(C) 2007 Prentice Hall, Inc.4-1 A Guide to Earnings and Financial Reporting Quality This chapter considers the quality of reported financial information,

(C) 2007 Prentice Hall, Inc.(C) 2007 Prentice Hall, Inc.

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A Guide to Earnings and A Guide to Earnings and Financial Reporting Financial Reporting QualityQuality

This chapter considers the quality of reported financial information, which is a critical element in evaluating financial statement data


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Why Earnings QualityWhy Earnings Qualityanalyst should developanalyst should develop

AN EARNINGS FIGUREAN EARNINGS FIGURE that reflects the that reflects the

FUTURE ONGOING POTENTIALFUTURE ONGOING POTENTIAL of the firmof the firm

THE OBJECTIVE IS NOT THE OBJECTIVE IS NOT FRAUD DETECTIONFRAUD DETECTION


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A Checklist for Earnings A Checklist for Earnings QualityQuality

I.I. SalesSales

II.II. Cost of Goods SoldCost of Goods Sold

III.III. Operating ExpensesOperating Expenses

IV.IV. Nonoperating Revenue and Nonoperating Revenue and ExpenseExpense

V.V. Other IssuesOther Issues

Major areas on the checklist include:


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SalesSales

1.1. Premature revenue recognitionPremature revenue recognition

2.2. Gross vs. net basisGross vs. net basis

3.3. Vendor financingVendor financing

4.4. Allowance for doubtful accountsAllowance for doubtful accounts

5.5. Price vs. volume changesPrice vs. volume changes

6.6. Real vs. nominal growthReal vs. nominal growth

Potential areas include:


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Sales Sales (cont.)(cont.)

1. Premature revenue recognition:

According to GAAP, revenue should notAccording to GAAP, revenue should not

be recognized until there is evidencebe recognized until there is evidence

that a true sale has taken placethat a true sale has taken place

Many firms have violated this accounting Many firms have violated this accounting

principle by recording revenue principle by recording revenue before the conditions for a true sale before the conditions for a true sale have been met have been met


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2. Gross vs. net basis:

Another tactic to boost revenues is Another tactic to boost revenues is to record sales at the gross to record sales at the gross rather than the net pricerather than the net price


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3. Vendor financing:

Some companies use vendor Some companies use vendor financing to increase revenues financing to increase revenues by lending their customers (other by lending their customers (other companies) money to purchase companies) money to purchase their productstheir products


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4. Allowance for doubtful accounts:

This is a type of reserve account that This is a type of reserve account that cancan

be manipulated by under- or be manipulated by under- or overestimating bad debt overestimating bad debt expensesexpenses


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5. Price vs. volume changes:In general, higher quality earnings would In general, higher quality earnings would

be the product of both volume and be the product of both volume and price increases (during inflation)price increases (during inflation)

6. Real vs. nominal growth:

Important to determine if sales are Important to determine if sales are growing in “real” (inflation-growing in “real” (inflation-adjusted) as well as “nominal” adjusted) as well as “nominal” (as reported) terms(as reported) terms


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Cost of Goods SoldCost of Goods Sold

7.7. Cost-flow assumption for inventoryCost-flow assumption for inventory

8.8. Base LIFO layer liquidationsBase LIFO layer liquidations

9.9. Fulfillment costsFulfillment costs

10.10. Loss recognitions on write-downs of Loss recognitions on write-downs of inventoriesinventories



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Cost of Goods SoldCost of Goods Sold

7. Cost-flow assumption for inventory:

LIFO results in the matching of LIFO results in the matching of current costs with current current costs with current revenues and produces higher revenues and produces higher quality earnings than either FIFO quality earnings than either FIFO or average costor average cost


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Cost of Goods Sold Cost of Goods Sold (cont.)(cont.)

9. Fulfillment costs:

An expense account that some An expense account that some companies add to operating companies add to operating expenses to record costs that are expenses to record costs that are typically classified as cost of typically classified as cost of goods sold, impacting their gross goods sold, impacting their gross profit margin and lowering their profit margin and lowering their quality of earningsquality of earnings


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Cost of Goods Sold Cost of Goods Sold (cont.)(cont.)

10. Loss recognitions on write-downs of inventories:

If the value of inventory falls below its If the value of inventory falls below its original cost, the inventory is original cost, the inventory is written down to market value.written down to market value.

When the write-down is included in When the write-down is included in cost of goods sold, the gross cost of goods sold, the gross profit margin is impactedprofit margin is impacted


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Operating ExpensesOperating Expenses

11.11. Discretionary expensesDiscretionary expenses

12.12. DepreciationDepreciation

13.13. Asset impairmentAsset impairment

14.14. ““Big bath” or restructuring chargesBig bath” or restructuring charges

15.15. ReservesReserves

16.16. In-process research and developmentIn-process research and development



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Operating Expenses Operating Expenses (cont.)(cont.)

11. Discretionary expenses:

If variable operating expenses such as repair If variable operating expenses such as repair and maintenance, research and and maintenance, research and development, and advertising and development, and advertising and marketing are reduced primarily to marketing are reduced primarily to benefit the current year’s reported benefit the current year’s reported earnings, the long-run impact on earnings, the long-run impact on operating profit may be detrimental and operating profit may be detrimental and lower the quality of those earningslower the quality of those earnings


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12. Depreciation:

misclassification of operating expenses misclassification of operating expenses as capital expenditures creates poor as capital expenditures creates poor quality of financial reporting on all quality of financial reporting on all financial statementsfinancial statements

comparing companies is difficult when comparing companies is difficult when they use different depreciation methods they use different depreciation methods and different estimates for the lives of and different estimates for the lives of their long-lived assetstheir long-lived assets


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13. Asset impairment:

The write-down of asset values, The write-down of asset values, following the principle of carrying following the principle of carrying assets at the lower of cost or assets at the lower of cost or market value, affects the market value, affects the comparability and thus the quality comparability and thus the quality

of financial dataof financial data


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14. “Big bath” or restructuring charges:

Large charges classified as restructuring Large charges classified as restructuring charges are sometimes used by charges are sometimes used by companies to clean up their balance companies to clean up their balance sheetsheet

Ongoing restructuring of a company can be Ongoing restructuring of a company can be a signal of underlying problemsa signal of underlying problems


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15. Reserves (Cookie Jar Reserves):

Often created to set aside funds today to Often created to set aside funds today to cover some known future costcover some known future cost

Abuse occurs when funds are set aside in Abuse occurs when funds are set aside in good years (i.e., reducing net income) good years (i.e., reducing net income) and then shifting the reserve amount and then shifting the reserve amount to the income statement in poor yearsto the income statement in poor years


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16. In-process research and development:

One-time charges taken at the time of an One-time charges taken at the time of an acquisitionacquisition

Can be problematic if companies write-off Can be problematic if companies write-off significant amounts of research and significant amounts of research and development in the year of acquisition development in the year of acquisition in order to boost earnings in later yearsin order to boost earnings in later years


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Nonoperating Revenue and Nonoperating Revenue and ExpenseExpense

17.17. Gains (losses) from sales of assetsGains (losses) from sales of assets

18.18. Interest incomeInterest income

19.19. Equity incomeEquity income

20.20. Discontinued operationsDiscontinued operations



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Nonoperating Revenue and Nonoperating Revenue and Expense Expense (cont.)(cont.)

17. Gains (losses) from sales of assets:

The sale of a major asset is sometimes The sale of a major asset is sometimes made to increase earnings and/or to made to increase earnings and/or to generate needed cash when the firm is generate needed cash when the firm is performing poorly. Such transactions performing poorly. Such transactions are not part of the normal operations are not part of the normal operations of the firm and should be excluded of the firm and should be excluded from net income when considering the from net income when considering the future operating potential of the future operating potential of the companycompany


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18. Interest income:

In assessing earnings quality, the In assessing earnings quality, the analyst should be alert to the analyst should be alert to the materiality and variability in the materiality and variability in the amount of interest income because amount of interest income because it is not part of operating incomeit is not part of operating income


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19. Equity income:

The net effect of using this method is The net effect of using this method is that the investor, in most cases, that the investor, in most cases, records more income than is records more income than is received in cashreceived in cash


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20. Discontinued operations:

Should be excluded in considering Should be excluded in considering future earningsfuture earnings

Appropriate to deduct the income on Appropriate to deduct the income on discontinued operations each year discontinued operations each year from earnings for comparative from earnings for comparative purposespurposes


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Other IssuesOther Issues

21.21. Material changes in number of sharesMaterial changes in number of shares

outstandingoutstanding

22.22. Operating earnings, a.k.a. core Operating earnings, a.k.a. core earnings,earnings,

or EBITDAor EBITDA



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Other Issues Other Issues (cont.)(cont.)

21. Material changes in number of shares outstanding: Changes can result from treasury Changes can result from treasury

stock purchases and the purchase and stock purchases and the purchase and retirement of a firm’s own common retirement of a firm’s own common stockstock

Reasons for the repurchase of Reasons for the repurchase of common stock should be determined common stock should be determined if possible to see if firm is spending if possible to see if firm is spending scarce resources to merely increase scarce resources to merely increase earnings per share (EPS)earnings per share (EPS)


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Other Issues Other Issues (cont.)(cont.)

22.Operating earnings, a.k.a. core earnings,

pro forma earnings, or EBITDA:Operating earnings are important for assessing Operating earnings are important for assessing

the ongoing potential of a firmthe ongoing potential of a firm

Variety of “company created” numbers have Variety of “company created” numbers have been created for users to reviewbeen created for users to review

Core earningsOperating Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)

Documents

(C) 2007 Prentice Hall, Inc.4-1 A Guide to Earnings and Financial Reporting Quality This chapter considers the quality of reported financial information,