Dennis Jullens - In Search of Real Earnings (16.10.12)

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In this presentation Dennis Jullens, Rotterdam School of Management, reflects on his experience of the ways in which companies tend to understate or overstate profit while staying within the letter of the rules, (sometimes referred to as 'aggressive accounting'). His talk broadens to include cash flow.

Dennis is former European Head, UBS, Valuation & Accounting Research.

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  • Dennis Jullens - In Search of Real Earnings (16.10.12)

    1. 1. In search of real earningsDennis Jullens16 October 2012
    2. 2. It is the time of the season…..16 October In search of real earningsStreet Breakfast – October2 Source: Wall 2012
    3. 3. Use of earningsPerformance ‘Stewardship role’Valuation ‘Economic decision making role’ 16 October In search of real earnings 3
    4. 4. Earnings, what earnings?Permanent versus transitory earningsRecurring versus non-recurring earningsCore versus non-core earningsOperating versus net earningsAccounting versus economic earnings 16 October In search of real earnings 4
    5. 5. IFRS and accounting earningsIFRS is a principle based accounting systemMore room for judgment, assumptions and modelsIFRS has limited guidance on presentation of the income statementIt does not provide definitions of EBIT and EBITDA IFRS earnings poses challenges for investors and analysts 16 October In search of real earnings 5
    6. 6. Analysts view on IFRS earnings Do you judge as adequate or inadequate the definition of operating profit in the income statement? Inadequate Adequate No opinion16 October Source: PwC 2012 In search of real earnings 6
    7. 7. Challenges with accounting earningsChoices in existing accounting standards Treatment of actuarial gains and losses in pensions Accounting for operating versus financing leases To qualify or not for hedge accountingDiscretion in applying accounting standards Purchase price allocation in business combinations Capitalization or expensing of development expenditure Choosing useful life for depreciation and amortization‘Discrepancy’ between economic and accounting earnings Amortization of purchased intangibles Expense of employee stock options Recognition of pension financing income16 October In search of real earnings 7
    8. 8. In search of real earnings16 October In search of real earningsAnheuser Busch Inbev 8 Source:
    9. 9. In search of real earnings16 October In search of real earnings Novartis Source: 9
    10. 10. Analyst view on non GAAP metrics Are you concerned with the widespread use of non-GAAP performance measures?Strongly disagree Disagree Agree Strongly agree 0% 5% 10% 15% 20% 25% 30% 35% 16 October Source: PwC 2012 In search of real earnings 10
    11. 11. Views on non-GAAP earnings “Non-GAAP measures give valuable company specific information” “I don’t place much reliance on what is disclosed in the income statement about one-time events but instead make my own judgments based on supplementary information from conversations with management”“Non-GAAP measures are often inconsistent. I use them as an alarm that something needs to be closely looked at” 16 October Source: PwC 2012 In search of real earnings 11
    12. 12. What analysts do to find real earningsAdjust for incomplete accountingAmend company defined adjusted earnings numbersInvestigate earnings quality 16 October In search of real earnings 12
    13. 13. Adjust for incomplete accountingCompanies currently present key items in the income statement Service costs Interest cost on the pension liability Expected return on plan assetsNet pension financing income is the difference between expected return onplan assets and the interest cost on the pension liability 16 October In search of real earnings 13
    14. 14. Adjust for incomplete accountingPensions at Philips (EUR m) 2009 2010 2011Expected return on pension assets 1,101 1,087 1,102Interest cost on pension liabilities -927 -939 -961Net pension financing income 174 148 141Pre-tax profit 448 1,943 1,374Net pension finance income as % of pre-tax profits 38.8% 7.6% 10.3% 16 October In search of real earnings 14
    15. 15. Amend company defined earningsARM Holding (Sterling 000) 2009 2010 2011Profit from operations - IFRS income statement 45,614 106,959 148,981Acquisition related charge-amortisation of intangibles 15,698 10,939 2,769Acquisition related charge-Other payments 456 456 3,634Share based payment costs and related payroll taxes 24,699 41,910 57,738Restructuring charges 8,471 -373 0Impairment of available investments 188 -37 1,748Linaro- related charges 0 4,485 6,851Normalised profit from operations 95,126 164,339 221,721 16 October In search of real earningsSource: ARM Holdings 15
    16. 16. Investigate earnings qualityEarnings Quality: Evidence from the field by Ilia Dichev, John Graham, Campbell Harvey and Shiva Rajgopal - Available on www.ssrn.com 16 October Source: Financial Times, October 2012 In search of real earnings 16
    17. 17. Investigate earnings qualityEarnings Quality: Evidence from the field by Ilia Dichev, John Graham, Campbell Harvey and Shiva Rajgopal - Available on www.ssrn.com 16 October Source: Financial Times, October 2012 In search of real earnings 17
    18. 18. Defining earnings quality (% agree)Reflect consistent reporting choices over time 94.1%Avoid long term estimates as much as possible 86.4%Are sustainable 80.5%Are useful predictors of future earnings 78.6%Are useful predictors of future cash flows 75.7%Have accruals that are eventually realized as cash flows 75.7%Do not include one-time or special items 71.4%Require fewer explanation in company communications 69.2%Result from conservative recognition of assets andliabilities 59.3%Recognize losses in a more timely manner than gains 49.7%Earnings Quality: Evidence from the field by Ilia Dichev, John Graham, Campbell Harvey and Shiva Rajgopal - Available on www.ssrn.com 16 October In search of real earningsDichev, Harvey, Rajgopal 2012 Source: 18
    19. 19. Investigating earnings quality‘I think when people are dishonest it is very hard for an analystwith just public information to tell, at least in the short-term.Eventually absence of cash flows always catches up with you.By doing comparison and some detective work, an analyst canstart to smell that something is not right, but unless it’s veryegregious behavior, it usually takes a long time before theycan have a conclusive argument that earnings are managed’ 16 October In search of real earnings 19
    20. 20. Investigating earnings quality: Enron Source: Is Enron Overpriced by Bethany McLean, March 2011http://money.cnn.com/2006/01/13/news/companies/enronoriginal_fortune/index.htm16 October In search of real earnings 20
    21. 21. Investigate earnings qualityDeviations between cash flows and earningsRevenue recognition policiesUse of provisionsChanges in relevant accounting policies 16 October In search of real earnings 21
    22. 22. What analysts do not do …Amend the discretion in IFRS by normalizing itemsReview differences in application of IFRSRead full set of consolidated financial statements 16 October In search of real earnings 22
    23. 23. In search of real earnings16 October In search of real earnings 23

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