Hello I'm Professor Brian Bushee. Welcome back. In this video we're going to continue our look at Discretionary Expenditure Models. I'm going to introduce two refinements that will help us better use these models to detect earnings management. One will be something called the Distance Measure, which will help us understand a manager's motives to manipulate earnings using a given expenditure. And second, we'll look at Quarterly Changes in the expenditures, to help us find Earnings Management. Once we go over those refinements, I've got three brief cases to show you how all this stuff will work. Let's get started. So we need to do some refinements to the discretionary expenditure models because they are very imprecise. We still haven't addressed the problem that the Economics of the firm may have shifted which warrants a legitimate change in expenditures making it harder to spot manipulation using discretionary expenditures. So our first refinement is we're gonna come up with something called a Distance Measure and I'll show you that in a little bit. But this distance measure will help us identify companies' earnings management motives during the year. So one type of company that distance measure will help us identify is a company that would miss its earnings target without a cut in expenditures. For example, unless they cut their R&D expense by say 2%, they won't meet their earnings target. We're gonna call these Meet or Beat firms, so their incentive is to cut their expenditure just that little bit so that they can meet or beat their earnings target. The distance measure will also identify a company that would miss its earnings target even with a cut in expenditures. So this means that if you cut your R&D all the way to zero, you would still miss your earnings target, it wouldn't be a big enough savings in expense to meet your earnings target, we're gonna call these Big Bath firms. Here the incentive is to increase their expenditures to make a bad year even worse, but save future expenses. For example, if a company accelerated its R&D spending, so things they planned to spend on next year it spent on it this year. It would make its bad year even worse, but it's still a bad year. But what it would do is it would help the recovery next year because next years R&D expenses would be lower and earnings higher because you've accelerated some of those into the current period. And the last group we can identify with the distance measure would be a company that would make an earnings target even with an increase in expenditure. So the company could increase it's R&D by 3% and still meet its earnings target, even with the higher expense. We're gonna call these smoothing firms. Here the incentive is to increase your expenditure to make a great year just a good year and again save future expenses. So if you increase R&D from 3% to 5%, it still allows you to make your earnings target and what you've done is you've saved some expenses in the future, helping next year's results. So that's what the Distance Measure's gonna help us do. The second refinement is to use quarterly expenses to identify unusual changes late in the year. As we've talked about before, normal business activities should cause changes to happen throughout the year, but earnings management is more likely to cause the changes to be concentrated late in the year, when the manager realizes they need to do something to manipulate earnings. >> Another oxymoron? I have been to Bath and it is certainly not big! >> This is not referring to Bath, England. I've never been able to find a definitive source for the origin of this term. What I've heard is that it's a reference to the fact that companies used to write losses in red ink. So profits would be written in black ink, losses in red ink. And so a loss meant the company was taking a bath in red ink and so a big loss would be a big bath in red ink. So big bath means big loss. I mean, whatever the origin, it's become a well established term for incentives to take a huge loss this period in order to try to make your earnings look better in future periods. Let's take a look at how to calculate the distance measure and we'll look at R&D first. So the Distance Measure = (Current Pre-R&D Earnings- Prior Pre-R&D Earnings) / Prior R&D Expense. When I say Pre-R&D Earnings, what I mean is the Pre-tax Income. Plus R&D expense, so we remove R&D from Pre-tax Income to see what the income would be without any R&D spending, and then you can also do this for SG&A and advertising. You just replace R&D with one of those two. So, here's an example of how it's calculated. Let's say, in 2014, Pre-tax Income was 500, 2015 it's 505/ R&D Expense was 90 and 84 so if we add Pre-tax Income and R&D Expense, we get 590 in 2014 and 589 in 2015. So the Distance Measure in this case would be (589-590) / 90 = -0.011. The way to interpret that is the company would need to cut R&D by 1.1%, say from 90 to 89, to equal last year's earnings. And you can see this in the table. If they had cut R&D from 90 to 89, their pretax income would have been 500 and they would have just met last year's earnings. Now as it turns out, they cut R&D by more than that and what it did was it allowed them to take what would have been a decline in Pre-R&D Earnings and turn it into an increase in Pre-tax Income. So the companies that we're gonna look at as Meet and Beat Incentives will be ones where the distance measures between zero and negative 0.20, or negative 20% or so. Because in that case, the company could cut r and d enough to meet its earnings target. >> I love the exacting imprecision of -0.20 or so. My sister says one should always avoid strikingly soft demarcations. >> [LAUGH] Exacting imprecision, nice use of oxymoron again. Yeah, so I don't know where this cut-off is. I do know that at some point if a company cut too much R&D, then they're destroying the company's value because they could be sacrificing investment in projects they need to perform well in the future. And if they cut too much, it's just gonna simply be very noticeable to investors, and they'll see right through it. So I don't where the number is, it's probably the case that some companies have cut 25% to manage earnings, where as other companies have needed to cut 15%, but didn't because they thought it was too large. This is gonna be somewhere in this neighborhood and it's gonna be exactingly imprecise. Anyway, a Big Bath incentive would be indicated by a Distance Measure that's less than -0.20 or so. So less than 20%. Cuz in that case the company could really not feasibly cut enough R&D to meet their earnings target. Sure, they may be able to cut 40% of their R&D or 80% of their R&D to meet the target. But then that would also be very obvious to people, which would not make it a very effective way to manipulate your earnings. And finally, the Distance Measure will indicate a smoothing incentive anytime the Distance Measure's greater than zero, cuz in that case, the company could increase R&D and still meet its earnings target. Second refinement we're gonna look at are Quarterly Changes in these expenditures. Some firms report quarterly amounts of expense. I say some firms because it's not mandatory. It's essentially a voluntary disclosure. To give you a sense of how voluntary it is, in 2015 about 95% of companies reported quarterly SG&A because that's somebody that all investors want to see even though it's not required. But 30% of companies reported quarterly R&D and nobody actually reported quarterly advertising expense. So we can't use it for advertising. We're gonna look at our year over year change or YOY change, which would be the expense this quarter minus the expense the same quarter the last year divided by that expense the same quarter the last year. If discretionary expenditures are used to manipulate annual earnings, we would expect that the YOY change in the 4th quarter is different than the other 3 quarters. So for the Meet and Beat incentive, you would expect to see cuts in R&D in the fourth quarter, as they try to meet their target, whereas for Big Bath or Smoothing incentives, you might see a big increase in R&D in the fourth quarter, as they realized they should accelerate some of these expenditures to make their earnings lower this year, but help their earnings next year. So we wanna look at the pattern of quarterly changes in these expenses, when available, in conjunction with the discretionary expenditure measures and the distance measure, to get the most complete evidence on whether there might be manipulation going on. >> Can we make any definite guesses about earnings management? Based on whether companies transparently hide their quarterly R&D? >> Excellent question. I think the big thing that determines whether a company discloses quarterly R&D or not is how important R&D is for the company. So companies where R&D is a huge part of their business, investors will demand the information on a quarterly basis and companies will provide it, companies where R&D's not as important, there's not as much demand to see it quarterly and you won't see it. Now if a company did start disclosing a quarterly and then stopped, that would be very suspicious to investors. They would try to figure out hey, why are they taking away this disclosure. And the inference would be that maybe they are trying to manipulate. So for that reason, if a company really was trying to manipulate its R&D, it would probably still continue to disclose it, so as to not raise immediate suspicion as to what it's doing. So, we tend to see the companies, once they report quarterly R&D, tend to always do it. And so, we're gonna look at the quarterly changes to try to make attributions not whether they reported or not. Now, we're gonna look at a number of cases to illustrate how to use these tools. And instead of making you wait through all the data in a spreadsheet, I pulled summaries into Power Point to make it easy for us to look at. The first case is a company that had a possible meet or beat incentive to manipulate their expenditures. And in each case, we're going to look at research and development. So this is Dog-Techno Corp. In 2013 they had a negative discretionary R&D measure. Which was a bigger negative than in the past, so that means they spent less on R&D than expected, potentially cut it to manipulate their earnings. If we look at their distance measure, it was a very James Bondian -0.007. What that means is that if they cut their R&D, by just seven-tenths of a percent, they would have reversed their Pre-R&D earnings decline and made it a positive change in pretax income. So, they're very close to their target. If we look at their quarterly changes in R&D, you can see that the quarterly changes get smaller each quarter, and then are actually negative in quarter four, suggesting a cut R&D relative to the prior year in quarter four. And in the last column is the change in Pre-tax income divided by revenue, just scaling it to make it easy to look at. So if this is positive, it means their income was higher than last year, negative means it's lower and, sure enough, they meet their earnings target this year. And this would be a pattern which would suggest a cut in R&D in order to meet your earnings target from the prior year. Second case is a possible Big Bath situation. This is Rexido Corp. So if we look at their discretionary R&D in 2007, it was a big positive number, much bigger than in the past. Which means they spent more on R&D than expected which is gonna reduce their earnings. If we look at their distance measure, it was -0.634 which means they would have to cut R&D by 63% in order to meet their earnings target which makes it a potential big bath. And then we look at the quarterly changes, the quarterly changes get bigger each quarter and then it's an enormous 435% increase in R&D in the fourth quarter. And sure enough the last column shows that they missed their earnings target by a lot. Their earnings were down by 13% of revenue versus the prior year, so this would be consistent with a Big Bath. They knew they couldn't meet last year's target. So they accelerated some of next year's R&D into this year to make the bad year worse, but then hopefully help their turnaround in the following year. And then the last situation is a potential Smoothing situation. The company we're gonna look at here is NDOGTHA. They also had a big, positive discretionary R&D in 2006, indicating they spent more on R&D than expected. Their distance measure was 0.935, which means they could increase their R&D by 93% over the prior year. And still have an increase in earnings. When we look at the quarterly pattern, we see a big increase in YoY R&D in the forth quarter and in the last column, they still did meet their earnings target. They were 5.8% of revenue above last year's Pre-tax income. So this is consistent with smoothing where they made a great year a good year by accelerating some R&D expenses from last year, next year into the fourth quarter of this year to reduce earnings but then save some expenditures for the future. And that wraps up our look at Discretionary Expenditure Models. So you have another tool for your toolkit in detecting earnings management. In the next video we're gonna take a different approach to trying to look for manipulation. We're gonna look at models that take a look at firms that we know have committed fraud. Compare them to firms that didn't commit fraud and try to see what makes them different. What makes them different are variables that we could use to potentially predict fraud. I'll see you next time. >> See you next video.
