9/14/2020

Financial Reporting
Quality
Lecture Materials by Bushra Ferdous Khan

In an ideal world, analysts would expect

to have access to financial reports that
are based on sound financial reporting
standards…

But we don’t live in an ideal world

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There have been a number of

famous accounting scandals…
The Enron Scandal of 2001
The WorldCom Scandal of 2002
The Lehman Brothers Scandal of 2008
The Bernie Madoff Scandal of 2008
The Satyam Scandal of 2009
The Olympus Scandal of 2011
The Tesco Accounting Scandal of 2014
The Steinhoff Scandal of 2019
However, it is an important to understand that high-profile
financial scandals reflect only those instances of
misreporting that were identified.

Research suggests that

“in any given period, about 20% of
companies manage earnings to
misrepresent economic
performance”
(Dichev, Graham, Harvey, and Rajgopal,
2013 )

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Topic 1: Look for Warning

Signs

1. Pay attention to revenue

1.1 “Examine the accounting policies note for a company’s
revenue recognition policies.”

“Are they allowing pre-mature recognition of revenue before a

good or service has actually been delivered to the customer?”

“Are they recognizing revenue before the full risks associated

with ownership of the goods have been transferred to clients?”

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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1. Pay attention to revenue

1.2 “Compare a company’s revenue growth with its
primary competitors or its industry peer group.”
2018 2019 Revenue Growth
Firm A 250 million 295 million 118%

Firm B 230 million 245 million 107%

Firm C 220 million 475 million 216%

1. Pay attention to revenue

1.3 “Compare accounts receivable with revenues over
several years.”
Firm A 2016 2017 2018 2019
Revenue 250 million 295 million 315 million 500 million

Accounts 130 million 245 million 260 million 550 million

Receivable
Accounts 52% 83% 83% 110%
Receivable
as a
Percentage
of Revenue

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1. Pay attention to revenue

1.4 “Calculate receivables turnover and DSO for
several years.”
Firm A Firm B Firm C
2019 2018 2019 2018 2019 2018
Revenue BDT 500,000 BDT BDT 250,000 BDT BDT 450,000 BDT
100,000 125,000 150,000
Growth in 500% 200% 300%
Revenue
Receivables .45 1.8 6.7 7 4.2 4
Turnover
Revenue /
Average Receivables
DSO 800 days 200 days 54 days 51 days 86 days 90 days
Days in period /
Receivable turnover

1. Pay attention to revenue

1.5 “Calculate asset turnover for several years.”
Firm A 2016 2017 2018 2019 2020
Revenue 250 million 350 million 375 million 370 million Expected
revenue 375
million
Assets 150 million 200 million 500 million 500 million 300 million

Asset 1.6 1.75 0.75 0.74 1.25

Turnover
Revenue/Assets

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2. Pay attention to signals from inventories

“Compare growth in inventories with competitors. If a
company’s inventory growth is out of line with its peers,
without any concurrent sales growth, then investigate the
reason”.

“Check if current gross and net profits are overstated

because of growing inventory”.

“Calculate the inventory turnover ratio. Declining inventory

turnover could suggest obsolescence problems that should be
recognized”.

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

2. Pay attention to signals from inventories

Firm A 2014 2015 2016 2017
Revenue 180 million 200 million 250 million 300 million
Growth in Revenue 11.1% 25% 20%
COGS 144 million 160 million 200 million 240 million
Inventory 45 million 50 million 250 million 275 million
Growth in Inventory 11.1% 400% 10%
Production Cost 165 million 400 million 285 million
(DM+DL+MOH)
Inventory Turnover 3.36 1.67 1.14
COGS/ Average Inventory

Firm B 2014 2015 2016 2017

Revenue 140 million 150 million 175 million 200 million
Growth in Revenue 7.1% 16.7% 14.3%
COGS 112 million 120 million 140 million 160 million
Inventory 38 million 40 million 45 million 50 million
Growth in Inventory 5.3% 12.5% 11.1%
Inventory Turnover 3.1 3.3 3.4
COGS/ Average Inventory

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3. Pay attention to capitalization

policies and deferred costs
“Examine the company’s accounting policy note for its
capitalization policy for long-term assets, including interest costs,
and for its handling of other deferred costs.”

“Compare the company’s policy with the industry practice.”

“If the company is the only one capitalizing certain costs while
other industry participants treat them as expenses, a red flag is
raised.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

4. Pay attention to the relationship of

cash flow and net income
“Net income propels stock prices, but cash flow pays bills.”

“If a trend is spotted of net income being higher than cash

provided by operations, take it as a red flag.”

“Increasing earnings in the presence of declining cash

generated by operations may signal accounting irregularities.”

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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4. Pay attention to the relationship of

cash flow and net income
Year 1 Year 2 Year 3 Year 4 Year 5
Confidence Net Income
Cement 239,276,307 665,985,110 498,124,144 374,240,323 389,267,545
Net Cash
Generated
by Operating (95,451,291) 569,518,506 420,691,052 (509,132,575) (474,191,222)
Activities

Meghna Net Income 63,840,379 51,341,821 65,431,748 81,452,544 72,203,953

Cement Net Cash
Generated
by Operating
Activities
4,414,302,436 17,439,876 773,628,947 (201,647,735) 976,386,503

Topic 2: Choices That Affect

Financial Reporting

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Study Exhibit 22 “Areas Where Choices and Estimates Affect

Financial Reporting” from Chapter 11, Page 601 of the textbook

Topic 3: General Steps to

Evaluate Quality of Financial
Reports

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Study Section 3.1 “General Steps to Evaluate the Quality of

Financial Reports” from Chapter 17, Page 885 of the textbook

Topic 4: Beneish
M-Score Calculation

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Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Topic 5: Case Studies on

Evaluating Earnings Quality
(Optional Reading)

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Study Section 4.2 “Evaluating the Earnings Quality of a

Company (Cases)” from Chapter 17, Page 899 of the textbook
This section contains detailed analysis of three cases on Sunbeam Corporation, MicroStrategy
Inc., and WorldCom Corp. These cases are optional reading that you are encouraged to study
for building your conceptual clarity.

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