There's No Accounting for Quants, Evan S. Grace and Diane ... · §Exercise Date §Vesting Date n ... § Quants: it’s a negative estimate revision Theoretical Foundations of Earnings

“There’s No Accounting for Quants”

Evan S. GraceDiane M. Garnick

Presentation to Northfield Conference

March 16, 2003

2

Efficiency at Risk

n Earnings Complexity is on the rise

§ Options Accounting

§ Pension Accounting

§ Transition Alternatives

n Fewer Analysts on the job

§ Record lay offs

§ Increase in names per analyst

§ GAAP not generally accepted

n Positioning for Neglect

§ Size is key

§ Less potential for IB business

Return of the Neglect and Revision Effects?

3

Theoretical Foundations of Earnings Complexity

nWhat are reasonable assumptions to make about option expenses?

nHas the actuarial smoothing embedded in pension accounting diluted representational faithfulness of corporate liabilities?

nWhat are the implications of alternative transition methods for accounting standards?

nWhat are the implications for investors?

Theory vs. Empirical Evidence

4

What are reasonable assumptions to make about options expenses?


nWhat investors need to make rational decisions:

§ Transparency

§ Timely access to data

§ Representational faithfulness

5

What Do We Have? Many Options for Options


nCalculation methods can vary;

§ Intrinsic Value

§ Fair Value

n If fair value is used, dates can vary;

§ Grant Date

§ Exercise Date

§ Vesting Date

nAvailability of data varies;

§ Appear on the face of the financials

§ Disclose in the footnotes

§ Long delays in data release diminishes its usefulness

§ Currently annually only, on the 10-K

6

Data are difficult to obtain; more difficult to analyze


nRelatively unique: different treatments for same item

§ APB 25 (issued 1973)

§ Requires intrinsic value accounting– No charge for at-the-money option issuance

§ SFAS 123 (issued 1996)

§ “Prefers” fair value accounting as of grant date

§ Spread cost over vesting period

§ Can still use APB 25 if disclose impact, but no method proscribed– EIX Volatility range was 17% -52%

§ SFAS 148 (issued December 2002)

§ Better, more frequent disclosure

§ Three transition methods– Prospective, Modified Prospective, Retroactive Restatement

7

n Inefficient market reactions

§ Wal*Mart will begin expensing options as of 2/1/03

§ Net effect is a $0.02-$0.03 incremental expense for 2003

n The debate creates confusion in the marketplace

§ Bulls: it’s just an accounting change

§ Bears: it was always an expense, now we’re counting it

§ Quants: it’s a negative estimate revision


What are the implications of alternative accounting methods?

8


Inefficient Market ReactionsWal*Mart Relative to S&P500

90

92

94

96

98

100

102

10401

/31/

2003

02/0

1/20

03

02/0

2/20

03

02/0

3/20

03

02/0

4/20

03

02/0

5/20

03

02/0

6/20

03

02/0

7/20

03

02/0

8/20

03

02/0

9/20

03

02/1

0/20

03

02/1

1/20

03

02/1

2/20

03

02/1

3/20

03

02/1

4/20

03

02/1

5/20

03

02/1

6/20

03

02/1

7/20

03

02/1

8/20

03

02/1

9/20

03

02/2

0/20

03

Inde

xed

to 1

00 o

n Ja

nuar

y 31

, 200

3

S&P 500

Wal*Mart

WMT will begin expensing options as of 2/1/03 following FAS 123. This will result in a reduction to EPS estimated at $0.02-$0.03 for the year, equally distributed.

9


nOptions Expensing regained importance as the percentage of earnings represented by options increased

Impact of Options on Core Earnings

Historical S&P 500

5.40

6.62

2.92

3.55

4.15

6.15

-1.27 -1.30 -1.32 -1.31 -1.28 -1.32

20%

45%

22%

37%

31%

24%

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

06/30/2002 03/31/2002 12/31/2001 09/30/2001 06/30/2001 03/31/2001

S&

P C

ore

Ear

nin

gs

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Op

tio

n E

xpen

se %

Ear

nin

gs

Core EPSOption Expense PS

Percentage Options Represent

10


nDifferent pattern of income recognition

§ Prospective: Expense gradually increases

§ Nearly all “early adopters” use this; to be phased out in 2003

§ Modified Prospective: Sudden one-time increase in expense

§ Retroactive Restatement: Restate history such that no change over time

§ Example: Coca Cola (source: Bear Stearns)

§ July 2002: Will use prospective method (only choice)– $0.01 per share impact in 2002

§ Post-FAS 148: Changed to modified prospective method– $0.11 per share impact in 2002– Old expense would have “ramped up” to $0.11 over time– Impact on profit growth, momentum, possibly revisions

Implications of Alternative Transition Methods

11


n It’s not in the databases

§ Traditional quant solutions won’t work

§ Sell side

§ Accounting research suddenly popular, for some reason...

§ Big resource allocation to options

§ S&P

§ http://www/standardandpoors.com

§ Interns/Fundamental analysts

So what can you do about it?

12

Pensions: Income Statement Impact

n Accounting designed to smooth changes in projected benefit obligation funding status

§ Not necessarily a bad thing, but can be abused

§ Fine art of “Actuarial Smoothing”

n 52 companies in the S&P 500 have positive net pension income, but pension plans in deficit

n “Net pension charge/credit” is in operating income, but not a separate line item

§ Currently reported in either COGS or SG&A

n Example: Pension assumptions impacting EPS growth

§ Cinergy Net Income Growth ‘00-’01 = $42 million

§ Pension expense declined $8 million

§ 20% of net income growth due to pensions

13

Pensions: Balance Sheet Impact

n Theory: Matching Principle

§ Expense future pension commitments of current employees

§ Set aside current assets to pay for future obligations

n Reality: This asset often doesn’t reflect the true funding level

§ Substantial off balance sheet items

§ Unrecognized net actuarial loss

§ Unrecognized prior service cost

§ Unrecognized transition obligation/asset

n Example: GM is the poster child

§ Balance Sheet asset: “Prepaid benefit Cost” = $18.3 Billion

§ Off-Balance Sheet: “Funded Status” = -$12.6 Billion

14

Pensions: Funding Crisis?

nBalance Sheet Funding Status improving, but mixedHistorical Funded Status of Current S&P 500 Companies

205

17

88

108

54

28

184

20

97

139

44

16

147

54

181

80

29

9

0

50

100

150

200

250

< 50% 50% - 75% 75% - 100% 100% - 125% 125% - 150% > 150%

1991

19962001

15

Pensions: Funding Requirements

n Key Question: Are contributions necessary? If so, when?

§ ERISA requirement: underfunded if actuarial value of assets is less than 90% of current plan liabilities

§ Funding deficiency subject to excise tax of 5-10%

§ Need IRS Form 5500 to determine this– Filed 7-9.5 months after end of plan year

§ Different calculations for funding decision than for annual report– Different actuarial methods, assumptions, measurement dates

» Example: DJIA average interest rate for funding calculation 100 basis points lower than average interest rate for other financial reporting

§ PBGC Requirement: Underfunded plans must pay additional premiums

§ Additional $9/$1,000 underfunded vested benefits

16

Pensions: What’s a Quant To Do?n Set aside the question of whether pensions “matter” for the market

§ Different treatment of the same obligation for different stocks is the stock picker’s focus

n Simplest screen: Got a DB plan?

§ 142 S&P 500 companies with no DB plan (25 % of mcap)

§ 1,386 Russell 2000 companies with no DB plan (65 % of mcap)

n Size up the potential impact (all in Compustat)

§ Plan Assets/Market Cap

§ Expected Return of Plan Assets

§ Discount Rate

§ Interest Cost

§ Rate of Compensation Increase

17

Pensions: What’s a Quant To Do?

n Sell side

§ As before, sudden, inexplicable interest in accounting research...

§ Can provide line item data not easily available elsewhere

n Interns/Fundamental Analysts

§ Tear through Ks and Qs

§ Adjust valuation/growth metrics for pension distortions

18

Transition Alternatives

nCommon themes with Options and Pensions

§ Data availability is limited; accuracy is questionable

§ Accounting changes impair comparability

§ Cross-sectional and time series data set are impaired

19


n Frequency of changes in accounting data impacts validity of back testsS&P500 Earnings Per Share

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

1990

Q1

1990

Q3

1991

Q1

1991

Q3

1992

Q1

1992

Q3

1993

Q1

1993

Q3

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

Some of the "lumpiness" in earnings is attributable to changes in accounting standards

FASB 112 Employers ' Accounting for Postemployment

Benef i ts—an amendment of FASB Statements No. 5 and 43

(November 1992)

FASB 118 Accounting by Creditors for Impairment of a Loan—Income Recognit ion and Disclosures—an amendment o f FASB Statement

No. 114 (October 1994)

FASB 123 Account ing for Stock-Based Compensat ion (October 1995)

FASB 128 Earnings per Share (February 1997)

FASB 142 Goodwil l and Other Intangible Assets (June 2001)

20


S & P 5 0 0 R e p o r t e d v s . O p e r a t i n g E a r n i n g s

- 1 . 0 0

0 . 0 0

1 . 0 0

2 . 0 0

3 . 0 0

4 . 0 0

5 . 0 0

Mar

-77

Mar

-78

Mar

-79

Mar

-80

Mar

-81

Mar

-82

Mar

-83

Mar

-84

Mar

-85

Mar

-86

Mar

-87

Mar

-88

Mar

-89

Mar

-90

Mar

-91

Mar

-92

Mar

-93

Mar

-94

Mar

-95

Mar

-96

Mar

-97

Mar

-98

Mar

-99

Mar

-00

Mar

-01

Dif

fere

nce

R e p o r t e d e a r n i n g s a r e g r e a t e r t h a n o p e r a t i n g

O p e r a t i n g e a r n i n g s a r e g r e a t e r t h a n r e p o r t e d

T h e s p r e a d b e t w e e n o p e r a t i n g a n d r e p o r t e d e a r n i n g s h a s r e c e n t l y h i t a n a l l t i m e h i g h

nAlternative transition methods fuel credibility concerns§ The spread between reported and operating earnings is near an all time high

§ Integrity of models that rely on accounting data without regard to multiple transition alternatives needs to be questioned

21

Common Thread: What are Earnings?

nNo clear, agreed upon definition§ Operating?

§ Best reflection of “continuing operations” of the company

§ Subjective. Too many recurring non-recurring items

§ Reported?

§ Pure in some sense; it’s what actually happened

§ Can be misleading; want to know about core operations

§ Core?

§ Right idea, bad execution. Likely to be revised

22


nWould the real P/E ratio please stand up?S&P 500 Forward P/E Ratio

15.6

21.5

28.1

0

5

10

15

20

25

30

Operating Reported Core

EPS Metric

Fo

rward

P/E

23


nBack Test ImplicationsP/E vs. P/EBITDA

Calendar Year 2002 Performance

-60.00

-50.00

-40.00

-30.00

-20.00

-10.00

0.00

10.00Q1 Q5 Q1-Q5

Quartile

Tota

l Ret

urn

(%)

P/E

P/EBITDA

24

It’s Not Just Tech

n “Pro-forma” earnings have an impact across all sectorsS&P 500:

Percentage of Companies where GAAP=Pro Forma

0

10

20

30

40

50

60

70

80

90

100

1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02

25

What is to be Done?

nSector-Specific Models

§ Solves problem of cross-sector comparisons

§ Define sectors carefully: also includes large industries

§ Comparability across time can still be a challenge

§ Check for consistency in returns

§ Dynamic weighting schemes

nEarnings Quality Variables

n Independent variables additive to quant models

n Identify potential for manipulation

26

What is to be Done?

nTotal Net Accruals is a very promising factorNet Accruals Factor: Top Decile vs. Bottom Decile

0.00

50.00

100.00

150.00

200.00

250.00

300.00

350.00

400.00

450.00

91:4

92:1

92:2

92:3

92:4

93:1

93:2

93:3

93:4

94:1

94:2

94:3

94:4

95:1

95:2

95:3

95:4

96:1

96:2

96:3

96:4

97:1

97:2

97:3

97:4

98:1

98:2

98:3

98:4

99:1

99:2

99:3

99:4

00:1

00:2

00:3

00:4

27

What is to be Done?

nCall your Congressman (or FASB)§ Mandatory comment period for all new “FAS” standards

§ Typically one-sided commentary skews FASBs positions.

§ Have your voice heard!

Documents

There's No Accounting for Quants, Evan S. Grace and Diane ... · §Exercise Date §Vesting Date n ... § Quants: it’s a negative estimate revision Theoretical Foundations of Earnings