Fin361 Appendix 3a

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A Guide to Earnings and Financial Reporting Quality

A Guide to Earnings and Financial Reporting Quality
Quality of reported financial information is a critical element in evaluating financial statement data. The higher the quality of financial reporting, the more useful the information is for business decision making. 5-2

A Guide to Earnings and Financial Reporting Quality
There are a number of areas on the earnings statement that provide management with opportunities for influencing the outcome of reported earnings.

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A Guide to Earnings and Financial Reporting Quality
These areas include • accounting choices, estimates, and judgments • changes in accounting methods and assumptions • discretionary expenditures • nonrecurring transactions • nonoperating gains and losses • revenue and expense recognitions that do not match cash flow 5-4

A Guide to Earnings and Financial Reporting Quality
The financial statement analyst should • consider the qualitative as well as the quantitative components of earnings for an accounting period • develop an earnings figure that reflects the future ongoing potential of the firm 5-5

A Guide to Earnings and Financial Reporting Quality
In addition to earnings quality, the quality of information on the balance sheet and statement of cash flows is equally important. Because these financial statements are interrelated, quality of financial reporting issues often affects more than one financial statement. 5-6

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A Checklist for Earnings Quality
I. II. III. IV. V. Sales Cost of Goods Sold Operating Expenses Nonoperating Revenue and Expense Other Issues

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A Checklist for Earnings Quality Sales
Key areas that affect earnings quality 1. 2. 3. 4. 5. Premature revenue recognition Gross vs. net basis Allowance for doubtful accounts Price vs. volume changes Real vs. nominal growth 5-8

Sales Premature revenue recognition
Revenue should not be recognized until there is evidence that a true sale has taken place. Many firms record revenue before the conditions for a true sale have been met.

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Sales Premature revenue recognition
Analysts should • look at revenue recognition policy • evaluate any changes in revenue recognition policies • study the relationship among sales, accounts receivable, and inventory

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Sales Gross versus net basis
Another tactic to boost revenues is to record sales at the gross rather than the net price. Gross refers to the total amount that the final customer pays for an item. Net refers to the gross amount less the cost of the sale. 5-11

Sales Gross versus net basis
Revenues appear larger when reported at gross amounts. Gross profit margins appear better when revenues are reported at net amounts. Analysts should read the notes to determine how revenue is recorded. 5-12

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Sales Allowance for doubtful accounts
There should be a consistent relationship between the rate of change in sales, accounts receivable, and allowance for doubtful accounts. Analyst should be alert to the potential for manipulation through the allowance account. 5-13

Sales Price versus volume changes
If sales are changing, it is important to determine whether the change is a result of price, volume, or both. In general, higher quality earnings would be the product of both volume and price increases (during inflation).

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Sales Real versus nominal growth
It is important to determine if sales are growing in “real” (inflation-adjusted) as well as “nominal” (as reported) terms. Change in sales in nominal terms can be readily calculated from figures on the income statement. 5-15

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Sales Real versus nominal growth
An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to make a comparison of the changes in real and nominal terms.

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Sales Real versus nominal growth
To make the calculation, begin with the sales figure from...
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