CHAPTER 11

FINANCIAL REPORTING QUALITY

Lecture by: Say Vichheka
 FINANCIAL REPORTING QUALITY VS. QUALITY
OF REPORTED RESULTS
Financial Reporting Quality Quality of Reported Results (aka
• Decision-useful information “Earnings Quality”)
• Faithful representation of • Sustainable activity
economic reality • Adequate returns
• Compliant with standards • Increases the company’s value

2
 FINANCIAL REPORTING QUALITY AND
EARNINGS QUALITY ARE INTERRELATED

3
QUALITY SPECTRUM OF FINANCIAL REPORTS

4
QUALITY SPECTRUM OF FINANCIAL REPORTS
Excerpt from Toyota Motor Corporation’s
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...

5
QUALITY SPECTRUM OF FINANCIAL REPORTS
• Biased accounting choices,
assumptions, estimates:
- “Aggressive” choices increase a
company’s 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.

6
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 World’s Fair charge,
compared to $5.3 million or $0.24 per
share in 1998.

7
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 World’s 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 Income—not shown in
this excerpt—was $67.5 million
loss, not a $14 million profit.

8
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.

9
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.

10
QUALITY SPECTRUM OF FINANCIAL REPORTS
Fictitious Transactions

• Equity Funding Corp. (1970s)

created fictitious revenues and even
fictitious policy holders.
• Crazy Eddie’s (1980s) reported
fictitious inventory as well as
fictitious revenues supported by fake
invoices.
• Parmalat (2004) reported fictitious
bank balances.

11
 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
management’s 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

12
CONDITIONS CONDUCIVE TO ISSUING LOW-
QUALITY FINANCIAL REPORTS

Opportunity

Rationalization Motivation

13
MECHANISMS THAT DISCIPLINE FINANCIAL
REPORTING QUALITY

Regulatory Authority

Auditors

Private Contracting

14
MECHANISMS THAT DISCIPLINE FINANCIAL
REPORTING QUALITY

Regulatory Authority

Auditors

Private Contracting

15
MECHANISMS THAT DISCIPLINE FINANCIAL
REPORTING QUALITY

Regulatory Authority

Auditors

Private Contracting

16
 MECHANISMS THAT DISCIPLINE FINANCIAL
REPORTING QUALITY – POTENTIAL LIMITATIONS

Regulatory Authority

Auditors

Private Contracting

17
 COMPANIES’ PRESENTATION CHOICES
• What information to present—beyond 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

18
 PRESENTATION CHOICES:
GROUPON’S NON-GAAP METRIC

Originally Shown After SEC’s Review

(June S-1 filing) (November S-1 filing)

19
 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

20
 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 sheet—not as
current as with FIFO.
- A blend of old and new costs in cost of sales on the income statement—more
current than with FIFO.

21
 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?

22
 ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Units Cost per Unit Total Cost First costs in are
Purchase 1 5 $100 $500 first costs out to
Purchase 2 5 150 750 cost of goods
Purchase 3 5 180 900 sold: $3,150
Purchase 4 5 200 1,000
Purchase 5 5 240 1,200 Last in are in ending
Cost of goods available for sale $4,350 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?

23
 ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Units Cost per Unit Total Cost First costs in are
Purchase 1 5 $100 $500 first costs out to
Purchase 2 5 150 750 cost of goods
Purchase 3 5 180 900 sold: $3,150
Purchase 4 5 200 1,000
Purchase 5 5 240 1,200 Last in are in ending
Cost of goods available for sale $4,350 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?

24
 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?

25
 ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS
Units Cost per Unit Total Cost
Purchase 1 5 $100 $500 Average cost
Purchase 2 5 150 750 per unit =
Purchase 3 5 180 900 $4,350/25
Purchase 4 5 200 1,000 units = $174
Purchase 5 5 240 1,200
25 Ending
Cost of goods available for sale $4,350 inventory =
A company starts operations with no inventory at the 5 × $174 =
beginning of a fiscal year and makes five purchases of $870
goods for resale, as shown in the table. During the
period, the company sells all of the goods purchased Cost of
except for five units. 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?
26
 ACCOUNTING CHOICES:
INVENTORY COST FLOW ASSUMPTIONS

27
 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:
Use the same interest expense/capitalization Operating $18,000
I. proportions to allocate the interest payments
between operating and investing activities Investing $9,000

Offset the entire $3,000 of non-cash discount Operating $17,000

II. amortization against the $20,000 treated as
expense and included in operating cash flow Investing $10,000

Offset the entire $3,000 of non-cash discount Operating $20,000

III. amortization against the $10,000 capitalized and
included in financing cash flow Investing $7,000

28
 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.]

29
 SUMMARY OF ANALYSTS’ CONSIDERATIONS:
REVENUE RECOGNITION
• Timing of revenue recognition
• Multiple deliverables
• Allowances for sales returns
• Days sales outstanding
• Rebates

30
 ANALYTICAL PROCEDURES TO DETECT
WARNING SIGNS: REVENUE RECOGNITION
Examine the accounting policies note for a company’s 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

31
 ANALYTICAL PROCEDURES TO DETECT WARNING
SIGNS: REVENUE RECOGNITION (CONTINUED)
Look at revenue relationships.
• Compare a company’s 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 company’s days sales outstanding (DSO) or receivables turnover
with that of relevant competitors or an industry peer group.
• Examine asset turnover

32
 SUMMARY OF ANALYSTS’ CONSIDERATIONS:
INVENTORY METHODS
• Method compared with competitors
• Reserves for obsolescence
• LIFO liquidation

33
 ANALYTICAL PROCEDURES TO DETECT
WARNING SIGNS: INVENTORY
Look at inventory relationships.
• Compare a company’s inventory growth—relative to sales growth—with 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

34
 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

35
 ANALYTICAL PROCEDURES TO DETECT
WARNING SIGNS: LONG-LIVED ASSETS
• Examine the company’s accounting policy note for its capitalization policy for
long-term assets, including interest costs, and for its handling of other deferred
costs.
• Compare the company’s policy with industry practice.
• If the company’s policy is an outlier, cross-check asset turnover and profitability
margins with others in the industry.

36
 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 company’s accrual accounts.

37
 ALLOWANCE FOR BAD DEBT
“. . . Generally, UAP’s 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 UAP’s FY 2000, the former UAP COO (chief operating officer),
in the presence of other UAP employees, ordered that UAP’s 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 UAP’s income before income taxes because UAP had
failed to record sufficient bad debt expense.”
SEC Accounting and Auditing Enforcement Release

38
 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 PowerLinx’s 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 PowerLinx’s “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

39
 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.

40
 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.

41
 IMPORTANCE OF CONTEXT IN JUDGING
WARNING SIGNS
• Companies with an unblemished record of meeting growth projections
(especially younger companies)
• Minimalist approach to disclosure—for example, highly aggregated segment
reporting
• Fixation on reported earnings—for 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

42
 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 company’s 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.

43