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CHAPTER 16 EVALUATING FINANCIAL REPORTING QUALITY Presenter’s name Presenter’s title dd Month yyyy
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. Copyright © 2013 CFA Institute 2
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 ASSETSLIABILITIES & EQUITY Cash$100Liabilities0 Equity Common stock$100 Total$100Total$100 Copyright © 2013 CFA Institute 3
CASH-BASIS AND ACCRUAL-BASIS ACCOUNTING: EXAMPLE 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. Copyright © 2013 CFA Institute 4 CASH BASISACCRUAL BASIS Revenue$20Revenue$25 Expenses$0Expenses$0 Net income$20Net Income$25 Cash$120Cash$120 Accounts receivable$25 Liabilities$0Liabilities – Unearned revenue$20 Common stock$100Common stock$100 Retained earnings$20Retained earnings$25
CASH-BASIS AND ACCRUAL-BASIS ACCOUNTING: EXAMPLE 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. Copyright © 2013 CFA Institute 5 CASH BASISACCRUAL BASIS Net income$20Net Income$25 Total beginning assets$100Total beginning assets$145 Total ending assets$120Total ending assets$145 ROA18.2%ROA20.4%
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 Copyright © 2013 CFA Institute 6
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 Copyright © 2013 CFA Institute 7
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. Copyright © 2013 CFA Institute 8
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. Copyright © 2013 CFA Institute 9
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 Copyright © 2013 CFA Institute 10
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. Copyright © 2013 CFA Institute 11
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: Earnings t+1 = 0 + 1 Earnings t + (1) Earnings t+1 = 0 + 1 Accruals t + 2 Cash Flows t + (2) where earnings, accruals, and cash flows are all scaled by total assets. Evidence that 1 is consistently smaller than 2 indicates that the cash flow component of earnings is more persistent than the accruals component. Copyright © 2013 CFA Institute 12
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 Copyright © 2013 CFA Institute 13
MEASURES OF EARNINGS QUALITY: BALANCE-SHEET-BASED ACCRUALS RATIO Copyright © 2013 CFA Institute 14
MEASURES OF EARNINGS QUALITY: CASH FLOW STATEMENT-BASED ACCRUALS RATIO Copyright © 2013 CFA Institute 15
MEASURES OF EARNINGS QUALITY 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. Copyright © 2013 CFA Institute 16
MEASURES OF EARNINGS QUALITY 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. Copyright © 2013 CFA Institute 17
A QUALITY-OF-EARNINGS COMPARISON OF TWO COMPANIES 2006 (%) 2005 (%) Siemens14.218.7 General Electric11.64.1 2006 (%) 2005 (%) Siemens8.418.3 General Electric9.03.3 Copyright © 2013 CFA Institute 18
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 Copyright © 2013 CFA Institute 19
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. Copyright © 2013 CFA Institute 20
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 income34,78643,273 Equals cash collected from customers$3,006,486$2,537,619 Revenue/Cash collected from customers96.7%101.9% Copyright © 2013 CFA Institute 21
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 Copyright © 2013 CFA Institute 22
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. Copyright © 2013 CFA Institute 23
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. Copyright © 2013 CFA Institute 24
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 as restructuring 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. Copyright © 2013 CFA Institute 25
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. Copyright © 2013 CFA Institute 26
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 Copyright © 2013 CFA Institute 27
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. Copyright © 2013 CFA Institute 28
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