PastPaperHero | Multinational operations and reporting quality - Earnings quality detection adjustments and red flags

Learning Outcomes

This article explains how to evaluate earnings quality in multinational companies for the CFA Level 2 exam, including:

Distinguishing between high-quality, sustainable earnings and results driven by aggressive accounting, accruals, or one-off items
Identifying common red flags in multinational financial statements, such as revenue–cash flow mismatches, unusual receivables growth, or recurring “non-recurring” items
Assessing how foreign operations, multiple accounting standards, and currency translation can obscure true performance or facilitate manipulation
Reclassifying non-recurring or non-operating items and reversing aggressive capitalization to derive more comparable, decision-useful earnings measures
Applying quantitative tests—such as accrual ratios, cash flow support, and trends in deferred taxes or impairments—to detect low-quality earnings patterns
Formulating clear, exam-ready recommendations on adjustments, disclosures to scrutinize, and follow-up analytical steps when warning signs appear in a case vignette
Integrating qualitative and quantitative evidence into a coherent judgment about reporting quality, and explaining that judgment concisely in constructed-response or item set answers

CFA Level 2 Syllabus

For the CFA Level 2 exam, you are required to understand earnings quality issues when evaluating multinational companies, with a focus on the following syllabus points:

Recognizing indicators of low-quality earnings in global firms
Recommending adjustments to reported financials to improve earnings comparability and reliability
Identifying common warning signals of manipulated or unsustainable reported performance
Explaining how multinational operations complicate the detection of poor reporting quality

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

Orion Global is a large manufacturing group headquartered in the United States with subsidiaries in Europe and Latin America. The group prepares consolidated financial statements under IFRS.

Recent information includes:

Revenue increased 18%, while cash flow from operations (CFO) rose only 3%. Accounts receivable grew 40%, and days’ sales outstanding increased.
The company began capitalizing “customer acquisition costs” as an intangible asset (€60 million) instead of expensing them. Industry peers expense such costs.
Orion has reported “restructuring expenses” in each of the last five years, all presented within operating expenses and described as “non-recurring.”
The effective tax rate fell from 27% to 18% due to a large one-time tax credit related to a foreign subsidiary.
Orion recorded material foreign exchange (FX) gains from remeasurement of monetary items in a hyperinflationary subsidiary and included these gains within operating income.
For the last 12 quarters, reported EPS has exceeded the consensus analyst forecast by exactly €0.01.

Which observation is the clearest quantitative red flag indicating potential revenue recognition or collection problems?
a) Revenue up 18% while CFO up 3%
1. A one-time tax credit lowering the effective tax rate
2. Accounts receivable up 40% with rising days’ sales outstanding
3. FX remeasurement gains included in operating income
Which adjustment is most appropriate to improve comparability of Orion’s earnings with peers regarding “customer acquisition costs”?
a) Leave the capitalization as reported and adjust peers upward
1. Expense the €60 million in the current period and reduce intangible assets
2. Amortize the €60 million over an assumed 20-year life
3. Reclassify the €60 million as goodwill
The pattern of EPS exceeding consensus forecasts by €0.01 for 12 consecutive quarters most likely suggests:
a) Strong evidence of high-quality, sustainable earnings
1. Possible earnings management designed to meet or beat expectations
2. Understated accruals and conservative accounting estimates
3. No analytical concern because the beats are small
How should an analyst most appropriately treat the recurring “non-recurring” restructuring expenses and FX remeasurement gains when assessing Orion’s sustainable operating performance?
a) Include both in operating profit because they affect cash flows
1. Exclude restructuring costs but leave FX gains in operating profit
2. Reclassify both items as non-operating and adjust operating profit accordingly
3. Capitalize both items as part of intangible assets and amortize them

Introduction

Multinational companies often operate with complex financial reporting environments involving different accounting standards, currencies, tax regimes, and regulatory expectations. These complications can obscure the fundamental economics of the business and make it harder to assess earnings quality.

From a CFA Level 2 standpoint, the task is not simply to read the income statement but to evaluate:

Whether current earnings are supported by cash flows
Whether the pattern of accruals and non-recurring items is consistent with sustainable performance
Whether multinational features (foreign subsidiaries, currency translation, local GAAP reporting) are being used to manage reported results

Key Term: Earnings Quality
Earnings quality is the degree to which reported earnings reflect a company’s true, sustainable economic performance. High-quality earnings are supported by cash flows, derived from core operations, and based on unbiased accounting estimates rather than aggressive accruals or one-time items.

Accrual accounting, foreign currency translation, and management discretion can all create a gap between accounting earnings and economic reality. The analyst’s job is to bridge that gap through careful detection of red flags and targeted adjustments.

Common Red Flags in Multinational Reporting

Low-quality earnings often stem from management bias or aggressive accounting choices. In global companies, diverse operations, varied regulations, and complex transactions create additional opportunities for manipulation or for obscuring weak performance.

Qualitative and Structural Red Flags

Common red flags include:

Revenue growth far outpacing cash flow from operations
Accounts receivable increasing faster than revenues
Rapid growth in non-operating or non-recurring income booked as operating profit
Frequent changes in accounting policies, segment definitions, or key assumptions without clear explanation
Sustained meeting or slight beating of consensus estimates, particularly when supported by accruals or “one-off” items
Large and unexplained increases in inventory
Lower effective tax rates not explained by business mix or tax law

Each of these indicators should be interpreted in context:

Revenue–cash flow mismatch: If revenues grow strongly but CFO lags, the earnings are being driven by accruals, not cash. This may be justified in early growth phases but is a concern if the pattern persists.
Receivables outpacing sales: This suggests looser credit terms, slow collections, or premature revenue recognition. Rising days’ sales outstanding (DSO) is a classic red flag.
Non-operating items in operating profit: Gains on asset sales, FX gains, or fair value gains on securities should typically be classified as non-operating. When they are presented as operating income, core performance is overstated.
Frequent accounting changes: Revisions to revenue recognition policies, capitalization policies, or segment reporting may be legitimate—but if they consistently boost earnings and lack economic rationale, skepticism is warranted.
Consistent small beats of analyst estimates: This pattern may indicate “earnings smoothing” via accruals or real actions (e.g., pulling forward sales), especially when fundamentals are volatile.
Inventory build-up: Rapidly rising inventories without a convincing growth or product launch story may indicate overproduction to absorb overhead or capitalizing unfavorable variances.
Unusually low effective tax rate (ETR): A falling ETR can reflect geographic mix, tax holidays, or recognition of deferred tax assets. If the explanation is weak or non-transparent, consider whether the tax benefit is one-off and unsustainable.

Key Term: Accrual Accounting
Accrual accounting records revenues when earned and expenses when incurred, not when cash is received or paid. While it improves period matching, it introduces subjectivity and provides scope for earnings management.

Key Term: Non-Recurring Item
A non-recurring item is income or expense arising from events not expected to persist, such as major asset disposals, restructuring charges, or litigation settlements.

In multinational groups, red flags can also appear in less obvious areas:

Segment reporting: Underperformance in mature regions may be masked by high growth in new markets or by changing segment definitions.
Related-party transactions: Sales to affiliated entities in low-transparency jurisdictions can be used to accelerate revenue or shift profits.
Fair value estimates: When a large proportion of assets are valued using unobservable inputs, earnings become more sensitive to management assumptions.

Key Term: Fair Value Hierarchy
The fair value hierarchy classifies valuation inputs into Level 1 (quoted prices for identical assets), Level 2 (observable but indirect inputs), and Level 3 (unobservable, model-based inputs). Heavy reliance on Level 3 inputs increases estimation risk and potentially lowers earnings quality.

Worked Example 1.1

A multinational electronics group reports revenue growth of 16% while cash flow from operations increases only 2%. Accounts receivable increase by 25% over the same period. Days’ sales outstanding has risen for three consecutive years.

Answer:
The discrepancies between revenue, cash flow, and accounts receivable suggest aggressive revenue recognition and potential channel stuffing (shipping more goods than distributors can sell). The rising DSO confirms collection risk. Additional scrutiny of revenue cut-off policies, changes in credit terms, and analysis of the cash conversion cycle is warranted.

Key Term: Channel Stuffing
Channel stuffing occurs when a company accelerates revenue by pushing more goods to distributors than the market can absorb, often accompanied by favorable credit terms or rights of return.

Adjustments Required for Reliable Earnings Assessment

When evaluating the earnings quality of multinational companies, it is essential to adjust reported results to improve comparability and strip out unsustainable components.

Typical Adjustments

Key adjustments include:

Reclassifying non-recurring items: Move non-recurring gains and losses (asset sales, restructuring, litigation, FX translation gains) out of operating earnings into a separate line. Recompute adjusted operating profit, EBIT, and EPS.
Reversing aggressive capitalization: If costs that should be expensed (e.g., routine advertising, customer acquisition, minor software upgrades) are capitalized, remove them from assets and expense them in the income statement.
Normalizing depreciation and amortization: Align useful lives and depreciation methods to industry norms if management’s assumptions are unusually optimistic and materially inflate current earnings.
Removing one-off tax benefits: Exclude discrete tax credits, prior-period adjustments, or releases of valuation allowances from the effective tax rate used to project future earnings.
Separating FX translation effects: Treat translation adjustments that bypass profit or loss (OCI items) differently from FX transaction gains/losses. FX gains arising from remeasurement, especially in hyperinflationary environments, should generally be treated as non-operating.
Standardizing cash flow classification: Under IFRS, some interest and dividends can be classified as operating, investing, or financing. For cross-company comparison, reclassify to a consistent policy before computing ratios like CFO/net income or the accruals ratio.

Key Term: Core Earnings
Core earnings (also called persistent earnings) are earnings adjusted to exclude non-recurring, non-operating, and accounting-driven items, providing a better measure of the firm’s sustainable earning power.

Worked Example 1.2

A global consumer goods company capitalized $50 million in advertising costs, deviating from industry practice. Adjusted earnings, accounting for expensing these costs, would change net income and asset balances.

Answer:
The $50 million should be removed from intangible assets and included as an expense in the period incurred. This decreases net income by $50 million and reduces total assets by $50 million. The adjusted results better reflect recurring, sustainable profit and improve comparability with peers that expense advertising.

Recurring “Non-Recurring” Items

A particular concern in practice—and often in item set vignettes—is recurring “non-recurring” items, such as restructuring costs reported every year.

For such items:

Review several years of financials to see if they recur.
If they recur, treat them as part of normal cost of doing business, not as exceptional.
Either:
- Include an average of these costs in normalized operating expenses, or
- Classify them as operating but highlight the volatility they introduce.

Worked Example 1.3

A multinational industrial company reports restructuring charges in four of the last five years, always labeled “non-recurring” and included within operating expenses. Over the five-year period, restructuring expenses average 4% of sales.

Answer:
Because these charges recur, it is inappropriate to treat them as one-off. For valuation and performance analysis, the analyst should include a normalized restructuring charge (e.g., 4% of sales) in operating costs. Presenting an “adjusted EBIT” that excludes these expenses would overstate sustainable earnings.

Challenges Specific to Multinational Operations

Multinational firms face extra issues that complicate earnings quality analysis:

Multiple accounting standards: Subsidiaries may report under local GAAP, then be converted to IFRS or US GAAP at the group level. Conversions provide scope to adjust estimates or reclassify items.
Foreign currency translation: Fluctuations in exchange rates can affect both the magnitude and volatility of reported earnings. Translation effects may mask fundamental trends in local-currency performance.
Tax-driven profit shifting: Use of transfer pricing, intercompany financing, and intangible asset ownership in low-tax jurisdictions can significantly affect where profits are reported, and thus the consolidated effective tax rate.
Local disclosure quality: Some jurisdictions have weaker disclosure requirements and enforcement. Earnings management may occur in foreign subsidiaries where investors and regulators pay less attention.

Key Term: Currency Translation Adjustment
A currency translation adjustment (CTA) is the component of equity or other comprehensive income that captures the effect of translating foreign operations’ financial statements into the parent company’s reporting currency.

Specific analytical steps when foreign operations are significant:

Compare local-currency growth rates of revenue and operating profit with reported growth. Large divergences suggest that currency movements, not business performance, are driving results.
Separate translation effects (usually recorded in OCI) from transaction FX gains/losses (recorded in profit or loss). Treat transaction gains/losses as non-operating unless the business model inherently involves FX trading.
Review segment disclosures:
- Are high-growth or high-margin segments concentrated in countries with weak governance?
- Are intercompany sales significant, and how are transfer prices determined?
Examine tax disclosures and reconciliation between statutory and effective tax rates. One-off foreign tax rulings or release of deferred tax allowances should be removed when estimating future earnings.

Quantitative Indicators of Low-Quality Earnings

Qualitative red flags should be supported by quantitative analysis. Several metrics are central to Level 2 questions on earnings quality.

Cash Flow Support for Earnings

A basic test is the relationship between net income and CFO:

If CFO is consistently below net income, especially over multiple years, earnings are heavily accrual-driven and may be less sustainable.
A single year of divergence may be benign (e.g., due to working capital investment), but persistent divergence is problematic.
The CFO/net income ratio is a simple indicator; a ratio significantly below 1 over time suggests low earnings quality.

Accruals and the Accruals Ratio

Earnings can be decomposed into a cash component (CFO) and an accrual component. Higher reliance on accruals generally implies lower quality because accruals are more subjective and tend to revert.

Key Term: Accrual Ratio
The accrual ratio measures the proportion of earnings explained by accruals rather than cash flows. Higher accrual ratios are associated with lower earnings persistence and poorer earnings quality.

There are two common ways to compute aggregate accruals and the accrual ratio.

Balance sheet approach

Net operating assets (NOA) are defined as:

Operating assets = total assets − cash, cash equivalents, and marketable securities
Operating liabilities = total liabilities − short- and long-term debt

Then:

\text{Accruals}^{BS} = \text{NOA}_{\text{end}} - \text{NOA}_{\text{begin}}

The balance-sheet-based accruals ratio is:

\text{Accruals Ratio}^{BS} = \frac{\text{NOA}_{\text{end}} - \text{NOA}_{\text{begin}}} {\left(\text{NOA}_{\text{end}} + \text{NOA}_{\text{begin}}\right) / 2}

Cash flow statement approach

Accruals can also be viewed as the portion of net income not explained by CFO and cash flow from investing (CFI):

\text{Accruals}^{CF} = \text{Net Income} - \text{CFO} - \text{CFI}

Scaled by average net operating assets:

\text{Accruals Ratio}^{CF} = \frac{\text{Net Income} - \text{CFO} - \text{CFI}} {\left(\text{NOA}_{\text{end}} + \text{NOA}_{\text{begin}}\right) / 2}

Interpretation:

A low accruals ratio indicates that earnings are close to cash flows and are likely to be more persistent.
A high accruals ratio suggests that earnings rely heavily on accruals and are likely to revert more quickly toward normal levels (low persistence).

Key Term: Mean Reversion
Mean reversion in earnings is the tendency for unusually high or low earnings to move back toward a normal level over time. Earnings driven by accruals (especially discretionary accruals) revert faster than cash-based earnings.

Worked Example 1.4

A multinational group’s net income is $200 million, but cash flows from operations total $130 million due to a $55 million rise in accounts receivable and a $15 million increase in inventory. What does this indicate about earnings quality?

Answer:
Net income exceeds CFO by $70 million, primarily due to increases in receivables and inventory. This indicates that earnings are supported by accruals rather than cash collections, signaling potential revenue recognition issues or overproduction. If this pattern persists over several years, it is a strong indicator of low earnings quality.

Other Quantitative Red Flags

Beyond accruals ratios and CFO support, look for:

Large increases in deferred tax assets: A build-up of deferred tax assets, especially those dependent on future profitability (e.g., net operating loss carryforwards), may be optimistic if the core business is weak.
Declining loss allowances or provisions relative to risk exposure: For lenders or insurers, a drop in provisions relative to non-performing loans or insured risk may signal under-reserving.
Frequent impairment charges and reversals: Repeated impairments suggest that previous asset valuations were overly optimistic. Subsequent reversals (where allowed) may be used to manage earnings.
Volatile trading or fair value gains: For financial institutions, heavy reliance on trading income or Level 3 fair value gains reduces earnings predictability.

Sector-Specific Example: Bank Loan Loss Reserves

For banks, under-provisioning for loan losses is a common form of earnings management.

Relevant ratios include:

Allowance for loan losses / non-performing loans
Allowance for loan losses / net write-offs
Provision for loan losses / net write-offs

A declining allowance relative to non-performing loans or net write-offs suggests that provisions are not keeping pace with actual credit deterioration, potentially inflating current earnings.

Exam Warning

Many candidates neglect to adjust for non-recurring items included in operating income or assume that all reported earnings are sustainable. In item set questions, always:

Identify non-recurring and non-operating items in the income statement and notes
Check whether such items are classified within operating results
Recompute adjusted operating income, margins, and EPS before drawing conclusions

Revision Tip

For the exam, practice:

Reconciling net income to CFO and identifying unusual or non-cash items
Computing and interpreting accruals ratios and DSO trends
Distinguishing between translation vs transaction FX effects
Normalizing earnings for recurring “non-recurring” items and one-off tax impacts

Focus particularly on scenarios where multinational factors—foreign subsidiaries, FX, or cross-border tax planning—are present, as these often conceal key red flags.

Summary

Detecting low earnings quality is essential when analyzing multinational companies. Key tasks include:

Identifying qualitative red flags such as revenue–cash flow mismatches, rapid growth in receivables, recurring “non-recurring” items, and aggressive use of fair value estimates
Recognizing how multinational complexity—multiple GAAPs, currency translation, foreign tax structures, and weaker local disclosure regimes—can mask or facilitate earnings management
Applying quantitative diagnostics like CFO/net income, accruals ratios, changes in provisions, and trends in deferred tax assets to test the sustainability of reported earnings
Making disciplined adjustments to reported figures: reclassifying non-operating items, reversing inappropriate capitalization, normalizing tax rates, and isolating FX effects

In a Level 2 vignette, your goal is to combine these qualitative and quantitative signals into a coherent judgment about reporting quality, then clearly state necessary adjustments and their implications for valuation and risk.

Key Point Checklist

This article has covered the following key knowledge points:

Recognize core red flags indicating poor earnings quality in multinational companies
Understand how revenue–cash flow mismatches, rising DSO, and aggressive capitalization affect earnings quality
Recommend adjustments to reported figures to reflect sustainable, comparable profit, including reclassifying non-recurring and non-operating items
Apply accruals ratios and cash flow–based diagnostics to quantify the degree of earnings reliance on accruals
Interpret how currency translation, foreign tax strategies, and multi-GAAP reporting increase reporting quality risk
Treat recurring “non-recurring” items and one-off tax benefits appropriately when estimating core earnings

Key Terms and Concepts

Earnings Quality
Accrual Accounting
Non-Recurring Item
Fair Value Hierarchy
Channel Stuffing
Core Earnings
Currency Translation Adjustment
Accrual Ratio
Mean Reversion

Multinational operations and reporting quality - Earnings qu...