Part III: Earnings management or normal stuff?

In each case below, discuss whether or not the firm may be managing earnings and framing investor perceptions to be OVERLY optimistic about the firms prospects. What would be the explanation for your assessment? In parts c) and d) make an assessment of likely Price / reported earnings ratios for the two firms.

Sallys Grills: year ending December 31 (GAAP Earnings)

2020 2021

Sales 2000 2320

COGS 1700 2003

Gross profit 300 317

Administrative expense 80 94

Advertising Expense 20 17

EBIT 200 206

Taxes 50 52.5

Net Income 150 153.5

Average Shares for year 100 102.3

EPS (rounded) 1.50 1.50

Accounts Receivable 200 380

Inventory 200 228

Sallys Grills announced a flat earnings per share on a 16% increase in revenues for the year ending December 31, 2021. Sallys sells outdoor grills in the upper Midwest and attributed the increase in sales to strong Christmas sales. Sally is ecstatic with the results in that she has entered into a 10-B-5 plan filed with the SEC to sell off 20,000 shares of her stock in each of the next three months. Sallys Grill also attached the following GAAP vs non-GAAP earnings table. Share based compensation (after-tax) that is part of Administrative expenses was added back to income since they were non-cash expenses.

Non-GAAP reconciliation of earnings (EPS)

2020 2021

GAAP Net Income 150 152.5

After-tax share-based compensation adjustment 5 5.1

NON-GAAP Income 155 157.6

NON-GAAP EPS 1.55 1.55 (rounded)

1. Assessment of Sallys Grills earnings (is earnings management likely?)

Sandys Furniture year ending December 31 (GAAP Earnings)

2020 2021

Sales 1000 1120

COGS 850 950

Gross Profit 150 170

Administrative Expense 40 45

Advertising Expense 10 12

Loss on sale of property 0 12

EBIT 100 101

Taxes 75 75

Net Income 75 76

Shares 100 100

EPS .75 .75

Accounts Receivable 100 112

Inventory 100 110

Sandys Furniture announced flat earnings per share for 2021 despite a 12% sales increase. CEO Sandy Winters said that the year was actually quite solid and that earnings would have been almost $0.84 cents per share instead of 75 cents per share if not for a loss arising from the sale of the old Sandys distribution and manufacturing center that resulted in an almost 9 cents after taxes loss per share ($9 million after-tax). The sale arose after the structure was deemed inadequate for capacity and due to its poor proximity to the new interstate link in North Carolina. Sally says we view this is a one-time hit to earnings and are encouraged by expanding sales and expanding profits independent of the unusual loss item. Sandys also reported Non-GAAP earnings below:

2020 2021

Sandys GAAP earnings 0.75 0.75

After-tax loss 0.00 0.09

Non-GAAP earnings 0.75 0.84

2. Assessment of Sandys Furnitures earnings (are they managed up?)

Related Questions (see write-up on Price to eanings ratios): Markets usually understnad the nuances of GAAP and non-GAAP earnings. If these two companies had similar beta stock risk which of the two firms do you think should trade at

3. a higher Price to reported GAAP EPS ratio? Explain briefly (GAAP means numbers conform to generally accepted accounting principles)

4. a higher price to reported Non-GAAP EPS ratio (Explain briefly)