Copyright © 2011 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 9 Accounting Quality

Chapter: 092 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. Provide relevant information for forecasting future earnings and cash flows.

Chapter: 093 High Accounting Quality Reflects Economic Information Content. Leads to Earnings Persistence Over Time.

Chapter: 094 Economic Information Content 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: 095 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: 096 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: 097 The Income Statement Infrequent items Discontinued operations Extraordinary items Changes in accounting principles Impairment losses on long-lived assets Restructuring and other charges Changes in estimates

Chapter: 098 The Income Statement (Contd.) Gains and losses from peripheral activities Items in other comprehensive income (NOT on income statement)

Chapter: 099 The Income Statement

Chapter: 0910 Discontinued Operations Must be a separate business or component with clearly separable operations and cash flows. Measurement date vs. Disposal date.

Chapter: 0911 Discontinued Operations 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: 0912 Extraordinary Items Must be Unusual in nature Infrequent in occurrence Material in amount Reported net of tax. Included in cash flows from operations.

Chapter: 0913 Changes in Accounting Principles Prior 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: 0914 Changes in Accounting Principles 2006 forward: SFAS No.154 Retrospective Treatment. If impractical, then adjustment to Retained Earnings. No cash flow effects. Again, read disclosures carefully!

Chapter: 0915 Changes in Accounting Principles Reporting Methods Compared

Chapter: 0916 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: 0917 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: 0918 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: 0919 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: 0920 Gains and Losses from Peripheral Activities Included in income from continuing operations. Not sustainable. So should be removed from earnings.

Chapter: 0921 Restated Financial Data Firm 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: 0922 Account Classifications Firms may classify by function. Or by type of expense. Have to reclassify in order to perform comparisons.

Chapter: 0923 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 provides U.S. investors with two sets of accounting principles- IFRS and U.S. GAAP.

Chapter: 0924 Earnings Management Commonplace? Possibly thin line between this and fraud? Detectable? Boundaries of Earnings Management.