Assessing Earnings Quality: Nuware, Inc.

Q2 Answer:

After having performed the adjustments on account receivables, inventory policy, fixed assets, and securities, it can be concluded that Nuware Inc.’s accounting policy is relatively aggressive, especially when compared to the close competitor R.P. Stuart, which shows conservative figures. Given the fact that the two companies share the same business model, researchers can adjust Nuware’s earnings by applying the methods and assumptions used by R.P. Stuart. The result is quite alarming. (See Appendix-Cumulative Effect.) EBT of Nuware in 2013 would have been 27.63% less (37 million less) than it is currently reported if accounted in a conservative and prudent way. Over one quarter of the total EBT is far from an amount that can be ignored. A tendency of increase in differences between using two accounting methods can also be observed through the analysis, implying that the method used by Nuware may have become more and more aggressive every year, in order to show a fast and continuous growth even when sales did not significantly increase. In the following paragraphs, the four adjustments will be explained in detail to prove the conclusion.

Reserve for Receivables

Both companies use the allowance method to account for reserves for uncollectibles and while Nuware relies on percentage of sales as estimates, R.P. Stuart estimates its uncollectibles on the basis of a more in-depth analysis of its customers. In the calculations, the Allowances/Net sales ratio was taken as the component to estimate the reserves.

First, by analyzing the account receivables and the estimated allowance for uncollectibles, it can be noticed that the ratio Reserves for uncollectibles/Net sales, drops from c.a. 1% in 2012 to c.a. 0.5% in 2013. This drop shows unexplained inconsistency with the previous year and, given that the same ratio for R.P. Stuart stands at around 2% per annum, it can be inferred that no particular event could explain such drop in Nuware’s estimate. The change in the estimate, in turn, produces an increase of 19.29% in the earnings before taxes, corresponding to $22,212. To correct for this, it was assumed that the figure R.P. Stuart uses, better reflects the reality of the business model of the two companies -they both rely on the use of special customer credit cards. Applying 2% of allowances on Nuware’s sales, it can be concluded that with the previous estimate the company’s EBT was generously inflated as evidenced by the decrease in earnings of 15.67% and 18.68% for 2012 and 2013 respectively when the two methods are compared.

Inventories

Regarding the inventory adjustment, we can check the effect of Nuware using FIFO instead of LIFO, as R.P. Stuart is using FIFO and both company are in the same business and thus rather similar. After a thorough analysis, we observe that using LIFO instead of FIFO allowed Nuware to increase its EBT by 4%, representing a 5.6 million dollar increase. Indeed, should Nuware had used FIFO, its inventory would have increased to $277,002 and $266,011 thousands respectively for 2013 and 2012. The difference here is due to the LIFO reserve, which we know from the notes amounts to $29,500 thousands for 2013 and $35,100 thousands for 2012. Thus, computing the difference in LIFO reserve (-5,600) and adding this figure to the LIFO COGS, we get the FIFO COGS, which would thus be equal to $1,007,492 thousands for 2013. We cannot compute that for 2012 because we do not have the LIFO reserve for 2011 so we cannot compute the difference. Finally, by restating the Income Statement using the FIFO COGS instead of the LIFO COGS, we realise that this method would have reduce the EBT by 5.6 million dollars. As a result, Nuware Inc. accounting policy is rather aggressive compare to the one of R.P. Stuart.