Understanding

Financial Statements
NINTH EDITION

Lyn M. Fraser
Aileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1

 Copyright Notice
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reproduced, stored in a retrieval system, or
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without the prior written permission of the publisher.
Printed in the United States of America.

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Chapter 5: 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.

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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
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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

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

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

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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.
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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.
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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.

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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.

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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 the income
statement, and adjust years prior to
the current year with the CPI (or other
price index).

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Sales
Real versus nominal growth
Sales (in millions) 2007 2006 % Change
As reported (nominal) $178,199 $171,179 4.10
Adjusted (real) $178,199 $176,019 1.24

Using base period CPI (1982-1984=100)

(2007CPI/2006CPI) x 2006 Sales = Adjusted Sales
(207.3/201.6) x $171,179 = $176,019
When adjusted for inflation, sales grew at a rate of
1.24%, which means that sales growth has kept
pace with general inflation.
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Cost of Goods Sold
Key areas that affect earnings quality
6. Cost-flow assumption for inventory
7. Base LIFO layer liquidations
8. Loss recognitions on write-downs of
inventories

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Cost of Goods Sold
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.
Inventory accounting system used is
described in the note that details
accounting policies or the note that
discusses inventory.
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Cost of Goods Sold
Base LIFO layer liquidation
Base LIFO layer liquidation occurs when
companies are shrinking rather than
increasing inventories.
There is an actual reduction of inventory
levels, but the earnings boost stems
from the cost flow assumption that
the older and lower-priced products
are being sold.
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Cost of Goods Sold
Base LIFO layer liquidation
Effects of LIFO reductions are disclosed in
the notes and can be substantial.
Reduces the quality of earnings, because
there is an improvement in operating
profit from what would generally be
considered a negative occurrence:
inventory reductions.

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Cost of Goods Sold
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.
Amount of the write-down will affect
comparability and quality of profit
margins.

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Cost of Goods Sold
Loss recognitions on write-downs of
inventories
When write-down is included in cost of
goods sold, the gross profit margin is
affected.
Analyst should be aware of the impact of
write-downs on the gross profit margin
when comparing between periods.

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A Checklist for Earnings Quality
Operating Expenses
Key areas that affect earnings quality
9. Discretionary expenses
10. Depreciation
11. Asset impairment
12. Reserves
13. In-process research and development
14. Pension accounting-interest rate
assumptions
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Operating Expenses
Discretionary expenses
A company can increase earnings by
reducing variable operating expenses in a
number of areas such as
• repair and maintenance of capital
assets
• research and development
• advertising and marketing

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Operating Expenses
Discretionary expenses
If such discretionary expenses are reduced
to benefit the current year’s reported
earnings, the long-run impact on the
firm’s operating profit may be
detrimental and thus the quality
lowered.

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Operating Expenses
Depreciation
Amount of depreciation expense depends
on
• the choice of depreciation method
(straight-line or accelerated)
• estimates regarding the useful life
and salvage value

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Operating Expenses
Depreciation
Straight-line method
• is used more often
• produces a smoother earnings stream and
higher earnings in the early years of the
depreciation period
• does not reflect the economic reality of
product usefulness
• is lower in quality

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Operating Expenses
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.
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Operating Expenses
Asset impairment
The write-down of asset values affects the
comparability and thus the quality.
Reasons for write-downs are also
important in assessing quality.
Information on asset write-downs is
presented in the notes.

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Operating Expenses
Reserves
Creation and use of reserve accounts is
required to properly match revenues
and expenses.
Abuse of reserve accounts has been an
ongoing issue.

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Operating Expenses
Reserves
Cookie-jar accounting occurs when
companies create or use reserve
accounts for setting aside funds in
good years and reducing or reversing
charges in poor years.
Firms often take enormous write-offs in
one period (big bath charges) to clean
up balance sheets.
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Operating Expenses
In-process research and development
One-time charges taken at the time of an
acquisition
Can be written off immediately
Can increase earnings in later years due
to revenue gains from the research

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Operating Expenses
Pension accounting – interest rate
assumptions
A change in the pension interest rate
assumption can impact earnings equality.
• If the rate is decreased, the annual
pension cost and the present value
of the benefits will increase.
• If the rate is increased, pension
cost and the present value of the
benefits will decrease.
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A Checklist for Earnings Quality
Nonoperating Revenue and Expense
Key areas that affect earnings quality
15. Gains (losses) from sales of assets
16. Interest income
17. Equity income
18. Income taxes
19. Unusual items
20. Discontinued operations
21. Extraordinary items
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Nonoperating Revenue and Expense
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.
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Nonoperating Revenue and Expense
Interest Income
Results primarily from short-term
temporary investments in marketable
securities to earn a return on cash not
immediately needed.
Analyst should be alert to the materiality
and variability in the amount of
interest income because it is not part
of operating income.
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Nonoperating Revenue and Expense
Equity income
Use of equity method permits the
investor to recognize as investment
income the investor’s percentage
ownership share of the investee’s
reported income.
Net effect is that the investor, in most
cases, records more income than is
received in cash.
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Nonoperating Revenue and Expense
Income taxes
Provision for income tax expense on the income
statement differs from the tax actually paid.
It is important to differentiate between increases
and decreases to net earnings caused by tax
events.
Significant change in effective tax rate may be a
one-time nonrecurring item.
Income tax notes reveal year-to-year changes in
deferred tax accounts.
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Nonoperating Revenue and Expense
Unusual items
Some companies will create a line item on
the income statement for unusual items
or special charges.
Analyst should always investigate these
items to determine if these items are
nonoperating and/or nonrecurring.

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Nonoperating Revenue and Expense
Discontinued Operations
Should be excluded in considering
future earnings
Two items recorded if discontinued
operations have been sold
• Gain (loss) from operations of the
division up to the time of sale
• Gain (loss) as a result of the sale,
both net of tax
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Nonoperating Revenue and Expense
Extraordinary items
Gains and losses that are both unusual
and infrequent in nature
Should be eliminated from earnings
when evaluating a firm’s future
earnings potential

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A Checklist for Earnings Quality
Other Issues
Key areas that affect earnings quality
22. Material changes in number of shares
outstanding
23. Operating earnings, a.k.a. core
earnings, pro forma earnings, or
EBITDA

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Other Issues
Material Changes in Number of Shares
Outstanding
Changes can result from treasury stock
purchases and the purchase and
retirement of 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.
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Other Issues
Operating earnings, a.k.a. core earnings,
pro forma earnings, or EBITDA
Operating earnings are important for
assessing the ongoing potential of a
firm.
Companies have created their own
operating profit numbers and tried
to convince users that these figures
are the ones to focus on.

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Other Issues
Operating earnings, a.k.a. core earnings,
pro forma earnings, or EBITDA
“Company created” numbers go by a variety
of names such as core earnings, pro
forma earnings, or EBITDA (operating
earnings before interest, tax,
depreciation, and amortization expenses
are deducted).
SEC requires companies that report pro forma
financial information to do so in a
manner that is not misleading.
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What are the Real Earnings?
Each individual user of financial
statements should adjust the earnings
figure to reflect what they believe is
relevant to the decision at hand.

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Quality of Financial Reporting
The Balance Sheet
Items discussed in the earnings quality
section also impact balance sheet
quality.
When evaluating balance sheet several
other items should also be assessed:

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Quality of Financial Reporting
The Balance Sheet
Type of debt used to finance assets should
generally be matched (short-term debt for
current assets and long-term debt/equity for
long-term assets).
“Commitments and Contingencies” disclosures in
the notes should be carefully evaluated as
information on off-balance-sheet financing and
other complex financing arrangements are
located here.
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Quality of Financial Reporting
The Statement of Cash Flows
The cash flows from operations (CFO)
figure, while highly useful, can be
manipulated by
• recording operating expenses as
capital expenditures
• managing current asset and liability
accounts to cause increases to CFO

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Quality of Financial Reporting
The Statement of Cash Flows
Cash flows from the following types of
items should be removed from CFO for
analytical purposes:
• Investments in trading securities
• Discontinued operations
• Nonrecurring expenses or income

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