Assessing Earnings Quality at Nuware

Richard Hamilton Mike Rakes Brandon Sather Theresa Sexton

Nuware, Inc. Consolidated Balance Sheets as of January 31, 2003 2003 Current Assets Cash including available for sale investments of 59,716 and 35,076 Beneficial interest in securitized receivables Accounts receivable, net adjusted reserve Inventory Prepaid expenses/other Total current assets Properties, Net Other noncurrent assets Total Assets Liabilities and Shareholder Equity Current Liability Current portion of long-term debt accounts payable gift cards, gift certificates and merchandise credits outstanding Accrued income tax payable Other accrued liabilities Total current liabilities Long-term debt other noncurrent liabilities $ 192,114 $ 2002 55,609

$ 291,618 $ 362,331 $ 277,002 $ 266,011 $ 56,179 $ 43,286 $ 816,913 $ 727,237 $ 374,493 $ 370,262 $ 49,411 $ 47,895 $ 1,240,817 $ 1,145,394

$ $ $ $ $ $ $ $

393 176,702 117,495 35,798 192,348 522,736

$ $ $ $ $ $

356 129,076 139,852 29,738 170,053 469,075 25,356 43,265

25,007 $ 54,962 $

Shareholder Equity Common Stock, $0.10 par, 500,000,000 authorized, 100,883,000 issued $ 10,088 $ 10,088 Paid in capital $ 479,074 $ 440,190 Retained Earnings $ 298,816 $ 242,644 Cumulative other comprehensive income (loss) Less: 10,045,000 and 7,362,000 common shares in treasury, at cost Total liablities and Shareholder Equity $ (11,210) $ (4,702)

$ (138,656) $ (80,521) $ 1,240,817 $ 1,145,395

Nuware allowance as a % of AR RP allowance as a % of AR Accounts Receivable Gross New Allowance Adjusted Accounts Receivable Net Remove beneficial interest in Securitized receivables Remove beneficial interest from retained earnings Move from Lifo to Fifo Add to cost of sales Add from inventory Addback Advertising expenses Addback Stock Compensation Expenses Back out Interest and investment income Add Adjust to tax reserve to RP Stuart -- 39% $

3.09% 4.49%

4.25% 4.54%

$ 305,326 $ 379,564 $ 13,708 $ 17,233 $ 291,618 $ 362,331 40538 40538 29500 29500 10200 1071 -9382 1,648 $ 34620 34620 35100 35100 8700 707 -5784 1,232

1. Provide a context for the concept of earnings quality Earnings quality is a concept that covers multiple accounting concerns and consists of two main elements. First, it touches on the idea that the accounting is a fair representation of the firms performance. For this first element, the idea of accounting being a fair representation of the firms performance entails the removal of bias, especially management bias, from the firms financials. Bias can occur via a managers optimism or a managers incentive to report numbers pessimistically. Whether or not a firms financials is a fair representation of its performance is also difficult given the fact that there can be subjectivity in choosing

among accounting principles, not to mention the additional uncertainly that arises because estimates are often used when applying these principles. Second, earnings quality entails the idea that the information thats provided is relevant for forecasting the firms expected earnings and future financial position. 2. Why is Harry Malone concerned about relying on Nuwares reported performance? If Nuware follows GAAP shouldnt the financial statements be reliable? In this instance, Harry Malone is particularly concerned about relying on Nuwares reported performance given the in depth research done on R.P. Stuart, his personal relationships with R.P. Stuart management, his belief in the transparency of their reporting and the fact that though Nuware and R.P. Stuart have virtually identical business models, R.P. Stuart struggled to match last years profitability and Nuware increased its earnings by almost 20%. Theoretically firms that follow GAAP should release reliable financial statements. However, management still plays a significant role in deciding how earnings will be stated. Despite the rules based system of GAAP, the unique circumstances of individual businesses still allow for areas of gray. There is room for deciding which accounting principle to apply and how to estimate values when applying that estimate, be it an estimate of bad debt expense, future costs of warranty programs or the fair value of financial instruments, to name a few.

Moreover, as accounting scandals have proven, sometimes management doesnt make erroneous accounting representations because of uncertainty, bias or estimates, but because they intend to deceive and they intentionally misrepresent their firms financial position. 3. Assume the roles of Hereford and restate the companys 2003 earnings as if the companies had used a similar accounting method and assumptions. After such restatement, how do the earnings and growth compare to R.P. Stuart? The available for sale securities that Nuware lists as a current asset should be backed out. Given that they are discussed in the footnotes as the only financial instrument with a fair value different from the recorded value, this leads one to believe that these securities are being held for an indefinite period and should be classified as long terms assets at fair value, with any cumulative gain or loss reported at fair value in the accumulated other comprehensive income section of shareholder equity. This provides a much better depiction of Nuwares liquid assets in relation to R.P Stuart. As the accounts receivable for Nuware decreased, Nuware reduced its allowance for doubtful accounts, thereby estimating that more of its receivables would be realizable. R.P. Stuart, in turn, kept its allowance estimate steady. By adjusting the allowance, Nuwares earnings are more in line with the actual risk it bears on credit sales. Although advertising is undertaken with the expectation that it will provide value, whether it will or not is uncertain. Thus GAAP requires immediate expensing of advertising costs. As such, advertising Costs that are committed but not realized, i.e. $10.2MM and 8.7MM in 2003 and 2002,

respectively,

must

be

expensed.

This

depicts

expenses

much

more

realistically as between Nuware and Stuart. Given that R.P. Stuart accounts for its stock compensation using the fair value method it included stock compensation expense in its operating income. As such, Nuwares net income is more appropriately stated when stock compensation expense of $1,071k and .707k is added back to operating income. Interest and investment income $9,382K $5,784k and $5,014K in 20032001 should appropriately backed out given that their inclusion goes against the second element of earnings quality, namely including information thats representative of a firms financial future. By backing out these peripheral items, Nuwares income from operations and ability to compete with R.P. Stuart on an operations level is more accurately depicted. For a lot of companies, cost of sales is the largest expense on the income statement. Because LIFO tends to result in less variability in the gross margin percentage over the business cycle, Nuware is better able to accomplish income smoothing reporting using LIFO. As such, a LIFO adjustment was made on the balance sheet (add 29.5MM and 35.1MM in 2003 & 2002) and a LIFO adjustment was made on the income statement by adding 29.5MM and 35.1MM in 2003 and 2002 to the cost of sales. 4. Would you characterize the accounting discretion applied by Nuware management as aggressive? In your opinion, has the company been managing earnings?

Based on the analysis done in question three, we would characterize at least some of the accounting discretion applied by Nuware as aggressive. There are many examples that we will highlight again here. First, when the Accounts Receivable are adjusted using the allowance used by RP, they decrease from the stated balance by $1M in 2002 and $4.2M in 2003. This would suggest that Nuware's method for calculating the allowance over estimates what they actually will collect. Second, another indicator of aggressive accounting is the way Nuware accounts for advertising expenses - choosing to expense them in the period when the benefit is realized. Advertising expenses are nearly impossible to tie directly to accounting benefits, and this practice allows Nuware to move the expenses into a future period as they see fit. This is evidence of earnings management on the part of Nuware, and the data shows that adding these expenses back in 2002 and 2003 ($8.7M and $10.2M, respectively) significantly deflates the bottom line income. Lastly, the Gross Profit Margin in each of the three years after adjusting to RP's numbers drops between 1.7% - 2.1% which, again, indicates that the accounting practices employed by Nuware were such that the position of the company was over stated.

Net Income NI per DS ROA ROE Tax Rate EPS Growth Sales Growth Gross Profit Margin

2003 $52,924.00 $0.50 0.043 0.067 39% 0.33 0.027 0.412

2002 $39,565.00 $0.38 0.035 0.057 39% -0.31 0.061 0.388

2001 $56,654.00 $0.56 --39% --0.429

NI over Assets NI over Equity Use RPs here Actual Sales are not adjusted