CHAPTER 16

EVALUATING FINANCIAL REPORTING QUALITY

Scott Richardson

London, United Kingdom

imagerem Tuna

London, United Kingdom

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

  • Contrast cash-basis and accrual-basis accounting, and explain why accounting discretion exists in an accrual accounting system.
  • Describe the relation between the level of accruals and the persistence of earnings and the relative multiples that the cash and accrual components of earnings should rationally receive in valuation.
  • Explain opportunities and motivations for management to intervene in the external financial reporting process and mechanisms that discipline such intervention.
  • Describe earnings quality and measures of earnings quality, and compare the earnings quality of peer companies.
  • Explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion.
  • Explain potential problems that affect the quality of financial reporting, including revenue recognition, expense recognition, balance sheet issues, and cash flow statement issues, and interpret warning signs of these potential problems.

1. INTRODUCTION

Financial statement analysis involves taking a systematic approach to using information contained in the financial statements to assist in decision making. The set of decision makers using financial statements is varied. ...

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