FSA: Carlos A. Mello-e-Souza

1title

Quality of Accounting Quality of Accounting Information and Information and

International ComparisonsInternational Comparisons

Quality of Accounting Quality of Accounting Information and Information and

International ComparisonsInternational Comparisons

byby Carlos A. Mello-e-Souza Carlos A. Mello-e-Souza

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FSA: Carlos A. Mello-e-Souza

Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:

Before we begin…

toc

1. analyze economics of industry

1. analyze economics of industry

2. analyze company strategies

2. analyze company strategies

3. assess quality of

accounting

3. assess quality of

accounting

4. analyse profitability

and risk

4. analyse profitability

and risk

5. value the firm

5. value the firm

3

FSA: Carlos A. Mello-e-Souza

Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:

Before we begin…

toc

1. analyze economics of industry

1. analyze economics of industry

2. analyze company strategies

2. analyze company strategies

3. assess quality of

accounting

3. assess quality of

accounting

4. analyse profitability

and risk

4. analyse profitability

and risk

5. value the firm

5. value the firm

4

FSA: Carlos A. Mello-e-Souza

What is accounting quality?What is accounting quality?

Why is accounting quality important?Why is accounting quality important?

Measurement of accounting qualityMeasurement of accounting quality

Focus on: international comparisonsFocus on: international comparisons

Focus on: earnings managementFocus on: earnings management

What is accounting quality?What is accounting quality?

Why is accounting quality important?Why is accounting quality important?

Measurement of accounting qualityMeasurement of accounting quality

Focus on: international comparisonsFocus on: international comparisons

Focus on: earnings managementFocus on: earnings management

Accounting Quality:

toc

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FSA: Carlos A. Mello-e-Souza

What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?

what is AQ?

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

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FSA: Carlos A. Mello-e-Souza

What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?

what is AQ?

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• The objective of accounting:

… is to provide information for capital allocation decisions by investors.(SFAC No. 1 of 1978)

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FSA: Carlos A. Mello-e-Souza

What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?

what is AQ?

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

1. AQ is revealed by strength of association between observable accounting earnings and unobservable economic earnings.

… the “value relevance approach”

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FSA: Carlos A. Mello-e-Souza

What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?

what is AQ?

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

2. “Accounting that portrays the most realistic possible presentation of an enterprise’s financial position and results of operations.” (Bernstein)

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FSA: Carlos A. Mello-e-Souza

What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?

what is AQ?

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• AQ…1. Reflects information content.

Accounting should provide relevant information to forecast the firm’s expected earnings and cash flows. (RELEVANCE)

2. Signals earnings persistence.Accounting information should be a fair and complete representation of firm’s performance, position, and risk. (RELIABILITY)

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FSA: Carlos A. Mello-e-Souza

What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?

what is AQ?

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• AQ is affected by the quality of: standards and regulations incentives (enforcement) application of principles estimates

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FSA: Carlos A. Mello-e-Souza

Importance of accounting qualityImportance of accounting qualityImportance of accounting qualityImportance of accounting quality

importance

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• Value of equity = ? (RIM)

1

0

1 1t e t

e

e tt

CI BVErV BVEr

Note:

1 1t t t te eCI BVE ROE r BVEr

12

FSA: Carlos A. Mello-e-Souza

Importance of accounting qualityImportance of accounting qualityImportance of accounting qualityImportance of accounting quality

importance

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• Value of equity = ? (RIM)

1

0

1 1te

e

te t

t

CI BVEB rV VEr

Note:

1 1t t t te eCI BVE R rOE BVEr

13

FSA: Carlos A. Mello-e-Souza

Importance of accounting qualityImportance of accounting qualityImportance of accounting qualityImportance of accounting quality

importance

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• for the firm: as AQ improves the cost of capital tends to fall.(Botosan, 1997, and many other studies)

• for the economy: AQ is positively associated with development of the financial sector and with growth. (Levine et al, 1999)

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FSA: Carlos A. Mello-e-Souza

Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality

measurement

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• By evidence of factors that compromise AQ, such as:• earnings management• accounting errors and omissions• aggressiveness• generic “scoring” models

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FSA: Carlos A. Mello-e-Souza

Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality

measurement

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• By mechanical methods:• accrual based methods

net income vs. operating cash flow behavior of current, non-current, total

accruals (Richardson, et al) behavior of discretionary accruals (Jones)

• probability of manipulation methods (Beneish)

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FSA: Carlos A. Mello-e-Souza

Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality

measurement

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• Looking for quality on the balance sheet:

Cash

Receivables

Inventory

PP&E

Investments

Intangibles

Cash

Receivables

Inventory

PP&E

Investments

Intangibles

A/P

Taxes payable

Contingencies

Interest bearing debt

Other LT liabilities

SE

A/P

Taxes payable

Contingencies

Interest bearing debt

Other LT liabilities

SE

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FSA: Carlos A. Mello-e-Souza

Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality

measurement

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• Looking for quality in the income statement and statement of comprehensive income:

RevenuesCost of salesOperating expensesOther income (expense)Tax expenseDiscontinued operationsExtraordinary itemsNet incomeOther comprehensive incomeComprehensive income

RevenuesCost of salesOperating expensesOther income (expense)Tax expenseDiscontinued operationsExtraordinary itemsNet incomeOther comprehensive incomeComprehensive income

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FSA: Carlos A. Mello-e-Souza

Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality

measurement

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• Looking for quality in the footnotes and in MDA:

MDA

Footnotes

MDA

Footnotes

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FSA: Carlos A. Mello-e-Souza

Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality

measurement

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• High quality disclosures allow investors to differentiate: IMPLICATIONS FOR

FUTURE EARNINGS?

NO YES

ACTUAL vs EXPECTED EARNINGS

NO SURPRISE

S#1:no price effect

S#4:price effect from future

SURPRISE!

S#3:price effect

from surprise

S#2:price effect from future & surprise

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FSA: Carlos A. Mello-e-Souza

AQ: important cross-border factorsAQ: important cross-border factorsAQ: important cross-border factorsAQ: important cross-border factors

international

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• Degree of TAX-GAAP linkage(affects value relevance; makes it hard to interpret accrual-based diagnostics)

• Quality of enforcement(standards alone do not guarantee good disclosures)

• Special strategies, culture, institutions• Convert financial statements to common

accounting standards

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FSA: Carlos A. Mello-e-Souza

Earnings ManagementEarnings ManagementEarnings ManagementEarnings Management

smoothing

Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

• GAAP has room for earnings management• Is it good or bad? when? for whom?• Arguments for:

• to maximize compensation, job security• to avoid default• to influence stock price• to avoid regulatory action

• Arguments against:• can’t do it forever• risk of penalties (SEC)

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FSA: Carlos A. Mello-e-Souza

measurement

Accounting Quality: conclusion