Page 100 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 18.g: Explain mean reversion in earnings and
how the accruals component of earnings affects READING 18: EVALUATING QUALITY OF FINANCIAL REPORTS
the speed of mean reversion.
Earnings at extreme levels tend to revert back to normal levels over time. MODULE 18.3: EVALUATING EARNINGS QUALITY, PART 2

Basic economics tells that:
• the competitive marketplace corrects poor performance; thus, losses are eliminated as firms abandon negative value projects.
• Conversely, capital is attracted to successful projects thereby increasing competition and lowering returns.

Because of mean reversion, analysts should not expect extreme earnings (high or low) to continue indefinitely. When earnings are largely comprised of accruals, mean
reversion will occur faster—and even more so when the accruals are largely discretionary.
LOS 18.h: Evaluate the earnings quality of a company.

Basic steps in detection of revenue recognition issues: Basic steps in detection of expense capitalisation issues:
1. Understand the basics: Including relevant shipping terms, return policies, rebates, and the
existence of multiple deliverables. 1. Understand the basics: Cost capitalization policies, also gather information about
2. Evaluate ageing receivables: Compare with past and with the industry median.
3. Cash versus accruals. Evaluate proportion! depreciation policies and how they compare with peers.
4. Compare financials with physical data: Correlate sales with capacity utilization data. 2. Trend and comparative (peer) analysis: Evaluate changes in non-current assets over
5. Evaluate revenue trends and compare with peers. Narrow down such analysis by segments. time to see if there are any anomalies which could be explained by cost capitalization.
6. Check for related party transactions. For example, a company might artificially boost fourth- 3. Check for related party transactions: The company is shifting resources to a privately
quarter revenues by recognizing a large sale to an affiliated entity. held company that is owned by senior managers. On the other hand, analysts should
also watch for propping practices whereby profits from related entities temporarily prop
up an ailing public company. (Managers might prop up a public company to preserve the
option of misappropriating funds in the future.)