12 (FS&A) - Evaluating Quality of Financial Reports

Question 1

What does high-quality reporting provide to investors?

Answer 1

Decision-useful information. This is information that is accurate as well as relevant.

Question 2

What are high-quality earnings?

Answer 2

Earnings that are sustainable and meet the required return on investment. High-quality earnings assume high-quality reporting as well.

Question 3

What are the two key “conceptual framework” questions for assessing the quality of a company’s reports?

Answer 3

1. Are the underlying financial reports GAAP compliant and decision-useful?
2. Are the earnings of high-quality?

Question 4

Ranking order of financial reports (#1-5)

Answer 4

1. GAAP complaint and decision useful, high-quality earnings.
2. GAAP complaint and decision useful, low-quality earnings.
3. GAAP complaint but decision useful, (biased choices by management_
4. Not-compliant accounting
5. Fraudulent accounting

Question 5

What are the major potential problems that affect the quality of financial reports?

Answer 5

1. Measurement and timing issues and/or (e.g. aggressive revenue recognition, etc.)
2. Classification issues
3. Biased accounting - Accounting decisions that seek to further a specific cagenda…to sell a story.
4. Accounting for business combinations

Question 6

What is the big difference between measurement/timing issues and classification issues?

Answer 6

Measurement/timing issues effect multiple financial statements whereas classification issues typically affect one financial statement (i.e. element)

Question 6

Does GAAP compliance result in high-quality financial reporting?

Answer 6

No. GAAP compliance is necessary but not a sufficient condition for high-quality financial reporting.

Question 7

What are the seven steps in evaluating the quality of financial reports?

Answer 7

1. Understand the company, the industry, and accounting principles
2. understand management including compensation and insider trading, etc.
3. Identify material areas of accounting that are vulnerable to subjectivity
4. make cross-sectional (with peers) and time series (present vs. the past) comparisons of financial statements and ratios.
5. Check for warning signs of poor-quality reporting
6. Check for shifting of profits/revenues to different parts of businesses, specific to multinational firms.
7. Use quantitative tools to evaluate misreporting (e.g. the Benish model)

Question 8

The Benish Model

Answer 8

A probit model that estimates the probability of earnings manipulation using eight independent variables. estimates the probability by generating an M-Score.

Question 9

What is the important variable when interpreting the Benish Model?

What is the cutoff value?

Answer 9

M-Score

-1.78

m-score greater than -1.78 = greater potential of earnings manipulation
M-score lower than -1.78 = less potential of earning manipulation

Question 10

How to interpret the various variables of the Benish model?

Answer 10

When any of the variables are increasing (specifically to >1), this indicates increased likeliness of earning manipulation based on that metric.

Question 11

What are the limitations of the Benish model?

Answer 11

As managers become more aware of such models, they are likely to game the model’s inputs. This concern is supported by an observed decline in the predictive power of he Benish model over time.

Question 12

What is the Altman model?

Answer 12

Similar to the Benish model, but it generates a Z-score (as opposed to an M-score) based on five account variables (as opposed to 8).

The big difference is a higher z-score is better and indicates less likelihood of bankruptcy.

Similar limitations to the Benish model as its based on accounting information and could be gamed by management.

Question 13

What are the two key indicators (i.e. characteristics) of high-quality earnings?

Answer 13

1. Sustainable - high-quality earnings tend to persist in the future.
2. Adequate - high-quality earnings cover the company’s cost of capital (i.e. required return)

Question 14

What three indicators (i.e. characteristics) could cause low-quality earnings?

Answer 14

1. Earnings below company’s cost of capital
2. Earnings that are not sustainable
3. Poor reporting quality - not useful information on firm performance

Having any one of these three would cause low-quality earnings.

Question 15

What are sustainable/persistent earnings?

Answer 15

Earnings that are expected to recur in the future. In other words, a company with earnings with a high-proportion of non-recurring items (one-time items) are considered non-sustainable and thus, lower quality.

Question 16

What does mean reversion in earnings signal?

Answer 16

This is the tendency of earnings at extreme levels to revert back to normal levels over time. This implies that very-high (e.g. extreme) levels o earnings are not sustainable in the long term.

Question 17

When will mean reversion in earnings happen more quickly? When will it move ever faster to that?

Answer 17

Companies that use accruals-based earnings.

Will move even faster if the accruals are largely discretionary to be determined by management.

Question 18

What are the two major contributors to earnings manipulation?

Answer 18

1. Revenue recognition issues
2. Expense recognition issues (i.e. capitalization)

Question 19

What are two examples of aggressive revenue recognition practices?

Answer 19

1. Bill-and-hold sales.
2. Channel stuffing.

Question 20

What two financial metrics indicate poor revenue quality?

Answer 20

1. DSO - Days sales outstanding (if increasing)
2. Receivables turnover ratio (if declining)

A higher growth rate if AR relative t the growth rate of revenue is a red flag. Increasing DSO over time indicates poor-quality revenue.

Important to compare these metrics against the industry or a sub-set of peers.

Question 21

What will cost capitalization (i.e. expense recognition issues) result in?

Answer 21

An excessive asset base. Asset base is growing way too quickly, indicating they are not recognize expenses or capitalizing assets accordingly.

This can be spotted by doing a comparative analysis with other peers with common-size balance sheets.

Question 22

What are the indicators of high-quality cash flow?

Answer 22

A company’s reported cash flow was high (i.e. they had good economic performance) and the underlying reporting data was also high.

Question 23

What are the critical elements to check when evaluating the cash flow quality of a company?

Answer 23

1. Unusual items or items that have not shown up in prior years.
2. Revenue quality, typically looking for excessive outflow of receivables and inventory due to aggressive revenue recognition.
3. Strategic provisioning (or the reversal) for restructuring charges and other non-cash expenses.

Question 24

What are the indicators of a high-quality balance sheet?

Answer 24

1. Completeness
2. Unbiased measurement
3. Clarity of presentation

Question 25

What would compromise the completeness of a high-quality balance sheet?

Answer 25

The existence of off-balance-sheet liabilities. Examples would include purchase agreements structured as take-or-pay contracts.

Question 26

What matters are subjective to management with regard to balance sheet quality?

Answer 26

The measurement (i.e. determining the value) of assets or liabilities such as pension obligations, goodwill, investments, inventory, and other assets.

Question 27

What would the overstatement of asset values result in?

Answer 27

An overstatement of profitability and equity, which would result in a low-quality balance sheet

Question 28

What are the sources of information risk when evaluating a company?

Answer 28

1. Financial statements
2. Auditor’s report
3. Notes to financial statements
4. Management discussion and analysis (MD&A)
5. SEC Form “NT”
6. Financial press