Reading 33 LOS's

Question 1

LOS 33a: Distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items)

Answer 1

Financial reporting quality refers to the usefulness of information contained in the financial reports, including disclosures in notes

• High-quality reporting provides information that is useful in invesment decision making in tha tit is relevant and faithfully represents the company’s performance and position

Earnings quality ( or quality of reported results) Pertains to earnings and cash generated by the company’s core economic activities and its resulting financial condition.

• High quality earnings 1) come from activites that the company will be able to sustain in the future and 2) provide an adequate return on the company’s investment

These two attributes are interrelated because earnings quality cannot be evaluated until there is some assurance regarding the quality of financial reporting. If financial reporting quality is low, the information provided is not useful in evaluating company performance or to make investment decisions

Question 2

LOS 33b: Describe a spectrum for assessing financial reporting quality

LOS 33c: Distinguish between conservative and aggressive accounting

Answer 2

The Quality Spectrum is described below, starting with the highest quality

GAAP, Decision-useful, Sustainable, and Adequate Returns

These are high quality reports that provide useful information about high-quality earnings

High quality financial reports:

• Confrom to the accounting standards acceptable in the company’s jurisdiction
• Adhere to all the characteristics of decision-useful information, which are relevance and faithful representation
• They also meet the enhancing characteristics of useful information as defined by the Conceptual Framework, including comparability, verifiability, timeliness, and understandability

High quality earnings indicate an adequate return on investments. Further, earnings must be derived from activities that the company will likely be able to sustain in the future. Sustainable earnings that provide a high return on investment increase company value

• An adequate level of return means a return that exceeds the cost of investment and also meets the expected return
• sustainable activities and sustainable earnings are those that are expected to recur in the future

GAAP, Decision - Useful, but Sustainable?

This level refers to a situation where high-quality reporting provides useful information, but the information reflected earnings that are not sustainable. earnings may be unsustainable because:

• the company cannot expect to earn the same level of return on investment in the future
• Earnings, though sustainable, will not generate a return on investment sufficient to sustain the company

Within GAAP, but biased accounting choices

Biased choices result in financial reports that do not faithfully represent the company’s true economic situation

• Management can make aggressive or conservative accounting choices, both of which go against the concept of neutrality. Investors may prefer conservative accounting, but biased reporting adversely affects a user’s ability to evaluate a company
  
  • Aggresive choices increase a company’s financial performance and position in the current period. These choices can 1) increase reported revenues 2) increase reported earnings 3) increase reported operating cash flow, 4) decrease reported expenses and/ or 5) decrease reported debt in the current period. NOTE that aggresive accounting choices in the current period may lead to depressed reported financial performance and financial position in later periods, thereby creating a sustainability issuer
  • Conservative Choices decrease a company’s reported financial performance and financial position in the current period. Do the opposite of above
• Another source of bias is understatement od earnings volatility. This can result from employing conservative assumptions to understate performance when the company is actually doing well and then using aggresive assumptions when the company is not doing well
• Aside from biases in determing reported amounts, biases can also creep into the way info is presented

Poor reporting quality often comes with poor earnings quality, as aggressive accounting assumptions may be employed to obscure poor performance. However it is also possible for poor reporting quality to come with high-quality earnings if:

• The company is unable to produce high quality reports due to inadequate intenal controls
• The company employs conservative accounting assumptions to make current performance look worse. A company may do this to avoid political attention or to keep hidden reserves

Within GAAP, but “Earnings Management”

Earnings management can be define as “making intentional choices or taking deliberate action to influence reported earnings and their interpretation. There are 2 ways earnings can be managed:

1. They can be managed by taking real actions
   
   • For example a company may defer R&D expenses until the next year to improve reported performance in the current year
2. They can be managed through accounting choices
   
   • For example, a company may change certain accounting estimates such as estimated product returns to manipulate reported performance

Departures from GAAP- Noncompliant Accounting

Financial info that deviates from GAAP is obviously low quality. Further such financial information cannot be used to assess earnings quality, as comparisons with other entities or earlier periods cannot be made

Departures from GAAP - Fictitious Transactions

There have been instances of companies using fictitious transactions to 1) fraudulently obtain investments by inflating company performance or 2) obscure fraudulent misappropriation of company assets

Differentiate between Conservative and Aggressive Accounting

When it comes to financail reporting, the ideal situation would be if financial reporting were ubiased. It may seem like investors would favor conservative accounting and managers would favor aggressive, however when it comes to establishing expectation of the future, neutral accounting works best.

Conservatism in Accounting standards

While neutrality is supported, there are some conservatively biased standards. An example is how recognition of revenues generally requires a higher level of verification than recognition of expenses. Other examples of conservatism in accounting standards inclue research costs, litigation costs, insurance recoverables, and commodity invetories

Benefits of Conservatism

• it may protect contracting parties with less information and higher risk
• It reduces the possibility of litigation
• Protects politicians and lawmakers, as it reduces the possibility that companies under their jurasdiction have overstated earnings or assets

Bias in the Application of Accounting Standards

In order to characterize the application of an accounting standard as conservative or aggressive, we must look at intent. Examples of biased accounting disguised as conservatism include:

• Big bath Behavior- this refers to the strategy of manipulating a company’s income statement to make poor results look even worse. This is done in a bad year, to lower expectations, which will hopefully lead to growth surprises
• Cookie jar reserve accounting - This refers to the practice of creating a liability when a company incurs an expense that cannot be directly linked to a specific accounting period

Question 3

LOS 33d: Describe motivations that might cause management to issue financial reports that are not high quality

Answer 3

Motivations

• To make 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 forecast. Exceeding forecasts typically increases the companies stock price (Equity Market Effects) and can increase management compensation (trade effects)
• To address managers’ concerns regarding their careers. Managers may be concerned that working for a company that is struggling would affect their future career opportunites adversely
• To avoid debt covenant violations

Question 4

LOS 33e: Describe conditions that are conductive to issuing low-quality, or even fraudulent, financial reports

Answer 4

These 3 conditions exist:

1. Opportunity Poor internal controls, an ineffective board of directors, or accounting standards that allow divergent choices and/or provide minimal consequences for inappropriate choice can give rise to opportunities for management to issue low-quality financial reports
2. _Motivation-_Can come from personal reasons or corporate reasons
3. Rationalization This is important because individuals need to justify their choices to themselves

Question 5

LOS 33f: Describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms

Answer 5

Markets: Companies compete for capital and the cost of capital is directly related to the level of perceived risk. In the absence of any other conflicting incentives, companies should aim to provide high-quality financial reports to minimize their long-term cost of capital

Regulatory Authorities market regulators establish and enforce rules. They directly affect financial reporting quality through:

• Registration Requirements- companies that plan to issue securities must register them with market regulators before offering them to the public
• Disclosure Requirements- Publicly traded companies are required to make periodic financial reports available to the public
• Auditing Requirements - Financial statements must be accompanied by an audit opinion certifying that presented financials confrom to standards
• Management Commentaries- Financial reports issued by publicly traded companies must include statements by management including a review of the company’s business and description of principal risks and uncertainties facing the company
• Responsibility Statements- persons responsible for the company’s filings are required to explicitly acknowledge responsibility

Auditors

while Public companies are required to have their financial statements audited by an independent auditor, private companies also obtain audit opinions

Limitations of Audit opinions:

• An audit opinion is based on info prepared by the company, so if a company deliberately intends to deceive an auditor, a review of provided info might not uncover misstatements
• An audit is based in a sample of info and the sample might not reveal 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 auditied bears the cost of the audit, so the auditor may be lenient.

Private Contracting

Parties that have a contractual agreement with a company have an inventive to monitor the company’s performance and to ensure that financial reports are of high quality. Consider the following provisions:

• Loan agreements contain covenants that if violated can result in a technical defaults of the borrower
• Certain investment contracts contain provisions that enable the investor to recover all or part of its investment if certain financial triggers occur

Question 6

LOS 33g: Describe presentation choices, including non GAAP measures that could be used to influence an anlaysts opinion.

Answer 6

Presentation Choices

During the Tech Boom, companies earnings couldn’t justify their extremely high stock price, so market participants tried to justify these valuations with metrics as “eyeballs captures” or the “stickiness” of websites.

Companies have also used “pro forma earnings”, where they remove certain restructuring charges to show they have good operating performance

Before 2001 there were 2 methods for acquisitions

1. pooling-of-interests method (no longer permitted), did not result in goodwill amortization charges going forward
2. The purchase method, which entail significant goodwill chares

The companies that had to use the purchase method felt at a disadvantage, so to make up for it they stopped reporting amortizing charges all together

EBITDA has been widely used because it is the earnings before certain accounting policies can manipulate them. Companies are now finding a way to manipulate EBITA by excluding items such as:

• Rental payments for operating leases
• Equity-based compensation
• Acqusition-related charges
• Impairment charges for goodwill and long-lived assets
• Litigation Costs

Question 7

LOS 33h: Describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items

Answer 7

Revenue Recognition

• Does the company recognize revenue upon shipment (FOB shipping point) or upon delivery (FOB destination) of goods?
  
  • Sometimes management will push shipments (called channel stuffing) out the door under FOB shipping point arrangements to recognize revenues in the current accounting period. If the ratio of accounts receivable to revenues is high, there is a chance of channel stuffing
  • At other times management may set shipping terms as FOB destination, because there was an overabundance of orders during the current period and it does not want analysts to get too optimistic
• A company can reduce its allowance for sales returns as a proportion of sales to reduce expenses and increase profits. Analysts should examine whether the company’s actual collection experience has tended to be different from histroical provisions
• If company participates in “bill and hold” transactions (where customer pays but has good remain with seller till later date), it is possible that it is recognizing fictitious sales by reclassifying end-of -period inventory as “sold but held”
• If the company seperates its revenue arrangements into multiple deliverables of goods or services, investors should look out for any changes in the allocation of revenue across deliverables

Depreciation Policies Regarding Long-Lived Assets

• Companies can use changes in depreciation estimates and depreciation methods to manipulate reported earnings and profits
• If the company has recorded significant asset write-downs in the recent past, it may suggest that the company’s policies relating to asset lives need to be examined

Capitalization Policies Relating to Intangibles

• In classifying a payment made, management must determine whether the payment will benefit the company only in the current period(making it an expense) or whether it will benefit the company in future periods ( capitalized as an asset)
• In accounting for an acquisition, the purchase price must be allocated to different assets acquired based on their fair values. management may use low fair-value estimates in order to depress future depreciation expense and inflate future profitability
• Goodwill reporting brings further avenues for manipulation. Since it is neither depreciated or amortized, companies must decide whether goodwill is recoverable. If it is not, goodwill must be written down
• Analysts should also examine how the company’s capitalization policies compare with the competition and determine whether its amortization policies are reasonable

Inventory Cost Methods

In a period of rising prices and stable or increasing inventory quantities:

• LIFO COGS is greater than FIFO COGS, which results in greater profitability under FIFO
• FIFO Ending Inventory is greater than LIFO EI, which results in greater liquidity/solvency under FIFO
• Analysts should determine how a company’s inventory methods compare with others in its industry
• If the company uses reserves for obsolescence in its inventory valuation, unusual fluctuations in this reserve might suggest that the company is manipulating them to attain a desired level of earnings
• If a company uses LIFO in an inflationary environment, it can temporarily increase reported profits through LIFO liquidation

Deferred Tax Assets and Valuation Accounts

Company’s can carry losses forward to reduce their taxes payable. In order to recognize these deferred tax assets, there must be an expectation that the company will generate enough taxable income in the future. Otherwise the value of these tax assets must be reduced through a contra asset account known as the valuation allowance

• Analysts must evaluate whether the company’s estimate of the valuation allowance is reasonable given its current operating environment and future prospects. Specifically they should:
  
  • Determine whether there are contradictions between the management commentary and the allowance level
  • Look for changes in the tax asset valuation account

Warranty Reserves

Analysts should examine whether these reserves have been manipulated to meet earnings targets. Further the trend in actual costs relative to amounts allocated to reserves should be assessed, as it can offer insight into the quality of products sold

Related Party Transactions

If the company engages in extensive dealings with nonpublic companies under management control, the nonpublic companies could be used to absorb losses in order to improve the public company’s reported performance

Choices that affect the cash flow statement

Many investory scutinize the operating section of the cash flow statement in detail, as they believe that operating cash flow serves as a reality check on earnings; significant earnings that can be attributed to accrual accounting and are unsupported by actual cash generation may indicate earnings manipulation. The operating section can still be managed in the following ways:

• 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 results in an increase in cash generated from operations. To detect this analysts could:
  
  • Examine changes in working capital to look for unusual patterns that may indicate manipulation of cash provided from operations
  • Compare the company’s cash generation with the cash operating performance of its competitors
  • Compare the relationship between cash generated from operations and net income.
• Misclassifying cash flows: A company may misclassify uses of operating cash flow into the investing or financing section of the cash flow statement to inflate cash generated from operating activities
• Taking advantage of flexibility in cash flow statement reporting:
  
  • In certain ares where investors may not even be aware that choices exist, accounting standards offer companies the flexibility to manage cash generated from operations
  • Certain jurisdictions offer significant flexibility in classification of certain cash flows

Question 8

LOS 33i: Describe accounting warning signs and methods for detecting manipulation of information in financial reports

Answer 8

Warning Signs related to Revenue

Analysts should:

• Determine whether company policies make it easy to prematurely recognize revenue by allowing use of FOB shipping point terms and bill-and-hold arrangements
• Determine whther a significant portion of revenues comes from barter transactions
• Evaluate the impact of estimate relating to the company’s rebate programs on revenue recognition
• look for sufficient clarity regarding revenue recognition practices relating to each item or service delivered under multiple-deliverable arrangements of goods and services
• Determine whether the company’s revenue growth is in line with its competitors, its industry, and the overall economy
• Determine whether receivables are increasing as a percentage of sales
• Determine whether there are any unusual changes in the trend in receivables turnover and seek an explanation for any changes
• Compare the company’s receivables turnover (or DSO) with competitors, and look out for suggestions that revenues have been recognized prematurely of that provision for doubtful accounts is insufficient

Warning Signs Related to Inventories

Analysts should:

• Compare growth in inventories with competitors and industry benchmarks
  
  • If inventory levels are increasing with no accompanying increase in sales it could suggest 1) poor inventory management or 2) inventory obsolescence.
• Compute the inventory turnover ratio
  
  • Declining inventory turnover could also suggest inventory obsolescence
• Check for inflated profits through LIFO liquidations

Warning Signs related to Capitalization Policies and Deferred Costs

Analysts should examine the company’s accounting policy notes for its capitalization policy for long-term assets and for its handling of other deferred costs, and compare those policies with industry practice.

Warning Signs Related to the Relationship between Cash Flow and Income

If a company’s net income is persistently higher than cash provided by operations, it raises the possibility that aggressive accrual accounting policies have been used to shift current expenses to later periods. Analysts may construct a time series of cash generated by operations divided by net income. If the ratio is consistently below 1.0, or has declined consistently, there may be a problem in the company’s accrual accounts

Other Potential Warning Signs

• Depreciation methods and useful lives - Analysts should compare a company’s policies with those of its competitors to determine whether they are significantly different
• Fourth-quarter surprises- Analysts should be concerned if the first 3 quarters dissapoint and then there is a great surprise in the fourth
• Presence of related-party transactions - Related-party transactions are often an issue when company founders are still involved in its day-to-day running, and have their own wealth and reputations tied to the company’s performance
• Nonoperating income and one-time sales included in revenue - A company may engage in such behavior to cover weak revenue growth
• Classification of an expense as nonrecurring - This would inflate reported operating profits
• Gross/operating margins out of line with competitors or industry- Could be good or bad, point is further analysis is needed
• Younger companies with unblemished record of meeting growth projections - The company can be tempted to keep their success in meeting expectations by manipulating financial info
• Management has adopted a minimalist approach to disclosure - Analysts should be concerned when large companies only have one reportable segment, or when management commetary is similar from period to period
• Management fixation on earnings reports- Analysts should be wary of companies whose management is obsessed with reported earnings, as this may be to the detriment of real drivers of value