Reading 12: Evaluating Quality of Financial Reports

Page No. 16126th September 2022 MondayDate / /0ReadingEvaluating Quality9financial Report 5M 13.1 : Quality of financial ReportReporting QualityResuts qualityEarning QualityDecision useful informationAssesment of the info disclosedPertains to the earnings &Cash generated by thein financial reports.Accurate (GAP Compliant) & relevantROE Cover CostCompanyROLL > WAACROE >RSustainableConceptual framework - ans these two questionHigh -quality earningHigh -quality ReportingCompany Can havelow quality earnings and high qualityreporting but Cannot have high quality earning 4low quality reportingmig9/0 Page No. 162Date//Quality Spec trum of financial reportsHigI GRAP Compliant and decision-useful high- quality earnings2GRAP Complaint and decision -useful , low - quality earnings3GRAP Complaint but not decision useful (biased)59 Non-Complaint accountingFraudulent acountingLowfiliousProblem Affecting QualityffilouD1] Measurement and timing issuesAffectmultiple financial statement elsement (interconnectedExamples:create- - Overly aggressive / Conservative revenue recogniting sustanibilityOmission or postponenment of exp ecognition 5issue2] Classification within a financial StatementOperating Vs non operating itemsDoes not affect MCurrent Vs. noncurrent assets CARNolonyer term ar)Current Vs noncurrent eliabilityExample1ARSelling themfailtopgfillingstransfering to SPEConverting to notes receivablesInflate equity 4 firm Reclassify valuation as long term receivables Page No. 163Date//2Selling AR or treating them as long-term receivable )3 Reclassification of inventory to long- -term assetsReclasification ofnoncovicrevenueasrevenue34fromCore continuing operations5Treating investing cash flowasoperatingCash flow(i.e on asset disposal)Biased Accounting2Mechanisms to misstate profibilityAggressive revenue recognitions , channel stuffing t bill andhold sales t fake salesLessor use of finance lease classificationClassification ofnon operatingrevenuesClassification of operation expchannel gains through M 4 losses through OCIRevenue growth higherWarning Sigh of Misstate profitabilitythanpeerReceivables growthhigherthanrevenueHigher rategrowthofreturn from customersHigher 04 RevenuesUn explained boostto(FO loweroperatingmarginsthanInconsistent classification earningsitem over timeofoperation l non- operatingExecutive CompensationAggressive accounting assumptions Page No. lbsDate / /2] Mechanishms to Misstate asset 1 LiabilityModel Choice and model inputs affecting est valuesClassification from currenttononcurrentOver- or understandingallowancesand reservesUnderstanding identifiableassetsandoverstategoodwillinbiz CombinationProcedes X% FMV Net asset (x)GWXInconsistant in model inputs for valuation ofWarnings Signs of misstate AILassets Vs. liabilitiesTypical Current assets being treated as non-currentAllowanceandreserveseitherout of line withpeers or fluctuatingHigh goodwill relative to tatal assetsUse of SPEsoff -balance sheetliabilitiesFluctuating deferred tax assets l liability3Mechanismstooverstate Cash flow from operations GCFOManaging activities to affects CFOBKMisclassifying cash Flow into (FO Page No. 165Date / /Warning Sign of Overstated CFOIncreases inpayables combinedwith decreasesininventory and receivablesCapitalized expenditures CCFI not (Fo)Sale andlease back transactionsIncreasesinbank overdraftBiz CombinationsIssues ;Motivation :- Boost decliningCFO ?Stock based acquisitions :-IAcquirer incentive to boost stock price using aggressiveaccording to accountingTarget incentive to bost Stock price priorto2acquisition (Max sale price)Pursuing acquisition to by hide pre-acquisition accountingirregularitiesUnderstate identifiable acquired net asset to boostgoodwill (& future earnings) Operating leasequalifyPage No. 166FinancieleasequalityDate //Failing to Reflect Economic substanceIssue : Compliance with relevant GARP but not reflectingeconomic substanceExamples : Avoidance of consolidating SPEs (Enion) prior to FinilleRestrustucing provision and impairment:Overstatementprovisionsenable of earnings in prior periodsImpairments boost future earnings via lower depearly recognition of future expensesReversal of prassions bust future earnings.M 13.2 : Evaluating Earnings QualityStep 1 : Understand the Company industry + accounting principleand appropriateness2Understand the management , Commpensation + insider tradesand related party transaction3Identify material accounting areas open to subjectiveandest4Make Cross Sectional and time series Comparisons ofstatements and ratios Page No. 16727th September 2022 ThuesdayDate / /5Check for warning Signs6Conglomerates check segmental disclosure for shiftingprofits (transfer pricing)7Use quantitative tools to evaluate likelihood of earningsmanagementThe Beneish Model Probit regression moldProbit regression model est the probability of earningsmanu manipulationusing eigh variablesM- Score 1) -4.84 +0.920 (DSR)) + 0.528 (GMI) + 0.404 (AQI) t 0.892(SGI) + 0.115(DEP1) $172 (SGA)) t 4.61 (Accruals) - -0.327 ( (Levi)M- - Score > -1.78 = Possible earnings management.2-score3-87pm of earning managementLimitation : Cannot deve detemime Cause & effect bet" modelVariableIRelieson accounting data that may not reflects economicsubstance2Gaming the model - predictive power decreasingpeople known this middlusedsogelthey make intioaccordingly Page No.168Date//DSRI=daysalesreceivableindex92Day sales outstanding 1 Currentin DSRIRev inflatiesDay Sales outstanding T-1 priviousGMI =GrossmarginIndex0.528GMT-1meansprofitmarginovertimeGM(incentive for managementAQI =dicateAssetexcessvileCapofexp0.404qualityIndexNon-Current asset Total asset')assetiftheNon-currentindicate/proportingTotalassets)ofassettell w Sales grouth is +ve of negtiveincleasing 3LProbVariables :1815ProbI Working Capitalto ta asset2RIEHigher valueTotal asset= higher Z -score= lower bankruply Risk3Operating profitlower chanse of manupulatingByTotal assetE/D4Market value of equityBV of liabilities5SaleTotal assetslow Quality EarningsRUE Cost of Capital = economic profitEconomic losses eliminated by abandoning negativeEconomic profit attracts Competitionvalue projectsEarnings generating by accruals will reverse leg earngeneratedfromunrealistically low depreciation rateshouldbe reversedbyfuturein pairmentlosses on disposal)More accrualFast ReversionLess accualsslow11- Pro-formal earnings are not prepred with GAAPPage No. 172Date//Evaluating Earnings QualityRevenue recognition issuesubjectiveareasEvductingquality and quantityConcerns:Accelerated revenueRelated party transactionClong term Contracts)Collectability of DSO credit A sale -Channel stuffingBill- and-holdsalesDeterioration of margins -discountingFake salesExamples:Daniel Springs IncIndustry Avg20x1201220x120x2 20x336520x3Sales12,11713122 147666Dso10.2 2260 22.80 22.4AR127215732363ARTIO16.216016.3ICompute theinrevenue andrecivables2Comment on the trend in DSO and receivables T/o3Comment potential Rev recognition issueon Page No. 178Date//Sol"DanielSpringsInc(analysis)20XI20x220X3in Sales-8-2%12.6%Ain Receivables-23.7%50.2%Receivables10.5%12.0%16.0%RevenueA in Rec/Rev-14.37.33.3%DSO38.2 days43.8 days58.4 dayRec T109.58.36.3Warning SignGrowth in ARgreaterthansales growthDSOgreaterthanindustrynormsandincreasingConclusionsPossiblecreditControlissuesClowqualityfakesales/lowqualitysalesofreceivables)PossibleRev ofDSIarepotentialinferiorqualityStep inAnalysisStepIUnderstandtherevrecognitionpracticesShipping/credittermsRetuinpolicyMultipledeliverablesPracticeofpeergroupcompanies . Page No. 175Date / /2Evaluating ageing of RecTime seriescross - sectional(peergroup)Comparison3Cash Vs. AccrualsCash Vs.accruals - basedearningsevaluation4financialswithphysicaldataCompangreprovidedby theCompany :Capacity utilization lul, + order bookCompare Rev trends to peers:5Use segmental analysis6Check for related party transactionsTransactions with associatesTransfer pricingCapitalizing ExpIncorrect Capitalization :Exp missing from I/SassetscreatedinB/SLong - LiveinI/SDefers Cost recognitionWarning SignDeterioration in asset H/PP&ETotal assetin Capex / gross PP4EMargin ImprovementCapex growth > Sales growth Page No. 176Date / /Steps in analysing exp recoIReviewsCost captalization disclosure, depreciationdisclosures + and Compare to peers.2Evaluate changes in non-current assets , t margins,depreciation exp Liate , & CapexTime seriesCross sectional3Check for related party transactionsshifting assets to associatespropping up earnings.Cash Flow QualityHigh quality operating CF (CFO) :CFO positive and sustainableCFO > Capex + debt service + dividends pakeilutigu)Management may try to shift tve CFs from CFI of CFItoCFOHigh-quality CFs : good eco performance andhighseportingLow-quality Ch : bad economic performance or misrepresentanof economic reality Page No. 177Date//For a start-up Co. it is okay to have Ve CFO -veCFIand +ve CFF , but if a mature company has -ve (Fo (Fsit is a signal that these are low- qualityManipulation:classification bet CFO CFI & CFFIFRS flexibility: dividends , interestWorking Capital management :- Delaying pay" to suppliers- - Reducing inventory levelsSelling ARAnalysis of CF qualityIReview for unsualitems2Check for revenue quality :Outflows due to increased AROutflows due to inventory increase when fakeSales are reversed3ProvisionsProvisions for restructuring - CF inflow when created.Balance Sheet QualityCompleteness :Lack of off BIS finance :- Opretingleases-Take@Comodity of Pre pay t or agreementsEquity accounted order bor associates Page No. 178Date//2Unbiased MeasurementPension liabilityValue of illiquidinvenstmentsSubjectiveGoodwill impairmentinputsInventory valuation and writedownsImpairments of PP&E& intangiblesReally subjective3Clear PresentationEasy & ful infoSources of Information about riskFinancial statementsAudit report (size and change of audit firm )Note to financial statements- - Disclosure of accounting to principles.Disclosure of changes to accounting estmates- Disclosure on liability amt and timings- Contingent liability disclosure- Financial instrumentmarket risk , anddisclouse (credit risk, liquidity risk,pensionassumptions)Management discussion and analysis (MD4A)- Principle risk unique to biz- Often low utility -Management are biased- Unaccided - b bad thingSEC form NT-Filed if Company is unable to file req financialstatements in time. Page No. 179Date //Financialpress- MustConductdue (own)diligence