FINANCIAL REPORTING QUALITY
Agenda
• Reporting Quality
• Accounting Choices/Estimates
• Warning Signs
Reporting Quality
Reporting vs earnings quality
• (Financial) reporting quality means: (i) compliance with accounting standards, (ii)
decision usefulness (relevance, faithful representation)
o Relevance: useful to decision making (credit decisions, equity investment decisions)
o Faithful representation: completeness, freedom from errors, neutrality
• Earnings quality: earnings sustainability, earnings adequacy (sufficient returns to capital
providers), cash conversion from accounting earnings
• A firm may demonstrate good reporting quality and, at the same time, have low earnings
quality (e.g. financial statements presents true & fair view of company financials, but
earnings are below industry average and come from one-off sources)
Reporting - earnings quality spectrum
Compliant reporting – sustainable,
adequate, cash generative earnings
Compliant reporting – unsustainable
or inadequate earnings
Compliant reporting but biased
Reporting quality
choices/estimates – low earnings quality
Compliant reporting but active
earnings management
Non-compliant reporting but
close to actual economic reality
Non-compliant reporting and
fictitious/fraudulent numbers
Earnings quality
Conservative & aggressive accounting
• Conservative accounting tends to lower reported earnings & financial position
• Aggressive accounting tends to increase reported earnings & financial position
Conservative Accounting Aggressive Accounting
Expense current period costs Capitalize current period costs
Shorter estimates of useful lives of long-lived assets Longer estimates of useful lives of long-lived assets
Lower estimates of salvage values Higher estimates of salvage values
Accelerated depreciation Straight-line depreciation
Early recognition of impairment Delayed recognition of impairment
Higher/early provision for bad debt Lower/delayed provision for bad debt
Larger valuation allowance on deferred tax assets Lower valuation allowance on deferred tax assets
Why deliver poor reporting quality?
Motivation Opportunity
Secure bonus/share price-linked compensation Weak internal controls
Avoid violating debt covenants Inadequate oversight of board of directors
Reserve earnings for future to alleviate growth Approved accounting standards allow wide range of
pressure from shareholders accounting treatment/choices
Mechanisms to discipline reporting quality
Securities regulations
Registration process for newly issuance securities Periodic release of financial statements
Regulatory review of newly issued securities Independent audit of financial statements
Signed statement of FS preparer & top management Establishment of internal controls & internal audit teams
Enforcement actions of regulators Enforcement actions of other parties
Administrative fines Early redemption of loans/bonds by banks/bondholders
Suspension of issuance & trading of securities Put option exercise by private equity investors
Criminal prosecution
• Note: Even independent audit reports from top auditors do NOT provide 100% GUARANTEE that financial
statements are “fairly presented”. Audit reports provide REASONABLE ASSURANCE of “fairly reported” FS
Beware “Adjusted” metrics
• Companies provide both GAAP and “Adjusted” (Non-GAAP, Non-IFRS) metrics in their
performance presentation
• While such adjusted metrics provide insights into underlying operating performance of
the companies, these numbers are unaudited and subject to manipulation → potentially
misleading to investors
• Rationale for adjusted metrics: Remove noise & enhance comparability by leaving out
“one-off”, “non-core”, “non-operating”, “non-recurring” income/cost items
• How to handle? Request reconciliation from GAAP to Non-GAAP numbers and
explanation for so-called “one-off” items
Quiz Time (1)
Quiz Time (1)
Accounting Choices/Estimates
Sales recognition
• Terms of delivery → timing of revenue recognition: EXW < FCA < FAS < FOB < CFR < CIF < CPT <
CIP < DPU < DAP < DDP
• Channel stuffing: over-shipping products to distributors/customers in the current period to
inflate revenue at the expense of subsequent periods. Top management may under-ship to
customers if they want to delay recognition in current period
• Bill-and-hold transactions: Company sells products, issues invoices to customers but still keep
products at its warehouse “at the request of customers” → inflate revenue
• Round tripping: Company sells products to Customer A, A sells the products to Customer B, B
sells the products back to Company → inflate revenue of all 3 entities
Provision account
• Provision for credit losses (bank loans/trade receivables)
Higher provision Lower provision
Higher G&A expense/provision expense Lower G&A expense/provision expense
Lower operating & net profit Higher operating & net profit
Lower net receivables, asset & equity Higher net receivables, asset & equity
• Provision for valuation of Deferred Tax Asset (DTA)
Higher provision Lower provision
Higher tax expense Lower tax expense
Lower net profit Higher net profit
Lower DTA balance, asset & equity Higher DTA balance, asset & equity
Depreciation & Amortization
Conservative Aggressive
Depreciation method Accelerated depreciation Straight-line
Estimate of useful lives Short useful lives Long useful lives
Estimate of salvage value Low salvage value High salvage value
Lower sales growth & terminal Higher sales growth & terminal
Assumptions in impairment test
growth, higher discount rate growth, lower discount rate
Income Statement impact Lower operating & net profit Higher operating & net profit
Balance Sheet impact Lower Asset & Equity Higher Asset & Equity
Inventory costing & related party transaction
Flat/rising prices environment FIFO Weighted average
COGS Lower Higher
Profit (gross & net) & profit margin Higher Lower
Inventory/Asset/Equity Higher Lower
Note: In deflationary environment, the above impacts are reversed
Related party transactions
Listed company Receivables/Payables Private related customers
(seller to private related customers,
buyers to private related suppliers)
Private related suppliers
*Note: Ultimate owner of such entities
Earnings/Cash flow
might be top management
• Through related party transactions, top management can manage/manipulate up or down the earnings,
cash flow and balance sheet of the listed company
Capitalization & Others
Capitalization Expensing
Earnings
Higher in current period, lower in later Lower in current period, higher in later
Asset/Equity
periods periods
Operating cash flow
Investing cash flow Higher Lower
Total cash flow Unchanged Unchanged
• Top management can manipulate cash flow by stretching trade receivables/payables via transactions
with independent/related party customers & suppliers
Warning Signs
Key warning indicators
Category Warning indicators
Recognition methods
Bill-and-hold
Channel stuffing and lower trade receivables turnover
Revenue
Round tripping
Inclusion of one-off/significant non-recurring items in revenue
Sales growth confusingly above peers/industry norm
Lower inventory turnover
Inventory
LIFO liquidation
Capitalization policies Policies atypical of industry norms/peers
Operating cash flow vs accounting profit Operating cash flow/accounting net profit < 1 persistently
Key warning indicators (2)
Category Warning indicators
Methods, estimated useful lives, estimated salvage values out of
Depreciation
industry norms/peers
Profit margins Profitability far above or below industry norms/peers
Quarterly sales/earnings growth Growth deviating from industry/seasonality norms/peers
Related party transactions Significant number and value of related party transactions
Costs/income labelled as ”non-recurring” but keep showing in
“One-off” items classification
financial statements from one period to another
Limited additional info provided by top management, company simply
Information/Guidance disclosure
provides required financial reporting data
Over-emphasis on “Non-GAAP” metrics without sufficient
“Adjusted” metrics
reconciliation/explanation between GAAP and Non-GAAP numbers
Quiz Time (2)
