Subject 4. Detection of Financial Reporting Quality Issues

There is really nothing new in this reading, just a review of the previous material. A lot of the accounting practices are highlighted elsewhere in the curriculum but are reiterated here.

Presentation Choice

If a company uses a non-GAAP financial measure in an SEC filing, it is required to provide the most directly comparable GAAP measure with equivalent prominence in the filing. In addition, the company is required to provide a reconciliation between the non-GAAP measure and the equivalent GAAP measure.

Similarly, IFRS require that any non-IFRS measures included in financial reports must be defined and their potential relevance explained. The non-IFRS measures must be reconciled with IFRS measures.

Accounting Choices and Estimates

Managers' considerable flexibility in choosing their companies' accounting policies and formulating estimates provides opportunities for aggressive accounting.

Examples include:

  • Revenue recognition policies.
  • Inventory cost flow assumptions.
  • Capitalization policies.
  • Estimates of uncollectible account receivable.
  • Estimated realizability of deferred tax assets.
  • Depreciation method, estimated salvage value of depreciable assets, and estimated useful life of depreciable assets.

Cash flow, especially operating cash flow and free cash flow, are always at the heart of any discussion of financial performance and valuation. Investors, creditors, and analysts are all interested in whether a firm is generating cash flow and where that cash flow can be expected to recur.

Operating cash flow is usually unaffected by estimates and judgments. However, firms can still create the perception that sustainable operating cash flow is greater than it actually is. One technique is to misrepresent a firm's cash-generating ability by classifying financing activities as operating activities and vice versa. Additionally, management has discretion over the timing of cash flows and where to report cash flows.

Warning Signs

Analysts should pay attention to:

  • Revenue. Check revenue recognition policies and revenue relationship.
  • Inventories. Look at inventory relationships.
  • Capitalization policies and deferred costs.
  • The relationship of cash flow and net income.
  • Other warning signs.

User Contributed Comments 7

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azramirza: whats SPE's??
ndepierre: Special Purpose Entities
weldie: How can excessive use of operating lease is a sign?
czar: "operating" lease is off-balance sheet....this shows better (lower) debt to equity ratios - which makes the company look good....it also shows better (higher) asset turnover ratios
moneyguy: good answer, czar!
bidisha: How LIFO liquidations
benmingo: still dont get what trade relief is