Chapter_17 - Chapter 17 Chapter Analysis of the Quality of...

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Chapter 17 Chapter 17 Analysis of the Quality Analysis of the Quality of Financial Statements of Financial Statements
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Analysis of the Quality of Financial Analysis of the Quality of Financial Statements Statements
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What you will learn from this What you will learn from this chapter chapter Five questions to ask about the accounting quality of a financial report How accounting methods and estimates determine the sustainability of earnings The devices management can use to manipulate earnings How to carry out an accounting quality analysis How to develop diagnostics to detect manipulated earnings How an accounting quality analysis is combined with financial statement analysis and red-flag analysis to discover the quality of earnings How composite quality scoring works Accounting quality analysis establishes the integrity of the accounting to be used in forecasting
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Five Questions About Five Questions About Accounting Quality Accounting Quality 1. GAAP quality : is GAAP accounting deficient? 1. Audit quality : is the firm violating GAAP or committing outright fraud? 1. GAAP application quality : is the firm using GAAP accounting to manipulate reports? 1. Transaction quality : is the firm manipulating business to accommodate the accounting? a. Transaction timing b. Transaction structuring 1. Disclosure quality : are disclosures adequate to analyze the business? a. Disclosures that distinguish operating items from a financial items in the statements b. Disclosures that distinguish core operating profitability from unusual items c. Disclosures about the accounting used
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Detecting Income Shifting: The Detecting Income Shifting: The Accounting Leaves a Trail Accounting Leaves a Trail One trail: Operating income = Free cash flow + Change in net operating assets OI = C – I + ΔNOA “Hard” “Soft” A further trail: Change in net operating assets = Cash investment + Operating accruals ΔNOA = I + Operating accruals Capitalization Quality Accrual Quality
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Low Quality Accounting and Low Quality Accounting and RNOA RNOA For valuation, the analyst wants to forecast future RNOA. If there is manipulation, current RNOA cannot be maintained in the future. Manipulation has the following effects: As RNOA 0 = OI 0 /NOA -1 , manipulation involves adjusting current operating income, OI 0 But OI 0 = Free Cash Flow 0 + NOA 0 So a change in OI 0 must also change NOA 0 by the same amount So future RNOA 1 =OI 1 /NOA 0 must be reduced: Denominator effect Numerator effect
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How Accounting Manipulation Leaves How Accounting Manipulation Leaves a Trail in the Balance Sheet (1) a Trail in the Balance Sheet (1) The Case of No Growth with No Income Shifting Year -2 Year -1 Year 0 Year +1 Net operating assets 100 100 100 100 Operating income RNOA 12% 12% 12% 12 Free Cash Flow 12 12 12 12 12 12 12
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How Accounting Manipulation Leaves How Accounting Manipulation Leaves a Trail in the Balance Sheet (2) a Trail in the Balance Sheet (2) The Case of No Growth with Income Shifting
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Chapter_17 - Chapter 17 Chapter Analysis of the Quality of...

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