4. warnsig/shenancf/applic Flashcards
Describe incentives that might induce a company’s management to overreport or underreport earnings
Management may be motivated to overstate earning to:
- meet analyst expectations
- remain in compliance with debt covenants
- recieve higher incentive compensation
Management may be motivated to understae net income to:
- obtain trade relief in the form of quotas or protective tariff’s
- renegotiate advantageous repayment terms with existing creditors
- negotiate more advantageous union labour contracts
- or “save” earning to report in a future period
Describe activities that will result in a low quality of earnings
Low quality earnings are the result of:
- selecting acceptable accounting principles that misrepresent the economics of a transaction (ex. using units-of-production methods that results in lower depreciation than the straight-line method early in the asset’s life; earnings will be acceleerated to the early years of the asset’s life)
- structuring transactions to achieve a desired outcome (ex. a firm might structure the terms of a lease to avoid capital lease recognition, resulting in lower liabilites, lower leverage ratios, and lower fixed assets)
- Using aggressive or unrealistic estimates and assumptions (ex. lengthening the lives of depreciable assets or increaseing the salvage value will result in lower depreciation expense and higher earnings)
- Exploiting the intent of an accounting principle (ex. some firms have applied a narrow rule regarding unconsolidated special purposes entities (SPE) to a broad range of transactions, because leverage is lower if the firm does not consolidate the SPE
Describe 3 conditions that are generally present when fraud occurs, including the risk factors related to these conditions
The “fraud triangle” consists of:
Incentives and pressures - to motive to commit fraud
Oppotunities - the firm has a weak internal control system
Attitudes and rationalization -the mindset that fraud is justified
Risk factors related to incentives and pressures for fraud include:
- threats to the firm’s financial stability or profitability
- excessive third-party pressures on management
- threats to the personal net worth of management or board members
- excessive pressure on management and employees to meet internal targets
Risk factors related to opportunities for fraud include:
- the nature of the industry or operatins
- ineffective monitoring of management
- complex or unstable organization structure
- deficient internal controls
Risk factors related to attitudes and rationalizations for fraud include:
- inappropriate or inadequately supported ethical standards
- excessive participation by nonfinancial management in selecting accouting methods
- a history of legal and regulatory violations by management or baord members
- obsessive attention to the stock rpice or earning trend
- aggressive commitments to third parties
- failure to correct known compliance problems
- minimizing earning inappropriately for tax reporting
- continued use of materiality to justify inappropriate accounting
- a strained relationship with the current or previous auditor
Describe common accounting warning signs and methods for detecting each
Common warning signs of earnings manipulation include:
- aggressive revenue recognition
- different growth rates of operating cash flow and earning
- abnormal comparative sales growth
- abnormal inventory growth as compared to sales
- moving nonoperating income and nonrecurring gains up the income statement to boost revenue
- delaying expense recognition
- excessive use of off-balance-sheet financing arrangements including leases
- classifying expenses as extraordinary or nonrecurring and moving them down the income statement to boost income from continuing operations
- LIFO liquidatinos
- abnormal comparative margin ratios
- aggressive assumptions and estimates
- year-end surprieses
- equity method investments with little or no cash flow
Analyze and describe the following way to manipulate the cash flow statement:
stretching out payables; financing of payables; securitization of receivables; and using stock buybacks to offset dilution of earnings
stretching out payables
- transactions with supplers are usually reported as operating activites in the cash flow statement
- a firm can temporarily increase operating cash flow by simply tretching accounts payables; delaying payments to suppliers
- use days’ sales payables to determine if they are doing this
days’ dales in accounts payables = (account payables / COGS) * number of days
financing accounts payable
- arranging for a third party to finance (pay) a firm’s payables in one period so that the firm can account for repayment as a financing (rather than operating) cash flow in a later period
- this decreases operating cash flows in a period of seasonally high CFO and increases them in a subsequent period
securitization of receivables
- accelerates operating cash flow into the current period
- this source of cash is not sustainable and artifcially increases receivables turnover
- securitizing receivables may also allow the firm to immediately recognize gains in the income statement
using stock buybacks
- firms repurchase stock to offset the dilutive effect of the exercise of eomployee stock options
- analysts must determine whether the increase in operatin cash flow resulting from the income tax benefits of the exercise of employee stock options is sustainable
- for analysis, the net cash outflow to repurchase stock should be consideredan operating activity instead of a financing activity, since it is essentially a compensation expense
At the end of year, Silver Creek Company reported COGS of $250 million. Ending accounts payable is $50 million. Assuming there are 365 days in a year, calculate the number of days on average it takes Silver Creek to pay its suppliers.
day’s sales in accounts payable = (450/$250) * 365 = 73 days
Evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance
Trends in a company’s financial ratios and differences between its financial ratios those of its competitors or industry average ratios can reveal important aspects of its business strategy
Prepare a basic projection of a company’s future net income and cash flow
A company’s future income and cash flows can be projected by forecasting sales growth and using estiates of profit amrgins and the increase in working bapital and fized assets necessary to support the forecase sales growth
To estimate cash flows, the analyst must make assumptions about futures sources and uses of cash. The most important of these will be increase in working capital, capital expenditures on new fixed assets, issuance or repayments of debt, and issuance or repurchase of stock.
In the figure
- sale increase 5% per year
- COGS is 35% of sales
- operating expense are 55% of sales
- non cash working capital stays at 85% of sales
- fix capital requirements will be 5% of sales
- net income increases but cash decreases suggesting a need for financing
Describe the role of financial statement analysis in assessing the credit quality of potential debt investment
Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a firm’s creditworthiness include
- its scale and diversification
- operational efficiency
- margin stability
- and use of financial leverage
Describe the use of financial statement analysis in screening for potential equity investments
Potentially attractive equity investments can be identified by screening a universe of stocks, using minimum or maximum values of one or more ratios. Which (and how many) ratios to use, what minimum or maximum values to use, and how much importance to give each ratio all present challenges to the analyst
Determine and justriy appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company
When companies use different accounting methods or estimates relating to areas such as inventory accounting, depreciation, capitalization, and off-balance sheet financing, analysts must adjust the financial statements for comparability
Ajustments include
Investments in securities
- held-for-trading securities vs available for-sale securities;
- unrealized gains and losses are recorded in income vs. not
- unrealized gains and losses are reflected in the balance sheet vs. not
Inventory accounting differences
- LIFO ending inventory can be adjusted to FIFO basis by adding the LIFO reserve.
- LIFO COGS can be adjusted to FIFO basis by subtracting the change in the LIFO reserve
Differences in depreciation methods and estimates
- disclosures are not specific enough to permit adjustments to ensure comparability
- can use qualitative methods like looking atfirm’s estimates of useful lives and salvage values
Off-balance sheet financing
- capital leases and operating leases can be estimated by using the PC of operating lease liabilities and capital lease obligations to sum of future payments or make assumptions about the timing of payments
Goodwill
- adjustments include subtracting goodwill from assets when calculating financial ratios
- income statement expense from impairment in the current period is reversed
Other intangible assets
- use price to tangible book value ratio to remove both goodwill and intangible assets from equity to get tangible book value
When calculating solvency ratios, analysts should estimate the PC of operating lease obligations and add it to the firm’s liabilites
Albart Industries reports the following using the LIFO inventory costing method at the end of 2012.
Current assets - $10 million
Current liabilities - $5 million
2011 LIFO reserve - $500,000
2012 LIFO reserve - $700,000
A. What is the current ratio at the end of 2012 before and after the appropriate adjustment for comparability to a similar firm that reports using the FIFO inventory valuation method?
B. What is the appropriate adjustment to the firm’s 2012 COGS to make th efirm’s income statement comparable to that of a firm that reports under the FIFO method?
A. Before adjustment, current ratio = CA/ CL = 10/5 = 2 at the year-end 2012
Adding the LIFO reserve to current assets increases the current ratio:
adjusted ratio = 10.7 / 5 = 2.14
B. The appropriate adjustment is to subtract the increase in the LIFO reserve from COGS. COGS should be reduced by $700,000 - $500,000 = $200,000. This will increase gross profit, operating profit, and net income compared to LIFO reporting.
Abration Corp. reported the following for 2012:
Total assets - $30 million
Total debt - $10 million
Capital lease liability - $3 million
(figure)
PV of capital lease: $6.184 million
Estimate the PV of Abration’s operating leases
Method 1: Assumer operating leases have the same ratio of PV to payments as the firm’s capital leases
A total of $12 million in capital lease payments and $5.5 million in operating lease payments are due in the future. The ratio of the PV of Abration’s capital leases to its total future lease payments is $6.184 million / $12 million = 0.5153. Using this ratio, we can estimate the PC of their operating leases as 0.5153 * $5.5 million = $2.834 million
Method 2: Estimate discount rate for capital leases and apply it to operating leases
To calculate a single discount rate that would produce the reported PC of capital leases, we must make an assumption about the timing of capital lease payments beyond 2016. The annual payments, together with the reported PV, can be used to estimate a discout rate to use when calculating the PV of the operating lease payments
Some alternatives are as follows: all paid at the end of year 6, spread evenly over some specific number of years, or payments at the average of the prior five years until the obligation for future payents beyond 2016 is met.
$7 million in year 6:
CF0 = -6.184; C01 = 1; F01 = 5; C02 = 7; CPT IRR = 15.8%
$1.4 million in years 6-10
CFo = -6.184; C01 = 1; F01 = 5; C02 = 1.4; F02 = 5; CPT IRR = 13.0%
$1 million in years 6-12:
CF0 = -6.184; C01 = 1; F01 = 12; CPT IRR = 12%
Note that the further in the future we assume the payments are made, the lower their discount rate given the PV
If we choose to assume that capital lease payments beyond 2016 are spread evenly over 5 years ($1.4 million per year), we will use the discount rate 13%. Making the same assumption about lease payments beyond 2016 for the operating leases ($600,000 per year for five years), we can calculate the PV of these payments, and thus, the operating lease liability:
I/Y = 13; CF0 = 0; C01 = 500; F01 = 5; C02 = 600; F02 = 5; CPT NVP = 2,904
This amount, $2.094 million, should be added to the firm’s liabilities and assets (equity need not be adjusted) to better reflect the use of off-balance sheet financing and to calculate solvency ratios such as debt-to-equity and debt-to-assets.
