Earnings Quality

Question 1

Earnings are considered to be higher quality when… (3)

Answer 1

*They are persistent (expected to be sustained)
*They ensure adequate returns
*They are unbiased (not too conservative nor too agressive)

Question 2

Operating income (earnings) can be viewed as two separate components. What are these?

Answer 2

*Operating income
*Accruals

Question 3

The cash flow component of earnings is ___ ____ than the accruals component

Answer 3

more persistant

Question 4

A completely persistent earnings steam is one for which…

Answer 4

one dollar of earnings today implies a dollar of earnings for all future periods

Question 5

Mean reversion in earnings

Answer 5

extreme levels of earnings (both high and low), tend to revert to normal levels over time

Question 6

If earnings have a significant accruals component, it may…

Answer 6

make the earnings reversion to the mean faster

Question 7

The difference between accrual based earnings and cash earnings is known as

Answer 7

aggregate accruals

Question 8

How do you decompose reported accrual earnings into a cash flow and accrual component?

Answer 8

focus on information in the balance sheet or cash flow statement

Question 9

3 steps to calculating balance sheet based accruals ratio

Answer 9

1. Define net operating assets (NOA)
2. Measure total accurals for the period as the change in NOA (t - t-1)
3. Adjust for the differences by scaling total accruals by average NOA

Question 10

2 steps to calculating cash flow statement based accruals ratio

Answer 10

1. Measure total accruals for the period as the difference between net income and cash flow (from operating and investing)
2. Adjust for size differences by scaling total accruals by average NOA

Question 11

When measuring earnings quality the balance sheet and cash flow approach are…

Answer 11

conceptually equivalent however, do not generate the exact same numbers (differences are often small and can be ignored for the purpose of developing earnings quality measures)

Question 12

Financial reporting quality relates to…

Answer 12

the accuracy which a company’s reported financials reflect its operating performance and to their usefulness for forecasting future cash flows

Question 13

Requirements for financial reporting quality (2)

Answer 13

does it meet accounting standards?
does it provide useful information for decision making?

Question 14

Fundamental characteristics of financial statements (2)

Answer 14

• relevance (predictive value)
• faithful representation (completeness, neutrality, free from error)

Question 15

Enhancing characteristics of financial statements (4)

Answer 15

*Comparability
*Verifiability
*Timeliness
*Understandability

Question 16

Quality of Reported Results covers (3)

Answer 16

*Sustainable activity
*adequate returns
*Increases the company’s value

Question 17

High quality reported results characteristics (3)

Answer 17

*sustainable returns
*returns > cost of capital
*unbiased

Question 18

Low quality reported results characteristics (3)

Answer 18

*non-recurring returns
*returns < cost of capital
*biased

Question 19

If financial reporting quality is low…

Answer 19

you are unable to assess earnings quality (impedes assessment of earnings quality and valuation)

Question 20

Aggressive accounting

Answer 20

you want to make the current performance look better than it is (increase revenue, NI, OCF and decrease expenses and debt)

Question 21

Conservative accounting

Answer 21

decrease revenue, NI, OCF and increase expenses and debt

Question 22

Earnings smoothing

Answer 22

understatement of earnings volatility

Question 23

Revenue recognition issues (3)

Answer 23

timing
amount
classification

Question 24

Warning signs of revenue misstatement (4)

Answer 24

*large increases in accounts receivable
*examine days sales outstanding (DSO)
*consider the context
*large decreases in unearned revenue

Question 25

Expense recognition issues (3)

Answer 25

Understating expenses Deferring expenses classifying ordinary expenses as non-recurring or non-operating

Question 26

Warning signs of expense misstatement (4)

Answer 26

*change in depreciation assumptions * asset growth relative to sales growth *Large positive unexpected increase in core operating margin *inconsistency regarding items of expenses in operating income

Question 27

Balance sheet issues (3)

Answer 27

*off balance sheet obligations (that is, operating leases) * goodwill * classification issues

Question 28

Warning signs of balance sheet issues (3)

Answer 28

*tracking year over year changes *good will amounts when market cap is less than BV of equity *notes disclosure

Question 29

High quality cash flow results (4)

Answer 29

*positive OCF *OCF derived from sustainable sources *OCF adequate to cover CAPEX, dividends and debt repayments *OCF relatively low volatility

Question 30

Cash flow reporting quality considerations (4)

Answer 30

*timing issue *classification issues in the cash flow statement *omitted investing and financing activities *real earnings management activity

Question 31

Accounting Choices: CF classification - interest received can be either

Answer 31

operating or investing

Question 32

Accounting Choices: CF classification - interest paid can be either

Answer 32

operating or financing

Question 33

Accounting Choices: CF classification - dividends received can be either

Answer 33

operating or investing

Question 34

Accounting Choices: CF classification - dividends paidcan be either

Answer 34

operating or financing

Question 35

Management are motivated to report results that meet or exceed expectations so there is...

Answer 35

a positive market reaction

Question 36

Research provides evidence of propensity to meet or exceed various thresholds. These are... (2)

Answer 36

Historical earnings Concensus analysts' forecasts

Question 37

Management compensation contracts are...

Answer 37

when contracts are linked to accounting measures or stock prices and management are compensated for good performance

Question 38

Mechanisms for disciplining the financial reporting process include...

Answer 38

Internal auditors, external auditors, litigation, regulators and general market scrutiny

Question 39

Quantitative tool to assess the likelihood of misreporting

Answer 39

Beamish model

Question 40

Limitations of quantitative models to assess the likelihood of misreporting (2)

Answer 40

accounting is only a partial representation of economic reality, cause and effect relationships can only be determined by deeper analysis of actions * managers have learned to test the detectability of earnings manipulation tactics by using models to anticipate perceptions - predictive power has been declined