Audit fees and earnings quality

This is a bit of a twist on the usual story. The 'concern' about audit and advisory fees is usually expressed like this: higher fees (either absolute or at a relative level) can be thought of as akin to a 'bribe' to the auditors, who will then sign off on financial statements that present a company in a better light than they perhaps should. That's how the regulators seem to view the problem. It's been harder for researchers to 'prove' that this is the case: think about the difficulties in measuring both "earnings quality" and also the level of the 'economic bond' between auditor and client.

In this example (Diverseport Fixed Income), it looks like the auditors and advisors were going for the $ just before a collapse.

Earnings quality / pro forma earnings

Here's an oldie but a goodie. Businessweek from 2001.
Key graphs:

Sometimes, as in the case of Enron, fuzzy numbers result from questionable decisions in figuring net earnings. More often, though, the earnings chaos results from a disturbing trend among companies to calculate profits in their own idiosyncratic ways--and an increasing willingness among investors and analysts to accept those nonstandard tallies, which appear under a variety of names, from "pro forma" to "core." (Enron offers its own such version. Before investors untangled the importance of Enron's first announcement, its stock rose briefly because it told investors that its "recurring net income" had met expectations.) The resulting murk makes it difficult to answer the most basic question in investing: What did my company earn?

Why calculate a second set of earnings in the first place? Because the numbers reached by applying generally accepted accounting principles (GAAP) are woefully inadequate when it comes to giving investors a good sense of a company's prospects. Many institutional investors, most Wall Street analysts, and even many accountants say GAAP is irrelevant. "I don't know anyone who uses GAAP net income anymore for anything," says Lehman Brothers Inc. accounting expert Robert Willens. The problem is that GAAP includes a lot of noncash charges and one-time expenses. While investors need to be aware of those charges, they also need a number that pertains solely to the performance of ongoing operations.

That's what operating earnings are supposed to do. But because they're calculated in an ad hoc manner, with each company free to use its own rules, comparisons between companies have become meaningless. "No investor--certainly not any ordinary investor--can read these in a way that's useful," says Harvey L. Pitt, chairman of the Securities & Exchange Commission. The SEC is examining whether new rules are needed to clarify financial reports and perhaps restrict use of pro formas.

What's badly needed is a set of rules for calculating operating earnings and a requirement to make clear how they relate to net income. In the end, investors need two numbers--a standardized operating number and an audited net-income number--and a clear explanation of how to get from one to the other.

Currency movements and earnings

The Australian dollar has been trending up against the U.S. dollar. That will impact on the Australian dollar value of U.S. earnings reported by companies such as CSL. The CSL chair at the recent AGM stated (link):

However, Ms Alexander said CSL had no plans to hedge its currency exposure, as exchange rate movements did not have an impact on the company's underlying performance.
"Given translation for reporting purposes does not reflect a cash flow, CSL does not consider it appropriate or economic to hedge these earnings," she said.

This implies that the U.S. earnings (or more correctly, the U.S. cash flows) are not 'repatriated' back to Australia, but rather 'kept' in the U.S. If the U.S. dollar cash flows were heading back to Australia, then CSL may be taking more of an interest in hedging.

Earnings management and earnings quality

Kin Lo from the University of British Columbia has posted an easy-to-read (i.e., no statistical analysis) article about earnings quality and earnings management at this SSRN link.

* Photo of UBC by Kevin.Creamer - taken from his Flickr page.

Earnings quality - Coles

Elizabeth Knight in the Herald has a look at Coles' recent earnings announcement (you can find both the profit announcement and the media release on the ASX website here). The "underlying profit' (i.e. pro forma income) for Coles is just under $45m higher than their net profit. No surprise there. Here's how Elizabeth Knight describes them:

But here come the adjustments. Take off $34.5 million for accounting changes, adjust $55.9 million for ownership review costs, add another $23.9 million in advisory costs and $51.5 million in redundancy costs, then take out $53.5 million in property gains, then tax-effect it and, bingo, the end result is a profit 1 per cent down on last year. And this is not too far off the amount the company has indicated.

A more cynical analysis could come up with a result that was 16 per cent below last year, even after the adjustments.

Yep. That can happen. From the perspective of the Wesfarmers board, it's probably best for Coles to get as much 'bad news' out in the accounts now, so that WES can document improved performance going forward. Assuming that WES can find good managers, improving performance of the Coles stores shouldn't be beyond them!

Earnings quality - banks

Where are the banks most likely to have issues with their 'quality of earnings'? Provisioning and doubtful debts, that's where. Here's The Australian's Adele Ferguson explaining things.