IFT Notes for Level I CFA® Program
R29 Financial Reporting Quality
How Accounting Choices and Estimates Affect Earnings and Balance Sheets
This section identifies areas where choices affect financial reporting and the questions analysts must ask to assess the quality of reporting.
When evaluating a company’s revenue recognition practices, an analyst should ask the following questions:
- How is the revenue recognized, upon shipment or upon delivery of goods?
- Is the company engaged in “channel stuffing” – the practice of overloading a distribution channel with more product than it is normally capable of selling? For example, a washing machine manufacturer pressurizes a retailer to sell more machines through special discounts. The threat is that the retailer may return unsold units.
- Does the company engage in bill-and-hold transactions? A company bills the customer, recognizes revenue but does not ship the product.
- Does the company use rebates as part of its marketing approach? If so, how significantly do the estimates of rebate fulfillment affect net revenues? And have any unusual breaks with history occurred?
- Does the company separate its revenue arrangements into multiple deliverables of goods or services?
Long-Lived Assets: Depreciation Policies
- Companies have a choice to use one of the three depreciation methods: Straight-line, accelerated double-declining-balance method, or units-of-production method.
- Depreciation expense: Depends on the method used and the salvage value of the assets being depreciated. We have seen the effect on operating margins and depreciation expense in the earlier reading.
- Analysts must consider if the estimated life spans of the associated assets make sense, or are they unusually low compared with others in the same industry? And if there have been changes in depreciable lives that have a positive effect on current earnings.
Inventory Costing Method
Companies cannot arbitrarily switch between inventory costing methods once the policy decision is made. For example, a cost flow assumption between FIFO vs. weighted average cost can lead to different values for income statement and balance sheet items, and eventually affect profitability. Let us take an example of a company that sells one good. There are four pieces of that good whose costs are 1, 1, 2, and 2 respectively. If two pieces are sold then, according to:
- FIFO: COGS = 2; Ending inventory = 4. FIFO understates cost and overstates ending inventory.
- Weighted average cost: COGS = 3; Ending inventory = 3. The balance sheet is a mix of old and new inventory costs. Understates inventory if costs are rising.
Analysts must examine the following:
- Does the company use a costing method that produces fair reporting results in view of its environment? How do its inventory methods compare with others in its industry? Are there differences that will make comparisons uneven if there are unusual changes in inflation?
- Does the company use reserves for obsolescence in its inventory valuation? If so, are they subject to unusual fluctuations that might indicate adjusting them to arrive at a specified earnings result?
- If a company reports under US GAAP and uses last-in, first-out (LIFO) inventory accounting, does LIFO liquidation (assumed sale of old, lower-cost layers of inventory) occur through inventory reduction programs? This inventory reduction may generate earnings without supporting cash flow, and management may intentionally reduce the layers to produce specific earnings benefits.
Capitalization Policies of Intangible Assets
Another example of how choices affect both the balance sheet and income statement is in the use of capitalization. If the payment benefits only the current period, then it must be classified as an expense. If it will be used in future periods, then it must be capitalized.
- Does the company capitalize expenditures related to intangibles, such as software?
- Does its balance sheet show any R&D capitalized as a result of acquisitions?
- Or, if the company is an IFRS filer, has it capitalized any internally generated development costs?
When a company acquires another company, and the acquiring company pays more than its fair value, then goodwill is created. The fair value of the assets created is based on the management’s estimate. The depreciable value of assets is kept low to lower the depreciation expense, and the amount that cannot be allocated to specific assets is classified as goodwill.
The initial value of the goodwill is objective. Over time, the value of goodwill is subjective. Companies must test goodwill for impairment annually on a qualitative basis. The value of the assets reported depends on the management’s intent; if the fair value of assets cannot be recovered, the company must write-down goodwill. To avoid writing down goodwill, the company may project a better future performance.
Allowance for Doubtful Accounts/Loan Loss Reserves
- Are additions to such allowances lower or higher than in the past? For example, if the allowance for doubtful accounts must be 3% based on historical transactions, a company can report 2% instead in order to boost earnings. Analysts must verify if the allowances are justified.
- Does the collection experience justify any difference from historical provisioning?
- Is there a possibility that any lowering of the allowance may be the result of industry difficulties along with the difficulty of meeting earnings expectations?
- Is the company engaged in transactions that disproportionately benefit members of management? Does one company have control over another’s destiny through supply contracts or other dealings?
- Do extensive dealings take place with non-public companies that are under management control? If so, non-public companies could absorb losses (through supply arrangements that are unfavorable to the private company) and make the public company’s performance look good. This scenario may provide opportunities for an owner to cash out.
Tax Asset Valuation Accounts
- Tax assets, if present, must be stated at the value at which management expects to realize them, and an allowance must be set up to restate tax assets to the level expected to eventually be converted into cash. Determining the allowance involves an estimate of future operations and tax payments. Does the amount of the valuation allowance seem reasonable, overly optimistic, or overly pessimistic? For example, if a company records a DTA which expires in three years, analysts must analyze if a company can become profitable within this period.
- Are there contradictions between the management commentary and the allowance level, or the tax note and the allowance level? There cannot be an optimistic management commentary and a fully reserved tax asset, or vice versa. One of them has to be wrong.
- Look for changes in the tax asset valuation account. It may be 100% reserved at first, and then “optimism” increases whenever an earnings boost is needed. Lowering the reserve decreases tax expense and increases net income. If the valuation allowance is lower, then DTA and net income increases.
4.3. Warning Signs
Warning signs of information manipulation in financial reports can be seen as manipulation in:
- Biased revenue recognition.
- Biased expense recognition.
The bias may be with respect to:
- Timing of recognition: Deferring expenses by capitalizing.
- Location of recognition: Showing a loss in other comprehensive income instead of the income statement.
Analysts must look at the following for warning signs:
- Pay attention to revenue. Examine the accounting policies note for a company’s revenue recognition policies. Studies have shown that most manipulations relate to revenue recognition; the largest number on the income statement.
- Does the company recognize revenue prematurely; revenue recognition upon shipment of goods or bill-and-hold sales?
- Does the company engage in barter transactions?
- Are rebates offered? If yes, by how much, as these can affect revenue recognition?
- How will revenue be recognized for multiple-deliverable arrangements of goods and services?
- Look at revenue relationships.
- Compare a company’s revenue growth with that of its competitors, industry, or the economy. If the company outperforms, then there must be a justifiable performance like superior management or product differentiation. If not, it should be a cause of concern.
- Compare accounts receivable with revenue to see if it is increasing as a percentage of revenue over the years. It may indicate relaxed credit terms or channel stuffing.
- Analyze asset turnover to see if the assets are efficiently used. If an asset turnover is declining, then it indicates assets may be written down in the future.
- Pay attention to signals from inventories.
- Look at the growth in inventories relative to competitors and industry.
- Look at the inventory turnover ratio. If the ratio is declining, it may mean obsolescent inventory.
- US GAAP allows use of LIFO for inventory accounting. If prices increase, analysts must check to see that old inventory has not been passed through earnings (LIFO liquidation) to boost net profits.
- Pay attention to capitalization policies and deferred costs.
- Compare a company’s accounting policy for capitalization of long-term assets, interest costs, and handling of deferred costs with that of its competitors and the industry. If only this company is capitalizing costs while others are expensing, then it is a warning sign.
- Pay attention to the relationship of cash flow and net income.
- Construct a time series of cash flow from operations divided by net income. If the ratio is consistently less than 1.0, then it indicates a problem with accrual accounts, i.e., net income is shown higher than it should be.
Other Potential Warning Signs
Other areas that require further analysis include:
- Depreciation methods and useful lives.
- Fourth-quarter surprises: For non-seasonal businesses, over- or under-performance in the fourth quarter of a year routinely is a red flag.
- Presence of related-party transactions: What is the intent behind related-party transactions, often by founding members of a company?
- Non-operating income or one-time sales included in revenue: To mask declining revenues, companies may include one-time gain as part of revenue. Ex: In 1997, Trump Hotels included a one-time gain from a lease termination as part of revenue.
- Classification of expenses as non-recurring.
- Gross/operating margins out of line with competitors or industry.
- Younger companies with an unblemished record of meeting growth projections.
- Management has adopted a minimalist approach to disclosure: Is the management withholding information from competitors?
- Management fixation on earnings reports.
- Financial reporting quality can be thought of as spanning a continuum.
- Reporting quality pertains to the information disclosed. High-quality reporting represents the economic reality of the company’s activities during the reporting period and the company’s financial condition at the end of the period.
- Results quality (commonly referred to as earnings quality) pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition, relative to expectations of current and future financial performance.
- An aspect of financial reporting quality is the degree to which accounting choices are conservative or aggressive. “Aggressive” typically refers to choices that aim to enhance the company’s reported performance and financial position by inflating the amount of revenues, earnings, and/or operating cash flow reported in the period; or by decreasing the amount of expenses reported in the period and/or the amount of debt reported on the balance sheet.
- Conservatism in financial reports can result from either:
- Accounting standards that specifically require a conservative treatment of a transaction or an event.
- Judgments necessarily made by managers when applying accounting standards that result in more- or less-conservative results.
- Motivation: Managers may be motivated to issue less than high quality financial reports in order to mask poor performance, to boost the stock price, to increase personal compensation, and/or to avoid violation of debt covenants.
- Conditions that are conducive to the issue of low-quality financial reports include cultural environment attributes that result in fewer or less transparent financial disclosures, the book/tax conformity that shifts emphasis toward legal compliance and away from fair presentation, and limited capital markets regulation.
- Mechanisms that discipline financial reporting quality include the free market and incentives for companies to minimize cost of capital, auditors, contract provisions specifically tailored to penalize misreporting, and enforcement by regulatory entities.
- Pro forma earnings (also commonly referred to as non-GAAP or non-IFRS earnings) adjust earnings as reported on the income statement. Pro forma earnings that exclude negative items are a hallmark of aggressive presentation choices.
- Companies are required to make additional disclosures when presenting any non-GAAP or non-IFRS metric.
- Managers’ considerable flexibility in choosing their company’s accounting policies and in formulating estimates provides opportunities for aggressive accounting.
- Examples of accounting choices that affect earnings and balance sheets include inventory cost flow assumptions, estimates of uncollectible accounts receivable, estimates of how much of deferred tax assets can be realized, depreciation method, estimated salvage value of depreciable assets, and estimated useful life of depreciable assets.
- Cash from operations is a metric of interest for investors that can be enhanced by operating choices, such as stretching accounts payable, and potentially by classification choices.