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
OUR OBJECTIVE IS NOT
FRAUD DETECTION
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A Guide to Earnings and
Financial Reporting Quality (cont.)
The earnings statement provides
management with opportunities for
influencing the outcome of reported
earnings in ways that may not best
represent economic reality or the
future operating potential of a firm
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A Guide to Earnings and
Financial Reporting Quality (cont.)
•
The primary focus of this chapter:
• To provide a step-by-step guide
• To provide an approach to use in analyzing
and interpreting the qualitative factors
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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
17. Pension accounting-interest rate assumptions
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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:
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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Operating Expenses
(cont.)
17. Pension accounting-interest rate
assumptions:
A change in the pension interest rate assumption
can impact earnings equality
 if the rate is decreased, the annual pension
cost and the present value of the benefits will
increase
 if the rate is increased, the annual pension
cost and the present value of the benefits will
decrease
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Nonoperating Revenue and
Expense
Potential areas include:
18. Gains (losses) from sales of assets
19. Interest income
20. Equity income
21. Income taxes
22. Unusual items
23. Discontinued operations
24. Accounting changes
25. Extraordinary items
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Nonoperating Revenue and
Expense (cont.)
18. 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.)
19. 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.)
20. 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.)
22. Unusual items:
Analyst should always investigate these
items by reading the notes and the
MD&A to determine if these items are
nonoperating and/or nonrecurring
Also called special charges
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Nonoperating Revenue and
Expense (cont.)
23. 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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Nonoperating Revenue and
Expense (cont.)
25. Extraordinary items:
Gains and losses that are both unusual and
infrequent in nature
Amounts should be eliminated from earnings
when evaluating a firm’s future earnings
potential
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Other Issues
Potential areas include:
26.
Material changes in number of shares
27.
outstanding
Operating earnings, a.k.a. core earnings,
or EBITDA
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Other Issues
(cont.)
26. 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.)
27.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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What are the Real Earnings?
Each individual user of financial statements
should adjust the earnings figure to reflect
what they believe is relevant to the decision
at hand
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Quality of Financial ReportingThe Balance Sheet
Items discussed in the earnings quality section
such as the value attached to accounts
receivable, inventory and long-term assets
also impact balance sheet quality
Other items to assess and evaluate include…..
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Quality of Financial ReportingThe Balance Sheet (cont.)


Type of debt used to finance assets should
generally be matched (short-term debt for
current assets and long-term debt/equity for
long-term assets)
“Commitments and Contingencies”
disclosures in the notes should be carefully
evaluated as information on off-balancesheet financing and other complex financing
arrangements are located here
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Quality of Financial ReportingThe Statement of Cash Flows
The cash flows from operations (CFO)
figure, while highly useful, can be
manipulated by


Recording operating expenses as
capital expenditures
Managing current asset and liability
accounts to cause increases to CFO
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Quality of Financial ReportingThe Statement of Cash Flows (cont.)
Cash flows from the following types of items
should be removed from CFO for analytical
purposes:



Investments in trading securities
Discontinued operations
Nonrecurring expenses or income
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Turkish Companies-Public
Manipulation-Earnings Overstatement
65%
Manipulation-Earnings Understatement 22%
Manipulation-Other
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Manipulation- Earnings Overstatement
Adding financial expenses to the cost of inventories/property plant and
equipment etc…
Inadequate allowance for doubtful receivables
Recording consignment shipments as revenues
Recording sales through fictitious invoice
Recording revaluation of property plant and equipment as income
16%
8%
8%
6.5%
6%
Manipulation- Earnings Understatement
Overstatement of the cost of goods purchased from related parties
Recording financial expense on investments as expense directly
All other related party transactions
(Especially by the financial institutions)
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9.5%
5%
50%
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