University:
Massachusetts Institute of Technology
Course:
15.535 | Business Analysis Using Financial Statements
Academic year:

2023
Views:

447

Pages:

8
Author:

Valisonezv

Detecting Earnings Management Recap: Why firms/managers “Cook the books?” • Central theme: Firms & managers often have incentives to misstate earnings/balance sheet items: – Contracting incentives: • • • • Avoid violating contracts Maximize bonus (managers) Avoid regulatory/government/union intervention Avoid detection of managerial shirking – Stock market incentives: Meet analysts’ targets Why do we care about earnings management? • Avoid being fooled!: • Earnings used in deriving numbers for DCF and multiples (P/E, PEG, etc) valuation analysis. – Use the wrong numbers & you will misvalue the firm • Earnings (and other accounting #’s) to determine financial health and the ability of the firm to pay obligations: – – – – Employees Creditors Suppliers Etc • What is the outcome when accounting misstatement is detected? • Stock price reaction and legal recourse is immediate! Watch Out for “Expectations Management” of Analysts! Forecast Error= (Actual EPS – Forecast EPS) Methods for Detecting Earnings Management • Compare volatility of accrual income measures with underlying volatility of sales and CFO: Vol(Op Inc) = stdev(Op Inc over 5 years)/average (Op Inc over 5 years) Vol(Sales) stdev(Sales over 5 years)/average (Sales over 5 years) Vol(Op Inc) = stdev(Op Inc over 5 years)/average (Op Inc over 5 years) Vol(CFO) stdev(CFO over 5 years)/average (CFO over 5 years) Vol( NI ) = stdev( NI over 5 years) / average (NI over 5 years) Vol(CFO) stdev(CFO over 5 years)/average (CFO over 5 years) Analysis: Shared Medical Systems – Perform quality of sales analysis – Test for Earnings Smoothing AR/SALES % Growth in AR % Growth in Sales 25.2% 26.4% 23.9% 18.2% Vol(Op Inc) = Std(Op Inc)/Avg(Op Inc) Vol(CFO) = Std(CFO)/Avg(CFO) 24.20% 32.64% Vol(Op Inc)/Vol(CF0) 74.13% 27.4% 22.2% 17.9% 28.0% 19.6% 16.9% 29.9% 34.8% 26.1% Team Project: Methods for Detecting Earnings Management – What you must calculate for Part I of your Project: • Compare % growth in sales with the % growth in AR over the past 5 years (quarters). • Calculate the ratio of the scaled standard deviation of Operating Income over the past 5 years to the scaled standard deviation of CFO over the past 5 years. Also, calculate this same ratio for two of the firm's competitors and then make a relative comparison of these ratios. – Other things you might look at (depending on your industry): • Compare change in NI to change in Basic EPS (Is firm “managing” the EPS number by adjusting number of shares outstanding?) • Check list of Diagnostics from last class. Where Next? • Quiz #1 in Class on Thursday. – Open notes. No laptop computers/PDAs/cellphones, pagers! – Bring a calculator – 50 minutes long. – Priority for review: • • • • Review sample questions Review class notes Review all class handouts Skim over selected reading assigned in class • Review Session this evening in this room.