Earnings Quality Flashcards
Earnings are considered to be higher quality when… (3)
*They are persistent (expected to be sustained)
*They ensure adequate returns
*They are unbiased (not too conservative nor too agressive)
Operating income (earnings) can be viewed as two separate components. What are these?
*Operating income
*Accruals
The cash flow component of earnings is ___ ____ than the accruals component
more persistant
A completely persistent earnings steam is one for which…
one dollar of earnings today implies a dollar of earnings for all future periods
Mean reversion in earnings
extreme levels of earnings (both high and low), tend to revert to normal levels over time
If earnings have a significant accruals component, it may…
make the earnings reversion to the mean faster
The difference between accrual based earnings and cash earnings is known as
aggregate accruals
How do you decompose reported accrual earnings into a cash flow and accrual component?
focus on information in the balance sheet or cash flow statement
3 steps to calculating balance sheet based accruals ratio
- Define net operating assets (NOA)
- Measure total accurals for the period as the change in NOA (t - t-1)
- Adjust for the differences by scaling total accruals by average NOA
2 steps to calculating cash flow statement based accruals ratio
- Measure total accruals for the period as the difference between net income and cash flow (from operating and investing)
- Adjust for size differences by scaling total accruals by average NOA
When measuring earnings quality the balance sheet and cash flow approach are…
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)
Financial reporting quality relates to…
the accuracy which a company’s reported financials reflect its operating performance and to their usefulness for forecasting future cash flows
Requirements for financial reporting quality (2)
does it meet accounting standards?
does it provide useful information for decision making?
Fundamental characteristics of financial statements (2)
- relevance (predictive value)
- faithful representation (completeness, neutrality, free from error)
Enhancing characteristics of financial statements (4)
*Comparability
*Verifiability
*Timeliness
*Understandability
Quality of Reported Results covers (3)
*Sustainable activity
*adequate returns
*Increases the company’s value
High quality reported results characteristics (3)
*sustainable returns
*returns > cost of capital
*unbiased
Low quality reported results characteristics (3)
*non-recurring returns
*returns < cost of capital
*biased
If financial reporting quality is low…
you are unable to assess earnings quality (impedes assessment of earnings quality and valuation)
Aggressive accounting
you want to make the current performance look better than it is (increase revenue, NI, OCF and decrease expenses and debt)
Conservative accounting
decrease revenue, NI, OCF and increase expenses and debt
Earnings smoothing
understatement of earnings volatility
Revenue recognition issues (3)
timing
amount
classification
Warning signs of revenue misstatement (4)
*large increases in accounts receivable
*examine days sales outstanding (DSO)
*consider the context
*large decreases in unearned revenue
Expense recognition issues (3)
Understating expenses
Deferring expenses
classifying ordinary expenses as non-recurring or non-operating
Warning signs of expense misstatement (4)
*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
Balance sheet issues (3)
*off balance sheet obligations (that is, operating leases)
* goodwill
* classification issues
Warning signs of balance sheet issues (3)
*tracking year over year changes
*good will amounts when market cap is less than BV of equity
*notes disclosure
High quality cash flow results (4)
*positive OCF
*OCF derived from sustainable sources
*OCF adequate to cover CAPEX, dividends and debt repayments
*OCF relatively low volatility
Cash flow reporting quality considerations (4)
*timing issue
*classification issues in the cash flow statement
*omitted investing and financing activities
*real earnings management activity
Accounting Choices: CF classification - interest received can be either
operating or investing
Accounting Choices: CF classification - interest paid can be either
operating or financing
Accounting Choices: CF classification - dividends received can be either
operating or investing
Accounting Choices: CF classification - dividends paidcan be either
operating or financing
Management are motivated to report results that meet or exceed expectations so there is…
a positive market reaction
Research provides evidence of propensity to meet or exceed various thresholds. These are… (2)
Historical earnings
Concensus analysts’ forecasts
Management compensation contracts are…
when contracts are linked to accounting measures or stock prices and management are compensated for good performance
Mechanisms for disciplining the financial reporting process include…
Internal auditors, external auditors, litigation, regulators and general market scrutiny
Quantitative tool to assess the likelihood of misreporting
Beamish model
Limitations of quantitative models to assess the likelihood of misreporting (2)
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
