Accounting 452, Spring 2024
Assignment 2 - Earnings Quality
Instructions: Submit answers at the adjacent link by April 23. The assignment consists of questions bolded and in green for ease of identification. Resources required for the assignment are provided as blue hyperlinks.
Part 1 - Earnings Quality at Atos in 2020
Atos SE is a troubled French IT services conglomerate with revenue of more than €10.5 billion and 95,000 employees working in 71 countries. It is a member of the CAC 40 (Euronext Paris) and is seen by the French government as playing a systemically important role in the country’s industrial policy. Several mainstream news outlets recently published prominent articles about the company’s problems and the government’s rescue attempts:
Why France’s onetime $15 billion tech champion needs state aid (Bloomberg, April 9, 2024) French ITfirm Atos was once a crown jewel valued at $15 billion. Now, it’s drowning in debt, and the government is helping it stay afloat (Fortune, April 10, 2024)
The company’s decline can be seen in the following stock price chart:
The share price was volatile and slightly rising during 2019-2020 (€71 to €76). However, from January 2021, it steadily declined, losing 98% of its value as of April 2024.
This exercise will examine Atos’s earnings quality based on the financial statements published through 2020. While working on the exercise, students should try to place themselves in the position of a investor or board member at Atos in late 2020 or early 2021 and consider the extent to which the company’s earnings quality might have foreshadowed future problems.
Background:
Atos grew rapidly through acquisitions in the prior decade. As a result of this growth, it offers a dizzying array of services, as can be seen from this description of its business taken from CapitalIQ:
Atos offers cloud, cybersecurity, and computing solutions comprising orchestrated hybrid cloud, big data, business applications, and digital workplace solutions, as well as business technology solutions for public and private sector organizations. The company’s solutions include advanced computing; analytics, artificial intelligence, and automation; cloud solutions; customer journey analytics and digital customer experience; advance detection and response, data protection and governance, and trusted digital identities, as well as digital workplace, hybrid cloud, and IoTand OT security; digital consulting; digital workplace; and edge computing and Internet of things. It also offers infrastructure and foundation services. The company primarily operates under the Atos andAtos|Syntel brands. It serves energy and utilities,financial services and insurance, healthcare and life sciences, manufacturing, public sector and defense, telecommunications and media, transport and logistics, retail, hospitality, and majority events industries.
Atos was formed when the Dutch company Origin B.V. acquired KPMG Consulting, which had been separated from KPMG in 2002 as required by the Sarbanes-Oxley reforms. Among Atos’s many subsequent acquisitions, the following were the most prominent: Siemens IT Solutions in 2010, Bull SA in 2014, Xerox IT Outsourcing in 2014, Syntel in 2018, and Chicago-based Maven Wave in 2018. The Maven Wave acquisition, while small, cemented Atos’s partnership with Google Cloud. Atos and Google jointly operate AI-focused centers in Dallas, London, Munich, and Paris.
Atos had also exited a number of businesses. On February 4, 2020, it sold Worldline, a payments processor that was sometimes compared to Wirecard before the latter’s collapse in the summer of 2020.Atos’s 2020 results included a €171 million gain from the Worldline disposal. Overall, the moniker serial acquirer was a fair description of Atos. Grant Thornton's qualified audit opinion, which was linked to cross-border controls at U.S. entities added general concerns about the Atos’s ability to govern its far flung multifaceted operations.
Most of our analysis will be based on the 2020 annual report (linked here as background only), which contains this description of Atos’s key performance indicators, as well as the compensation scheme of Elie Girard, the CEO. The three most important financial metrics that Atos’s board and senior management used to manage the company were: 1) sales revenue growth, 2) operating margin, and 3) free cash flow.
Question 1: Two sustainability-linked KPIs - the Dow Jones Sustainability Index ranking and carbon intensity reduction - each received a 10% weighting. What was the direct effect of these ESG metrics on the CEO’s variable (incentive) compensation?
The remaining questions in this assignment focus on the Atos’s sales revenue and operating margin. Serial acquirers generally have quality of cash flow issues, and Atos is no exception. We’ll discuss those later in the course.
Sales Revenue Growth:
This link provides selected slides used in the company’s last three earnings calls thru early 2021.
Question 2: How much was the guidance for 2020 organic sales revenue growth published on February 19, 2020 (in conjunction with the earnings call for full-year 2019 results)?
Question 3: By how much did Atos downwardly adjust 2020 revenue growth guidance in the Q1-20 earnings call made on April 20, 2020?
Question 4: Did Atos achieve its revised revenue growth guidance according to the results announced on February 18, 2021?
Question 5: This link provides the equivalent of Atos’s reconciliation between GAAP and non-GAAP performance taken from its 2020 annual report . When working with non-U.S. financial statements, students should be prepared to encounter variations in wording and format. Here, the term statutory is equivalent to IFRS per EU regulations, and we’ll refer to IFRS as GAAP for the purposes of this assignment because it is “EU GAAP,” so to speak. Did Atos base its calculations of revenue growth using GAAP or non-GAAP revenue when it reported its performance in the February 18 earnings call (referenced immediately above)?
Question 6: How much was the revenue decline between 2019 and 2020 on a GAAP basis?
Question 7: The scope adjustment attempted to remove the effects of inorganic revenue growth, i.e., revenue from recently acquired companies, from GAAP revenue growth. The result was organic growth. Decompose the difference between GAAP and non-GAAP revenue growth (decline) into a scope effect and the constant exchange rate effect.
Question 8: This link allows you to directly compare revenue growth guidance provided in the 2019 and 2020 earnings calls. The guidance in 2019 was for 2020 revenue growth and the guidance in 2020 was for 2021 revenue growth. However, the two guidance figures are not directly comparable. There is a word missing from the 2021 guidance that was present in guidance provided for earlier years. What is the missing word?
Question 9: How important is the missing word? You have enough information to make a back- of-the-envelope assessment. Hint: The first linked document that you examined above contained this slide. Review it one more time. What information in the slide is relevant to consider when comparing year-over-year sales growth performance? Answer in one or two sentences.
Operating Margin - General Questions:
30% of the CEO’s incentive compensation was linked to operating margin. To answer the questions about this metric, we’ll need to base much of our analysis on the consolidated income statement from the 2020 annual report, linked here.
Question 10: What was the company’s original operating margin guidance for 2020 as presented in the 2019 earnings call? You’ll need to combine the numbers from the earnings call slides (linked earlier) with information from the income statement about the 2019 operating margin.
Question 11: Atos revised its operating margin guidance range to 9.0% to 9.5% and reported achieving the 9.0% the lower bound with a green checkmark in the earnings call slide. Engineers in the class might define this range as real numbers greater than or equal to 0.0900000 but less than or equal to 0.0950000. Based on this engineer’s definition of the range, did Atos achieve its operating margin guidance? Explain in one sentence.
Operating Margin - Below the Line Adjustments:
Operating margin is generally defined as (Operating Income ÷ Revenue). However, Atos stripped out a number of items that would normally be considered part of operating income and grouped these under the heading Other operating income and expense. It also moved into this category items that are generally not considered “operating” at all, including gains and losses on the disposal of business units. Review this list of the items included in Other operating income and expense. Footnote 5 provides additional detail, including a numerical breakdown of the income statement line item into component pieces.
Question 12: This table provides a compilation of the components of Other operating income and expense taken from half-year and annual financial statements published through H1-2020. I have broken out the gain from the disposal of Worldline equal to €171 million from the Other items line because this large gain is worth considering separately. Atos sold its controlling interest in Worldline in February of 2020, in other worlds in 1H20. Complete the 2H20 and the FY20 columns.
Question 13: For each of the line items in the table, answer two questions:
- Should the line item be in operating income/expense? Answer with Yes or No. Don’t answer “It depends…” even though there are certainly nuances that might make theses categorization ambiguous in practice.
- Is the item recurring or non-recurring? Again, answer recurring or non-recurring for each line item. To answer this portion of the question, simple inspect the history of the item presented in the table.
Question 14: Evaluate the net effect of the items that you designated both operating and
recurring. (Exclude other items.) Would you say that the overall effect is best characterized as 1) growing over time, 2) shrinking over time, or 3) in a steady state?
Question 15: This question is the heart of the earnings quality exercise, although it overlaps substantially with Question 13. You are tasked with adjusting 2020 as-reported operating margin for below the line items listed in Other operating income and expense. The company excluded each from its computation of operating margin. Decide whether you would include each by filling out the table at the bottom of Part 1 (this section of the assignment). For rows A thru G enter two things:
• The amount by which you would adjust operating margin in € millions. Enter your
adjustment as a negative if you want include an expense. Enter the full amount listed in Footnote 5 if you believe that an adjustment should be made for a particular item. Enter a zero if you believe no adjustment should be made for the item. For simplicity, don’t enter partial adjustments; they should be all or nothing
• The degree to of subjectivity that affects amounts allocated to the line item (high,
medium, or low). Atos’s computation of the operating margin will look better the more expense it is able to move into the Other operating income and expense line. The split between amounts allocated above or below the operating margin line may be based on subjective judgments. Here you are asked to speculate on the degree of subjectivity for each of the categories listed in Footnote 5. (All thoughtful answers will be accepted for full credit.)
Operating Margin - Capitalized Cost Adjustments:
In this section, I’ll lead you through three additional adjustments to the 2020 as-reported operating margin related to capitalized costs. These are numerically less significant than the adjustments that you considered above. However, they provide a useful illustration of the issues that one should consider in earnings quality analysis.
Question 16: As required under IFRS (but prohibited under U.S. GAAP),Atos capitalized a portion of its development costs. This area of IFRS gives companies substantial discretion in the timing of R&D expense recognition.
Unlike Siemens Gamesa (covered in class) or European auto companies (covered in Accounting 451),Atos does not disclose enough information to allow us to compare the amounts capitalized against total R&D spending or the total capitalized balances on the balance sheet. In addition, in 2020 Atos extended the maximum useful life over which it amortizes capitalized development costs from 13 to 15 years, creating an extra layer of opacity. These are very long amortization horizons, especially given the nature of the IP that Atos develops.
Given Atos’s lack of transparency in accounting for R&D, we’ll convert the R&D expense to a cash basis, which makes it consistent with U.S. accounting. Further justification for this adjustment comes from the following response by Atos to an analyst query in the 2020 earnings call:
“[Historically high R&D capitalization] will generate amortization in the coming years, thus reducing the gap between the additions and amortization of capitalized costs. ”
This quote suggests that moving the R&D expense from a capitalization to a full expensing basis will better reflect recurring profitability than making no adjustment. To make the required adjustment, note that the equation to compute equation the IFRS expense is on the left. This equation implies the adjustment on the right:
This link provides information on Atos’s capitalized development costs. Use this information to calculate Adjustment H and enter it in the table at the bottom of this section. Note that you should enter the above difference as a negative number. If development costs capitalized exceed past development costs amortized, moving to a cash basis will reduce operating profit.
Question 17: Similar accounting discretion and a lack of transparency plaguedAtos’s capitalization of software and other internally generated intangibles. Capitalized amounts are referred to as Additions in the above table. Here too, the company admitted that “the difference between additions and amortization is expected to decrease in the coming years.” Thus, an appropriate adjustment is move expenditure on these items to a full expense basis, i.e., assuming no capitalization is appropriate. The adjustment to do this is on the right; the accounting justification for the adjustment is on the left:
Use this information to calculate Adjustment I and enter it in the table at the bottom of this section.
Question 18: Atos capitalizes acquisition costs of certain multi-year service contracts, along with “transition costs” to fulfill the contracts. Information about this policy is presented in Footnote 3 . This practice is allowed in limited circumstances under both U.S. GAAP and IFRS, although in practice it is rare and often considered aggressive. Atos’s auditors flagged it as one of the key auditor matters in their 2020 audit opinion .
Given the nature of Atos’s business, these capitalized costs are similar to other capitalized intangibles and subject to the same earnings quality concerns. Therefore, we’ll move these costs to a full expensing basis. Information on the contract cost asset was provided in Footnote 6 of the 2020 annual report. The difference between a capitalization regime and a full expensing regime is simply the year-over-year change in the balance sheet values the contract cost asset. Subtract the increase in this asset as Adjustment C.
Question 19 (the final question pertaining to Atos) is on the next page.
Question 19: Wrap up your numerical analysis by computing adjusted operating margin percentage (Entry Kin the table below).
Part 2 - Revenue Forensics for KBR (formerly Kellogg Brown & Root)
KBR ("Kellogg Brown & Root") is an engineering and construction company based in Houston . It uses percentage of completion accounting for a majority of its contracts. In 2013, forensic accountants detected a series of earnings red flags in the KBR's quarterly financial statements that were leading indicators of serious governance problems that came to light the next year.
We'll look at items in the 10-Q for the first quarter of 2013. Similar items appeared in 10-Qs for the second and third quarters. These accompanied a string of earnings misses - earnings less than analyst estimates. Things became more serious from there:
• The CEO resigned after the third quarter earnings call.
• KBR's 2013 10-K, published Feb. 27, 2014, reported a material weakness in internal controls related to how the company recognized revenue from unapproved claims and change orders .
• On May 1, 2014, KBR announced that due to material errors in its 2013 financial statements, these could not be relied upon and needed to be restated.
• Also on May 1, KBR announced that it had violated covenants of a $1 billion loan
agreement requiring that financial statement certifications provided to the lenders not be materially false .
• On April 1, 2015, the SEC sued KBR in a landmark whistleblower protection case .
KBR's employment contracts contained language that restricted employees from disclosing accounting problems to outside parties, including the SEC. (SEC press release describing the lawsuit)
Use these selections from 10-Qs for Q1-13 and Q1-12 to answer the questions below.
Question 20: Compute net DSO in the first quarter of 2013 and compare it with net DSO in the first quarter of 2012. Did it increase or decrease? By how many days? Be sure to include noncurrent receivables in your calculation. By "net" I mean receivables net of advance billings (unearned revenue) .
Question 21: Unbilled revenue on uncompleted contracts is an account that is particularly vulnerable to forensic risk. It includes revenue recognized for unapproved change orders .
Compute the percentage decline in operating income that would occur if none of the revenue on unapproved change orders had been considered sufficientlyprobable to have been booked.
Question 22: Analysts generally consider fixed price contracts to be riskier than cost-reimbursable contracts. What is the percentage of contract backlog that is attributable to fixed price contracts as of March 31, 2013? How much has this percentage increased since 2011?
Question 23: How much did changes of estimate add to operating income during the quarter? Compute the percentage change if you were to strip these changes out of income.