Quality of earnings - Making the right investment decision:PwC

As the South African economy continues to ride out the effects of the global slump, the number of companies experiencing financial distress has increased dramatically in 2009. Good companies with solid fundamental business structures are struggling to maintain their position in the markets. As a result, these institutions could find themselves up for sale.

As the credit markets improve, vendor price expectations fall and a number of forced sales occur there will be a significant increase of opportunities to acquire businesses at attractive values. Analysing and evaluating these opportunities is a key element when making an informed business investment decision.

Andreas Welke, associate director for Advisory Transaction Services: PricewaterhouseCoopers (PwC) says, “When purchasing a distressed business or indeed any business within this economic environment, it is vital to obtain a comprehensive and accurate understanding of the company’s earnings. This is a critical component of the valuation and due diligence investigation and is a vital step to making informed investment decisions.”

The concept of earnings quality is based on the judgemental nature of accounting. This means that the methods of accounting used to report earnings information for the company are based on accounting standards and the interpretation thereof. Close scrutiny is required to determine the true earnings quality of the company. The approach of analysing earnings quality has evolved from investors using fundamental analyses to search for undervalued investment opportunities.

Welke states, “A commonly used definition of quality of earnings is the extent to which the reported net income is sustainable into the future.”

The quality of a company’s earnings can be categorised into two sections:

High Earnings Quality

When a company provides reliable financial information on its current and future performance, the buyer is presented with a true and fair picture as to the history and sustainability of the company’s operations. Sustainable earnings should always consider the performance of the company in light of the current market situation, and support the assessment of the company. A high Quality Earnings analysis is required to reliably assess value and justify the investment decision.

Low Earnings Quality

When a company provides limited or unreliable information in relation to its current and future financial performance, the analysis may lead to an incorrect or overpriced investment decision being made.

Financial position prior to sale

The use of judgement by management increases the chances that the earnings presented in a company’s financial statements may have been presented to reflect a favourable position prior to the sale of a business.

Welke continues, “The responsibility for reliable financial statements lies with the management of a company. The possibility that results may reflect an inaccurate but more favourable view must be considered. Management’s ability to achieve desired reported accounting results should not be underestimated.”

PwC has a wealth of experience in identifying the true value of a company and has highlighted the following factors that may impact the true quality of earnings of a company:

  • Improving income with once off gains – Profits from sale of assets
  • Cut-off – Shifting income or expenses to a different period
  • Reduced liabilities – Failing to record or reducing liabilities
  • Provisioning – Impact of provisioning levels between periods
  • Capital expenditure – Deferral of capital expenditure programmes or capitalisation of expenses
  • Accounting policy changes – Constantly changing accounting policies
  • Fair value adjustments – Adjustments to non financial assets and liabilities
  • Revenue recognition – Inappropriate or aggressive revenue recognition

Earnings quality is usually associated with the use of conservative accounting policies. However, conservatism in a financial period may allow for aggressiveness in a future financial period. For example, a conservative provisioning policy during good economic times, allows for the release of such provisions in future financial periods. This means that conservative decisions by management in a single period should not be used as the sole proof of earnings quality. The motives of vendors and management should be considered when performing analyses in order to arrive at an investment decision.

In conclusion Welke says, “During the current economic environment investors should continue to focus on earnings quality when considering an investment opportunity. The earnings should prove that the business is sustainable in the long-term.”