A Guide to Earnings and Financial Reporting Quality

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A Guide to Earnings and Financial Reporting
Quality
This chapter considers the quality of reported
financial information, which is a critical
element in evaluating financial statement data
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Why Earnings Quality

• analyst should develop
• AN EARNINGS FIGURE
• that reflects the
• FUTURE ONGOING POTENTIAL
• of the firm

THE OBJECTIVE IS NOT FRAUD DETECTION
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A Checklist for Earnings Quality
Major areas on the checklist include

• Sales
• Cost of Goods Sold
• Operating Expenses
• Nonoperating Revenue and Expense
• Other Issues

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Sales
Potential areas include

• 1. Premature revenue recognition
• Gross vs. net basis
• Vendor financing
• Allowance for doubtful accounts
• Price vs. volume changes
• Real vs. nominal growth

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Sales (cont.)
1. Premature revenue recognition
According to GAAP, revenue should not be
recognized until there is evidence that a true
sale has taken place Many firms have violated
this accounting principle by recording revenue
before the conditions for a true sale have been
met

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Sales (cont.)
2. Gross vs. net basis
Another tactic to boost revenues is to record
sales at the gross rather than the net price

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Sales (cont.)
3. Vendor financing
Some companies use vendor financing to increase
revenues by lending their customers (other
companies) money to purchase their products

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Sales (cont.)
4. Allowance for doubtful accounts
This is a type of reserve account that can be
manipulated by under- or overestimating bad debt
expenses

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Sales (cont.)
5. Price vs. volume changes
In general, higher quality earnings would be the
product of both volume and price increases
(during inflation)
6. Real vs. nominal growth
Important to determine if sales are growing in
real (inflation-adjusted) as well as nominal
(as reported) terms

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Cost of Goods Sold
Potential areas include

• Cost-flow assumption for inventory
• Base LIFO layer liquidations
• Fulfillment costs
• Loss recognitions on write-downs of inventories

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Cost of Goods Sold
7. Cost-flow assumption for inventory
LIFO results in the matching of current costs
with current revenues and produces higher quality
earnings than either FIFO or average cost

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Cost of Goods Sold (cont.)
9. Fulfillment costs
An expense account that some companies add to
operating expenses to record costs that are
typically classified as cost of goods sold,
impacting their gross profit margin and lowering
their quality of earnings

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Cost of Goods Sold (cont.)
10. Loss recognitions on write-downs of
inventories

If the value of inventory falls below its
original cost, the inventory is written down to
market value. When the write-down is included in
cost of goods sold, the gross profit margin is
impacted

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Operating Expenses
Potential areas include

• Discretionary expenses
• Depreciation
• Asset impairment
• Big bath or restructuring charges
• Reserves
• In-process research and development

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Operating Expenses (cont.)
11. Discretionary expenses
If variable operating expenses such as repair and
maintenance, research and development, and
advertising and marketing are reduced primarily
to benefit the current years reported earnings,
the long-run impact on operating profit may be
detrimental and lower the quality of those
earnings

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Operating Expenses (cont.)
12. Depreciation

• misclassification of operating expenses as
  capital expenditures creates poor quality of
  financial reporting on all financial statements
• comparing companies is difficult when they use
  different depreciation methods and different
  estimates for the lives of their long-lived assets

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Operating Expenses (cont.)
13. Asset impairment
The write-down of asset values, following the
principle of carrying assets at the lower of cost
or market value, affects the comparability and
thus the quality of financial data

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Operating Expenses (cont.)
14. Big bath or restructuring charges
Large charges classified as restructuring charges
are sometimes used by companies to clean up their
balance sheet Ongoing restructuring of a company
can be a signal of underlying problems

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Operating Expenses (cont.)
15. Reserves (Cookie Jar Reserves)
Often created to set aside funds today to cover
some known future cost Abuse occurs when funds
are set aside in good years (i.e., reducing net
income) and then shifting the reserve amount to
the income statement in poor years

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Operating Expenses (cont.)
16. In-process research and development
One-time charges taken at the time of an
acquisition Can be problematic if companies
write-off significant amounts of research and
development in the year of acquisition in order
to boost earnings in later years

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Nonoperating Revenue and Expense
Potential areas include

• Gains (losses) from sales of assets
• Interest income
• Equity income
• Discontinued operations

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Nonoperating Revenue and Expense (cont.)
17. Gains (losses) from sales of assets
The sale of a major asset is sometimes made to
increase earnings and/or to generate needed cash
when the firm is performing poorly. Such
transactions are not part of the normal
operations of the firm and should be excluded
from net income when considering the future
operating potential of the company

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Nonoperating Revenue and Expense (cont.)
18. Interest income
In assessing earnings quality, the analyst should
be alert to the materiality and variability in
the amount of interest income because it is not
part of operating income

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Nonoperating Revenue and Expense (cont.)
19. Equity income
The net effect of using this method is that the
investor, in most cases, records more income than
is received in cash

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Nonoperating Revenue and Expense (cont.)
20. Discontinued operations
Should be excluded in considering future
earnings Appropriate to deduct the income on
discontinued operations each year from earnings
for comparative purposes

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Other Issues
Potential areas include

• 21. Material changes in number of shares
• outstanding
• Operating earnings, a.k.a. core earnings,
• or EBITDA

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Other Issues (cont.)
21. Material changes in number of shares
outstanding

• Changes can result from treasury stock purchases
  and the purchase and retirement of a firms own
  common stock
• Reasons for the repurchase of common stock should
  be determined if possible to see if firm is
  spending scarce resources to merely increase
  earnings per share (EPS)

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Other Issues (cont.)

• Operating earnings, a.k.a. core earnings,
• pro forma earnings, or EBITDA

Operating earnings are important for assessing
the ongoing potential of a firm Variety of
company created numbers have been created for
users to review
Core earnings Operating Earnings Before Interest,
Tax, Depreciation and Amortization (EBITDA)