READING 18 - EVALUATING QUALITY OF FINANCIAL REPORTS

LOS a – Demonstrate the use of a conceptual framework for assessing the quality of a company’s financial
reports.

Quality of Financial Reports

Conceptual Framework for Assessing the Quality of Financial Reports

1. Quality Spectrum of Financial Reports

i. GAAP, Decision Useful, Sustainable, and Adequate returns
ii. GAAP, Decision Useful, but Sustainable? Low “earnings quality”
iii. Within GAAP, but biased choices
iv. Within GAAP, but “earnings management” (EM), real EM or accounting EM
v. Non-compliant accounting
vi. Fictitious Transactions
2. Analysts needs to answer two questions
i. Are the financial reports GAAP compliant and decision-useful?
ii. Are the results (earnings) of high quality? In other words, do they provide an adequate level of
return, and are they sustainable?

LOS b – Explain potential problems that affect the quality of financial reports.

Potential Problems that Affect the Quality of Financial Reports Reported Amounts and Timing of
Recognition

1. Choices will affect at least the income statement and the balance sheet
Choices that effect income statement effect equity and therefore either liabilities or assets
2. Examples:
i. Aggressive, premature, and fictitious revenue recognition results in overstated income and thus
overstated equity. Assets, usually accounts receivable are also overstated
ii. Conservative revenue recognition, such as deferred recognition of revenue, results in
understated net income, understated equity, and understated assets
iii. Omission and delayed revenue recognition of expenses results in understated expenses and
overstated income, overstated equity, overstated assets, and/or understated liabilities
iv. Understatement of contingent liabilities is associated with overstated equity resulting from
understated expenses and overstated income or overstated other comprehensive income
v. Overstatement of financial assets and understatement of financial liabilities, reported at fair
value, are associated with overstated equity resulting from overstated unrealized gains or
understated unrealized losses
vi. Cash flow from operations may be increased by deferring payments on payables, accelerating
payments from customers, deferring purchases of inventory, and deferring other expenditures
related to operations, such as maintenance and research

Classifications
1. Affect how something is classified on the balance sheet and may affect OCI and NI
2. Often used to effect financial ratios
3. Selling AR to an external entity, or perhaps reclassifying them to long term receivables
4. Can choose to classify earnings in operating or non-operating
 5. Can classify cash flows as operating or non-operating. i.e. selling long term assets and putting into
operating

Problems and signs table

Potential Issues Possible Actions/Choices Warning Signs

Overstatement or non-  Contingent sales with rights of  Growth in revenue higher than
sustainability of operating income return, “channel stuffing”, that of industry or peers
and/or net income “bill and hold” sales  Increases in discounts to and
 Overstated or accelerated  Lessor use of finance (capital returns from customers
revenue recognition leases)  Higher growth rate in
 Understated expenses  Fictitious (fraudulent) revenue receivables than revenue
 Misclassification of revenue,  Capitalizing expenditures as  Large proportion of revenue in
gains, expenses, or losses assets final quarter of year for non-
 Lessee use of operating leases seasonal business
 Classifying non-operating  Cash flow from operations is
income or gains as part of much lower than operating
operations income
 Classifying ordinary expenses  Inconsistency over time in
as non-recurring or non- items included in operating
operating revenue and operating
 Reporting gains through net expenses
income and losses through  Increases in operating margin
other comprehensive income  Aggressive accounting
assumptions, such as long,
depreciable lives
 Losses in non-operating
income or other
comprehensive
 income and gains in operating
income or net income
 Compensation largely tied to
financial results
Misstatement of balance sheet  Choice of models and model  Models and model inputs that
items (may affect income inputs to measure fair value bias fair value measures
statement)  Classification from current to  Inconsistency in model inputs
 Over or understatement of non-current when measuring fair value of
assets  Over or understating reserves assets compared with that of
Over or understatement of and allowances liabilities
liabilities  Understating identifiable  Typical current assets, such as
 Misclassification of assets assets and overstating AR and inventory included in
and/or liabilities goodwill non-current assets
 Allowances and reserves that
fluctuate over time or are not
comparable with peers
 High goodwill value relative to
total assets
 Use of special purpose vehicles
  Large changes in deferred tax
assets and liabilities
 Significant off balance sheet
liabilities
 Overstatement of cash flow  Managing activities to affect  Increase in accounts payable
from operations cash flow from operations and decrease in accounts
 Misclassifying cash flows to receivable and inventory
positively affect cash flow  Capitalized expenditures in
from operations investing activities – Sales and
leaseback
 Increases in bank overdrafts

a) Channel Stuffing: inducing customers to order products they would otherwise not order or order at a
later date through generous terms
b) Bill and Hold sales: encouraging customers to order goods and retain them on seller’s premise

Quality issues and mergers and acquisitions

1. M&A provide opportunities and motivation to manage financial results
2. Companies with bad cash flow may be motivated to acquire other companies to increase cash flow
from operations
a. May or may not be sustainable
3. When making an acquisition with stock, managers may manipulate earnings to increase stock price in
order to
4. Acquired company may manipulate earnings to receive a better offer
5. Companies that have misstated stuff in the past are more likely to make acquisitions
a. Also more likely to purchase a company that would reduce the comparability and consistency of
their financial statements
6. Overstating goodwill to increase ROA, and reduce depreciation expense in the future

Financial Reporting that diverges from economic reality despite compliance with accounting rules
1. Analyst may have to adjust reporting so that it falls more in line with economic reality
2. Not consolidating an entity created is an example. Variable Interest Entities were created for this
purpose
3. Restructuring/reorganization charges as well as impairment charges may require the analyst to re-
evaluate past net incomes
a. Perhaps all of the costs shouldn’t have been involved in just the current period
b. If reversals happen, it may artificially raise future net incomes as well
c. Should these charges be treated as a one off, or are they going to reoccur?
4. Analyst should normalize earnings by either
a. Spreading the restructuring or impairment charges over the previous and current periods to
make it match
b. Taking it out of earnings because it truly is a one off occurrence
5. Items that must commonly be questioned
a. Revisions to ongoing estimates, such as the remaining economic lives of assets, may lead an
analyst to question whether an earlier change in estimate would have been more appropriate
 b. Sudden increases to allowances and reserves could call into question whether prior estimates
resulted in overstatement of prior periods earnings instead of an unbiased picture of economic
reality
c. Large accruals for losses (environmental or litigation related liabilities) suggest that prior
periods’ earnings may have been overstated because of the failure to accrue losses earlier
6. Management can smooth earnings by adjusting reserves and allowances
7. Off balance sheet assets and liabilities can be used
8. Differences in classification of marketable securities can affect net income and other comprehensive
income
9. R&D not being allowed to be capitalized can make it hard to judge how big assets are
10. Order backlogs (airplane industry) is a significant asset that is not shown in financial statements
11. Should we include items in OCI in Net Income during analysis
a. Unrealized holding gains and losses on certain investments in equity securities
b. Unrealized holding gains (and subsequent losses) on items of property and equipment for
which the “revaluation option” is elected (IFRS only)
c. Effects on owners’ equity resulting from the translation of the foreign currency denominated
financial statements of a foreign operation to the reporting currency of the consolidated entity
d. Certain changes to net pension liability or asset
e. Gains and losses on derivative financial instruments (and certain foreign currency denominated
non derivative financial instruments) accounted for as a hedge of future cash flows

LOS c – Describe how to evaluate the quality of a company’s financial reports

Evaluating the Quality of Financial Reports

1. Questions to ask:
a. What is the purpose of the analysis? What questions will this analysis answer?
b. What level of detail will be needed to accomplish this purpose?
c. What data are available for this analysis?
d. What are the factors or relationships that will influence the analysis?
e. What are the analytical limitations, and will these limitations potentially impair the analysis?
2. In the context of evaluating quality of financial statements, the analyst is answering two questions:
a. Are the financial reports GAAP-compliant and decision useful?
b. Are the results (earnings) of high quality? Do they provide an adequate level of return, and are
they sustainable?

General Steps to Evaluate the Quality of Financial Reports

1. Develop an understanding of the company and its industry
a. Understanding economic activities provides a basis for why particular accounting principles may
be appropriate
b. Understanding the accounting principles used in the industry lets the analyst know if the
company is normal
2. Learn about management. Evaluate whether the company's management has any particular incentives
to misreport.
3. Identify significant accounting areas, especially those in which management judgement or unusual
accounting rules are significant determinant of reported performance
4. Make comparisons:
a. Compare the company's financial statements and significant disclosures in the current year's
report with that of prior year's report. Are there major differences in disclosures or line items?
Why?
 b. Compare the company's accounting policies with those of its closest competitors. Are there
significant differences? Why and what effect do they have?
c. Using ratio analysis, compare the company's performance with its peers
5. Check for warning signs of possible issues with quality of financial reports
a. Declining receivables turnover could suggest that some revenues are fictitious or recorded
prematurely or that allowance for doubtful accounts is insufficient
b. Declining inventory turnover could suggest obsolescence problems that should be recognized
c. Net income greater than cash provided by operations could suggest that aggressive accounting
policies have shifted current expenses to later periods
6. For firms operating in multiple segments by geography or product, consider whether inventory, sales,
and expenses have been shifted to make it appear that company is positively exposed to a geographic
or product segment that the investment community considers to be a desirable growth area.
7. Use appropriate quantitative tools to assess the likelihood of misreporting

LOS d - Evaluate the quality of a company’s financial reports.

Quantitative Tools to Assess the likelihood of Misreporting

Beneish Model

1. The probability of manipulation (M-Score) is estimated using a probit model

2.
M-Score=−4.84 +0.920(DSR )+ 0.528(GMI )+0.404 ( AQI)+0.892( SGI )+0.115(DEPI )−0.172( SGAI )+ 4.679( Acc
a. Days’ Sales Receivables Index: changes in the relationship between receivables and sales could
indicate inappropriate revenue recognition
Receivable st
'
Day s Sales Outstandin g t Sale s t
DSRI= '
=
Day s Sales Outstandin gt −1 Receivable s t−1
Sale st −1

b. Gross Margin Index: deterioration in margins could predispose companies to manipulate

earnings
Gross Margi n t−1
GMI =
Gross Margi nt

c. Asset Quality Index: change in the percentage of assets other than in PPE and CA could indicate
excessive expenditure capitalization
Noncurrent Assets PP E t +C A t

AQI=
(
Total Assets t
=
) 1−
T At
Noncurrent Assets PP Et−1 +C A t−1
( Total Assets )
t−1
1−
T A t−1
i. PPE = property plant and equipment
ii. CA = current assets
iii. TA = total Assets

d. Sales Growth Index: managing the perception of continuing growth and capital needs from
actual growth could predispose companies to manipulate sales and earnings
 Sale s t
SGI=
Sale st −1

e. Depreciation Index: declining depreciation rates could indicate understated depreciation as a

means of manipulating earnings
Depreciation Rat e t−1 Depreciation Expense
DEP I = =
Deprecation Rat e t Depreciation Expense+ PPE

f. Sales, General, and Administrative Expense Index: an increase in fixed SGA expenses suggest
decreasing administrative and marketing efficiency, which could predispose companies to
manipulate earnings
SG At
Sale s t
SGAI=
SG A t −1
Sale st −1
g. Accruals: it has the highest weighting in the model. Higher accruals can indicate earnings
manipulation.
Income before extraordinary items−CFO
Accruals=
Total Assets

h. Leverage Index: increasing leverage could predispose companies to manipulate earnings

Total Deb t t
Leverag e t Total Asset st
LEVI= =
Leverag et −1 Total Debt t−1
Total Asset s t−1
3. The model is a normally distributed random variable with a mean of 0 and a std. deviation of 1
a. Therefore, we can use the z score
b. The lower the z score the better
c. M-score > –1 .78 = possible earnings management (> 3.8% probability of earnings manipulation)

Other Quantitative Models

Other variables that have been found useful are
1. Accruals’ quality
2. Deferred Taxes
3. Auditor Change
4. Market-to-book ratio
5. Whether the company is publicly listed and traded
6. Growth rate differences between financial and non-financial variables
i. Number of patents, employees, and products
7. Certain aspects of corporate governance and incentive compensation

Limitations of Quantitative Models

1. Accounting is only partial reality to models based on them are only capable of establishing associations
between variables
2. The predictive power of the Beneish model is falling over time
3. Managers can test their companies with the model, and manipulate the standards to get around it
LOS e - Describe the concept of sustainable (persistent) earnings.
LOS f - Describe indicators of earnings quality.
LOS g - Explain mean reversion in earnings and how the accruals component of earnings affects the speed of
mean reversion.

Indicators of Earnings Quality

Higher earnings quality is earnings that are sustainable and represent returns equal to or in excess of the
companies cost of capital

Recurring Earnings
1. Earnings that may not be recurring
a) Subsidiaries that are expected to be disposed of
b) One-off asset sales
c) One-off litigation settlements
d) One-off tax settlements
2. Classification shifting can be used to manipulate operating income
3. Companies sometimes aid the analyst by providing non-GAAP measures that exclude non-recurring
items

Earnings Persistence and Related Measures of Accruals

1. Persistence can be expressed as the coefficient on current earnings in a simple model
a. Earningst+1 = a + B1Earningst + ε
b. Higher coefficient B represents more consistent earnings
2. Earnings can also be broken down into a cash component and an accrual component
a. Earningst+1 = a + B1(Cash Flowt) + B2Accrualst + ε
b. Cash flow usually has a higher coefficient and is more consistent than accruals
3. There is an important distinction between accruals from normal transactions (non-discretionary) and
accruals that result from the intention to distort (discretionary)
4. You can regress total accruals on the factors expected to give rise to normal accruals (depreciation,
credit sales) and the residual is due to abnormal accruals
5. You can also screen for abnormal accruals by scaling accruals by total assets or sales and comparing
across companies, abnorm ally high ratios may indicate abnormal accruals
6. When a company reports positive net income but negative operating cash flows
7. Capitalizing instead of expensing leads to cash flows from operations being high, as capitalizing comes
from investing cash flows and not operating

Mean Reversion in Earnings

1. Extreme levels of earnings, both high and low, tend to revert to normal levels over time
a. This is also true for many other measures including residual income, return on equity, return on operating
assets, core sales profit margins and others

Beating Benchmarks
1. A company that consistently reports earnings that exactly meet or only narrowly beat benchmarks can raise
questions about its earnings quality

LOS h - Evaluate the earnings quality of a company.

Evaluation the Earnings Quality of a Company (Cases)

The most common accounting misrepresentation occurs in the area of revenue recognition
Revenue Recognition Cases
Premature/Fraudulent Revenue Recognition
If customers are induced into buying goods which they do not yet need through favourable payment terms or
given substantial leeway in returning such goods to the seller (channel stuffing), days' of sales outstanding
(DSO) may increase and returns may also increase.
a) Problems with and changes in collections, expressed through accounts receivables metrics, can give
the analyst clues about the aggressiveness of the seller
b) DSO will increase and therefore accounts receivable turnover would be decreasing
c) There will also be an increasing percentage of receivables to revenue

Multiple-Element Contracts
a) Companies that provide service with their product have to recognize revenue separately if they are
separable, but it complicates things and opens up to manipulation
b) This can be used to recognize revenues at different times depending on how the manager may want to
manipulate them
c) Hard to analyze without in depth knowledge of the contracts
d) Can analyze the proportion of revenues from different sources, should remain fairly consistent or at
least show a logical trend

Looking for Quality in Revenues

1. Start with the basics
Fully understand revenue recognition policies in the annual report
a. What are the shipping terms?
b. What rights of return does a customer have: Limited or extensive?
c. Do rebates affect revenues, and if so, how are they accounted for? What estimates are
involved?
d. Are there multiple deliverables to customers for one arrangement? If so, is revenue deferred
until some elements are delivered late in the contract? If there are multiple deliverables, do
deferred revenues appear on the balance sheet?
2. Age matters
A Study of DSO can reveal much about their quality. Receivables do not improve with age
a. Compare the trend in DSOs or receivables turnover over a relevant time frame
b. Compare the DSO of one company with the DSOs of similar competitors over similar time
frames
3. Is it cash or accrual?
A high percentage of accounts receivables to revenues might mean nothing, but could also mean that
channel stuffing is taking place
a. Compare the percentage of accounts receivables to revenue over a relevant time frame
b. Compare the company's percentage of accounts receivable to revenues with that of
competitors or industry measures over similar time frames
4. Compare with the real world when possible
If a company reports non-financial data on a routine bases, try relating revenues to those data to
determine if trends in the revenue make sense
a. Airlines reporting extensive information about miles flown and capacity, enabling an analyst to
relate increases in revenues to increases in these
b. Retailers reporting square footage used and number of stores open
c. Companies across all industries reporting employee head counts
5. Revenue Trends and Composition
 Trend analysis can bring up questions for managers, or discomfort about quality of earnings
a. Trends in the relationships between types of revenue recognized
b. Relationship between overall revenue and accounts receivable
6. Relationships
Does the company transact business with entities owned by senior officers or shareholders?

Cost Capitalization Case

Property/Capital Expenditures Analysis

1. Improper capitalization of expenses can lead to higher operating cash flows, higher income, and higher
assets than otherwise
2. Look for trends in property plant and equipment over time

Looking for Quality in Expense Recognition

1. Start with the basics – Fully understand cost capitalization policies
a. What costs are capitalized in inventory? How is obsolescence accounted for? Are there reserves
established for obsolescence that might be artificially raised or lowered?
b. What are the depreciation policies, including depreciable lives? How do they compare with competitors'
policies? Have they changed from previous years?
2. Trend Analysis – Trend analysis over time and compare to competitors
a. Each quarter, non-current asset accounts should be examined for quarter to quarter and year to year
changes to see whether there are any unusual increases in costs.
b. Profit margins are often observed by analysts in the examination of quarterly earnings. They are not
often related to changes in the balance sheet, but they should be. If unusual build ups of non-current
assets as well as profit margins increasing, this is a bad sign.
c. Look at trends in turnover ratios for total assets and PPE. Decreasing revenues might mean that the
assets are used to make a product with declining demand and portend future asset write downs.
Increasing revenues and decreasing turnover might indicate improper cost capitalization.
d. Compute depreciation expense compared to relevant asset base. Compare to competitors.
e. Compare the relationship of capital expenditures with gross PPE over time. If the proportion is
increasing It may signify that the company is capitalizing costs more aggressively.
3. Relationships

Bankruptcy Prediction Models

Altman Model
 Z-Score Model
Net Working Capital Retained Earnings
Z-score=1.2 ( Total Assets ) (
+1.4
Total Assets )
+3.3 ¿

 Higher Z-score is better.

 Score of less than 1.81 indicated a high probability of bankruptcy
 Scores greater than 3 was a low probability
 Scores between 1.81 and 3 were not clear indicators

Developments in Bankruptcy Prediction Models

1. Altman model can be limited because it only uses one period of data, some models have been created
to incorporate past data as well
2. Altman model uses accounting numbers, and therefore assumes a going concern, which is obviously
not the case for companies that will go bankrupt
3. Market based models such as Merton's concept as equity as a call option on the company's assets can
be used to infer the default probability
LOS I - Describe indicators of cash flow quality.

Indicators of Cash Flow Quality

1. Operating cash flow is the cash flow component that is most important
2. High quality Operating Cash Flow OCF would have:
a. Positive OCF
b. OCF Derived from sustainable sources
c. OCF adequate to cover capital expenditures, dividends, and debt repayments
d. OCF with relatively low volatility (relative to industry participants)
3. OCF is less easily manipulated than Net Income
4. One can manipulate timing of cash flows
a. Selling receivables to a third party causes early recognition
i. Would increase DSO and decreases days of payables
5. Management may try to classify things differently between types of cash flows

LOS j – Evaluate the cash flow quality of a company.

Evaluating Cash Flow Quality

1. Look for outstanding items not usually included in cash flow statement
2. Be alert to year over year changes in classifications of the cash flow statement
a. Flexibility of accounting standards must be understood and accounted for

LOS k - Describe indicators of balance sheet quality.

LOS l - Evaluate the balance sheet quality of a company.

Balance Sheet Quality

1. High quality reporting is completeness, unbiased measurement, and clear presentation
2. High results quality is indicated by optimal mount of leverage, adequate liquidity, and economically
successful asset allocation
3. Watch out for off-balance sheet obligations
4. Examples of unbiased measurement
a. Understatement of impairment charges for inventory, PPE, equipment, and goodwill
i. Results in overstatement of assets and equity
b. Understatement of valuation allowance for deferred tax assets would understate tax expenses
and overstate the value of the assets
c. A company's investments in debt and equity of another company would ideally be based on
observable market data
i. Accounting models and inputs must be analysed
d. Pension liabilities require a lot of estimates

LOS m - Describe sources of information about risk.

Sources of Information about Risk

1. High leverage ratios can signal financial risk
2. Models that incorporate various data can signal bankruptcy risks
3. Audit opinions can provide information about reporting risk (not really timely)
4. Notes to the financial statements and MD&A are key