week 11 from slides - reporting quality and governance

Question 1

what are some questions to assess the financial reporting quality

Answer 1

does the financial reporting provide relevant faithfully information that represents the economic reality of the company’s activities and financial position?

does it mitigate the agency problem between investor and manager/board of Directors and manager/ problem in debt contracting

if the reported earnings sufficient and sustainable?

Question 2

what’s the spectrum of financial report quality

Answer 2

no sustainable earnings - 1 time gains and losses

biased choice (unintentionally alter earnings)
- choice of depreciation method, inventory valuation, optimism about bad debt allowance, estimation of contingent liabilities

earnings management (intentionally alter earnings)
- real earnings management - overproducing, cut discretionary expenses, delay maintenance
- accrual earnings management (alters accounting estimates or policies, allowances, etc)

Question 3

how to measure financial reporting quality

Answer 3

1. earnings properties
   - accruals residuals, income smoothing, target beating marginally, others
2. external indicators
   - accounting and auditing enforcement release (AAER), restatement, audit opinion, change of CFO, resign of auditor

Question 4

what do accruals measure

Answer 4

measure the difference between net income and OCF, representing revenue or expenses recognized before corresponidng cashflow occurs

earnings = cashflows = accruals

Question 5

what are residuals

Answer 5

represent management discretion or estimation errors, both of which reduce decision usefulness. Higher residual represent lower earnings quality

Question 6

what’s income smoothing measured by

Answer 6

income smoothing is measured by variation in net income relative to the variation in operating cash flows - a lower relative variation in net income is evidence of income smoothing

Question 7

why do firms do restatements

Answer 7

necessary when it’s determined that a previous statement contained a material inaccuracy

Question 8

what are the 4 types of audit opinions

Answer 8

1. unqualified - clean opinion
2. qualified - minor issues
3. Adverse - significant misstatement, unreliable
4. disclaimer - unable to form an opinion

Question 9

What’s insider trading

Answer 9

trading of a public company’s stock or other securities by company insiders

insiders = directors and officers of the company and shareholders with 10% or more of the company’s outstanding stock

insider trading must be disclosed within 2 days of trading through SEC form 4: statement of changes in beneficial ownership

Question 10

what are the categories of insider trading

Answer 10

1. liquidity trading - sell stock regularly or rebalance portfolio
2. informed trading - earnings abnormal return based on material non-public information

Question 11

what’s a related party transaction

Answer 11

a transfer of resources, services or obligations between related parties regardless of whether a price is charged

related parties = execs, directors, major shareholders and their direct family members

transactions involving related parties cannot be presumed to be carried out on an arm’s length basis

RPTs = investment red flag

Question 12

how to control related party transactions

Answer 12

internal governance - RPT policy; no RPT, written or not, RPT review authority

accounting standards - ASC 850, IAS 24

auditing standard - AS 18

SOX - mandate effective internal control, prohibit loans to executives

disclose the nature of the related party relationship, the parties involved (include entities, individuals, or close family members), describe the transaction (amounts, terms and conditions), describe the impact on balance sheets