Valuation Considerations — Earnings Quality and Accruals

As your company seeks funding from early investors and then from an IPO, improving financial performance becomes a key priority. Financial indicators such as net income, EBITDA¹, and NOPAT² are a concern for investors who want to ensure that the company will create a return on their investment. While increasing earnings or decreasing losses should be a major company goal when seeking financing, the quality of those earnings is a major consideration for potential investors. Whether you decide to pursue an IPO or sale on the M&A market, investors will consider your earnings quality when valuing your company.

This article will define earnings quality, consider the factors that affect it, explain how it can be improved, and discuss how these issues should be disclosed to investors. Ultimately, by gaining an understanding of these factors, your company will understand how to increase your earnings quality, which will increase investor confidence in your financial statements.

The concepts in this article are mainly focused on late-stage valuations. Young start-up companies without an extensive financial history will generally be valued based on factors such as the potential of proposed products and the size of the total addressable market instead of earnings.

What is Earnings Quality?

Earnings quality refers to the reliability and credibility of your reported earnings. Earnings quality is reflected in two main ways: (1) how closely your earnings reported in the GAAP financial statements reflect economic performance and (2) how useful your current period GAAP earnings are in predicting future period earnings³.

Reflects Economic Performance

Ideally, earnings would perfectly reflect the economic performance of a company. However, factors such as estimation errors, earnings management, and excessive accruals create a division between economic performance and reported earnings. Evaluating earnings quality is the practice of evaluating financial statement data to estimate how wide that gap between economic performance and reported earnings actually is.

When the gap between GAAP earnings and economic reality is slim, earnings quality is high; when that gap is wide, earnings quality is low. The overarching financial goal of a company is to increase earnings by increasing sales and/or decreasing costs; however, if a company uses accounting tricks to increase reported earnings instead of improving its economic performance, then earnings quality decreases.

It is important to note that in place of GAAP earnings, investors will often use other measures that they believe will better reflect the economic performance of the company. The measures they use will depend on both the industry and the investor, and will often give more weight to recurring, stable cash flows rather than GAAP earnings.

Helps Predict Future Earnings

Another aspect of earnings quality is how reliably future earnings can be predicted based on past and current earnings. This consideration is especially relevant to investors because they will often project future earnings based on current and historical financial statements to value the company. If investors’ projections are based on unreliable data, their valuations will not reflect the actual value of the company. To counteract this issue, investors will often create a quality of earnings report and adjust earnings during the due diligence process. The quality of earnings report is a quantitative and qualitative assessment of a company’s earnings. The report is designed to help investors evaluate the quality of past and current earnings and better predict future performance.

Also keep in mind that if your company’s earnings are volatile, forecasting future earnings will be more difficult; however, that does not mean that earnings quality is low. For example, when managers intentionally “smooth” earnings⁴ to decrease volatility, forecast accuracy may improve, but earnings quality decreases. Therefore, it is important to note that volatile earnings or a single quarter or year of lower earnings does not necessarily mean that earnings quality is low—in those cases, the performance of a company may need to be considered over a longer period.

Accruals

Accruals are a major consideration when evaluating earnings quality because they contribute to the difference between economic performance and reported earnings. Because accruals are non-cash, estimated journal entries, they may not always properly represent a company’s economic performance. For example, a company should record an estimate for sales returns and allowances. Accounting for future sales returns and allowances is appropriate and relevant because sales will be overstated if future returns are not considered. However, the subjective nature of this accrual, which is made before any return actually happens, makes it less reliable to investors. This trade-off between reliability and relevance is why earnings quality is such an important consideration.

Total Accrual to Assets Ratio

During a valuation, investors can use the following ratio to evaluate the prevalence of accruals in a company’s financial statements:

‍Total accruals to assets = (Net Income – Operating Cash Flow) / Beginning Total Assets

‍If your company has recorded high levels of income-increasing accruals, your total accrual to assets ratio will be higher than other companies in similar growth phases in your industry. If that is the case, investors may be concerned about your earnings quality. In order to compensate for this issue, investors will likely look for accruals that are too aggressive and adjust earnings accordingly.

Net Income vs. Cash Flow Ratio

Another way that investors analyze the effect of accruals on earnings quality is by comparing net income to operating cash flow⁵. Analysts use these two measures to calculate the quality of earnings ratio as follows:

‍quality of earnings ratio = net cash from operating activities / net income

‍If a company posts high net income but low or negative operating cash flow, its quality of earnings ratio will be low. Depending on the maturity of the company, investors will become very concerned if the ratio falls below one for an extended period. Investors and analysts are worried that continual differences between net income and cash flow indicate that the company’s investments are not providing a sufficient return and that the company will have significant asset write-downs in the future. Therefore, if a company is posting high earnings but has a lack of cash flow, investors will be more skeptical about the company’s true economic performance and outlook.

However, while the difference between net income and cash flow are a concern for more mature companies, it may not be as large of a concern for start-ups. Start-ups are often expected to have more net income than cash flow as they spend heavily to gain market share and make large investments that will not pay off immediately. Investors will expect to see this difference reverse as the company matures.

Accounting Estimates

All accruals require a certain level of estimation, but the range of acceptable estimates and the subjectivity of those estimates can have a significant impact on earnings quality. Consider the following example from the AICPA publication Quality of Earnings and Earnings Management:

A retail business might have net income equal to 3% of revenues. A change in its estimates of uncollectible accounts by two-tenths of a percent or by 20 basis points, such as from 2.0% to 2.2%, will have a 4.0% effect on net income… The wider the range of reasonable estimates, the more management’s choice will influence bottom-line net income.

This example illustrates the large impact that small changes in estimates can have on net income. It also demonstrates why investors would be concerned about earnings quality if a company’s subjective estimates have the potential to make a large impact on reported earnings. Investors will likely evaluate the reasonableness of a company’s estimates and adjust earnings in their valuations if they think those estimates are too aggressive.

In order to decrease the effect that these estimates have on earnings quality, your company can follow these best practices:

• Maintain consistent accounting policies from quarter to quarter
• Compare your accounting policies to industry norms
• Disclose any changes in estimation methods
• Maximize the objective measures used in estimates and decrease subjective measures
• Keep track of the data needed to better inform your estimates
• Ensure that personnel have the skills necessary to make accounting estimates
• Consider consulting specialists for certain estimates
• Compare previous estimates with actual results
• Consider whether your estimates are consistent with your operational plans

Legitimate circumstances may arise that necessitate changes in accounting estimates. Following these best practices can help your company determine if changes are appropriate.

Earnings Management

Public companies are under intense investor scrutiny, and the pressure to increase earnings every quarter can lead companies to engage in earnings management. Earnings management refers to the use of subjective estimates, changes in business practices, and accounting techniques to intentionally manipulate a company’s earnings. Because earnings management improves reported earnings without improving economic performance, increased earnings management leads to a decrease in earnings quality. Engaging in earnings management could damage investors’ perception of the reliability of your company’s financial statements. Private equity firms, hedge funds, and other investors will likely be hesitant to invest in a company that they believe is trying to artificially inflate earnings.

Importance of Disclosure

The Management Discussion and Analysis (MD&A), together with other financial statement disclosures, informs investors of earnings components that help determine overall earnings quality. The Deloitte article Quality of Earnings: Focus on Integrity and Quality encourages companies to explain within their disclosures that subjectivity in estimates is caused by the nature of transactions, and not by management. The article also states, “It is helpful to provide the reader with enough information to facilitate an understanding of the various components of earnings and risks and uncertainties that influence the future results of the company.” By properly disclosing the subjectivity of estimates and other aspects of your earnings quality in your financial statements, you can help ease some of the uncertainty that investors face when evaluating your financial performance, increasing their confidence in your financial results.

For more information on the MD&A, see our articles titled Drafting an S-1 and Writing an Effective MD&A.

Case Study: Jones & Co.

Jones & Co. is preparing for its Series E funding round and is seeking funding from Velocity Fund. Jones & Co. reported the following financial results in the most recent year:

Based on these results, Jones & Co. suggested the following valuation:

As part of the due diligence process, Velocity Fund will evaluate Jones & Co.’s earnings quality and make adjustments to NOPAT if necessary.

Quality of Earnings Ratio

To begin, Velocity Fund calculates Jones & Co.’s quality of earnings ratio as follows:

‍quality of earnings ratio = net cash from operating activities / net income

‍quality of earnings ratio = $48.3 million / $57.4 million = 0.84

Because this ratio is less than Velocity Fund would expect from a company in Jones & Co.’s position, Velocity Fund determines that it should perform a more in-depth analysis of Jones & Co.’s accruals. The analysis reveals issues with bad debt expense and warranty expense.

Bad Debt Expense

Consistent with previous years, Jones & Co. recorded bad debt expense equal to 5% of sales. However, Velocity Fund recognizes that because Jones & Co. loosened their credit requirements for customers, bad debt expense should be closer to 7% of sales. This 2% increase in bad debt expense decreases EBIDTA by $10.9 million.

Warranty Expense

Jones & Co.’s accrual for warranty expense was based on the estimate that approximately 4.5% of sales would need to be replaced at cost. Velocity Fund agrees with this assessment for products sold during 2018; however, a defect has recently been discovered in products sold in years prior to 2018, and Jones & Co. has not increased warranty expense based on this discovery. Based on this information, Velocity Fund believes that warranty expense should be increased by $3 million, which decreases EBITDA by $3 million.

Earnings Quality Adjustments Summary

Velocity Fund did not identify any other accruals that needed to be considered. The adjustments to EBITDA and the new valuation are summarized below:

Overall, the adjustments decreased Jones & Co.’s valuation by over $116 million. While Jones & Co. could still negotiate with Velocity Fund to increase their valuation, this example underscores the large impact that earnings quality can have on a company’s valuation.

Conclusion

Your company’s earnings quality will be a major issue for pre-IPO and IPO investors. By understanding the importance of accruals, the relationship between net income and operating cash flow, accounting estimates, and earnings management, your company will be in a better position to report high quality earnings that match your economic performance. Additionally, properly disclosing earnings quality will help increase investor confidence in your financial statements. Overall, earnings quality can drastically affect the valuation of your company.

Resources Consulted

• PCAOB AU Section 342
• Deloitte Quality of Earnings, Focus on Integrity and Quality