Never wrestle with a pig in the mud,

you and the pig will get dirty, but the pig
will enjoy it.

1
 Quality of Accounting Information

Objectives
•Understand the concept of quality financial reports.
•Understand the factors that affect earnings quality.
•Understand the concept of earnings management and the
conditions under which managers might be more likely
to practise it.
•Understand how to obtain relevant information and how
to manage that information.
•Understand the techniques for financial statement
comparability.
 Overview
Analysts would prefer to analyse financial
statements that are prepared according to
sound accounting standards issued by the
International Accounting Standards Board
(IASB) or the Financial Accounting Standards
Board (FASB) that are free from
manipulation.
 High Quality Financial Reports

High quality financial reports are prepared using

sound accounting standards, are free from
manipulation, free from material error, relevant,
neutral and provide a fair and complete
representation of the firms economic performance so
that the analyst can assess the current performance
of an entity and to forecast the entity’s future
earnings and cash flows.
 Poor Quality Financial Reports

•Poor quality financial reports contains inaccurate,

incomplete and, or misleading information.
•The consequences of poor financial reports are,
financial losses, scandals and loss of confidence in
audited financial statements.
•An EY 2013 survey of 3,000 board members across
several continents reveal that 20% of the
respondents have seen manipulation, such as
overstated revenue and understated expenses.
 Quality of Accounting Information
•Questions the Analyst should ask:
•Does the company change accounting policies
regularly?
•How different are the accounting policies from
their competitors?
•Does the company adopt aggressive or
conservative policies?
•Does the company change auditors frequently?
•Are there negative media reports being
circulated?
 Earnings Quality

•Earnings quality refer to the ability of an entity to

sustain from economic activities, earnings and
cash flows that provide a reasonable return on
investment in the future.
•A true picture of the earnings quality of an entity
can only be obtained if the analyst is provided with
high quality financial reports.
•Quality financial reporting and earnings quality are
therefore interrelated.
 Factors Affecting Earnings Quality
• Earnings quality is affected by:
• One-off activities
• Discontinued operations
• Impairment losses
• Restructuring charges
• Gains and losses from peripheral activities
• Changes in accounting policies required by the IFRS
standards
• Management choices
• Changes in accounting policies not required by IFRS
standards
• Financial Reporting Judgment
• Changes in estimates
• Choice of business strategy
 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?

Allows the analyst to determine the impact

on current and future earnings
Chapter: 09 9
 Impairment Losses

• The standards require the value of an asset is to be

reviewed when one of a number of activities occur such
as:
• Significant decrease in market value of assets over a
‘prolonged’ period (could be six months)
• Significant change in the extent or manner asset is
used
• Adverse change in legal factors or business climate
• Write-downs by competitors and other industry
leaders
 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: 09 11
 Restructuring Charges
Restructuring charges are included in the
financial statements when a specific plan
has been approved by the Board of
Directors which cannot be reversed.

•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: 09 12
 Gains and Losses

•Specified gain or loss – while IFRS no longer

permits the use of the term extraordinary gains
or losses, it permits a firm to have a line item for
something that is material and unusual (e.g.
redundancy/restructuring charges) in nature so
that analysts can measure its impact
Changes in Accounting Policies Required by
IFRS
•Periodically a new standard is issued by the IASB
which requires changes from existing policies to
a new policy to be in compliance with the new
or revised standard.
 Management Choices

•It must be borne in mind that the objectives of

management vary, according to culture, and the
type of ownership structure such as
•Owner/Manager vs Professional Managers
•Widely held share ownership vs closely held
companies
 Management Choices

Changes in Accounting Policies not Required by

IFRS
•Management is not precluded from changing
their accounting policy, it is only recommended
that any change should result in better
information to the user.
•Management sometimes change the accounting
policies to reflect a better performance and a
better financial position.
 Management Choices

• Financial Reporting Judgment

• Analysts must understand the judgment made by
managers in selecting the policies and why the
specific policy was selected.
• Aggressive accounting policies increase an entity’s
earnings performance and financial position in the
current financial year and no doubt will decrease
the entity’s financial performance and financial
position in future years. Conservative accounting
policies do the opposite.
 Management Choices
Changes in Estimates
•The quality of the information is influenced by the
use of estimates and judgment calls
•Financial statements entail many estimates.
•Changes in estimates are not unusual.
•Changes in estimates are accounted for
prospectively (in current and future periods), e.g.,
under-provision in taxation
•The Analyst should examine changes in estimates
carefully.
 Hope of the Analyst
•To obtain high quality information that signals
earnings persistence over time
•That earnings for the current period is in line with
previous expectations and do not suggest any
changes in expected future earnings –this suggest
that earnings quality is high (Interim Statements)
•That the financial statements contains adequate
disclosure
•That financial statements are not restated -the
analyst should always question the reasons for the
restatement and the impact on future income and
the value of the firm
 Restated Financial Statements

•Many changes in accounting principles require

that the changes be retroactively applied
•Other times if a change in principle or
presentation is done, the comparative figures
are also restated to be on a similar basis as the
current information. The restatement should be
done for all periods shown
•Notwithstanding this the analyst may have
difficulty in doing analysis over a long term
 Financial Statement Influences

•Costs - influences on investment/management

decisions
•Capital and Revenue Expenditure
•Lease vs buy
•Rent vs buy
•Employees vs contractors / permanent vs
temporary staff
•Discretionary costs – e.g. training
 Earnings Management

•Earnings management occurs when managers

use judgment in financial reporting and in
structuring transactions to alter financial
reports to either mislead some stakeholders
about the underlying performance of the
company or to influence contractual outcomes
that depend on reporting accounting numbers
Stickney et al
 Earnings Management Motives
•Compensation of managers tied to performance
•Create job security for managers
•Create optimal borrowing capacity and to avoid
potential debt covenants
•Influence short-term stock price
•To thwart industry specific activities (poison
pills)
•Possibly thin line between this and fraud?
•Detectable?
 Obtaining Relevant Information
• Annual reports provide audited financial statements and
other relevant information, e.g., at least five year
statistical highlights
•The notes accompanying the audited financial
statements provide a wealth of information, with some
notes such as, the segment report note providing
detailed information
•The interim reports usually provide updated financial
information since the last audit report
•The prospectus, if one is available, provides additional
information, such as, the strategy of the company
 Managing Information

•Information Characteristics

•What is the source

•Is it reputable
•Does the information seem credible
•Can the information be verified elsewhere
 Managing Information
• Information Pyramid
• Economic conditions - inflation, unemployment rate,
business cycle stage, interest rates, exchange rates
(macroeconomic data). (World Bank, IMF & Central
Bank)

• Industry considerations - connects macroeconomic to

corporate, industry life cycle, growth rate, seasonality,
industry inflation, benchmark. (Bloomberg)

• Corporate Disclosures - annual reports, quarterly

reports, investor briefings, announcements to the stock
exchange. (Stock exchange & Bloomberg)
 Managing Information
• Information Processing Model
• Gather information related to the analysis
• Analyse the information
• Make decision or recommendation on basis of
information
• Assess Feedback
• Seek improvement
• improve inputs
• improve analysis
• improve output
 Financial Statement Comparability

•Comparability of the entity

•over time
•against competitors
•Tools
•The common size financial statement
•Vertical
•Horizontal
•Financial ratios
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Financial Statement Comparability

•Common Size Financial Statements

•Converts dollar amounts to percentages
•helps analysts evaluate financial statements
•allows comparisons across firms, ignoring size
•and establishes benchmark over time
•Note that it can be misleading for items that do
not move in unison with the base, i.e. revenue
or total assets

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 Financial Statement Comparability

•Vertical Common size financial statements

•Divide every reported line item in the income
statement by that period’s net revenues and
•for each line item on the balance sheet divide
by total assets
•This analysis contains information about different
accounts in the same period. (intra-period)

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 Vertical Analysis
 This Year Last Year
 Sales 100 % 100%
 Cost of Sales
 Direct Labour (22.2) (22.5)
 Overheads ( 6.7) ( 6.3)
 Material Usage (37.8) (41.2)

 Gross Margin 33.3 30.0

 Less Expenses
 Selling (13.3) (12.5)
 Prod. Devel. ( 3.3) ( 5.0)
 Administration ( 7.8) ( 5.0)

 Net profit 8.9 7.5 31

 Financial Statement Comparability

•Horizontal common size financial statements

•establish a base period where each line is
equal to 100% and in succeeding years each
item is reported as a percentage of its base
•the statement measures account changes over
time (inter-period)

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 Financial Statement Comparability

•Other tools of analysis

•Compound annual growth rates
•financial statement profiles
•moving averages
•Financial ratios

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Financial Statement Comparability

•Compound Annual Growth Rates (CAGR)

•Measures average rate of change over a
specified time period
•Computing CAGR = {((n-1)(tn/t1)) - 1} * 100
•where tn= total at ending period
• t1= total at beginning period
•The CAGR gives an accurate rate of growth
unlike the simple average rate which gives
an approximation
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Financial Statement Comparability
• Financial Statement Profiles
• For ease of analysis it is many times more
efficient or more easily understandable if
information are dealt with in broad categories
and averaged over a number of years
• This also reduces the effect of short-termism as
where management fails to implement an
expense one year it is very unlikely that it may be
deferred indefinitely

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 Financial Statement Comparability
• Moving Averages
• Lines of revenues and expenses are averaged over a
period of time (three or five years)
• The averages move by dropping the figures from the
earliest period and adding those of the most current
period
• The strength of moving averages is that it smooths
data
• The weakness of moving averages is that it reduces the
effect of significant changes that are occurring i.e.
obscuring new trends.
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Never wrestle with a pig in the mud, you
and the pig will get dirty, but the pig will
enjoy it.

37