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Chapter 6
Accounting Quality
6-1
in whole or in part.
CHAPTER 6
ACCOUNTING QUALITY
6.1 Concept of Earnings Quality. Many examples answer this question. For example,
a firm that reports earnings dominated by a substantial one-time gain from the sale
of real estate tangential to the firm’s operations represents poor earnings quality
If these items are transitory and the firm’s disclosure labels them in a way that
highlights the transitivity, the analyst may exclude the items and earnings quality is
high.
6.2 Balance Sheet Quality and Earnings Quality. Balance sheet and earnings quality
are related by financial statement articulation. The income statement measures
changes in assets and liabilities from transactions with non-owners. Therefore, low
quality asset and liability measurement on the balance sheet can lead to low quality
net income and understates liabilities.
Many examples also exist of management judgments, estimates, and choices
that may properly measure assets and liabilities on the balance sheet (high balance
sheet quality), but yield earnings that do not persist (low earnings quality). For
transitory does persist.
Chapter 6
Accounting Quality
6-2
6.3 Concept of Earnings Management. Healy and Wahlen provide the following
definition of earnings management:
Earnings management occurs when managers use judgment in financial
reporting and in structuring transactions to alter financial reports to either
Standard Setting,” Accounting Horizons (December 1999), pp. 365–383.]
Discovering earnings management is difficult because managers can exercise
judgment in financial reporting in many ways. One of the objectives of Chapters 7–9
earnings management.
6.4 Own Debt Profits. Gains from revaluation of debt are an example of achieving high
balance sheet quality at the expense of earnings quality. While a company’s credit
worthiness changes over time, the direction of the changes are generally transitory.
If the company pays off debt using the original schedule of interest and
maturity payments, cash flows are not affected by gains on revaluation of own debt.
However, if the company can reacquire or otherwise extinguish the debt in a trans-
6.5 Incentives to Manage the Balance Sheet. To obtain lower cost debt financing, the
corporation would prefer to show a higher current ratio (lower liquidity risk) and a
lower liabilities to assets ratio (lower solvency risk). For both ratios, the preferred
firm. Common accounting issues that emerge from the accounting analysis are:
• Adequate reserves for inventory obsolescence, and adequate allowances for ac-
counts and notes receivable bad debts and returns
when cash receipt precedes the earning of revenue)
Chapter 6
Accounting Quality
6-3
• The existence of transactions described in the chapter as “off-balance-sheet
6.6 Incentives to Manage Earnings Upward. Managers have numerous incentives to
manage earnings upward, including:
• To increase compensation payments under compensation contracts based on
earnings or stock prices
• To enhance job security for senior management by influencing the outcomes of
transactions that affect corporate control such as proxy fights and takeovers
6.7 Incentives to Manage Earnings Downward. Managers may also have incentives
to manage earnings downward, including:
• To discourage entry into the industry by potential competitors
• To reduce the probability of antitrust actions against the firm or other regulatory
interventions or political interference related to tax issues, capital requirements
It is also important to note that, when pressures to manage earnings upward are not
present, managers may manage earnings downward in order to create “cookie jar
6.8 Criteria to Identify Nonrecurring Items. The presumption in using reported
financial statement data is that they accurately portray the economic effects of a
firm’s decisions and actions during the current period and are informative about the
firm’s likely future profitability and risk. However, to make insightful decisions
Chapter 6
Accounting Quality
6-4
profitability and risk and valuing the firm. Accounting data is of highest quality
relevant information to forecast the firm’s expected future earnings and cash flows.
6.9 Restating Earnings for Litigation Loss. Pro forma earnings for 2004 are $1.03
million [–3.2 + (0.65 × 6.5)]. The calculation assumes a federal statutory tax rate of
6.10 Reporting Impairment and Restructuring Charges. The number of shares
outstanding for the fourth quarter of 2004 was 37,565,000 ($29.3 million/$0.78).
Net income excluding the impairment and restructuring charge for the fourth
tions. In addition, the firm believes that the trend of earnings, when excluding
the impairment and restructuring charges, will be viewed more favorably by share-
holders.
Note: Checkpoint reported restructuring charges and asset impairments of $10.9
on-going operations.
6.11 Concept of Peripheral Activity. Gains generated by investment firms in their
proprietary trading accounts are integral to the core operations of the banks. Alter-
Chapter 6
Accounting Quality
6-5
6.12 Reporting Impairment Charges. Many examples exist as answers to this
question. Students can use the examples provided in the chapter as clues for
identifying the types of firms and industries that are prone to reporting impairment
charges. In addition, the business press is strewn with examples, almost daily in
recent years. Firms report the impairment charge on a separate line in the income
statement if the amount is material, in a note to the financial statements, or both.
of the impairment loss to net income when computing cash flow from operations.
6.13 Effect of Alternative Accounting Standards on Financial Statement Analysis.
Cross-national analysis of firms entails a two-step approach: (1) achieve
comparability of the reporting methods and accounting principles employed by the
firms under scrutiny and (2) understand corporate strategies, institutional structures,
6.14 Accounting for Loss Contingencies. Contingent obligations may or may not give
rise to accounting liabilities. Financial reporting requires firms to recognize an
estimated loss from a contingency (called a loss contingency) and a related liability
only if both of the following conditions are met:
1. Information available prior to the issuance of the financial statements indicates
incurred.
2. The firm can estimate the amount of the loss with reasonable precision.
The first criterion for recognizing a loss contingency rests on the probability, or
of warranty liabilities, the provision for bad debts, and the accrual of litigation
losses.
Chapter 6
Accounting Quality
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in whole or in part.
6.15 Securitization of Receivables. The FASB requires that firms recognize transfers of
receivables as sales only if the transferor surrenders control of the receivables.
Firms surrender control only if all of the following conditions are met:
• The assets transferred (that is receivables) have been isolated from the selling
(“transferor”) firm (that is, neither the transferor nor a creditor of the selling
assets.
The goal is to identify the party involved in the transaction enjoys the economic
benefits and sustains the economic risk of the assets (receivables in this case).
6.16 Achieving Off-Balance-Sheet Financing.
Transfer of Receivables with Recourse. To be considered a sale, the transferor
must have surrendered control of the receivables: (1) the assets transferred have
been isolated from the selling firm (Diviney Company); (2) the buying firm
(Condon Company) obtains the right, free of any conditions, to pledge or exchange
the transferred assets, and no condition both constrains the transferee (Condon)
Diviney a possibly valuable resource that creditors might attach. Thus, the first cri-
terion appears to be violated. If interest rates decrease, Diviney can borrow funds at
the lower interest rate and repurchase the receivables. Because the receivables carry
a fixed interest return, Diviney enjoys the benefit of the difference between the
fixed interest return on the receivables and the lower borrowing cost. If interest
Chapter 6
Accounting Quality
6-7
in whole or in part.
If the call option were not present in this case, the transaction would more
would not likely qualify as a sale, but as a collateralized loan.
The economics of this transaction suggest that a sale of receivables took
place, but with a value placed on the call option and a liability recognized for
the estimated liability for excess uncollectible accounts. The economics of the
financial statements:
Cash.......................................................... Amount Received
Call Option ............................................... Market Value
Accounts Receivable ........................... Book Value
Estimated Recourse Liability .............. Estimated
Gain or (Loss) ...................................... Plug
economic risks of the inventory.
Diviney agrees to repurchase the inventory at a fixed price, thereby enjoying
the benefits and incurring the risk of changes in prices. The purchase price formula
includes a fixed interest rate, so Diviney also controls the benefits and risk of inter-
est rate changes. In addition, Diviney controls the benefits and risk of changes in
Throughput Contract. Financial reporting treats throughput contracts as executory
contracts and does not require their recognition as a liability. Note, however, the
similarity between a product financing arrangement (involving inventory) and a
throughput contract (involving a service). Diviney must pay specified amounts each
make highly probable future cash payments in amounts that cover the railroad’s
operating and financing costs. This transaction has the economic characteristics of a
Chapter 6
Accounting Quality
6-8
in whole or in part.
collateralized loan (the economics of the arrangement) even though U.S. GAAP and
the auditor would permit treatment as an executory contract with footnote
disclosure.
one-half of the operating and debt service costs as an executory contract, similar to
the throughput contract. Even though the probability of making future cash
payments is high, U.S. GAAP concludes that a liability does not arise until the firm
receives manufacturing services from Chemical each period. The only liability that
Diviney can use all of the capacity relinquished by Mission and make the required
debt service payments, Diviney still would not recognize any additional liability to
the bank. If, on the other hand, Mission defaults and Diviney cannot make the debt
service payments, Diviney would likely recognize a loss contingency in the amount
Research and Development Partnership. Firms must recognize financings related
R&D as liabilities if (1) the sponsoring firm (Diviney) must repay the financing
regardless of the outcome of the R&D work or (2) the sponsoring firm, even in the
absence of a loan guarantee, bears the risk of failure of the R&D effort. Diviney
investment. Thus, U.S. GAAP would not require Diviney to recognize a liability.
Chapter 6
Accounting Quality
6-9
in whole or in part.
If Diviney did not guarantee the bank loan and had an option to purchase the
output of the R&D effort, it would not seem to bear the risk of failure, again except
to the extent of its equity investment. Therefore, U.S. GAAP would not require
Diviney to recognize a liability.
Diviney bears the risk and would recognize a liability.
The economics of this arrangement suggest that Diviney bears the risk of
failure of the R&D effort and should recognize a liability.
event of loan default. Thus, Diviney’s loan guarantee is a third level of defense
against loan default. If default does occur and the first two lines of defense prove
inadequate to repay the loan in full, Diviney must recognize a liability for the
unpaid portion. The economics of this arrangement also probably suggest that no
liability for Diviney exists.
Summarizing Each Case
U.S. GAAP Economics
Transfer of Receivables Loan Sale with Option and Recourse
Liability
Product Financing Loan Loan
Chapter 6
Accounting Quality
6-10
in whole or in part.
6.17 Accounting Scandals.
Scandal How balance sheet and earnings quality were impaired
Waste
Management
quality is affected because the firm appears more profitable than it is.
Enron Underreporting debt affects balance sheet quality. Solvency risk
ratios using some measure of long-term debt in the numerator
incorrectly indicate lower solvency risk. Generally speaking, long-
expenses.
AIG Booking debt as revenue decreases debt and increases revenue.
Balance sheet quality is impaired because, if the debt is long-term,
solvency risk measures (those ratios using some measure of debt in the
used for valuation.
Lehman
Brothers
Claiming to have sold any asset, toxic or not, when an agreement to
problem is particularly significant for toxic assets with a far lower
probability of collection. Earnings quality is also impaired. Toxic
assets should probably be reported at lower amounts on the balance
sheet with associated charges to earnings. (A mitigating factor for this
