Essentials of Financial Statement Analysis

Chapter 5: Essentials of Financial Statement Analysis Evaluating accounting “quality”
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How do we define financial reporting quality? Qualitative characteristics of accounting Information:
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Understandability Decision usefulness Reliability Relevance Consistency Comparability
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Attributes of High Quality Financial Reporting
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Financial reporting (earnings) quality has been considered positively associated with the following:  High persistence of earnings and cash flows  High predictive ability of earnings and cash flows  High earnings response coefficient  Low level of earnings management  More voluntarily disclosure  Strong corporate governance
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Manipulating Income and Earnings Management
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Earnings management: a practice that earnings reported reflect more the desires of management than the underlying financial performance of the company. 1 Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance.
“Most managers prefer to report earnings that follow a smooth, regular, upward path.”2
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1. Arthur

Levitt, former SEC chairman. 2.Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.

What should the users be aware of ?
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Statement users must:  Understand current financial reporting settings and standards.  Recognize that management may manipulate the financial information.  Distinguish between reliable financial statement information and poor quality information.
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Financial statement analysis and accounting quality
Financial analysis tools: Commonsize statements, trend statements and financial ratios.  But they can be no better than the data from which they are constructed (i.e., the comparative financial statements).
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Financial statement analysis and accounting quality
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The accounting distortions need to be watched when using these tools. Examples include: