How Accurate are Corporate Earnings Reports?
Author: Tim McPoland
Researchers from Duke University and Emory University recently released surprising results of their study on the prevalence of corporate earnings “management.” As described in the report, “Earnings Quality: Evidence from the Field,” the researchers surveyed 169 CFOs of public companies and conducted in-depth interviews of 12 CFOs and two setters of accounting standards. Their report provides valuable insight into earnings manipulations that potentially could affect damages calculations and other legal matters.
Signs of quality
The report explains what constitutes high-quality earnings. According to the surveyed CFOs, a company’s earnings are “high quality” when they’re sustainable and backed by actual cash flows. Other, more-specific characteristics of quality include consistent reporting choices over time and avoidance of long-term estimates.
The study’s researchers indicate that this view of earnings quality is consistent with a valuation perspective because a company’s value is assessed by estimating and discounting the stream of future profits. Thus, current earnings should be considered high quality if they serve as a reliable guide to a company’s long-term profits.
What’s wrong with management?
For its part, earnings management is defined as manipulation that misrepresents performance but nonetheless falls within Generally Accepted Accounting Principles (GAAP). The CFOs estimated that, in any given period, roughly 20% of companies manage earnings, and that the typical misrepresentation was about 10% of reported earnings per share.
The study’s subjects believe that 60% of earnings management increases income, while 40% decreases income. While the latter figure may sound counterintuitive, the researchers attribute it to accounting practices such as “cookie jar reserves,” whereby, for example, a company records a discretionary expense in a period with high profits because it can afford to take the income hit.
“Big baths” is another accounting practice that could explain the 40% decrease. In that scenario, a company manipulates its income statement to make weak results appear even worse by, for example, shifting profits from a bad year forward to artificially enhance the following year’s earnings. Such manipulation produces a performance bonus.
Watch for red flags
Researchers asked the participants to list three red flags that would help detect earnings misrepresentations. The most commonly cited were:
- Earnings inconsistent with cash flows. More than 100 CFOs identified this or the similar “weak cash flows” and “earnings strength with deteriorating cash flows” as warning signs. The authors noted that the importance of the link between earnings and underlying cash flows was prominent throughout the study.
- Deviation from norms. Deviations from industry norms or experience registered 88 responses. Specific examples include disparity in financial statement items such as cash cycle, average profitability, revenue and investment growth, and asset impairments.
- Unusual accruals. Another red flag is “lots of accruals or unusual behavior in accruals,” including large jumps. The CFOs emphasized changes in accruals, as opposed to extreme levels of accruals.
With reported earnings playing a critical role in a variety of legal matters — from damages calculations to transaction prices — your clients can’t afford to take them at face value. A qualified financial expert can help detect managed earnings that misrepresent performance.
If you have any questions about reported earnings or any other forensic accounting issue, give us a call at 716.847.2651, or you may contact us here.
Court Allows Lost Profits Expert Testimony
Author: Tim McPoland
When an opposing party in a lawsuit challenges the admissibility of an expert’s testimony, the matter often comes down to one of two interpretations: whether the court believes the party’s arguments go to the admissibility of the evidence or to the weight of the evidence. The ruling in a federal district court case, BK Cypress Log Homes v. Auto-Owners Insurance Co., illustrates such determinations and highlights the need to present relevant expert testimony.
BK Cypress Log Homes sued Auto-Owners Insurance Company, alleging bad-faith conduct in the handling of a third-party claim. The defendant moved to exclude the plaintiff’s damages expert’s testimony on the grounds that his techniques weren’t generally accepted in the economic community. The expert used a two-part model, estimating lost profits with both the before-and-after and yardstick methods.
In his first calculation, he determined the plaintiff’s profit margins before and after the loss period. He attributed the difference to effects created by BK Cypress owner Jim Keeton’s participation in dispute-related activities that should have been handled by the defendant and that resulted in operational inefficiencies.
In the second calculation, the expert considered what the plaintiff’s sales would have been if the company had matched the industry average sales for the loss period. He used sales information from a log-home industry publication, as well as a “sample survey” of members of the Log Homes Council. Together, these sources yielded growth rate numbers for six companies.
Court rejects challenge
In the Florida court, the defendant asserted that the plaintiff’s before-and-after analysis wasn’t acceptable because it assumed that all loss in profitability was attributable to the defendant’s bad faith. In particular, Auto-Owners faulted the lack of data documenting:
- The amount of time Keeton spent attending to dispute-related matters, and
- The failure to account for time he would have expended on such matters even in the absence of bad faith.
The court concluded that the defendant’s criticisms should be raised through cross-examination of the expert and other witnesses regarding the assumptions underlying the damages calculation.
The defendant also argued that the yardstick analysis wasn’t acceptable because, among other things, the expert’s report didn’t establish that the businesses used to measure the losses were sufficiently similar to BK Cypress. The court denied the motion to exclude this part of the analysis — but without prejudice to the defendant’s right to exclude the testimony at trial if the plaintiff was unable to establish the survey data’s reliability through other evidence.
Rebuttable witness also rebuffed
Notably, the court also rejected the testimony of the defendant’s financial expert because he didn’t provide an estimate of damages. It characterized that expert’s testimony as a rebuttal opinion that failed to offer an alternative analysis methodology.
In the end, the court decided that the defendant’s expert’s testimony wouldn’t aid the jury in determining damages and would in fact be “redundant and unduly prejudicial.” Instead, the defendant was instructed to explore the criticisms in its expert’s report during cross-examination of the plaintiff’s expert and other witnesses.
If you have any questions about lost profits, testimony or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.
Court Confirms the “Gold Standard” of Valuation
Author: Tim McPoland
Business valuation arises in many legal contexts, including damages calculations in commercial litigation. In a recent case we have discussed, Malik v. Falcon Holdings, LLC, Seventh Circuit Court of Appeals Chief Judge Frank Easterbrook turned to what he called the “gold standard of valuation” to help determine damages for plaintiffs.
Aslam Khan held 40% of the common units in Falcon Holdings, a limited liability company that owned and operated 100 fast-food restaurants. Khan allegedly told Falcon’s managers that when he acquired full ownership of the company one day he would reward top managers with 50% of Falcon’s equity.
In 2005, Khan bought out Falcon’s other owners and became the company’s sole equity owner. When he failed to distribute common units to any of the managers, five of them took him to court.
The plaintiffs used the price Khan paid in the buyout to calculate that the company was worth about $48 million. They also determined that because 20 managers qualified for units under the terms of Khan’s offers, each plaintiff lost about $1.2 million ($48 million × 50%/20).
District court’s ruling
In summary judgment the district court found that Khan had promised the plaintiffs an equity stake in Falcon. But it held that the managers hadn’t adequately estimated their damages.
The court reasoned that the other owners didn’t own 100% of Falcon, making it impossible to derive the value of the whole firm from the amount Khan paid for their interests. Also, the amount the other owners were paid depended on how much Khan and Falcon could borrow — not on Falcon’s true value. Therefore, the plaintiffs’ approach was flawed.
Easterbrook questions analysis
On appeal, Judge Easterbrook rejected the district court’s analysis. That court’s two propositions ignore the fact that the “gold standard of valuation” is what a willing buyer will pay a willing seller in an arm’s-length transaction. Easterbrook concluded that the buyout of the other owners involved a willing buyer and a willing seller dealing at arm’s length, so the price they agreed on was the value of the asset.
But the judge also found fault with the plaintiffs’ damages estimate. The interest that plaintiffs valued and the interest Khan owned were different. The plaintiffs valued the entire company — or the sum of Falcon’s debt plus its equity. However, while Khan owned 100% of the equity, the bank held the debt interest. The judge found it unsound to assume that Khan’s equity interest in Falcon was worth 100% of the company’s total value.
Easterbrook also questioned the plaintiffs’ assumption that Khan would give each of the 20 managers 2.5% of Falcon’s equity units without attaching terms or conditions to them. He characterized this proposition as “a disaster not only for the ownership structure of a closely held firm but also from a tax perspective.”
Plaintiffs hold out hope
Easterbrook vacated the district court judgment and remanded the case for proceedings consistent with his opinion. The plaintiffs are still expected to receive something if they calculate damages according to the “gold standard,” but that amount will likely be less than the $1.2 million each manager had hoped for.
If you have any questions about the “gold standard” of valuation or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.