gross margin and one­ impact earnings quality (see Exhihit 2), EQA could fall to a variety of groups, time items) overlap in three models. applied as a "rolling evaluation" of all peri­ including financial analysts, corporate man­ The first step, then, is to develop a ods presented in the financial statements. agement, and auditors. Although Penman standard definition of earnings quality. One The EQA is more comprehensive than calls for a management-prepared quality­ of the objectives of FASB's Conceptual the eight models presented, considering of-earnings statement, the authors would

EXHIBIT 1 (continued from page 33) Criteria in Models for Measuring Earnings Quality

CFRA ERP FER l-T Ml RJ s&P UBS

Tax benefits of a declining tax rate X Employee stock options ' X X Gains/losses from sales X Ongoing restructuring charges X Pension gains X Purchased R&D expenses X I Reversal of prior-year charges and provisions X Unrealized hedging gains/losses X Other post-employment liabilities X Pension asset assumed returns X

CFRA: Center for Financial Research and Analysis; ERP: Empirical Research Partners; FER: Ford Research; L-T: Lev-Thiagarajan; ML Merrill Lynch (David Hawkins); RJ: Raymond James & Associates (Michael Krensavage); S&P: S&P Core Earnings; UBS: UBS (David Bianco) * One-time items include impairment charges, litigation or insurance settlements, and write-downs of intangibles and tangibles.

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Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. not go that far. Management should be EXHIBIT 2 responsible for making an assertion about Criteria in Earnings Quality Assessment (EGA) the company's quality of earnings, similar to the financial statement assertions cur­ rently required. Given management's inher­ Criteria Score ent bias. however, an evaluation of its own issues (Shifts of revenues to other periods: quality of earnings would not be viewed low EOA score of 1.) 1-5 by the public as reliable. Gross margin/sales ratio (High and improving relative to industry: Equity and credit analysts conduct their high EGA score of 5.) 1-5 own assessments of earnings quality for companies they cover. The analysts are not. Operating earnings/sales (High and improving relative to industry: however, privy to the considerable evi­ high score.) 1-5 dence that auditors gather during their Earnings variability (Great variability: low score.) 1-5 . In addition, the analysts are often Cash flow from operations exceeds net income (Greater difference: not independent of the companies they high score.) 1-5 cover, and they do not employ uniform procedures for measuring earnings quality. Expense recognition issues (Shifts of expenses to other periods: The authors propose that. for several rea­ low score.) 1-5 sons, auditors are the most logical choice Operating leases (Greater occurrence and amount: low score.) 1-5 to be responsible for the EQA. First, all R&D (Decreasing R&D : low score.) 1-5 of the criteria proposed for the EQA are Pension expenses and gains (Consider trend and industry. items that are already reviewed by auditors Greater occurrence and amount: low score.) as part of their audit procedures. Second. 1-5 the auditors would be independent evalu­ Employee stock option expense (Pro forma and large impact on EPS: ators of earnings quality. Due to recent low score.) 1-5 accounting scandals and widespread con­ Gain (loss) from asset sales/sales (Incidence is negative. Look at trend fusion about pro forma earnings. tinancial and industry.) 1-5 statement users need an independent mea­ Acquisitions/dispositions (Evaluate soundness relative to goals.) 1-5 sure of the quality of earnings. Third. through review of the underlying relation­ Discontinued operations (Consider trend and industry. Greater ships of the business transactions, audi­ occurrence and amount: low score.) 1-5 tors have the ability to see how the tinan­ Ongoing restructuring charges (Consider trend and industry. cial statements fit together. Auditors' Greater occurrence and amount: low score.) 1-5 insight and expertise in this area is much One-time items (Consider trend and industry. Greater occurrence like the expertise required to evaluate and and amount: low score.) 1-5 report on management's assessment of internal controls under section 404 of the Extraordinary items (Consider trend and industry. Greater occurrence Sarbanes-Oxley Act. Fourth. SAS 90. Audit and amount: low score.) 1-5 Committee Communications, requires audi­ Accounting changes (Consider trend and industry. Greater occurrence tors to discuss their judgment of the accept­ and amount: low score.) 1-5 ability and quality of the company's Reverses prior charges/provisions (Consider trend and industry. accounting principles with the audit com­ Greater occurrence and amount: low score.) 1-5 mittee for each SEC engagement. This dis­ Tax-rate percentage (High variance from statutory rate and high cussion should include the consistency. variance: low score.) 1-5 clarity, and completeness of itcms such as accounting policy changes. estimates, Share buyback/issuance (Examine degree and trend. High incidence: unusual transactions. and the timing of low score.) 1-5 transactions. Total possible rating 100 The auditors ' independent evaluation of earnings quality in the EQA will help Quality Grade Total investors assess future earnings potential Score and analysts to make better predictions. Excellent A 85--100 The EQA is forward-looking and has pre­ Good AB 69--84 dictive value. This is consistent with Fair B 52-W FAS8's Concepts Statement I and with Marginal BC 35--51 the recommendation made by the AICPA's Poor C 20--34 1994 Jenkins Committee Report that com-

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Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. EIGHT MODELS FOR MEASURING EARNINGS QUALITY

Center for Financial Research and Analysis • Percent change in sales minus percent change in order (www.cfraonline.com) backlog is considered an indication of future performance. • Four criteria to uncover methods used to manipulate • Labor force reductions and unqualified audit opinions earnings. are viewed favorably. • Report includes financial summary, accounting policy analy­ sis, discussion of areas of concern. Merrill Lynch (David Hawkins) (See also Quality of Earnings: Towards a 360 0 View of Reality, 2002.) Empirical Research Partners • Higher return on total capital percentage (pretax operating (See also Stock Selection: Research and Results March 2004; return on total capital) equates to higher quality of earnings. and J. Piotroski, "Value Investing: The Use of Historical Financial • Cash realization ratio (how close net income figure is to being Statement Information to Separate Winners from Losers," realized in cash) above 1.0 indicates higher quality of earnings. Journal of , Supplement, 2000.) • Productive asset reinvestment ratio (commitment to maintain • Three components: 1) net working-capital growth rate, net investment in capital assets) above 1.0 indicates higher quali­ noncurrent assets, deferred taxes; 2) incremental earnings ty of earnings. and free cash flow production relative to each new dollar of • Effective tax rate percentage (degree of reliance on reporting revenue or book value; and 3) nine financial indicators, put low tax rates) at or above average for all companies indi­ together for a single gauge of fundamentals. cates higher quality of earnings. • Items viewed favorably: positive return on assets and operat­ • Model also considers S&P long-term credit rating and S&P ing cash flow; increases in return on assets, current ratio, rank based on earnings and dividends growth stability over gross margin, asset turnover; operating cash flow that the last 10 years. exceeds net income. • Items viewed unfavorably: increases in long-term debt-to­ Raymond James & Associates (Michael Krensavage) assets; presence of equity offerings. (See also Earnings Quality Monitor, 2003.) • Each indicator given a 1 if favorable, a 0 if not; scores • A rating of 1 (worst) to 10 (best) assigned for each of 10 pro­ aggregated on a 0 to 9 scale. prietary benchmarks; equally weighted ratings are combined to determine earnings quality score. Ford Equity Research • Indicators of lower earnings quality: increases in receivables; (www.fordinv.com) earnings growth due to decreased tax rate; capitalization of • Earnings variability is minimum standard error of earnings for interest; high frequency/magnitude of one-time items. past eight years, fitted to an exponential curve. • Large acquisitions made in recent periods are penalized. • Growth persistence considers earnings growth consistency • Practicing conservative pension fund management and over 10 years; projected earnings growth rate is applied to nor­ increasing R&D faster than revenues are rewarded. mal earnings to derive long-term value. • Cash flow that grows along with net income and increases in • Operating earnings calculated by excluding unusual items, such gross margin positively impact earnings quality. as restructuring charges and asset write-downs; earnings trend analysis done on this adjusted figure. S&P Core Earnings • Repurchases of an entity's own shares are analyzed to (See also Core Earnings Technical Bul/etin, October 2002.) determine if results are favorable. • Attempts to give more-accurate representation of true perfor­ mance of ongoing operations. Lev-Thiagarajan • Included in core earnings: employee stock option grant (See also "Fundamental Information Analysis," Journal of expenses; restructuring charges from ongoing operations; Accounting Research, Autumn 1993.) write-downs of depreciable or amortizable operating assets; • Each fundamental is assigned a value of 1 for positive signal, pension costs; purchased R&D expenses; merger/acquisition ofor negative signal. expenses; and unrealized hedging gains and losses. • Each of 12 factors are equally weighted to develop • Excluded items: goodwill impairment charges; gains (losses) aggregate fundamental score. from sales of assets; pension gains; litigation or insurance set­ • Negative signals include: decrease in gross margins dispro­ tlements; and reversal of prior-year charges and provisions. portionate to sales; disproportionate (versus industry) decreases in capital expenditures and R&D; increases in UBS (David Bianco) S&A expenses disproportionate to sales; and unusual (See also S&P 500 Accounting Quality Monitor, 2003.) decreases in effective tax rate. • Compares GAAP to operating earnings; difference represents • Inventory and accounts receivable signals measure percent net one-time criteria. change in each (individually) minus percent change in sales; • Employee stock option expenses are deducted from inventory increases exceeding cost of sales increases and operating earnings. disproportionate increases in receivables to sales are consid­ • Assumed pension asset returns are adjusted to market value ered negative. times interest or discount rate. • Unusual changes in percent change of provision for doubtful • Health-care costs are inflation-adjusted if reported to be 300 receivables, relative to percent change in gross receivables, basis points higher than weighted average forecasted by are also viewed negatively. S&P 500 companies.

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Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. panies should disclose forward-looking team, completes the EQA. The consisten­ future earnings but that are not explicitly infonnation. Auditors' responsibility for the cy provided by use of the EQA model disclosed in the tinancial statements. EQA would improve auditors' involvement would enhance the comfort level of users The authors propose that auditors conduct in reporting, another recommendation made of the financial statements and the EQA. the EQA and issue a public report. Auditors' in the Jenkins Report. Additionally, audi­ EQA reports will provide higher"<\uality infor­ tor preparation of the EQA would help nar­ Need for Further Development mation to tinancial statement users and meet row the expectations gap between auditors' There is significant need for the devel­ the SEC's demand for greater a<;surance about responsibilities and public expectations. opment of a uniform definition and a the reliability of earnings figures. 0 Auditors should complete the EQA, gen­ consistent model to mea-;ure earnings qual­ erate a report, and communicate the find­ ity. This article provides such a defini­ ings to management and the audit com­ tion, positing that the quality of earnings Jodi L Bel/ovary, CPA, is a graduate stu­ mittee. The EQA report would be attached includes the ability of reported earnings dellt at Marquette University, Milwaukee, to the financial statements with the audit to retlect the company's true earnings, as Wis. DOli E. Giacomino, CPA, is a pro­ report. If the auditing profession does not well as the usefulness of reported earn­ fessor and Donald E. & Beverly L. Flynll take control of the situation, another group ings to predict future earnings. The authors Chair Holder at Marquette Unil'ersity. is likely to step in , much like when propose an Earnings Quality Assessment Michael D. Akers, CPA, CMA, CFE, Congress implemented the Sarbanes-Oxley (EQA) model that is consistent with this CIA, CBM, is a professor and chair, Act. As Lynn Turner, fonner SEC chief definition. The EQA recognizes many of department of accoullTing; and Charles T , commented: "If I'm an audi­ the fragilities of GAAP, and takes into HOl7lgrell Professor ofAccounting, also at tor, I don't want to be sitting there and have account factors that are expected to affect Marquerre University. Moody's come out and say my audit client is doing lousy accounting."

The Application of EOA To illustrate the process of applying the EQA, the authors chose two large phar­ maceutical companies, Merck and Wyeth. Each of the authors independently applied Revenue recognition issues 5 5 the EQA to Merck's and Wyeth's 2003 Gross margin/sales 5 3 financial statements, and then met to dis­ cuss their results. Based upon each indi­ Operating earnings/sales 4 3 vidual assessment and the subsequent dis­ Earnings variability 4 2 cussion, they reached an agreed-upon Cash flow from operations exceeds net income 4 1 score, presented in Exhibit 3. Expense recognition issues 5 4 This process is similar to what an engagement team would go through . Operating leases 4 4 Each member would complete the EQA R&D 5 4 independently, then the group would Pension expenses and gains 2 2 meet as a whole to discuss the assessment Employee stock option expense 3 2 and reach a conclusion. lbis process allows for varying levels of experience, and Gain (loss) from assets sales/sales 5 2 takes into account each team member's Acquisitions/dispositions 4 3 perspective based on exposure to various Discontinued operations 3 5 areas of the company. The audit team's discussion is also helpful when one mem­ Ongoing restructuring charges 3 ber finds an item that another might not One-time items 5 have, which may explain variances in the Extraordinary items 5 5 scores assigned by each individual. Accounting changes 5 5 For the illustration, the EQA was based solely on data provided in the financial Reverses prior charges/provisions 5 5 statements. The authors found a high Tax-rate percentage 4 2 level of agreement on the quality of earn­ Share buyback/issuance 4 4 ings measures, and there was little varia­ tion in the scores for both companies. One would expect even less variation when a group more intimately exposed to an Quality Good Fair organization, such as the audit engagement

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