Chapter 9

Accounting Quality

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Accounting Quality
Is not the same as reporting quality

(which can imply conservatism).

Accounting information should (be):
Fair complete representation of firms

economic performance, position, and risk.

Provide relevant information for forecasting
future earnings and cash flows.

Chapter: 09

High Accounting Quality

Reflects Economic Information Content.
Leads to Earnings Persistence Over Time.

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Economic Information Content

Elements of Economic Information Content:
A reflection of economics
Measurement error (or noise)
Bias

Many measurements require subjective

estimates.
GAAP allows choice of accounting policies.
Informative disclosures are most important.
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Evaluating Accounting Quality

Economic faithfulness of measurements.
Reliability of measurements.
How well GAAP selections fit firms

activities?
Reasonableness of estimates.
Quality and adequacy of disclosures.

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Quality of Earnings
Does an income statement item signal:
1) An unexpected change in earnings for

current period?
2) A change in expected earnings for future
periods?
3) Both?

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The Income Statement

Infrequent items
Discontinued operations
Extraordinary items
Changes in accounting principles
Impairment losses on long-lived assets
Restructuring and other charges
Changes in estimates

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The Income Statement (Contd.)

Gains and losses from peripheral activities
Items in other comprehensive income (NOT

on income statement)

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The Income Statement

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Discontinued Operations
Must be a separate business or

component with clearly separable

operations and cash flows.
Measurement date vs. Disposal date.

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Discontinued Operations
What does this mean to the analyst?
Do we include the discontinued business

assets and liabilities in our analysis?

Do we include income?
Gain or loss on disposal?

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Extraordinary Items
Must be
Unusual in nature
Infrequent in occurrence
Material in amount

Reported net of tax.

Included in cash flows from operations.

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Changes in Accounting Principles

Prior to 2006:
Must report cumulative effect on prior periods on

income statement below income from continuing

operations (net of tax).
May be voluntary (e.g., change in inventory cost
flow assumption).
May be mandatory (e.g., FASB issues new
pronouncement).
No cash flow effects.
Read disclosures carefully!
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Changes in Accounting Principles

2006 forward:
SFAS No.154
Retrospective Treatment.
If impractical, then adjustment to Retained

Earnings.
No cash flow effects.
Again, read disclosures carefully!

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Changes in Accounting Principles

Reporting Methods Compared

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Other Comprehensive Income

Persistent?
Predictive?
Examples include:
Marketable Equity Securities
Derivatives held as cash flow hedges
Minimum pension obligations
Investments in certain foreign operations

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Impairment Losses
Included in income before taxes from

continuing operations.
Firms not required to test every asset,
except goodwill and other intangibles with
unlimited lives every reporting period.
May be separate line item, or disclosed in
notes.
Usually no cash flow effect.
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Restructuring Charges
No specific FASB pronouncements.
Related to strategic decisions.
Some firms take all at once.
Some take charges over several years.
Look at industry conditions, economic

conditions, and type of change.

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Changes in Estimates
Financial statements entail many

estimates.
Changes in estimates are not unusual.
Accounted for prospectively (in current
and future periods).
Analyst should examine carefully.

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Gains and Losses from Peripheral

Activities
Included in income from continuing

operations.
Not sustainable.
So should be removed from earnings.

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Restated Financial Data

Firm must restate all years presented if:
it decides in current year to discontinue

operations of a segment.
it adopts changes in accounting principles.

Can lead to comparability and ratio

computation problems!

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Account Classifications
Firms may classify by function.
Or by type of expense.
Have to reclassify in order to perform

comparisons.

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Outside the U.S.

Different reporting methods and accounting

principles.
Corporate strategies, cultural practices,
institutional structures will differ by country.
Preparation of the reconciliation excluded: SEC
accepts financial reports of Non-U.S. filers
prepared in accordance with IFRS.
SEC Final Rule No.33-8879 provides U.S.
investors with two sets of accounting principlesIFRS and U.S. GAAP.
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Earnings Management
Commonplace?
Possibly thin line between this and fraud?
Detectable?
Boundaries of Earnings Management.

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