Chapter 17 Analysis of the Quality of Financial Statements

Chapter 17Chapter 17

Analysis of the QualityAnalysis of the Qualityof Financial Statementsof Financial Statements

Analysis of the Quality of Financial Analysis of the Quality of Financial StatementsStatements

What you will learn from this What you will learn from this chapterchapter• Five questions to ask about the accounting quality of a

financial report

• How accounting methods and estimates determine the sustainability of earnings

• The devices management can use to manipulate earnings

• How to carry out an accounting quality analysis

• How to develop diagnostics to detect manipulated earnings

• How an accounting quality analysis is combined with financial statement analysis and red-flag analysis to discover the quality of earnings

• How composite quality scoring works

Accounting quality analysis establishes the integrity of the accounting to be used in forecasting

Five Questions About Five Questions About Accounting QualityAccounting Quality

1. GAAP quality: is GAAP accounting deficient?

2. Audit quality: is the firm violating GAAP or committing outright fraud?

3. GAAP application quality: is the firm using GAAP accounting to manipulate reports?

4. Transaction quality: is the firm manipulating business to accommodate the accounting?

a. Transaction timing

b. Transaction structuring

5. Disclosure quality: are disclosures adequate to analyze the business?

a. Disclosures that distinguish operating items from a financial items in the statements

b. Disclosures that distinguish core operating profitability from unusual items

c. Disclosures about the accounting used

Detecting Income Shifting: The Detecting Income Shifting: The Accounting Leaves a TrailAccounting Leaves a Trail

One trail:

Operating income = Free cash flow + Change in net operating assets OI = C – I + ΔNOA

“Hard” “Soft”

A further trail:

Change in net operating assets = Cash investment + Operating accruals ΔNOA = I + Operating accruals

Capitalization Quality

Accrual Quality

Low Quality Accounting and Low Quality Accounting and RNOARNOA

For valuation, the analyst wants to forecast future RNOA. If there is manipulation, current RNOA cannot be maintained in the future.

Manipulation has the following effects:

• As RNOA0= OI0/NOA-1, manipulation involves adjusting current operating income, OI0

• But OI0 = Free Cash Flow0 + NOA0

• So a change in OI0 must also change NOA0 by the same amount

• So future RNOA1=OI1/NOA0 must be reduced: Denominator effect Numerator effect

How Accounting Manipulation Leaves How Accounting Manipulation Leaves a Trail in the Balance Sheet (1)a Trail in the Balance Sheet (1)

The Case of No Growth with No Income Shifting

Year -2 Year -1 Year 0 Year +1

Net operating assets 100 100 100 100

Operating income

RNOA 12% 12% 12%

12

Free Cash Flow

12 12

1212 12 12

12


The Case of No Growth with Income Shifting


Net operating assets 100 100 110 100

Operating income

2

RNOA 12% 22% 1.82%

12 12 22

12Free Cash Flow 12 12 12


The Case of Growth with No Income Shifting


100 105 110.25 115.76

Operating income 12 12 12.6 13.23

Growth rate in NOA 5% 5% 5%

RNOA 12% 12% 12%

7.35 7.72

Net operating assets

Free Cash Flow 712


The Case of Growth with Income Shifting


100 105 120.25 115.76

Operating income

3.23

Growth rate in NOA 5% 14.52% -3.73%

RNOA 12% 21.52% 2.69%

7.72

Net operating assets

12 12 22.6

Free Cash Flow 12 7 7.35

Two Directions for ManipulationTwo Directions for Manipulation1. Borrowing income from the future

Increase in current revenue Decrease in current expenses

2. Banking income for the future Decrease current revenue Increase current expenses

Distinguish: Conservative Accounting

vs. Liberal Accounting

Aggressive Accounting

vs. Big Bath Accounting

Both increase current NOA

Both reduce current NOA

A matter of Accounting Policy

A matter of short-term application of accounting that will reverse

How Specific Balance Sheet Items How Specific Balance Sheet Items are Managed to Increase Incomeare Managed to Increase Income

Balance Sheet Item

Earnings Management Effect on Income Flash Points

ASSETS

Gross receivables Book revenue in advance of their being earned

Higher revenues Contracts with multiple deliverables; long-term

Net receivables Decrease allowances for bad debts and sales returns

Higher revenues or lower selling expenses

Receivables with low credit quality; banks' loan loss reserves

Lease receivables Increase estimated residual values on lease termination

Higher lease revenues Aircraft leases; computer leases; equipment leases

InventoriesBook non-inventory costs to inventory; failure to write down obsolete inventories

Lower cost of goods sold

Technological change makes inventories obsolete quickly; inventory prices are falling

Prepaid expenses Overestimate amount of expenses prepaid

Lower SG&A expense Considerable expenses are paid in advance.

Property, Plant and Equipment

Book repairs and maintenance to PPE; increase estimated lives or estimated salvage values; excessive impairment charges.

Lower depreciation charges which appear all through the income statement, from cost of goods sold down.

Capital intensive manufacturing

Intangible Assets Charge inappropriate expenses to intangible assets; lower amortization rates

Lower amortization expense in SG&A

Knowledge-based companies; capitalized software costs

Deferred charges Classify too much current expense as deferred expense

Lower SG&A expense Valuation allowances on deferred tax assets; capitalized costs of

How Specific Balance Sheet Items are How Specific Balance Sheet Items are Managed to Increase Income (cont)Managed to Increase Income (cont)

Balance Sheet Item Earnings Management Effect on Income Flash Points

LIABILITIES

Deferred revenue Reduce deferred revenues Higher revenues Firms that defer revenues with multiple deliverables

Warranty liabilities Reduce warranty reserve Lower selling expenses Firms with guaranties and warranties on their products

Accrued expenses Reduce amount of expenses accrued

Lower expenses -- applying to all expense lines

All firms

Pension liabilities Reduce pension liabilities by changing actual assumptions and discount rate

Lower pension expense Defined benefit pension plans

Unpaid claim reserves Reduce the reserve Lower claims expense Insurance companies

Prelude to a Quality AnalysisPrelude to a Quality Analysis

• Understand the business

• Understand the accounting policy

• Understand the business areas where accounting quality is most doubtful

• Understand situations in which management are particularly tempted to manipulate

Flash Points: Accounting Areas where Flash Points: Accounting Areas where Manipulation is More LikelyManipulation is More Likely

Industry Flash Point

Banking Credit losses: quality of loan loss provisions

Computer hardware Technological change: quality of receivables and inventory

Computer software Market ability of products: quality of capitalized research and developmentRevenue recognition: quality of receivables and deferred revenue

Retailing Credit losses: quality of net accounts receivableInventory obsolescence: quality of carrying values of inventoryRebate programs: quantity of sales and estimated liabilities

Manufacturing Warranties: quality of warranty liabilitiesProduct liability: quality of estimated liabilities

Automobiles Overcapacity: quality of depreciation allowances

Telecommunications Technological change: quality of depreciation allowances

Equipment leasing Lease values: quality of carrying values for leases

Tobacco Liabilities for health effects of smoking: quality of estimated liabilities

Pharmaceuticals R&D: quality of R&D expendituresProduct liability: quality of estimated liabilities

Real estate Property values: quality of carrying values for real property

Aircraft and ship Revenue recognition: quality of estimates under percentage ofmanufacturing completion method and “program accounting”

Subscriber services Development of customer base: quality of capitalized promotion costsSubscriptions paid in advance: quality of deferred revenue

Flash Points: Institutional Situations Flash Points: Institutional Situations where Manipulation is More Likelywhere Manipulation is More Likely

• The firm is in the process of raising capital or renegotiating borrowing.

Watch public offerings

• Debt covenants are likely to be violated

• A management change

• An auditor change

• Management rewards (like bonuses) are tied to earnings

• Management is repricing executive stock options

• A weak governance structure: inside management dominate the board;

there is a weak audit committee or none at all

• Regulatory ratio requirements (like capital ratios for banks and insurance

companies) are likely to be violated

• Transactions are with related parties rather than at arm's length

• Special events such as union negotiations and proxy fights

• The firm is "in play" as a takeover target

• The firm engages in exotic arrangements (structured off-balance-sheet

vehicles)

• A change in accounting principles or estimates

• An earnings surprise

• A drop in profitability after a period of good profitability

• Constant sales or falling sales

• Earnings growing faster than sales

• Very low earnings (that might be a loss without manipulation)

• Small or zero increases in profit margins (that might be a decrease without

manipulation)

• A firm meets analysts’ earnings expectations, but just so.

• Differences in expenses for tax reporting and financial reporting

• Financial reports are used for other purposes, like tax reporting and union

negotiations.

• Accounting adjustments in the last quarter of the year

Flash Points: Financial Statement Flash Points: Financial Statement Indicators that Manipulation is More Indicators that Manipulation is More LikelyLikely

IPOs and ManipulationIPOs and Manipulation

______________________________________________________________________________ Year of _____ Year after IPO Diagnostic (%) IPO 1 2 3 4 5 6 ______________________________________________________________________________ Net income/sales 4.6 2.8 2.1 1.6 1.3 1.3 1.8 Abnormal accruals/book value 5.5 1.6 -0.4 -0.8 -2.0 -1.4 -2.7 Allowance for uncollectibles/gross accounts receivable 2.91 3.32 3.46 3.62 3.81 3.77 3.85 _______________________________________________________________________________ Source: S. Teoh, T. Wong and G. Rao, "Are Accruals During An Initial Public Offering Opportunistic?" Review of Accounting Studies, 1998.

Overview of Diagnostics to Detect Overview of Diagnostics to Detect ManipulationManipulation

To Detect Manipulated Sales

Net Sales/ Cash From Sales

Net Sales/ Net Accounts Receivable

Net Sales/ Unearned Revenue

Net Sales/ Warranty Liabilities

Compare % Change in Sales to % Changes in Net Receivables, Unearned Revenue and Warranty Liabilities

Bad Debt and Warranty Expense Ratios

To Detect Manipulated Core Expenses

Apply a Normalized Asset Turnover Normalized Operating Income/ Operating Income

Investigate Changes in ATO Watch For Declines in ATO Investigate Changes in Individual ATO’s

Challenge Depreciation and Amortization Adjusted EBITDA Depreciation/ Capital Expenditures

Challenge All Accruals Cash From Operations/ Operating Income Cash From Operations/ NOA Accruals/ Change in Sales

Challenge Expenses That Are Sensitive to Estimates Pension Expense/ SG&A Other Employment Expense/ SG&A

Challenge Tax Expense Effective Tax Rate on Operating Income Deferred Tax Components Valuation Allowances

Challenge the Balance Sheet Carrying Values Above Market Value Carrying Values Sensitive to Estimates Estimated Liabilities Off-Balance-Sheet Liabilities

To Detect Manipulated Unusual Items

Challenge Restructuring Charges

Challenge Merger Charges

Diagnostics to DetectDiagnostics to DetectManipulated SalesManipulated SalesNet Sales = Cash from Sales + Net Accounts Receivable

+ Allowance for sales returns + Unearned revenue - Warranty liabilities

Diagnostic: Net Sales/ Cash from SalesDiagnostic: Net Sales/Net Accounts Receivable

Diagnostic: Bad Debt Expense/Actual Credit

LossesDiagnostic: Bad Debt Reserves/Accounts

Receivable (Gross)Diagnostic: Bad Debt Expense/Sales

Diagnostic: Sales Return Expense/Actual Sales Returns

Diagnostic: Sales Return Reserves/Accounts Receivable (Gross)

Diagnostic: Sales Return Expense/Sales

Diagnostic: Warranty Expense/Actual Warranty ClaimsDiagnostic: Warranty Liabilities/Accounts Receivable (Gross)Diagnostic: Warranty Expense/Sales

Red Flags: RevenueRed Flags: Revenue

A Red Flag. In 2000, Gateway, the personal computer manufacturer decided to finance computer sales to high-risk customers that outside financing companies were shunning. Its consumer finance receivables, net of allowances for bad debts, increased from 3.3 percent of sales to 7.3 percent of sales over the year. In the first quarter of 2001, the firm wrote off $100 million of these receivables. A Red Flag. At the end of 1999, Bank of America’s allowance for credit losses on its bank loans stood at 1.84 percent of outstanding loans of $370.7 billion and, in the prior three years this ratio had not fallen below 1.98 percent. However, at the end of 2000, the ratio was down to 1.75 percent, even though actual charge-offs for bad loans increased from 0.61 percent of loans from 0.55 percent. A Red Flag. Xerox Corporation sells copiers to customers under sales-type leases. It books the present value of lease payments plus an estimated residual value of the equipment at the end of the lease. This present value is recognized as revenue and as a lease receivable. In 1999, gross receivables declined from $16,139 million to $14,666 million as customers moved away to digital technology which Xerox was slow to embrace. However, estimated residual values on the leases increased from 4.33 percent of gross lease value to 5.13 percent (even though the equipment was likely to become obsolete). The stock price subsequently declined dramatically and the firm came under SEC investigation.

A Torpedo. In March 2000, the shares of MicroStrategy, a software firm, fell from $227 to $87 (a loss of market value of $6 billion) on revelations that it had practiced aggressive revenue recognition on its software contracts. The firm had booked revenue from multi-year contracts in the first year of the contract.

Diagnostics to DetectDiagnostics to DetectManipulated ExpensesManipulated Expenses

1. Investigate Changes in NOA with Normalized ATO

OI = Free Cash Flow + NOA“Hard” “Soft”

So, NOA is to be investigated:

NOA = Cash investment + new operating

accruals“Hard”

“Soft”

Diagnostic: Restated OI/OI

Restated OI = Free Cash Flow + Sales/Normal ATO

This works if sales are not manipulated

Red Flag: Unusual Growth in NOARed Flag: Unusual Growth in NOA

A Red Flag. Gateway, the computer manufacturer, had always operated on a high asset turnover. In 1999, its ATO was 13.2 on sales of $8,965 million, and even higher in earlier years. In 2000 sales increased by $636 million to $9,601 million, resulting in operating income, after tax, of $231 million. Net operating assets, however, grew by $1,086 (more than sales), resulting in a negative free cash flow of $855 million. The firm was investing rapidly in new stores and inventory, providing consumer credit and increasing accruals, yet sales growth was modest. Normalized operating income was -$855 + (636/13.2) = -$807 million, considerably less than reported operating income. In 2001, Gateway wrote off $876 million of net operating assets and reported an after-tax operating loss of $983 million.


2. Investigate Changes in ATO

Red Flags: Unusual Changes in ATORed Flags: Unusual Changes in ATO

A Red Flag. Cisco Systems supplies the infrastructure for the internet economy. Up to 2001, it saw rapid revenue growth on low inventories. For the four quarters of its 2000 fiscal year, the ratios of inventory-to-sales, in percent, were 16.9, 16.0, 17.8, and 21.3, respectively. By the second quarter of 2001, the ratio had increased to 37.5 percent. In the third quarter of 2001, the firm took a charge for an inventory write down of over $2.2 billion dollars and sales and earnings subsequently slowed dramatically. The inventory buildup represented inventory whose sale prices had declined as the internet bubble burst. A Torpedo. Sunbeam Corporation, the household appliance manufacturer, hired new management in 1996 to turn its ailing business around. After a major restructuring, its stock rose 50 percent during 1997 with earnings improving to $109 million from a loss of $228 million in 1996. Sales increased by 18.7 percent. However, accounts receivable grew 38.5 percent, from 21.7 percent of sales to 25.3 percent, and inventory grew 57.9 percent, from 16.5 percent of sales to 21.9 percent.


3. Investigate Line Items Directly

(a) Challenge depreciation and amortization expense

Diagnostic:

Adjusted ebitda=OI (before tax) + Depreciation Amortization – Normal Capital Expense

Normal capital expense is approximated by the average capital expenditure over past years or normal depreciation and amortization for the level of sales, calculated from past (Depreciation + Amortization) / Sales ratios

ebitda

ebitda Adjusted

Red Flags: Depreciation and Red Flags: Depreciation and AmortizationAmortization

A Red Flag. Electronic Data Systems (EDS) has had many restructurings over the years. Restructurings are a response, in part, to depreciation charges being too low. In the third quarter of 2001, the firm reported (in the cash flow statement) depreciation and amortization expense that was 6.6 percent of revenues, down from 7.2 percent of sales a year earlier, accounting for nearly half of the growth in operating income. Analysts asked: Was the lower charge due to better asset utilization or did it forecast further restructuring charges? A Red Flag. AMR, the parent of American Airlines, reported that operating income, before tax, increased in 2000 to $1,381 million from the $1,156 million in 1999. Notes to the financial statements reveal that the firm increased estimated lives on some of its aircraft from 20 to 25 years and also increased estimated salvage values from 5 percent to 10 percent of cost,. The effect was to reduce depreciation for the year by $158 million, with an after-tax effect on income of $99 million, accounting for 80 percent of the increase in income before discontinued operations. Was management correct to claim that the change “more accurately reflects the expected life of its aircraft”?

Diagnostics to Detect Manipulated Diagnostics to Detect Manipulated Expenses (Step 3 continued)Expenses (Step 3 continued)

(b)Challenge total accruals

Diagnostic: CFO/OI

Diagnostic: CFO/Average NOA

(c) Challenge individual accruals

Diagnostic: Accruals/ Sales

Red and Green Flags: Unusual Red and Green Flags: Unusual AccrualsAccruals

A Red Flag. Shared Medical Systems, a supplier of information systems to hospitals and physicians, reported earnings of $18.3 million in its first quarter of 1999, almost unchanged from the previous quarter. However revenues declined from $339.3 million to $287.1 million. Level or increasing earnings on declining sales always waves a red flag. The cash flow statement revealed further ones: Accrued expenses declined from $86.5 million to $61.5 million and the amount of computer software capitalized in the balance sheet increased from $75.7 million to 81.1 million. Manipulation or legitimate business? Well, earnings significantly increased throughout the next year, on rising revenues, so a reversal was not apparent. A Green Flag. Microsoft Corporation writes software contracts with multiple deliverables and defers a significant portion of the revenue on these contracts. At the end of its 2005 fiscal year, deferred revenues stood at $9.17 billion or 23.0 percent of sales. The prospect of the firm bleeding this deferred revenue back into income is real, so the analyst has Microsoft on a watch. In 2005, the cash flow statement reveals that Microsoft added $12.5 billion to deferred revenue and transferred $11.3 of deferred revenue to revenue to the income statement. There is no sign of an excessive bleed back. A Red Flag. Cisco Systems reported revenue of $4,816 million for its second quarter of 2002 up from the $4,448 million in the preceding quarter and exceeding projections. It looked like the revenue decline, from the $6,000 million per quarter in 2001, was over. However, the firm pointed out that, for the first time, deferred revenue had reversed: The firm had recognized an unusually large amount of revenue on conditional shipments from prior periods.

Diagnostics to Detect Manipulated Diagnostics to Detect Manipulated Expenses Expenses

(Step 3 continued)

(d) Challenge expense components that depend on estimates

Diagnostic: Pension expense/Total operating

expense

Diagnostic: Other post employment expense/ total operating expense

See Chapter 12

Diagnostics to Detect Manipulated Diagnostics to Detect Manipulated ExpensesExpenses

(Step 3 continued)

(e) Challenge tax expense

Diagnostic: Tax on operating income/OI before taxes

Diagnostic: Deferred taxes/Total taxes

Diagnostic: Change in valuation

allowance for deferred tax asset


4. Investigate Balance Sheet Line Items Directly

Particular suspects: Assets whose carrying values are above their market

values: these are likely impairment candidates

Assets whose carrying values and amortization rates are subject to estimate: intangible assets, goodwill, deferred tax assets (particularly their valuation allowances), non-typical capitalization of expenses such as start-up costs, advertising and promotion, product development, and software development costs

Assets recorded at estimated fair values Estimated liabilities such as pension liabilities, other

employment liabilities, warranties, deferred tax liabilities, deferred revenue, and estimated merger and restructuring costs

Off-balance-sheet liabilities such as guarantees, recourse for assigned receivables or debt, purchase commitments, and contingent liabilities for lawsuits and regulatory penalties

Environmental liabilities (for clean up of pollution)

Red Flag: Fair Value AccountingRed Flag: Fair Value Accounting

A Red Flag. Enron, the energy company whose demise also brought down its Big-5 auditor, Arthur Andersen, employed fair value accounting extensively for its energy contracts and other investments. These energy contracts were traded in very thin markets, some of them organized by Enron, so fair values were very much an estimate. In 2000, prior to the firm’s demise, unrealized gains on marking these contracts to fair value accounted for more than half on the firm’s pretax income of $1.41 billion and about a third in 1999. The profits subsequently evaporated as the “fair” values proved to be fictitious.

The Cash Flow Statement is a Source The Cash Flow Statement is a Source of Information on Accrualsof Information on Accruals

Compare changes in net accounts receivable with changes in sales

for sales quality diagnostics

Compare changes in unearned revenue and warranty liabilities

with changes in sales for sales quality diagnostics

Use the depreciation and amortization number for the adjusted

ebitda and depreciation diagnostics.

Compare changes in prepaid expenses with changes in sales

Compare changes in accrued expenses with changes in sales

Use the deferred tax number for deferred tax diagnostics

Track restructuring charges and their reversals

Detecting Transaction TimingDetecting Transaction Timing• Core Revenue Timing (Channel Stuffing)

Unexpected sales increases or decreases in the final quarter

Structuring of lease transactions to qualify as sales-type leases in lessor’s books

• Core Expense Timing

Diagnostic: R&D Expense/Sales

Diagnostic: Advertising Expense/Sales

Watch for temporary liquidation of hidden reserves for firms using conservative accounting (eg. LIFO dipping)

• Cherry picking for sales of securities

• Releasing hidden reserves

Red Flag: Channel StuffingRed Flag: Channel Stuffing

A Red Flag. Krispy Kreme rose from a regional doughnut maker to a national taste sensation, and a “hot stock” IPO in 2000. As sales faltered, however, the firm shipped high-margin doughnut-making equipment to franchisees, long before they needed it. The company booked the revenue while the equipment sat in trailers controlled by Krispy Kreme. The firm also sold equipment to a franchisee and booked it as revenue immediately before it bought the franchisee for a price that was inflated for the equipment. In 2005, the firm was forced to restate results as far back as 2000, reducing pre-tax income by over $25 million. Once at a high of $49.37, its shares traded at $7.30 in 2005 after a report from the company on its accounting.

Red Flag: LIFO DippingRed Flag: LIFO Dipping

A Red Flag. In 2003, General Motors reported an unusually good year with $3.6 billion in pre-tax income from continuing operations. Footnotes revealed that cost of good sold was $200 million lower because of liquidation of LIFO inventories. Without the benefit of this LIFO dipping, future cost of goods sold are likely to increase. The increase will be greater in the firm needs also to replace the inventories at higher prices: Under LIFO, last in (at higher prices) is first out to cost of goods sold.

Detecting Transaction StructuringDetecting Transaction Structuring

• Related party transactions

• Structuring sales-type leases

• Grossing up commissions

• Swapping inventory

A Red Flag: Transaction StructuringA Red Flag: Transaction Structuring

A Red Flag. Global Crossing sold capacity on its extensive telecom network to telecoms under long-term contracts. In a deal known as a “capacity swap,” the firm exchanged capacity with these firms such that Global Crossing booked revenue for the capacity it “sold” but booked the capacity that it received in exchange as an asset. In a 2001 transaction with Qwest Communications, it signed a $100 million contract to supply capacity, only to “roundtrip” the cash by purchasing a similar amount of capacity from Qwest, but booking revenue. Both companies ran into regulatory problems and Global Crossing subsequently filed for bankruptcy.

Detecting Organizational Detecting Organizational ManipulationManipulation

• Off-Balance-Sheet Operations R&D Partnerships Pension Funds Special purpose entities

Frustrations with Disclosure QualityFrustrations with Disclosure Quality

• Consolidation accounting often makes the source of profitability hard to discover

• Line of business and geographical segment reporting is often not detailed enough

• Earnings in unconsolidated subsidiaries are hard to analyze. (Think of a firm that has all its earnings in subsidiaries in which it has less than 50% ownership: core profit margins are not transparent!)

• Disclosure to reconcile free cash flow in the cash flow statement to free cash flow calculated (as OI - NOA) from the income statement and balance sheet. Some of the problems arise from uncertainty about items to be included in OI and NOA

• Disclosures to calculate stock compensation expense are thin

• Information is often not available to calculate losses on conversion of convertible claims into common equity

• Details on selling, general and administrative expenses are often scare

Composite Quality ScoringComposite Quality Scoring

A composite score weights a number of diagnostics into one metric, as follows: Composite score = w1D1 + w2D2 + w3D3 + … + wnDn

Where D is a diagnostic and w is the weight given to each if the n diagnostics included in the composite.

Advantages:

(1) Redundancy reduced

(2) Provides an overall assessment of quality

Examples of Composite ScoresExamples of Composite Scores

M-Scores: Detects manipulation that is likely to result in an SEC investigation: M. Beneish, “The Detection of Earnings Manipulation,” Financial Analysts Journal, 1999, pp. 24-36. F-Scores: Discriminates on financial health among low price-to-book firms: J. Piotroski, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers,” Journal of Accounting Research, Supplement 2000, pp.1-41. Q-Scores: Scores how earnings are affected by the release of hidden reserves when conservative accounting is being used:

S. Penman and X. Zhang, “Accounting Conservatism, the Quality of Earnings, and Stock Returns,” The Accounting Review, April 2002, pp. 237-264.

S-Scores: The composite score indicates whether operating income is sustainable or will reverse: S. Penman and X. Zhang, Modeling Sustainable Earnings and P/E ratios Using Financial Statement Information, 2005. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=318967 Abnormal accrual models: Models have been developed that estimate the amount of accruals that are deemed to be abnormal. For example: J. Jones, “Earnings Management During Import Relief Investigations,” Journal of Accounting Research, Autumn 1991, pp. 193-223 and P. Dechow, R. Sloan, and A. Sweeney, “Detecting Earnings Management,” The Accounting Review, April 1995, pp. 193-225.

Detecting Sustainable RNOA with Detecting Sustainable RNOA with an S-Scorean S-Score

S = Probability that RNOA will increase

S = 0.5 indicates sustainable RNOA

RNOA

0.08

0.09

0.1

0.11

0.12

0.13

0.14

-5 -4 -3 -2 -1 0 1 2 3 4 5

Year

Low S

High S

Source: S. Penman and X. Zhang. 2005. Modeling Sustainable Earnings and P/E ratios Using Financial Statement Information. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=318967

Rewards to Sustainable Earnings Rewards to Sustainable Earnings AnalysisAnalysis

Returns to portfolio that goes long on firms with high S-Scores and short on firms with low S-Scores

Mean Size-adjusted Return

-0.3-0.2-0.1

00.10.20.30.40.50.60.7

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Chapter 17 Analysis of the Quality of Financial Statements