CHAPTER 16 EVALUATING FINANCIAL REPORTING QUALITY Presenter’s name Presenter’s title dd Month...

CHAPTER 16EVALUATING FINANCIAL REPORTING QUALITY

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Copyright © 2013 CFA Institute 2

CASH-BASIS AND ACCRUAL-BASIS ACCOUNTING

Cash-Basis Accounting

• Financial statements reflect transactions according to cash flow.

• Recognize revenues when receive cash.

• Recognize expenses when disburse cash.

Accrual-Basis Accounting

• Financial statements reflect transactions in the reporting period in which they occur, irrespective of the timing of cash flow.

• Recognize revenues when earned.

• Recognize expenses when incurred.


CASH-BASIS AND ACCRUAL-BASIS ACCOUNTING: EXAMPLE

At the start of the current year, the owner contributes $100 cash into the business.

Cadence Cycling Beginning Balance Sheet

ASSETS LIABILITIES & EQUITY

Cash $100 Liabilities 0

Equity

Common stock $100

Total $100 Total $100



During the year, there are two transactions:1. One customer pays $20 upfront. Cadence has not yet performed the

service.2. Second customer has not yet paid. Cadence has completed the

service.

CASH BASIS ACCRUAL BASIS

Revenue $20 Revenue $25

Expenses $0 Expenses $0

Net income $20 Net Income $25

Cash $120 Cash $120

Accounts receivable $25

Liabilities $0 Liabilities – Unearned revenue $20

Common stock $100 Common stock $100

Retained earnings $20 Retained earnings $25



During the year, there are two transactions:1. One customer pays $20 upfront. Cadence has not yet performed the

service.2. Second customer has not yet paid. Cadence has completed the service.

CASH BASIS ACCRUAL BASIS

Net income $20 Net Income $25

Total beginning assets $100 Total beginning assets $145

Total ending assets $120 Total ending assets $145

ROA 18.2% ROA 20.4%


ACCRUAL-BASIS ACCOUNTING: RELATIVE MERITS

Advantages of accrual basis relative to cash basis:

• More timely

• Better predictor of future cash flows

Disadvantages of accrual basis relative to cash basis:

• Requires estimates

• Involves more management discretion


SOURCES OF ACCOUNTING DISCRETION

• Revenue recognition

• Allowance for doubtful accounts and related provision for bad debts

• Depreciation choices

• Inventory choices

• Choices related to goodwill and other noncurrent assets

• Choices related to taxes

• Pension choices

• Financial asset/liability valuation

• Stock option expense estimates


MANAGEMENT’S MOTIVATIONS: CAPITAL MARKETS

• Motivation to report results that meet or exceed expectations: Positive market reaction.

• Research provides evidence of propensity to meet or exceed various thresholds:

- Beat historical earnings.

- Beat consensus analysts’ forecasts.

• Evidence of propensity to barely meet or exceed these thresholds suggests

- Management possibly using discretion in reported earnings to achieve target.

- In the case of analysts’ forecasts, management possibly moving the benchmark lower with strategic communications.


MANAGEMENT’S MOTIVATIONS: CONTRACTS

• Management compensation contracts

- Compensation linked explicitly to accounting measures (e.g., ROA, ROS).

- Compensation linked to stock prices, which can be affected by reported earnings numbers.

• Debt contracts

- Covenants based on accounting measures.

- Pricing structures linking interest cost to financial performance.


MECHANISMS DISCIPLINING THE FINANCIAL REPORTING PROCESS

• External auditors

• Internal auditors, audit committee, and the board of directors

• Management certification

• Litigation

• Regulators

• General market scrutiny—for example,

- Financial journalists

- Short sellers

- Activist institutions

- Employee unions

- Analysts


EARNINGS QUALITY

• Earnings that are considered to be higher quality:

- When they exhibit persistence (i.e., when the reported level of earnings can be expected to be sustained or continued).

- When they are unbiased—neither too conservative nor too aggressive.

• Sustainable earnings enable better forecasts of future cash flows or earnings.


EARNINGS PERSISTENCE• Earnings (operating income) can be viewed as two separate

components:

- Operating cash flows, and

- Accruals (the difference between operating income and operating cash flow).

• Research measures “persistence” as regression coefficients, using the following regressions:

Earningst+1 = a0 + a1Earningst + e (1)

Earningst+1 = g0+ g1Accrualst + g2Cash Flowst + e (2)

where earnings, accruals, and cash flows are all scaled by total assets.

• Evidence that g1 is consistently smaller than g2 indicates that the cash flow component of earnings is more persistent than the accruals component.


MEASURES OF EARNINGS QUALITY

• Contrasting financial statements prepared on a cash basis to those prepared on an accrual basis is a natural way to identify the extent of discretion embedded in the reported financial statements.

• Effectively, this amounts to comparing a pure change in cash measure of earnings with the reported earnings under accrual accounting. The difference is aggregate accruals or the accrual component of earnings.

Aggregate accruals = Accrual-based earnings – Cash earnings

• How do you decompose reported accrual earnings into a cash flow and accrual component?

- Focus on information in the balance sheet, or

- Focus on information in the statement of cash flows


MEASURES OF EARNINGS QUALITY: BALANCE-SHEET-BASED ACCRUALS RATIO

• Decompose reported accrual-based earnings into the cash flow and accrual component, using information on the balance sheet.

• Define net operating assets (NOA):

• Measure total accruals for the period as the change in NOA:

• Adjust for size differences by scaling total accruals by average NOA:


MEASURES OF EARNINGS QUALITY: CASH FLOW STATEMENT-BASED ACCRUALS RATIO

• Measure total accruals for the period as the difference between net income and cash flow (from operating and investing):

• Adjust for size differences by scaling total accruals by average NOA:



• The two approaches (balance sheet and statement of cash flows) are conceptually equivalent.

• However, the two approaches (balance sheet and statement of cash flows) will not generate the exact same numbers.

• Differences are typically small and can be ignored for the purpose of developing earnings quality measures.

• The typical correlation between a broad accrual measure based on balance sheet data with one based on statement of cash flow data is in excess of 0.80.

• An analyst should compare companies using the same method across companies.



• Research provides validation of these measures of earnings quality.

• Measures identify companies in advance of restatement announcements.

• Measures are leading indicators of U.S. SEC enforcement actions.


A QUALITY-OF-EARNINGS COMPARISON OF TWO COMPANIES

Balance-Sheet-Based Accrual Ratio 2006 (%)

2005 (%)

Siemens 14.2 18.7

General Electric 11.6 4.1

Cash-Flow-Statement-Based Accrual Ratio 2006 (%)

2005 (%)

Siemens 8.4 18.3

General Electric 9.0 3.3


POTENTIAL PROBLEMS THAT AFFECT THE QUALITY OF FINANCIAL REPORTING: REVENUE RECOGNITION

• Revenue recognition issues

- Revenue misstatement

- Accelerating revenue

• Inappropriate revenue recognition

- SEC enforcement actions

- Restatements

• Warning signs of revenue misstatement

- Large increases in accounts receivable

- Examine days’ sales outstanding (DSO)

- Consider in context

- Large decreases in unearned revenue


INAPPROPRIATE REVENUE RECOGNITION: EXAMPLE

• Diebold, Incorporated, has been engaged in an ongoing discussion with the Securities and Exchange Commission (SEC) regarding the company’s practice of recognizing certain revenue on a “bill and hold” basis within its North America business segment. As a result of these discussions, Diebold will discontinue the use of bill and hold as a method of revenue recognition in both its North America and international businesses.

• The change in the company’s revenue recognition practice, and the potential amendment of prior financial statements, would only affect the timing of recognition of certain revenue. Although the percentage of the company’s global bill and hold revenue varied from period to period, it represented 11% of Diebold’s total consolidated revenue in 2006.


INDICATOR OF POTENTIAL REVENUE RECOGNITION ISSUES: REVENUE VS. CASH COLLECTIONS

2006 2005

Revenue $2,906,232 $2,587,049

Plus decrease (minus increase) in accounts receivable

65,468 (92,703)

Plus increase in deferred income 34,786 43,273

Equals cash collected from customers $3,006,486 $2,537,619

Revenue/Cash collected from customers 96.7% 101.9%


INAPPROPRIATE REVENUE RECOGNITION: EXAMPLE

“Improper accounting for bill-and-hold transactions usually involves the recording of revenue from a sale, even though the customer has not taken title of the product and assumed the risks and rewards of ownership of the products specified in the customer’s purchase order or sales agreement. In a typical bill-and-hold transaction, the seller does not ship the product or ships it to a delivery site other than the customer’s site. These transactions may be recognized legitimately under GAAP when special criteria are met, including being done pursuant to the buyer’s request.”

“Report Pursuant to Section 704 of the Sarbanes–Oxley Act of 2002”

U.S. SEC


POTENTIAL PROBLEMS THAT AFFECT THE QUALITY OF FINANCIAL REPORTING: EXPENSE RECOGNITION

• Expense recognition issues

- Understating expenses.

- Deferring expenses.

- Classifying ordinary expenses as nonrecurring or nonoperating.

• Warning signs of expense misstatement

- Change in depreciation assumptions.

- Ratio of depreciation relative to the gross value of PP&E or change in depreciation relative to sales compared with other companies.

- Asset growth relative to sales growth.

- Large positive unexpected increase in core operating margin and a contemporaneous negative special item or nonrecurring charge.

- Inconsistency regarding items of expenses in operating income.


ACCOUNTING WARNING SIGNS: EXPENSES

Inconsistency over time in the items included in operating revenues and operating expenses.

May indicate opportunistic use of discretion to boost reported operating income.

Classification of ordinary expenses as nonrecurring or nonoperating.

May reflect an attempt to mask a decline in operating performance.

Increases in the core operating margin [(Sales – COGS – SGA)/Sales] accompanied by spikes in negative special items.

May indicate opportunistic classification of recurring expenses as nonrecurring.

Use of nonconservative depreciation and amortization estimates, assumptions, or methods—for example, long depreciable lives.

May indicate actions taken to boost current reported income. Changes in assumptions may indicate an attempt to mask problems with underlying performance in the current period.


ACCOUNTING WARNING SIGNS: EXPENSES

Buildup of high inventory levels relative to sales or decrease in inventory turnover ratios.

May indicate obsolete inventory or failure to take needed inventory write-downs.

Deferral of expenses by capitalizing expenditures as an asset—for example:

Customer acquisition costs

Product development costs

May boost current income at the expense of future income;

May mask problems with underlying business performance.

Use of reserves, such asrestructuring or impairment charges reversed in a subsequent period; Use of high or low level of bad debt reserves relative to peers.

May allow company to “save” profits in one period to be used when needed in a later period; May be used to smooth earnings and mask underlying earnings variability.


POTENTIAL PROBLEMS THAT AFFECT THE QUALITY OF FINANCIAL REPORTING: BALANCE SHEET ISSUES

• Balance sheet issues:

- Off-balance-sheet debt—that is, operating leases.

- Goodwill.

• Warning signs of balance sheet issues:

- Changes in reported goodwill.

- Goodwill amounts when market capitalization is less than book value of equity.


POTENTIAL PROBLEMS THAT AFFECT THE QUALITY OF FINANCIAL REPORTING: CASH FLOW ISSUES

• Statement of cash flow issues

- Classification issues in the cash flow statement

- Omitted investing and financing activities

- Real earnings management activity


SUMMARY• Financial reporting quality relates to the accuracy with which a company’s

reported financial statements reflect its operating performance and to their usefulness for forecasting future cash flows. Understanding the properties of accruals is critical for understanding and evaluating financial reporting quality.

• The application of accrual accounting makes necessary use of judgment and discretion. On average, accrual accounting provides a superior picture to a cash-basis accounting for forecasting future cash flows.

• Earnings can be decomposed into cash and accrual components. The accrual component has been found to have less persistence than the cash component, and therefore, (1) earnings with higher accrual components are less persistent than earnings with smaller accrual components, all else being equal, and (2) the cash component of earnings should receive a higher weighting in evaluating company performance.

• Aggregate accruals ratios are useful to rank companies for the purpose of evaluating earnings quality.

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