Assessing Earnings Quality at Nuware
Richard Hamilton Mike Rakes Brandon Sather Theresa Sexton
Nuware, Inc. Consolidated Balance Sheets as of January 31, 2003 2003 Current Assets Cash including available for sale investments of 59,716 and 35,076 Beneficial interest in securitized receivables Accounts receivable, net adjusted reserve Inventory Prepaid expenses/other Total current assets
2002
$ 192,114
$
$ 291,618 $ 277,002 $ 56,179 $ 816,913
$ 362,331 $ 266,011 $ 43,286 $ 727,237
Properties, Net Other noncurrent assets
$ 374,493 $ 49,411
$ 370,262 $ 47,895
Total Assets
$ 1,240,817 $ 1,145,394
Liabilities and Shareholder Equity Current Liability Current portion of long-term debt accounts payable gift cards, gift certificates and merchandise credits outstanding Accrued income tax payable Other accrued liabilities Total current liabilities
$ $ $ $ $ $
393 176,702 117,495 35,798 192,348 522,736
$ $ $ $ $ $
356 129,076 139,852 29,738 170,053 469,075
Long-term debt other noncurrent liabilities
$ $
25,007 54,962
$ $
25,356 43,265
Shareholder Equity Common Stock, $0.10 par, 500,000,000 authorized, 100,883,000 issue $ 10,088 Paid in capital $ 479,074 Retained Earnings $ 298,816
55,609
$ 10,088 $ 440,190 $ 242,644
Cumulative other comprehensive income (loss)
$ (11,210) $
(4,702)
Less: 10,045,000 and 7,362,000 common shares in treasury, at cost
$ (138,656) $
(80,521)
Total liablities and Shareholder Equity
$ 1,240,817 $ 1,145,395
Nuware allowance as a % of AR RP allowance as a % of AR Accounts Receivable Gross New Allowance Adjusted Accounts Receivable Net
3.09% 4.49% $ 305,326 $ 13,708 $ 291,618
4.25% 4.54% $ 379,564 $ 17,233 $ 362,331
Remove beneficial interest in Securitized receivables Remove beneficial interest from retained earnings Move from Lifo to Fifo Add to cost of sales Add from inventory
40538 40538
34620 34620
29500 29500
35100 35100
Addback Advertising expenses
10200
8700
1071
707
-9382
-5784
Addback Stock Compensation Expenses Back out Interest and investment income Add Adjust to tax reserve to RP Stuart -- 39%
$
1,648
$
1,232
1. Provide a context for the concept of “earnings quality”
Earnings quality is a concept that covers multiple accounting concerns and consists of two main elements. First, it touches on the idea that the accounting is a fair representation of the firm’s performance.
For this first element, the idea of accounting being a fair representation of the firm’s performance entails the removal of bias, especially management bias, from the firm’s financials. Bias can occur via a manager’s optimism or a manager’s incentive to report numbers pessimistically.
Whether or not a firm’s financials is a fair representation of its performance
is also difficult given the fact that there can be subjectivity in choosing
among accounting principles, not to mention the additional uncertainly that arises because estimates are often used when applying these principles.
Second, earnings quality entails the idea that the information that’s provided is relevant for forecasting the firm’s expected earnings and future financial
position.
2. Why is Harry Malone concerned about relying on Nuware’s reported performance? If Nuware follows GAAP shouldn’t the financial statements be reliable?
In this instance, Harry Malone is particularly concerned about relying on Nuware’s reported performance giv en the in depth research done on R.P.
Stuart, his personal relationships with R.P. Stuart management, his belief in the transparency of their reporting and the fact that though Nuware and R.P. Stuart have virtually identical business models, R.P. Stuart struggled to match last year’s profitability and Nuware increased its ea rnings by almost
20%.
Theoretically firms that follow GAAP should release reliable financial statements. However, management still plays a significant role in deciding how earnings will be stated. Despite the rules based system of GAAP, the unique circumstances of individual businesses still allow for areas of gray. There is room for deciding which accounting principle to apply and how to estimate values when applying that estimate, be it an estimate of bad debt expense, future costs of warranty programs or the fair value of financial instruments, to name a few.
Moreover, as accounting scandals have proven, sometimes management doesn’t make erroneous accounting representations because of uncertainty ,
bias or estimates, but because they intend to deceive and they intentionally misrepresent their firm’s financial position.
3. Assume the roles of Hereford and restate the company’s 2003 earnings as if the companies had used a similar accounting method and assumptions. After such restatement, how do the earnings and growth compare to R.P. Stuart?
The available for sale securities that Nuware lists as a current asset should be backed out. Given that they are discussed in the footnotes as the only financial instrument with a fair value different from the recorded value, this leads one to believe that these securities are being held for an indefinite period and should be classified as long terms assets at fair value, with any cumulative gain or loss reported at fair value in the accumulated other comprehensive income section of shareholder equity. This provides a much better depiction of Nuware’s liquid assets in relation to R.P Stuart.
As the accounts receivable for Nuware decreased, Nuware reduced its allowance for doubtful accounts, thereby estimating that more of its receivables would be realizable. R.P. Stuart, in turn, kept its allowance estimate steady. By adjusting the allowance, Nuware’s earnings are more in line with the actual risk it bears on credit sales.
Although advertising is undertaken with the expectation that it will provide value, whether it will or not is uncertain. Thus GAAP requires immediate expensing of advertising costs. As such, advertising Costs that are committed but not realized, i.e. $10.2MM and 8.7MM in 2003 and 2002,
respectively,
must
be
expensed.
This
depicts
expenses
much
more
realistically as between Nuware and Stuart.
Given that R.P. Stuart accounts for its stock compensation using the fair value method it included stock compensation expense in its operating income. As such, Nuware’s net income is more appropriately stated when
stock compensation expense of $1,071k and .707k is added back to operating income.
Interest and investment income $9,382K $5,784k and $5,014K in 20032001 should appropriately backed out given that their inclusion goes against the second element of earnings quality, namely including information that’s representative of a firm’s financial future. By backing out these peripheral items, Nuware’s income from operations and ability to compete with R.P.
Stuart on an operations level is more accurately depicted.
For a lot of companies, cost of sales is the largest expense on the income statement. Because LIFO tends to result in less variability in the gross margin percentage over the business cycle, Nuware is better able to accomplish income smoothing reporting using LIFO. As such, a LIFO adjustment was made on the balance sheet (add 29.5MM and 35.1MM in 2003 & 2002) and a LIFO adjustment was made on the income statement by adding 29.5MM and 35.1MM in 2003 and 2002 to the cost of sales.
4. Would you characterize the accounting discretion applied by Nuware management as aggressive? In your opinion, has the company been managing earnings?
Based on the analysis done in question three, we would characterize at least some of the accounting discretion applied by Nuware as aggressive. There are many examples that we will highlight again here.
First, when the
Accounts Receivable are adjusted using the allowance used by RP, they decrease from the stated balance by $1M in 2002 and $4.2M in 2003. This would suggest that Nuware's method for calculating the allowance over estimates what they actually will collect.
Second, another indicator of
aggressive accounting is the way Nuware accounts for advertising expenses - choosing to expense them in the period when the benefit is realized. Advertising expenses are nearly impossible to tie directly to accounting benefits, and this practice allows Nuware to move the expenses into a future period as they see fit. This is evidence of earnings management on the part of Nuware, and the data shows that adding these expenses back in 2002 and 2003 ($8.7M and $10.2M, respectively) significantly deflates the bottom line income. Lastly, the Gross Profit Margin in each of the three years after adjusting to RP's numbers drops between 1.7% - 2.1% which, again, indicates that the accounting practices employed by Nuware were such that the position of the company was over stated.
Net Income NI per DS ROA ROE Tax Rate EPS Growth Sales Growth Gross Profit Margin
2003 $52,924.00 $0.50 0.043 0.067 39% 0.33 0.027 0.412
2002 $39,565.00 $0.38 0.035 0.057 39% -0.31 0.061 0.388
2001 $56,654.00 $0.56 --39% --0.429
NI over Assets NI over Equity Use RPs here Actual Sales are not adjusted
