understanding earnings quality patricia m. dechow · – important for investing, auditing, sec in...
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Understanding Earnings Quality
Patricia M Dechow
Defining Earnings Quality
Understanding the factors that cause earnings quality to differ is a key research area in accounting
ndash Important for investing auditing SEC in monitoring and regulating banks providing loans etc
HIGH QUALITY EARNINGSReflect the economics of the business
Are sustainable (are a good indicator for the future)
LOW QUALITY EARNINGSDo not reflect the economics of the business
Have been manipulatedcontain errors Are not sustainable (are a poor indicator for the future)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β closer to 1 =gt earnings are more sustainable
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
Earnings Quality 1
Cup and straw= 005Lemon = 015
Sugar = 010Total = 030
ndash Chris starts a business
Earnings Quality 1
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Earnings Quality
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Thatrsquos perfect (my precious)
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Defining Earnings Quality
Understanding the factors that cause earnings quality to differ is a key research area in accounting
ndash Important for investing auditing SEC in monitoring and regulating banks providing loans etc
HIGH QUALITY EARNINGSReflect the economics of the business
Are sustainable (are a good indicator for the future)
LOW QUALITY EARNINGSDo not reflect the economics of the business
Have been manipulatedcontain errors Are not sustainable (are a poor indicator for the future)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β closer to 1 =gt earnings are more sustainable
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
Earnings Quality 1
Cup and straw= 005Lemon = 015
Sugar = 010Total = 030
ndash Chris starts a business
Earnings Quality 1
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Earnings Quality
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Thatrsquos perfect (my precious)
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β closer to 1 =gt earnings are more sustainable
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
Earnings Quality 1
Cup and straw= 005Lemon = 015
Sugar = 010Total = 030
ndash Chris starts a business
Earnings Quality 1
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Earnings Quality
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Thatrsquos perfect (my precious)
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
Earnings Quality 1
Cup and straw= 005Lemon = 015
Sugar = 010Total = 030
ndash Chris starts a business
Earnings Quality 1
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Earnings Quality
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Thatrsquos perfect (my precious)
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality 1
Cup and straw= 005Lemon = 015
Sugar = 010Total = 030
ndash Chris starts a business
Earnings Quality 1
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Earnings Quality
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Thatrsquos perfect (my precious)
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality 1
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Earnings Quality
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Thatrsquos perfect (my precious)
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
I will pay you $100 for that
delicious cup of lemonade
Thatrsquos perfect (my precious)
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality 1Chrisrsquo earnings Revenue
Cup of Lemonade= $100
ExpensesCosts of goods sold = -030
Earnings = 070
Cup and straw= 005Lemons = 015
Sugar = 010Total = 030
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
ndash Milli starts a business
Cups and straws= 100Lemons = 100
Box of sugar = 200 Total Costs = 400
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
TOMORROW
I will pay you $100 for that lemon sugar
drink
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
I will pay you $100 for that lemon sugar
drink
TOMORROW
ITrsquoS A DEAL
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Millirsquos Earnings(on a cash basis)Revenue = 0Expenses = $ -400
Cash earnings = -400
Earnings Quality 2
Cup and straws= 100Lemons = 100
Box of sugar = 200Total = 400
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Comparison of CASH FLOWSChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Similar transaction occurred but cash-based performance looks very different
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Accrual Accounting
THE TIMING OF CASH FLOW RECEIPTS AND PAYMENTS IS NOT IMPORTANT
Focus on underlying economics
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Millirsquos Earnings (Accrual basis)Revenue Cup of Lemonade= $100
ExpensesCosts of good sold = 030
Earnings = 070
Earnings Quality
Cup and straws= 100 ndash 005Lemons = 100 ndash 015
Box of sugar = 200 ndash 010 Inventory = 400
SOLD = ndash 030Inventory = 370
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Comparison of ACCRUAL EARNINGSChrisrsquo
EARNINGS+ accruals
070 = 070 + 0
Millirsquos
Earnings = EARNINGS + accruals
070 = $070 + $470
Earnings on accrual basis makes businesses comparable
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Reconciling Earnings to Cash FlowsChris
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
Earnings are the same even though cash flows are very different
ACCRUALS = + 100 + 370$470
100
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Quality Issues with Millirsquos accruals
Accounts Receivable
Gandalf may disappear
100
I will pay you $100 for that cup of
lemonade
TOMORROW
Sold LemonadeTimely useful information
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Millirsquos accruals
Inventory
High inventory Milli anticipates future sales
Obsolete inventoryNobody wants to buy lemonade
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Comparison of Business ModelsChrisrsquo
Has CashSimple business
Millirsquos
Accruals are indicators of growth in RISKY investments Accruals estimate these investments but they could be wrong
070 cash
ACCRUALS = + 100 + 370
100
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Comparison of Earnings QualityChrisrsquo
Earnings = cash flows + accruals
070 = 070 + 0
Millirsquos
Earnings = cash flows + accruals
070 = $-400 + $470
070 cash
ACCRUALS CAN BE FUZZY AND CONTAIN ERRORSCHRISrsquo EARNINGS ARE HIGHER QUALITY THAN MILLIrsquoS
ACCRUALS = + 100 + 370
100
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Operationalizing Earnings Quality
bull Empirical evidence earnings persistence
bull Earningst+1 = α + βEarningst + ε
bull Chrisrsquoβ gt β
bull Millirsquos
065085
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + β1Cash flowst + β2Accrualst + ε
β1 gt β2
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Understanding Earnings Quality
EARNINGS = CASH FLOWS + ACCRUALS
Earnings Quality research tries to disentangle
ldquoGoodrdquo Accrualsthat correctly reflect
the business
ldquoBadrdquo Accruals that reflect errors manipulation and
overinvestment
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspective ndash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Measure the value
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = Income
Market Values Follow a Random Walk
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Economic Perspective
Assetst ndash Liabilitiest = Shareholdersrsquo Equityt
Assetst+1 ndash Liabilitiest+1 = Shareholdersrsquo Equityt+1
Measure the value
Measure the value
∆ Value = are transitory and unpredictable
Market Values Follow a Random Walk
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
=β Economic orBalance Sheet
Perspective
0
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Accounting Rules and StandardsBalance Sheet
Perspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (Fair Value of Component)Debt ndash Fair ValueSecuritization ndash Fair valueInventory ndash lower of market or cost
Transitory gains and losses muddies up earnings
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
bull Philosophical Question bull What is objective of accrual accounting
FASBIFRS RULES
1 Economic perspectivendash Investors care about firm value The objective is to measure the
value of assets and liabilities
2 Performance evaluation (Income Statement perspective)ndash Investors want to know what management did this period The
objective is to measure how much income was generated this period
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOME measures how much sustainable cash flows the managers generated
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Credit Sales
Cash SalesCash Expenses
Cost of good sold
INCOMEt+2
Deferred Revenues
INCOMEt-1
Cash from previous credit Sales
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance EvaluationAccruals alter the timing of cash flow recognition in earnings
To be identify firm performance
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Performance Evaluation
INCOMEt
Cash flowst-1 Cash flowst+1Cash flowst-2 Cash flowst+2
CASH FLOWSt
More Timely and Relevant
Balance Sheetrsquos RoleKeeps track of the cash allocation and reversals
Assets = Spent cash in past DR (capitalized cost)
Liabilities = Spend cash in futureCR (Accounts payable)
Liabilities = Received cash in pastCR (Deferred Revenue)
Assets = Receive cash in futureDR (Accounts Receivable)
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β =gt 1Income StatementPerspective
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Income StatementPerspective
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Revenue Recognition Does not allow the anticipation of future salesCost of Goods Sold match to revenueDepreciation allocate over timeOperating Leases as paidSoftware Capitalize when technological feasibilityDeferred Revenue allocate over time
Mix of bothIncome StatementPerspective
Balance SheetPerspective
Goodwill Fair value ndash no amortizationMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
FASBIFRS RULES
Transitory gains and losses go through income
Historical Costs on Balance sheet
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
Use CASH BASISExpense RampDExpense start up costsExpense SGampA
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Accounting Rules and StandardsMix up both
Income StatementPerspective
Balance SheetPerspective
Revenue Recognition Cost of Goods Sold matchingDepreciation allocate over timeOperating Leases as paidSoftware Technological feasibilityDeferred Revenue (old rules)
Goodwill Fair valueMarketable securities Fair ValueImpairments of assets Fair ValueCapital Leases Fair ValueDeferred Revenue (new rules)Impaired Debt ndash Fair ValueSecuritization ndash Fair value
Transitory gains and losses go through income
Historical Costs on Balance sheet
CONSERVATISM
CASH BASISExpense RampDExpense start up costsExpense SGampA
Use Fair Values on the downsideBut not on the upside
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Income StatementPerspective
Balance SheetPerspective
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
ACCRUAL ACCOUNTING TENSION
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Operationalizing Earnings Quality
bull Concept of earnings persistence
bull Earningst+1 = α + βEarningst + ε
β gt βIncome StatementPerspective
Balance Sheet Perspective
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Consequence of moving accrual accounting to a balance sheet focus
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Matching implies a negative correlation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Ranking on AccrualsCorrelation between Cash flows and Accruals
Source Dechow and Ge (2005)
Low accrualsLow cash flows(positive correlations)
High accrualsLow cash flows(negative correlations)
Balance Sheet roleDistressed firms ndashLow EARNINGSTaking write-offs (low accrualsthat are transitory
Income statement RoleMatchingLow Cash flowsAccruals indicate Large investments
Two types of firms have low cash flows
Distressed firms ndash taking write-offs (low accruals)Growth firms ndash investing heavily (high accruals)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Accruals Association with Cash Flows
Newer cohorts (technology) do not have a negative association between cash flows and accruals
Bushman Lerman and Zhang (2016)
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
+ +-
Matching role of accruals has declined
Bushman Lerman and Zhang (2016)
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Good News BB still Holds(replication of Ball and Brown 1968 )
Data 1971 - 2012
Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Good news Earnings Announcements Still Informative
2001-20122001-2012
Volume Price Residual
1981-1990
Source Dechow Sloan and Zha (2014)
1981-1990
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings vs cash flows association with stock returns over time
Source Dechow Sloan and Zha (2014)
CFO
FCF
Earnings
Non-GAAP Earnings
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Market Solution
bull Declining association of stock returns with earnings
bull Declining matching role of accrualsbull Declining persistence of GAAP earnings
Rise of management guidanceRising use of non-GAAP performance metricsRising emphasis by management on meeting analystsrsquo non-GAAP EPS expectations
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Internal ControlsAudit QualityGovernance
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
ACCRUAL ACCOUNTING TENSION
Income StatementPerspective
Balance SheetPerspective
ManagementFinancial AnalystsInvestorsMediaCompensation consultantsAuditors
Standard SettersFund Managers
Debt holders (in firms in Financial distress)Academics
Marketrsquos Solution
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Is the market solution good
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
bull Roll-up strategy ndash Grow by acquiring companies with existing drugs ndash Cut RampD layoff workers increase the price of patented drugs
bull Strategy relies on easy access to capital markets to fund acquisitions
J Michael Pearson (started his reign as CEO and COB in 2008)
30 Acquisitions during tenure as CEO
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
J Michael Pearson (started his reign as CEO and COB in 2008)
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
0
50
100
150
200
250
300
Price
Price
Strategy works Stock Price increases 2000 percent
2008 2015
30 Acquisitions during tenure as CEO
By 2015 Pearson had nearly $3Billion in stock and options
J Michael Pearson (started his reign as CEO and COB in 2008)
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
bull Valeant consistently met analystsrsquo expectations
0
1
2008
0331
2008
0630
2008
0930
2008
1231
2009
0331
2009
0630
2009
0930
2009
1231
2010
0331
2010
0630
2010
0930
2010
1231
2011
0331
2011
0630
2011
0930
2011
1231
2012
0331
2012
0630
2012
0930
2012
1231
2013
0331
2013
0630
2013
0930
2013
1231
2014
0331
2014
0630
2014
0930
2014
1231
2015
0331
2015
0630
2015
0930
BeatMiss2008 2015
Beat analystsrsquo EPS forecasts
(26 times of 31 Quarters)
Beat
Miss
Analysts forecast of EPS
How did they consistently beat
Reported proforma EPS or ldquocash EPSrdquo (excludes amortization of intangible assets such as drug patents goodwill write-offs layoff costs acquisition costs etc)
J Michael Pearson (started his reign as CEO and COB in 2008)
Valeantrsquos Reconciliation
Valeantrsquos Reconciliation
Chart1
Sheet1
But then questions started being raised about sustainability and ethics of Valeantrsquos strategy
J Michael Pearson CEO
Going After Valeant for predatory pricing
bull Price tumbled today it is $15
J Michael Pearson CEO
2008
Valeant was not a stock that created real economic growth
But was a Darling of Wall Streetbull Met expectationsbull Raised financingbull Positive stock price momentumbull High institutional ownershipbull Strong analyst following
Do firms manipulate to consistently meet expectations
bull Toolsndash Guidancendash Put in more effortndash Take real economic actions ldquorealrdquo earnings
managementndash Massage accruals
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
50
60
70
80
90
100
o
f fir
ms t
hat b
eat o
r mee
t ana
lyst
srsquo
Earn
ings
fore
cast
s
All AAERsPopulation
Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
Source Chu Dechow Hui and Wang (2018)
Before manipulation period
After manipulation period
Manipulation period
Manipulators identified by SEC
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
| Amortization and impairments of finite-lived intangible assets and other non-GAAP charges ($M) | Restructuring integration acquisition-related and other costs ($M) | Total adjustments ($M) | |||||
| Q1 2012 | $20520 | $6984 | $37324 | ||||
| Q2 2012 | $21365 | $4387 | $33615 | ||||
| Q3 2012 | $23256 | $4748 | $34986 | ||||
| Q4 2012 | $31183 | $26180 | $46872 | ||||
| Q1 2013 | $33678 | $5688 | $43269 | ||||
| Q2 2013 | $31610 | $6154 | $40969 | ||||
| Q3 2013 | $91900 | $30454 | $145901 | ||||
| Q4 2013 | $38544 | $12827 | $60777 | ||||
| Q1 2014 | $36410 | $13510 | $62230 | ||||
| Q2 2014 | $38060 | $14270 | $52480 | ||||
| Q3 2014 | $40510 | $6330 | $44340 | ||||
| Q4 2014 | $44920 | $4690 | $34580 | ||||
| Q1 2015 | $36850 | $6480 | $73560 | ||||
| Q2 2015 | $58820 | $15290 | $95010 | ||||
| Q3 2015 | $68310 | $8260 | $91180 |
| Q1 2012 | Q1 2012 | Q1 2012 | |||
| Q2 2012 | Q2 2012 | Q2 2012 | |||
| Q3 2012 | Q3 2012 | Q3 2012 | |||
| Q4 2012 | Q4 2012 | Q4 2012 | |||
| Q1 2013 | Q1 2013 | Q1 2013 | |||
| Q2 2013 | Q2 2013 | Q2 2013 | |||
| Q3 2013 | Q3 2013 | Q3 2013 | |||
| Q4 2013 | Q4 2013 | Q4 2013 | |||
| Q1 2014 | Q1 2014 | Q1 2014 | |||
| Q2 2014 | Q2 2014 | Q2 2014 | |||
| Q3 2014 | Q3 2014 | Q3 2014 | |||
| Q4 2014 | Q4 2014 | Q4 2014 | |||
| Q1 2015 | Q1 2015 | Q1 2015 | |||
| Q2 2015 | Q2 2015 | Q2 2015 | |||
| Q3 2015 | Q3 2015 | Q3 2015 |
Sheet1
But then questions started being raised about sustainability and ethics of Valeantrsquos strategy
J Michael Pearson CEO
Going After Valeant for predatory pricing
bull Price tumbled today it is $15
J Michael Pearson CEO
2008
Valeant was not a stock that created real economic growth
But was a Darling of Wall Streetbull Met expectationsbull Raised financingbull Positive stock price momentumbull High institutional ownershipbull Strong analyst following
Do firms manipulate to consistently meet expectations
bull Toolsndash Guidancendash Put in more effortndash Take real economic actions ldquorealrdquo earnings
managementndash Massage accruals
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
50
60
70
80
90
100
o
f fir
ms t
hat b
eat o
r mee
t ana
lyst
srsquo
Earn
ings
fore
cast
s
All AAERsPopulation
Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
Source Chu Dechow Hui and Wang (2018)
Before manipulation period
After manipulation period
Manipulation period
Manipulators identified by SEC
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
| Amortization and impairments of finite-lived intangible assets and other non-GAAP charges ($M) | Restructuring integration acquisition-related and other costs ($M) | Total adjustments ($M) | |||||
| Q1 2012 | $20520 | $6984 | $37324 | ||||
| Q2 2012 | $21365 | $4387 | $33615 | ||||
| Q3 2012 | $23256 | $4748 | $34986 | ||||
| Q4 2012 | $31183 | $26180 | $46872 | ||||
| Q1 2013 | $33678 | $5688 | $43269 | ||||
| Q2 2013 | $31610 | $6154 | $40969 | ||||
| Q3 2013 | $91900 | $30454 | $145901 | ||||
| Q4 2013 | $38544 | $12827 | $60777 | ||||
| Q1 2014 | $36410 | $13510 | $62230 | ||||
| Q2 2014 | $38060 | $14270 | $52480 | ||||
| Q3 2014 | $40510 | $6330 | $44340 | ||||
| Q4 2014 | $44920 | $4690 | $34580 | ||||
| Q1 2015 | $36850 | $6480 | $73560 | ||||
| Q2 2015 | $58820 | $15290 | $95010 | ||||
| Q3 2015 | $68310 | $8260 | $91180 |
But then questions started being raised about sustainability and ethics of Valeantrsquos strategy
J Michael Pearson CEO
Going After Valeant for predatory pricing
bull Price tumbled today it is $15
J Michael Pearson CEO
2008
Valeant was not a stock that created real economic growth
But was a Darling of Wall Streetbull Met expectationsbull Raised financingbull Positive stock price momentumbull High institutional ownershipbull Strong analyst following
Do firms manipulate to consistently meet expectations
bull Toolsndash Guidancendash Put in more effortndash Take real economic actions ldquorealrdquo earnings
managementndash Massage accruals
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
50
60
70
80
90
100
o
f fir
ms t
hat b
eat o
r mee
t ana
lyst
srsquo
Earn
ings
fore
cast
s
All AAERsPopulation
Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
Source Chu Dechow Hui and Wang (2018)
Before manipulation period
After manipulation period
Manipulation period
Manipulators identified by SEC
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
bull Price tumbled today it is $15
J Michael Pearson CEO
2008
Valeant was not a stock that created real economic growth
But was a Darling of Wall Streetbull Met expectationsbull Raised financingbull Positive stock price momentumbull High institutional ownershipbull Strong analyst following
Do firms manipulate to consistently meet expectations
bull Toolsndash Guidancendash Put in more effortndash Take real economic actions ldquorealrdquo earnings
managementndash Massage accruals
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
50
60
70
80
90
100
o
f fir
ms t
hat b
eat o
r mee
t ana
lyst
srsquo
Earn
ings
fore
cast
s
All AAERsPopulation
Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
Source Chu Dechow Hui and Wang (2018)
Before manipulation period
After manipulation period
Manipulation period
Manipulators identified by SEC
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Do firms manipulate to consistently meet expectations
bull Toolsndash Guidancendash Put in more effortndash Take real economic actions ldquorealrdquo earnings
managementndash Massage accruals
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
50
60
70
80
90
100
o
f fir
ms t
hat b
eat o
r mee
t ana
lyst
srsquo
Earn
ings
fore
cast
s
All AAERsPopulation
Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
Source Chu Dechow Hui and Wang (2018)
Before manipulation period
After manipulation period
Manipulation period
Manipulators identified by SEC
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
Rules
Voluntary DisclosuresGuidance
Non-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
50
60
70
80
90
100
o
f fir
ms t
hat b
eat o
r mee
t ana
lyst
srsquo
Earn
ings
fore
cast
s
All AAERsPopulation
Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
Source Chu Dechow Hui and Wang (2018)
Before manipulation period
After manipulation period
Manipulation period
Manipulators identified by SEC
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
50
60
70
80
90
100
o
f fir
ms t
hat b
eat o
r mee
t ana
lyst
srsquo
Earn
ings
fore
cast
s
All AAERsPopulation
Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
Source Chu Dechow Hui and Wang (2018)
Before manipulation period
After manipulation period
Manipulation period
Manipulators identified by SEC
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
Panel A Working capital accruals
-4
-2
0
2
4
6
8
All AAERs Population
After manipulation period
Before manipulation period
Manipulationperiod
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Implicationsbull Earnings quality and properties of accruals have
changed over timendash Balance sheet focus combined with conservatism ndash
fair values on the downside ndash Conservatism ndash cash basis - lack of capitalizing
investment costs and so no creation of accruals in technology firms
bull Rise of non-GAAP earnings to solve these problems
bull Continuing pressure on management to guide and meet expectations
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
What can we do
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
What can we doI
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Project with Chad Larson and Bob Retesuk
Earnings = Cash Flows + Accruals
Earnings = CFO + ∆WC Accruals + Depreciation + (FOPO)
BIG DATA PROJECTDechow Larson Retesuk (2018)For each firm-year on Compustat go to SEC filings ndash find the Statement of Cash Flows and determine what is included in FOPO
COMPUSTAT
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
bull Messy but manageablebull 188132 FOPO lines for 67839 firm years (277 lines per
firm year)bull Nearly 40000 unique line item descriptions
ndash Over 2000 unique ways to describe bad debt expensendash provision for doubtful accounts provision for loan losses provision for
losses on accounts receivable provision for bad debts bad debt expense allowance for doubtful accounts provision for credit losses provision for doubtful accounts receivable provision for uncollectible accounts provision for losses on receivables provision for bad debt provision for loan and lease losses provision for uncollectible accounts receivable provision for allowance for doubtful accounts provision for doubtful receivables bad debt provision hellip
Data Analysis(Raw Line Item Data)
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Categorize into 32 different line items
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Findings so farhellip
bull Many ldquounusual and infrequentrdquo items are consistently reported by firmsndash Eg restructuring charges gains and losses on MSndash Relate to specific industries (bad debts)
bull Persistence and consistency are different aspects of EQ
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
OBJECTIVE OF DATA BASEbull GIVE RESEARCHERS THE DATA TO bull Better understand the details of specific
accruals ndash determine their characteristicsbull Develop improved discretionary accrual
modelsbull Develop industry level modelsbull Develop new approaches to thinking of EQbull Provide new insights into understanding
transitory components in earnings
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
Earnings Quality
Underlying Economics
Factors that Affect Earnings Quality
Industry Structure
Stage of Life Cycle
Firm Structure and Investment Opportunities
FASBIFRS RULES
Accrual Accounting System
Management Application of
RulesVoluntary Disclosures
GuidanceNon-GAAP metrics to aid in understanding
EQ
Internal ControlsAudit QualityGovernance
Big Data Analysis
Unconventional approaches
Governance Structure
Attitude at the topCEOExecutive team
Overconfidence Narcistic
competitive
Incentive Compensation
Influence of taxes
Influence of outside experts
lawyers compensation
consultants
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-
THANK YOU
- Slide Number 1
- Defining Earnings Quality
- Operationalizing Earnings Quality
- Slide Number 4
- Earnings Quality 1
- Earnings Quality 1
- Earnings Quality
- Earnings Quality 1
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality
- Earnings Quality 2
- Comparison of CASH FLOWS
- Accrual Accounting
- Earnings Quality
- Comparison of ACCRUAL EARNINGS
- Reconciling Earnings to Cash Flows
- Quality Issues with Millirsquos accruals
- Millirsquos accruals
- Comparison of Business Models
- Comparison of Earnings Quality
- Operationalizing Earnings Quality
- Operationalizing Earnings Quality
- Understanding Earnings Quality
- Slide Number 26
- Slide Number 27
- Slide Number 28
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Economic Perspective
- Operationalizing Earnings Quality
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 37
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Performance Evaluation
- Operationalizing Earnings Quality
- Slide Number 48
- Slide Number 49
- Slide Number 50
- Accounting Rules and Standards
- Accounting Rules and Standards
- Accounting Rules and Standards
- Slide Number 54
- Slide Number 55
- Slide Number 56
- Operationalizing Earnings Quality
- Slide Number 58
- Consequence of moving accrual accounting to a balance sheet focus
- Matching implies a negative correlation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Ranking on AccrualsCorrelation between Cash flows and Accruals
- Matching role of accruals has declined
- Accruals Association with Cash Flows
- Matching role of accruals has declined
- Slide Number 67
- Good News BB still Holds(replication of Ball and Brown 1968 )Data 1971 - 2012
- Good news Earnings Announcements Still Informative
- Earnings vs cash flows association with stock returns over time
- Earnings vs cash flows association with stock returns over time
- Market Solution
- Slide Number 73
- Slide Number 74
- Is the market solution good
- Slide Number 76
- Slide Number 77
- Slide Number 78
- Slide Number 79
- Valeantrsquos Reconciliation
- Slide Number 81
- Slide Number 82
- Do firms manipulate to consistently meet expectations
- Slide Number 84
- Percent of Manipulating firms consistently beat analystsrsquo expectations before and during the manipulation period
- Manipulating firms have high accruals before and during manipulation period ndash consistent with the use of more accounting flexibility
- Implications
- What can we do
- What can we do
- Project with Chad Larson and Bob Retesuk
- Data Analysis(Raw Line Item Data)
- Slide Number 92
- Slide Number 93
- Findings so farhellip
- OBJECTIVE OF DATA BASE
- Slide Number 96
- Slide Number 97
- Slide Number 98
- Thank you
-