Understanding Financial Statements EIGHTH EDITION

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Understanding Financial Statements EIGHTH
EDITION

• Lyn M. Fraser
• Aileen Ormiston

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A Guide to Earnings and Financial Reporting
Quality
This chapter considers the quality of reported
financial information, which is a critical
element in evaluating financial statement data
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A Guide to Earnings and Financial Reporting
Quality (cont.)
The higher the quality of financial reporting,
the more useful the information is for business
decision making

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A Guide to Earnings and Financial Reporting
Quality (cont.)
The earnings statement provides management with
opportunities for influencing the outcome of
reported earnings in ways that may not
best represent economic reality or the future
operating potential of a firm Potential areas
include.

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A Guide to Earnings and Financial Reporting
Quality (cont.)

• Accounting choices, estimates and judgments
• Changes in accounting methods and assumptions
• Discretionary expenditures
• Nonrecurring transactions
• Nonoperating gains and losses
• Revenue and expense recognitions that do
• not match cash flow

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A Guide to Earnings and Financial Reporting
Quality (cont.)
The primary focus of this chapter is to provide
the financial statement user with a step-by-step
guide that links the items on an earnings
statement with the key areas in the
financial statement data that affect
earnings quality

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A Guide to Earnings and Financial Reporting
Quality (cont.)
Another purpose is to provide the financial
statement user with an approach to use in
analyzing and interpreting the qualitative
factors

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A Checklist for Earnings Quality
Major areas on the checklist include

• Sales
• Cost of Goods Sold
• Operating Expenses
• Nonoperating Revenue and Expense
• Other Issues

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Sales
Potential areas include

• 1. Premature revenue recognition
• Gross vs. net basis
• Vendor financing
• Allowance for doubtful accounts
• Price vs. volume changes
• Real vs. nominal growth

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Sales (cont.)
1. Premature revenue recognition
According to GAAP, revenue should not be
recognized until there is evidence that a true
sale has taken place Many firms have violated
this accounting principle by recording revenue
before the conditions for a true sale have been
met

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Sales (cont.)
2. Gross vs. net basis
Another tactic to boost revenues is to record
sales at the gross rather than the net price

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Sales (cont.)
3. Vendor financing
Some companies use vendor financing to increase
revenues by lending their customers (other
companies) money to purchase their products

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Sales (cont.)3.
Vendor financing
Example of vendor financing disclosure in MDA
section of a companys 10K

• Customer Financing Arrangements
• Outstanding Finance Receivables The Company had
  net
• finance receivables of 260 million at
  December 31, ..,
• compared to 170 million at December 31, ..
  These
• finance receivables are generally interest
  bearing, with
• rates ranging from 3 to 10.....
• Data from SEC website, www.sec.gov

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Sales (cont.)
4. Allowance for doubtful accounts
This is a type of reserve account that can be
manipulated by under- or overestimating bad debt
expenses

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Sales (cont.)
5. Price vs. volume changes
In general, higher quality earnings would be the
product of both volume and price increases
(during inflation)

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Sales (cont.)
6. Real vs. nominal growth
Important to determine if sales are growing in
real (inflation-adjusted) as well as nominal
(as reported) terms

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Cost of Goods Sold
Potential areas include

• Cost-flow assumption for inventory
• Base LIFO layer liquidations
• Fulfillment costs
• Loss recognitions on write-downs of inventories

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Cost of Goods Sold
7. Cost-flow assumption for inventory
LIFO results in the matching of current costs
with current revenues and produces higher quality
earnings than either FIFO or average cost

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Cost of Goods Sold (cont.)
8. Base LIFO layer liquidation
Base LIFO layer liquidations occur when companies
are shrinking rather than increasing
inventories Reduces the quality of earnings
because there is an improvement in operating
profit from what would generally be considered a
negative occurrence inventory reductions

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Cost of Goods Sold (cont.)
9. Fulfillment costs
An expense account that some companies add to
operating expenses to record costs that are
typically classified as cost of goods sold,
impacting their gross profit margin and lowering
their quality of earnings

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Cost of Goods Sold (cont.)
10. Loss recognitions on write-downs of
inventories

If the value of inventory falls below its
original cost, the inventory is written down to
market value. When the write-down is included in
cost of goods sold, the gross profit margin is
impacted

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Operating Expenses
Potential areas include

• Discretionary expenses
• Depreciation
• Asset impairment
• Big bath or restructuring charges
• Reserves
• In-process research and development
• Pension accounting-interest rate assumptions

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Operating Expenses (cont.)
11. Discretionary expenses
If variable operating expenses such as repair and
maintenance, research and development, and
advertising and marketing are reduced primarily
to benefit the current years reported earnings,
the long-run impact on operating profit may be
detrimental and lower the quality of those
earnings

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Operating Expenses (cont.)
12. Depreciation

• straight-line method is lower in quality than an
  accelerated method
• misclassification of operating expenses as
  capital expenditures creates poor quality of
  financial reporting on all financial statements
• comparing companies is difficult when they use
  different depreciation methods and different
  estimates for the lives of their long-lived assets

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Operating Expenses (cont.)
13. Asset impairment
The write-down of asset values, following the
principle of carrying assets at the lower of cost
or market value, affects the comparability and
thus the quality of financial data

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Operating Expenses (cont.)
14. Big bath or restructuring charges
Large charges classified as restructuring charges
are sometimes used by companies to clean up their
balance sheet Ongoing restructuring of a company
can be a signal of underlying problems

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Operating Expenses (cont.)
15. Reserves
Often created to set aside funds today to cover
some known future cost Abuse occurs when funds
are set aside in good years (i.e., reducing net
income) and then shifting the reserve amount to
the income statement in poor years

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Operating Expenses (cont.)
16. In-process research and development
One-time charges taken at the time of an
acquisition Can be problematic if companies
write-off significant amounts of research and
development in the year of acquisition in order
to boost earnings in later years

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Operating Expenses (cont.)
17. Pension accounting-interest rate
assumptions

• A change in the pension interest rate assumption
  can impact earnings equality
• if the rate is decreased, the annual pension cost
  and the present value of the benefits will
  increase
• if the rate is increased, the annual pension cost
  and the present value of the benefits will
  decrease

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Nonoperating Revenue and Expense
Potential areas include

• Gains (losses) from sales of assets
• Interest income
• Equity income
• Income taxes
• Unusual items
• Discontinued operations
• Accounting changes
• Extraordinary items

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Nonoperating Revenue and Expense (cont.)
18. Gains (losses) from sales of assets
The sale of a major asset is sometimes made to
increase earnings and/or to generate needed cash
when the firm is performing poorly. Such
transactions are not part of the normal
operations of the firm and should be excluded
from net income when considering the future
operating potential of the company

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Nonoperating Revenue and Expense (cont.)
19. Interest income
In assessing earnings quality, the analyst should
be alert to the materiality and variability in
the amount of interest income because it is not
part of operating income

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Nonoperating Revenue and Expense (cont.)
20. Equity income
The net effect of using this method is that the
investor, in most cases, records more income than
is received in cash

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Nonoperating Revenue and Expense (cont.)
21. Income taxes

• Provision for income tax expense on the income
  statement differs from the tax actually paid
• Important to differentiate between increases and
  decreases to net earnings caused by tax events

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Nonoperating Revenue and Expense
(cont.)21. Income taxes
Examples of income tax expense compared to income
taxes paid from a selection of 10Ks

• in millions Income Tax Income
  Taxes
• Expense Paid
• Communications mfg. 1,921 693
• Pharmaceutical mfg. 2,733 1,700
• Restaurant chain 55 45
• Retailer 504 482
• Data from SEC website, www.sec.gov

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Nonoperating Revenue and Expense (cont.)
22. Unusual items
Analyst should always investigate these items by
reading the notes and the MDA to determine if
these items are nonoperating and/or
nonrecurring Also called special charges

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Nonoperating Revenue and Expense (cont.)
23. Discontinued operations
Should be excluded in considering future
earnings Appropriate to deduct the income on
discontinued operations each year from earnings
for comparative purposes

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Nonoperating Revenue and Expense (cont.)
24. Accounting changes

• SFAS 154, Accounting Changes and Error
  Corrections, makes comparability and consistency
  better
• Users of financial statements should carefully
  read any footnote disclosures regarding
  accounting changes
• A quality of earnings issue exists if a firm is
  changing accounting methods to boost earnings in
  the short-term

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Nonoperating Revenue and Expense (cont.)
25. Extraordinary items
Gains and losses that are both unusual and
infrequent in nature Amounts should be
eliminated from earnings when evaluating a firms
future earnings potential

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Other Issues
Potential areas include

• 26. Material changes in number of shares
• outstanding
• Operating earnings, a.k.a. core earnings,
• pro forma earnings, or EBITDA

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Other Issues (cont.)
26. Material changes in number of shares
outstanding

• Changes can result from treasury stock purchases
  and the purchase and retirement of a firms own
  common stock
• Reasons for the repurchase of common stock should
  be determined if possible to see if firm is
  spending scarce resources to merely increase
  earnings per share (EPS)

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Other Issues (cont.)

• Operating earnings, a.k.a. core earnings,
• pro forma earnings, or EBITDA

Operating earnings are important for assessing
the ongoing potential of a firm Variety of
company created numbers have been created for
users to review
Core earnings Pro forma earnings Operating
Earnings Before Interest, Tax, Depreciation and
Amortization (EBITDA)

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What are the Real Earnings?
Each individual user of financial statements
should adjust the earnings figure to reflect what
they believe is relevant to the decision at hand

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Quality of Financial Reporting-The Balance Sheet
Items discussed in the earnings quality section
such as the value attached to accounts
receivable, inventory and long-term assets also
impact balance sheet quality Other items to
assess and evaluate include..

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Quality of Financial Reporting-The Balance Sheet
(cont.)

• Type of debt used to finance assets should
  generally be matched (short-term debt for current
  assets and long-term debt/equity for long-term
  assets)
• Commitments and Contingencies disclosures in
  the notes should be carefully evaluated as
  information on off-balance-sheet financing and
  other complex financing arrangements are located
  here

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Quality of Financial Reporting-The Balance Sheet
(cont.)

• Commitments and Contingencies also contain
  information on

Operating leases Capital leases Environmental
matters Guarantees Legal proceedings

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Quality of Financial Reporting-The Statement of
Cash Flows
The cash flows from operations (CFO) figure,
while highly useful, can be manipulated by

• Recording operating expenses as capital
  expenditures
• Managing current asset and liability accounts to
  cause increases to CFO

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Quality of Financial Reporting-The Statement of
Cash Flows (cont.)
Cash flows from the following types of items
should be removed from CFO for analytical
purposes

• Investments in trading securities
• Discontinued operations
• Nonrecurring expenses or income

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The Journey Through the Maze Continues

• Ch. 6 The Analysis of Financial Statements