Earnings Quality is More than Adjusted EBITDA

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Buyers perform exhaustive pre-acquisition due diligence of target companies that spans financial, tax, legal, IT, operational, marketing, HR, and other matters.  Central to financial due diligence is the target’s earnings quality.  Discussion of earnings quality usually focuses solely on recent historical EBITDA, normalized by making various adjustments.  Of course, normalized EBITDA is critical information. Buyers use it to develop forecasts needed to value a target, negotiate its purchase price and acquisition financing, and determine its capacity to service acquisition debt while generating an acceptable return on the buyer’s investment.

But earnings quality is not just a dollar amount, it’s a qualitative assessment of a company’s earnings:

Earn•ings qual•i•ty (noun) The extent to which a business’ economic performance during a recent historical period:

  1. Is faithfully represented by its reported earnings during the period and
  2. Can be sustained (will persist) in future periods.

As with other qualities, it is judged to be “high,” “medium” or “low.”

Normalizing adjustments help a buyer evaluate whether a target’s historical earnings meet the second condition (sustainability or persistence).  But figuring out whether a company’s earnings meet the first condition (faithful representation) is challenging.  In addition to normalizing adjustments, buyers need answers to three questions:

  1. Do reported revenues and expenses largely reflect cash receipts and disbursements, respectively, rather than accounting accruals?
  2. Do those accounting accruals rely heavily on subjective judgments or difficult-to-make estimates?
  3. Are there indicators of earnings management?

In this post, let’s focus on the third question, regarding indicators of earnings management, another term that begs definition:

Earn•ings man•age•ment (verb) To manipulate reported income statement amounts by:

  • Accelerating sales using such unsustainable devices as “channel-stuffing,” bill-and-hold arrangements, unlimited customer right-of-return privileges, resale price protection, and customer “side agreements” that override normal terms of sale;
  • Delaying discretionary, but necessary, expenditures such as plant maintenance, advertising, and R&D – which increases earnings in the short term, but is unsustainable in the long run;
  • Improperly applying accounting standards, such as those standards governing revenue recognition;
  • Improperly capitalizing period costs, such as R&D, advertising or maintenance; and
  • Basing accounting accruals on unreasonable or unsupportable estimates or assumptions.

Earnings management indicators are sorted into three categories:

  1. Pressures or incentives,
  2. Opportunities, and
  3. Attitude or ability to rationalize.

Not surprisingly, the likelihood that earnings management has affected a company’s financial statements increases (i) with the number and severity of indicators present and (ii) if indicators from all three categories are present.

So, what are the indicators that a business’ financial statements are afflicted with earnings management?  In the context of nonpublic companies, the primary indicators are:

  1. Earnings management pressures or incentives:
  • The target’s industry is highly cyclical or intensely competitive.
  • The target’s products are trendy, fashion-sensitive, or subject to rapid technological change or physical deterioration.
  • The target’s debt agreements contain financial statement-based covenants, such as a minimum interest coverage ratio.
  • The target’s reported earnings deteriorated recently, or it has had trouble meeting budgeted
  • The target’s managers participate in incentive compensation arrangements based on accounting measures, such as pre-tax earnings.
  1. Opportunities for earnings management:
  • The target uses unusual or complex business arrangements or accounting methods that require significant use of judgment or estimates.
  • Pre-tax operating cash flow is consistently less than EBITDA, suggesting possible cash flow difficulties or manipulation of working capital-related accounting accruals – and often both.
  • The target changed accounting principles, with the effect of increasing reported earnings in the period of change and distorting period-to-period earnings trends (for example, changing from the LIFO inventory cost-flow assumption to FIFO during times of general rising production costs).
  1. An attitude or ability to rationalize earnings management:
  • Target has a weak control environment, lacks formal internal controls, or lacks riskmanagement policies and practices.

Consider the following case . . .

CarTech, Corp. is a $30 million manufacturer of electronic control units (ECUs) used with power sliding doors and rear hatches by manufacturers of minivans and SUVs.  CarTech was formed by its co-owners, Jerry and Dave, in 1998. Jerry and Dave are ready for new pursuits and are seeking a buyer for CarTech.

The Company’s accounting manager, Mark, is not a CPA and is not formally trained in accounting. Other than Mark and two accounting clerks who report to him – one for billing and collections and the other for payables and payroll – there are no financial or accounting personnel. Mark has broad responsibility for the Company’s financial affairs.  He’s been in the job for 12 years and seems very loyal to Jerry and Dave. Although he cannot sign checks (the owners do that), he is responsible for recording all transactions in the accounting records, reconciling cash account balances to bank statements, and approves payroll and the work of the accounting clerks.  The Company has no formal internal accounting controls.

{Poorly qualified financial and accounting personnel, a lack of segregation of incompatible accounting responsibilities, and a lack of formal, tested internal accounting controls suggest a weak control environment, an indicator of earnings management}

In addition:

  • The company has $8 million in secured bank debt. The related loan agreement contains financial covenants, one of which requires that CarTech maintain a minimum interest coverage (operating income-to-interest) ratio of 6.0.  (For purposes of evaluating earnings quality, the fact that a buyer will probably refinance CarTech’s debt is not relevant.)
  • The Company’s employees (other than its owners), including the accounting manager, Mark, and the sales-and-marketing manager, receive annual bonuses equal to 15 percent of base salary, provided the Company achieves 5.0 percent-or-better growth in pre-tax income over the previous year.

Presented below is summarized financial information of the Company for its fiscal years ended December 31, 2015 through 2017, annotated for indicators of earnings management present.

So, in light of the above information, do we know CarTech’s financial statements have been the subject of earnings management, thereby diminishing earnings quality?  No.  But, we’ve identified the presence of earnings management incentives and pressures, and earnings management opportunities.  And, CarTech’s weak control environment and lack of internal accounting controls suggest an attitude or ability to rationalize earnings management.  Concluding whether there’s earnings management, and consequently diminished earning quality, at CarTech based on this information requires the judgment of an experienced analyst.