Title LM05 Evaluating Quality of Financial Reports IFT Notes.pdf ✅

LM05 Evaluating Quality of Financial Reports 2023 Level II Notes © IFT. All rights reserved 1 LM05 Evaluating Quality of Financial Reports 1. Introduction ........................................................................................................................................................ 3 2. Conceptual Framework .................................................................................................................................. 3 2.1 Conceptual Framework for Assessing the Quality of Financial Reports ............................. 3 3. Potential Problems ........................................................................................................................................... 4 4. Classification ....................................................................................................................................................... 5 5. M&A Issues and Divergence from Economic Reality .......................................................................... 8 5.1 Financial reporting that diverges from economic reality despite compliance with accounting rules ............................................................................................................................................... 8 6. General Steps of Evaluation .......................................................................................................................... 9 6.1 General Steps to Evaluate the Quality of Financial Reports .................................................... 9 7. Quantitative Tools to Assess the Likelihood of Misreporting ......................................................10 8. Earnings Quality Indicators .......................................................................................................................13 8.1 Indicators of Earnings Quality .......................................................................................................... 13 9. Earnings Persistence and Related Measures of Accruals ...............................................................13 10. Mean Reversion in Earnings ...................................................................................................................13 11 - 13. Evaluating the Earnings Quality of a Company ......................................................................14 14. Bankruptcy Prediction Models ..............................................................................................................14 15. Cash Flow Quality .......................................................................................................................................15 15.1 Indicators of Cash Flow Quality ....................................................................................................15 15.2 Evaluating Cash Flow Quality ........................................................................................................15 16. Balance Sheet Quality ................................................................................................................................16 17 – 19. Sources of Information about Risk .............................................................................................17 Summary ................................................................................................................................................................18 This document should be read in conjunction with the corresponding reading in the 2023 Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Ver 1.0
LM05 Evaluating Quality of Financial Reports 2023 Level II Notes © IFT. All rights reserved 2 1. Introduction This reading covers how to assess the quality of financial reports. In the context of quality of financial reports, there are two interrelated terms: reporting quality and earnings quality. Reporting quality refers to the information disclosed in financial reports. High quality financial reporting provides information that is useful to analysts in assessing a company’s performance and prospects; it fairly represents the economic reality of a company. Low quality financial reporting contains inaccurate, misleading, or incomplete information. Earnings quality, on the other hand, refers to the quality of the earnings and cash generated by the company’s actual economic activities and the resulting financial condition relative to expectations of current and future financial performance. High-quality earnings result from activities that a company will likely be able to sustain in the future and provide a sufficient return on the company’s investment. This reading describes how to evaluate and identify potential problems with financial reporting quality, what attributes should a company with good earnings quality possess, and finally the sources of information about risk. 2. Conceptual Framework In this section, we look at a framework for assessing the quality of financial reports and identify problems that affect the quality of financial reports. 2.1 Conceptual Framework for Assessing the Quality of Financial Reports Financial reporting quality ranges from relevant and faithfully presented information to pure fabrication. Earnings quality ranges from high and sustainable to low and unsustainable. High quality financial reporting is a must to evaluate earnings quality. The table below reproduced from the curriculum shows the relationship between earnings quality and financial reporting quality: Financial Reporting Quality Low High Earnings (Results) Quality High LOW financial reporting quality impedes assessment of earnings quality and impedes valuation. HIGH financial reporting quality enables assessment. HIGH earnings quality increases company value. Low HIGH financial reporting quality enables assessment. LOW earnings quality decreases company value.
LM05 Evaluating Quality of Financial Reports 2023 Level II Notes © IFT. All rights reserved 3 Quality spectrum of financial reports From an investor’s perspective, the overall quality (i.e., combining reporting quality and earnings quality of financial reports), can be thought of as a continuous spectrum ranging from highest to lowest as depicted in the diagram below: Interpretation of the diagram:  The best possible scenario is at the top of the spectrum. These are companies with high financial reporting quality and high earnings quality. High quality reports are GAAP-compliant and decision-useful. Decision-useful information is relevant and faithfully represented. High-quality earnings provide an adequate level of return and is sustainable (that is earnings that can be sustained in the future).  As we go down the spectrum, there is a shift from high reporting quality and high earnings quality to low earnings quality/low reporting quality because of biased choices such as aggressive accounting or earnings management. Even though the reports are GAAP-compliant, they are not decision-useful.  At the lowest point of the spectrum are non-GAAP compliant reports and fictitious transactions, which is the worst possible case. 3. Potential Problems The two basic accounting choices that lead to problems in the quality of financial reports are:  reported amounts and timing of recognition
LM05 Evaluating Quality of Financial Reports 2023 Level II Notes © IFT. All rights reserved 4  classification Reported amounts and timing of recognition: The choice of reported amount and timing of recognition affects more than one financial statement item, as they are all interrelated. Examples: Accounting choice Effect Aggressive, premature and fictitious revenue recognition Overstated income and overstated equity Conservative revenue recognition Understated net income, understated equity, understated assets Omission and delayed recognition of expenses Understated expenses, overstated income, overstated assets, understated liabilities Understatement of contingent liabilities Understated expenses, overstated income Overstatement of financial assets and understatement of financial liabilities Overstated unrealized gains; understated realized losses and overstated equity Deferring payments on payables, accelerating payments from customers, deferring purchases of inventory, and deferring other expenditures related to operations Increases cash flow from operations 4. Classification Unlike reported amounts and timing of recognition, classification choices typically affect one financial statement and relate to how an item is classified within a particular financial statement. Example: Balance Sheet Reclassifications (This is based on Example 2 of the curriculum.) In the 2002 Annual Report, inventory was reported at $3,411.8 million. In the 2003 Annual Report, the 2002 inventory value was reported at $2,964.3 million and $447.5 million of inventory was included in other assets. This information was contained in Note 6 to the financial statements, reproduced in the following exhibit: Inventories at December 31 consisted of: ($ in millions) 2003 2002 Finished goods $552.5 $1,262.3 Raw materials and work in process 2,309.8 2,073.8