FRA Lvl 2 - Reading 21 (Eval Qual of Fin Reports) Flashcards
What is the Beneish Model used for?
It is a probit regression model that estimates the probability of earnings manipulations using eight dependent variables. the M-Score determines the probability of earnings manipulation. higher m-score = higher probability
What are the limitations of the Beneish model?
“relies on accounting data, which may not reflect economic reality”
Define the Altman Z-Score Model
provides “probability that a firm will file for bankruptcy.” higher z-score = less likelihood of bankruptcy
What is limitation of Altman Model?
it is a single-period model and does not capture changes in key variables over time. Also uses mostly accounting data
What are the two elements of earnings quality?
- “Sustainable: high-qual earnings tend to persist in the future” 2. “Adequate: high-qual earnings cover the company’s cost of capital”
define sustainable persistent earnings
“earnings that are expected to recur in the future”
Beneish Model Input DSRI: increase in DSRI is an indication of revenue inflation or deflation?
indication of revenue inflation (Days Sales Receivable Index)
Beneish Model Input GMI: declining margins is more or less likely to manipulate earnings?
more likely to manipulate earnings when declining (Gross Margin Index)
Beneish Model Input AQI: Increase could indicate more or less capitalization of expenses?
increase can indicate more/excessive capitalization of expenses (Asset Quality Index)
Beneish Model Input SGI: Increasing or decreasing could indicate manipulated earnings?
not a measure of manipulation itself, growth companies tend to manipulate earnings to meet ongoing expectations (Sales Growth Index)
Beneish Model Input DEPI: What does DEPI greater than 1 suggest?
suggests that assets “are being depreciated at a slower rate in order to manipulate earnings” (Depreciation Index)
Beneish Model Input SGAI: increase or decrease may suggest manipulation?
“increase in SGA expenses might predispose companies to manipulation” (Sales Gen & Admin Expens Index)
In the earnings regression model, alpha + (beta x earnings) + error term, what does a higher beta indicate?
higher beta value indicates higher persistence/recurring earnings
define non-discretionary accruals
accruals that are part of normal business
In the regression model for earnings where = alpha + (beta1 x cash flow) + (beta2 x accruals), is B1>B2 or
B1>B2
When earnings are largely comprised of accruals, mean reversion occurs faster or slower?
faster and “even more so when accruals are mainly discretionary” (because they will eventually be paid off)
what are the two major contributors to earnings manipulation?
- revenue recognition issues and 2. expense recognition issues
Which Financial Report Quality is higher, when it is GAAP Compliant and decision-useful with high qual earnings or when GAAP compliant, decision useful, but low qual earnings?
AAP Compliant and decision-useful with high qual earnings is highest quality
Which Financial Report Quality is higher, when it is GAAP compliant, decision useful, but low qual earnings or When GAAP compliant but not decision-useful (biased choices)?
GAAP compliant, decision useful, but low qual earnings is higher quality. highest quality is when it has high qual earnings and not low qual earnings
higher growth rate of receivables relative to growth rate of revenues is good or bad?
bad - red flag for analyst
Stable/improving profit margins but increase in non-current assets is good or red flag?
may be a warning sign that the company is capitalizing expenses to put them on balance sheet instead of expensing them
Stable/improving profit margins but decrease in asset turnover is good or red flag?
red flag that there might be cost capitalization where instead of expensing, the company is adding as cap. cost
Mgmt can affect cash flows via strategic decisions like timing issues. How does an analyst identify this?
Analyst would review activity rations (receivables/payables turnover) to see if mgmt is increasing OCF (op cash flow) via slowing down payments to suppliers for example
LVL 1 reminder - how are cash flows from sale of available-for-sale securities versus sale of trading securities treated in Cash Flow statement?
sale of available-for-sale securities = CFI while sale of trading securities = CFO
What are three components of high qual bal sheet?
completeness, unbiased measurement and clarity of presentation
Define completeness in balance sheet
when bal sheet includes off-bal sheet liabilities (e.g. Op Leases)
Define unbiased measurement in balance sheet
balance sheet “reflects subjectivity in measurement of some assets/liabilities”
Define clear presentation in balance sheet
companies can present items as single-line or grouped together. Clarity allows analyst to gather relevant info to make comparisons
