Evaluating Quality of Financial Reports Flashcards
Explain the quality spectrum of financial reports?
GAAP, decision useful, sustainable and adequate returns
GAAP, decision useful but maybe not sustainable (low earnings quality)
Within GAAP, but biased choices
Within GAAP but earnings management
Not GAAP - Non-compliant accounting
Fictitious transactions
Explain some potential quality problems with financial reports? (Hint: Revenues)
Aggressive, premature, fictitious revenue recognition results in overstated income and thus overstated equity. Assets (e.g AR will usually also be overstated)
Explain some potential quality problems with financial reports? (Hint: Expenses)
Omission and delayed recognition of expenses results in understated expenses and therefore higher NI, higher equity and higher assets and/or understated liabilities.
How can CFO be manipulated?
It could be falsely increased by deferring payments on payables, accelerating payments from customers, deferring purchases of inventory/R&D etc. Also Capex in investing activities.
What are some specific BS warning signs?
Selling AR’s, changes in classification, over/understating reserves, overstating goodwill, using SPV/VIE’s.
What are the potential issues with M&A in terms of financial quality?
M&A could be deployed as a way of concealing accounting misstatement. Goodwill is a possible issue, they may understate the value of amortizable intangibles - they can reverse it out as one-off much further down the line.
How can marketable securities be manipulated?
If classified as AFS - this would flow through OCI. If classified as Trading, the change in FV would flow through to Net Income.
Talk about the OCI vs. Net Income dilemma?
Holding gains/losses on financial assets/liabilities. Gains/losses on revaluations. Foreign currency translation gains/losses. Net pension asset/liability changes.
Discuss Beneish Model
An 8 factor model that attempts to capture the probability of manipulation.
Explain and interpret the Beneish Model
If the factors show evidence (e.g >1) then the M score would be higher and there’s more likely to be manipulation.
A less negative number implies a greater probability of manipulation.
One property of high quality earnings is earnings persistence. What is the simple model for this?
Where a higher coefficient (B1) represents more persistent earnings.
Explain earning persistence in the context of cash flow and accruals?
The cash component is more persistent than the accruals portion.
Accruals broadly = NI - CF
Non-discretionary accruals are better than discretionary accruals.
What is the Altman Z Model?
It attempts to quantify the likelihood that a company will default on its debt/declare bankruptcy.
The areas between 1.81 to 3 is the grey area, and does not provide a clear indication of bankruptcy risk.
What are some weaknesses of the Altman Z model?
Ratios are only at one point in time
Reflects past performance only
Assumes everything is of a going concern
What are the indicators of high cash flow quality?
- Positive operating cash flow
- OCF from sustainable sources
- OCF > (CAPEX + dividends + debt repayments)
- OCF with low volatility.
Describe sources of information about risk
Auditors report, notes to the statements, MD&A should also break out risks appropriately, 8-Ks, Financial press
Assume that a DB pension plan discount rate drops by 0.5%, what effect will this have on the financial statements?
Total shareholders equity will decrease - this is via the underfunded plan obligation, which will become even further underfunded.
A drop in ITO could indicate what?
It could indicate that the obsolescence allowance has been reduced, or mgmt have used reserves/allowances to manage or smooth earnings.
What is the difference in Interest received reporting in IFRS vs. US GAAP
Under IFRS - can be operating or financing.
Under GAAP - must be operating.
If a company needs to move from IFRS -> GAAP, then CFF would increase, CFO would decrease.
