fsa: carlos a. mello-e-souza 1 title quality of accounting information and international comparisons...
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FSA: Carlos A. Mello-e-Souza
1title
Quality of Accounting Quality of Accounting Information and Information and
International ComparisonsInternational Comparisons
Quality of Accounting Quality of Accounting Information and Information and
International ComparisonsInternational Comparisons
byby Carlos A. Mello-e-Souza Carlos A. Mello-e-Souza
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FSA: Carlos A. Mello-e-Souza
Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:
Before we begin…
toc
1. analyze economics of industry
1. analyze economics of industry
2. analyze company strategies
2. analyze company strategies
3. assess quality of
accounting
3. assess quality of
accounting
4. analyse profitability
and risk
4. analyse profitability
and risk
5. value the firm
5. value the firm
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FSA: Carlos A. Mello-e-Souza
Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:Process of financial statement analysis:
Before we begin…
toc
1. analyze economics of industry
1. analyze economics of industry
2. analyze company strategies
2. analyze company strategies
3. assess quality of
accounting
3. assess quality of
accounting
4. analyse profitability
and risk
4. analyse profitability
and risk
5. value the firm
5. value the firm
4
FSA: Carlos A. Mello-e-Souza
What is accounting quality?What is accounting quality?
Why is accounting quality important?Why is accounting quality important?
Measurement of accounting qualityMeasurement of accounting quality
Focus on: international comparisonsFocus on: international comparisons
Focus on: earnings managementFocus on: earnings management
What is accounting quality?What is accounting quality?
Why is accounting quality important?Why is accounting quality important?
Measurement of accounting qualityMeasurement of accounting quality
Focus on: international comparisonsFocus on: international comparisons
Focus on: earnings managementFocus on: earnings management
Accounting Quality:
toc
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FSA: Carlos A. Mello-e-Souza
What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?
what is AQ?
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
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FSA: Carlos A. Mello-e-Souza
What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?
what is AQ?
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• The objective of accounting:
… is to provide information for capital allocation decisions by investors.(SFAC No. 1 of 1978)
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FSA: Carlos A. Mello-e-Souza
What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?
what is AQ?
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
1. AQ is revealed by strength of association between observable accounting earnings and unobservable economic earnings.
… the “value relevance approach”
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FSA: Carlos A. Mello-e-Souza
What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?
what is AQ?
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
2. “Accounting that portrays the most realistic possible presentation of an enterprise’s financial position and results of operations.” (Bernstein)
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FSA: Carlos A. Mello-e-Souza
What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?
what is AQ?
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• AQ…1. Reflects information content.
Accounting should provide relevant information to forecast the firm’s expected earnings and cash flows. (RELEVANCE)
2. Signals earnings persistence.Accounting information should be a fair and complete representation of firm’s performance, position, and risk. (RELIABILITY)
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FSA: Carlos A. Mello-e-Souza
What is accounting quality?What is accounting quality?What is accounting quality?What is accounting quality?
what is AQ?
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• AQ is affected by the quality of: standards and regulations incentives (enforcement) application of principles estimates
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FSA: Carlos A. Mello-e-Souza
Importance of accounting qualityImportance of accounting qualityImportance of accounting qualityImportance of accounting quality
importance
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• Value of equity = ? (RIM)
1
0
1 1t e t
e
e tt
CI BVErV BVEr
Note:
1 1t t t te eCI BVE ROE r BVEr
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FSA: Carlos A. Mello-e-Souza
Importance of accounting qualityImportance of accounting qualityImportance of accounting qualityImportance of accounting quality
importance
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• Value of equity = ? (RIM)
1
0
1 1te
e
te t
t
CI BVEB rV VEr
Note:
1 1t t t te eCI BVE R rOE BVEr
13
FSA: Carlos A. Mello-e-Souza
Importance of accounting qualityImportance of accounting qualityImportance of accounting qualityImportance of accounting quality
importance
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• for the firm: as AQ improves the cost of capital tends to fall.(Botosan, 1997, and many other studies)
• for the economy: AQ is positively associated with development of the financial sector and with growth. (Levine et al, 1999)
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FSA: Carlos A. Mello-e-Souza
Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality
measurement
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• By evidence of factors that compromise AQ, such as:• earnings management• accounting errors and omissions• aggressiveness• generic “scoring” models
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FSA: Carlos A. Mello-e-Souza
Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality
measurement
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• By mechanical methods:• accrual based methods
net income vs. operating cash flow behavior of current, non-current, total
accruals (Richardson, et al) behavior of discretionary accruals (Jones)
• probability of manipulation methods (Beneish)
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FSA: Carlos A. Mello-e-Souza
Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality
measurement
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• Looking for quality on the balance sheet:
Cash
Receivables
Inventory
PP&E
Investments
Intangibles
Cash
Receivables
Inventory
PP&E
Investments
Intangibles
A/P
Taxes payable
Contingencies
Interest bearing debt
Other LT liabilities
SE
A/P
Taxes payable
Contingencies
Interest bearing debt
Other LT liabilities
SE
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FSA: Carlos A. Mello-e-Souza
Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality
measurement
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• Looking for quality in the income statement and statement of comprehensive income:
RevenuesCost of salesOperating expensesOther income (expense)Tax expenseDiscontinued operationsExtraordinary itemsNet incomeOther comprehensive incomeComprehensive income
RevenuesCost of salesOperating expensesOther income (expense)Tax expenseDiscontinued operationsExtraordinary itemsNet incomeOther comprehensive incomeComprehensive income
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FSA: Carlos A. Mello-e-Souza
Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality
measurement
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• Looking for quality in the footnotes and in MDA:
MDA
Footnotes
MDA
Footnotes
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FSA: Carlos A. Mello-e-Souza
Measurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting qualityMeasurement of accounting quality
measurement
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• High quality disclosures allow investors to differentiate: IMPLICATIONS FOR
FUTURE EARNINGS?
NO YES
ACTUAL vs EXPECTED EARNINGS
NO SURPRISE
S#1:no price effect
S#4:price effect from future
SURPRISE!
S#3:price effect
from surprise
S#2:price effect from future & surprise
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FSA: Carlos A. Mello-e-Souza
AQ: important cross-border factorsAQ: important cross-border factorsAQ: important cross-border factorsAQ: important cross-border factors
international
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• Degree of TAX-GAAP linkage(affects value relevance; makes it hard to interpret accrual-based diagnostics)
• Quality of enforcement(standards alone do not guarantee good disclosures)
• Special strategies, culture, institutions• Convert financial statements to common
accounting standards
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FSA: Carlos A. Mello-e-Souza
Earnings ManagementEarnings ManagementEarnings ManagementEarnings Management
smoothing
Accounting Quality: what is AQ ; importance ; measurement ; international ; smoothing
• GAAP has room for earnings management• Is it good or bad? when? for whom?• Arguments for:
• to maximize compensation, job security• to avoid default• to influence stock price• to avoid regulatory action
• Arguments against:• can’t do it forever• risk of penalties (SEC)