Financial Statement Analysis — Earnings Quality: Accruals, Persistence and Signs of Earnings Management

The same ₩10 billion of profit may be backed by cash and likely to recur next year, or it may have been made once by changing an estimate. Earnings quality is how faithfully reported profit represents a company’s sustainable performance. This chapter corresponds to “accounting analysis” among the four stages of chapter 1.

1. Profit = cash flow + accruals

Accrual-basis profit is cash flow plus accruals (revenues and expenses with no cash changing hands).

Total accruals and the accrual ratio

\text{Total accruals} = \text{Net profit} - \text{Operating cash flow}, \qquad \text{Accrual ratio} = \frac{\text{Total accruals}}{\text{Average total assets}}

Accruals are where estimates come in. The larger and more positive the accrual ratio, the less the profit is backed by cash.

Comparing two companies' accruals (unit: ₩100 million)
Item	FA	FF
Net profit	96	100
Operating cash flow	106	20
Total accruals	−10	80
Average total assets	950	1,000
Accrual ratio	−1.1%	8.0%

For FF, 80% of profit is accruals. Research (Sloan, 1996) showed that the profits of companies with high accrual ratios tend to fall the following year and that the market does not fully price this in. Accruals are eventually either realized in cash or reversed.

2. Persistence and normalization

Profit with one-off items removed, leaving only what will recur, is called normalized earnings.

FF’s net profit of ₩10 billion includes a ₩3 billion gain on disposal of property, plant and equipment and a ₩1 billion reversal of a litigation provision, and is after ₩1.5 billion of restructuring costs. At a 20% tax rate, normalized earnings are $100 - (30 + 10 - 15) \times 0.8 = 100 - 20 = 80$ , i.e. ₩8 billion.

Examples of one-off items
Nature	Examples
Disposal and remeasurement gains and losses	Gains and losses on disposal of PP&E and investments, fair value changes on investment property, gains and losses on loss of control
Restructuring and litigation	Restructuring costs, litigation settlements, recognition and reversal of provisions
Impairment	Impairment losses and reversals on goodwill and PP&E
Accounting changes	Cumulative effects of changes in estimates, remeasurement of deferred tax on a change in tax rates

A company that excludes restructuring costs every year as “one-off” is in effect hiding a recurring cost. Look at several years together before judging.

3. Typical signs of earnings management

Receivables growing faster than revenue: channel stuffing at period-end, loosened credit terms (chapter 4).
Inventory growing faster than cost of sales: obsolete stock not written down, overproduction deferring fixed costs (Cost Accounting chapter 12).
Sharp falls in or reversals of provisions and allowances: building them up in good years and releasing them in bad years to smooth profit.
Changes in depreciation policy: longer useful lives or higher residual values to cut expense.
A rising share of development costs capitalized: turning expenses into assets to boost profit (Intermediate Accounting chapter 4).
A persistent gap between operating cash flow and net profit.

Beneish’s (1999) M-score combines eight variables — including the days’ sales in receivables index, gross margin index, asset quality index, sales growth index, depreciation index, SG&A index, accruals and leverage index — to estimate the likelihood of earnings manipulation.

Check your understanding

FG’s net profit is ₩15 billion, operating cash flow ₩6 billion and average total assets ₩120 billion. Profit includes a ₩5 billion fair value gain on investment property, and the tax rate is 20%. What are the accrual ratio and normalized earnings excluding the fair value gain? How would you assess the quality of this company’s earnings?

Total accruals are $150 - 60 = 90$ (₩9 billion) and the accrual ratio $90 / 1{,}200 = 7.5\%$ . Normalized earnings are $150 - 50 \times 0.8 = 110$ (₩11 billion). A large share of profit comes from a non-cash fair value gain and accruals, so earnings quality is low. If accruals remain large even after removing the fair value gain, check the notes for the causes of the change in working capital.

References

Richard Sloan, “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?,” The Accounting Review (1996)
Messod Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal (1999)
Krishna Palepu, Paul Healy and Erik Peek, Business Analysis and Valuation: IFRS Edition, ch. 3–4