Essentials of Financial Statement Analysis
Chapter 5: Essentials of Financial Statement Analysis Evaluating accounting “quality”
How do we define financial reporting quality? Qualitative characteristics of accounting Information:
Understandability Decision usefulness Reliability Relevance Consistency Comparability
1
Attributes of High Quality Financial Reporting
Financial reporting (earnings) quality has been considered positively associated with the following: High persistence of earnings and cash flows High predictive ability of earnings and cash flows High earnings response coefficient Low level of earnings management More voluntarily disclosure Strong corporate governance
2
Manipulating Income and Earnings Management
Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance.
“Most managers prefer to report earnings that follow a smooth, regular, upward path.”2
3
1. Arthur
Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.
What should the users be aware of ?
Statement users must: Understand current financial reporting settings and standards. Recognize that management may manipulate the financial information. Distinguish between reliable financial statement information and poor quality information.
4
Financial statement analysis and accounting quality
Financial analysis tools: Commonsize statements, trend statements and financial ratios. But they can be no better than the data from which they are constructed (i.e., the comparative financial statements).
5
Financial statement analysis and accounting quality
The accounting distortions need to be watched when using these tools. Examples include:
How do we define financial reporting quality? Qualitative characteristics of accounting Information:
Understandability Decision usefulness Reliability Relevance Consistency Comparability
1
Attributes of High Quality Financial Reporting
Financial reporting (earnings) quality has been considered positively associated with the following: High persistence of earnings and cash flows High predictive ability of earnings and cash flows High earnings response coefficient Low level of earnings management More voluntarily disclosure Strong corporate governance
2
Manipulating Income and Earnings Management
Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance.
“Most managers prefer to report earnings that follow a smooth, regular, upward path.”2
3
1. Arthur
Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.
What should the users be aware of ?
Statement users must: Understand current financial reporting settings and standards. Recognize that management may manipulate the financial information. Distinguish between reliable financial statement information and poor quality information.
4
Financial statement analysis and accounting quality
Financial analysis tools: Commonsize statements, trend statements and financial ratios. But they can be no better than the data from which they are constructed (i.e., the comparative financial statements).
5
Financial statement analysis and accounting quality
The accounting distortions need to be watched when using these tools. Examples include: