Chapter 6

Accounting Quality

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 Accounting Quality
• 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: 06 2
 Evaluating Accounting Quality
• Economic faithfulness of measurements.
• Reliability of measurements.
• How well GAAP selections “fit” firm’s
activities?
• Reasonableness of estimates.
• Quality and adequacy of disclosures.

Chapter: 06 3
 High Accounting Quality
• Reflects Economic Reality.
• Leads to the Ability to Assess Earnings
Persistence Over Time.

Chapter: 06 4
 Economic Reality
• Elements of Economic Information Content:
– A reflection of economics
– Measurement error (or noise)
– Bias
• Many measurements require subjective
estimates.
• GAAP allows choice of accounting policies.
• Informative disclosures are most important.
Chapter: 06 5
 Earnings Quality vs Balance Sheet
Quality
• Earnings Quality
– accurate assessment of current performance and
a foundation for predicting future performance
• Balance Sheet Quality
– accurate assessment of key descriptions of risk:
liquidity, financial flexibility, and solvency

Chapter: 06 6
 Earnings Management

• Commonplace?
• Possibly thin line between this and fraud?
• Detectable?
• Boundaries of Earnings Management.

Chapter: 06 7
 Recognizing and Measuring
Liabilities
A liability is recognized when:
•The obligation involves a probable future
sacrifice of economic benefits.
•The firm has a present obligation (not a
possible future obligation) and little or no
discretion to avoid the transfer.
•The transaction or event that gave rise to the
obligation has already occurred.
Chapter: 06 8
Classification of Accounting
Liabilities

Chapter: 06 9
 Off-Balance-Sheet Financing
Arrangements
• Either (or a combination of approaches):
– Sale of an existing asset or sale-leaseback.
– Use of another entity (uncontrolled entity) to
obtain financing.
• Ways to avoid consolidation:
– Joint venture
• Financial reporting does not recognized
mutually unexecuted contracts as liabilities;
they are mere promises.
Chapter: 06 10
 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: 06 11
 The Income Statement
(Slide 1 of 3)
• Infrequent items
– Discontinued operations
– Extraordinary items
– Changes in accounting principles
– Impairment losses on long-lived assets
– Restructuring and other charges
– Changes in estimates

Chapter: 06 12
 The Income Statement
(Slide 2 of 3)
– Gains and losses from peripheral activities
– Items in other comprehensive income (not on
income statement)

Chapter: 06 13
 The Income Statement
(Slide 3 of 3)
Cotton 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: 06 14
 Discontinued Operations
(Slide 1 of 2)
• Must be a separate business or component
with clearly separable operations and cash
flows.
• Measurement date vs. Disposal date.

Chapter: 06 15
 Discontinued Operations
(Slide 2 of 2)
• What 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: 06 16
 Extraordinary Items
• Must be
– Unusual in nature
– Infrequent in occurrence
– Material in amount
• Reported net of tax.
• Included in cash flows from operations.

Chapter: 06 17
 Changes in Accounting Principles

• SFAS No.154
• Retrospective Treatment
• If impractical, then adjustment to Retained Earnings
• No cash flow effects
• Again, read disclosures carefully!

Chapter: 06 18
 Other Comprehensive Income
• Persistent?
• Predictive?
• Examples include:
– Marketable Equity Securities
– Derivatives held as cash flow hedges
– Minimum pension obligations
– Investments in certain foreign operations

Chapter: 06 19
 Impairment Losses
• Included 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: 06 20
 Restructuring Charges
• No 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: 06 21
 Changes in Estimates
• Financial statements entail many estimates.
• Changes in estimates are not unusual.
• Accounted for prospectively (in current and
future periods).
• Analyst should examine carefully.

Chapter: 06 22
 Gains and Losses from Peripheral Activities

• Included in income from continuing

operations.
• Not sustainable.
• So should be removed from earnings.

Chapter: 06 23
 Account Classifications

• Firms may classify by type of expense.

• Or by type of expense.
• Have to reclassify in order to perform
comparisons.

Chapter: 06 24
 Tools in the Assessment of
Accounting Quality
• Partition earnings into its cash flow and accrual
components to gain a better understanding of
the persistence of earnings.
• Beneish Manipulation Index to assess the
likelihood of financial statement manipulation

Chapter: 06 25
 Outside the U.S.

• Different reporting methods and accounting

principles.
• Corporate strategies, cultural practices, and
institutional structures will differ by country.
• SEC Final Rule No.33-8879 provides U.S. investors
with two sets of accounting principles: IFRS and U.S.
GAAP.

Chapter: 06 26