LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• demonstrate the use of a conceptual framework for assessing the quality of a company's financial reports;
• explain potential problems that affect the quality of financial reports;
• describe how to evaluate the quality of a company's financial reports;
• evaluate the quality of a company's financial reports;
• describe the concept of sustainable (persistent) earnings;
• describe indicators of earnings quality;
• explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion;
• evaluate the earnings quality of a company;
• describe indicators of cash flow quality;
• evaluate the cash flow quality of a company;
• describe indicators of balance sheet quality;
• evaluate the balance sheet quality of a company;
• describe sources of information about risk.

SUMMARY OVERVIEW

• The quality of financial reporting can be thought of as spanning a continuum from the highest quality to the lowest.
• Potential problems that affect the quality of financial reporting broadly include revenue and expense recognition on the income statement; classification on the statement of cash flows; and the recognition, classification, and measurement of assets and liabilities on the balance sheet.
• Typical steps involved in evaluating financial reporting quality include an understanding of the company's business and industry in which the company is operating; comparison of the financial statements in the current period and the previous period to identify any significant differences in line items; an evaluation of the company's accounting policies, especially any unusual revenue and expense recognition compared with those of other companies in the same industry; financial ratio analysis; examination of the statement of cash flows with particular focus on differences between net income and operating cash flows; perusal of risk disclosures; and review of management compensation and insider transactions.
• High-quality earnings increase the value of the company more than low-quality earnings, and the term “high-quality earnings” assumes that reporting quality is high.
• Low-quality earnings are insufficient to cover the company's cost of capital and/or are derived from non-recurring, one-off activities. In addition, the term “low-quality earnings” can be used when the reported information does not provide a useful indication of the company's performance.
• Various alternatives have been used as indicators of earnings quality: recurring earnings, earnings persistence and related measures of accruals, beating benchmarks, and after-the-fact confirmations of poor-quality earnings, such as enforcement actions and restatements.
• Earnings that have a significant accrual component are less persistent and thus may revert to the mean more quickly.
• A company that consistently reports earnings that exactly meet or only narrowly beat benchmarks can raise questions about its earnings quality.
• Cases of accounting malfeasance have commonly involved issues with revenue recognition, such as premature recognition of revenues or the recognition of fraudulent revenues.
• Cases of accounting malfeasance have involved misrepresentation of expenditures as assets rather than as expenses or misrepresentation of the timing or amount of expenses.
• Bankruptcy prediction models, used in assessing financial results quality, quantify the likelihood that a company will default on its debt and/or declare bankruptcy.
• Similar to the term “earnings quality,” when reported cash flows are described as being high quality, it means that the company's underlying economic performance was satisfactory in terms of increasing the value of the firm, and it also implies that the company had high reporting quality (i.e., that the information calculated and disclosed by the company was a good reflection of economic reality). Cash flow can be described as “low quality” either because the reported information properly represents genuinely bad economic performance or because the reported information misrepresents economic reality.
• For the balance sheet, high financial reporting quality is indicated by completeness, unbiased measurement, and clear presentation.
• A balance sheet with significant amounts of off-balance-sheet debt would lack the completeness aspect of financial reporting quality.
• Unbiased measurement is a particularly important aspect of financial reporting quality for assets and liabilities for which valuation is subjective.
• A company's financial statements can provide useful indicators of financial or operating risk.
• The management commentary (also referred to as the management discussion and analysis, or MD&A) can give users of the financial statements information that is helpful in assessing the company's risk exposures and approaches to managing risk.
• Required disclosures regarding, for example, changes in senior management or inability to make a timely filing of required financial reports can be a warning sign of problems with financial reporting quality.
• The financial press can be a useful source of information about risk when, for example, a financial reporter uncovers financial reporting issues that had not previously been recognized. An analyst should undertake additional investigation of any issue identified.

PROBLEMS

The following information relates to Questions 1 through 4

Mike Martinez is an equity analyst who has been asked to analyze Stellar, Inc. by his supervisor, Dominic Anderson. Stellar exhibited strong earnings growth last year; however, Anderson is skeptical about the sustainability of the company's earnings. He wants Martinez to focus on Stellar's financial reporting quality and earnings quality.

After conducting a thorough review of the company's financial statements, Martinez concludes the following:

1. Conclusion 1 Although Stellar's financial statements adhere to generally accepted accounting principles (GAAP), Stellar understates earnings in periods when the company is performing well and overstates earnings in periods when the company is struggling.
2. Conclusion 2 Stellar most likely understated the value of amortizable intangibles when recording the acquisition of Solar, Inc. last year. No goodwill impairment charges have been taken since the acquisition.
3. Conclusion 3 Over time, the accruals component of Stellar's earnings is large relative to the cash component.
4. Conclusion 4 Stellar reported an unusually sharp decline in accounts receivable in the current year, and an increase in long-term trade receivables.

1. Based on Martinez's conclusions, Stellar's financial statements are best categorized as:
   1. non-GAAP compliant.
   2. GAAP compliant, but with earnings management.
   3. GAAP compliant and decision useful, with sustainable and adequate returns.
2. Based on Conclusion 2, after the acquisition of Solar, Stellar's earnings are most likely:
   1. understated.
   2. fairly stated.
   3. overstated.
3. In his follow-up analysis relating to Conclusion 3, Martinez should focus on Stellar's:
   1. total accruals.
   2. discretionary accruals.
   3. non-discretionary accruals.
4. What will be the impact on Stellar in the current year if Martinez's belief in Conclusion 4 is correct? Compared with the previous year, Stellar's:
   1. current ratio will increase.
   2. days sales outstanding (DSO) will decrease.
   3. accounts receivable turnover will decrease.