Seminar 12

Earnings Quality Analysis and Revision

 Valuation flow chart
Capital market analysis
• Ownership
• Information environment
• Information disclosure
• Liquidity
• Information analysis

Business analysis Financial analysis

• Macroeconomic and other
external macro factor
analysis
Earnings Risk
• Industry analysis
quality and analysis Valuation
• Business strategy analysis
accounting Forecast
&
analysis discount
Management quality and rate
corporate governance
analysis
• Management quality
• Internal CG
• External CG
2
 Accrual quality analysis

Accounting quality can be analysed using qualitative and quantitative methods.

In week 5 and week 6 we learn qualitative measures of accounting quality analysis

• In this approach we go deeper into the financials of the company to identify issues that
suggest there are issues with the reported accruals.

3
 Financial Reporting Quality

When financial reporting is of high quality, it allows users

to form an unbiased assessment of reported performance
and forecast future performance more accurately.
Noise in financial statements mislead investors and lead
them to make sub-optimal valuations.
Corporate governance used as a proxy measure of
financial reporting quality

4
 The quality of financial reports

We can estimate the quality of financial data by estimating the quality of earnings and accrual.

When earnings figures are manipulated the quality of financial statements is low

Estimation of earnings and accrual quality is therefore important.

Earnings consist of an accrual and cash component and it is the accrual component of earnings
through which earnings manipulation mainly occur (e.g. inflating accounts receivable,
deflating depreciation expense)

We can therefore employ earnings or accruals quality as a measure of accounting quality.

5
 Factors Influencing
Financial Reporting Quality

It is necessary to allow managers some discretion in applying accounting

standards

There are two potential sources of noise and bias in accounting information:

1. Rigidity in accounting standards

2. Management bias

6
 Rigidity in Accounting Standards

Mandatory accounting treatment inconsistent with the economic reality of

the transaction

No discretion afforded management in the accounting process

• Research expenditure

7
 Management Bias: Forecast Errors

In complying with accrual accounting, managers cannot predict future

consequences of current transactions with precision

• Allowance for doubtful debts

• Depreciation expense

8
 Evaluating Financial Reporting Quality

 Where should we start?

Earnings

 Earnings are the net benefits of a corporation's operation. Many alternative terms for
earnings are in common use, such as income and profit. ( NPAT: net profit after tax)

 When earnings figures are manipulated, earnings quality is low. Financial reporting
quality is low.

 Measure earnings quality is therefore important

9
 Earnings Quality

When earnings quality is high it will reflect current period performance

accurately and convey information about expected future profits and
cash flows.

So earnings quality is therefore also dependent on earnings persistence

– the extent to which current period earnings are indicative of future
earnings.

Stated differently, earnings persistence refers to the ability of current

earnings to predict future earnings.

Earnings that are more persistent are of higher quality.

10
 (1) Earnings Persistence

Earnings persistence is the ability of current earnings to predict future

earnings

Earnings that are more persistent are of higher quality

• Persistent earnings are desirable because they are recurring (earnings
sustainability)

Empirical evidence:
• Sloan (1996) finds that operating income has a persistence coefficient of 0.84 (US
data);
• Coulton et al. (2005) find a coefficient of 0.57 (Australian data)

11
 (1) Earnings Persistence

As stated earlier, earnings persistence is measured as the extent to

which current earnings are indicative of future earnings

We can estimate this quantitatively:

EARt+1 = α0 + α1EARt +εt

Where EAR is earnings (or earnings per share)

The higher the coefficient of EARt the higher the persistence of

earnings

Refer to BHP illustration

12
 (1) Earnings Persistence

Download earnings and total asset data from Orbis

Run regression in Excel

The coefficient of X is the estimate for earnings persistence

SUMMARY
OUTPUT

The coefficient of 0.58 indicates

Regression Statistics
Multiple R 0.540834247 company’s earnings in one period
R Square 0.292501683 is a reasonable indicator of that in
Adjusted R Square 0.204064393
Standard Error 0.011467335 the next period.
Observations 10

ANOVA
Significance
  df SS MS F F
0.00043 3.3074473 0.10647371
Regression 1 0.000434929 5 9 8
0.00013
Residual 8 0.001051998 1
Total 9 0.001486927      

Lower Upper
  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0%
1.08961 0.3076121 - 0.0329291 0.03292911
Intercept 0.010566585 0.009697524 7 8 0.01179595 2 -0.0117959 5
1.81863 0.1064737 - 1.3229320 -
X Variable 1 0.583307624 0.320738564 9 2 0.15631683 8 0.1563168 1.32293208 13
Example of earnings persistence comparison

X Ltd  Coefficients t Stat p-level

Intercept 0.041 1.01245 0.13131
Lag scaled net income 0.3679 2.11027 0.01478

Peer Comparison    
Ticker Symbol Earnings Persistence Coefficient Descriptive statistics
GST 0.84992 Mean 0.538961
AUQ 0.58023 Standard Error 0.0657932
EVU 0.45629 Median 0.521835
FMI 0.73136 Count 10
NGC 0.25464 Standard Deviation 0.2080564
AVY 0.30261 Sample Variance 0.0432875
SMF 0.76247 Skewness 0.0653479
DRD 0.33465 Range 0.59528
CEP 0.65400 Minimum 0.25464
CGG 0.46344 Maximum 0.84992
Average 0.53896 Sum 5.38961

14
 (2) Accrual Quality

Under accrual accounting

Earnings = cash (transactions-based) + accruals (adjustments-based)

Can be manipulated:
Little manipulation
earnings management

Accruals, therefore, play an important role in the credibility of

accounting information in financial statements
15
 (2) Accruals Quality

 Earnings=cash +accruals

 discretionary non-discretionary
 component component
The non-discretionary component is not subject to managerial
manipulation and are “innate accruals”
Driven by innate features of the firm’s business model and operating
environment
The discretionary component is subject to managerial bias

Driven by managerial accounting policy choices and managerial error

16
 (2) Accruals Quality

Consider the following:

• Management of a firm not meeting its earnings targets will be aware that the release
of lower than expected earnings will adversely affect its share price
• In an effort to avoid this, managers may artificially inflate earnings (and accounts
receivable) by understating bad debt provisions
• This is an example of a discretionary accrual and contributes to lower quality
earnings since it is not a true representation of the firm’s financial position

17
 (2) Accruals Quality

Step 1: calculate the Accrual Model components

Step 2: estimate the Accrual Model regression

DWCi,t =CFOi,t- 1+CFOi,t +CFOi,t+1 + DREVENUEi,t + PPE + ei,t

Step 3: use coefficients from the components to predict the level of accruals

Step 4: find the difference between actual and predicted accruals

Step 5: find the standard deviation of all the differences

Note:

The larger the absolute value of discretionary accruals, the lower is accruals/earnings/financial
reporting quality

Both cross sectional and time series methodologies can be used for earnings quality estimation

18
 Accruals Quality: Example

A detailed example of calculating accruals quality will be conducted in class using

data from Datanalysis

Limitations of the approach:

1. It requires one firm to have multiple years of data

2. The residuals from the regression can still be estimation noise rather than
discretionary component of accruals

3. The residuals may be driven by particular firm policies which the model does not
control for

Accrual estimation error model (Dechow and Dichev, 2002) using the modified
version based on Francis, LaFond and Schipper (2005), is used to estimate the
quality of accruals.

19
Revision- last 6 weeks

20
Revision- last 6 weeks

21
Revision- last 6 weeks

22
Revision- last 6 weeks

23
Revision- last 6 weeks

24
Revision- last 6 weeks

25
Revision- last 6 weeks

26
Revision- last 6 weeks

27
 Reminder

Assignment Part 2 due in week 12 on Friday (Oct 22 nd) by 4pm

Soft copy (word only single attachment and eVal. On the cover page, please list out the
seminar stream you are attending (Monday 10am), the names, emails and student
IDs of your group members): chen.chen2@monash.edu
Marked reports will be made available at the end of SWOTVAC week
Feedback and marks will be delivered by email
Students must also submit the group reflection on Moodle at the same time, due in
SWOCTVAC on Monday (Oct 25th) by 3pm, every group member must hand in their
own one before the due day. Otherwise, their group assignment will not be marked.
 Exam Information
Question No. Topic Type of questions and topics of importance Marks allocated
1 Capital market analysis Theory – quality of the information environment [2 + 5 + 2] = 9 marks
Theory – quality of the information environment
Calculation – quality of the information environment (formula not provided)

2 Business analysis Theory – Segment reporting [3 + 3+3 ] = 9 marks

Theory – GDP growth
Theory – income and consumption

3 Management Quality Theory – corporate governance analysis 11 marks

and Corporate
governance analysis
4 Overview of accounting Theory – accounting distortion [3 + 3 + 4] = 10 marks
analysis Theory – earnings manipulation
Simple calculation and theory – identification of red flags
5 Implementation of Theory – accounting distortion identification [6 + 4] = 10 marks
accounting analysis Calculation – Implementation of accounting analysis
6 Financial Analysis Theory – ratio analysis [2 + 4 ] = 6 marks
Calculation – decomposition of earnings (formula provided)

7 Forecasting Theory –forecasting [3 + 11] = 14 marks

Calculation – forecasting of financial statement (formula not provided)
8 Risk analysis and Cost of Theory – identify risks [6 + 4 + 3] = 13 marks
capital Calculation – WACC (formula not provided)
Theory – risk analysis
9 Valuation Calculation – Valuation (formula not provided) 7 marks

10 Accrual quality Simple calculation and theory (formula not provided) [5 + 6] = 11 marks
Simple calculation and theory – accruals quality (formula not provided)

29
Exam period consultation

Information on availability of teaching staff will be emailed

before the SWOT VAC week
 Thank you
&
Wish you all the best

Presentation title 31