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Chapter 9. Accounting Quality. Accounting Quality. Is not the same as “reporting quality” (which can imply conservatism). Accounting information should (be): Fair complete representation of firm’s economic performance, position, and risk. - PowerPoint PPT Presentation
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Chapter 9Chapter 9
Accounting QualityAccounting Quality
Chapter: 09 2
Accounting QualityIs not the same as “reporting quality”
(which can imply conservatism).Accounting information should (be):
Fair complete representation of firm’s economic performance, position, and risk.
Provide relevant information for forecasting future earnings and cash flows.
Chapter: 09 3
High Accounting QualityReflects Economic Information Content.Leads to Earnings Persistence Over Time.
Chapter: 09 4
Economic Information ContentElements of Economic Information Content:
A reflection of economicsMeasurement error (or noise)Bias
Many measurements require subjective estimates.
GAAP allows choice of accounting policies.Informative disclosures are most important.
Chapter: 09 5
Evaluating Accounting QualityEconomic faithfulness of measurements.Reliability of measurements.How well GAAP selections “fit” firm’s
activities?Reasonableness of estimates.Quality and adequacy of disclosures.
Chapter: 09 6
Quality of Earnings Does an income statement item signal:
1) An unexpected change in earnings for current period?
2) A change in expected earnings for future periods?
3) Both?
Chapter: 09 7
The Income StatementInfrequent items
Discontinued operationsExtraordinary itemsChanges in accounting principlesImpairment losses on long-lived assetsRestructuring and other chargesChanges in estimates
Chapter: 09 8
The Income Statement (Contd.)Gains and losses from peripheral activitiesItems in other comprehensive income (NOT
on income statement)
Chapter: 09 9
The Income StatementCotton Spring Products, Inc.
Income Statement For Year Ended Jan. 31, 20XX
Sales $ 100,000 Cost of goods sold 50,000 Gross profit $ 50,000 Selling and administrative expenses 19,200 Income from continuing operations before tax $ 30,800 Tax on income from continuing operations 10,780 Income from continuing operations $ 20,020 Discontinued operations: Income from operation, net of tax of $3,500 $6,500 Gain on disposal, net of tax of $5,250 9,750 Net Income from Discontinued Operations $16,250 Extraordinary item: Loss from earthquake, net of tax of $4,200 ($7,800) Net income $ 28,470
Chapter: 09 10
Discontinued OperationsMust be a separate business or component
with clearly separable operations and cash flows.
Measurement date vs. Disposal date.
Chapter: 09 11
Discontinued OperationsWhat does this mean to the analyst?
Do we include the discontinued business’ assets and liabilities in our analysis?
Do we include income?Gain or loss on disposal?
Chapter: 09 12
Extraordinary ItemsMust be
Unusual in natureInfrequent in occurrenceMaterial in amount
Reported net of tax.Included in cash flows from operations.
Chapter: 09 13
Changes in Accounting PrinciplesPrior to 2006:Must report cumulative effect on prior periods on
income statement below income from continuing operations (net of tax).
May be voluntary (e.g., change in inventory cost flow assumption).
May be mandatory (e.g., FASB issues new pronouncement).
No cash flow effects.Read disclosures carefully!
Chapter: 09 14
Changes in Accounting Principles2006 forward:SFAS No.154Retrospective Treatment.If impractical, then adjustment to Retained
Earnings.No cash flow effects.Again, read disclosures carefully!
Chapter: 09 15
Changes in Accounting PrinciplesReporting Methods Compared
Chapter: 09 16
Other Comprehensive IncomePersistent?Predictive?Examples include:
Marketable Equity SecuritiesDerivatives held as cash flow hedgesMinimum pension obligationsInvestments in certain foreign operations
Chapter: 09 17
Impairment LossesIncluded in income before taxes from
continuing operations.Firms not required to test every asset,
except goodwill and other intangibles with unlimited lives every reporting period.
May be separate line item, or disclosed in notes.
Usually no cash flow effect.
Chapter: 09 18
Restructuring ChargesNo specific FASB pronouncements.Related to strategic decisions.Some firms take all at once.Some take charges over several years.Look at industry conditions, economic
conditions, and type of change.
Chapter: 09 19
Changes in EstimatesFinancial statements entail many
estimates.Changes in estimates are not unusual.Accounted for prospectively (in current
and future periods).Analyst should examine carefully.
Chapter: 09 20
Gains and Losses from Peripheral Activities
Included in income from continuing operations.
Not sustainable.So should be removed from earnings.
Chapter: 09 21
Restated Financial DataFirm must restate all years presented if:
it decides in current year to discontinue operations of a segment.
it adopts changes in accounting principles.
Can lead to comparability and ratio computation problems!
Chapter: 09 22
Account ClassificationsFirms may classify by function.Or by type of expense.Have to reclassify in order to perform
comparisons.
Chapter: 09 23
Outside the U.S.Different reporting methods and accounting
principles.Corporate strategies, cultural practices,
institutional structures will differ by country.Preparation of the reconciliation excluded: SEC
accepts financial reports of Non-U.S. filers prepared in accordance with IFRS.
SEC Final Rule No.33-8879 provides U.S. investors with two sets of accounting principles-IFRS and U.S. GAAP.
Chapter: 09 24
Earnings ManagementCommonplace? Possibly thin line between this and fraud?Detectable?Boundaries of Earnings Management.
