CFA Reading 25- Evaluating Financial Reporting Quality

1. Four differences in the cash basis and accrual basis:

1). Unearned revenue: cash received, but revenue is not recognized
2). Accrued revenue: cash is not received, but revenue is recognized. (Like Accounts Receivables)
3). Deferred expense: cash is payed, but expense is not recognized
4). Accrued expense: cash is not payed, but expense is recognized

2. Oppotunities and motivations for management to intervene in the external financial reporting

Motivation:
1). Influence capital markets (strategies munipulation)
2). Satisfy contractual provisions (high earning, high bonus)

Mechanisms to deter strategic manipulation
1). Independent audit
2). BOD: audit committee and internal auditors
3). Certification by senior management: CEO and CFO must certify the financial statements
4). Class action litigation: Lawsuits
5). Regulators
6). General market scrutiny: journalists, analyst...

CFA Reading23 - The Lessons We Learn

What can we learn from recent accounting scandals?
Do we really understand those finanical reports?

First Lesson: Read It All
Beyond the financial statements, footnotes and management discussion and analysis(MD&A) section are where most of the detail and explanation are found.
Footnotes: accounting principles, estimates, assumptions
MD&A: liquidity, capital resources, results of operations

Second Lesson: Be Skeptical
Remember: Too good to be true
A good insight: Earning growth is not sustainable in the long run without growth in CFO. In the short run, earning growth can be financed with debt; but in the long run, the external financing will dry up, so the firm must reply on its internal financing, such as cash flow.

Third Lesson: Evaluate The Disclosures
EBITDA>EBIT>Income from continuing operations>Net Income

Fourth Lesson: Check For Cash Flow
CFO is more reliable than net income because it is less subject to estimates and judgements. In the long run, the two should have a fairly stable relationship.

Fifth Lesson: Understand The Risks
Common risks: interest rate risks, foreign exchange risk, accounts receivable risk, price risk
Solutions: derivative hedge
Type of hedges:
1) Fair value hedge (Gain/Loss in IS)
Example: Options to hedge equity investment
2) Cash flow hedge (Gain/Loss in Other comprehensive income)
Example: forward to hedge the future cash flows of an anticipated transaction
3) Net Investment hedge of a foreign subsidiary (Gain/Loss in Other comprehensive income)
Example: foreign exchange forward
PS: If the firm uses derivatives to speculate, gains and losses are recognized in IS.