Exam 2 (11,12) Flashcards
What is financial reporting quality?
It refers to the decision-usefulness of information, ensuring faithful representation of economic reality and compliance with accounting standards.
What is earnings quality?
It pertains to the sustainability of reported earnings, adequate returns, and the ability to enhance a company’s value.
What are some motivations for low-quality financial reporting?
Masking poor performance, meeting market expectations, increasing stock price temporarily, boosting compensation linked to earnings, and avoiding debt covenant violations.
What are examples of biased accounting choices?
“Aggressive” accounting to inflate performance or “conservative” accounting to underreport current results for future benefits.
Name a mechanism to ensure financial reporting quality.
Regulatory authorities, auditors, and private contracting enforce high-quality financial reporting.
What are the four main applications of financial statement analysis?
Evaluating past performance, projecting future performance, assessing credit risk, and screening for equity investments.
What is the importance of forecasting in financial statement analysis?
Forecasting helps in estimating sales, expenses, operating profits, assets, liabilities, and cash flows.
What is credit analysis?
It evaluates the credit risk by assessing a debtor’s overall creditworthiness and risk in a particular transaction.
What are stock screening criteria examples?
Market capitalization thresholds, P/E ratio, liabilities-to-assets ratio, positive operating income/sales, and dividend yield.
What adjustments might analysts make to reported financials?
Adjustments for differences in accounting standards, methods, and materiality to ensure comparability.
What warning signs might suggest revenue recognition issues?
Premature recognition, bill-and-hold arrangements, or unusual trends in receivables turnover.
Why analyze inventory turnover?
To detect issues like poor management, obsolescence, or overstated profits.
How can operating cash flow versus net income indicate issues?
Consistently higher net income than operating cash flow may suggest accrual manipulation.
What are valuation reserves for deferred tax assets?
Estimates used to determine if deferred tax assets will be realized, requiring scrutiny for reliability and reasonableness.
Why adjust for goodwill and intangible assets?
To calculate tangible book value and refine the market-to-book ratio for cross-company comparisons.
What are common problems affecting financial reporting quality?
Aggressive timing of revenue recognition, misclassification of expenses, biased accounting choices, and fraud.
What does classification shifting involve?
Reclassifying items (e.g., expenses as nonrecurring) to inflate operating income or distort cash flow metrics.
What is the Beneish Model used for?
It evaluates the likelihood of earnings manipulation using financial ratios like Days Sales Receivable Index (DSR) and Gross Margin Index (GMI).
Why is mean reversion significant in earnings analysis?
Extreme earnings levels, whether high or low, tend to return to normal over time, especially if accruals are involved.
What are signs of nonrecurring earnings?
Earnings boosted by one-time events like asset sales or restructuring rather than sustainable operations.
What are the six steps in the financial analysis framework?
Define the purpose, collect data, process data, analyze data, develop conclusions, and follow up.
What does a DuPont analysis decompose?
It breaks down Return on Equity (ROE) into Net Profit Margin, Asset Turnover, and Financial Leverage.
How can segment analysis aid decision-making?
It identifies profitable or underperforming business segments and evaluates if capital allocation aligns with returns.
What is an example of a financial reporting adjustment for equity analysis?
Removing earnings and assets from affiliates (e.g., Nestlé’s investment in L’Oréal) to focus on core operations.
