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Web3ch17 - CHAPTER SEVENTEEN Analysis of the Quality of...

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CHAPTER SEVENTEEN Analysis of the Quality of Financial Statements Stephen H. Penman The web page for this chapter runs under the following headings: What this Chapter is Doing Why a Quality Analysis is Important Comprehensive Quality Analysis The Key Point to Appreciate The Key Diagnostic Some Perspective on the Quality of GAAP Accounting Composite Quality Scores Earnings Quality by Dechow and Schrand Quality of Financial Statements During the Bubble Earnings Prediction Financial Statement Analysis and the Prediction of Stock Returns What this Chapter is Doing This chapter lays out an approach to assessing the quality of the accounting in financial statements. The approach is a structured one that ensures that all aspects of the financial statements are covered. The output is a series of diagnostics that can indicate possible quality problems. Much of the analysis in Part II of the book bears on the issue of earnings quality (see the section below on “Comprehensive Quality Analysis”), so this Chapter is really a capping off of material that precedes it.
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Why a Quality Analysis is Important Current financial statements are the basis for forecasting future financial statements (in the pro forma analysis of Part III of the book) from which valuations are made. Clearly, reliance on poor quality financial statements leads to poor quality pro formas and poor valuations. Further, when accounting issues surface for a firm, the stock price typically takes a big hit. The analyst tries to avoid taking that hit by a diligent appraisal of the quality of the accounting statements. More proactively, the analyst who anticipates emerging accounting problems can profit from that prediction (by shorting the stock). Comprehensive Quality Analysis If you reflect on the material covered in the book to this point, you will appreciate that much of that material – particularly the analysis in Part II – is concerned with defining quality accounting numbers to use in equity valuation: 1. The choice of accrual accounting valuation models in Part I was based on the observation that the cash accounting implied by Discounted Cash Flow Analysis is not “good quality” accounting for valuation purposes. That is, free cash flow is not a good measure of value added because it treats investment as a outflow of value. The closing section of Chapter 16 titled, The Quality of Cash Accounting and Discounted Cash Flow Analysis comes back to this theme. General Electric consistently generates negative free cash flow, as does Home Depot and Starbucks, but these are valuable companies. Of course, accrual accounting, with its reliance on estimates to correct the problems with cash flows, can also be poor quality – and thus the need for accrual-based valuations to be supported by a sound analysis of the quality of the accrual accounting.
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