While most of the level 2 Financial Reporting Analysis is quantitatively intense, there are a couple of sections that are more conceptual and include only basic formulas. Even the formulas within the material can be remembered through a basic understanding of the cash flow statement or balance sheet.
The Learning Outcome Statements and curriculum for evaluating financial reporting quality are fairly easy points if you get down the general concepts and remember a few relationships. In the 2012 curriculum, these are LOS 25a-26f and are available here.
The readings revolve around manipulation of earnings, where to look for it and how to measure quality of earnings. The income statement lends itself to management manipulation in quite a few areas so most of the reading focuses on the statement.
** You need a solid base of understanding in the Financial Statements** If you cannot reconstruct the basic framework for the balance sheet, income statement and cash flows and understand what everything is and where it comes from, time would be VERY well spent by reviewing this material. You are going to need it throughout the level 2 and into the level 3 exam as well (besides most likely in your job).
Discretion in Accrual Basis Accounting
Remember that the accrual basis of accounting more accurately reflects the company’s financial performance because revenues and expenses are more closely matched. The disadvantage, relative to cash basis accounting, is that accrual basis lends itself to management discretion in matching and possibly manipulation of earnings.
For the income statement, understand management discretion in the line items: EBITDA, Operating Income, EBIT, Income from continuing, Income before extraordinary, and Net Income
While the curriculum reminds candidates to check Management’s MD&A and footnotes for a number of issues, you are never really shown how to do this. For the exam, your really only need to know that a lot of information can be buried here and that you should look it over skeptically.
Some areas where discretion in reporting may lead to manipulation:
- Revenue recognition: sales can be booked too early, too late, or smoothed over a period to change the company’s revenue picture
- Expenses: accounting for costs in the current period or over time by capitalizing expenses
- Depreciation: management selects the method of calculating depreciation as well as the useful life of the assets
- Inventory: the determination of cost flow assumption (LIFO, FIFO, or weighted average) is a big part of the curriculum here and elsewhere
- Classifying events as continuing operations, non-recurring, or extraordinary
- Calculation and impairment of goodwill and other intangibles
- Assumptions in post-retirement benefit accounting
Management Incentives to Cheat
This section covers basic reasons management might want to manipulate earnings and what companies do to avoid the problem. Again, just high-level conceptual stuff and fairly intuitive.
There is pressure on management to meet or beat expectations set by the market. Management will try to speed up revenue recognition or delay expenses if it looks like results will come in below expectations. Conversely, management may actually slow down revenue recognition or pay for future expenses in order to smooth earnings into upcoming quarters.
The curriculum talks about contract-based incentives in a few different places. While tying management compensation to performance is a good way to promote shareholder interests, it can also lead to earnings manipulation as management looks to make their bonus or an options payout. Covenants in debt instruments can also incentivize earnings manipulation to avoid default or rate adjustments.
Mechanisms to avoid earnings manipulation revolve mostly around outside supervision like corporate governance, external audits, and regulation. General market oversight by analysts is also mentioned as a balance to keep management from manipulating statements.
Balance-sheet and Cash-flow based Aggregate Accruals
The only quantitatively-based material in the section is the calculation of aggregate accruals and the net operating assets. The calculation and concept has a few steps and lends itself well to an item-set question. Aggregate accruals are used to measure the ‘discretionary’ component of earnings apart from cash earnings. Aggregate accruals are basically the current period’s change in non-cash balance sheet items. It excludes cash and debt because these accounts are subject to less manipulation.
The curriculum shows two ways to calculate aggregate accruals and net operating assets, through the balance-sheet and through the statement of cash flows.
Aggregate Accruals = NOAt – NOA t-1
Where Net Operating Assets (NOA) =
(Total Assets – Cash) – (Total Liabilities – Total Debt)
The absolute measure of aggregate accruals, compared to previous periods, is used to measure the company’s earnings quality and to forecast possible reversion of earnings. If management is increasing the amount of overall earnings, not by actual cash earnings, but by accrual accounting manipulation then the possibility of a reduction in earnings or earnings growth is high. Conversely, a company with low or declining aggregate accruals should have more persistent earnings and higher quality.
The accrual ratio is used to compare companies of different sizes. This is just the aggregate accruals divided by the average net operating assets between the balance sheet periods. **Remember, since the balance sheet is a snapshot in time you need to take the average between current and last period for many of your ratios.
Accruals Ratio = (NOAt – NOA t-1)/ ((NOAt + NOA t-1)/2)
This ratio can then be compared across companies for a relative analysis of earnings quality.
Statement of Cash Flows Method
A preferred measure of aggregate accruals is found using the Statement of Cash Flows. The measure is found by reducing Net Income, which is highly susceptible to manipulation, by cash flows from operations and investing.
Aggregate Accruals = Nit – (CFOt + CFIt)
Again, the measurement can be standardized by taking the average net operating assets for the period to compare across companies.
Accruals Ratio = Nit – (CFOt + CFIt)/ (NOAt + NOA t-1)/2
The two measures of aggregate accruals will generally not give you the same result but will usually yield the same directional theme on earnings. The difference comes from noncash transactions and classification differences in accounts.
I have applied this measure of earnings quality in a recent post on the website Seeking Alpha. Click here to see the example of the calculation performed on the financial statements of Johnson & Johnson and several consumer staples companies.
Next week, we’ll look at the advantages and disadvantages of valuation multiples and some of the key takeaways you need for the level 2 CFA exam.
Joseph Hogue, CFA