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QUALITY of EARNINGS and Earnings Management a Primer for Audit Committee Members by Roman L

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QUALITY of EARNINGS and Earnings Management a Primer for Audit Committee Members by Roman L QUALITY OF EARNINGS AND EARNINGS ManageMENT A Primer for Audit Committee Members BY ROMAN L. WEIL » FEBRUARY 09 collection on the one hand, and expense recognition and cash expenditure on As an audit committee member, you are familiar with the terms the other. For them, the shorter the “quality of earnings” and “earnings management.” This primer delay, the higher the quality. A company defines these terms and explains your role in performing oversight with all cash sales, no warranty or other of a company’s financial statements. after-market promises, and no long- term assets has high-quality earnings. A company engaged in a long-term What is Quality of Earnings?1 term imponderables, such as how long construction project with cash collections a person will live or future earnings on The terms “quality of earnings” and near project’s end, and construction investments. Such estimates are difficult “earnings quality” have no single, equipment with long depreciable lives, has to quantify, or fuzzy, which gives the agreed-upon meaning. Both terms are low-quality earnings. company the opportunity to report a used when making accounting choices; wide range of periodic earnings. The considering the business cycle, including • Still others use the phrase to mean the result: even if management does not timing of transactions; and discussing degree to which managers, when faced use fuzzy estimates to manipulate its earnings management [see page 2]. with a choice of items that have a high earnings, the opportunity is there — impact on earnings, choose items that which causes users to think earnings Accounting Choices result in income recognition that’s more numbers are of low quality. likely to lead to recurring patterns of • Some use “quality of earnings” to mean income. For them, the more likely an • Others use the phrase to mean the degree to which management’s item of earnings is to recur, the higher its the degree to which management choices of accounting estimates can quality will be. takes advantage of its flexibility. For affect reported income (these choices them, an insurance company that does occur every period). For example: • Consider, for example, a car dealer not vary its methods and estimating those who use the term in this manner who leases cars to customers. The techniques, despite the opportunity judge an insurance company’s earnings leasing dealer who uses operating to do so, has high-quality earnings. to be of low quality. The company’s lease accounting has perfectly matching management must re-estimate its future revenue recognition and cash collection, • Some have in mind the proximity in time payments to the insured, by period — but the recurring nature of the between revenue recognition and cash and the estimates are made about long- revenue, with monthly receipts, might 1: This section uses material from the textbook Financial Accounting: An Introduction to Concepts, Methods, and Uses, 13th edition, published by South-Western, Cengage Learning, 2010, and written by Clyde P. Stickney, Roman L. Weil, Katherine Schipper and Jennifer Francis. 2 mislead the unwary reader of financial Business Cycles is unlikely to say that any one estimate for statements into thinking that the key, uncollectibles in the range of 2.0 to 2.2% of income-generating transaction — the In regard to business cycles, management’s sales is better than another. Management signing of the lease — recurs. actions often have no impact on the can choose the number in that range and stability and recurrence of earnings. effect a swing of 4% in net income. Often, the latter two groups trade off: Compare a company that sells consumer Consider the dealer leasing a car long- products and has repeat sales every The SEC has long recognized that accrual term and receiving monthly collections. week vs. a construction company that accounting requires such estimates and, since The dealer who uses sales-type lease builds to order. Companies in noncyclical 2003, has required companies to list the accounting scores low on proximity of businesses, such as some public utilities, critical accounting judgments and estimates revenue recognition (all at the time of likely have more stable earnings than ones that underlie its financial reporting. signing the lease) to cash collection, but in cyclical businesses, such as steel. Some highlights the non-repetitive nature of use “quality of earnings” to refer to the Focus on something concrete, such as the transaction. The leasing dealer who stability and recurrence of basic revenue- the expected percentage of uncollectible uses operating lease accounting exactly generating activities. Those who use the accounts illustrated above. There will matches revenue recognition and cash phrase this way rarely associate earnings inevitably be a range, such as from 1.50% collection, but disguises the fact that the quality with accounting issues. to 1.75%, within which no one number key transaction — leasing the car — is most accurate. Management has happens only once. What is Earnings Management?2 to choose a number. Under ordinary circumstances with non-declining business “Earnings management” is not a technical When considering the company’s income- operations, the higher the number, the term in accounting or finance. However, it earning event, one could mean the lower the income reported this period. occurs when 1.) firm management has the underlying economic event (car dealer signs The wider the range of reasonable opportunity to make accounting decisions the lease) or the revenue recognition (the estimates, the more management’s choice that change reported income, and 2.) dealer using operating lease accounting will influence bottom-line net income and exploits those opportunities. receives cash). This is a good example of the comprehensive income. (The SEC’s fair need for careful interpretation of “quality of value release suggests companies and, by Accounting Estimates earnings” in discussions and documents. implication, their audit committees need A writer who focuses on the episodic Accounting for business operations to focus more on clear presentations nature of signing lease agreements may requires judgment and estimates. For of Other Comprehensive Income and deem this company’s earnings low quality example, one can’t measure revenue Comprehensive Income than heretofore.) because transactions do not regularly without estimating when customers will Management’s ability to choose a number recur, while a writer who focuses on cash pay, how many will not pay, how many from a reasonable range and be confident flow will consider the earnings high quality will return goods for refund, and costs to no one can say some other number is because the cash flow is regular. the seller for fulfillment of warranty or better gives them the opportunity to maintenance promises. Some who refer to “earnings quality” manage earnings. When management’s suspect that managers usually will make For example, a retail business might have number-choice is made with an eye to its choices that enhance current earnings net income equal to 3% of revenues. A effect on net or comprehensive income, it and present the firm in the best light, change in its estimates of uncollectible is engaging in “earnings management.” regardless of the firm’s ability to generate accounts by two-tenths of a percent or by Timing of Transactions future, similar earnings. 20 basis points, such as from 2.0% to 2.2%, will have a 4.0% effect on net income. One Management can decide to paint the office 2: This section adapted from a book on corporate governance for board members that Roman L. Weil , the author of this piece, is writing with John D. Wilson, Esq. of Shearman & Sterling LLC. 3 in December. All other things being equal, 1) Understand the transactions that 4) Most important, understand the potential management will report lower earnings in require management to make the a given choice provides for earnings that office-painting period than in other judgment or estimate. (For example, a management. (If you don’t know how a periods. Management can choose when to company that mentions its accounting company using LIFO can manage earnings paint and, thereby, manage earnings. for inventory as significant is telling by delaying year-end purchases, you won’t us it has more goods for sale during a know to ask whether there have been In a more complex example, management period than it in fact sells.) unusual year-end accelerated or deferred of a company that uses a LIFO cost- purchases.) flow assumption for inventories has an 2) Understand the choices available to opportunity to manage earnings by timing management in U.S. GAAP or, now, under When you understand how a company’s end-of-year purchases. In times of rising IFRS, to account for the transactions in transactions intertwine with its prices, management can buy during this item 1. (In the U.S., the company can use accounting principles, you will be able to period (thus increasing cost of goods sold FIFO or LIFO or weighted-average cost- determine whether a company engages in and reducing income) or delay purchases flow assumptions or specific identification. earnings management. until the next period (thus decreasing this The company reporting under IFRS period’s cost of goods sold and increasing cannot use LIFO.) Roman L. Weil, Ph.D., CPA, is V. Duane Rath Professor Emeritus of Accounting at the University of Chicago Booth income). Management can choose when School of Business. He is Program Fellow at Stanford Law to buy and, thereby, manage earnings. 3) Understand what management chose School and Visiting Professor of Accounting at Harvard Law and why. (A company choosing LIFO School. He is co-founder of the Chicago/Stanford/Tuck Many writers restrict the term “earnings likely does it to defer income tax Directors’ Consortium and the Advanced Curriculum for Fund Directors.
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