Exam 2 (11,12)

Question 1

What is financial reporting quality?

Answer 1

It refers to the decision-usefulness of information, ensuring faithful representation of economic reality and compliance with accounting standards.

Question 2

What is earnings quality?

Answer 2

It pertains to the sustainability of reported earnings, adequate returns, and the ability to enhance a company’s value.

Question 3

What are some motivations for low-quality financial reporting?

Answer 3

Masking poor performance, meeting market expectations, increasing stock price temporarily, boosting compensation linked to earnings, and avoiding debt covenant violations.

Question 4

What are examples of biased accounting choices?

Answer 4

“Aggressive” accounting to inflate performance or “conservative” accounting to underreport current results for future benefits.

Question 5

Name a mechanism to ensure financial reporting quality.

Answer 5

Regulatory authorities, auditors, and private contracting enforce high-quality financial reporting.

Question 6

What are the four main applications of financial statement analysis?

Answer 6

Evaluating past performance, projecting future performance, assessing credit risk, and screening for equity investments.

Question 7

What is the importance of forecasting in financial statement analysis?

Answer 7

Forecasting helps in estimating sales, expenses, operating profits, assets, liabilities, and cash flows.

Question 8

What is credit analysis?

Answer 8

It evaluates the credit risk by assessing a debtor’s overall creditworthiness and risk in a particular transaction.

Question 9

What are stock screening criteria examples?

Answer 9

Market capitalization thresholds, P/E ratio, liabilities-to-assets ratio, positive operating income/sales, and dividend yield.

Question 10

What adjustments might analysts make to reported financials?

Answer 10

Adjustments for differences in accounting standards, methods, and materiality to ensure comparability.

Question 11

What warning signs might suggest revenue recognition issues?

Answer 11

Premature recognition, bill-and-hold arrangements, or unusual trends in receivables turnover.

Question 12

Why analyze inventory turnover?

Answer 12

To detect issues like poor management, obsolescence, or overstated profits.

Question 13

How can operating cash flow versus net income indicate issues?

Answer 13

Consistently higher net income than operating cash flow may suggest accrual manipulation.

Question 14

What are valuation reserves for deferred tax assets?

Answer 14

Estimates used to determine if deferred tax assets will be realized, requiring scrutiny for reliability and reasonableness.

Question 15

Why adjust for goodwill and intangible assets?

Answer 15

To calculate tangible book value and refine the market-to-book ratio for cross-company comparisons.

Question 16

What are common problems affecting financial reporting quality?

Answer 16

Aggressive timing of revenue recognition, misclassification of expenses, biased accounting choices, and fraud.

Question 17

What does classification shifting involve?

Answer 17

Reclassifying items (e.g., expenses as nonrecurring) to inflate operating income or distort cash flow metrics.

Question 18

What is the Beneish Model used for?

Answer 18

It evaluates the likelihood of earnings manipulation using financial ratios like Days Sales Receivable Index (DSR) and Gross Margin Index (GMI).

Question 19

Why is mean reversion significant in earnings analysis?

Answer 19

Extreme earnings levels, whether high or low, tend to return to normal over time, especially if accruals are involved.

Question 20

What are signs of nonrecurring earnings?

Answer 20

Earnings boosted by one-time events like asset sales or restructuring rather than sustainable operations.

Question 21

What are the six steps in the financial analysis framework?

Answer 21

Define the purpose, collect data, process data, analyze data, develop conclusions, and follow up.

Question 22

What does a DuPont analysis decompose?

Answer 22

It breaks down Return on Equity (ROE) into Net Profit Margin, Asset Turnover, and Financial Leverage.

Question 23

How can segment analysis aid decision-making?

Answer 23

It identifies profitable or underperforming business segments and evaluates if capital allocation aligns with returns.

Question 24

What is an example of a financial reporting adjustment for equity analysis?

Answer 24

Removing earnings and assets from affiliates (e.g., Nestlé’s investment in L’Oréal) to focus on core operations.

Question 25

How is accrual ratio fluctuation linked to earnings quality?

Answer 25

Significant changes suggest potential manipulation in timing or recognition of earnings.

Question 26

What did the Satyam fraud involve?

Answer 26

Fictitious bank statements, inflated cash balances, fake salary accounts, and fraudulent customer invoices.

Question 27

What is “channel stuffing”?

Answer 27

A practice where companies induce customers to buy more products than needed, inflating current sales at the expense of future demand.

Question 28

Why is analyzing the cash flow statement critical?

Answer 28

Persistent discrepancies between cash flows and net income may indicate unsustainable earnings practices.

Question 29

What role do disclosures play in risk assessment?

Answer 29

Notes on litigation, credit, liquidity, and market risks provide crucial insights into financial health.

Question 30

What are indicators of overstated goodwill?

Answer 30

Goodwill levels exceeding a company’s market capitalization, suggesting potential impairment risks.