Chapter 9 Financial reporting quality & FS manipulation Reading: CFA Curriculums 2024 LV1 Vol 3 – LM2: Financial reporting quality Content • Compare financial reporting quality with the quality of reported results • Describe a spectrum for assessing financial reporting quality • Explain the difference between conservative and aggressive accounting • Describe motivations that might cause management to issue financial reports that are not high quality and conditions that are conductive to issuing low – quality, or even fraudulent, financial reports • Describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms • Describle presentation choices, including non – GAAP measures, that could be used to influence an analysts’ opinion • Describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow and balance sheet items • Describe accouting warning signs and methods for detecting manipulation of information in FS Financial reporting quality Example: • Low quality earning (BAX) • Low quality FS (ITA) • SPEs (ROS/ Enron) => It is necessary to talk about the financial reporting quality High quality FS - Concepts What is a high quality FS? High quality FS provides information that is useful to analysts in assessing a company’s performance and prospects. These information is relevant, complete, neutral and free from error, as well as faithfully represents the economic reality of the company’s activities during the reporting periods as well as the company’s financial condition at the end of the period. In contrast, low quality FS contains inaccurate, misleading or incomplete information => Results not only in investor losses but also in reduced confidence in the financial system. High quality FS vs. High quality earnings High – quality earnings: results from activities that a company likely will be able to sustain in the future and provide a sufficient return on the company’s investment. An adequate level of return on investment exceeds the cost of the investment and also equals or exceeds the expected returns. Sustainable activities and sustainable earnings are those expected to recur in the future. “Earnings quality” and “FS quality” are interrelated because a correct assessment of earnings quality is possible only when there is some basic level of FS quality. A company with high FS quality can have low earning quality Quality spectrum of financial reports Quality spectrum provides a basis for evaluating better vs. poorer quality reports: • GAAP, decision – useful, sustainable and adequate returns • GAAP, decision – useful but sustainable? Low “earning quality”. • Within GAAP, but biased choices • Within GAAP, but “earning management”? (Real EM/ Accounting EM) • Non – compliant accounting • Fictious transactions Quality spectrum of financial reports q GAAP, decision – useful, sustainable and adequate returns “GAAP, decision – useful, sustainable and adequate returns” are high – quality reports that provide useful information about high quality earnings. • High quality FS conform to the generally accepted accounting principles (GAAP) of the jurisdiction. • High quality FS also embody the characteristics of decision – useful information: relevant and faithful representation. Quality spectrum of financial reports q GAAP, decision – useful but sustainable? High – quality reporting provides useful information, but that information reflects results or reanings that are not sustainable (lower earnings quality) The earnings may not be sustainable because the company cannot expect earnings that generate the same level of ROI in the future or because the earnings, although replicable, will not generate sufficient ROI to sustain the company. Example: A company that generates a loss/ earnings that do not provide an adequate ROI/ earnings that resulted from non – recurring activites. The relatively undesirable economic reality could nonetheless be depicted in financial reporting that provides high – quality, decision – useful information. Quality spectrum of financial reports q Within GAAP, but biased choices Biased choices: the FS do not faithfully represent the economic substance of what is being reported. • Aggressive choices: if they increase a company’s reported performance and financial positions in the period under review by increase the amount of revenues, earnings or operating CF/ decreasen expenses, reduce the level of debts … => Lead to a reduction in the company’s reported performance and it is financial position in later periods. • Conservative choices: If they decrease a company’s performance and financial position in the reporting period by (i) lowering the reported revenues, earnings, or operating CF or (ii) increasing expenses, reporting a higher level of debt. • “Earning smoothings”/ Understatement of earnings volatility: Conservative choices to understate earnings in periods when a company’s operations are performing well, building up (often hidden) reserves that allow aggressive choices in periods when its operations are struggling. Biased choices can also be made in the context of how information is presented. Example: Companies can disclose information in a manner that aim to obscure unfavorable or emphasize favorable information. Quality spectrum of financial reports q Within GAAP, but biased choices Non – GAAP reporting adds yet another dimension of management discretion. Non – GAAP earnings, which are created by companies “that adjust standards – compniant earnings to exclude items required by accounting standards or to include items not permitted by accounting standards”. Non – GAAP operating metrics do not relate directly to the financial statements and include metrics that are typically industry – driven (subscriber number, active users, and occupancy rates). Non – GAAP FS has become increasingly common, presenting challenges to analysts. Example: • Diminishes comparability across FS. • Differences in terminology The reconciliation between as – reported measures and as – adjusted measures can provide important information to analysts. Quality spectrum of financial reports q Within GAAP, but biased choices • Often poor reporting quality occurs simultaneously with poor earnings quality. Example: Aggressive accounting choices are made to obscure poor performance. • It is also possible for poor reporting quality to occur with high – quality earnings. Example: A company with good performance might not be able to produce high – quality reports because of inadequate internal systems. • A company with good performance might deliberately produce reports based on “conservative” rather than aggressive accounting choices => Make current performance look worse because: v They want to avoid unwanted political attention v Management had already exceeded targets before the end of the period and thus made conservative accounting choices that would delay reporting profits until the following periods (hidden reserves). v The trajectory of future results would appear more attractive (example: The company want to accelerate losses in the first year of an acquisition or the first year of a new CEO’ tenure so that the trajectory of future results would appear more attrative) Overall, unbiased financial reporting is optimal. Biased reporting, whether conservative or aggressive, adversely affects a user’s ability to assess a company. Quality spectrum of financial reports q Within GAAP, but “earnings management” Earning management (EM): Making intentional choices that create biased financial reports. Earning management represents “deliberate actions to influence reported earnings and their interpretation”. Earnings can be “managed” upward (increased) by taking real actions, such as deferring R&D expenses into the next reporting period or accounting choices, such as changing accounting estimates. Example: The amount of estimated product returns, bad debt expense, asset impairment could be decreased Quality spectrum of financial reports q Departures from GAAP FS that departs from GAAP generally can be considered to be low quality. In such situations, earning quality is likely difficult or impossible to be assess because comparisons with earlier periods and/or other entities cannot be made. Example: • Enron (2001) inappropriate ised of off – balance - sheet structures and other complex transactions resulted in vastly understated indebtedness as well as overstated profits and operating cash flow. • WorldCom (2002), by improperly capitalizing certain expenditures, dramatically understated its expenses and thus overstated its profits. Fabricated reports portray fictitious events, either to deceive investors my misrepresenting the company’s performance or to obscure fraudulent misappropriation of the company’s assets. Differentiate between conservative & aggressive accounting q The difference between conservative and aggressive accounting Some investors may prefer or be perceived to prefer conservative rather than aggressive accounting choices, because a positive surprise is acceptable. Conservativism do not typically create a sustainability issue. In contrast, management may make, or be perceived to make, aggressive accounting choices because they increase the company’s reported performance and financial position. Aggressive choices might creates a sustainability issues. In terms of establishing expectations for the future, financial reporting that is relevant and faithfully representative is the most useful. Example: Conservatism is not an absolute but is characterized by degrees, such as “the accountants’ tendency to require a higher degree of verification to recognize good news as gains than to recognize bad news as losses”. From this perspective, “verification” drives the degree of conservatism. Mechanisms that discipline FS quality q Mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms Market regulatory authorities: National regulations, and the regulators that establish and enforce rules, play a significant role in FS quality. Typical features of a regulatory regim that most directly affect FS quality include: • Registration requirements • Disclosure requirements • Auditing requirements • Management commentaries • Responsibility statements • Regulatory review of filings • Enforcement mechanisms Auditors & Auditor opinions: Unqualified opinions/ Qualified opinions/ Disclaimer of opinions/ Adverse Private contracting: Aspects of private contracts can discipline poor financial reporting quality (Loan agreements/ Investment contracts...) Accounting choices and estimates affect FS Accounting choices and estimates affect FS Accounting choices that affect FS Area of choice/estimates Analyst concerns Revenue recognition • • • • • • • How is revenue recognized: upon shipment or upon delivery of goods? Is the company engaging in “channel stuffing” – overloading a distribution channel with more product than it is normally capable of selling? Is there unusual activity in the allowance for sales returns relative to past history? Does the company’s days sales outstanding show any collection issues? Does the company engage in “bill – and – hold” transaction? Does the company use rebates as part of its marketing approach? Does the company separate its revenue arrangements into multiple deliverables of goods or services Accounting choices that affect FS Area of choice/estimates Analyst concerns Long - lived assets: Depreciation policies • • • Intangibles: Capitalization policy? • • • Do the estimated life spands of the associated assets make senses, or are they unusually low compared with others in the same industry? Have there been changes in depreciable lives that have a positive effect on current earnings? Do recent asset write – downs indicates that company policy on asset lives might need to be reconsidered? Does the company capitalize expenditures related to intangibles? Does its balance sheet show any R&D capitalized as a result of acquisitions? How do the company’s capitalization policies compare with the competition? Are amortization policies reasonable? Allowance for doubtful accounts/ loan loss reserves? • • • Are addition to such allowances lower or higher than in the past Does the collection experience justify any difference from historical provisioning? Is there a possibility that any lowering of the allowance may be the result of industry difficulties along with the difficulty of meeting earnings expectations? Inventory cost methods • Does the company use a costing method that produces fair reporting results in view of its environment? How do it inventory methods compare with others in its industries Does the company use reserves for obsolescence in its intenvory valuation? • Accounting choices that affect FS Area of choice/estimates Analyst concerns Tax asset valuation accounts • • Tax assets, if present, must be stated at the value at which management expects to realize them, and an allowance must be set up to restate tax assets to the level expected to eventually be converted into cash. Look for changes in the tax asset valuation account. Goodwill • • Companies must annually assess goodwil balances for imparment on a qualitative basis Do the disclosures on goodwill testing suggest that the exercise was skewed to avoid impairment charges? Warranty reserves • Have additions to the reserves been reduced, perhaps to make earnings targets? Related – party transactions • Is the company engaged in transactions that disproportionately benefit members of management? Does one company have control over another’s destiny through supply contracts or other dealings? Do extensive dealings take place with non – public companies that are under management controls? Those companies could absorb loosses to make the public company’s performance look good. • Warning signs Pay attention to revenue • Examine the accounting policies note for a company’s revenue recognition policies • Look at revelue relationship: Compare a company’s revenue growth with its primary competitors or its industry peer group. • Compare AR with revenues over several years. • Examine asset turnover Pay attention to signals from inventories • Look at inventory relationship • Compare growth in inventories with competitors and industry benchmark • Companies reporting under LIFO inventory cost flow assumptions might be a red flag, especially when a company operates in an inflationary environment. Warning signs Pay attention to capitalization policies and deferred costs • Examine the company’s accounting policy note for its capitalization policy for long – term assets, including interest costs, and for its handling of other deferred costs. Pay attention to the relationship between cash flow and net income • Construct a time series of cash generated by operations divided by net income. If the ratio is consistently below 1.0 or has declined repeatedly, the company’s accrual accounts may have problems. Look for other potential warnings signs • Depreciation methods and useful lives • Fourth - quarter surprise • Presence of related – party transactions • Non – operating incoem or one – time sales included in revenue • Classification of expenses as “non – recurring” • Gross/ Operating margins out of line with competitors or industry • Younger companies with an unblemished record of meeting growth projections • Management has adopted a minimalist approach to disclosure. • Management fixation on earnings reports Warning signs q Describe accounting warning signs and methods for detecting manipulation of information in financial reports Company culture A company’s culture is an intangible that investors should bear in mind when they are evaluating FS for the possibility of accounting manipulation. Restructuring or impairment charges At times, a company;s stock price has been observed to rise after after it recognized a big bath charge to report earnings. Management has a merger and acquisition orientation FS manipulation - Example • Cookie jar: The company created "Cookie Jar" (sweet candy jar) with the goal of "saving" profits. “Cookie Jar” is created from reserve accounts, pre-recording expenses and deferring revenue recognition <= Vietnamese Bank 2022. • Take a big bath: The company removed "hanging" items on the balance sheet to "clean up" the financial statements. Usually the "Take a big bath" operation will cause the company to make a big loss, but has a very clear purpose for the next periods. • Big bet on the future: The company "bets on the future" by applying loopholes in accounting standards to record all possible future profits in the current year <= Case DXG and LDG/ CII and LGC. • Throw out the problem child: The company eliminates the worst parts of its financial statements through financial transactions with third parties. <= Case TTF divestment from TTI • Change GAAP: The company uses tricks to change accounting policies to achieve the desired profit target. • Sales and lease back <= EIB (2016) sold assets to Eximland and bought it later • Use of SPEs: The company uses "special purpose entities - SPEs" to create revenue and hide debt.<= TTF (2010)/ JVC (2014)/ DCL (2014) • Above the line, below the line: “Above the Line” refer to the income and expenses that a company incurs due to normal operations. It is also the gross margin that a business earns. Whereas below the line is operating expenses, interest, and taxes. • Cherry picking: A common trick when companies skillfully "select" products to sell and invest in securities to increase sales profits. • Holding gain: Company’s profit comes from revaluation of assets instead of selling goods or services Thank you !!!
