adminAlbert Norumedzo Business Correspondent
As equity market players undertake financial statement analysis to aid in the investment decision making process, the quality of reported earnings becomes of paramount interest. The ZSE has 63 actively trading counters all of which attract the attention of a diverse range of financial market stake holders.
Among the pool of stake holders are equity investors and analysts, shareholders, credit investors, tax authorities, and employees among others, all of which have need to estimate the future cash flows of reporting companies. 2013 earnings results are expected to exhibit a mixed blend of pre and post election environment anxiety that characterised the business environment throughout 2013, as such positive earnings surprises are highly unlikely given the circumstances. Economic growth and activity slowed down in the last half of 2013, liquidity inevitably declined to worrying levels suppressing demand aggregates and consequently inflation to 1,3 percent, all this became the ingredients for suppressed business performance.
In the wake of such a playing field, growth in margins are expected to be suppressed, the little growth that will be recorded will mainly be from cost containment strategies as well as enhanced operational efficiency.
With margins falling under pressure from local economic hurdles, any major movements in reported earnings will in most cases be supported by a huge accruals component stirred mainly by revaluations and other technical accounting shenanigans.
In efforts to limit the adverse impact of disappointing earnings management may find itself under pressure to smoothen reported earnings through technicalities and in some cases earnings management activity. Among the most pressing earnings manipulation incentives are the expectations of capital market participants.
Valuation on equities markets is largely a function of earnings in relation to future cash flow forecasts and relative peer group valuations, reported earnings affect key valuation multiples like price to earnings, enterprise value to earnings before interest, tax, depreciation and amortisation, EV/EBITDA, a fall in earnings per share is likely to trigger a fall in the hare price, holding other things constant.
In order to protect the share price management many feel the need to butter coat reported earnings to sustain the share price.
In a market which is still in need of financing for operational restructuring and capital structure realignment, key balance sheet ratios have strong bearing on leverage ratios used in capital funding decisions by providers of capital, (debt or equity).
Ratios such as interest coverage (net income before tax/interest expense), return on equity (net income/total equity), leverage ratios (total asset/ total equity) will form the fabric upon which the decision to lend or invest in a company will be based on.
In order to attract funding management may be inclined to manage certain income statement and balance sheet variables to portray a favourable performance.
The prevalent liquidity situation in the country demands prudence in the use and management of cash flows, taxation though vital to national interests has a direct and immediate negative cash flow implication, with the intend to limit cash outflows to the fiscal coffers companies may feel the nudge to understate performance.
Contractual obligations tied to accounting data also present a push towards earnings management, if management is bound by certain agreements to maintain certain ratios or accounting variables at designated levels in order to meet a certain objective or gain access to some financial or technical benefit, the need to manage earnings or other accounting variables might be accommodated.
The list of incentives for earnings management covers a wide spectrum of motives that answer specific management and company situations, management can manage earnings without violating international financial reporting standards and still have the right to claim that reported financials are fair accurate and complete.
From performance based contracts, share option schemes, debt covenants to the expectations of market participants all these form a formidable earnings management thrust.
The responsibility remains with the users of financial statements to isolate the noise from reported earnings and be able to come up with information that will reflect the true position of the company and its future cash flows.
Watch out for fair Value adjustments not justified by prevailing market conditions. Many companies listed on the ZSE have often made significant revaluations to their property portfolios despite the suppressed property market environment that has been hampered by lack of liquidity in the local space, declining business activity has increased vacancy rates with some high rise buildings like Joina City failing to achieve 60 percent occupancy to mention but a few. The question to answer remains: Are property revaluations justified in this market?
The profit on revaluations goes directly to the income statement thereby increasing Earnings for the period. In the Zimbabwean market the most prominent and probably earnings management means lies in fair value adjustments. When evaluating company performance it is imperative to isolate the accrual component of earnings from reported earnings as it is not sustainable nor does it give a true reflection of the business ‘s performance and potential.
Other earnings manipulation means lie in the use of biased accounting estimates in accounting for depreciation, impairments and estimated useful life of assets, all of these are at management’s discretion and can have direct impact on reported earnings. Longer useful lives for assets lead to a lower depreciation charge thereby inflating earnings as does a lenient depreciation.
Management‘s discretion in revenue and expense recognition can also present opportunities for earnings manipulation.
Expensing and capitalisation decisions also present an opportunity for companies to manage earnings through inaccurately capitalising interest or expenses that should be expensed in the income statement, this has the impact of artificially inflating earnings in the early years when the expenses are capitalised.
Despite the various checks and balances in place to ensure fair and accurate reporting chief among them external auditors, companies can find ways of working around accounting policies and standards to stir reported earnings towards desired outcomes. In some cases in both the developed and developing economies auditors have in some cases failed to neither detect nor prevent the fall of big corporations at the mercy of flawed corporate governance, risk management and financial reporting standards. There is need to increase disclosures in financial statement reporting to give market participants enough information for informative decision making.
Financial statements should provide fair complete and accurate information if it is to aid in the decision making process, as management falls under pressure from both the operational environment and various market participants to deliver expected performance outcomes, the quality of reported earnings in the industry will also fall under pressure.
One way to track the quality of earnings is to look at the trend in cash flow from operations v net income, cash flow from operations are harder to manipulate than reported earnings.
A consistent huge disparity between the two variables indicates potential poor quality earnings; the ratio of cash flow from operations to net income becomes worrying as it gets smaller, this is an indication that the accruals component in reported earnings is increasingly outweighing real cash generated by the business, a sign of earnings management.
Earnings growth patterns will in some way mirror the general economic environment, with the economy having gone through a high growth phase (GDP at 10,6% in2011) followed by retarding growth that saw GDP fall to 4,4% in 2012, earnings are not going to be immune to the economic trajectory and in an economically constrained environment margins will come under pressure from prevailing macroeconomic fundamentals, it is under such circumstances that the quality of earnings deteriorates
Albert Norumedzo is an Equities and Alternative Investments Analyst FBC Securities. Feedback: [email protected]
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