Another thing to think about when assessing the quality of earnings is, how close to analysts expectations were these earnings? The idea being that, it's a little all too convenient if the consensus analysts forecasts of earnings is $2.02 per share, and you have this company with hundreds of different dials occurring, potentially hundreds of different companies all over the world rolled up into a conglomerate, and low and behold, while the analysts were forecasting $2.02 per share, earnings comes in at $2.03 per shares. More generally, you're not going to see very many instances of $2.01 per share when the consensus analysts work as is 2.02. That's because there truly is an earnings game being played, there's also an analyst expectation game being played. But, what you really want to look at is the trend in the difference between actual earnings as reported in analyst expectations. And it is the case that it's going to give you more comfort in the integrity of management if there are cut times when they do beat analysts forecasts and other times when they do not. In other words, there's no indication that they are beholden to meeting analyst expectations. One of the problems with always having a trend of consistently nearly missing, excuse me, barely beating analysts forecasts at earnings, if you barely beat year 1, and say 4 quarters in year 1, 4 quarters in year 2 and year 3. What happens is that creates more and more pressure to keep that trend going, and that means that there's increased pressure to engage in earnings management and really perhaps, earnings manipulation that could be tantamount to fraud. How close to management's plans were earnings? And is there a trend between actual earnings and management's plan. So these are just markers, if you're an audit committee or an auditor of the likelihood, that there's something besides just the natural earnings process that's being captured in the financial statements. Another thing to pay close attention to is, looking at things like the current ratio, current assets divided by current liabilities, or the quick ratio, where you just basically asset ratio where you look at only cash divided by current liabilities. You do want to look and see how close is the reported financial performance to being bad enough to cause a violation of a debt covenant. Now when a debt covenant is violated one of the things that can happen is that the lender can call all that debt and make it due immediately or on a much more aggressive payback to set of terms, than what's under the contract without the violation of the debt covenant. So, this is just some marker of management's motivation to engage in manipulation. Similarly, if there are bonuses and other compensation based on earnings, how close were these earnings to the threshold for the triggering these bonuses, the idea being that management has an incentive of course, to get enough earnings to get bonuses this year, and then they have an incentive to store earnings that should be recognized this year as earnings that will be recognized next year. And of course you can do that by having a higher liability this year in the form of a deferred revenue. There's famous research papers that show that this thing does occur on average, and of course just because it occurs on average doesn't mean it's happening for your client, but it does mean it's something that you need to watch out for. In general, you want to know are there any adjustments to earnings to determine pro forma earnings for the purposes of determining bonuses or other compensation. And if so, did the appropriate committees of the board review these matters? Some more questions here. Are the company's earnings trends significantly different from those of its peers or those dictated by market conditions? This is really, and we'll talk more about this company later in the course, WorldCom was so different than its peers in a market that was a market that existed within a highly regulated industry. And you had WorldCom, a huge telecom that had invested significantly in underwater fiber optics cables, just really outperforming [inaudible] like AT&T. There's even instances of employees at these other companies getting fired because they weren't performing as well as WorldCom, but the problem was is that WorldCom was not really performing at that level either, they were fraudulently reporting their performance. Another thing you worry about, if you're an audit committee member or an auditor, before you let the earnings go out with your... as an audit firm your name on the audit opinion. And if you're an audit committee member, this is going to affect your reputation. To what extent did a nonrecurring transaction affect earnings in the current period? And in particular, if the nonrecurring transaction is consummated, and initiated consummated such that it occurred right at year end and it was needed to meet these benchmarks. That makes you a little bit more suspicious of the neutrality, representational faithfulness, and relevance and really persistence, of these earnings. Again, we've talked about related parties already, but that's something you also want to look at. When you look at the overall financial statement presentation and disclosure, going back to one of our continuum, whether it's an estimate or not, what significant level, are there any significant assets and liabilities are recorded at fair value as opposed to historical cost, or some other more easily determined carrying value? If so, which ones? What was the method used for determining fair value? What impact did the recording at fair value have on earnings?
