Earnings and Financial Reporting

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 11

Understanding Understanding Financial Financial

StatementsStatementsNINTHNINTH EDITION EDITION

Lyn M. Fraser Lyn M. Fraser Aileen OrmistonAileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-5-22

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Chapter 5: A Guide to Chapter 5: A Guide to Earnings and Financial Earnings and Financial Reporting QualityReporting QualityQuality of reported financial

information is a critical element in evaluating financial statement data.

The higher the quality of financial reporting, the more useful the information is for business decision making.


A Guide to Earnings and A Guide to Earnings and Financial Reporting Financial Reporting QualityQualityThere are a number of areas on the

earnings statement that provide management with opportunities for influencing the outcome of reported earnings.


A Guide to Earnings and A Guide to Earnings and Financial Reporting Financial Reporting QualityQualityThese areas include• 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


A Guide to Earnings and A Guide to Earnings and Financial Reporting QualityFinancial Reporting Quality

The financial statement analyst should

• consider the qualitative as well as the quantitative components of earnings for an accounting period

• develop an earnings figure that reflects the future ongoing potential of the firm


A Guide to Earnings and A Guide to Earnings and Financial Reporting QualityFinancial Reporting Quality

In addition to earnings quality, the quality of information on the balance sheet and statement of cash flows is equally important.

Because these financial statements are interrelated, quality of financial reporting issues often affects more than one financial statement.


A Checklist for Earnings A Checklist for Earnings QualityQuality

I.I. SalesSalesII.II. Cost of Goods SoldCost of Goods SoldIII.III. Operating ExpensesOperating ExpensesIV.IV. Nonoperating Revenue and Nonoperating Revenue and

ExpenseExpenseV.V. Other IssuesOther Issues


A Checklist for Earnings A Checklist for Earnings QualityQualitySalesSales

1.1. Premature revenue recognitionPremature revenue recognition2.2. Gross vs. net basisGross vs. net basis3.3. Allowance for doubtful accountsAllowance for doubtful accounts4.4. Price vs. volume changesPrice vs. volume changes5.5. Real vs. nominal growthReal vs. nominal growth

Key areas that affect earnings quality


SalesSalesPremature revenue Premature revenue recognitionrecognition

Revenue should notRevenue should not be recognized be recognized until there is evidenceuntil there is evidencethat a true that a true sale has taken place.sale has taken place.

Many firms record revenue before Many firms record revenue before the conditions for a true sale the conditions for a true sale have been met.have been met.


Sales Sales Premature revenue Premature revenue recognitionrecognition

Analysts shouldAnalysts should• look at revenue recognition policylook at revenue recognition policy• evaluate any changes in revenue evaluate any changes in revenue

recognition policiesrecognition policies• study the relationship among study the relationship among

sales, accounts receivable, and sales, accounts receivable, and inventoryinventory


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

Gross refers to the total amount that Gross refers to the total amount that the final customer pays for an the final customer pays for an item.item.

Net refers to the gross amount less Net refers to the gross amount less the cost of the sale.the cost of the sale.

SalesSalesGross versus net basisGross versus net basis


Revenues appear larger when Revenues appear larger when reported at gross amounts.reported at gross amounts.

Gross profit margins appear better Gross profit margins appear better when revenues are reported at net when revenues are reported at net amounts.amounts.

Analysts should read the notes to Analysts should read the notes to determine how revenue is determine how revenue is recorded.recorded.

SalesSalesGross versus net basisGross versus net basis


There should be a consistent There should be a consistent relationship between the rate of relationship between the rate of change in sales, accounts change in sales, accounts receivable, and allowance for receivable, and allowance for doubtful accounts.doubtful accounts.

Analyst should be alert to the Analyst should be alert to the potential for manipulation through potential for manipulation through the allowance account.the allowance account.

SalesSalesAllowance for doubtful Allowance for doubtful accountsaccounts


If sales are changing, it is important to If sales are changing, it is important to determine whether the change is a determine whether the change is a result of price, volume, or both.result of price, volume, or both.

In general, higher quality earnings In general, higher quality earnings would be the product of both volume would be the product of both volume and price increases (during inflation).and price increases (during inflation).

SalesSalesPrice versus volume Price versus volume changeschanges


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

Change in sales in nominal terms Change in sales in nominal terms can be readily calculated from can be readily calculated from figures on the income statement.figures on the income statement.

SalesSalesReal versus nominal growthReal versus nominal growth


An adjustment of the reported sales An adjustment of the reported sales figure with the Consumer Price figure with the Consumer Price Index (or some other measure of Index (or some other measure of general inflation) will enable the general inflation) will enable the analyst to make a comparison of the analyst to make a comparison of the changes in real and nominal terms.changes in real and nominal terms.



To make the calculation, begin with To make the calculation, begin with the sales figure from the income the sales figure from the income statement, and adjust years prior statement, and adjust years prior to the current year with the CPI to the current year with the CPI (or other price index).(or other price index).



Using base period CPI (1982-1984=100)Using base period CPI (1982-1984=100)(2007CPI/2006CPI) x 2006 Sales = Adjusted Sales(2007CPI/2006CPI) x 2006 Sales = Adjusted Sales(207.3/201.6) x $171,179 = $176,019(207.3/201.6) x $171,179 = $176,019When adjusted for inflation, sales grew at a rate When adjusted for inflation, sales grew at a rate

of 1.24%, which means that sales growth has of 1.24%, which means that sales growth has kept pace with general inflation.kept pace with general inflation.

SalesSalesReal versus nominal growthReal versus nominal growthSales (in millions)Sales (in millions) 20072007 20062006 % Change% ChangeAs reported As reported (nominal)(nominal)

$178,199$178,199 $171,179$171,179 4.104.10

Adjusted (real)Adjusted (real) $178,199$178,199 $176,019$176,019 1.241.24


Cost of Goods SoldCost of Goods Sold

6.6. Cost-flow assumption for inventoryCost-flow assumption for inventory7.7. Base LIFO layer liquidationsBase LIFO layer liquidations8.8. Loss recognitions on write-downs of Loss recognitions on write-downs of

inventoriesinventories



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

Inventory accounting system used is Inventory accounting system used is described in the note that details described in the note that details accounting policies or the note that accounting policies or the note that discusses inventory.discusses inventory.

Cost of Goods SoldCost of Goods SoldCost-flow assumption for Cost-flow assumption for inventoryinventory


Base LIFO layer liquidation occurs when Base LIFO layer liquidation occurs when companies are shrinking rather than companies are shrinking rather than increasing inventories.increasing inventories.

There is an actual reduction of inventory There is an actual reduction of inventory levels, but the earnings boost stems levels, but the earnings boost stems from the cost flow assumption that from the cost flow assumption that the older and lower-priced products the older and lower-priced products are being sold.are being sold.

Cost of Goods SoldCost of Goods SoldBase LIFO layer liquidationBase LIFO layer liquidation


Effects of LIFO reductions are disclosed Effects of LIFO reductions are disclosed in the notes and can be substantial.in the notes and can be substantial.

Reduces the quality of earnings, Reduces the quality of earnings, because there is an improvement in because there is an improvement in operating profit from what would operating profit from what would generally be considered a negative generally be considered a negative occurrence: inventory reductions.occurrence: inventory reductions.

Cost of Goods SoldCost of Goods SoldBase LIFO layer liquidationBase LIFO layer liquidation


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

Amount of the write-down will affect Amount of the write-down will affect comparability and quality of profit comparability and quality of profit margins.margins.

Cost of Goods SoldCost of Goods SoldLoss recognitions on write-downs of Loss recognitions on write-downs of inventoriesinventories


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

Analyst should be aware of the Analyst should be aware of the impact of write-downs on the gross impact of write-downs on the gross profit margin when comparing profit margin when comparing between periods.between periods.

Cost of Goods SoldCost of Goods SoldLoss recognitions on write-downs of Loss recognitions on write-downs of inventoriesinventories


A Checklist for Earnings A Checklist for Earnings QualityQualityOperating ExpensesOperating Expenses

9.9. Discretionary expensesDiscretionary expenses10.10. DepreciationDepreciation11.11. Asset impairmentAsset impairment12.12. ReservesReserves13.13. In-process research and developmentIn-process research and development14.14. Pension accounting-interest rate Pension accounting-interest rate

assumptionsassumptions



Operating ExpensesOperating ExpensesDiscretionary expensesDiscretionary expenses

A company can increase earnings by A company can increase earnings by reducing variable operating expenses reducing variable operating expenses in a number of areas such asin a number of areas such as• repair and maintenance of repair and maintenance of

capital assetscapital assets• research and developmentresearch and development• advertising and marketingadvertising and marketing


Operating ExpensesOperating ExpensesDiscretionary expensesDiscretionary expenses

If such discretionary expenses are If such discretionary expenses are reduced to benefit the current reduced to benefit the current year’s reported earnings, the long-year’s reported earnings, the long-run impact on the firm’s operating run impact on the firm’s operating profit may be detrimental and thus profit may be detrimental and thus the quality lowered.the quality lowered.


Operating ExpensesOperating ExpensesDepreciationDepreciation

Amount of depreciation expense Amount of depreciation expense depends ondepends on• the choice of depreciation the choice of depreciation

method (straight-line or method (straight-line or accelerated)accelerated)

• estimates regarding the useful estimates regarding the useful life and salvage valuelife and salvage value



Straight-line methodStraight-line method• is used more oftenis used more often• produces a smoother earnings produces a smoother earnings

stream and higher earnings in the stream and higher earnings in the early years of the depreciation periodearly years of the depreciation period

• does not reflect the economic reality does not reflect the economic reality of product usefulnessof product usefulness

• is lower in qualityis lower in quality



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 statements.financial statements.

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


The write-down of asset values The write-down of asset values affects the comparability and thus affects the comparability and thus the quality.the quality.

Reasons for write-downs are also Reasons for write-downs are also important in assessing quality.important in assessing quality.

Information on asset write-downs is Information on asset write-downs is presented in the notes.presented in the notes.

Operating ExpensesOperating ExpensesAsset impairmentAsset impairment


Creation and use of reserve Creation and use of reserve accounts is required to properly accounts is required to properly match revenues and expenses.match revenues and expenses.

Abuse of reserve accounts has been Abuse of reserve accounts has been an ongoing issue.an ongoing issue.

Operating ExpensesOperating ExpensesReservesReserves


Cookie-jar accounting occurs when Cookie-jar accounting occurs when companies create or use reserve companies create or use reserve accounts for setting aside funds in accounts for setting aside funds in good years and reducing or good years and reducing or reversing charges in poor years.reversing charges in poor years.

Firms often take enormous write-offs in Firms often take enormous write-offs in one period (big bath charges) to one period (big bath charges) to clean up balance sheets.clean up balance sheets.

Operating ExpensesOperating ExpensesReservesReserves


Operating ExpensesOperating ExpensesIn-process research and In-process research and developmentdevelopment

One-time charges taken at the time One-time charges taken at the time of an acquisitionof an acquisition

Can be written off immediatelyCan be written off immediatelyCan increase earnings in later years Can increase earnings in later years

due to revenue gains from the due to revenue gains from the researchresearch


Operating ExpensesOperating ExpensesPension accounting – interest rate Pension accounting – interest rate assumptionsassumptions

A change in the pension interest rate A change in the pension interest rate assumption can impact earnings assumption can impact earnings equality.equality.• If the rate is decreased, the annual If the rate is decreased, the annual

pension cost and the present pension cost and the present value of the benefits will increase.value of the benefits will increase.

• If the rate is increased, pension If the rate is increased, pension cost and the present value of the cost and the present value of the benefits will decrease.benefits will decrease.


A Checklist for Earnings A Checklist for Earnings QualityQualityNonoperating Revenue and Nonoperating Revenue and ExpenseExpense

15.15. Gains (losses) from sales of assetsGains (losses) from sales of assets16.16. Interest incomeInterest income17.17. Equity incomeEquity income18.18. Income taxesIncome taxes19.19. Unusual itemsUnusual items20.20. Discontinued operationsDiscontinued operations21.21. Extraordinary itemsExtraordinary items



Nonoperating Revenue and Nonoperating Revenue and ExpenseExpenseGains (losses) from sales of Gains (losses) from sales of assetsassets

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 generate needed cash when the firm is performing poorly.firm is performing poorly.

Such transactions are not part of the Such transactions are not part of the normal operations of the firm and normal operations of the firm and should be excluded from net should be excluded from net income when considering the future income when considering the future operating potential of the company.operating potential of the company.


Nonoperating Revenue and Nonoperating Revenue and ExpenseExpenseInterest IncomeInterest Income

Results primarily from short-term Results primarily from short-term temporary investments in marketable temporary investments in marketable securities to earn a return on cash securities to earn a return on cash not immediately needed.not immediately needed.

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 it amount of interest income because it is not part of operating income.is not part of operating income.


Nonoperating Revenue and Nonoperating Revenue and ExpenseExpenseEquity incomeEquity income

Use of equity method permits the Use of equity method permits the investor to recognize as investor to recognize as investment income the investor’s investment income the investor’s percentage ownership share of percentage ownership share of the investee’s reported income.the investee’s reported income.

Net effect is that the investor, in Net effect is that the investor, in most cases, records more income most cases, records more income than is received in cash.than is received in cash.


Nonoperating Revenue and Nonoperating Revenue and ExpenseExpenseIncome taxesIncome taxesProvision for income tax expense on the income Provision for income tax expense on the income

statement differs from the tax actually paid.statement differs from the tax actually paid.It is important to differentiate between It is important to differentiate between

increases and decreases to net earnings increases and decreases to net earnings caused by tax events.caused by tax events.

Significant change in effective tax rate may be Significant change in effective tax rate may be a one-time nonrecurring item.a one-time nonrecurring item.

Income tax notes reveal year-to-year changes Income tax notes reveal year-to-year changes in deferred tax accounts.in deferred tax accounts.


Nonoperating Revenue and Nonoperating Revenue and ExpenseExpenseUnusual itemsUnusual items

Some companies will create a line Some companies will create a line item on the income statement for item on the income statement for unusual items or special charges.unusual items or special charges.

Analyst should always investigate Analyst should always investigate these items to determine if these these items to determine if these items are nonoperating and/or items are nonoperating and/or nonrecurring.nonrecurring.


Nonoperating Revenue and Nonoperating Revenue and ExpenseExpenseDiscontinued OperationsDiscontinued OperationsShould be excluded in considering Should be excluded in considering

future earningsfuture earningsTwo items recorded if discontinued Two items recorded if discontinued

operations have been soldoperations have been sold• Gain (loss) from operations of the Gain (loss) from operations of the

division up to the time of saledivision up to the time of sale• Gain (loss) as a result of the sale, Gain (loss) as a result of the sale,

both net of taxboth net of tax


Nonoperating Revenue and Nonoperating Revenue and ExpenseExpenseExtraordinary itemsExtraordinary items

Gains and losses that are both Gains and losses that are both unusual and infrequent in unusual and infrequent in naturenature

Should be eliminated from earnings Should be eliminated from earnings when evaluating a firm’s future when evaluating a firm’s future earnings potentialearnings potential


A Checklist for Earnings A Checklist for Earnings QualityQualityOther IssuesOther Issues

22.22. Material changes in number of Material changes in number of sharessharesoutstandingoutstanding

23.23. Operating earnings, a.k.a. core Operating earnings, a.k.a. core earnings, pro forma earnings, or earnings, pro forma earnings, or EBITDAEBITDA



Other IssuesOther IssuesMaterial Changes in Number of Shares Material Changes in Number of Shares OutstandingOutstandingChanges can result from treasury stock Changes can result from treasury stock

purchases and the purchase and purchases and the purchase and retirement of common stock.retirement of common stock.

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


Other IssuesOther IssuesOperating earnings, a.k.a. core Operating earnings, a.k.a. core earnings, pro forma earnings, or earnings, pro forma earnings, or EBITDAEBITDA

Operating earnings are important for Operating earnings are important for assessing the ongoing potential assessing the ongoing potential of a firm.of a firm.

Companies have created their own Companies have created their own operating profit numbers and operating profit numbers and tried to convince users that tried to convince users that these figures are the ones to these figures are the ones to focus on.focus on.


Other IssuesOther IssuesOperating earnings, a.k.a. core Operating earnings, a.k.a. core earnings, pro forma earnings, or earnings, pro forma earnings, or EBITDAEBITDA

““Company created” numbers go by a Company created” numbers go by a variety of names such as core variety of names such as core earnings, pro forma earnings, or earnings, pro forma earnings, or EBITDA (operating earnings before EBITDA (operating earnings before interest, tax, depreciation, and interest, tax, depreciation, and amortization expenses are deducted).amortization expenses are deducted).

SEC requires companies that report pro SEC requires companies that report pro forma financial information to do so forma financial information to do so in a manner that is not misleading.in a manner that is not misleading.


What are the Real Earnings?What are the Real Earnings?

Each individual user of financial Each individual user of financial statements should adjust the statements should adjust the earnings figure to reflect what earnings figure to reflect what they believe is relevant to the they believe is relevant to the decision at hand.decision at hand.


Quality of Financial Quality of Financial ReportingReportingThe Balance SheetThe Balance Sheet

Items discussed in the earnings Items discussed in the earnings quality section also impact balance quality section also impact balance sheet quality.sheet quality.

When evaluating balance sheet When evaluating balance sheet several other items should also be several other items should also be assessed:assessed:


Quality of Financial Quality of Financial ReportingReportingThe Balance SheetThe Balance Sheet

Type of debt used to finance assets should Type of debt used to finance assets should generally be matched (short-term debt for generally be matched (short-term debt for current assets and long-term debt/equity current assets and long-term debt/equity for long-term assets).for long-term assets).

““Commitments and Contingencies” Commitments and Contingencies” disclosures in the notes should be carefully disclosures in the notes should be carefully evaluated as information on off-balance-evaluated as information on off-balance-sheet financing and other complex sheet financing and other complex financing arrangements are located here.financing arrangements are located here.


Quality of Financial Quality of Financial ReportingReportingThe Statement of Cash The Statement of Cash FlowsFlowsThe cash flows from operations from operations (CFO) figure, while highly useful, (CFO) figure, while highly useful, can be manipulated bycan be manipulated by

• recording operating expenses recording operating expenses as capital expendituresas capital expenditures

• managing current asset and managing current asset and liability accounts to cause liability accounts to cause increases to CFOincreases to CFO


Quality of Financial Quality of Financial ReportingReportingThe Statement of Cash The Statement of Cash FlowsFlows

Cash flows from the following types of items should be removed from CFO for analytical purposes:

• Investments in trading Investments in trading securitiessecurities

• Discontinued operationsDiscontinued operations• Nonrecurring expenses or Nonrecurring expenses or

incomeincome

Documents

Earnings and Financial Reporting