1. (C) 2007 Prentice Hall, Inc.4-1 A Guide to Earnings and Financial Reporting Quality This chapter considers the quality of reported financial information, which is a critical element in evaluating financial statement data

2. (C) 2007 Prentice Hall, Inc.4-2 Why Earnings Quality analyst should develop AN EARNINGS FIGURE that reflects the FUTURE ONGOING POTENTIAL of the firm THE OBJECTIVE IS NOT FRAUD DETECTION

3. (C) 2007 Prentice Hall, Inc.4-3 A Checklist for Earnings Quality I. Sales II. Cost of Goods Sold III. Operating Expenses IV. Nonoperating Revenue and Expense V. Other Issues Major areas on the checklist include:

4. (C) 2007 Prentice Hall, Inc.4-4 Sales 1.Premature revenue recognition 2. Gross vs. net basis 3. Vendor financing 4. Allowance for doubtful accounts 5. Price vs. volume changes 6. Real vs. nominal growth Potential areas include:

5. (C) 2007 Prentice Hall, Inc.4-5 Sales (cont.) 1. Premature revenue recognition: According to GAAP, revenue should not be recognized until there is evidence that a true sale has taken place Many firms have violated this accounting principle by recording revenue before the conditions for a true sale have been met

6. (C) 2007 Prentice Hall, Inc.4-6 Sales (cont.) 2. Gross vs. net basis: Another tactic to boost revenues is to record sales at the gross rather than the net price

7. (C) 2007 Prentice Hall, Inc.4-7 Sales (cont.) 3. Vendor financing: Some companies use vendor financing to increase revenues by lending their customers (other companies) money to purchase their products

8. (C) 2007 Prentice Hall, Inc.4-8 Sales (cont.) 4. Allowance for doubtful accounts: This is a type of reserve account that can be manipulated by under- or overestimating bad debt expenses

9. (C) 2007 Prentice Hall, Inc.4-9 Sales (cont.) 5. Price vs. volume changes: In general, higher quality earnings would be the product of both volume and price increases (during inflation) 6. Real vs. nominal growth: Important to determine if sales are growing in “real” (inflation-adjusted) as well as “nominal” (as reported) terms

10. (C) 2007 Prentice Hall, Inc.4-10 Cost of Goods Sold 7. Cost-flow assumption for inventory 8. Base LIFO layer liquidations 9. Fulfillment costs 10. Loss recognitions on write-downs of inventories Potential areas include:

11. (C) 2007 Prentice Hall, Inc.4-11 Cost of Goods Sold 7. Cost-flow assumption for inventory: LIFO results in the matching of current costs with current revenues and produces higher quality earnings than either FIFO or average cost

12. (C) 2007 Prentice Hall, Inc.4-12 Cost of Goods Sold (cont.) 9. Fulfillment costs: An expense account that some companies add to operating expenses to record costs that are typically classified as cost of goods sold, impacting their gross profit margin and lowering their quality of earnings

13. (C) 2007 Prentice Hall, Inc.4-13 Cost of Goods Sold (cont.) 10. Loss recognitions on write-downs of inventories: If the value of inventory falls below its original cost, the inventory is written down to market value. When the write-down is included in cost of goods sold, the gross profit margin is impacted

14. (C) 2007 Prentice Hall, Inc.4-14 Operating Expenses 11. Discretionary expenses 12. Depreciation 13. Asset impairment 14. “Big bath” or restructuring charges 15. Reserves 16. In-process research and development Potential areas include:

15. (C) 2007 Prentice Hall, Inc.4-15 Operating Expenses (cont.) 11. Discretionary expenses: If variable operating expenses such as repair and maintenance, research and development, and advertising and marketing are reduced primarily to benefit the current year’s reported earnings, the long-run impact on operating profit may be detrimental and lower the quality of those earnings

16. (C) 2007 Prentice Hall, Inc.4-16 Operating Expenses (cont.) 12. Depreciation:  misclassification of operating expenses as capital expenditures creates poor quality of financial reporting on all financial statements  comparing companies is difficult when they use different depreciation methods and different estimates for the lives of their long- lived assets

17. (C) 2007 Prentice Hall, Inc.4-17 Operating Expenses (cont.) 13. Asset impairment: The write-down of asset values, following the principle of carrying assets at the lower of cost or market value, affects the comparability and thus the quality of financial data

18. (C) 2007 Prentice Hall, Inc.4-18 Operating Expenses (cont.) 14. “Big bath” or restructuring charges: Large charges classified as restructuring charges are sometimes used by companies to clean up their balance sheet Ongoing restructuring of a company can be a signal of underlying problems

19. (C) 2007 Prentice Hall, Inc.4-19 Operating Expenses (cont.) 15. Reserves (Cookie Jar Reserves): Often created to set aside funds today to cover some known future cost Abuse occurs when funds are set aside in good years (i.e., reducing net income) and then shifting the reserve amount to the income statement in poor years

20. (C) 2007 Prentice Hall, Inc.4-20 Operating Expenses (cont.) 16. In-process research and development: One-time charges taken at the time of an acquisition Can be problematic if companies write-off significant amounts of research and development in the year of acquisition in order to boost earnings in later years

21. (C) 2007 Prentice Hall, Inc.4-21 Nonoperating Revenue and Expense 17. Gains (losses) from sales of assets 18. Interest income 19. Equity income 20. Discontinued operations Potential areas include:

22. (C) 2007 Prentice Hall, Inc.4-22 Nonoperating Revenue and Expense (cont.) 17. Gains (losses) from sales of assets: The sale of a major asset is sometimes made to increase earnings and/or to generate needed cash when the firm is performing poorly. Such transactions are not part of the normal operations of the firm and should be excluded from net income when considering the future operating potential of the company

23. (C) 2007 Prentice Hall, Inc.4-23 Nonoperating Revenue and Expense (cont.) 18. Interest income: In assessing earnings quality, the analyst should be alert to the materiality and variability in the amount of interest income because it is not part of operating income

24. (C) 2007 Prentice Hall, Inc.4-24 Nonoperating Revenue and Expense (cont.) 19. Equity income: The net effect of using this method is that the investor, in most cases, records more income than is received in cash

25. (C) 2007 Prentice Hall, Inc.4-25 Nonoperating Revenue and Expense (cont.) 20. Discontinued operations: Should be excluded in considering future earnings Appropriate to deduct the income on discontinued operations each year from earnings for comparative purposes

26. (C) 2007 Prentice Hall, Inc.4-26 Other Issues 21. Material changes in number of shares outstanding 22. Operating earnings, a.k.a. core earnings, or EBITDA Potential areas include:

27. (C) 2007 Prentice Hall, Inc.4-27 Other Issues (cont.) 21. Material changes in number of shares outstanding:  Changes can result from treasury stock purchases and the purchase and retirement of a firm’s own common stock  Reasons for the repurchase of common stock should be determined if possible to see if firm is spending scarce resources to merely increase earnings per share (EPS)

28. (C) 2007 Prentice Hall, Inc.4-28 Other Issues (cont.) 22.Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA: Operating earnings are important for assessing the ongoing potential of a firm Variety of “company created” numbers have been created for users to review Core earnings Operating Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)