Level II - Financial Reporting and Analysis

Evaluating Quality of Financial Reports

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Reproduced and republished with permission from CFA Institute. All rights reserved.
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 Contents
1. Introduction
2. Quality of Financial Reports
3. Evaluating the Quality of Financial Reports
4. Earnings Quality
5. Cash Flow Quality
6. Balance Sheet Quality
7. Sources of Information about Risk

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 1. Introduction
• Quality of financial reports can vary greatly
 High-quality financial reporting provides information that is useful to analysts in
assessing a company’s performance and prospects
 Low-quality financial reporting contains inaccurate, misleading, or incomplete
information

• Quality of reported results

 High-quality earnings result from activities that a company will likely be able to
sustain in the future and provide a sufficient return on the company’s
investment

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 2. Quality of Financial Reports
2.1. Conceptual framework for assessing the quality of financial reports…

Financial Reporting Quality

The lowest-quality reports contain High-quality reports contain information that is

information that is pure fabrication. relevant, complete, neutral, and free from error.

LOW financial reporting quality Enables assessment.

impedes assessment of earnings
quality and impedes valuation.

Earnings (Results) Quality

Low and High and

unsustainable. sustainable.
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 Quality Spectrum of Financial Reports
GAAP, decision-useful,
sustainable, and
adequate returns

GAAP, decision-useful,
but sustainable? Low
“earnings quality”

Within GAAP, but

biased choices

Within GAAP, but

“earnings management”
• Real EM
• Accounting EM Non-compliant
accounting
a. demonstrate the use of a conceptual framework for
assessing the quality of a company’s financial reports
Fictitious
transactions
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 Potential Problems that Affect the Quality of Financial
Reports
• Reported Amounts and Timing of Recognition
 Aggressive, premature, and fictitious revenue recognition
 Conservative revenue recognition
 Omission and delayed recognition of expenses
 Understatement of contingent liabilities
 Overstatement of financial assets and understatement of financial liabilities
 Cash flow from operations may be manipulated

• Classification
 Classification choices typically affect one financial statement and relate to how an item is classified within
a particular financial statement

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 Example 2 – Balance Sheet Reclassifications
In the 2002 Annual Report, inventory was reported at $3,411.8 Note 6. Inventories
million. In the 2003 Annual Report, the 2002 inventory value was Inventories at December 31 consisted of:
reported at $2,964.3 million and $447.5 million of inventory was
($ in millions) 2003 2002
included in other assets.
Inventories valued under the LIFO method comprised approximately Finished goods $552.5 $1,262.3
51% and 39% of inventories at December 31, 2003 and 2002,
Raw materials and work in process 2,309.8 2,073.8
respectively. Amounts recognized as Other assets consist of
inventories held in preparation for product launches and not Supplies 90.5 75.7
expected to be sold within one year. The reduction in finished goods
Total (approximate current cost) $2,952.8 $3,411.8
is primarily attributable to the spin-off of Medco Health in 2003.
Reduction to LIFO cost — —
1. The reclassification of a portion of inventory to other assets
will most likely result in the days of inventory on hand: $2,952.8 $3,411.8
A. decreasing. Recognized as:
B. staying the same.
C. increasing. Inventories $2,554.7 $2,964.3
Other assets 398.1 447.5
2. As a result of the reclassification of a portion of inventory to
other assets, the current ratio will most likely:
A. decrease.
B. stay the same.
C. increase.

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 Exhibit 4: Accounting Warning Signs
Potential Issues
Overstatement or non-
sustainability of operating
income and/or net income
• Overstated or
accelerated revenue
recognition
• Understated expenses
• Misclassification of
revenue, gains,
expenses, or losses
Possible Actions/Choices
• Contingent sales with right of return,
“channel stuffing” (the practice of inducing
customers to order products they would
otherwise not order or order at a later date
through generous terms), “bill and hold”
sales (encouraging customers to order goods
and retain them on seller’s premises)
• Lessor use of finance (capital) leases
• Fictitious (fraudulent) revenue
• Capitalizing expenditures as assets
• Lessee use of operating leases
• Classifying non-operating income or gains as
part of operations
• Classifying ordinary expenses as non-
recurring or non-operating
• Reporting gains through net income and
losses through other comprehensive income
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Warning Signs
• Growth in revenue higher than that of industry or
peers
• Increases in discounts to and returns from
customers
• Higher growth rate in receivables than revenue
• Large proportion of revenue in final quarter of year
for a non-seasonal business
• Cash flow from operations is much lower than
operating income
• Inconsistency over time in the items included in
operating revenues and operating expenses
• Increases in operating margin
• 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
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 Exhibit 4: Accounting Warning Signs
Potential Issues
Misstatement of balance sheet items
(may affect income statement)
• Over- or understatement of
assets
• Over- or understatement of
liabilities
• Misclassification of assets and/or
liabilities
Overstatement of cash flow from
operations
Possible Actions/Choices
• Choice of models and model
inputs to measure fair value
• Classification from current to
non-current
• Over- or understating reserves
and allowances
• Understating identifiable assets
and overstating goodwill
• Managing activities to affect
cash flow from operations
• Misclassifying cash flows to
positively affect cash flow from •
operations
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Warning Signs
• Models and model inputs that bias fair value measures
• Inconsistency in model inputs when measuring fair
value of assets compared with that of liabilities
• Typical current assets, such as accounts receivable and
inventory, included in 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
• Increase in accounts payable and decrease in accounts
receivable and inventory
• Capitalized expenditures in investing activities
Sales and leaseback
• Increases in bank overdrafts
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 Quality Issues and Mergers and Acquisitions
Mergers and acquisitions provide opportunities and motivations to manage financial
results.
• Companies with declining CFO might acquire to boost CFO; cash spent on the acquisition will be
shown under CFI
• A potential acquisition may create an incentive for a company to report using aggressive choices or
even misreport
• Misreporting can be an incentive to make an acquisition
• The default accounting treatment for goodwill provides an incentive to acquirers to understate the
value of amortizable intangibles when recording an acquisition

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Financial Reporting that Diverges from Economic Reality Despite
Compliance with Accounting Rules
• Example 3. Treatment of Variable Interest (Special Purpose) Entities

• Example 4. Asset Impairments and Restructuring Charges

• Items that are commonly encountered by analysts include the following:

 Revisions to ongoing estimates
 Sudden increases to allowances and reserves
 Large accruals for losses (e.g., environmental or litigation-related liabilities)

• Management may use items such as reserves and allowances to manage or smooth earnings

• No basis of accounting can be expected to recognize all of the economic assets and liabilities

• OCI and net income

b. explain potential problems that affect
the quality of financial reports

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 3. Evaluating the Quality of Financial Reports
Prior to beginning any financial analysis, an analyst should clarify the purpose and
context and clearly understand the following:
• What is the purpose of the analysis? What questions will this analysis answer?
• What level of detail will be needed to accomplish this purpose?
• What data are available for the analysis?
• What are the factors or relationships that will influence the analysis?

In the context of evaluating the quality of financial reports, an analyst is attempting to

answer two basic questions:
1. Are the financial reports GAAP-compliant and decision-useful?
2. Are the results (earnings) of high quality? Do they provide an adequate level of return, and are they
sustainable?

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3.1. General Steps to Evaluate the Quality of Financial Reports
1. Develop an understanding of the company and its industry
2. Learn about management
3. Identify significant accounting areas, especially those in which management judgment or an unusual
accounting rule is a significant determinant of reported financial performance
4. Make comparisons:
 Compare the company’s financial statements and significant disclosures in the current year’s report with
the financial statements and significant disclosures in the prior year’s report
 Compare the company’s accounting policies with those of its closest competitors
 Using ratio analysis, compare the company’s performance with that of its closest competitors
5. Check for warnings signs of possible issues with the quality of the financial reports
6. For firms operating in multiple segments by geography or product consider whether inventory,
sales, and expenses have been shifted
7. Use appropriate quantitative tools to assess the likelihood of misreporting

c. describe how to evaluate the quality of a company’s financial reports

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3.2. Quantitative Tools to Assess the Likelihood of Misreporting
Beneish Model
M-score = – 4.84 + 0.920 (DSR) + 0.528 (GMI) + 0.404 (AQI) + 0.892 (SGI) + 0.115 (DEPI)
– 0.172 (SGAI) + 4.670 (Accruals) – 0.327 (LEVI)
• M-score = Score indicating probability of earnings manipulation; normally distributed
random variable with a mean of 0 and a standard deviation of 1.
• DSR (days sales receivable index) = (Receivablest/Salest)/(Receivablest–1/Salest–1).
• GMI (gross margin index) = Gross margint–1/Gross margint.
• AQI (asset quality index) = [1 – (PPEt + CAt)/TAt]/[1 – (PPEt–1 + CAt–1)/TAt–1], where PPE is
property, plant, and equipment; CA is current assets; and TA is total assets.
• SGI (sales growth index) = Salest/Salest–1.
• DEPI (depreciation index) = Depreciation ratet–1/Depreciation ratet, where Depreciation rate
= Depreciation/(Depreciation + PPE).
• SGAI (sales, general, and administrative expenses index) = (SGAt /Salest)/(SGAt–1/Salest–1).
• Accruals = (Income before extraordinary items – Cash from operations)/Total assets.
• LEVI (leverage index) = Leveraget/Leveraget–1

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 Example 5: Application of the Beneish Model
Coefficient
1. Would the results of the Beneish model lead Value of
from Beneish Calculations
Variable
an analyst, using a –1.78 M-score as the cutoff, Model
to flag XYZ as a likely manipulator? DSR 1.300 0.920 1.196
GMI 1.100 0.528 0.581
AQI 0.800 0.404 0.323
2. The values of DSR, GMI, SGI, and DEPI are all
greater than one. In the Beneish model, what SGI 1.100 0.892 0.981
does this indicate for each variable? DEPI 1.100 0.115 0.127
SGAI 0.600 –0.172 –0.103
Accruals 0.150 4.670 0.701
LEVI 0.600 –0.327 –0.196
Intercept –4.840
M-score –1.231
Probability of
10.91%
manipulation

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 More on Quantitative Tools…
• Other Quantitative Models

• Limitations of Quantitative Models

d. evaluate the quality of a company’s financial reports;

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 4. Earnings Quality

1. Indicators of Earnings Quality

2. Evaluating the Earnings Quality of a Company

3. Bankruptcy Prediction Models

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 4.1. Indicators of Earnings Quality
High quality earnings: earnings are sustainable and represent returns
equal to or in excess of the company’s cost of capital

1. Recurring Earnings

2. Earnings Persistence and Related Measures

of Accruals e. describe the concept of sustainable
(persistent) earnings
3. Mean Reversion in Earnings
f. describe indicators of earnings quality
4. Beating Benchmarks
g. explain mean reversion in earnings and
how the accruals component of earnings
5. External Indicators of Poor-Quality Earnings affects the speed of mean reversion

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 4.2. Evaluating the Earnings Quality of a Company
Revenue recognition
• Understand the revenue recognition policies as stated in the most recent annual
report.
• Study the DSO trend
• Consider cash versus accrual revenue
• Compare with the real world
• Study revenue trends and composition
• Look for transactions with related parties

Sunbeam: Premature/Fraudulent Revenue Recognition

MicroStrategy: Multiple-Element Contracts

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 Evaluating the Earnings Quality of a Company (Cont…)
Property/Capital Expenditures Analysis
• Understand the cost capitalization policies as stated in the most recent annual
report
• Trend analysis:
 non-current asset accounts
 gross and operating profit margins
 Turnover ratios
 Depreciation compared to asset base
 Capital expenditure relative to PPE
• Look for transactions with companies by senior officers or shareholders

WorldCom Corp: Property/Capital Expenditures Analysis

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 4.3. Bankruptcy Prediction Models
Using discriminant analysis, Altman developed a model to discriminate between two groups: bankrupt
and non-bankrupt companies. Altman’s Z-score is calculated as follows:

Z-score = 1.2 (Net working capital/Total assets) + 1.4 (Retained earnings/Total assets) + 3.3 (EBIT/Total
assets) + 0.6 (Market value of equity/Book value of liabilities) + 1.0 (Sales/Total assets)

h. evaluate the earnings quality of a company

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 5. Cash Flow Quality
5.1. Indicators of Cash Flow Quality
Focus on operating cash flow; high quality operating cash flow means:
 Actual (economic) performance was good AND
 Reporting quality is high

Consider corporate life cycle and industry profile

High-quality cash flow for a mature company would typically mean:

• Positive OCF
• OCF derived from sustainable sources
• OCF adequate to cover capital expenditures, dividends, and debt repayments
• OCF with relatively low volatility (relative to industry participants)

i. describe indicators of cash flow quality;

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 5.2. Evaluating Cash Flow Quality
• OCF is viewed as being less subject to manipulation than earnings

• Mangers might have an incentive to manipulate reported OCF

• OCF manipulation techniques:

 Sell receivables to third party
 Delay paying payables
 Inappropriate classification of cash flows to overstate OCF

• Flexibility in accounting standards

 Classifying interest/dividend paid/received
 Cash-flow from non-trading securities; versus cash-flow from trading securities

• Cannot rely on computerized models which compare net income with OCF
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 Case Studies
Satyam
• $53 million non-cash item labeled “Gain/(loss) on foreign exchange forward and options contracts”
• steady growth in receivables (DSO)
• Increasing amounts invested in current accounts

Sunbeam
• Cash flow statement prepared using the indirect method
• In 1996 restructuring charges were overstated; these were reversed in 1997
• Revenue recognition on transactions which lacked economic substance

Nautica Enterprises
• Shifting cash flow classification

j. evaluate the cash flow quality of a company

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 6. Balance Sheet Quality
High financial reporting quality:
• Completeness
• Unbiased measurement
• Clear presentation

High financial results quality:

• Optimal amount of leverage
• Adequate liquidity
• Economically successful asset allocation

k. describe indicators of balance sheet quality;

l. evaluate the balance sheet quality of a company;

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 7. Sources of Information about Risk

• Company’s financial statements

 Limited Usefulness of Auditor’s Opinion as a Source of Information about Risk
 Risk-Related Disclosures in the Notes

• Management commentary (also referred to MD&A)

• Required disclosures

• Financial press

m. describe sources of information about risk.

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 Summary
a. demonstrate the use of a conceptual framework for assessing the
quality of a company’s financial reports
b. explain potential problems that affect the quality of financial reports
c. describe how to evaluate the quality of a company’s financial reports
d. evaluate the quality of a company’s financial reports
e. describe the concept of sustainable (persistent) earnings
f. describe indicators of earnings quality
g. explain mean reversion in earnings and how the accruals component
of earnings affects the speed of mean reversion
h. evaluate the earnings quality of a company
i. describe indicators of cash flow quality
j. evaluate the cash flow quality of a company
k. describe indicators of balance sheet quality
l. evaluate the balance sheet quality of a company
m. describe sources of information about risk

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