FRA Lvl 2 - Reading 21 (Eval Qual of Fin Reports)

Question 1

What is the Beneish Model used for?

Answer 1

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

Question 2

What are the limitations of the Beneish model?

Answer 2

“relies on accounting data, which may not reflect economic reality”

Question 3

Define the Altman Z-Score Model

Answer 3

provides “probability that a firm will file for bankruptcy.” higher z-score = less likelihood of bankruptcy

Question 4

What is limitation of Altman Model?

Answer 4

it is a single-period model and does not capture changes in key variables over time. Also uses mostly accounting data

Question 5

What are the two elements of earnings quality?

Answer 5

1. “Sustainable: high-qual earnings tend to persist in the future” 2. “Adequate: high-qual earnings cover the company’s cost of capital”

Question 6

define sustainable persistent earnings

Answer 6

“earnings that are expected to recur in the future”

Question 7

Beneish Model Input DSRI: increase in DSRI is an indication of revenue inflation or deflation?

Answer 7

indication of revenue inflation (Days Sales Receivable Index)

Question 8

Beneish Model Input GMI: declining margins is more or less likely to manipulate earnings?

Answer 8

more likely to manipulate earnings when declining (Gross Margin Index)

Question 9

Beneish Model Input AQI: Increase could indicate more or less capitalization of expenses?

Answer 9

increase can indicate more/excessive capitalization of expenses (Asset Quality Index)

Question 10

Beneish Model Input SGI: Increasing or decreasing could indicate manipulated earnings?

Answer 10

not a measure of manipulation itself, growth companies tend to manipulate earnings to meet ongoing expectations (Sales Growth Index)

Question 11

Beneish Model Input DEPI: What does DEPI greater than 1 suggest?

Answer 11

suggests that assets “are being depreciated at a slower rate in order to manipulate earnings” (Depreciation Index)

Question 12

Beneish Model Input SGAI: increase or decrease may suggest manipulation?

Answer 12

“increase in SGA expenses might predispose companies to manipulation” (Sales Gen & Admin Expens Index)

Question 13

In the earnings regression model, alpha + (beta x earnings) + error term, what does a higher beta indicate?

Answer 13

higher beta value indicates higher persistence/recurring earnings

Question 14

define non-discretionary accruals

Answer 14

accruals that are part of normal business

Question 15

In the regression model for earnings where = alpha + (beta1 x cash flow) + (beta2 x accruals), is B1>B2 or

Answer 15

B1>B2

Question 16

When earnings are largely comprised of accruals, mean reversion occurs faster or slower?

Answer 16

faster and “even more so when accruals are mainly discretionary” (because they will eventually be paid off)

Question 17

what are the two major contributors to earnings manipulation?

Answer 17

1. revenue recognition issues and 2. expense recognition issues

Question 18

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?

Answer 18

AAP Compliant and decision-useful with high qual earnings is highest quality

Question 19

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)?

Answer 19

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

Question 20

higher growth rate of receivables relative to growth rate of revenues is good or bad?

Answer 20

bad - red flag for analyst

Question 21

Stable/improving profit margins but increase in non-current assets is good or red flag?

Answer 21

may be a warning sign that the company is capitalizing expenses to put them on balance sheet instead of expensing them

Question 22

Stable/improving profit margins but decrease in asset turnover is good or red flag?

Answer 22

red flag that there might be cost capitalization where instead of expensing, the company is adding as cap. cost

Question 23

Mgmt can affect cash flows via strategic decisions like timing issues. How does an analyst identify this?

Answer 23

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

Question 24

LVL 1 reminder - how are cash flows from sale of available-for-sale securities versus sale of trading securities treated in Cash Flow statement?

Answer 24

sale of available-for-sale securities = CFI while sale of trading securities = CFO

Question 25

What are three components of high qual bal sheet?

Answer 25

completeness, unbiased measurement and clarity of presentation

Question 26

Define completeness in balance sheet

Answer 26

when bal sheet includes off-bal sheet liabilities (e.g. Op Leases)

Question 27

Define unbiased measurement in balance sheet

Answer 27

balance sheet “reflects subjectivity in measurement of some assets/liabilities”

Question 28

Define clear presentation in balance sheet

Answer 28

companies can present items as single-line or grouped together. Clarity allows analyst to gather relevant info to make comparisons