Report quality

Question 1

What is financial reporting quality?

Answer 1

It refers to the usefulness of the information contained in the financial reports, including disclosures in notes.

Question 2

What is the concept of earnings quality?

Answer 2

It pertains to the earnings and cash generated by the company’s core economic activities and its resulting financial condition.

Question 3

Describe the “GAAP, Decision-useful, sustainable, and adequate returns” part of the quality spectrum.

Answer 3

• Financial reporting is of high quality, and the economic reality being depicted is of high quality.
• Financial reports do represent the company’s true economic situation.
• The activities of the company are sustainable which means that they generate earnings/CF that are expected to recur in the future.
• A return that exceeds the cost of investment and also meets the expected return.

Question 4

Describe the “GAAP, Decision-useful, but sustainable?” part of the quality spectrum.

Answer 4

• Financial reporting is of high quality, but the economic reality being depicted is not of high quality.
• The company cannot expect to earn the same level of return on investment in the future.
• The return does not exceed the cost of investment.

Question 5

Describe the “within GAAP, but biased accounting choices” part of the quality spectrum.

Answer 5

• Financial reporting is not of high quality, and the economic reality being depicted is often not of high quality.
• Management can make aggressive choices to increase the profit in the short term.
• Management can make conservative choices that provide steady growth but less surprising profit expectations.

Question 6

Describe the “Whitin GAAP, but earnings management” part of the quality spectrum.

Answer 6

Change accounting estimates to manipulate reported performance.

Question 7

Describe the “Departures from GAAP – Non-compliant accounting” part of the quality spectrum.

Answer 7

Capitalize a significant amount of operating expenses to overstate profits.

Question 8

Describe the “Departures from GAAP – Fictitious transactions” part of the quality spectrum.

Answer 8

Fictitious revenues, policyholders, bank balances.

Question 9

Why does conservatism directly conflict with the concept of neutrality?

Answer 9

Because it leads to biased estimates of assets, liabilities, and earnings.

Question 10

What is the main benefit of conservatism?

Answer 10

Asymmetrical information because conservatism may protect contracting parties with less information and higher risk.

Question 11

What is the big bath behavior?

Answer 11

It is a strategy of manipulating a company’s income statement to make poor results look even worse.

Question 12

What is the cookie jar reserve accounting?

Answer 12

It is the practice of creating a liability when a company incurs an expense that cannot be directly linked to a specific accounting period.

Question 13

Why would management issue financial reports that are not of high quality?

Answer 13

• To mask poor performance, such as loss of market share or lower profitability than other companies in the industry.
• To meet or beat analysts’ forecasts or management’s own forecast.
• To address managers’ concerns regarding their careers.
• To avoid debt covenant violations.

Question 14

What are the 3 conditions when low-quality financial reports are issued?

Answer 14

• Opportunity: poor internal controls, an ineffective board of directors, or accounting standards that allow divergent choices and/or provide minimal consequences for inappropriate choices can give rise to opportunities for management to issue low-quality financial reports.
• Motivation: motivation to issue low-quality financial reports can come from personal reasons or corporate reasons.
• Rationalization: This is important because individuals need to justify their choices to themselves.

Question 15

How do markets discipline financial reporting quality?

Answer 15

The cost of capital is directly related to the level of perceived risk.

Question 16

What are the registration requirements?

Answer 16

Companies that plan to issue securities must register them with market regulators before offering them to the public.

Question 17

What are the disclosure requirements?

Answer 17

Publicly traded companies are required to make periodic financial reports available to the public.

Question 18

What are auditing requirements?

Answer 18

Financial statements must be accompanied by an audit opinion certifying that the presented financials conform to relevant accounting standards.

Question 19

What are the management commentaries?

Answer 19

Financial reports issued by publicly traded companies must include statements by management, including a review of the company’s business and a description of principal risks and uncertainties facing the company.

Question 20

What are the responsibility statements?

Answer 20

Persons responsible for the company’s filings are required to explicitly acknowledge responsibility and attest to the correctness of financial reports.

Question 21

What is the regulatory review of filings?

Answer 21

Regulators usually undertake a review process to ensure that companies have followed all rules.

Question 22

What are the enforcement mechanisms?

Answer 22

Regulators are granted various power to enforce securities market rules.

Question 23

Which provisions can motivate borrowers/investees to manipulate reported results to avoid unfavorable repercussions?

Answer 23

• Loan agreements contain covenants that, if violated, can result in a technical default of the borrower.
• Certain investment contracts contain provisions that enable the investor to recover all parts of his investment if certain financial triggers occur.

Question 24

What is the disadvantage of the purchase method for acquisition?

Answer 24

It entails significant goodwill amortization charges, resulting in lower earnings over an extended period.

Question 25

What do companies must do if they use non-GAAP financial measures in an SEC filing?

Answer 25

• It must display the most directly comparable GAAP measure with equal prominence.
• It must provide a reconciliation of the non-GAAP measure and the equivalent GAAP measure.
• It explains why it believes that the non-GAAP financial measures provide useful information regarding the company’s financial condition and operations.

Question 26

What is channel stuffing, and why is it used?

Answer 26

• Sometimes, management may be pushing shipments out the door,
• Management does that to maximize revenue recognized in the current accounting period.

Question 27

When can revenue be recognized?

Answer 27

• When goods reach the customer.
• When goods are dispatched.

Question 28

What is a bill-and-hold transaction?

Answer 28

• It is when a customer purchases goods but requests that the goods remain with the seller until a later date.
• It recognizes fictitious sales by reclassifying end-of-period inventory as “sold but held” through minimal effort and fake documentation,

Question 29

Why would management reduce its allowance for sales return as a proportion of sales?

Answer 29

To reduce expenses and increase profits.

Question 30

What does a higher allocation to goodwill do to the reported financial statement going forward?

Answer 30

It improves reported financial performance going forward.

Question 31

What strategies can be used if a public company is dealing with nonpublic companies?

Answer 31

The nonpublic companies can absorb some losses to decrease the losses of the public company.

Question 32

What are the 2 ways that the CFO can be manipulated?

Answer 32

• With the stretching out of payables.
• With the misclassifying of CF.

Question 33

Describe the “stretching out payables” concept.

Answer 33

Management may try to delay payments to creditors until after the BS date so that the increase in A/P over the period results in an increase in cash generated from operations.

Question 34

Describe the “misclassifying cash flows” concept.

Answer 34

A company may misclassify uses of CFO into the investing or financing section of the CF statement to inflate cash generated from operating activities.

Question 35

Which classification of CF is flexible under IFRS?

Answer 35

• Interest paid can be classified as operating or financing CF.
• Interest and dividends received may be classified as CFO or CFI.
• Dividends paid may be classified as CFO or CFF.

Question 36

What should an analyst do regarding the warning signs related to revenue?

Answer 36

• He should determine whether company policies make it easy to prematurely recognize revenue.
• He should determine whether receivables are increasing as a percentage of sales.
• He should evaluate the impact of estimates relating to the company’s rebate programs on revenue recognition.
• He should compare the company’s receivables turnover with competitors and look out for suggestions that the provision for doubtful accounts is insufficient.

Question 37

What should an analyst do regarding the warning signs related to inventories?

Answer 37

• He should compare growth in inventories with competitors and industry benchmarks.
• If inventory levels are increasing with no accompanying increase in sales, it could suggest poor inventory management or inventory obsolescence.

Question 38

What is the main red flag regarding the signs related to capitalization policies and deferred costs?

Answer 38

If the company is the only one capitalizing on certain costs while other industry participants expense them, it is a red flag.

Question 39

What is a warning sign related to the relationship between CF and income?

Answer 39

We need to evaluate the relationship between net income and CFO to make sure that there are not too many aggressive accrual accounting policies.

Question 40

What are the 4 most important minor warning signs?

Answer 40

• Depreciation methods and useful lives: compare depreciation policies to industry to make sure it’s adequate.
• Presence of related-party transactions: it is an issue when company founders are still involved in its day-to-day running and have their own wealth and reputations tied to performances.
• Gross/operating margins out of line with competitors or industry: It may indicate the presence of accounting manipulation.
• Restructuring and/or impairment charges: Analysts should appreciate that the restructuring charge suggests that expenses reported over prior years were probably understated and therefore make appropriate adjustments to prior years’ earnings.