Part 11. Financial Reporting Quality

Question 1

Financial reporting quality

Answer 1

This refers to the characteristics of firms financial statements, with primary criterion being adherence to generally accepted accounting principles (GAAP) in the jurisdiction in which firm operates.

Question 2

High quality financial reporting

Answer 2

This must be decision useful.

2 characteristics:

• relevance - must also be material in that knowledge of it would likely affect decision of users of financial statements.
• faithful representation - encompasses the qualities of completeness, neutrality, and absence of errors.

Question 3

Quality of earnings

Answer 3

• This can be judged based on the sustainability of earnings as well as on their level.
• Sustainability can be evaluated by determining the proportion of reported earnings that can be expected to continue in the future.
• Increase in reported earnings resulting from a change in ER or by sales of assets have appreciated over many periods are not typically sustainable, but higher profits from increased efficiency or market share are.
• The higher probability that high-quality earnings will continue in future periods increases their impact on the value of the firm, calculated as PV of expected future earnings.

Question 4

Importance of level of earnings/quality:

Answer 4

• Reported earnings must be high enough to sustain the company’s operations and existence over time, and high enough to provide an adequate return to companies investors.
• sustainability of reported cash flows in determining the quality of reported earnings, the value of items reported on the balance sheet.
• inadequate accruals for probable liabilities and overstatement of asset values can decrease quality or reported earnings and bring sustainability to question.
• it is possible for firm has high financial reporting quality, but low quality of reported earnings, such as earnings reported may be GAAP compliant and relevant, but low sustainability or low enough in the amount that provision of adequate investor returns.

Question 5

Categorisation of quality levels of financial reports from best to worse:

Answer 5

1. Reporting compliant with GAAP and decision-useful; earnings are sustainable and adequate.
2. Reporting is compliant with GAAP and decision-useful, but earnings quality is low (earnings are not sustainable or adequate).
3. Reporting is compliant with GAAP, but earnings quality is low, and reporting choices and estimates are biased.
4. Reporting is compliant with GAAP, but the amount of earnings is actively managed to increase, decrease, or smooth reported earnings.
5. Reporting is not compliant with GAAP, although the numbers presented are based on the company’s actual economic activities.
6. Reporting is not compliant and includes numbers that are essentially fictitious or fraudulent.

Question 6

Conservative accounting

Answer 6

The choices made within GAAP wrt reported earnings, if they tend to decrease the companys reported earnings and financial positon for the current period.

This results in increase future period earnings.

Often used by management for different periods to smooth earnings overtime as greater earnings volatility tends to reduce value of company shares.

Question 7

Aggressive accounting

Answer 7

The choices that increase reported earnings or improve the financial position for the current period.

This results in decreased earnings in future periods.

Question 8

Earnings smoothing

Answer 8

This is accomplished through adjustment of accrued liabilities based on management estimates.

• In higher than expected earnings, management may employ conservative bias by adjusting accrued liability upward to reduce reported earnings for that period.
• This allows deferral of recognition of earnings to future period that are less expected.
• In future period, accrued liability adjusted downward increases reported earnings for that period to meet market expectations.

Question 9

Examples of aggressive accounting

Answer 9

• capitalising current period costs
• longer estimates of lives of depreciable assets
• higher estimates of salvage values
• straight line depreciation
• delayed recognition of impairments
• less accrual of reserves for bad debt
• smaller valuation allowances on DTA

Question 10

Examples of conservative accounting

Answer 10

• expensing current period costs
• shorter estimates of lives of depreciable assets
• lower estimates of salvage values
• accelerated depreciation
• early recognition of impairments
• more accrual of reserves for bad debt
• larger valuation allowances on DTA

Question 11

Bias

Answer 11

• This can be present in the way financial results are presented.
• A company may present transparent statements helping analysts understand results and activities led to them.
• A company may provide minimal disclosure in attempt to emphasise positive developments and obscure info from negative developments.

Question 12

Examples where GAAP introduce conservatism:

Answer 12

• Imposing higher standard of verification for revenue and profit that for expenses and accrual of liabilities:
  e. g. research costs expensed in period incurred due to uncertainty about future benefits to be provided from research activities, while associated revenue not reocgnised until some future period.
  e. g. accrual for legal liabilities recorded when future payment becomes probable, while standard recognising increasing accrued asset value is stricter.
  e. g. US GAAP write downs of inventory values required when FV likely impaired, but increases in inventory value may not be recorded until inventory is sold.

Question 13

Benefits of conservative bias

Answer 13

• Reducing probability for future litigation from users claiming they were misled, in reducing current period tax liability, and in protecting interests of those who have less complete information than company management, such as buyers of company debt.

Question 14

Manager motivations

Answer 14

For aggressive accounting:

• choices meet or exceed benchmark number for earnings per share.
• report earnings greater than earnings guidance offered earlier by management.
• report earnings greater than consensus analyst expectations.
• report earnings greater than those of same period in prior year.

reasons:

• career orientated, seeking to enhance reputation and improve career opportunities.
• beating benchmarks is important to subsequent stock price movements
• motivated by incentive compensation (bonus) that depends on stock returns.
• gain credibility with equity market investors
• improve the way company is viewed by customers and suppliers.
• for highly leveraged companies and unprofitable companies, it is a desire to avoid violating debt covenants.

Question 15

3 factors where management provide low quality financial reporting:

Answer 15

1. motivation
2. opportunity
3. rationalisation of behaviour i.e. “ill fix it next period”

Question 16

Circumstances where low quality, or fraudulent financial reporting is more probable:

Answer 16

• the company has weak internal controls.
• the board of directors provide inadequate oversight.
• applicable accounting standards provide large ranf of acceptable accounting treatments, provide for inconsequential penalties in case of accounting fraud or both.

Question 17

Securities regulations require:

Answer 17

• a registration process for issuance of new publicly traded securities.
• specific disclosure and reporting requirements, including periodic financial statements and accompanying notes.
• an independent audit of financial reports.
• a statement of financial conditions (or management commentary) made by management.
• a signed statement by person responsible for preparation of financial reports
• a review process for newly registers securities and periodic reviews after registration

US - the management must include assessment of effectiveness of firms internal controls.

Question 18

Enforcement actions by securities regulators

Answer 18

• Fines
• Suspension of participation in issuance and trading of securities
• Public disclosure of results of disciplinary proceedings
• Criminal prosecution of fraudulent or illegal activities

A clean audit opinion does not guarantee no fraud has occurred, but only offers reasonable assurance financial reports have been fairly reported.

Question 19

non-GAAP measures:

Answer 19

Firms reporting accounting measures that are not defined or required under GAAP.

• These typically exclude some items in order to make firms performance look better that using measures defined/required by GAAP.
• This claim often made certain items excluded as are one time or nonoperating costs that will not affect operating earnings going forward, as are non-cash charges or improve comparing with companies using different accounting methods.

Question 20

US companies report non-GAAP measures in financial statements are required to:

Answer 20

• display most compaarble GAAP measure with equal prominence.
• provide an explanation by management as to why non-GAAP measure is thought to be useful.
• reconcile differences between the non=GAAP measure and most comparable GAAP measure.
• disclose other purposes for which the firm uses non-GAAP measure.
• include, in any non-GAAP measure, any items likely to recur in future, even those treated as nonrecurring, unusual or infrequent in financial statements.

Question 21

IFRS requires firms using non-IFRS measures in financial reports must:

Answer 21

• define and explain relevance of such non-IFRS measures.

- reconcile differences between non-IFRS measure and most comparable IFRS measure.

Question 22

Why are non-GAAP measures used?

Answer 22

The supposition that firms use non-GAAP measures in an attempt to control metrics on which they are evaluated and reduce focus of analysts and investors on GAAP measures.

Question 23

Timing of revenue recognition - free on board example :

Answer 23

• A firms choice of where in the shipping process that customer actually takes title to the goods.
• A firm may choose terms with their customer of free-on-board (FOB) at shipping point (firm’s loading dock) or FOB at destination (customers location).
• Choosing terms of FOB at shipping point will mean revenue is recognised earlier compared to FOB at the destination.

Question 24

Timing of revenue recognition - channel stuffing example :

Answer 24

• Firms can manage this by accelerating or delaying the shipment of goods, if additional revenue is required to meet targets.
• Firms can offer discounts or special financing terms to increase orders in current period, or ship goods to distributions without receiving an order.
• Channel stuffing - overloading a distribution channel with more goods than would normally be sold during period.
• In periods where high earnings are expected, management may wish to delay recognition of revenue in next period and hold or delay customer shipments to achieve this.

Question 25

Timing of revenue recognition - bill and hold transaction example :

Answer 25

• The customer buys the goods and receives an invoice but requests that the firm keep the goods at their location for period of time.
• The use of fictitious bill and hold transactions can increase earnings in current period by recognising revenue for goods that actually still in inventory.
• Revenue for future periods will be decreased as real customer orders for bill and hold items are filled but not recognised in revenue, offsetting previous overstatement of revenue.

Question 26

Estimates of credit losses

Answer 26

• Example of accounting choices that affect financial reports is estimation of losses from uncollectable customer credit accounts.
• On the BS, the reserve for uncollectible debt is an offset to accounts receivable.
• If management determines probability that accounts receivable will be uncollectible is lower than current estimate, a decrease in reserve of uncollectible accounts will increase net receivables reported on BS, reduce expenses on IS and increase net income.
• Increase in allowance for bad debt would have opposite effect, decreasing net receivables on BS, increasing expenses and decreasing net income.
• Firm underestimating the percentage of receivables uncollectible will report higher receivables and net income as a result, and vice versa.
• Management can adjust bad debt reserve to smooth earnings, with period of high earnings allowance of bad debt is increased to reduce reported earnings for later use, with subsequent periods earnings below benchmark values, with bad debt reserve reduced to meet earnings targets.
• Other reserves, such as warranty expense can be changed to manage reported earnings; a decrease in estimated warranty expense as percentage of sales will increase earnings, and vice versa.

Question 27

Valuation allowance

Answer 27

This reduces carrying value of deferred tax asset based on probability it will not be realised.

If increases, it will decreases the net deferred tax asset on BS, and reduce net income for period, and vice versa.

This can be understated to show higher asset values, and also can be adjusted over time to smooth earnings.

Question 28

Depreciation methods

Answer 28

• An accelerated method of depreciation increases expenses, decreases net income in early years of asset life.
• In later years of asset life, expenses are lower, net income higher when accelerated method is used.
• The CV of depreciable asset on BS will decrease more rapidly with accelerated depreciation than SL.
• A greater salvage value will slow depreciation so CV of asset is greater, depreciation expense is less, and net income is higher, the opposite effect for smaller salvage value.
• If salvage value is higher than actual sale price at end of asset life, a loss on sale of asset will decrease net income in period which asset is sold.
• Use of longer est. useful life of depreciable asset decreases in periodic depreciation expense, increases net income in early years of asset life compared to shorter estimated useful life.

Question 29

Amortisation & Impairment

Answer 29

• intangible asset is not amortised but subject to test of impairment.
• ignoring/delaying recognition of impairment charge for good will, management can increase earnings in current period.

Question 30

Inventory method

Answer 30

• In period of rising prices, COGS under FIFO method will be less than COGS under weighted average costing method.
• Gross profit, gross margin, and earnings will be all greater under FIFO method than weighted average method as a result.
• BS inventory method is greater under FIFO than weighted average.
• In periods of decreasing prices, the opposite is true.
• With relevance, in environment of increasing or decreasing prices, FIFO results in more accurate BS inventory values as its closer to current replacement cost than weighted average cost method.
• COGS are closer to current (replacement) cost under weighted average cost method, so gross profit and margin better reflect economic reality.
• Gross profit under FIFO is distorted in that it includes gains from rising prices (or losses from decreasing prices), so weighted average cost method produces better info on IS.
• Financial reports are transparent, providing users with info needed to understand how choice of inventory cost method affects IS and BS values considered to be higher quality.

Question 31

Related Party transacations

Answer 31

A public firm does business with supplier that is private and controlled by management, adjusting price of goods supplied shifts profits either to or from private company to manage earnings reported by public company.

Question 32

Capitalisation

Answer 32

A expense capitalised creates an asset on BS, where its impact can be spread over many years.

e.g. firm with marketing expense $1.5m chooses to capitalise this expense, and amortise over 3 years.

In period where expense is incurred, capitalisation will reduce expense on IS from $1.5m to $0.5m, increasing pretax income by $1m.

At end of period, the related BS asset is $1m, and amortised expense of $0.5m will be taken (and reduced net income) in each of following 2 years.

Greater capitalisation of R&D costs will shift net income to current period.

Capitalisation affects cash flow classification, where if expense is capitalised, the entire amount is classified as investing cash outflow so operating cash flow os increase by that amount.

Question 33

Other cash flow effects

Answer 33

• Taking longer to pay suppliers increases operating cash flows = stretching payables.
• Delaying payments normally be made near end of reporting period until beginning of next accounting period will increase operating cash flow in current period, and reduce in subsequent period.
• There is no effect on reported earnings in current period stretching payables.
• Capitalising interest expense will decrease cash flow from investing, and increase from operations, along with effects on pattern of earnings from depreciating interest expense over time than current period.
• The ability under IFRS to classify interest and dividends paid as either CFO or CFF, and interest and dividends received as CFO or CFI gives management additional way to manage reported operating cash flow.