Wednesday, October 7, 2009

Duke Energy: Earnings Management or Prudent Policies?

Earnings management is an ugly term; it carries with it the implication that a company has strategically timed and/or manipulated its financial statements in order to reach a more desirable earnings outcome. One of the areas that is susceptible to such tactics is the portion of the balance sheet labeled "Accounts Receivable"(AR).

Generally speaking, AR represents goods or services that a company has sold to a buyer on credit, i.e it has not yet received cash for the good/service, but it has booked the sale as revenue. The obvious question to arise from this scenario, especially during a recession is: what if the customer doesn't pay? The most precise answer to that question is that an aging analysis is performed, whereby increasing rates of loss are applied to the receivables based upon the number of days since credit was extended to the customer. For instance, we could classify all of our receivables as being 0-30 days outstanding, 30-60, and 90+. Experience might tell us that 2% of receivables in the 0-30 day category will end up defaulting, whereas a bill that's been out for over 90 days will "go bad" 10% of the time. These estimated loss rates are multiplied with the dollar value of receivable in each category, generating a loss estimate known as "Allowance for Doubtful Accounts". Interestingly, this number immediately counts as an expense in the income statement for the current quarter. If and when the debt is actually classified as "bad", there is no (net) effect on the balance sheet or income statement. Thus, the potential exists for a corporation to over estimate bad accounts in one quarter, and slowly bleed the "loss" back into the income statement over subsequent quarters. Need an extra 10 cents/share to beat analyst estimates? No problem, just dip into the "bad" accounts cookie jar and take it.

Now, I'm in no way claiming that Duke Energy (DUK) is engaging in this sort of chicanery. In fact, I own the stock and consider it to be a well-managed company. That being said, I'm intrigued by the fact that, since the recession began in December 2007, DUK's allowance for doubtful accounts, as a percentage of gross receivables, has steadily declined. On 3/31/2007, Duke classified 4.5% of it's outstanding invoices as "Doubtful". By 3/31/2009, in the depths of the recession, Duke only classified 2.79% of receivables as doubtful. These small percentage changes add up when you consider that DUK had $1.5Billion worth of accounts receivable as of the most recent reporting period. I'm surprised at this trend because I would assume that more households would forgo paying the electric bill during the recession than before.

There is of course another explanation which I, as a DUK shareholder, would prefer to believe. Duke Energy could simply be tightening its credit standards for new accounts. Presumably, that action would reduce the number of non-payers. Since I don't think the electric company can outright deny service to a household, my best guess is that they are either requiring a deposit of some sort, or are requiring less credit worthy individuals to set up an automatic account draft. Another possibility is that households are being forced to put their electric account in the name of a more credit worthy family member. Finally, Duke might simply be shutting off power to non-payers quicker than before, essentially eliminating several months worth of noncollectable accounts.

Obviously, Duke Energy has a fairly reliable and predictable stream of revenue. Other corporations may not, and as such, investors should be cognizant of this accounting trick before they pony up for potentially over valued common shares.

*long DUK Sphere: Related Content

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