Book 3 - FRA - Financial Reporting Quality: Red Flags Flashcards
Describe incentives that might induce a company’s management to overreport or underreport earnings.
Firms are motivated to manage earnings because of the potential benefits. Management may be motivated to overstate net income to:
- Meet earnings expectations.
- Remain in compliance with lending covenants.
- Receive higher incentive compensation.
Managing earnings can also involve understating net income. Management may be motivated to underreport earnings to:
- Obtain trade relief in the form of quotas or protective tariffs.
- Negotiate favorable terms from creditors.
- Negotiate favorable labor union contracts.
Firms may also be motivated to manage the balance sheet. For example, by overstating assets or understating liabilities, the firm appears more solvent. Conversely, a firm might understate assets or overstate liabilities to appear less solvent in order to negotiate concessions with creditors and other interested parties.
Describe activities that will result in a low quality of earnings.
Generally accepted accounting principles (GAAP) can be exploited by a firm to achieve a specific outcome while meeting the letter, but not the spirit, of the accounting standards; however, earnings quality will usually deteriorate. Low quality earnings are the result of:
- Selecting acceptable accounting principles that misrepresent the economics of a transaction. For example, a firm might choose the units-of-production method of depreciation in periods when the consumption of the asset is better measured by the straight-line or accelerated methods. If the units-of-production method results in lower depreciation than the straight-line method early in the asset’s life, earnings will be accelerated to the early years of the asset’s life.
- Structuring transactions to achieve a desired outcome. For example, a firm might structure the terms of a lease to avoid capital lease recognition, resulting in lower liabilities, lower leverage ratios, and lower fixed assets.
- Using agigress ve or unrealistic estimates and assumptions. For example, lengthening the lives of depreciable assets or increasing the salvage value will result in lower depreciation expense and higher earnings.
- Exploiting the intent ofan accounting principle. For example, 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 the three conditions that are generally present when fraud occurs, including the risk factors related to these conditions.
Read the Notes - Page 50.
Describe common accounting warning signs and methods for detecting each.
Aggressive revenue recognition. The most common earnings manipulation technique is recognizing revenue too soon. Recall that revenue is recognized in the income statement when it is earned and payment is reasonably assured. Usually revenue is recognized
at delivery but, in some cases, revenue can be recognized before delivery takes place. Firms are required to report their revenue recognition policies in the financial statement footnotes. It is important to understand when revenue recognition takes place.
Different growth rates of operating cash flow and earnings. Over time, there should
be a fairly stable relationship between the growth of operating cash flow and earnings. If not, earnings manipulation may be occurring. A firm that is reporting growing earnings, but negative or declining operating cash flow, may be recognizing revenue too soon and/or delaying the recognition of expense.
Abnormal sales growth as compared to the economy, industry, or peers. Abnormal growth may be the result of superior management or products, but may also indicate accounting irregularities. Receivables that are growing faster than sales, as indicated by an increasing average collection period, may be evidence of aggressive revenue recognition.
Abnormal inventory growth as compared to sales growth. Increasing inventory may be an indication of obsolete products or poor inventory management, but it could also result from overstating inventory, decreasing the cost of goods sold and thereby increasing gross profit and net profit.
Boosting revenue with nonoperating income and nonrecurring gains. Some firms try to reclassify nonoperating income and nonrecurring gains as revenue, in effect, moving these items “up” the income statement. Net income is the same but revenue growth is higher.
Delaying expense recognition. By capitalizing operating expenditures, the firm delays expense recognition to future periods. Watch for an increase in assets with unusual sounding names such as “deferred marketing charges” or “deferred customer acquisition costs.”
Abnormal use of operating leases by lessees. Operating leases are common in most firms. However, some firms use this off-balance-sheet financing technique to improve ratios and reduce perceived leverage. Analysts should compare the firm’s use of leasing, as a financing source, to its industry peers. For analytical purposes, consider treating operating leases as capital leases.
Hiding expenses by classifying them as extraordinary or nonrecurring. The result is to move expenses “down” the income statement and boost income from continuing operations.
LIFO liquidations. When a LIFO firm sells more inventory than it purchases or produces during a period of rising prices, it reduces the cost of goods sold and increases profit, although taxes are higher as well. Such profits are not sustainable because the firm will eventually run out of inventory. A declining LIFO reserve (the difference between LIFO inventory and what it would be under FIFO, which must be disclosed by firms that use LIFO) is an indication of a LIFO liquidation. Firms should disclose the effects of a LIFO liquidation in the financial statement footnotes.
**Abnormal gross margin and operating margin as compared to industry peers. **Abnormal margins may be the result of superior management or cost controls; however, they may be an indication of accounting irregularities. Determine the firm’s conservatism by comparing the firm’s accounting principles, as disclosed in the footnotes, to those of its industry peers.
Extending the useful lives of long-term assets. Depreciating or amortizing the cost of an asset over more periods results in higher reported earnings. Compare the useful lives of the firm’s assets with those o f its industry peers.
Aggressive pension assumptions. Aggressive assumptions such as a high discount rate, low compensation growth rate, or high expected rate of return on pension assets will result in lower pension expense and higher reported earnings. Compare these assumptions with those of its industry peers.
Year-end surprises. Higher earnings in the fourth quarter that cannot be explained by seasonality may be an indication of manipulation.
Equity method investments and off-balance-sheet special purpose entities. Equity method investments are not consolidated. However, the pro-rata share of the investee’s earnings are included in net income. Watch for frequent use of nonconsolidated special purpose entities.
Other off-balance-sheet financing arrangements including debt guarantees. Firms must disclose these arrangements in the financial statement footnotes. For analytical purposes, consider increasing balance sheet liabilities for these arrangements.
