CHAPTER 3: THE QUALITY

OF FINANCIAL
INFORMATION

Quality of Financial Information

Flexibility in choice of accounting methods makes choices

influence reported financial information

SOX ACT and changes in accounting that followed
increased transparency of financial statements
Transparent= easy for investors to understand condition
Companies with transparent statements are considered to
have higher value, as uncertainty of lack of transparency
reduces value
Earning management: work within GAAP to produce
results that beneficiate company or manager

 Several avenues for earning management that

analysts should keep an eye out for and will be

covered through presentation:
Accruals management
Revenue and expense recognition
Non-operating and non-recurring items
Goodwill impairment
Inventory Accounting
Depreciation
Income and expenses related to segments

Accruals Management
Accounting adjustments that relate earnings to cash flows
Expect that accruals will increase as revenues increase

and that depreciation will increase as company increases

investment in plant and equipment
Two types: discretionary and nondiscretionary
Nondiscretionary accruals: Arise from normal course of
business (sales on credit for example)

 Discretionary accruals:
Not stated as discretionary or nondiscretionary in statement,
analyst has to differentiate them himself
Keep a watch on allowance for doubtful accounts(estimate of
uncollectible accounts receivable)
Percentage is determined by judgment of manager
The percentage of uncollectible accounts should be relatively
constant unless there is a change in customer base or the
economy in overall
Uncollectible rate should also be similar between companies
in same industry
Net income and cash flow trends should be moving in

the same direction, a misalignment may suggest a

mismanagement with accruals

General Electric Example (0.92

correlation)

Eastman Kodak Example (0.32

correlation)

Are similar at beginning in Kodak, but after

2006 they converge, filed for bankruptcy on
January 19, 2012

Revenues and Expense Recognition

Basic Guiding Principle of Accounting: Revenues and

expenses are matched

Revenues are recognized in period in which they are earned
Expenses are matched to coordinate with the corresponding

revenue
Due to accrual accounting that is mostly used revenues and
expenses do not necessarily correspond with cash inflow and
outflow
Managers determine timing of revenue and expense recognition,
which gives birth to potential manipulation through judicious timing

 Principle of conservatism: If there is flexibility in

recognition of revenue and expenses, the most

conservative approach should be used
Techniques used to inflate revenue:
Cookie-jar reserves: Company makes inappropriate
assumptions about liabilities, often overstating them in good
earning years. In the future when period earnings are not as
good they reserve this transaction
Channel stuffing: inflation of earnings of manufacturers or
suppliers by forcing distributors or outlets to take on more
units than they are able to sell. Speeds up revenue at the
expense of future periods revenues and earnings

Extraordinary and Non-recurring Items

Company earning and cash flows should be generated of

its business rather than nonrecurring means

Non operating gains are nonrecurring therefore unusual
Reported as part of operating expenses
Costs of Closing a store
Losing a lawsuit
Change in accounting principle(presented in balance sheet as

adjustment to stockholders equity

Extraordinary items are presented in income statement

after continuing operations and net of tax

Nonrecurring are included in operating results and are
unavoidable, extraordinary are reported in non operating
portion of statement

Deferred Taxes
Large difference between reported income and taxable

income suggests inclusion of revenues or expenses in the

reported income that are not recognized for tax purposes
in current period
Examining difference between accounting net income and
taxable income is not possible because the tax returns are
not made public
Examining sources and changes in deferred taxes (using
notes to the financial statements) can provide clues about
how accounting and taxable income diverge

 Differences between income reported in financial

statements and taxable income arise from many

sources, including differences in accounting for:
Depreciation
Installment sales
Leases
Warranties
Pensions

Analyst should focus on relationship between

reported earnings and taxable income diverge

significantly, which is indicated by a significant
change in the deferred tax liability or asset

Goodwill Hunting
Difference between the purchase price of the acquired

company and the fair value of the acquired companys

asset
If difference Is positive it is reported as intangible asset
If negative it is written down to current value, which will
hurt the earnings of said year but would result in improved
return of assets in future years
Example: in 2003 and 2004 Yahoo! Paid $2.9 billions
acquiring other companies; 2.1 were allocated to goodwill
and rest allocated to either tangible and amortizable
intangible assets

 Goodwill is a difficult to identify intangible asset

In a study of goodwill impairment, Duff & Phelps

found that:
Impairments are related to economic declines. In financial

crisis a larger proportion of impairments will be reported on

certain industries affected (ex: service companies in recent
financial crisis)
Impairments tend to follow a decline in performance, with
investors anticipating goodwill impairments
Events likely to trigger impairment include legal or regulatory
issues, changes in economic climate and changes in
competition in the companys market

Inventory Accounting
Method chosen to account for inventory affects value of

inventory, cost of goods sold and earnings reported,

taxable income and taxes. Ultimately affecting both cash
flows and financial statements
Methods:
FIFO (first in, first out): first items purchases are sold
first(cost of older inventory recorded as COGS)
LIFO (last in, first out): assumes last items purchases are
the first sold (cost of new inventory recorded as COGS)
Average cost: uses same costs(average) for item sold and
in inventory

Inventory Accounting
If selling prices are less flexible than prices of materials

then companys profits will be more volatile using FIFO

than LIFO
If a company reduces its inventory substantially during a
period and uses LIFO accounting, there will be an artificial
earning boost from the sale of older, lower priced inventory
Companies in same industry may use distinct methods,
making comparison harder

Write-Downs
Companies are permitted to write-down value of inventory

when the carrying value exceeds fair value of inventory

Questions that should arise on write-downs:
Writing down with expectation of selling it at aa higher profit in future

periods?
Is the company not writing down devalued inventory so that they do
not dampen earnings?
Is the company writing down its inventory on a timely basis?
What changes in business have caused the loss in value of
inventory?
When inventory is written down, does the company still have
possession of the inventory? Will this inventory be sold in future
periods?

 There are cases of companies writing down inventory and

later selling them at higher profit margin in future periods

According to SEC Sunbeam Corporation wrote down value
of perfect inventory by $2.1 million in one year to sell it
next year and report said amount of greater profit

Depreciation
A companys depreciation method and choice of useful life

decisions affect quality of earnings

Assets that are more productive in earlier years of useful
life, provide higher quality earnings using the accelerated
method in comparison to straight-line method
Three methods:
Straight line: uniform depreciation through useful life
Accelerated: higher weight on early years
Units of production: estimate is made by the use of the asset, in

which the expense in any period reflects the usage in said period

 Over the life of asset, same depreciation is expensed

against income, but for each period said value varies

according to method
Most companies use straight line method for reporting
Companies provide limited information regarding the
depreciation method and useful lives in notes o their
financial statements

Changes in Estimates
Useful life and salvage value of an asset are estimated;

thus they can be reviewed and changed accordingly

When revising depreciable life of an existing asset, the
company is required to account for the change in the
period that it occurred, but is not permitted to restate priorperiods financial accounts retroactively
Company that is depreciating a $1 million asset, with a
$100,000 salvage value over 20 years
Revises and determines useful life to be 30 years rather
than 20, then depreciation expense will be decreasing
from 45,000 to 22,500 per year. Said revision also affects
carrying value of said asset

Pension Valuation Assumptions

Pension Plan: agreement under which an employer agrees to

pay benefits to employees once the employees period of

service ends
May be:
Defined Contribution Plan: employers makes only a specified
contribution
Defined benefit plan: specific monetary benefit is promised;
benefits depend on certain requirements specified by
employers, such as employees age and number of years of
service
Employer creates pension fund, intermediary used to meet
promised obligations, making payments to the fund which are
invested and then paid to the employees as pension

 These plans differ in accounting terms

Defined contribution plan is simpler; pension costs

equal contribution made and employer reports an

asset or liability reflecting the difference between
actual payments made and the required payments
In defined benefit: promised payments are not known
with certainty and represent a liability because said
benefits will be paid in the future; in this case
employer invest in plan assets that are intended to
pay off the expected pension liability.

 The unknowns are:

Expected return on plan assets. Forecast of return on the

assets set aside to meet pension obligations

Discount rate: Discount rate reflects the time value of
money with respect to the pension liability
The rate of compensation increase: for pension plans in
which benefits are provided on the basis of compensation
at a future point in time, the rate at which the employees
compensation will increase

 Pension expense are reported on income statement

Pension liability on the balance sheet
Companies are expected to provide detail in a

footnote of their financial statements with respect to

the value of assets, expected liability and the
assumptions used in these calculations, among other
things
Obligations that may be reported:
ABO, Accumulated Benefit Obligation: present value of

pension benefits earned as of the balance sheet date based

on current salaries
PBO, Projected Benefit Obligation: Present value of pension
benefits earned as of the balance sheet date based on
projected salaries. Relevant for plans with benefits that
depend on career average or final pay
VBO, Vested Benefit Obligation: Present value of the pension
benefits for employees vested in the pension plan

 Goal is to find funding status: which is difference

between projected benefit obligation and the fair

value of plan assets
Muddying the waters: when company changes its
plans, any change in costs is spread over the
remaining service life of employees. Some pension
expense slips by the income statement and goes
directly to shareholders equity
Companies may revise assumptions used in
calculation of the benefit obligation and pension
expense. The change of these assumptions has the
following effect on obligation and expense:

Restatements and Financial Analysis

Companies restate their financial results if there was an error in

the previous reported results or the company is correcting

financial results because of detected fraudulent reporting.
The General Accounting Office (GAO) examined over 1,000
restatements by publicly traded companies in 20022 through
2006.
The most common reason for restatement in its analysis was
related to costs and expenses.
A stealth restatement is a restatement that is disclosed as part
of a current financial filing with the SEC, instead of a separate
8-K filing.
The analyst needs to take a close look at SED filings to
determine the reason behind the restatement.

Tell-Tale Signs
There are a number of tell-tale signs that can alert the

analyst to actual or potential problems.

There are several results from the engagement of an
auditor to review of the companys financial statements:
A unqualified opinion: statements are presented fairly.
A qualified opinion: further research by the analyst.
An adverse opinion: financial statements do not present the

companys financial position.

A disclaimer of opinion: unable to form an opinion regarding the
financial statements.
Withdrawal of opinion: suspected illegal activities by the audited
company.

Other Signs