1. FSA: Carlos A. Mello-e-Souza 1 title Quality of Accounting Information and International Comparisons by Carlos A. Mello-e-Souza

2. FSA: Carlos A. Mello-e-Souza 2 Process of financial statement analysis: Before we begin… toc 1. analyze economics of industry 2. analyze company strategies 3. assess quality of accounting 4. analyse profitability and risk 5. value the firm

3. FSA: Carlos A. Mello-e-Souza 3 Process of financial statement analysis: Before we begin… toc 1. analyze economics of industry 2. analyze company strategies 3. assess quality of accounting 4. analyse profitability and risk 5. value the firm

4. FSA: Carlos A. Mello-e-Souza 4 What is accounting quality? Why is accounting quality important? Measurement of accounting quality Focus on: international comparisons Focus on: earnings management What is accounting quality? Why is accounting quality important? Measurement of accounting quality Focus on: international comparisons Focus on: earnings management Accounting Quality: toc

5. FSA: Carlos A. Mello-e-Souza 5 What is accounting quality? what is AQ? Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing

6. FSA: Carlos A. Mello-e-Souza 6 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)

7. FSA: Carlos A. Mello-e-Souza 7 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”

8. FSA: Carlos A. Mello-e-Souza 8 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)

9. FSA: Carlos A. Mello-e-Souza 9 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)

10. FSA: Carlos A. Mello-e-Souza 10 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

11. FSA: Carlos A. Mello-e-Souza 11 Importance of accounting quality importance Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing Value of equity = ? (RIM) Note:

12. FSA: Carlos A. Mello-e-Souza 12 Importance of accounting quality importance Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing Value of equity = ? (RIM) Note:

13. FSA: Carlos A. Mello-e-Souza 13 Importance 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)

14. FSA: Carlos A. Mello-e-Souza 14 Measurement 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

15. FSA: Carlos A. Mello-e-Souza 15 Measurement 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)

16. FSA: Carlos A. Mello-e-Souza 16 Measurement 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

17. FSA: Carlos A. Mello-e-Souza 17 Measurement 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: Revenues Cost of sales Operating expenses Other income (expense) Tax expense Discontinued operations Extraordinary items Net income Other comprehensive income Comprehensive income Revenues Cost of sales Operating expenses Other income (expense) Tax expense Discontinued operations Extraordinary items Net income Other comprehensive income Comprehensive income

18. FSA: Carlos A. Mello-e-Souza 18 Measurement 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

19. FSA: Carlos A. Mello-e-Souza 19 Measurement of accounting quality measurement Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing High quality disclosures allow investors to differentiate: IMPLICATIONS FOR FUTURE EARNINGS? NOYES 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

20. FSA: Carlos A. Mello-e-Souza 20 AQ: 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

21. FSA: Carlos A. Mello-e-Souza 21 Earnings 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)

22. FSA: Carlos A. Mello-e-Souza 22 measurement Accounting Quality: conclusion