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Chapter 9

Chapter 9. Accounting Quality. 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.

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Chapter 9

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  1. Chapter 9 Accounting Quality

  2. 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: 09

  3. High Accounting Quality • Reflects Economic Information Content. • Leads to Earnings Persistence Over Time. Chapter: 09

  4. 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: 09

  5. 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: 09

  6. Quality of Earnings • Does an income statement item signal: • An unexpected change in earnings for current period? • A change in expected earnings for future periods? • Both? Chapter: 09

  7. 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: 09

  8. The Income Statement (Contd.) • Gains and losses from peripheral activities • Items in other comprehensive income (NOT on income statement) Chapter: 09

  9. The Income Statement Chapter: 09

  10. Discontinued Operations • Must be a separate business or component with clearly separable operations and cash flows. • Measurement date vs. Disposal date. Chapter: 09

  11. 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: 09

  12. Extraordinary Items • Must be • Unusual in nature • Infrequent in occurrence • Material in amount • Reported net of tax. • Included in cash flows from operations. Chapter: 09

  13. 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: 09

  14. 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: 09

  15. Changes in Accounting PrinciplesReporting Methods Compared Chapter: 09

  16. 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: 09

  17. 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

  18. 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: 09

  19. 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: 09

  20. Gains and Losses from Peripheral Activities • Included in income from continuing operations. • Not sustainable. • So should be removed from earnings. Chapter: 09

  21. 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: 09

  22. Account Classifications • Firms may classify by function. • Or by type of expense. • Have to reclassify in order to perform comparisons. Chapter: 09

  23. 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.33-8879 provides U.S. investors with two sets of accounting principles-IFRS and U.S. GAAP. Chapter: 09

  24. Earnings Management • Commonplace? • Possibly thin line between this and fraud? • Detectable? • Boundaries of Earnings Management. Chapter: 09

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