Page 95 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 18.b: Explain potential problems that READING 18: EVALUATING QUALITY OF FINANCIAL REPORTS
affect the quality of financial reports.

Measurement and Timing Issues MODULE 18.1: QUALITY OF FINANCIAL REPORTS
• Aggressive revenue recognition increase reported revenues, profits, equity, and assets.
• Conservative revenue recognition reduce reported revenues, profits, equity, and assets.
• Omission or postponement of expense recognition would increase profits, equity, and assets.

Classification Issues
Classification of expenses as operating vs. non-operating in the income statement Warnings signs of misstated profitability:
• Revenue growth higher than peers’.
• Receivables growth higher than revenue growth.
• High rate of customer returns.
• High proportion of revenue is received in final quarter.
• Unexplained boost to operating margin.
• Operating cash flow lower than operating income.
• Inconsistency in operating versus non-operating classification over time.
• Aggressive accounting assumptions (e.g., high estimated useful lives).
• Executive compensation largely tied to financial results.
Mechanisms to misstate assets/liabilities:
• Choosing inappropriate models and/or model inputs and thus affecting estimated
values of financial statement elements (e.g., estimated useful lives for long-lived
assets).
• Reclassification from current to non-current.
• Over- or understating allowances and reserves.
• Understating identifiable assets (and overstating goodwill) in acquisition method
accounting for business combinations.
Warnings signs of misstated assets/liabilities:
• Inconsistency in model inputs for valuation of assets versus valuation of liabilities.
• Typical current assets (e.g., inventory, receivables) being classified as non-
current.
• Allowances and reserves differ from those of peers and fluctuate over time.
• High goodwill relative to total assets.
BIASED ACCOUNTING • Use of special purpose entities.
• Large fluctuations in deferred tax assets/liabilities.
Mechanisms to misstate profitability: • Large off-balance-sheet liabilities.
• Aggressive revenue recognition, including channel stuffing (aggressively selling Mechanisms to overstate operating cash flows:
products to distributors on generous terms such as lax return policies), bill and • Managing activities to affect cash flow from operations (e.g., stretching payables).
hold sales (where economic title to goods may not truly pass to customers), and • Misclassifying investing cash flow as cash flow from operations.
outright fake sales. Warnings signs of overstated operating cash flows:
• Lessor use of finance lease classification. • Increase in payables combined with decreases in inventory and receivables.
• Classifying non-operating revenue/income as operating, and operating • Capitalized expenditures (which flow through investing activities).
expenses as non-operating. • Increases in bank overdraft.
• Channeling gains through net income and losses through OCI.