Reading 29: Financial Reporting Quality Flashcards
Explain the warning sign that is restructuring and/or impairment charges.
At times, it has been observed that a company’s stock price rises upon recognition of a “big bath” charge against current income. The rationale is that management has identified and parted with underperforming portions of the company and has shifted its attention to more profitable activities. Analysts should appreciate that the restructuring charge suggests that expenses reported over prior years were probably understated and therefore make appropriate adjustments to prior years’ earnings.
Describe the limitations of audit opinions.
An audit opinion is based on information prepared by the company, so if a company intends to deceive its auditor, provided information might not uncover misstatements.
An audit is based on a sample of information, which might not reveal any misstatements.
An “expectations gap” may exist between the auditor’s actual role and what the public perceives the auditor’s role to be.
Audit fees are often established through a competitive process, and the company being audited bears the cost of the audit.
Define financial reporting quality.
It refers to the usefulness of information contained in the financial reports, including disclosures in notes.
High-quality reporting provides information that is useful in investment decision making, in that it is relevant and faithfully represents the company’s performance and position.
Give examples, under IFRS, of significant flexibility in classification of certain cash flows offered by certain jurisdictions.
Interest paid can be classified as operating or financing cash flow.
Interest and dividends received may be classified as operating or investing cash flow.
Dividends paid may be classified as operating or financing cash flow.
Differentiate between FOB shipping point and FOB destination.
Under FOB shipping point, revenue (and associated profit) is recognized upon dispatch of goods, while under FOB destination, revenue (and associated profit) is recognized later when goods reach the customer.
Identify the warning signs related to inventories.
Compare growth in inventories with competitors and industry benchmarks.
Compute the inventory turnover ratio.
Check for inflated profits through LIFO liquidations (only applicable for firms using LIFO).
Explain earnings quality.
It pertains to the earnings and cash generated by the company’s core economic activities and its resulting financial condition.
High-quality earnings (1) come from activities that the company will be able to sustain in the future and (2) provide an adequate return on the company’s investment.
Note that the term “earnings quality” encompasses quality of earnings, cash flow, and balance sheet items.
Explain big bath behavior.
This refers to the strategy of manipulating a company’s income statement to make poor results look even worse. The big bath is often implemented in a bad year with a view to inflating subsequent period earnings. New management teams sometimes use the big bath so that poor current performance can be blamed on previous management, while they take credit for the impressive growth that follows in subsequent periods.
Explain stretching out payables.
Management may try to delay payments to creditors until after the balance sheet date so that the increase in accounts payable over the period (source of cash) results in an increase in cash generated from operations.
Differentiate between conservative and aggressive accounting.
The common perception is that investors may prefer conservative accounting because positive surprises are more acceptable than negative surprises, while management may prefer aggressive accounting as it improves reported financial performance in the current period. However, when it comes to establishing expectations about the future, financial reporting that is relevant and faithfully representative is most useful.
Explain the warning sign when gross/operating margins are out of line with competitors or industry.
While this could signal superior management performance, it may also indicate the presence of accounting manipulation. The point is that it is a sign that further analysis is required.
List the items that tend to be excluded to manipulate reported performance.
Rental payments for operating leases, resulting in EBITDAR.
Equity-based compensation. Exclusion of this is usually justified on the grounds that it is a noncash expense.
Acquisition-related charges.
Impairment charges for goodwill or other intangible assets.
Impairment charges for long-lived assets.
Litigation costs.
Loss/gain on debt extinguishments.
List the ways in which regulations directly affect financial reporting quality.
Registration requirements
Disclosure requirements
Auditing requirements
Management commentaries
Responsibility statements
Regulatory review of filings
Enforcement mechanisms
What motivates management to issue financial reports that are not of high quality?
To mask poor performance, such as loss of market share or lower profitability than other companies in the industry.
To meet or beat analysts’ forecasts or management’s own forecasts.
To address managers’ concerns regarding their careers. Managers may be concerned that working for a company that is struggling would affect their future career opportunities adversely.
To avoid debt covenant violations. Managers of highly leveraged unprofitable companies can be motivated to inflate earnings to get around debt covenant violations.
