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:
I. Sales
II. Cost of Goods Sold
III. Operating Expenses
IV. Nonoperating Revenue and Expense
V. Other Issues
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Sales
Potential areas include:
1. Premature revenue recognition
2. Gross vs. net basis
3. Vendor financing
4. Allowance for doubtful accounts
5. Price vs. volume changes
6. 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:
7.
8.
9.
10.
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:
11. Discretionary expenses
12. Depreciation
13. Asset impairment
14. “Big bath” or restructuring charges
15. Reserves
16. 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 year’s
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 longlived 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:
17.
18.
19.
20.
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
22.
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 firm’s 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.)
22.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)
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