Assessing Earnings Quality at Nuware

1. In general, what types of issues come to mind when you hear analysts question a firm's "earnings quality"? Earnings quality, in accounting, refers to the overall reasonableness of reported earnings. It is an assessment criterion for how "repeatable, controllable and bankable" a firm's earnings are, amongst other factors, and has variously been defined as the degree to which earnings reflect underlying economic effects, are better estimates of cash flows, are conservative, or are predictable A fundamental aspect of the valuation process is obtaining a clear understanding of a target's quality of earnings. An analysis of the quality and sustainability of earnings should be conducted early on. Doing so enables a faster go or no-go decision and ensures that baseline valuation measures are reasonable and defensible in the determination of pricing and other deal terms. Understanding the sustainability of earnings and how that impacts transaction value and forecast modeling is key to navigating the unique aspects of any deal. The below factors lead to investors needing to assess the extent to which a firm's reported earnings are lowered : *Recording revenue too soon or of questionable quality, *Recording fictitious revenue, *Boosting income with one-time gains, *Shifting current expense to a different period, *Failing to record or improperly reducing liabilities, *Shifting current revenue to a later period, and *Shifting future expenses to the current period as a special charge Earnings quality is a concept that covers multiple accounting concerns and consists of two main elements. First, it touches on the idea that the accounting is a fair representation of the firm’s performance. For this first element, the idea of accounting being a fair representation of the firm’s performance entails the removal of bias, especially management bias, from the firm’s financials. Bias can occur via a manager’s optimism or a manager’s incentive to report numbers pessimistically. Whether or not a firm’s financials is a fair representation of its performance is also difficult given the fact that there can be subjectivity in choosing among accounting principles, not to mention the additional uncertainly that arises because estimates are often used when applying these principles. Second, earnings quality entails the idea that the information that’s provided is relevant for forecasting the firm’s expected earnings and future financial position.

Implications of earning quality can be seen in the following table:

Earnin gs Qualit y

Direction of Stabilit Likelihood of Eventual y of Earnings Earnings Future Earnin Overstateme Readjustme Earnin gs nt nt gs

Low

Low

High

Down

Low

High

High

Low

Up

High

2. Why is Harry Malone concerned about relying on Nuware's reported performance? If Nuware follows GAAP, shouldn't the company's reported financial statements be reliable? In this instance, Harry Malone is particularly concerned about relying on Nuware’s reported performance given the in depth research done on R.P. Stuart, his personal relationships with R.P. Stuart management, his belief in the transparency of their reporting and the fact that though Nuware and R.P. Stuart have virtually identical business models, R.P. Stuart struggled to match last year’s profitability and Nuware increased its earnings by almost 20%. Theoretically firms that follow GAAP should release reliable financial statements. However, management still plays a significant role in deciding how earnings will be stated. Despite the rules based system of GAAP, the unique circumstances of individual businesses still allow for areas of gray. There is room for deciding which accounting principle to apply and how to estimate values when applying that estimate, be it an estimate of bad debt expense, future costs of warranty programs or the fair value of financial instruments, to name a few. Moreover, as accounting scandals have proven, sometimes management doesn’t make erroneous accounting representations because of uncertainty, bias or estimates, but because they intend to deceive and they intentionally misrepresent their firm’s financial position.

The following table shows how cash and accrual accounting compare with respect to relevance and reliability and how management decision can change it:

-

Relevance

Reliability

Low, due instability earnings Cash Accounting measurement

to of High, because deals with completed transactions

Accrual Accounting

Low, because it relies on to management\'s expectations

High, due periodicity

3. Assume the role of Hereford and restate Nuware's 2003 earnings as if the company had used a similar accounting method and assumptions. After such restatement, do Nuware's earnings and earnings growth remain superior to that of R. P. Stuart? a) For a lot of companies, cost of sales is the largest expense on the income statement. Because LIFO tends to result in less variability in the gross margin percentage over the business cycle, Nuware is better able to accomplish income smoothing reporting using LIFO. As such, a LIFO adjustment was made on the balance sheet (add 29.5MM and 35.1MM in 2003 & 2002) and a LIFO adjustment was made on the income statement by adding 29.5MM and 35.1MM in 2003 and 2002 to the cost of sales. b) Although advertising is undertaken with the expectation that it will provide value, whether it will or not is uncertain. Thus GAAP requires immediate expensing of advertising costs. As such, advertising Costs that are committed but not realized, i.e. $10.2MM and 8.7MM in 2003 and 2002, respectively, must be expensed. This depicts expenses much more realistically as between Nuware and Stuart. c) Given that R.P. Stuart accounts for its stock compensation using the fair value method it included stock compensation expense in its operating income. As such, Nuware’s net income is more appropriately stated when stock compensation expense of $1,071k and . 707k is added back to operating income.

d) The available for sale securities that Nuware lists as a current asset should be backed out. Given that they are discussed in the footnotes as the only financial instrument with a fair value different from the recorded value, this leads one to believe that these securities are being held for an indefinite period and should be classified as long terms assets at fair value, with any cumulative gain or loss reported at fair value in the accumulated other comprehensive income section of shareholder equity. This provides a much better depiction of Nuware’s liquid assets in relation to R.P Stuart. e) As the accounts receivable for Nuware decreased, Nuware reduced its allowance for doubtful accounts, thereby estimating that more of its receivables would be realizable. R.P. Stuart, in turn, kept its allowance estimate steady. By adjusting the allowance, Nuware’s earnings are more in line with the actual risk it bears on credit sales. f) Interest and investment income $9,382K $5,784k and $5,014K in 2003-2001 should appropriately backed out given that their inclusion goes against the second element of earnings quality, namely including information that’s representative of a firm’s financial future. By backing out these peripheral items, Nuware’s income from operations and ability to compete with R.P. Stuart on an operations level is more accurately depicted 4. Would you characterize the accounting discretion applied by Nuware management as aggressive? Do you think the company has been "managing" earnings? Based on the analysis done in question three, we would characterize at least some of the accounting discretion applied by Nuware as aggressive. There are many examples that we will highlight again here. First, when the Accounts Receivable are adjusted using the allowance used by RP, they decrease from the stated balance by $1M in 2002 and $4.2M in 2003. This would suggest that Nuware's method for calculating the allowance over estimates what they actually will collect. Second, another indicator of aggressive accounting is the way Nuware accounts for advertising expenses - choosing to expense them in the period when the benefit is realized. Advertising expenses are nearly impossible to tie directly to accounting benefits, and this practice allows Nuware to move the expenses into a future period as they see fit. This is evidence of earnings management on the part of Nuware, and the data shows that adding these expenses back in 2002 and 2003 ($8.7M and $10.2M, respectively) significantly deflates the bottom line income. Lastly, the Gross Profit Margin in each of the three years after adjusting to RP's numbers drops between 1.7% - 2.1% which, again, indicates that the accounting practices employed by Nuware were such that the position of the company was over stated.

Net Income NI per DS ROA ROE Tax Rate EPS Growth Sales Growth

2003 $52,924.00 $0.50 0.043 0.067 39% 0.33 0.027

2002 $39,565.00 $0.38 0.035 0.057 39% -0.31 0.061

2001 $56,654.00 $0.56 --39% ---

NI over Assets NI over Equity Use RPs here Actual Sales are not adjusted

Gross Profit Margin

0.412

0.388

0.429