Reading 31- Financial Reporting Quality

Question 1

Distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items).

Answer 1

1.) Quality of financial reporting=

Financial reporting quality is best described as the ability to follow GAAP principles in the jursidiction in which the firm operates.

If you follow GAAP, then QUALITY FINANCIAL STATEMENT should be:

“Decision Useful” = a.) RELEVANT b.) FAITHFULLY REPRESENTED

faithful representation means:

• completeness,
• neutrality,
• absence of errors

2. ) Quality of Reported Results

Quality of Earnings=
*sustainability of net income (operational efficiency- increased efficiency, increased cost cutting)

*unsustainable net income (it was a fluke as in an appreciation of assets from for an example revaluation model from IFRS)

Question 2

Describe a spectrum for assessing financial reporting quality.

Answer 2

HIGH END COMPLIANT= GAAP COMPLIANT, DECISION USEFUL, REPORTED EARNINGS THAT ARE SUSTAINABLE. REPRESENTED ADEQUATE RETURN ON INVESTOR CAPITAL.

Question 3

Distinguish between conservative and aggressive accounting.

Answer 3

Conservative Accounting- GAAP principle base; generally are conservative, decreased reported earnings, etc.

Aggressive Accounting- non-GAAP; INCREASED Reported Earnings which are based on flukes; improved financial position to LOOK GOOD FOR INVESTORS AND BANKS.

Question 4

Describe motivations that might cause management to issue financial reports that are not high quality.

Answer 4

1. ) Seek to Enhance Reputation
2. ) Career-Oriented Motives by Managers
3. ) To keep in terms of DEBT COVENANTS W/ CREDITORS
4. ) Manager Motives

Question 5

Describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports.

Answer 5

There are 3 key factors:

1. ) Motivation to do so
2. ) A given opportunity to do so
3. ) A rationalization of the behavior

BEST SCENARIOS:

• Company has WEAK INTERNAL CONTROLS
• Board of Directors give inadequate oversight of accounting department within a company controlled by self-interested managers.

Question 6

Describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms.

Answer 6

SEC that regulates the admittance of a financial report that does NOT FOLLOW GAAP Guidelines. EMSA is the European securities exchange committee.

Security Regulations typically require:

• an external audit and checking of the effectiveness of the firm’s internal controls ***
• a registration process for the issuance of new publicly traded securities.
• an independent audit of financial reports.
• a signed statement by the person responsible for the preparation of the financial reports.

Question 7

Describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion.

Answer 7

The analyst should ALWAYS assume that a company not using GAAP measures is trying to control the metrics and advance aggressive accounting practices to influence the audience.

Question 8

Describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items.

Answer 8

A.) Revenue Recognition

• channel stuffing
• increase inventory and decrease net income

B.)Bill-and-Hold Transactions
-increase sales revenue by writing false/fake service receipts and claiming them for collection

C.) Estimates of Credit Losses

• result in HIGHER NET INCOME + LOWER DEBT
• Because AR is written off & credit expenses are written off.

D.) Valuation Allowance
- decreased valuation allowance once obtained from the tax year-> INCREASED NET INCOME

E.) DEPRECIATION METHODS

F.) AMORTIZATION OF LONG-LIVED ASSETS

G.) INVENTORY METHOD USED TO CALCULATE THE COGS

Question 9

Describe accounting warning signs and methods for detecting manipulation of information in financial reports.

Answer 9

• Receivables Turnover INCREASING overtime
• Decreases in total asset turnover, especially when a company is growing through acquisition of other companies.
• declining inventory turnover ratio (CHANNEL STUFFING)
• LIFO Liquidations
• there is always a X<1 for [OCF: NI]