Analysis of the Quality

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Chapter 17

• Analysis of the Quality
• of Financial Statements

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Analysis of the Quality of Financial Statements
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What you will learn from this chapter

• Five questions to ask about the accounting
  quality of a financial report
• How accounting methods and estimates determine
  the sustainability of earnings
• How to carry out an accounting quality analysis
• The devices management can use to manipulate
  earnings
• How to develop diagnostics to detect manipulated
  earnings
• How an accounting quality analysis is combined
  with financial statement analysis and a red-flag
  analysis to discover the quality of earnings
• How quality analysis is incorporated into
  forecasting
• Accounting quality analysis establishes the
  integrity of the accounting to be used in
  forecasting

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Five Questions About Accounting Quality

• GAAP quality is GAAP accounting deficient?
• Audit quality is the firm violating GAAP or
  committing outright fraud?
• GAAP application quality is the firm using GAAP
  accounting to manipulate reports?
• Business timing quality is the firm manipulating
  business to accommodate the accounting?
• Revenue timing
• Expenditure timing
• Disclosure quality are disclosures adequate to
  analyze the business?
• Disclosures that distinguish operating items from
  a financial items in the statements
• Disclosures that distinguish core operating
  profitability from unusual items
• Disclosures about the accounting used

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Accounting Quality Analysis is one Component of a
Quality of Earnings Analysis

• Quality of Earnings Analysis

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Detection of Low Quality AccountingWhere to Look

• For valuation, the analyst wants to forecast
  future RNOA. If there is manipulation, current
  RNOA cannot be maintained in the future.
• Manipulation has the following effects
• As RNOA0OI0/NOA-1, manipulation involves
  adjusting current operating income, OI0
• But OI0 Free Cash Flow0 DNOA0
• So a change in OI0 must also change NOA0 by the
  same amount
• So future RNOA1OI1/NOA0 must be reduced
• Denominator effect
• Numerator effect

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Two Directions for Manipulation

• Borrowing income from the future
• Increase in current revenue
• Decrease in current expenses
• Banking income for the future
• Decrease current revenue
• Increase current expenses
• Distinguish
• Conservative Accounting
• vs.
• Liberal Accounting
• Aggressive Accounting

Both increase current NOA
Both reduce current NOA
A matter of Accounting Policy
A matter of short-term application of accounting
that will reverse
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Prelude to a Quality Analysis

• Understand the business
• Understand the accounting policy
• Understand the business areas where accounting
  quality is most doubtful
• Understand situations in which management are
  particularly tempted to manipulate

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Flash Points Accounting Areas where Manipulation
is More Likely
Industry Flash Point Banking Credit losses
quality of loan loss provisions Computer
hardware Technological change quality of
receivables and inventory Computer
software Market ability of products quality of
capitalized research and development Revenue
recognition quality of receivables Retailing Cr
edit losses quality of net accounts
receivable Inventory obsolescence quality of
carrying values of inventory Rebate programs
quantity of sales and estimated
liabilities Manufacturing Warranties
quality of warranty liabilities Product
liability quality of estimated
liabilities Automobiles Overcapacity quality
of depreciation allowances Telecommunications Tec
hnological change quality of depreciation
allowances Equipment leasing Lease values
quality of carrying values for leases Tobacco
Liabilities for health effects of smoking
quality of estimated liabilities Drugs RD
quality of RD expenditures Product liability
quality of estimated liabilities Airlines
Frequent flier programs estimated liabilities
for travel awards Real estate Property
values quality of carrying values for real
property Aircraft and ship Revenue recognition
quality of estimates under percentage
of manufacturing completion method and program
accounting Subscriber services Development of
customer base quality of capitalized promotion
costs Subscriptions paid in advance quality of
deferred revenue
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Flash Points Institutional Situations where
Manipulation is More Likely

• The firm is in the process of raising capital or
  renegotiating borrowing. Watch public offerings
• Debt covenants are likely to be violated
• A management change
• An auditor change
• Management rewards (like bonuses) are tied to
  earnings
• Management is repricing executive stock options
• A weak governance structure inside management
  dominate the board there is a weak audit
  committee or none at all
• Regulatory ratio requirements (like capital
  ratios for banks and insurance companies) are
  likely to be violated
• Transactions are with related parties rather than
  at arm's length
• Special events such as union negotiations and
  proxy fights
• The firm is "in play" as a takeover target
• The firm engages in exotic arrangements
  (structured off-balance-sheet vehicles)

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Flash Points Financial Statement Indicators that
Manipulation is More Likely

• A change in accounting principles or estimates
• An earnings surprise
• A drop in profitability after a period of good
  profitability
• Constant sales or falling sales
• Earnings growing faster than sales
• Very low earnings (that might be a loss without
  manipulation)
• Small or zero increases in profit margins (that
  might be a decrease without manipulation)
• A firm meets analysts earnings expectations, but
  just so.
• Differences in expenses for tax reporting and
  financial reporting
• Financial reports are used for other purposes,
  like tax reporting and union negotiations.
• Accounting adjustments in the last quarter of the
  year

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IPOs and Manipulation
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Overview of Diagnostics to Detect Manipulation
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Diagnostics to DetectManipulated Sales

• Net Sales Cash from Sales D Net Accounts
  Receivable
• Diagnostic Net Sales/ Cash from Sales
• Diagnostic Net Sales/Net Accounts Receivable
• Diagnostic Bad Debt Expense/Actual Credit
• Losses
• Diagnostic Bad Debt Reserves/Accounts
  Receivable (Gross)
• Diagnostic Bad Debt Expense/Sales
• Diagnostic Sales Return Expense/Actual Sales
  Returns
• Diagnostic Sales Return Reserves/Accounts
  Receivable (Gross)
• Diagnostic Sales Return Expense/Sales
• Diagnostic Warranty Expense/Actual Warranty
  Claims

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Diagnostics to DetectManipulated Expenses

• Investigate Changes in NOA with Normalized ATO
• OI Free Cash Flow D NOA
• Hard Soft
• So, D NOA is to be investigated
• D NOA Cash investment new operating
  accruals
• Hard Soft
• Diagnostic Restated OI/OI
• Restated OI Free Cash Flow
• D Sales/Normal ATO
• This works if sales are not manipulated

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Diagnostics to DetectManipulated Expenses

• Investigate Changes in ATO

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Diagnostics to DetectManipulated Expenses

• Investigate Line Items Directly
• Challenge depreciation and amortization expense
• Diagnostic
• Adjusted ebitdaOI (before tax) Depreciation
  Amortization Normal
  Capital Expense
• Normal capital expense is approximated by the
  average capital expenditure over past years or
  normal depreciation and amortization for the
  level of sales, calculated from past
  (Depreciation Amortization) / Sales ratios
• Challenge depreciation and amortization and
  working capital accruals
• Diagnostic CFO/OI
• Diagnostic CFO/Average NOA
• Diagnostic Accruals/D Sales
• Challenge other components of expense that
  depends on estimates
• Diagnostic Pension Expense/OI
• Diagnostic Other Post-Employment
  Exp./SGA Exp.

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Diagnostics to Detect Manipulated Expenses
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Diagnostics to DetectManipulated Expenses

• Investigate Balance Sheet Line Items Directly
• Particular suspects
• Assets whose carrying values are above their
  market values these are likely impairment
  candidates
• Assets whose carrying values and amortization
  rates are subject to estimate intangible assets,
  goodwill, deferred tax assets (particularly their
  valuation allowances), non-typical capitalization
  of expenses such as start-up costs, advertising
  and promotion, product development, and software
  development costs
• Assets recorded at estimated fair values
• Estimated liabilities such as pension
  liabilities, other employment liabilities,
  warranties, deferred tax liabilities, deferred
  revenue, and estimated merger and restructuring
  costs
• Off-balance-sheet liabilities such as guarantees,
  recourse for assigned receivables or debt,
  purchase commitments, and contingent liabilities
  for lawsuits and regulatory penalties
• Environmental liabilities (for clean up of
  pollution)

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The Cash Flow Statement is a Source of
Information on Accruals
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Detecting Transaction Timing

• Core Revenue Timing (Channel Stuffing)
• Unexpected sales increases or decreases in the
  final quarter
• Structuring of lease transactions to qualify as
  sales-type leases in lessors books
• Core Expense Timing
• Diagnostic RD Expense/Sales
• Diagnostic Advertising Expense/Sales
• Watch for temporary liquidation of hidden
  reserves for firms using conservative accounting
  (eg. LIFO dipping)
• Cherry picking for sales of securities

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Detecting Organizational Manipulation

• Off-Balance-Sheet Operations
• RD Partnerships
• Pension Funds
• Special purpose entities

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Frustrations with Disclosure Quality

• Consolidation accounting often makes the source
  of profitability hard to discover
• Line of business and geographical segment
  reporting is often not detailed enough
• Earnings in unconsolidated subsidiaries are hard
  to analyze. (Think of a firm that has all its
  earnings in subsidiaries in which it has less
  than 50 ownership core profit margins are not
  transparent!)
• Disclosure to reconcile free cash flow in the
  cash flow statement to free cash flow calculated
  (as OI - ?NOA) from the income statement and
  balance sheet. Some of the problems arise from
  uncertainty about items to be included in OI and
  NOA
• Disclosures to calculate stock compensation
  expense are thin
• Information is often not available to calculate
  losses on conversion of convertible claims into
  common equity
• Details on selling, general and administrative
  expenses are often scare

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Abnormal Returns to Quality Analysis
Source R. Sloan, "Do Stock Prices Fully Reflect
Information in Accruals and Cash Flows About
Future Earnings?" Accounting Review 71 (1996),
p. 312.
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Behavior of Earnings with High or Low Accrual
Components
Source R. Sloan, "Do Stock Prices Fully
Reflected Information in Accruals and Cash Flows
About Future Earnings?" p. 301.