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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

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
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

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:

Earnings Quality

Stability of Earnings

Likelihood of Earnings Overstatement

Direction of Eventual Earnings Readjustment

Future Earnings

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:


Cash Accounting
Low, due to instability of earnings measurement
High, because deals with completed transactions

Accrual Accounting

High, due to periodicity

Low, because it relies on management\'s expectations

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?

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.
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.

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.

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.

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.

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

NI over Assets
NI over Equity
Tax Rate
Use RPs here
EPS Growth

Sales Growth
Actual Sales are not adjusted
Gross Profit Margin