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Financial Reporting Quality
Terms in this set (12)
What criteria do we use to determine if financial reporting is high quality?
Aside from adherence to GAAP (or IFRS) financial reporting is the base criteria. But because managers still have significant discretion we should also look for financial reporting that is:
- Decision useful
- Relevant - Timely, material
- A faithful representation of the facts - Complete, neutral, error free
Essentially we want management to clearly present financial results in a way that is easy to interpret and helpful in understanding the results and how they were obtained.
What criteria defines high quality earnings?
Here we are referring to the quality of the earnings themselves not the way they are reported.
High quality earnings should be judged based on:
- The sustainability of the earnings
- Can be measured as the % of earnings expected to continue in the future
- Look for greater market share and or greater efficiency
- The level of the earnings and margins
- High enough to sustain company's existence over time
- Provide an adequate return to investors
- The quality of the balance sheet
What is a common spectrum for assessing financial reporting quality?
This is just one framework:
1. Best: Decision useful, GAAP compliant, sustainable & adequate earnings
2. 2nd Best: Decision useful, GAAP compliant, low earnings quality
3. Middle: GAAP compliant, biased reporting choices/estimates, low earnings quality
4. Lower Middle: GAAP compliant, earnings actively managed or massaged
5. Getting terrible: Not compliant, but earnings are accurate reflections
6. Worst: Not compliant, fictiuous or fraudulent numbers are reported
Why might management report low quality earnings?
Managers are human, they may have career, financial, or reputation tied up in their company's earnings.
Specific goals might include:
- Meeting or exceeding EPS benchmarks, especially when tied to compensation
- Beating earnings guidance
Avoiding negative debt covenants (for highly levered companies)
Improving perception of the firm with customers/suppliers
Note: When benchmarks are beat management might employ conservative principles in order to "bank" earnings for future period.
How can a manager "improve" performance in either the current period or later period?
Improve performance in the current period
- Prematurely recognize revenue
- Increase profit via non-recurring transactions (sell something)
- Defer expenses to later periods
- Remeasure assets (liabilities) at a higher (lower) value
Improve performance in later periods
- Save current income to be reported later
- Recognize future expenses in the current period
What distinguishes conservative accounting from aggressive accounting?
In general something is considered conservative accounting when it decreases the company's reported earnings and erodes its balance sheet for the current period. This will tend to increase reported earnings in future periods.
Aggressive accounting would increase reported earnings and improve the balance sheet for the current period. The problem with aggressive accounting is that it will often result in decreased earnings in future periods.
Management may alternate between conservative and aggressive to try to smooth earnings (by adjusting accrued liabilities). Thus during periods of higher expected earnings management may adjust accrued liabilities up & reduce earnings and change tactics during periods of lower expected earnings.
Note conservative and aggressive choices are not inherently good/bad
Distinguish between common examples of aggressive and conservative accounting
Remember most of the differences result in how we treat deferred liabilities.
Aggressive vs. Conservative Accounting Practices
- Using straight-line depreciation
- Capitalizing current period costs
- Lengthening estimate of useful life of depreciable assets
- Increasing estimate of salvage values
- Delaying recognition of impairments
- Taking smaller valuation allowances on DTAs
- Using accelerated depreciation methods
- Expensing current period costs
- Lowering estimate of useful life of depreciable assets
- Decreasing estimate of salvage values
- Early recognition of impairments
- Larger valuation allowances on DTAs
What internal company conditions can increase the odds of low-quality financial reporting?
Low quality or fraudulent financial reporting usually stems from a combination of motivation, opportunity, and rationalization.
- Weak internal company controls
- The board of directors fails to provide oversight
- Relevant accounting standards provide significant discretionary latitude
- Penalties for fraud are minimal or nonexistent
What are the features of a strong regulatory regime?
A strong regulatory framework with enforceable rules can provide a valuable mechanism for promoting and enforcing financial reporting quality. Requirements can include:
- Registrations requirements for newly traded securities & established review process
- Disclosure requirements including periodic reporting and notes
- Independent auditing
- Mandated management commentary on the reports & sign-off
Private (debt) agreements can also impose discipline as these third parties will have incentive to monitor the firms quite closely. A clean audit offers reasonable assurance that the statements are free of error but doesn't guarantee absence of fraud.
What are warning signs regarding revenue recognition that an analyst should pay attention to?
- Revenue growth way out of line with comparable companies
- Decreasing receivables turnover over multiple accounting periods
- Decreases in asset turnover, especially when a company is growing via acquisition
- Changes in the revenue recognition method
- Use of bill-and-hold transactions or barter transactions or channel stuffing
- Using rebate programs that require estimating rebate impact on revenue
- Inclusion of non-operating items / significant one-time sales in revenue
What are warning signs regarding inventory that an analyst should pay attention to?
- Falling inventory turnover ratios
- LIFO liquidation in order to lower COGS for the current period (during inflationary periods)
- Inventory growth that is out of line with industry benchmarks
What are the other warning signs regarding capitalization, cash flow, etc that an analyst should pay attention to when evaluating a firm's financial reporting?
- Capitalizing costs when other comparable companies are expensing them
- A CFO ratio < 1 or consistently declining net income
- A depreciation method / useful life estimate out of line with the industry
- Classifying expenses as non-recurring
- Gross margins out of line with industry
- Minimal disclosures and financial footnotes
- Management appears fixated on earnings reports
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