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 company’s 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 company’s 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 company’s 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 company’s 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 prior-period’s 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 employee’s 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 employee’s 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 company’s 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

company’s 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