Reading 13: Evaluating Quality of Financial Reports Flashcards
Quality of Financial Reports
- Earnings Quality: high level and sustainability of earnings
- Reporting Quality: assessment of the information disclosed in financial reports (decision useful information)
***You cannot have low-quality reporting and high-quality earnings; high quality earnings assume high-quality reporting
Two Questions
1) Are the underlying fin reports GAAP compliant and decision-useful
2) Are the earnings of high quality?
Fin Reporting Quality (High to Low)
1) GAAP compliant and decision-useful, high-quality earnings
2) GAAP compliant and decision-useful, low-quality earnings
3) Non-compliant accounting
4) Fraudulent accounting
Issues Affecting Quality of Fin Reporting
1) Measurement and timing issues and/or
2) Classification Issues
Classification Issues
- refers to how an individual financial statement element is categorized within a particular financial statement.
- Usually just affects one financial statement element
Ex:
- Reclassifying inventory as other LT assets (increases inventory turnover ratio)
- Reclassifying non-core revenues as core revenues
- Reclassifying expenses as non-operating (causes analysts to treat recurring expenses as one-time costs)
Mechanisms to misstate Profitability
- aggressive revenue recognition (channel stuffing, bill and hold, fake sales)
- Lessor use of finance lease classification
- Classifying non-operating revenue/income as operating, and operating expenses as non-operating
- Channeling gains through NI and losses through OCI
Warning Signs of misstated profitability
- revenue growth higher than peers
- receivables growth higher than revenue growth
- High rate of customer returns
- High proportion of revenue received in final quarter
- Unexplained boost to operating margin
- Operating cash flow lower than operating income
- Inconsistency in operating vs non-operating classification over time
- Aggressive accounting assumptions
- Executive comp tied to fin results
Mechanisms to misstate assets/liabilities
- Choosing inappropriate models and/or model inputs and thus affecting estimated values of financial statement elements (estimated useful lives for long-lived assets).
- Reclassification from current to non-current
- Over- or understating allowances and reserves
- Understanding identifiable assets (and overstating goodwill) in acquisition method accounting for business combinations.
Warning Signs of misstated assets/liabilities
- Inconsistency in model inputs for valuation of assets versus liabilities
- Typical current assets (inventory, receivables) being classified as non-current
- Allowances and reserves differ from those of peers and fluctuate over time
- High goodwill relative to total assets
- Use of special purpose entities
- Large fluctuations in deferred tax assets/liabilities
- Large off-balance-sheet liabilities
Mechanisms to overstate cash flows
- Managing activities to affect cash flow from operations (stretching payables)
- Misclassifying investing cash flow as cash flow from operations
Warning signs of overstated operating cash flows
- Increase in payables combined with decreases in inventory and receivables
- Capitalized expenditures (which flow through investing activities)
- Increases in bank overdraft
Beneish Model
- Estimates the probability of earnings manipulation using eight variables.
- Mscore > -1.78 indicates higher than acceptable probability of earnings manipulation
-SGAI and LEVI are negative
Altman Model
- used to assess the probability that a firm will file for bankruptcy
- Elements used:
- net working capital/total assets
- retained earnings/total assets
- operating profit/total assets
- market value of equity/book value of liabilities
- sales/total assets
- **Higher z-score is better: lower likelihood for bankruptcy
- ***Single period model so doesn’t capture changes over time
Earnings Quality Elements
1) Sustainable: high-quality earnings tend to persist in the future
2) Adequate: high-quality earnings cover the company’s cost of capital
Accruals
- Accrual method: revenues are recognized when earned and expenses are recognized when incurred, regardless of the timing of cash flow. (High level of subjectivity)
- Accrual component of income is less persistent than the cash component.
***Separate discretionary and non-discretionary accruals
