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FINANCIAL REPORTING QUALITY ISSUES

PT LIPPO CIKARANG TBK

6TH GROUP:
AFRA HASANAH (1406578501)
FARHANSYAH ARDITYA I (1406611726)
HOTASI DOLI M (1406565915)
MONICA SELLA (1406534361)
PUTRI PRASTICA (1406534071)

FAKULTAS EKONOMI DAN BISNIS


UNIVERSITAS INDONESIA
2017
DEPOK
CHAPTER 11. FINANCIAL REPORTING QUALITY
1. CONCEPTUAL OVERVIEW
Financial Reporting Quality
Low High
High financial reporting
quality enables assessment.
High
Low financial reporting quality High earnings quality increases
Earnings company value.
impedes assessment of
(Results)
earnings quality and its High financial reporting
Quality
valuation quality enables assessment.
Low
Low earnings quality decreases
company value
From the table above, if financial reporting quality is low, the information provided is not useful
to assess the companys performance and thus to make investment and other decisions. High-
quality reports contain information that is relevant, complete, neutral, and free from error. The
lowest-quality reports contain information that is pure fabrication. Earnings (results) quality can
range from high and sustainable to low and unsustainable. The results of combining the two
quality variable, earnings quality and financial reporting quality can be shown on the quality
spectrum below.
There are 6 qualities as a result of a combination both earning quality and financial reporting
quality, those are:
1. GAAP, Decision-Useful, Sustainable, and Adequate Returns
The first quality means high quality reports that provide useful information about high-quality
earnings. High-quality financial reports conform to the generally accepted accounting principles
(GAAP) of the jurisdiction, such as IFRS, US GAAP, or PSAK (for Indonesia). High-quality
financial reports also embody the characteristics of decision-useful information such as those
devined in Conceptual Framework which are relevance and faithful representation. The desirable
characteristics for financial information require trade-offs. One of the example of trade-offs is
financial reports must balance the aim of providing information that is produced quickly enough
to be timely and thus relevant, and yet not so quickly that errors occur. High-quality information
results when these and other trade-offs are made in an unbiased, skilful manner. High-quality
earnings indicate an adequate level of return on investment and derive from activities that a
company will likely be able to sustain in the future. Sustainable earnings that provide a high
return on investment contribute to higher valuation of a company and its securities.
2. GAAP, Decision-Useful, but Sustainable? Low Earnings Quality
The second quality refers to circumstances in which high-quality reporting provides useful
information, but that information reflects results or earnings that are not sustainable (lower
earnings quality). The earnings may not be sustainable because the company cannot expect
earnings that generate the same level of return on investment in the future or because the
earnings, although replicable, will not generate sufficient return on investment to sustain the
company. For example, consider a company that generates a loss, or earnings that do not provide
an adequate return on investment, or earnings that resulted from non-recurring activities. The
relatively undesirable economic reality could nonetheless be depicted in financial reporting that
provides high-quality, decision-useful information.
3. Within GAAP, but biased choices
The third quality means that there are biased choices result in financial reports that do not
faithfully represent economic phenomena. Those choices are well known as earnings
smoothing. There are two kind of choices, aggresive and conservartive.
Aggresive if they increase a companys reported performance and financial position in
the current period. The choice can increase the amount of revenues, earnings, and/or
operating cash flow reported in the period or decreases the amount of expenses reported
in the period and/or the amount of debt reported on the balance sheet. Aggressive choices
may decrease the companys reported performance and financial position in later period.
Conservative if they decrease a companys reported performance and financial position in
the current period. Conservative choices may decrease the amount of revenues, earnings,
and/or operating cash flow reported in the period or increases the amount of expenses
reported in the period and/or the amount of debt reported on the balance sheet.
Conservative choices may increase the companys reported performance and financial
position in later periods.
Biased choices can be made not only in the context of reported amounts but also in the context of
how information is presented. For example, companies can disclose information transparently
and in a manner that facilitates analysis, or they can disclose information in a manner that aims
to obscure unfavourable information and/or to emphasize favourable information. Investors may
prefer conservative choices rather than aggressive ones, however, because a positive surprise is
easier to tolerate than a negative surprise. Biased reporting, whether conservative or aggressive,
adversely affects a users ability to assess a company.
4. Within GAAP but earnings management
The fourth quality means the company financial reporting follows the GAAP but using earnings
management. Earnings management defined as making intentional choices that create biased
financial reports. It almost the same as biased choices, but differed in the intention of the
company. Earnings management represents deliberate actions to influence reported earnings and
their interpretation. Earnings can be managed upward (increased) by taking real actions, such
as deferring research and development (R&D) expenses into the next reporting period, changing
the amount of estimated product returns, bad debt expense, or asset impairment.
5. Non-compliant Accounting
The fifth quality states that company produces financial reporting that departs from GAAP and
can generally be considered low quality. Earnings quality is likely difficult or impossible to
assess because comparisons with earlier periods and/or other entities cannot be made since the
company may use different standars for different periods.
6. Fictitious Events
The last and the worst quality means that company creates fictitious events to fraudulently obtain
investments by misrepresenting the companys performance and/or to obscure fraudulent
misappropriation of the companys assets.
2. CONTEXT FOR ASSESSING FINANCIAL REPORTING QUALITY
In assessing financial reporting quality, it is useful to consider whether a companys managers
may be motivated to issue financial reports that are not high quality to mask poor performance.
Even when there is no need to mask poor performance, managers frequently have incentives to
meet or beat market expectations as reflected in analysts forecasts and/or managements own
forecasts. Exceeding forecasts typically increases stock price, if only temporarily. Additionally,
exceeding forecasts can increase management incentive compensation that is linked to increases
in stock price or to reported earnings. Beside incentive compensation, career concerns may also
motivate managements on choosing the accounting standars for the company. Managers might
be concerned that working for a company that performs poorly will limit their future career
opportunities. The surveyed managers indicated a greater concern with career implications of
reported results than with incentive compensation implications.
There are three conditions that influence managers to issue low-quality financial reports:
opportunity, motivation, and rationalization. Opportunity can be the result of internal conditions,
such as poor internal controls or an ineffective board of directors, or external conditions, such as
accounting standards that provide scope for divergent choices or minimal consequences for an
inappropriate choice. Motivation can result from pressure to meet some criteria for personal
reasons, such as a bonus, or corporate reasons, such as concern about financing in the future.
Rationalization is important because if an individual is concerned about a choice, he or she needs
to be able to justify it to him- or herself.
To discipline the Financial Reporting Quality, there are 3 mechanisms:
1. Market Regulatory Authorities
Typical features of a market regulatory regime that most directly affect financial reporting
quality are:
Registration Requirements; requires publicly traded companies to register securities
before offering the securities for sale to the public.
Disclosure Requirements Registration; requires publicly traded companies to make public
periodic reports, including financial reports and management comments.
Auditing Requirements; requires companies financial statements to be accompanied by
an audit opinion attesting that the financial statements conform to the relevant set of
accounting standards.
Management Commentaries; requires publicly traded companies financial reports to
include statements by management.
Responsibility Statements; require a statement from the person or persons responsible for
the companys filings
Regulatory Review of Filings; Regulators typically undertake a review process to ensure
that the rules have been followed.
Enforcement Mechanisms; Regulators are granted various powers (assessing fines,
suspending or permanently barring market participants, and bringing criminal
prosecutions) to enforce the securities market rules.
2. Auditors
As mention above, regulatory authorities typically require that publicly traded companies
financial statements be audited by an independent auditor. Private companies also obtain audit
opinions for their financial statements, either voluntarily or because audit reports are required by
an outside party, such as providers of debt or equity capital.
Although audit opinions provide discipline for financial reporting quality, inherent limitations
exist. First, an audit opinion is based on a review of information prepared by the company. If a
company deliberately intends to deceive its auditor, a review of information might not uncover
misstatements. Second, an audit is based on sampling, and the sample might not reveal
misstatements. Third, an expectations gap may exist between the auditors role and the
publics expectation of auditors. An audit is not typically intended to detect fraud; it is intended
to provide assurance that the financial reports are fairly presented. Finally, the company being
audited pays the audit fees, often established through a competitive process. This situation could
provide an auditor with an incentive to show leniency to the company being audited, particularly
if the auditors firm provides additional services to the company.
3. Private Contracting
Many parties that have a contractual arrangement with a company have an incentive to monitor
that companys performance and to ensure that the companys financial reports are high quality.
Because the financial reports prepared by the investees or borrowers directly affect the
contractual outcomes-potentially creating a motivation for misreporting-investors and lenders are
motivated to monitor financial reports and to ensure that they are high quality.
3. DETECTION OF FINANCIAL REPORTING QUALITY ISSUES
3.1 PRESENTATION
There is no unusual presentation in the Lippo Cikarang tbk 2016 financial statements. However
the management does give an important consideration in the determination of accounting policies
in its notes to consolidated financial statements. In there the management stated that for the
recognition of the revenue from the sale of shopping centers and apartment units are recognized
using the percentage of completion method (will be explain further in 4.2 accounting choices and
estimates). To determine the percentage of completion for the revenue recognition, the
management uses physical progress approach that is determined based on the survey report for
each project or the part of the project. There are chance that this survey will lead to negligence in
determining the percentage of completion at the reporting date can result in revenue recognition
errors for the subsequent reporting year, in which the material error correction will be carried out
retrospectively. For the year of 2016, there is no error in revenue recognition.
3.2 ACCOUNTING CHOICE AND ESTIMATE
Here are several items that need to be consider in Lippo Cikarang Tbk accounting choice and
estimates:
3.2.1 INVENTORIES AND LAND FOR DEVELOPMENT
In Lippo Cikarang Tbk notes to consolidated financial statements 2.J inventories and land for
development is explaining about the choice and estimation of two main account in its statement
of financial position which are Inventories (which included as current assets), Land for
Development (which included as non current assets). The management consider land under
development, residential houses, shophouses, apartments including buildings (houses) under
construction, are inventories and use the carried at the lower of cost and net realizable value. The
cost of inventories determined using the average method. Using average method at one side were
good because it less affected by prices compared to FIFO method (LIFO method is forbidden in
both IFRS and Indonesia GAAP (PSAK)). However using average method could also lead to
difficulties to determine the cost per unit of the product.
While the account of Land for Development in non current assets means that Lippo Cikarang
Tbk has land but not yet being being develop or any improvement. The value of the Land being
measured using its acquisition cost.
If the excess of carrying value of inventories over their estimated recoverable value is exists, it
would be recognized as impairment loss under provision for decline in value of inventories in
profit or loss.
3.2.2 INVESTMENT PROPERTIES
Investment properties are properties (land or a building or part of a building or both) held by the
owner or the lessee under a finance lease to earn rentals or for capital appreciation or both, rather
than for use in the production or supply of goods or services or for administrative purposes; or
sale in the daily business activities.
Investment property is recognized as an asset if, and only if it is probable that the future
economic benefits that are associated with the investment property will flow to the entity; and
the cost of the investment property can be measured reliably.
After initial recognition, the Group choose to use cost model and measure its investment
property at acquisition cost less accumulated depreciation and accumulated impairment losses if
any.
3.2.3 PROPERTY AND EQUIPMENT
Property and equipment are initially recognized at cost, which comprises its purchase price and
any cost directly attributable in bringing the assets to the location and condition necessary for it
to be capable of operating in the manner intended by management.
After initial recognition, property and equipment, except land, are carried at its cost less any
accumulated depreciation, and any accumulated impairment losses, if any.
Depreciation of property and equipment starts when its available for use and its computed by
using straight line method based on the estimated useful lives of assets as follows:
Items Year
Buildings 20
Machineries and Equipment 4
Vehicle 4
Office Equipment 4

3.2.4 REVENUE RECOGNITION


The method of Lippo Cikarang Tbk to recognize its revenue were stated in its financial
statements:
(i) Revenues from sales of lots that do not require the seller to construct building are recognized
under the full accrual method if all of the following conditions are met:
a. total payments by the buyer are at least 20% of the agreed selling price and the amount is not
refundable;
b. the selling price is collectible;
c. the receivable is not subordinated to other loans in the future;
d. The land development process is complete so that the seller has no further obligations related
to the lots sold, such as obligation to construct amenities or obligation to build other facilities
applicable to the lots sold as provided in the agreement between the seller and the buyer or
regulated by law; and
e. Only the lots are sold, without any requirement of the sellers involvement in the construction
of building on the lots.
(ii) Revenues from sales of houses, shop houses, and other similar property and related land are
recognized under the full accrual method if all of the following conditions are met:
a. a sale is consummated;
b. the selling price is collectible;
c. the sellers receivable is not subject to future subordination against other loans which will be
obtained by the buyer; and
d. The seller has transferred the risks and rewards of ownership to the buyer through a
transaction that is in substance a sale and does not have substantial continuing involvement with
the property.
(iii) Revenues from sales apartments are recognized using the percentage-of-completion method
if all of the following conditions are met:
a. the construction process has already commenced, i.e., the building foundation has been
completed and all of the requirements to commence construction have been fulfilled;
b. total payments by the buyer are at least 20% of the agreed selling price and the amount is not
refundable; and
c. the amount of revenue and the cost of the property can be reliably estimated.
The method used to determine the level of development activity completion is based on a
percentage of actual activities accomplished to total development activities that need to be
accomplished.
4. EVALUATING THE QUALITY OF FINANCIAL REPORTS
There are 2 approaches when evaluating the quality of financial reports: qualitative and
quantitative. We can start from the qualitative approach. First, for the company itself, PT Lippo
Cikarang Tbk is a property company since 1988. The company is a listed company since 1997.
Then, this company is an urban development which includes development of real estate and
industrial estate, development of infrastructure and public facilities, and providing supporting
services. The current product of this company is Meikarta. Because this is a property company
that use an installment system, so the financial report basically use the accural method of
accounting. And it has an impact to the liquidity level of a company, that is not really liquid.
And then, if we compare the financial reports in 2016 to the prior year, we can conclude
that the financial conditions from the company is good. Because, assets of the company increase
in 2016, while liability decrease, and equity increase. And if we see the whole performance of
their financial reports, there are no significant issues that can effect the companys report. So, we
can say, that the financial reports of the company is good.
4.1 EARNINGS QUALITY
Evaluating earnings quality of a company can be done within 4 alternatives: recurring earnings,
earnings persistence and related measures of accruals, mean reversion in earnings, beating
benchmarks, external indicators of poor quality earnings. We choose 2 alternative indicators of
earning evaluation. First, from income statement of PT Lippo Cikarang Tbk, we can see that
there are not any non-recurring items in 2015 and 2016. All the items are inluded as recurring
items. It means that, the company will revenues item not only in one year, but also in the next
year. Of course, this is a good trend for the company. Next, for the earnings persistence, we think
that cash component is less than accrual component for the recurring items of revenue. It
happens because our company is a property company, the company gained revenue mostly from
the installment system, like we can see in the figure below:

It means that the revenue of PT Lippo Cikarang Tbk is not really persistent because the
company have more accrual component than cash component. Then, for the whole earnings
performance, there is no additional information on disclosures for the revenue and expenses
component. The company only dislose what items on each revenue and expense accounts. But, in
our opinion, we can conclude that the earnings quality of the company is not really good because
there are some decline in revenue items meanwhile the expenses mostly increases.
4.2 CASH FLOW QUALITY
As it is expected that cash flow are free from any discretion due to accrual accounting used, it
mainly use as the main analysis in financial reporting analysis. High quality cash flow can be
seen by how good companys economic performance and the disclosure are clearly stated. For
PT Lippo Cikarang case, the cash flow statement shows a positive cash flow and also has the
number of disclosure to disclose the information regarding to the use of cash during the reporting
period. Even though the property industry is facing a decrease, PT Lippo Cikarang still able to
generate revenue from their main operation and save some money for their investment in the
next project.
4.3 BALANCE SHEET QUALITY
For the quality of balance sheet we examine the completeness, unbiased measurement and clear
presentation. The first step to analyze PT Lippo Cikarang balance sheet quality is seeing their
leverage, liquidity and asset allocation which we have been calculated in the 2nd week. Those all
ratio shows a good number even though some of them face a decrease compare to 2015. Even
after a comparison with PT Jababeka, it still shows a good number. Which means PT Lippo
Cikarang is going well even compared to other company in same industry. As for the
completeness and clear measurement, we can easily see it in the Balance sheet report of PT
Lippo Cikarang and their disclosures.
4.4 SOURCES OF INFORMATION ABOUT RISK
1. Limited usefulness of auditors opinion as a source of information about risk
A clean audit opinion states that the financial statements present the information fairly and on
conformity with the relevant accounting principles. It also shows how good the companys
internal control is. In the independent auditors report of RSM for PT Lippo Cikarang it is stated
that the financial report audited by them there is no material misstatement found and all part was
presented fairly and comply with accounting standard.
2. Risk-related disclosure in the notes
As notes of financial statement contain more detail information regarding to the number shown
in the overall report, this disclosure shows more understandable companys risk that is required
by the standard used. As PT Lippo Cikarang operates in Indonesia, their financial statement
should disclose any information required in PSAK. For example we can see the financial
instrument and financial risk management of the company in the notes 37 where it disclose about
credit risk, liquidity risk and market risk
3. Management Commentary
Management commentary can help financial report user in understanding the companys risk
exposure, approach to managing risk and the effectiveness of risk management. It should contain
(1) nature of the business, (2) objectives and strategies, (3) resource, risk and relationship, (4)
results and prospects and (5) performance measures and indicators. This data can be seen in the
Annual Report of PT Lippo Cikarang
4. Other Required Disclosures
It is required for the company to disclose a specific event such as capital rising, non-timely filing
of financial reports, management changes or mergers and acquisitions. Those information also
important for risk assessment. In PT Lippo Cikarang notes there are:
Notes 11 about Investment in Associates and Notes 12 about Investment in Joint
Venture shows the companys investing activities
Notes 35 about Significat Commitments and Agreements that disclose the operational
and management agreements, property financing agreement and joint operation
agreement
Notes 38 about Business combination