Chapter 18 - Analysis of the Quality of Financial Statements

CHAPTER EIGHTEEN

Analysis of the Quality of Financial Statements

Stephen H. Penman

The web page for Chapter 18 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

Fair Value Accounting

Composite Quality Scores

Earnings Quality by Dechow and Schrand

Earnings Quality by Francis, Olsson, and Schipper

Quality of Financial Statements During the Bubble

Earnings Prediction

Financial Statement Analysis and the Prediction of Stock Returns

Readers Corner

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.

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Chapter 18 - Analysis of the Quality of Financial Statements

Much of the analysis in Part Two 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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Chapter 18 - Analysis of the Quality of Financial Statements

Why a Quality Analysis is Important

Current financial statements are the basis for forecasting future financial statements (in
the pro forma analysis of Part Three 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 Two 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 17 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.

2. The analysis of the equity statement (in Chapter 9) is designed to identity

comprehensive income, a better quality number than net income because it
includes dirty-surplus items missing from net income. Further, the identification
of hidden dirty-surplus items recognizes gains and losses such as the loss
from employee stock options -- that are omitted by (poor quality) GAAP
accounting.

3. The separation of net operating assets (NOA) from net financial obligations
(NFO) in balance sheet reformulations (Chapter 10) distinguishes assets and
liabilities that are well-measured (typically the NFO) from those that are not (the
NOA). We made good use of this distinction in valuation (in Chapter 14) by
recognizing that, for the well-measured NFO, the valuation is complete in the
balance sheet so pro forma analysis is not required. Of course we always
challenge the quality of balance sheet measures so that, even if marketable equity
securities are marked to market in the balance sheet, we do incorporate that
market value in a valuation if we feel that the market value is a bubble price.

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4. The separation of operating income form financing income in reformulated

income statements (Chapter 10) distinguished types of income that have different
implications for valuation and thus can be seen as having different quality. So, if
the NFO are at market value in the balance sheet, the net financing expense
component of earnings is ignored.

5. The distinction between core income and non-core income (Chapter 13) is a
distinction between types of income that have different implications for the future
and thus are different quality. Income from pension assets must not be confused
with core income from sales, for example. Chapter 13, indeed, is a prelude to the
quality analysis in Chapter 18. With its discussion of restructuring charges and
their bleed-backs, it introduces the notion of shifting income between periods with
accrual estimates. The IMB case (M13.3) is a good introduction to Chapter 18.

6. The analysis of leverage in Chapter 14 is designed to distinguish earnings growth

that comes for operations (and is important to valuation) from growth that comes
from borrowing (which the investor should not pay for).

The Accounting Quality Watch at the end of a number of preceding chapters summarized
the quality issues you have run into prior to this chapter. This chapter provides the
capstone to the quality analysis of the earlier chapters.

The Key Point to Appreciate

Heres the key point to appreciate in an analysis of earnings quality: Accrual accounting
is a set of rules that determine in which period earnings are to be recognized; with some
discretion allowed, accrual accounting can shift income between periods. Current income
can be increased (with accounting methods) only by reducing future income (thus
borrowing from the future.) Decreasing current income (with accounting methods) has
the consequence of increasing future income (saving for the future). With the
forecasting of future income in mind (for valuation), current income must therefore be
tested if it is to be relied on as an indicator of future income.

The Key Diagnostic

Because net financial expenses (NFE) are usually well measured, earnings quality
analysis focuses on operating income (OI). From earlier in the book (Chapter 8), we
know that the following relation always holds:

OI = Free cash flow NOA

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Free cash flow is a relatively hard number although one must be attentive to firms
timing cash flows (see Chapter 10). The change in net operating assets, NOA is the
relatively soft number so is the primary number to be analyzed. Much of Chapter 17 is
designed to do this. Note that

NOA = Investment + operating accruals

So, NOA and any manipulation of operating income comes from two sources:

(i) Misclassification of investments (capitalization policy)

(ii) Accrual estimates.

The expression for operating income (OI) here shows that, any manipulation of income
must leave a trail in the balance sheet through the amount of NOA. Following that trail
to changes in accounts receivable, accrued expenses, deferred revenues, etc. is the
exercise of a sound quality analysis. Many of the quality diagnostics in Chapter 18
amount to defining the trail to be followed to challenge the NOA (and thus the operating
income) reported for a period.

Some Perspective in the Quality of GAAP Accounting

After reading Chapter 18, you might get the impression that GAAP accrual accounting
has a lot of quality problems. The financial scandals on the early 2000s reinforce that
impression. GAAP accounting has a number of deficiencies, most of which have been
highlighted in this book. But we must have a sense of perspective. While remaining
skeptical about the accounting in financial reports, we must remember that accrual
accounting, in principle, serves the valuation analyst well. It might be worthwhile, at this
point, to go back to Chapters 2 and 4 where the basic principles of accrual accounting
and particularly its positive features are emphasized.

Lets try to weigh the good and bad features of GAAP accounting. First, some
problems with GAAP accounting, most of which are covered earlier in the book.

Problematic Features of GAAP

1. The accounting for the shareholders equity statement is poor. In particular, gains
and losses are not recognized when shares are issued or repurchased at a price
different from market value. This results in hidden gains and losses (mostly
losses) when warrants, convertible bonds, convertible preferred stock, put and call
options, and employee stock options are involved. (Chapter 9)

2. GAAPs emphasis on Net Income and EPS and the reporting of Other
Comprehensive Income in the equity statement can obscure the profitability
picture. For example, firms can cherry pick realized gains into Net Income
while reporting unrealized losses in the equity statement.

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3. As a consequence of the poor accounting for claims that are contingent on a firms
stock price, contingent liabilities are omitted from the balance sheet. For example,
the value of the option overhang that is important to valuation is omitted. (Chapter
14 has the remedy)

4. Gains on pension assets are netted to operating costs in the income statement,
distorting margins. (Chapter 13)

5. The cash flow statement does not make a clean distinction between cash from
operating/investment activities and cash from financing activities. (Chapter 11)

6. If securities markets are inefficient, mark-to-mark accounting can introduce

bubble gains into the financial statements. (Chapter 13)

7. Liabilities are omitted from the balance sheet, in particular operating leases,
obligations with respect to special entities, and the option overhang. (Chapter 20)

8. The lack of disclosure can be frustrating to the analyst. Here are some
observations, along with some recommendations:

The US income statement is a disgrace. Often it is reduced to a few lines.

There is little detail on S G & A expense. This item is typically 20 percent

of sales, but there is little breakdown on the multitude of sins that it
covers. Firms even credit gains from asset sales to S G & A. It would seem
a simple matter to report executive compensation, gains on pension fund
assets (distinguished from service costs), gains and losses from asset sales,
and reversals of restructuring charges (to name a few) as separate lines on
the face on the income statement. With before-tax operating profit margins
typically less than 12 percent of sales, an investors request to report any
expense greater than 2 percent of sales -- along with more sensitive lesser
items such executive, director and auditor compensation -- seems
reasonable.

An analysis of net revenue, a reconciliation of gross revenue to net

revenue, and a breakdown of booked and deferred revenue is needed.

Transitory items need to be clearly displayed on the income statement, so

the reader can get an understanding of core operating earnings.

The obscurity introduced by consolidations is troubling. The reader cannot

get a clear picture of how assets and liabilities are structured through
joint ventures, alliances, special entities, R&D partnerships and other
networking relationships. Transparency can be improved with

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organizational diagrams, disaggregated reporting, and proportionate

presentations, for example.

A presentation of how current earnings are affected by changes in

estimates in prior periods is needed. This table would include amounts
bled back to earnings from reversals of restructuring charges, dipping into
cookie jar reserves, reducing deferred tax asset allowances, and bad debt
and loan loss experience relative to prior estimates.

Also needed is a discussion of accruals for which there is particular

uncertainty and a ranking of accrual estimates by their perceived
uncertainty, giving the reader a better sense of what numbers are hard
and soft and a better appreciation of the likelihood that earnings will be
sustainable.

Include a quality of earnings statement by management, supplemented

by a statement of significant uncertainties by auditors.

Desirable Features of GAAP

As we have emphasized in this book, the basic features of GAAP are desirable from
the equity analysts point of view:

1. With the exception of fair value accounting for securities and some financial
assets, equity prices are not in the financial statements. This suits the analyst, for
she wishes to use the accounting to challenge stock prices so does not want the
accounting to reflect those prices. During the technology boom of the 1990s,
commentators who justified high stock prices relative to book values assailed
accounting for not recognizing the intangible assets. One saw calculations where
analysts measured the value of intangibles as the difference between the value of
tangible assets (with some premium applied) and (bubble) market values for the
whole firm. With the exceptions noted above, GAAP does not make this mistake;
GAAP does not bring prices into financial statements. Quality accounting
recognizes that market prices are inherently speculative, for they are based on
beliefs about the future.

2. Revenue recognition and matching. Shareholders buy future earnings and thus
speculate as to what those earnings might be when they buy shares. But sound
accounting understands that the shareholder is best served if you dont mix what
you know with speculation about what you dont know. This restatement of the
reliability criterion, embraced under the FASBs Conceptual Framework, is also a
maxim of fundamental investing.

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Accounting recognizes that a firm adds value for shareholders only if it

gets customers and receives more value from customers than is
given up in servicing customers. Shareholder value is added in the stock market,
but the source of that added value is value added from the firms trading with
customers in product markets and suppliers in the input markets. It is this source
of value that the shareholder wants to understand: how much was earned this
period from trading with customers and suppliers? The investor uses this hard
information, uncontaminated by speculative information, to speculate on the
firms ability to generate earnings from customers in the future. Revenue
recognition and matching, the hallmark of the traditional financial reporting
model, implements these ideas. See Chapter 2.

Regrettably, the principle has been abused in practice. Excessive write-downs,

merger charges, cookie jar reserving, front-end revenue recognition, and under- or
over-estimating of allowances for credit losses, warranties, and deferred tax assets
(to name a few) with the associated intertemporal shifting of earnings are
failures in applying basic accounting, not a failure of principle. Auditing and
corporate governance institutions sometimes do not enforce unbiased revenue
recognition and matching.

The move to more fair value accounting -- currently under discussion among
standard setters should proceed with care, particularly for non-financial
institutions. The danger is that we lose the information from revenue realization
and matching and substitute (possibly bubble) market prices or biased and
imprecise fair value estimates. Historical cost accounting provides information
(about the profitability of trading with customers) to inform about prices. Fair
value accounting often gets the information from prices, so may destroy the
ability to inform about prices.

3. Accrual accounting is, in principle, good accounting for equity analysis. This
accounting does, of course, invite some speculation in the estimation of accruals
that are needed to match revenues with expenses. This is the tension in earnings
measurement: quality earnings require accruals, but accruals are estimates that
can be poor quality. Auditors and directors are a check (ideally), but some
expenses like amortization and depreciation are intrinsically hard to measure.
For some costs, there may be no accounting solution. Expensing R&D
expenditures, for example, results in (gross) mismatching. But to capitalize and
amortize may just introduce arbitrary amortizations into the matching. The
reliability criterion overrides. Be it as it may, accounting quality is the less for the
inability to measure.

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4. Speculation about intangible assets in not allowed in GAAP. The traditional

financial reporting model was assailed during the late 1990s bubble for not
recognizing the value of intangible assets, particularly knowledge assets. No
one knows what the value of a knowledge asset is (or even precisely what it is!).
One suspects that commentators were imputing these assets from bubble prices.
Recognizing the value of these assets in the balance sheets would be pure
speculation, and subsequent fuzzy amortization of a fuzzy number would destroy
information in matching. Do we really want to entertain the idea that Dell
Corporation should recognize the value of its supply chain, its direct-to-customer
strategy, its culture and organization on its balance sheet and then amortize
these assets to income? Or do we want to relegate such notion to fantasy, ill-
conceived ideas of a bubble mentality? Do we rather not want to stick to the
notions of revenue recognition and matching so that the value of such assets is
recognized when a firm gets a customer and the associated expenses are also
recognized to get a measure of value added accrual earnings -- from these
assets? After all, we have managed to analyze and value Dell quite well in this
book (in examples, exercises and cases) using historical cost/revenue recognition
accounting. And we found that Coca Cola lent itself to a simple valuation (in Box
15.4 in Chapter 15) without recognizing its brand value on the balance sheet.

Financial statements actually do report on knowledge assets, not in balance

sheets, but (eventually) in income statements. Knowledge assets have value
because they lead to earnings from customers. Earnings are reported, but only as
customers are booked. Accounting confirms whether investors speculation about
the value of knowledge assets is justified, but does not engage in the speculation.

Chapter 9 of S. Penman, Accounting for Value, also provides a critique of GAAP

accounting from the perspective of the fundamental investor.

Fair Value Accounting

Fair value accounting involves marking assets and liabilities to fair value. It is applied
to a limited number of assets and liabilities, mainly financial assets, derivatives, and
trading and available-for-sale securities. However, firms have a fair value option to fair
value a wider range of assets and liabilities under FASB Statement 159 in the U.S. and
IAS 39 under IFRS.

FASB Statement 157 provides guidance for measuring fair value, distinguishing Level 1
fair values (where market prices in liquid markets indicate fair value), Level 2 (where
prices for the specific asset dont exist but can be inferred from other market data), and
Level 3 where the firm has to estimate market prices. In all cases the market price, or the
estimate market price, is the prices at which the firm could sell the asset or pay to be
relieved of the liability (so-called exit value).

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Level 3 fair values clearly pose a quality problem: estimates contain error and can be
biased. The issues rose in the credit crisis of 2008-09 when banks had to estimate fair
values of assets (like collateralized debt obligations) that earlier had traded in liquid
market which then dried up. Any observed traded prices were suspect as depressed
prices or fire-sale prices that did not (some say) represent value to the banks holding
them. Clearly fair values come with a huge product warning label in this case.

But Level 1 fair values also pose a problem. First, traded prices may be bubble prices.
Indeed, some claimed that the 2008-09 credit crisis was due to banks booking fair value
profits as real estate price and the assets derived from them went up in a real estate
bubble. The higher profits and resultant higher bank capital reserves induced more bad
lending against fake value in real estate, leading to the crash. Remember our warning,
form as far back as Chapter 1, about putting prices in the financial statements. Second,
exit value is not necessarily value to the enterprise: the value as which a bank can sell
mortgage loans what someone else would pay is not the value to the bank from
working with its own customers to get through their credit difficulties and pay back the
loan. More so it the market price is a depressed price.

So, in a quality analysis, challenge fair values on the balance sheet and fair value gains
and losses reported in comprehensive income.

These and other issues are addressed in the following CEASA White Paper:

Principles for the Application of Fair Value Accounting, at

http://www4.gsb.columbia.edu/ceasa/research/papers/white_papers

Also see a CEASA paper by Doron Nissim on fair value accounting in the banking
industry:

http://www4.gsb.columbia.edu/ceasa/events/news/item/7636/Occasional+paper+on+f
air+value+policy+in+the+banking+industry+is+now+available+online

Chapter 8 of S. Penman, Accounting for Value, also provides a critique of fair value
accounting from the perspective of the fundamental investor.

Composite Quality Scores

Chapter 18 provides quite a few quality diagnostics, and some of them tell the same story.
One can combine measures into a single quality score that summarizes the information
that a set of financial statement measures convey as a whole. The following papers
contain examples.

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Chapter 18 - Analysis of the Quality of Financial Statements

Piotroski, J. 2000. Value Investing: The Use of Historical Financial Statement

Information to Separate Winners from Losers. Journal of Accounting Research 38
(Supplement): 1-41.

This paper calculates a score that distinguishes financial well being among firms with
low price-to-book ratios.

Penman, S., and X. Zhang. 2004. Modeling sustainable earnings and P/E ratios with
financial statement analysis. Download the document at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=318967

This paper weights a variety of measures to derive one composite score, an S score or
sustainable earnings score that ranges from zero to one. See the text.

S. Penman and X. Zhang, Modeling Sustainable Earnings and P/E Ratios with
Financial Statement Analysis at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=318967

Beneish, M. 1999. The Detection of Earnings Manipulation. Financial Analysts Journal

55(5): 24-36.

This paper calculates a score that gives an indication of earnings manipulation.

Chapter 20 also gives examples of composite scoring to indicate the probability of

default or bankruptcy.

Earnings Quality by Dechow and Schrand

For a broad ranging coverage of earnings quality, see

P. Dechow and C. Schrand, Earnings Quality. CFA Institute, 2005.

Earnings Quality by Francis, Olsson, and Schipper

For another survey of research in this area, go to

J. Francis, P. Olsson, and K. Schipper, Earnings Quality, Foundations and Trends in

Accounting at

http://www.nowpublishers.com/product.aspx?product=ACC&doi=1400000004

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Quality of Financial Statements During the Bubble

The following paper discusses accounting quality issues that arose in the late 1990s
bubble:

Penman, S., The Quality of Financial Statements: Perspectives from the Recent
Stock Market Bubble, Accounting Horizons (Supplement 2003), 77-96. The
paper can be downloaded at:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=319262

See also:

Penman, S., Quality Accounting for Equity Analysis, Emanuel Saxe Lecture,
Zicklin School of Business, Baruch College. Available at:

http://newman.baruch.cuny.edu/digital/saxe/toc.htm

Earnings Prediction

Chapter 18 adopts the idea that current (operating) earnings are of good quality if it is a
good predictor of future earnings. Accordingly, any method that predicts how future
earnings will be different from current earnings is in fact an exercise in earnings quality
analysis because it serves to correct the forecast that one would make solely on the
basis of reported earnings. There has been considerable research on predicting earnings
through financial statement analysis. Some of the relevant papers are:

Fairfield, P., R. Sweeney, and T. Yohn. 1996. Accounting Classification and the Predictive
Content of Earnings. The Accounting Review 71 (3): 337-355.

Fairfield, P., and T. Yohn. 2001. Using Asset Turnover and Profit Margin to Forecast
Changes in Profitability. Review of Accounting Studies 6 (4): 371-385.

Fama, E., and K. French. 2000. Forecasting Profitability and Earnings. Journal of
Business 73 (2): 161-175.

Freeman, R., Ohlson, J., and S. Penman. 1982. Book Rate-of-Return and Prediction of
Earnings Changes: An Empirical Investigation. Journal of Accounting Research
(Autumn): 639-653.

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Chapter 18 - Analysis of the Quality of Financial Statements

Nissim, D., and S. Penman. 2003. Financial Statement Analysis of Leverage and How It
Informs About Profitability and Price-to-book Ratios. Review of Accounting
Studies, Vol. 8, No. 4 (December 2003), 531-560.

Ou J., and S. Penman. 1989. Financial Statement Analysis and the Prediction of Stock
Returns. Journal of Accounting and Economics 11 (4): 295-329.

Financial Statement Analysis and the Prediction of Stock Returns

The material in the last section of Chapter 18 shows how a particular quality analysis
(that produces the S-Score) predicts stock returns. This is just one example of research
that shows that financial statement analysis predicts stock returns at least in the past.
Other findings are found in the papers below.

Abarbanell, J. and B. Bushee. 1997. Fundamental Analysis, Future Earnings, and Stock
Prices. Journal of Accounting Research 35 (1): 1-24.

Abarbanell, J. and B. Bushee. 1998. Abnormal Returns to a Fundamental Analysis

Strategy. Accounting Review 73: 19-45.

Basu, S.1977. Investment Performance of Common Stocks in Relation to their Price-

Earnings Ratios: A Test of the Efficient Market Hypothesis. Journal of Finance
32: 663-682.

Bernard, V., and J. Thomas. 1990. Evidence that Stock Prices do not Fully Reflect the
Implications of Current Earnings for Future Earnings. Journal of Accounting
Research 13: 305-340

Chan, K., L.Chan, N. Jagadeesh, and J. Lakonishok. 2001. Earnings Quality and Stock
Returns: The Evidence from Accruals. Working paper, National Taiwan
University and University of Illinois at Urbana-Champaign.

Fairfield, P., J. Whisenant, and T. Yohn. 2003. Accrued Earnings and Growth:
Implications for Earnings Persistence and Market Mispricing. The Accounting
Review

Hribar, P. 2001. The Market Pricing of Components of Accruals. Working paper, Cornell
University.

Lev, B., and S. Thiagarajan. 1993. Fundamental Information Analysis. Journal of

Accounting Research 31 (2): 190-215.

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Chapter 18 - Analysis of the Quality of Financial Statements

Ou J., and S. Penman. 1989. Financial Statement Analysis and the Prediction of Stock
Returns. Journal of Accounting and Economics 11 (4): 295-329.

Ou J., and S. Penman. 1989. Accounting Measurement, Price Earnings Ratio, and the
Information-Content of Security Prices. Journal of Accounting Research 27: 111-
144.

Penman, S., and X. Zhang. 2002. Accounting Conservatism, Quality of Earnings, and
Stock Returns. The Accounting Review 77(2): 237-264.

Piotroski, J. 2000. Value Investing: The Use of Historical Financial Statement

Information to Separate Winners from Losers. Journal of Accounting Research 38
(Supplement): 1-41.

Richardson, S., and R. Sloan. 2003. External Financing and Future Stock Returns.
Working paper, University of Michigan.

Richardson, S., R. Sloan, M. Soliman, and I. Tuna. 2002. Information in Accruals About
Earnings Persistence and Future Stock Returns. Working paper, University of
Michigan.

Thomas, J., and H. Zhang. 2002. Inventory Changes and Future Returns. Forthcoming,
Review of Accounting Studies.

Readers Corner

This supplement has already given you a lot of reading material! But here are a couple of
quality-of-earnings books you might look at:

Sherman, Young, and Collingwood, Profits You Can Trust: Spotting & Surviving
Accounting Landmines, Prentice-Hall, 2003.

Mulford and Comiskey, The Financial Numbers Game: Detecting Creative Accounting
Practices, Wiley, 2002.

H, Schilit, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in

Financial Reports (McGraw-Hill, 2002).

Here is a survey of CFOs about earnings management:

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Chapter 18 - Analysis of the Quality of Financial Statements

Dichev, I., , J. Graham, and S. Rajgopal, Earnings Quality: Evidence from the Field.
Unpublished paper, 2012, Duke University and Emory University.

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