Potential Problems Affecting the Quality of Financial Reports

Measured amounts and timing of recognition and classification are the fundamental choices that result in possible issues that distort the quality of financial statements.

Measured Amounts and Timing of Recognition

Since financial statements are interrelated, one choice of a measured amount and timing of recognition may focus on one financial statement entry but may end up affecting more than one financial statement. For example, choices related to income statement entries may affect the balance sheet through equity. If equity is altered, another balance sheet entry has to be manipulated to rebalance the balance sheet.

Poor Choices of Reported Amounts and Timing of Recognition their Impact on the Reporting Quality

• Aggressive and fraudulent revenue recognition leads to overstated revenue, profits, equity, and, consequently, assets, usually the accounts receivable.
• Conservative revenue recognition practices understate net income, equity, and assets.
• Omission or postponement recognition practices overstate income, equity, assets, and understate expenses and ultimately reduce the liabilities.
• Understating expenses and overstating income and other comprehensive income increases equity and leads to an understatement of contingent liabilities.
• Deferring payments on payables increases payments from customers, deferring the purchase of inventory, and other expenditures relating to operations, and this increases cash flow from operations.

For example, Satyam became India’s Enron after the CEO handed over a resignation letter revealing that he had been overstating the company revenue for years. There was a striking gap between the reported profits and the actual profit in the books. The company had acquired two companies owned by relatives to close the gap, which failed due to serious scrutiny. In an attempt to mislead the external auditors, Satyam’s management had fabricated documents such as bank statements, employee salary records, customer accounts, and invoices, and others.

A smart reader of the financial statements may look for warning signs of misstated profits. These include: revenue growth higher than peers and receivables growth higher than revenue growth. Similarly, a high rate of customer returns and a high proportion of revenue received in the final quarter are indicators of misstated profits.

Classification

How an individual financial statement element is categorized may give rise to possible financial report problems, for example, classification of revenue as operating versus non-operating in the income statement. Unlike reported amounts/timing of recognition issues that affect more than one financial statement entry, classification only affects one entry.

Misclassification and Potential Impact on the Reporting Quality

If the company’s goal is to make the balance sheet ratios more attractive and mask issues, it may focus on manipulating the accounts receivable. It may decide to remove the accounts receivable from the balance sheet by selling them, converting them to notes receivable, or reclassifying them as long-term receivables. The latter lowers the account receivable and thus skewing the receivables turnover.

Reclassifying inventory to other assets decreases the amount of stock relative to the cost of goods and services, which decreases days of stock on hand. Similarly, it reduces the current ratio as the current assets fall while the current liabilities remain constant.

The classification of revenues as either operating or non-operating helps the users of financial statements to determine the sustainability of a company’s earnings. Companies misuse this to hide issues. The classification of revenue as core continuing operations instead of non-core revenues and misclassifying expenses as non-operating mislead analysts into considering inflated income amounts as sustainable. Additionally, the designation of an item as being reported in other comprehensive income instead of the income statement distorts the analysis and comparison of financial statements.

The decision of the management to treat investing cash flows (e.g., sale of long-term assets) as operating cash flows overstates the company’s ability to generate cash from its operations. Finally, the management may misclassify cash flows to overstate cash flow from operations by capitalizing expenditures in investing activities.

Mergers and Acquisitions

Companies use the acquisition accounting method in reporting business combinations. Acquisition occurs when a company with declining cash-generating activities has the motivation to increase cash flow from operating activities. A possible acquisition creates the motivation for a company to use aggressive recognition methods. The managers may manipulate the reported earnings before acquisition to inflate the share value used to pay for the acquisition. Similarly, target company managers may also be motivated to increase their firm’s stock price to fetch an attractive price at acquisition.

Since acquisitions hide previous accounting misstatements, misreporting may be the driver to make an acquisition. The acquirers, in this case, target companies that have less public information and different operations to reduce the comparability and consistency of their financial statements.

The difference between the purchase price over the recognized value of the acquired assets and liabilities is known as goodwill. The default accounting treatment for goodwill is that it does not require amortization unless there are impairment charges. Therefore, acquirers are motivated to overstate goodwill by understating the value of amortizable intangibles to increase future reported profits. They postpone the recognition of the inflated goodwill until the emergence of impairment charges of goodwill. Besides, companies may downplay impairment losses as a one-off, non-recurring event.

GAAP Compliant Accounting Rules that Diverge from the Economic Reality

An accounting treatment might follow the reporting standards but lead to less useful financial reports, i.e., those that do not reflect the actual economic reality. For example, before mandatory consolidation requirements for variable interest entities (VIE) under U.S. GAAP, Enron avoided the consolidation of various special purpose entities (SPEs) due to insufficient voting rights. Therefore, this kept significant losses and liabilities off-balance-sheet.

Even in the absence of voting control, consolidation is necessary. The company can exercise consolidation if the investor can exert influence on the policies of the entity and has rights to variable returns in the entity. Although IFRS does not employ the term VIE, its provisions are similar.

Asset Impairments and Restructuring Charges

Asset impairment refers to asset write-downs that are required when circumstances indicate that the carrying amount of the asset is excessive compared to the expected future benefits. On the other hand, a restructuring charge is used under IFRS to reflect the sale or termination of a line of business, closure of a business location, changes in the management structure, or a fundamental reorganization. These events may result in commitment to make severance pay benefits to employees, close to a research facility, massive loss of jobs, and promises to settle a lease.

Recognizing impairment loss and restructuring charges in a single period, although consistent with most GAAP, can impact the net period in several ways:

1. Overstating the prior period’s net income since the impairment and restructuring were most likely the results of past activities and should be put into consideration when analyzing past net revenues.
2. Understating the current period’s net income unless there is an expectation of repeating impairment or restructuring.
3. Reversals overstate future periods’ net profit.

Charging the entire impairment loss and restructuring charges in the current period is a form of conservative accounting.

Question

A finance analyst is analyzing XYZ Investment Corporation. XYZ showed strong earnings growth in the previous financial year. The analyst wants to establish whether the company’s earnings are sustainable. He finds out that XYZ reported an unusual sharp fall in accounts receivable in the current year, and a rise in long-term trade receivables.

What is the most accurate impact on XYZ’s current year if the analyst’s finding is correct?

   A. A decrease in the days’ sales outstanding (DSO).

   B. A reduction in the accounts receivable turnover.

   C. An increase in the current ratio.

Solution

The correct answer is A.

Lower accounts receivable than those reported in the past leads to lower DSO:

$$\frac{\text{Accounts receivable}}{\text{Revenues}}\times365$$

B is incorrect.

$$\frac{365}{\text{Days’ Sales Outstanding}}$$

Increases with the lower DSO, giving the false impression of a faster turnover.

C is incorrect.

The company’s current ratio is:

$$\frac{(\text{Current Assets})}{\text{Current Liabilities}}$$

Decreases because the current assets decrease while the current liabilities remain constant.

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (b) Explain potential problems that affect the quality of financial reports.