Financial analysts are concerned with more than just the bottom line of the income statement—net income. The presentation of the components of net income and the related supplemental disclosures provide clues to the user of the statement in an assessment of earnings quality. Earnings quality is used as a framework for more in-depth discussions of operating and nonoperating income.
The term earnings quality refers to the ability of reported earnings (income) to predict a company's future earnings. refers to the ability of reported earnings (income) to predict a company's future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company's transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future. Later in the chapter we address two items that, because of their transitory nature, are required to be reported separately at the bottom of the income statement. Analysts begin their assessment of permanent earnings with income before these two items, that is, income from continuing operations.
It would be a mistake, though, to assume income from continuing operations reflects permanent earnings entirely. In other words, there may be transitory earnings effects included in income from continuing operations. In a sense, the phrase continuing may be misleading.
Earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings.
Manipulating Income and Income Smoothing
A Fortune magazine article “Hocus-Pocus: How IBM Grew 27% a Year” contained a subtitle “Do you want to believe in the IBM miracle? Then don't look too closely at the numbers.”7 The article is highly critical of IBM's earnings management practices that allowed the company to report earnings per share growth of 27% per year from 1994 through 1999 with only minimal growth in revenues. The article's author attributes the increase in earnings per share to share buybacks, the sale of assets, and gains in pension fund assets, not a growth in permanent earnings.
KEN SCHAPIRO—CONDOR CAPITAL MANAGEMENT
IBM has run out of easy things to do to generate earnings growth. Now they have to do the hard stuff.6
An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. One author states that “Most executives prefer to report earnings that follow a smooth, regular, upward path. They hate to report declines, but they also want to avoid increases that vary wildly from year to year; it's better to have two years of 15% earnings increases than a 30% gain one year and none the next. As a result, some companies ‘bank’ earnings by understating them in particularly good years and use the banked profits to polish results in bad years. ”8
ARTHUR LEVITT, JR.
While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their estimates. I recently read of one major U.S. company that failed to meet its so-called numbers by one penny and lost more than six percent of its stock value in one day.9
Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. A 1998 BusinessWeek issue was devoted entirely to the topic of earnings management. The issue, entitled “Corporate Earnings: Who Can You Trust,” contains articles that are highly critical of corporate America's earnings manipulation practices. Arthur Levitt, Jr., former Chairman of the Securities and Exchange Commission, has been outspoken in his criticism of corporate earnings management practices and their effect on earnings quality. In an article appearing in the CPA Journal, he states,
Many believe that corporate earnings management practices reduce the quality of reported earnings.
Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding commonsense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion. (emphasis added)10
How do managers manipulate income? Two major methods are (1) income shifting and (2) income statement classification. Income shifting is achieved by accelerating or delaying the recognition of revenues or expenses. For example, a practice called “channel stuffing” accelerates revenue recognition by persuading distributors to purchase more of your product than necessary near the end of a reporting period. The most common income statement classification manipulation involves the inclusion of recurring operating expenses in “special charge” categories such as restructuring costs (discussed below). This practice sometimes is referred to as “big bath” accounting, a reference to cleaning up company balance sheets. Asset reductions, or the incurrence of liabilities, for these restructuring costs result in large reductions in income that might otherwise appear as normal operating expenses either in the current or future years.
Mr. Levitt called for changes by standard setters to improve the transparency of financial statements. He did not want to eliminate necessary flexibility in financial reporting, but wanted to make it easier for financial statement users to “see through the numbers” to the future. A key to a meaningful assessment of a company's future profitability is to understand the events reported in the income statement and their relationship with future earnings. Let's now revisit the components of operating income.
Operating Income and Earnings Quality
Should all items of revenue and expense included in operating income be considered indicative of a company's permanent earnings? No, not necessarily. Sometimes, for example, operating expenses include some unusual items that may or may not continue in the future. Look closely at the 2009 and 2008 partial income statements of JDS Uniphase Corporation, a leading provider of optical products for telecommunications service providers, presented in Graphic 4-3. What items appear unusual? Certainly “Impairment of goodwill,” “Impairment of long-lived assets,” and “Restructuring costs,” require further investigation. We discuss restructuring costs first.
Partial Income Statements—JDS Uniphase Corporation
Real World Financials
RESTRUCTURING COSTS. It's not unusual for a company to reorganize its operations to attain greater efficiency. When this happens, the company often incurs significant associated restructuring costs. Facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs. Restructuring costs are incurred in connection with:
A program that is planned and controlled by management, and materially changes either the scope of a business undertaken by an entity, or the manner in which that business is conducted.11
Restructuring costs appear frequently in corporate income statements. In fact, a recent survey reports that in 2008, of the 500 companies surveyed, 45% included restructuring costs in their income statements.12 For instance, consider again our JDS Uniphase Corporation example. A disclosure note accompanying the company's financial statements indicates 2009 workforce reductions in North American, Asian, and European locations. Graphic 4-4 reports a portion of the disclosure note related to the restructuring costs incurred during the second quarter of 2009.
Disclosure of Restructuring Costs—JDS Uniphase Corporation
Real World Financials
Restructuring Costs (in part)
During the second quarter of fiscal 2009, the Company recorded $6.6 million in restructuring costs which included $4.6 million for severance and benefits, $1.0 million for manufacturing transfer cost, and $1.0 million to adjust accruals on previously restructured leases. One hundred and five employees were notified for termination.
Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations.
Restructuring costs are recognized in the period the exit or disposal cost obligation actually is incurred. As an example, suppose terminated employees are to receive termination benefits, but only after they remain with the employer beyond a minimum retention period. In that case, a liability for termination benefits, and corresponding expense, should be accrued in the period(s) the employees render their service. On the other hand, if future service beyond a minimum retention period is not required, the liability and corresponding expense for benefits are recognized at the time the company communicates the arrangement to employees. In both cases, the liability and expense are recorded at the point they are deemed incurred. Similarly, costs associated with closing facilities and relocating employees are recognized when goods or services associated with those activities are received.
GAAP requires that restructuring costs be recognized only in the period incurred.
GAAP also establishes that fair value is the objective for initial measurement of the liability, and that a liability's fair value often will be measured by determining the present value of future estimated cash outflows. We discuss such present value calculations at length in later chapters, particularly in Chapters 6 and 14. Because some restructuring costs require estimation, actual costs could differ. Also, the costs might not occur until a subsequent reporting period. As we discuss later in this chapter and throughout the text, when an estimate is changed, the company should record the effect of the change in the period the estimate is changed rather than by restating prior years' financial statements to correct the estimate. On occasion, this process has resulted in a negative expense amount for restructuring costs due to the overestimation of costs in a prior reporting period.
Fair value is the objective for the initial measurement of a liability associated with restructuring costs.
Now that we understand the nature of restructuring costs, we can address the important question: Should investors attempting to forecast future earnings consider these costs to be part of a company's permanent earnings stream, or are they transitory in nature? There is no easy answer. For example, JDS Uniphase incurred restructuring costs in both 2009 and 2008. Will the company incur these costs again in the near future? Consider the following facts. During the 10-year period from 1999 through 2008, the Dow Jones Industrial 30 companies reported 113 restructuring charges in their collective income statements. That's an average of approximately 3.77 per company. But the average is deceiving. Three of the 30 companies reported no restructuring charges during that period. However, Pfizer incurred restructuring charges in 8 of the 10 years. The inference: an analyst must interpret restructuring charges in light of a company's past history. In general, the more frequently these sorts of unusual charges occur, the more appropriate it is that the analyst include them in the company's permanent earnings stream. Information in disclosure notes describing the restructuring and management plans related to the business involved also can be helpful.
Should restructuring costs be considered part of a company’s permanent earnings stream?
Two other expenses in JDS Uniphase's income statements that warrant additional scrutiny are impairment of goodwill and impairment of long-lived assets. These expenses involve what is referred to as asset impairment losses or charges. Any long-lived asset, whether tangible or intangible, should have its balance reduced if there has been a significant impairment of value. We explore property, plant, and equipment and intangible assets in Chapters 10 and 11. After discussing this topic in more depth in those chapters, we revisit the concept of earnings quality as it relates to asset impairment.
Is it possible that financial analysts might look favorably at a company in the year it incurs a substantial restructuring charge or other unusual expense such as an asset impairment loss? Perhaps so, if they view management as creating higher profits in future years through operating efficiencies. Would analysts then reward that company again in future years when those operating efficiencies materialize? Certainly this double halo effect might provide an attractive temptation to the management of some companies.
ARTHUR LEVITT, JR.
When a company decides to restructure, management and employees, investors and creditors, customers and suppliers all want to understand the expected effects. We need, of course, to ensure that financial reporting provides this information. But this should not lead to flushing all the associated costs—and maybe a little extra—through the financial statements.13
These aren't the only components of operating expenses that call into question this issue of earnings quality. For example, in Chapter 9 we discuss the write-down of inventory to comply with the lower-of-cost-or-market rule. Earnings quality also is influenced by the way companies record income from investments (Chapter 12) and account for their pension plans (Chapter 17).
Earnings quality is affected by revenue issues as well. As an example, suppose that toward the end of its fiscal year, a company loses a major customer that can't be replaced. That would mean the current year's revenue numbers include a transitory component equal to the revenue generated from sales to the lost customer. Of course, in addition to its effect on revenues, losing the customer would have implications for the transitory/permanent nature of expenses and net income.
Unusual or infrequent items included in operating income require investigation to determine their permanent or transitory nature.
Another revenue issue affecting earnings quality is the timing of revenue recognition. Companies face continual pressure to meet their earnings expectations. That pressure often has led to premature revenue recognition, reducing the quality of reported earnings.
Accelerating revenue recognition has caused problems for many companies. For example, Lucent Technologies' revenue recognition practices attracted the attention of the SEC. Nine current and former employees were charged with securities fraud for improperly recognizing sales of $1.15 billion in fiscal 2000. The SEC accused the former employees of falsely inflating revenues through aggressive sales practices, including the filing of false documents on sales to Winstar Communications, which later went bankrupt.14 In 2008, International Rectifier Corporation, a manufacturer of power management products, was named defendant in a federal class action suit related to numerous irregularities including premature revenue recognition. The company admitted shipping products and recording sales with no obligation by customers to receive and pay for the products.
Real World Financials
We explore these issues in Chapter 5, when we discuss revenue recognition in considerable depth, and in Chapter 13, when we discuss liabilities that companies must record when they receive payment prior to having actually earned the related revenue. Now, though, let's discuss earnings quality issues related to nonoperating items.
Nonoperating Income and Earnings Quality
Most of the components of earnings in an income statement relate directly to the ordinary, continuing operations of the company. Some, though, such as interest and gains or losses are only tangentially related to normal operations. These we refer to as nonoperating items. Some nonoperating items have generated considerable discussion with respect to earnings quality, notably gains and losses generated from the sale of investments. For example, as the stock market boom reached its height late in the year 2000, many companies recorded large gains from sale of investments that had appreciated significantly in value. How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent? Let's consider an example.
Intel Corporation is the world's largest manufacturer of semiconductors. Graphic 4-5 shows the nonoperating section of Intel's income statements for the 2000 and 1999 fiscal years. In 2000, income before taxes increased by approximately 35% from the prior year. But notice that the gains on investments, net (net means net of losses) increased from $883 million to over $3.7 billion, accounting for a large portion of the increase in income. Some analysts questioned the quality of Intel's 2000 earnings because of these large gains.
Gains and losses from the sale of investments often can significantly inflate or deflate current earnings.
Income Statements (in part)—Intel Corporation
Real World Financials
Consider Hecla Mining, a precious metals company. In a recent fiscal year, the company reported income before income taxes of $61.8 million. Included in this amount was a $36.4 million gain on the sale of investments, representing 59% of total before-tax income. Can Hecla sustain these gains? Should they be considered part of permanent earnings or are they transitory? There are no easy answers to these questions. It's interesting to note that in the prior two years Hecla reported no investment gains.
Companies often voluntarily provide a pro forma earnings actual (GAAP) earnings reduced by any expenses the reporting company feels are unusual and should be excluded. number when they announce annual or quarterly earnings. Supposedly, these pro forma earnings numbers are management's view of “permanent earnings,” in the sense of being a better long-run performance measure. For example, in January of 2009, Google Inc. announced that its income for the fourth quarter was $382 million or 1.21 per share. At the same time, the company announced that its pro forma net income (for which Google excluded stock-based compensation, impairment charges, and costs related to the settlement of a copyright infringement lawsuit) for the quarter was $1.62 billion or $5.10 per share. These pro forma earnings numbers are controversial because determining which items to exclude is at the discretion of management. Therefore, management could mislead investors. Nevertheless, these disclosures do represent management's perception of what its permanent earnings are and provides additional information to the financial community.
Many companies voluntarily provide pro forma earnings — management’s assessment of permanent earnings.
Real World Financials
The Sarbanes-Oxley Act addressed pro forma earnings in its Section 401. One of the act's important provisions requires that if pro forma earnings are included in any periodic or other report filed with the SEC or in any public disclosure or press release, the company also must provide a reconciliation with earnings determined according to generally accepted accounting principles.15
We now turn our attention to two income statement items—discontinued operations and extraordinary items—that, because of their nature, are more obviously not part of a company's permanent earnings and, appropriately, are excluded from continuing operations.
The Sarbanes-Oxley Act requires a reconciliation between pro forma earnings and earnings determined according to GAAP.
6 Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.
9 Arthur Levitt, Jr. “The Numbers Game,” The CPA Journal, December 1998, p. 16.
8 Ford S. Worthy, “Manipulating Profits: How It's Done,” Fortune, June 25, 1984, p. 50.
10 Ibid., p. 14.
11 FASB ASC 420–10–20: Exit or Disposal Cost Obligations—Overall—Glossary (previously “Accounting for Costs Associated with Exit or Disposal Activities,” Statement of Financial Accounting Standards No. 146 (Norwalk, Conn.: FASB, 2002)).
12Accounting Trends and Techniques—2009 (New York: AICPA, 2009), p. 340.
13 Arthur Levitt, Jr. “The Numbers Game,” The CPA Journal, December 1998, p. 16.
14 Jeffrey Marshall, “The Perils of Revenue Recognition,” Financial Executive, July–August 2004.
15 The Congress of the United States of America, The Sarbanes-Oxley Act of 2002, Section 401 (b) (2), Washington, D.C., 2004.