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Reading 29: Financial Reporting Quality (Manipulative accounting methods…
Reading 29: Financial Reporting Quality
Financial Reporting Quality vs. Quality of Reported Results
Financial Reporting Quality
The characteristics of a Financial Statement.
Financial reporting quality is high, if
Reporting is compliant with GAAP, IFRS
Information is relevant, neutral, complete, free from errors, and decision-useful
Statement faithfully represent economic reality of activities and financial position
Quality of Reported Results
The level and sustainability of a firm's earnings, cash flows and balance sheet items.
High-quality earnings are high enough to provide the firm's investor with adequate return and are sustainable in the future period.
Earning quality is high, if
Earnings are sustainable
Earnings provide adequate return to investors
Financial Reporting Quality Spectrum
(regarding FS quality and Earnings quality)
Highest: Reporting is compliant with GAAP and decision-useful; earnings are sustainable and adequate.
Reporting is compliant and decision-useful, but earning quality is low
Reporting is compliant; but reporting choices and estimates are biased; earning quality is low
Reporting is compliant; but earnings are actively manipulated
Reporting is not compliant, but numbers presented are based on actual economic activities
Reporting is not compliant, having fictitious/fraudulent data
Conservative vs. Agressive Accounting
Conservative Accounting
Tend to decrease a company's reported earnings and financial position for current period.
Agressive Accounting
Tend to increase reported earnings or financial position for the current period.
Biased accounting choices
Employing conservative accounting during high-earning period and aggressive accounting during low-earning period to artificially smooth earnings.
Emphasizing good news and/or obscuring bad news
Financial reports are most decision-useful when they are unbiased (neutral)
Low-quality Reporting
Motivations
Career considerations
Increase compensation
Improve perception for the firm in public
Meet the terms of debt covenant.
Pressure to meet or exceed earning targets.
Increase stock price
Conditions that encouraging low-quality report
Opportunities
Weak internal control
Inadequate oversight (no-one checks management)
Wide ranges of acceptable accounting treatment
Minimal consequences (punishment) for inappropriate choices
Rationalization: Managers develop reasons to justify behavior
Financial Reporting Quality Discipline mechanism
Government regulation
Securities registration
Disclosure and auditing requirements
Management commentary, review of business, principal risks and uncertainties
Management responsibility for reporting
Enforcement: fines, suspension, prosecution
Auditing
Clean Audit opinion offer assurance that FS are free from material errors but DOES NOT GUARANTEE there is no error or fraud.
Auditors provide opinion on financial reporting
Auditor is selected, paid by companies
Private contracts
may have loan covenants, specific methods to calculate accounting measures, financial triggers for return of investment
Non-GAAP Presentation Choices
Can be used to attempt to influence analyst's opinion
IFRS requires firms to define and explain any non-GAAP measures and reconcile them with the most comparable IFRS measures.
Companies may present non-GAAP (pro forma) accounting measures designed to influence analysts' earnings expectations and valuations
Non-GAAP measures often remove negative items
GAAP: non-GAAP measure cannot be more prominent than GAAP equivalents; must have reconciliation with GAAP measures
Manipulative accounting methods
Revenue recognition
Shipping terms: recognize at shipping point or destination
Discounts to increase orders in current period
Delay shipments to defer revenue to later period
Increase shipments to distributors ("channel stuffing")
Bill-and-hold transactions: recognize revenue for goods that have not been shipped
Estimates of reserves for uncollectible account or warranty expenses
Management of accruals: allowance for bad debt, warranty expense
Depreciation method: Straight-line versus accelerated;
this is a change in account estimate, a.k.a companies do not have to restate prior year's number
Depreciation estimates: Economic life, salvage value
(GAAP only) Valuation allowance on deferred tax assets
Valuation allowance shows the amount of deferred tax asset that you may not be able to utilize in the future
Higher valuation allowance -> reduce deferred tax asset (in BS) but also increase tax expense (IS) and thus reduce net income
Inventory cost flow methods
With increasing prices, FIFO CoGS < Weighted-average CoGS < (GAAP only) LIFO CoGS
Capitalization of expense
Capitalization defers expenses to future periods
Related-party transactions.
Can move earnings into or out of the firm
Transfer to other non-public companies controlled by director
Companies must disclose related parties that are under control of the current management
Impairments
Delaying recognition of impairment charges
Asset carrying value > fair value, thus must be written down
Managing CFO
Capitalization of purchases
Stretching payables
Capitalizing construction interest
IFRS has flexibility
Classifying interest and dividends paid as CFF (rather than CFO)
Classifying dividends and interest received as CFO (rather than CFF)
Accounting warning signs & Manipulation Detecting Methods
Accounting warning signs
Only means that more analysis is required
Revenue
growth out of line with peers
Change in revenue recognition method
Bill-and-hold transactions
Changes in rebate estimates
Receivables turnover, total asset turnover decreasing over time
Non-operating or one-time items included in revenue
Net income not supported by CFO
Forth-quarter earning pattern not caused by seasonality
Frequent appearance of non-recurring items
Emphasis on non-GAAP measures, Lack of transparency in disclosure in Financial Report.
Inventory
Inventory turnover ratio declining over time
Decrease in inventory under LIFO; results in unsustainably low CoGS
Capitalization
Capitalization of costs that industry peers do not capitalize
Ratio of CFO to net income is consistently < 1 or declining over time
Depreciation methods, useful lives, salvage values out of line with peers
Significant related-party transactions