Financial Reporting Quality 1 Limitations of Financial Reporting

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Financial Reporting Quality 1

Financial Reporting Quality 1

Limitations of Financial Reporting “What is your net income? ” “What do you want

Limitations of Financial Reporting “What is your net income? ” “What do you want it to be? ” Considerable discretion allows companies to manipulate their finance performance. Why? 1. Accounting policies and estimates q FIFO, average cost, specific identification q Straight-line, accelerated depreciation q Useful life, bad debts expense 2. Valuation of assets, liabilities, and equities q Historical cost versus fair value q Assets may be excluded if developed internally q Off-balance sheet assets and liabilities 3. Classification of assets and liabilities q Long-term versus current assets or liabilities q Liability versus equity 4. Poor quality of earnings q Revenue recognition q Cost recognition q Timing of discretionary expenses, asset revaluations, impairment losses and reversals q Classifying revenues and expenses as operating or non-operating 2

IFRS Relevant to Financial Reporting Quality Revenue recognition Discontinued operations Comprehensive income Non-IFRS compliance

IFRS Relevant to Financial Reporting Quality Revenue recognition Discontinued operations Comprehensive income Non-IFRS compliance Accounts and notes receivable Inventories Property, plant, and equipment Cost model Revaluation model Borrowing costs Intangible assets Leases R&D costs Exploration costs Investments q Portfolio q Associate q Joint ventures q Subsidiaries Goodwill Provisions Related party relationships Contingent liabilities and assets Changes in accounting policy Changes in accounting estimates and errors Events after the reporting period Post-employment benefit plans Long-term liabilities Deferred income taxes Derivatives and hedge accounting 3

Earnings Quality q Definition of earnings quality q Aggressive practices q Conservation practices q

Earnings Quality q Definition of earnings quality q Aggressive practices q Conservation practices q Earnings quality dilemma q Maximize management compensation q Attract new managers q Meet loan requirements q Avoid the scrutiny of the board of directors and stock markets Smooth Inflate EPS q Earnings management q Inflating and “smoothing” earnings q Revenue recognition strategies q Cost recognition strategies q Classification strategies q Warning signs or “red flags” of earnings management Time 4

Beneish Model M-score = -4. 84 + 0. 920 (DSRI) + 0. 528 (GMI)

Beneish Model M-score = -4. 84 + 0. 920 (DSRI) + 0. 528 (GMI) + 0. 404 (AQI) + 0. 892 (SGI) + 0. 115 (DEPI) – 0. 172 (SGAI) + 4. 679 (Accruals) - 0. 327 (LEVI) Earnings manipulator M-score = -1. 78 or higher Days sales receivable index (DSR) (Receivables t / Sales t) / (Receivables t-1 / Sales t-1) Gross margin index (GMI) Gross margin t-1 / Gross margin t Asset quality index (AQI) (1 – (PPE t + Current assets t) / Total assets t) / (1 – (PPE t + Current assets t-1) / Total assets t-1) Sales growth index (SGI) Sales t / Sales t-1 Depreciation index (DEPI) (Depreciation t-1 / (Depreciation t– 1 + PPE t-1)) / (Depreciation t + PPE t)) Sales, general, and administration expenses index (SGAI) (SGA t / Sales t) / (SGA t-1 / Sales t-1) Accruals (Continuing income t – Cash flow from operations t) / Total assets t Leverage index (LEVI) (Debt t / Total assets t) / (Debt t-1 / Total assets t-1) 5

Limitations of the Beneish Model q DEPI, SGAI, and LEVI are not statistically significant

Limitations of the Beneish Model q DEPI, SGAI, and LEVI are not statistically significant q SGAI and LEVI have the wrong signs q Companies have learned to “game” the inputs to lower their M-score, so the predictive power of the model is declining 6

Cash Flow Quality 7

Cash Flow Quality 7

Balance Sheet Quality q q q Re-classification of asset and liabilities Inventories Fair value

Balance Sheet Quality q q q Re-classification of asset and liabilities Inventories Fair value accounting Fixed assets and intangibles Mergers and acquisitions and goodwill Asset turnover ratios Investments in associates Special purpose entities Off-balance sheet financing Deferred income tax assets Contingent liabilities Net benefit plan asset or liability 8