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product defects after the sale are key areas of concern. In each of these cases, the analyst
has to identify the accounting measures the ¬rm uses to capture these business con-
structs, the policies that determine how the measures are implemented, and the key esti-
mates embedded in these policies. For example, the accounting measure a bank uses to
capture credit risk is its loan loss reserves, and the accounting measure that captures
product quality for a manufacturer is its warranty expenses and reserves.


Step 2: Assess Accounting Flexibility
Not all ¬rms have equal ¬‚exibility in choosing their key accounting policies and esti-
mates. Some ¬rms™ accounting choice is severely constrained by accounting standards
and conventions. For example, even though research and development is a key success
factor for biotechnology companies, managers have no accounting discretion in report-
ing on this activity. Similarly, even though marketing and brand building are key to the
success of consumer goods ¬rms, they are required to expense all their marketing out-
lays. In contrast, managing credit risk is one of the critical success factors for banks, and
bank managers have the freedom to estimate expected defaults on their loans. Similarly,
software developers have the ¬‚exibility to decide at what points in their development
cycles the outlays can be capitalized.
If managers have little ¬‚exibility in choosing accounting policies and estimates re-
lated to their key success factors (as in the case of biotechnology ¬rms), accounting data
are likely to be less informative for understanding the ¬rm™s economics. In contrast, if
managers have considerable ¬‚exibility in choosing the policies and estimates (as in the
case of software developers), accounting numbers have the potential to be informative,
depending upon how managers exercise this ¬‚exibility.
Regardless of the degree of accounting ¬‚exibility a ¬rm™s managers have in measur-
ing their key success factors and risks, they will have some ¬‚exibility with respect to
several other accounting policies. For example, all ¬rms have to make choices with re-
spect to depreciation policy (straight-line or accelerated methods), inventory accounting
policy (LIFO, FIFO, or Average Cost), policy for amortizing goodwill (write-off over
forty years or less), and policies regarding the estimation of pension and other post-em-
ployment bene¬ts (expected return on plan assets, discount rate for liabilities, and rate
of increase in wages and health care costs). Since all these policy choices can have a sig-
ni¬cant impact on the reported performance of a ¬rm, they offer an opportunity for the
¬rm to manage its reported numbers.


Step 3: Evaluate Accounting Strategy
When managers have accounting ¬‚exibility, they can use it either to communicate their
¬rm™s economic situation or to hide true performance. Some of the strategy questions
one could ask in examining how managers exercise their accounting ¬‚exibility include
the following:
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• How do the firm™s accounting policies compare to the norms in the industry? If they
are dissimilar, is it because the firm™s competitive strategy is unique? For example,
consider a firm that reports a lower warranty allowance than the industry average.
One explanation is that the firm competes on the basis of high quality and has in-
vested considerable resources to reduce the rate of product failure. An alternative
explanation is that the firm is merely understating its warranty liabilities.
• Does management face strong incentives to use accounting discretion for earnings
management? For example, is the firm close to violating bond covenants? Or, are
the managers having difficulty meeting accounting-based bonus targets? Does
management own significant stock? Is the firm in the middle of a proxy fight or
union negotiations? Managers may also make accounting decisions to reduce tax
payments, or to influence the perceptions of the firm™s competitors.
• Has the firm changed any of its policies or estimates? What is the justification?
What is the impact of these changes? For example, if warranty expenses decreased,
is it because the firm made significant investments to improve quality?
• Have the company™s policies and estimates been realistic in the past? For example,
firms may overstate their revenues and understate their expenses during the year by
manipulating quarterly reports, which are not subject to a full-blown external audit.
However, the auditing process at the end of the fiscal year forces such companies
to make large fourth-quarter adjustments, providing an opportunity for the analyst
to assess the quality of the firm™s interim reporting. Similarly, firms that expense
acquisition goodwill too slowly will be forced to take a large write-off later. A his-
tory of write-offs may be, therefore, a sign of prior earnings management.
• Does the firm structure any significant business transactions so that it can achieve
certain accounting objectives? For example, leasing firms can alter lease terms (the
length of the lease or the bargain purchase option at the end of the lease term) so
that the transactions qualify as sales-type leases for the lessors. Firms may structure
a takeover transaction (equity financing rather than debt financing) so that they can
use the pooling of interests method rather than the purchase method of accounting.
Finally, a firm can alter the way it finances (coupon rate and the terms of conversion
for a convertible bond issue) so that its reported earnings per share is not diluted.
Such behavior may suggest that the firm™s managers are willing to expend eco-
nomic resources merely to achieve an accounting objective.


Step 4: Evaluate the Quality of Disclosure
Managers can make it more or less easy for an analyst to assess the ¬rm™s accounting
quality and to use its ¬nancial statements to understand business reality. While account-
ing rules require a certain amount of minimum disclosure, managers have considerable
choice in the matter. Disclosure quality, therefore, is an important dimension of a ¬rm™s
accounting quality.
In assessing a ¬rm™s disclosure quality, an analyst could ask the following questions:
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• Does the company provide adequate disclosures to assess the firm™s business strat-
egy and its economic consequences? For example, some firms use the Letter to the
Shareholders in their annual report to clearly lay out the firm™s industry conditions,
its competitive position, and management™s plans for the future. Others use the Let-
ter to puff up the firm™s financial performance and gloss over any competitive dif-
ficulties the firm might be facing.
• Do the footnotes adequately explain the key accounting policies and assumptions
and their logic? For example, if a firm™s revenue and expense recognition policies
differ from industry norms, the firm can explain its choices in a footnote. Similarly,
when there are significant changes in a firm™s policies, footnotes can be used to dis-
close the reasons.
• Does the firm adequately explain its current performance? The Management Dis-
cussion and Analysis section of the firm™s annual report provides an opportunity to
help analysts understand the reasons behind the firm™s performance changes. Some
firms use this section to link financial performance to business conditions. For ex-
ample, if profit margins went down in a period, was it because of price competition
or because of increases in manufacturing costs? If the selling and general adminis-
trative expenses went up, was it because the firm is investing in a differentiation
strategy, or because unproductive overhead expenses were creeping up?
• If accounting rules and conventions restrict the firm from measuring its key success
factors appropriately, does the firm provide adequate additional disclosure to help
outsiders understand how these factors are being managed? For example, if a firm
invests in product quality and customer service, accounting rules do not allow the
management to capitalize these outlays, even when the future benefits are certain.
The firm™s Management Discussion and Analysis can be used to highlight how
these outlays are being managed and their performance consequences. For exam-
ple, the firm can disclose physical indexes of defect rates and customer satisfaction
so that outsiders can assess the progress being made in these areas and the future
cash flow consequences of these actions.
• If a firm is in multiple business segments, what is the quality of segment disclosure?
Some firms provide excellent discussion of their performance by product segments
and geographic segments. Others lump many different businesses into one broad
segment. The level of competition in an industry and management™s willingness to
share desegregated performance data influence a firm™s quality of segment disclo-
sure.
• How forthcoming is the management with respect to bad news? A firm™s disclosure
quality is most clearly revealed by the way management deals with bad news. Does
it adequately explain the reasons for poor performance? Does the company clearly
articulate its strategy, if any, to address the company™s performance problems?
• How good is the firm™s investor relations program? Does the firm provide fact
books with detailed data on the firm™s business and performance? Is the manage-
ment accessible to analysts?
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Step 5: Identify Potential Red Flags
In addition to the above analysis, a common approach to accounting quality analysis is
to look for “red ¬‚ags” pointing to questionable accounting quality. These indicators sug-
gest that the analyst should examine certain items more closely or gather more informa-
tion on them. Some common red ¬‚ags are:
• Unexplained changes in accounting, especially when performance is poor. This
may suggest that managers are using their accounting discretion to “dress up” their
financial statements.14
• Unexplained transactions that boost profits. For example, firms might undertake
balance sheet transactions, such as asset sales or debt for equity swaps, to realize
gains in periods when operating performance is poor.15
• Unusual increases in accounts receivable in relation to sales increases. This may
suggest that the company might be relaxing its credit policies or artificially loading
up its distribution channels to record revenues during the current period. If credit
policies are relaxed unduly, the firm may face receivable write-offs in the subse-
quent periods as a result of customer defaults. If the firm accelerates shipments to
the distribution channels, it may either face product returns or reduced shipments
in the subsequent periods.
• Unusual increases in inventories in relation to sales increases. If the inventory
build-up is due to an increase in finished goods inventory, it could be a sign that the
demand for the firm™s products is slowing down, suggesting that the firm may be
forced to cut prices (and hence earn lower margins) or write down its inventory. A
build-up in work-in-progress inventory tends to be good news on average, probably
signaling that managers expect an increase in sales. If the build-up is in raw mate-
rials, it could suggest manufacturing or procurement inefficiencies, leading to an
increase in cost of goods sold (and hence lower margins).16
• An increasing gap between a firm™s reported income and its cash flow from oper-
ating activities. While it is legitimate for accrual accounting numbers to differ from
cash flows, there is usually a steady relationship between the two if the company™s
accounting policies remain the same. Therefore, any change in the relationship be-
tween reported profits and operating cash flows might indicate subtle changes in
the firm™s accrual estimates. For example, a firm undertaking large construction
contracts might use the percentage-of-completion method to record revenues.
While earnings and operating cash flows are likely to differ for such a firm, they
should bear a steady relationship to each other. Now suppose the firm increases rev-
enues in a period through an aggressive application of the percentage-of-comple-
tion method. Then its earnings will go up, but its cash flow remains unaffected. This
change in the firm™s accounting quality will be manifested by a change in the rela-
tionship between the firm™s earnings and cash flows.
• An increasing gap between a firm™s reported income and its tax income. Once
again, it is quite legitimate for a firm to follow different accounting policies for fi-
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nancial reporting and tax accounting, as long as the tax law allows it.17 However,
the relationship between a firm™s book and tax accounting is likely to remain con-
stant over time, unless there are significant changes in tax rules or accounting stan-
dards. Thus, an increasing gap between a firm™s reported income and its tax income
may indicate that the firm™s financial reporting to shareholders has become more
aggressive. As an example, consider that warranty expenses are estimated on an ac-
crual basis for financial reporting, but are recorded on a cash basis for tax reporting.
Unless there is a big change in the firm™s product quality, these two numbers bear
a consistent relationship to each other. Therefore, a change in this relationship can
be an indication either that the product quality is changing significantly or that fi-
nancial reporting estimates are changing.
• A tendency to use financing mechanisms like research and development partner-
ships and the sale of receivables with recourse. While these arrangements may
have a sound business logic, they can also provide management with an opportunity
to understate the firm™s liabilities and/or overstate its assets.18
• Unexpected large asset write-offs. This may suggest that management is slow to in-
corporate changing business circumstances into its accounting estimates. Asset
write-offs may also be a result of unexpected changes in business circumstances.19
• Large fourth-quarter adjustments. A firm™s annual reports are audited by the exter-
nal auditors, but its interim financial statements are usually only reviewed. If a
firm™s management is reluctant to make appropriate accounting estimates (such as
provisions for uncollectable receivables) in its interim statements, it could be
forced to make adjustments at the end of the year as a result of pressure from its
external auditors. A consistent pattern of fourth-quarter adjustments, therefore,
may indicate an aggressive management orientation towards interim reporting.20
• Qualified audit opinions or changes in independent auditors that are not well jus-
tified. These may indicate a firm™s aggressive attitude or a tendency to “opinion
shop.”
• Related-party transactions or transactions between related entities. These transac-
tions may lack the objectivity of the marketplace, and managers™ accounting esti-
mates related to these transactions are likely to be more subjective and potentially
self-serving.
While the preceding list provides a number of red ¬‚ags for potentially poor account-
ing quality, it is important to do further analysis before reaching ¬nal conclusions. Each
of the red ¬‚ags has multiple interpretations; some interpretations are based on sound
business reasons, and others indicate questionable accounting. It is, therefore, best to use
the red ¬‚ag analysis as a starting point for further probing, not as an end point in itself.21


Step 6: Undo Accounting Distortions
If the accounting analysis suggests that the ¬rm™s reported numbers are misleading,
analysts should attempt to restate the reported numbers to reduce the distortion to the
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extent possible. It is, of course, virtually impossible to undo all the distortion using out-
side information alone. However, some progress can be made in this direction by using
the cash ¬‚ow statement and the ¬nancial statement footnotes.
A ¬rm™s cash ¬‚ow statement provides a reconciliation of its performance based on
accrual accounting and cash accounting. If the analyst is unsure of the quality of the

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