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CHAPTER 11

FINANCIAL REPORTING QUALITY


Presenters name
Presenters title
dd Month yyyy

FINANCIAL REPORTING QUALITY VS. QUALITY


OF REPORTED RESULTS
Financial Reporting Quality
Decision-useful information
Faithful representation of
economic reality
Compliant with standards

Quality of Reported Results (aka


Earnings Quality)
Sustainable activity
Adequate returns
Increases the companys value

FINANCIAL REPORTING QUALITY AND


EARNINGS QUALITY ARE INTERRELATED

QUALITY SPECTRUM OF FINANCIAL REPORTS

QUALITY SPECTRUM OF FINANCIAL REPORTS


Excerpt from Toyota Motor Corporations
Consolidated Financial Results
Consolidated vehicle unit sales in
Japan and overseas decreased by 37
thousand units, or 1.6%, to 2,232
thousand units in FY2014 first quarter
compared with FY2013 first quarter
operating income increased by
310.2 billion, or 87.9%, to 663.3 billion
in FY2014 first quarter compared with
FY2013 first quarter. The factors
contributing to an increase in operating
income were the effects of changes in
exchange rates of 260.0 billion...

QUALITY SPECTRUM OF FINANCIAL REPORTS


Biased accounting choices,
assumptions, estimates:
- Aggressive choices increase a
companys reported performance
and financial position in the current
period.
- Conservative choices decrease
current reported performance but
may increase future reported.
Biased presentation choices:
- Obscure unfavorable information
and/or
- Emphasize favorable information.

QUALITY SPECTRUM OF FINANCIAL REPORTS


TRUMP HOTELS & CASINO
RESORTS THIRD QUARTER
RESULTS
October 25, 1999
EBITDA INCREASED TO $106.7
MILLION VS. $90.6 MILLION IN 1998
NET PROFIT INCREASED TO 63
CENTS PER SHARE VS. 24 CENTS
PER SHARE IN 1998
Net income increased to $14.0
million or $0.63 per share, before a
one-time Trump Worlds Fair charge,
compared to $5.3 million or $0.24 per
share in 1998.

QUALITY SPECTRUM OF FINANCIAL REPORTS


EBITDA INCREASED TO $106.7
MILLION VS. $90.6 MILLION IN 1998
NET PROFIT INCREASED TO 63
CENTS PER SHARE VS. 24 CENTS
PER SHARE IN 1998
Net income increased to $14.0 million
or $0.63 per share, before a one-time
Trump Worlds Fair charge, compared to
$5.3 million or $0.24 per share in 1998.
The problem?
EBITDA of $106.7 excluded a one-time
charge but included a one-time gain.
GAAP Net Incomenot shown in this
excerptwas $67.5 million loss, not a
$14 million profit.

QUALITY SPECTRUM OF FINANCIAL REPORTS


Earnings Management:
Deliberate actions to influence
reported earnings
- Real Earnings Management, for
example:
Defer R&D expenses into the next
quarter in order to meet earnings
targets.
- Accounting Earnings Management,
for example:
Change accounting estimates in
order to meet earnings targets.

QUALITY SPECTRUM OF FINANCIAL REPORTS


Non-Compliant Accounting
Enron (2001) used special purpose
entities to understate debt and
overstate profits and cash flow
WorldCom (2002) capitalized certain
expenditures to understate
expenses and thus overstate
earnings and operating cash flow
New Century Financial (2007)
reserved minimal amounts for loan
repurchase losses for subprime
mortgages.

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QUALITY SPECTRUM OF FINANCIAL REPORTS


Fictitious Transactions
Equity Funding Corp. (1970s)
created fictitious revenues and even
fictitious policy holders.
Crazy Eddies (1980s) reported
fictitious inventory as well as
fictitious revenues supported by fake
invoices.
Parmalat (2004) reported fictitious
bank balances.

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MOTIVATIONS POTENTIALLY ASSOCIATED


WITH LOW FINANCIAL REPORTING QUALITY
Mask poor performance (e.g., declining profitability or lower profitability than
competitors)
Meet or beat market expectations (e.g., analysts forecasts and/or
managements guidance)
- Increase stock price, if only temporarily
- Increase credibility with market participants
Increase compensation that is linked to reported earnings
Avoid violation of debt covenants

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CONDITIONS CONDUCIVE TO ISSUING LOWQUALITY FINANCIAL REPORTS

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MECHANISMS THAT DISCIPLINE FINANCIAL


REPORTING QUALITY

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MECHANISMS THAT DISCIPLINE FINANCIAL


REPORTING QUALITY

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MECHANISMS THAT DISCIPLINE FINANCIAL


REPORTING QUALITY

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MECHANISMS THAT DISCIPLINE FINANCIAL


REPORTING QUALITY POTENTIAL LIMITATIONS
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COMPANIES PRESENTATION CHOICES


What information to presentbeyond required disclosures?
- Operating metrics (eyeballs, clicks, users)
- Pro forma measures (a.k.a. Non-GAAP or non-IFRS measures)
How to present the information?
- Emphasize the positive aspects of performance
- Include boilerplate and excessive or irrelevant detail

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PRESENTATION CHOICES:
GROUPONS NON-GAAP METRIC
Originally Shown
(June S-1 filing)

After SECs Review


(November S-1 filing)

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ACCOUNTING CHOICES
Choices exist among accounting methods and estimates, including the following:
Revenue recognition
- Timing
- Amounts
Expense recognition
- Inventory cost flow
- Capitalizing versus expensing
- Depreciation method and estimates
- Allowances for realization of assets

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ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Trade-offs exist, and investors should be aware of how accounting choices
affect financial reports.
FIFO (first-in-first-out) cost assumption:
- More current costs are included in ending inventory on the balance sheet.
- Older costs are included in cost of sales on the income statement.
Weighted-average cost assumption:
- A blend of old and new costs in inventory on the balance sheetnot as
current as with FIFO.
- A blend of old and new costs in cost of sales on the income statementmore
current than with FIFO.

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ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Units Cost per Unit Total Cost
Purchase 1
5
$100
$500
Purchase 2
5
150
750
Purchase 3
5
180
900
Purchase 4
5
200
1,000
Purchase 5
5
240
1,200
Cost of goods available for sale
$4,350
A company starts operations with no inventory at the beginning of
a fiscal year and makes five purchases of goods for resale, as
shown in the table. During the period, the company sells all of the
goods purchased except for five units.
What are the ending inventory and cost of goods sold if the
company uses the FIFO method of inventory costing?

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ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Units Cost per Unit Total Cost
Purchase 1
5
$100
$500
Purchase 2
5
150
750
Purchase 3
5
180
900
Purchase 4
5
200
1,000
Purchase 5
5
240
1,200
Cost of goods available for sale
$4,350

First costs in are


first costs out to
cost of goods
sold: $3,150
Last in are in ending
inventory $1,200

A company starts operations with no inventory at the beginning of


a fiscal year and makes five purchases of goods for resale, as
shown in the table. During the period, the company sells all of the
goods purchased except for five units.
What are the ending inventory and cost of goods sold if the
company uses the FIFO method of inventory costing?

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ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Units Cost per Unit Total Cost
Purchase 1
5
$100
$500
Purchase 2
5
150
750
Purchase 3
5
180
900
Purchase 4
5
200
1,000
Purchase 5
5
240
1,200
Cost of goods available for sale
$4,350

First costs in are


first costs out to
cost of goods
sold: $3,150
Last in are in ending
inventory: $1,200

A company starts operations with no inventory at the beginning of


a fiscal year and makes five purchases of goods for resale, as
shown in the table. During the period, the company sells all of the
goods purchased except for five units.
What are the ending inventory and cost of goods sold if the
company uses the FIFO method of inventory costing?

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ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Units Cost per Unit Total Cost
Purchase 1
5
$100
$500
Purchase 2
5
150
750
Purchase 3
5
180
900
Purchase 4
5
200
1,000
Purchase 5
5
240
1,200
Cost of goods available for sale
$4,350
A company starts operations with no inventory at the beginning of
a fiscal year and makes five purchases of goods for resale, as
shown in the table. During the period, the company sells all of the
goods purchased except for five units.
What are the ending inventory and cost of goods sold if the
company uses the weighted-average method of inventory
costing?
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ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Purchase 1
Purchase 2
Purchase 3
Purchase 4
Purchase 5

Units
5
5
5
5
5

Cost per Unit


Total Cost
$100
$500
150
750
180
900
200
1,000
240
1,200

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Cost of goods available for sale

$4,350

A company starts operations with no inventory at the


beginning of a fiscal year and makes five purchases of
goods for resale, as shown in the table. During the
period, the company sells all of the goods purchased
except for five units.

Average cost
per unit =
$4,350/25
units = $174
Ending
inventory =
5 $174 =
$870

Cost of
goods sold =
20 $174 =
What are the ending inventory and cost of goods sold
$3,480
if the company uses the weighted-average method of
inventory costing?

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ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS

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ACCOUNTING CHOICES: CAPITALIZING VS.


EXPENSING AN EXPENDITURE
Capitalizing versus expensing affects cash flows as well as earnings and the
balance sheet. Assume a company incurs total interest cost of $30,000,
composed of $3,000 discount amortization and $27,000 interest payments. Of
the total, $20,000 is expensed and the remaining $10,000 is capitalized as plant
assets. The following cash flow classification alternatives for the $27,000 exist:
Operating

$18,000

Investing

$9,000

Offset the entire $3,000 of non-cash discount


II. amortization against the $20,000 treated as
expense and included in operating cash flow

Operating

$17,000

Investing

$10,000

Offset the entire $3,000 of non-cash discount


III. amortization against the $10,000 capitalized and
included in financing cash flow

Operating

$20,000

Investing

$7,000

I.

Use the same interest expense/capitalization


proportions to allocate the interest payments
between operating and investing activities

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ACCOUNTING CHOICES: CASH FLOW


CLASSIFICATION
Presentation choices permitted in IAS 7, Statement of Cash Flows, offer flexibility in
classification of certain items on the cash flow statement that is not available under US
GAAP.
This flexibility can significantly change the results in the operating section of the cash flow
statement.
IAS 7, Paragraphs 33: Interest paid and interest and dividends received are usually
classified as operating cash flows for a financial institution. However, there is no
consensus on the classification of these cash flows for other entities. Interest paid and
interest and dividends received may be classified as operating cash flows because they
enter into the determination of profit or loss. Alternatively, interest paid and interest and
dividends received may be classified as financing cash flows and investing cash flows
respectively, because they are costs of obtaining financial resources or returns on
investments. [Emphasis added.]
IAS 7, Paragraph 34: Dividends paid may be classified as a financing cash flow because
they are a cost of obtaining financial resources. Alternatively, dividends paid may be
classified as a component of cash flows from operating activities in order to assist users to
determine the ability of an entity to pay dividends out of operating cash flows. [Emphasis
added.]
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SUMMARY OF ANALYSTS CONSIDERATIONS:


REVENUE RECOGNITION
Timing of revenue recognition
Multiple deliverables
Allowances for sales returns
Days sales outstanding
Rebates

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ANALYTICAL PROCEDURES TO DETECT


WARNING SIGNS: REVENUE RECOGNITION
Examine the accounting policies note for a companys revenue recognition
policies.
Consider whether the policies make it easier to prematurely recognize revenue
- Recognizing revenue immediately upon shipment of goods
- Bill-and-hold arrangements
Consider estimates and judgments required by the policies
- Barter transactions can be difficult to value properly
- Rebate programs involve many estimates
- Multiple-deliverable arrangements require allocation of revenue and timing of
revenue recognition for each item or service

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ANALYTICAL PROCEDURES TO DETECT WARNING


SIGNS: REVENUE RECOGNITION (CONTINUED)
Look at revenue relationships.
Compare a companys revenue growth with its primary competitors or its
industry peer group and understand the reasons for major differences
- Superior management or products and services?
- Revenue quality?
Compare accounts receivable with revenues
- Examine the trend in receivables as a percentage of total revenues.
- Examine the trend in receivables turnover for unusual changes and seek an
explanation if they exist.
- Compare a companys days sales outstanding (DSO) or receivables turnover
with that of relevant competitors or an industry peer group.
Examine asset turnover

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SUMMARY OF ANALYSTS CONSIDERATIONS:


INVENTORY METHODS
Method compared with competitors
Reserves for obsolescence
LIFO liquidation

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ANALYTICAL PROCEDURES TO DETECT


WARNING SIGNS: INVENTORY
Look at inventory relationships.
Compare a companys inventory growthrelative to sales growthwith its
primary competitors or its industry peer group and understand the reasons for
major differences
Examine trend in inventory turnover
- Poor inventory management?
- Obsolescence? Future write-offs?
- Overstated current gross and net profits?
If company uses LIFO (allowed under US GAAP), note whether LIFO
liquidations occurred

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SUMMARY OF ANALYSTS CONSIDERATIONS:


LONG-LIVED ASSETS
Estimated life spans compared with others in the same industry
Changes in depreciable lives
Asset write-downs
Policies compared with competitors
Capitalization

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ANALYTICAL PROCEDURES TO DETECT


WARNING SIGNS: LONG-LIVED ASSETS
Examine the companys accounting policy note for its capitalization policy for
long-term assets, including interest costs, and for its handling of other deferred
costs.
Compare the companys policy with industry practice.
If the companys policy is an outlier, cross-check asset turnover and profitability
margins with others in the industry.

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ANALYTICAL PROCEDURES TO DETECT WARNING


SIGNS: OPERATING CASH FLOW VS. NET INCOME
Pay attention to the relationship of cash flow and net income.
If net income is consistently higher than operating cash flow, it can signal
accrual accounting policies that shift revenue to current period and/or current
expenses to later periods.
Construct a time series of cash generated by operations divided by net income.
If the ratio is consistently below 1.0 or has declined repeatedly, there may be
problems in the companys accrual accounts.

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ALLOWANCE FOR BAD DEBT


. . . Generally, UAPs policy required that accounts which were past due
between 90 days and one year should be reserved at 50%, and accounts over
one year past due were to be reserved at 100%.
. . . In FY 1999 and continuing through FY 2000, UAP had substantial bad debt
problems. In FY 2000, certain former UAP senior executives were informed that
UAP needed to record an additional $50 million of bad debt expense. . . .just
prior to the end of UAPs FY 2000, the former UAP COO (chief operating officer),
in the presence of other UAP employees, ordered that UAPs bad debt reserve
be reduced by $7 million in order to assist the Company in meeting its PBT
target for the fiscal year. . . At the end of FY 2000, former UAP senior executives
reported financial results to ConAgra which they knew, or were reckless in not
knowing, overstated UAPs income before income taxes because UAP had
failed to record sufficient bad debt expense.
SEC Accounting and Auditing Enforcement Release
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VALUATION RESERVE FOR DEFERRED TAX


ASSETS
PowerLinx improperly recorded on its fiscal year 2000 balance sheet a deferred
tax asset of $1,439,322 without any valuation allowance. The tax asset was
material, representing almost forty percent of PowerLinxs total assets of
$3,841,944. PowerLinx also recorded deferred tax assets of $180,613, $72,907, and
$44,921, respectively, in its financial statements for the first three quarters of 2000.
PowerLinx did not have a proper basis for recording the deferred tax assets.
The company had accumulated significant losses in 2000 and had no
historical operating basis from which to conclude that it would be profitable in
future years. Underwater camera sales had declined significantly and the company
had devoted most of its resources to developing its SecureView product. The sole
basis for PowerLinxs expectation of future profitability was the purported $9 million
backlog of SecureView orders, which management assumed would generate
taxable income; however, this purported backlog. . . did not reflect actual demand
for SecureView cameras and, consequently, was not a reasonable or reliable
indicator of future profitability.
SEC Accounting and Auditing Enforcement Release
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ANALYTICAL PROCEDURES TO DETECT


WARNING SIGNS: ALLOWANCES
Examine allowances for which estimates can impact earnings, for example:
Accounts Receivable Allowance for Doubtful Accounts
- Examine changes in allowances as a percentage of the asset account.
- Collection experience.
Tax Asset Valuation Accounts
- Assess reasonableness of level.
- Examine changes in the valuation account.
- Compare allowance level with information in the management commentary.
- Compare allowance level with information in the tax note.

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OTHER POTENTIAL WARNING SIGNS:


AREAS THAT MIGHT SUGGEST FURTHER ANALYSIS
Depreciation methods and useful lives compared with those of its peers
Fourth-quarter surprises routinely occurring
Presence of related-party transactions
Non-operating income or one-time sales included in revenue
Classification of expenses as non-recurring
Gross/operating margins out of line with competitors or industry, an ambivalent
signal.

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IMPORTANCE OF CONTEXT IN JUDGING


WARNING SIGNS
Companies with an unblemished record of meeting growth projections
(especially younger companies)
Minimalist approach to disclosurefor example, highly aggregated segment
reporting
Fixation on reported earningsfor example, the use of aggressive non-GAAP
metrics or frequent special items
Restructuring and/or impairment charges
Merger and acquisition activity, including allocation of purchase price in an
acquisition

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SUMMARY
Financial reporting quality can be thought of as spanning a continuum.
Reporting quality pertains to the information disclosed whereas results quality
(commonly referred to as earnings quality) pertains to the earnings and cash
generated by the companys actual economic activities.
Motivations to issue lower-quality financial reports include masking poor
performance, boosting the stock price, increasing personal compensation, and/or
avoiding violation of debt covenants.
Mechanisms that discipline financial reporting quality include the free market and
incentives for companies to minimize cost of capital, auditors, contract provisions,
and enforcement by regulatory entities.
Examples of accounting choices that affect earnings and balance sheets include
revenue recognition, inventory cost flow assumptions, estimates of realizability of
assets (such as accounts receivable and deferred tax assets), depreciation
method, estimated salvage value, and useful life of depreciable assets.
Warning signals of potential accounting manipulation should be evaluated
cohesively, not on an isolated basis.
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