There are several points an analyst must consider when analyzing accounting changes. First, accounting changes are “cosmetic” and yield no cash flow consequences either present or future. This means the financial condition of a company is not affected by a change in accounting. Second, while an accounting change is cosmetic, it can sometimes better reflect economic reality. For example, a company’s decision to extend the depreciable lives of its machinery might be an attempt to better match costs with actual usage patterns. In principle, a necessary condition for a change in accounting methods is that the change better reflect the underlying economics.
Third, an analyst must be alert to earnings management. Earnings management is less of an issue in the adoption of new standards although managers may time its adoption for a period when its effect is most favorable (or least detrimental). However, in the case of voluntary accounting changes, earnings management is a likely motivation. While managers sometimes manage earnings through changes in accounting principles, the more popular and shrewd method of earnings management is by changing accounting estimates. Unlike a change in accounting principle, where the cumulative effect is highlighted in the income statement, information about changes in estimates often is buried in the notes. To illustrate, the motive for Delta Airlines’ change in depreciation policy, described in Illustration 6.2, is apparent when we examine its pattern in operating losses around that time: Year 2, $(675) million; Year 3, $(575) million; Year 4, $(447) million. This pattern depicts a marked improvement over time a compounded decrease in losses of 13% per annum. However, when we restate reported numbers as per the original depreciation methods, we see the following pattern in operating losses: Year 2, $(675) million; Year 3, $(609) million; Year 4, $(583) million. This shows the accounting change increases income by $34 million in Year 3 and by $136 million in Year 4. The decline in operating losses using the original data is, thus, amere 5% per annum.
Third, an analyst must be alert to earnings management. Earnings management is less of an issue in the adoption of new standards although managers may time its adoption for a period when its effect is most favorable (or least detrimental). However, in the case of voluntary accounting changes, earnings management is a likely motivation. While managers sometimes manage earnings through changes in accounting principles, the more popular and shrewd method of earnings management is by changing accounting estimates. Unlike a change in accounting principle, where the cumulative effect is highlighted in the income statement, information about changes in estimates often is buried in the notes. To illustrate, the motive for Delta Airlines’ change in depreciation policy, described in Illustration 6.2, is apparent when we examine its pattern in operating losses around that time: Year 2, $(675) million; Year 3, $(575) million; Year 4, $(447) million. This pattern depicts a marked improvement over time a compounded decrease in losses of 13% per annum. However, when we restate reported numbers as per the original depreciation methods, we see the following pattern in operating losses: Year 2, $(675) million; Year 3, $(609) million; Year 4, $(583) million. This shows the accounting change increases income by $34 million in Year 3 and by $136 million in Year 4. The decline in operating losses using the original data is, thus, amere 5% per annum.
Another concern with accounting changes is earnings manipulation. Unlike earnings management, which is window dressing within the confines of GAAP, earnings manipulation arises when companies stray beyond acceptable practices. When the SEC staff spots such accounting practices, the company is asked to restate its financial statements. Such restatements, reported in Accounting Enforcement Releases (or AERs), suggest that a company is adopting excessively aggressive accounting practices. While honest errors do arise, an analyst should be concerned when a company is forced by the SEC to restate its financial statements. At a minimum, this reflects poor earnings quality, and an analyst must take extra care when analyzing financial statements of such companies.
Fourth, an analyst must assess the impact of accounting changes on comparisons across time. It is important for an analyst to compare “apples with apples.” This means making sure any comparisons (especially across time) are made with a consistent set of accounting rules. Such comparisons are possible under the latest accounting rules, at least for the years reported in the latest financial statements. However, there is no such guarantee for changes in estimates and when examining prior information that is many years earlier. If the company reports the effects of accounting changes for prior years’ data in its notes, the income history can be adjusted. If no such information is reported, an analyst must be aware of the potential limitations for any comparisons across time. This is important because companies sometimes change accounting estimates to window-dress earnings history.
Finally, an analyst would want to evaluate the effect of an accounting change on both economic income and permanent income. For estimating permanent income, the analyst can use the reported numbers under the new method and ignore the cumulative effect, if any. For estimating economic income of the current period, both the current and cumulative effect are included. More generally, an analyst must evaluate the ability of the change to better reflect economic reality. If the change is arbitrary or seems to impair the ability of the numbers to reflect economic reality, then we can undo the effects of the change using note information.
Special Items
Special items refer to transactions and events that are unusual or infrequent, but not both. These items are typically reported as separate line items on the income statement as part of income from continuing operations. Often, special items are nonroutine items that do not meet the criteria for classification as extraordinary items. Special items constitute the most common and important class of nonrecurring items. As reported in Exhibit 6.5, their frequency is increasing. The frequency of special items has increased dramatically, from 1% of reporting companies through the 1980s to nearly 48% of reporting companies. Most of this increase has been concentrated in special items that reduce income, primarily restructuring expenses. The magnitude of special items has remained fairly constant at about 2% of sales, with negative effects consistently higher in absolute value than positive effects. These items, when they occur, can have a significant impact on reported profits, often turning a profitable year into a loss. They are generally the most transitory item in income from continuing operations.
Exhibit 6.6 shows the makeup of one-time special charges both by frequency and by dollar value. Restructuring charges and asset write-offs of goodwill, inventory, and property, plant, and equipment (PP&E) form the bulk of such charges. Of these, impairment of long-lived assets and restructuring charges constitute the two major categories of special items. There are two differences between them. First, restructuring charges are
Fourth, an analyst must assess the impact of accounting changes on comparisons across time. It is important for an analyst to compare “apples with apples.” This means making sure any comparisons (especially across time) are made with a consistent set of accounting rules. Such comparisons are possible under the latest accounting rules, at least for the years reported in the latest financial statements. However, there is no such guarantee for changes in estimates and when examining prior information that is many years earlier. If the company reports the effects of accounting changes for prior years’ data in its notes, the income history can be adjusted. If no such information is reported, an analyst must be aware of the potential limitations for any comparisons across time. This is important because companies sometimes change accounting estimates to window-dress earnings history.
Finally, an analyst would want to evaluate the effect of an accounting change on both economic income and permanent income. For estimating permanent income, the analyst can use the reported numbers under the new method and ignore the cumulative effect, if any. For estimating economic income of the current period, both the current and cumulative effect are included. More generally, an analyst must evaluate the ability of the change to better reflect economic reality. If the change is arbitrary or seems to impair the ability of the numbers to reflect economic reality, then we can undo the effects of the change using note information.
Special Items
Special items refer to transactions and events that are unusual or infrequent, but not both. These items are typically reported as separate line items on the income statement as part of income from continuing operations. Often, special items are nonroutine items that do not meet the criteria for classification as extraordinary items. Special items constitute the most common and important class of nonrecurring items. As reported in Exhibit 6.5, their frequency is increasing. The frequency of special items has increased dramatically, from 1% of reporting companies through the 1980s to nearly 48% of reporting companies. Most of this increase has been concentrated in special items that reduce income, primarily restructuring expenses. The magnitude of special items has remained fairly constant at about 2% of sales, with negative effects consistently higher in absolute value than positive effects. These items, when they occur, can have a significant impact on reported profits, often turning a profitable year into a loss. They are generally the most transitory item in income from continuing operations.
Exhibit 6.6 shows the makeup of one-time special charges both by frequency and by dollar value. Restructuring charges and asset write-offs of goodwill, inventory, and property, plant, and equipment (PP&E) form the bulk of such charges. Of these, impairment of long-lived assets and restructuring charges constitute the two major categories of special items. There are two differences between them. First, restructuring charges are
associated with major reorganizations of a company as a whole or within a division. Restructuring often involves a change in business strategy, financing, or physical reorganization of the business. On the other hand, asset impairments are narrower in scope, involving the write-down or write-off of a class of assets. A second major difference is that asset impairments are mainly accrual accounting adjustments, while restructuring charges often involve substantial cash flow commitments either contemporaneously or in the future. Special items pose challenges for analysis. First, the economic implications of special items, such as restructuring charges, are complex. Second, many special items are discretionary and, hence, serve earnings management aims. The remainder of this section focuses on the two major types of special items: asset impairments and restructuring charges.
No comments:
Post a Comment