What is the quality of liabilities?
If liabilities are understated, net income is overstated because it does not include necessary charges to reflect the proper valuation of liabilities.
Examine trends in current liabilities to total liabilities, to stockholders' equity, and to sales. Rising trends may point to liquidity problems. Determine whether liabilities are "patient" or "pressing." A "patient" supplier with a long relationship may postpone or modify the debt payable for a financially troubled company. "Pressing debt" includes taxes and loans payable. These have to be paid without excuse. A high ratio of "pressing liabilities" to "patient liabilities" points to greater liquidity risk.
If you find that reserves are used to manage earnings, add back the amounts charged to earnings and deduct the amounts credited to earnings. A firm having an unrealistically low provision for future costs has understated earnings. EXAMPLE: It is inconsistent for a company to have a lower warranty provision when prior experience points to a deficiency in product quality.
The company has greater liquidity risk in 20X5 as reflected by the higher ratios of current liabilities to total liabilities, current liabilities to sales, and "pressing" current liabilities to "patient" current liabilities.
How do adjustments of estimated liabilities affect earnings?
Arbitrary adjustments of estimated liabilities should be eliminated in deriving corporate earning power. Estimated liability provisions should be realistic given the nature of the circumstances. EXAMPLE: Profits derived from a recoupment of prior year reserves may necessitate elimination. An overprovision in estimated liabilities is sometimes made. In effect, the company is providing a reserve for a "rainy day." EXAMPLE: Profits are too high, and management wants to bring them down.
Poor earnings quality is indicated when more operating expenses and losses are being charged to reserve accounts compared to prior years.
Are some liabilities off the balance sheet?
o Unrecorded liabilities are not reported on the financial statements but do require future payment or services. EXAMPLES: Lawsuits and noncapitalized leases.
o Useful disclosures of long-term obligations are mandated by FASB 47.
o FASB Interpretation 34 requires disclosure of indirect guarantees of indebtedness. Included are contracts in which a company promises to advance funds to another if financial problems occur, as when sales drop below a stipulated level.
o Preferred stock with a maturity date or subject to sinking fund requirements is more like debt than equity. However, convertible bonds with an attractive conversion feature are more like equity than debt since there is an expectation of conversion.
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