A Quality-of-Earnings Comparison of Two Companies Siemens AG is a global electronics and electrical engineering company headquartered in Munich, Germany. Selected data (in € millions) from Siemens’ financial statements for the years

Question

A Quality-of-Earnings Comparison of Two Companies

Siemens AG is a global electronics and electrical engineering company headquartered in Munich, Germany. Selected data (in € millions) from Siemens’ financial statements for the years ended 30 September 2006, 2005, and 2004 are presented below.

General Electric is a diversified global industrial corporation headquartered in Fairfield, Connecticut, USA. Selected data (in $ millions) from GE’s financial statements for the years ended 31 December 2006, 2005, and 2004 are presented below.

Based on the information given, address the following:

1. Calculate net operating assets for Siemens and GE for each year presented.
2. Calculate aggregate accruals using both the balance sheet and cash flow statement methods for Siemens and GE for each year presented.
3. Calculate the balance-sheet-based and cash-flow-statement-based accruals ratios for Siemens and GE for each year presented.
4. A. State and explain which company had higher earnings quality in 2005 and 2006.
B. Identify any trends in earnings quality for each company.

5. Would the results of question 4 be different if the accruals ratios were calculated based only on continuing operations?
6. General Electric recorded net financing receivables of $334,232 in 2006 and $292,639 in 2005. It describes these receivables in the notes to its financial statements as largely relating to direct financing leases. Evaluate this disclosure with respect to GE’s earnings quality.

Accepted Answer

Solution to 1. Net operating assets is defined as (Total assets - Cash and marketable securities) - (Total liabilities - Total debt). For example, in 2006 Siemens reported total assets of 90,973 and cash and marketable securities of 10,214 + 596 = 10,810. Total liabilities were 61,667 and total debt was 2,175 + 13,399 = 15,574. (90,973 - 10,810) - (61,667 – 15,574) = 80,163 - 46,093 = 34,070. The values for each firm are summarized below.

Solution to 2. Balance sheet aggregate accruals are defined as the change in net operating assets. As such, only two years worth of accruals can be calculated from the data given. For example, for Siemens, using the answers to Problem 1, balance sheet aggregate accruals for 2006 equals €34,070 - €29,547 = €4,523.

Cash flow statement aggregate accruals are defined as Net income - (Cash flows from operating activity + Cash flows from investing activity). For example, for Siemens in 2006, cash flow statement aggregate accruals is found as NI of €3,033 - [CFO of €4,981 + (CFI of - €4,614)] = €3,033 - €367 = €2,666.

Solution to 3. The accrual ratio is defined as aggregate accruals divided by average net operating assets. Because the denominator requires an average of two years’ data, only two years of accrual ratios can be calculated. For example, for Siemens, average net operating assets for 2006 were (€34,070 + €29,547) ÷ 2 = €31,808.5. With aggregate accruals for 2006 of €4,523 and €2,666 by the balance sheet and cash flow statement methods respectively, the corresponding accrual ratios were €4,523 ÷ €31,808.5 = 14.2 percent and €2,666 ÷ €31,808.5 = 8.4 percent.

Solutions to 4.
A. Using the balance-sheet-based accrual ratio, General Electric has higher earnings quality (i.e., lower accruals ratio) in both years. Using the cash-flow statement-based measure, GE actually shows lower earnings quality than Siemens only in 2006.
B. Using either earnings quality measure, Siemens shows improving earnings quality from 2005 to 2006, while GE shows deteriorating earnings quality.

Solution to 5. Subtracting the results of discontinued operations from net income and using the cash flow data from continuing operations, the results of the calculations are:

Using continuing operations does not significantly alter either the level or trends in accruals for these companies.

Solution to 6. The $41,593 million change in financing receivables accounts for a large portion of GE’s $53,879 million change in net operating assets. Compared to treating the leases as operating leases (see the chapter on long-term liabilities), accounting for leases as direct financing leases increases net income in the early years of a lease but the same total net income is recognized over the lease life. Under operating lease accounting, operating cash fl ow is lower, but investing cash flows are higher. When considering the cash versus accrual portions of earnings, this disclosure allows us to conclude that GE’s 2006 earnings are likely less persistent (of lower quality) than its 2005 earnings.

Siemens AG: Fiscal Years Ended 30 September (€ millions)
Selected Income Statement Data	2006	2005	2004
Net sales	87,325	75,445	70,237
Income from continuing operations, before tax	4,371	4,185	4,369
Income (loss) from discontinued operations	(54)	(810)	(45)
Net income	3,033	2,248	3,405
Selected Balance Sheet Data as of 31 December
Cash and equivalents	10,214	8,121	12,190
Marketable securities	596	1,789	1,386
Total current assets	51,611	46,803	45,946
Total assets	90,973	86,117	79,518
Short-term debt	2,175	3,999	1,434
Total current liabilities	38,957	39,631	33,372
Long-term debt	13,399	8,436	9,785
Total liabilities	61,667	59,095	52,663
Selected Statement of Cash Flows Data
Net cash provided by (used in) operating activities	4,981	3,121	5,080
Net cash provided by (used in) operating activities— continuing operations	5,174	4,217	4,704
Net cash provided by (used in) investing activities	(4,614)	(5,824)	(1,818)
Net cash provided by (used in) investing activities— continuing operations	(4,435)	(5,706)	(1,689)
Net cash provided by (used in) financing activities	1,802	(1,403)	(3,108)

General Electric Company and Consolidated Affiliates, Years Ended 31 December ($ millions)
Selected Income Statement Data	2006	2005	2004
Net sales	163,391	147,956	134,291
Income from continuing operations, before tax	24,620	22,696	20,297
Income (loss) from discontinued operations	163	(1,950)	559
Net income	20,829	16,711	17,160
Selected Balance Sheet Data as of 31 December
Cash and equivalents	14,275	8,825	12,152
Marketable securities	47,826	42,148	56,923
Total current assets	87,456	76,298	93,086
Total assets	697,239	673,321	750,507
Short-term debt	172,153	158,156	157,195
Total current liabilities	220,514	204,970	200,047
Long-term debt	260,804	212,281	207,871
Total liabilities	577,347	555,916	627,083
Selected Statement of Cash Flows Data
Net cash provided by (used in) operating activities	30,646	37,691	36,493
Net cash provided by (used in) operating activities— continuing operations	33,019	32,664	30,872
Net cash provided by (used in) investing activities	(51,402)	(35,099)	(38,423)
Net cash provided by (used in) investing activities— continuing operations	(51,019)	(29,366)	(30,772)
Net cash provided by (used in) financing activities	23,230	(6,119)	4,594

Question 17.2: A Quality-of-Earnings Comparison of Two Companies Siemens AG...

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