4. Evaluating Quality Of Finanancial Reports

Question 1

Which is the two highly dimensions of the quality of financial reports?

Answer 1

Earnings quality and reporting quality.

Question 2

One company can have both low-quality reporting and high-quality earnings, true or false?

Answer 2

False. High-quality earnings assume high-quality reporting.

Question 3

One company can have both high-quality reporting but low-quality earnings, true or false?

Answer 3

True. For example, a strike during the reporting period may have resulted in LIFO liquidation and, hence, given a one-off boost (i.e., earnings have low persistence) to reported earnings. However, the underlying reporting was accurate and decision-useful.

Question 4

Which are two questions of the conceptual framework for assessing the quality of a company’s report?

Answer 4

1. Are the underlying financial reports GAAP compliant and decision-useful?
2. Are the earnings of high quality?
   * for this discussion, GAAP is used in a generic sense and refers to either US GAAP or IFRS.

Question 5

Which are five classifications of the continuum of high to low quality of financial reports?

Answer 5

1. GAAP compliant and decision-useful, high quality earnings
2. GAAP compliant and decision-useful, low quality earnings
3. GAAP compliant but not decision-useful (biased choices)
4. Non-compliant accounting
5. Fraudulent accounting

Question 6

Which are the two elements of high-quality earnings?

Answer 6

1. Sustainable earnings: high-quality earnings tend to persist in the future.
2. Adequa-te earnings: high-quality earnings cover the company’s cost of capital.

Question 7

Describe discretionary and non-discretionary accruals.

Answer 7

Discretionary: result from non-normal transactions or non-normal accounting choices, and are sometimes used to manipulate earnings.

Non-discretionary: accruals that occur as part of normal business

Question 8

In the equation;

Earnings (t+1) = a +b1.earnings+ E

Higher proportions of cash-based earnings as opposed to accrual-based earnings lead to higher b1 or lower b1?

Answer 8

Higher.

Cash-based earnings are more persistent than accruals-based earnings. Hence, companies with a higher proportions of cash-based earnings will have a higher persistence of earnings and, hence, a higher beta coefficient in the AR(1).

Question 9

Companies with smaller or larger proportions of accruals-based earnings historically have experienced more rapid reversions to the mean?

Answer 9

Large. Studies have shown the accruals-based earnings are less sustainable than cash-based earnings and, hence, revert to the mean more quickly.