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Question 1

Moody’s credit analysis focuses on the fundamental factors and key business drivers relevant to an issuer’s long-term and short-term risk profile. The foundation of Moody’s methodology rests on two basic questions:

Answer 1

1. What is the risk to the debtholder of not receiving timely payment of principal and interest on this specific debt security?
2. How does the level of risk compare with that of all other debt securities?

Question 2

Actions to reduce earnings management and accounting fraud - What are some key actions done in the last decades to reduce earnings management and accounting fraud?

Answer 2

Key mechanisms introduced after 2001 have been to tighten regulations – came after the IT bubble and Enron scandal:
1) More detailed accounting rules, and the discussion of ‘true and fair’ view
2) Improved enforcement and oversight boards
3) Stricter regulation of auditors
4) Increased requirements for corporate governance, some hard law and
others soft law

Question 3

Assets consist of operating non-current and current assets, and financing assets. What are the different sources of financing these?

Answer 3

Equity, non-current and current financing (interest-bearing) liabillities and operating liabilities

Question 4

By what ability is a firm’s liquidity risk influenced by?

Answer 4

Its ability to generate positive net CF in both the short and long term.

Question 5

Define accounting quality by the two fundamental questions

Answer 5

Is the financial reporting a faithful representation: complete, neutral, and free from error
Relevant information for users: information about the firm’s underlying economic position and performance’

There are different ways for defining accounting quality. The most common is Gaynor and it also depends on the audience (users) “more complete, neutral and free from error and provides more useful predictive or confirmatory information about the firm’s underlying economic position and performance’” Gaynor et. al. (2016)

Question 6

Define accounting quality from the analysts

Answer 6

“the extent to which an issuer’s reported historical performance is a sound basis for forecasting its future financial performance.”

Question 7

Describe the course of the rating process, a Moody’s analyst

Answer 7

• Gathers information sufficient to evaluate risk to investors who might own or buy a given security, - evaluate the risk
• Develops a conclusion in committee on the appropriate rating,
• Monitors the security on an ongoing basis to determine whether the rating should be changed, and
• Informs the marketplace of Moody’s actions.

Question 8

DuPont model– three categories when you grow EVA

Answer 8

Changes in core business: operations, investments in existent businesses, and investments in new business segments

• Transitory items: country changes its tax rate, accounting principles, accounting estimaties
• Financial items (WACC): capital structure, interest rate, risk, and tax rate

Question 9

Example of financial performance measures (incentive plans) and what are the issues with them?

Answer 9

• Revenue growth
• EBITDA
• EBIT
• Consolidated Profit
• eps (earnings per share)
Issues
• Change in accounting
• ”Extra-ordinary” items
• Alignment, example EPS and share buy-backs (that impacts the EPS)

Question 10

Example of non-financial performance measures (incentive plans) and the issues?

Answer 10

• Customer satisfaction
• Customer retention
• Employee satisfaction
• Specific activities (for example Selling Russian operation)

Issues
• How to measure
• Judgments (based on judgements)

Question 11

Example of stock returns measures (incentive plans)

Answer 11

• Absolute returns
• Relative returns
  * to market
  * to comparable
• Short and long-term

Question 12

Explain the normal, flat, and inverted yield curve

Answer 12

Normal - increasing interest rate over time
Flat - no difference between time and interest rates
Inverted - the long-term interest rate is lower than the short-term interest rate

Question 13

FFO (funds from opeations) formula (S&P)

Answer 13

EBITDA - net interest expense - current tax expense (plus or minus all applicable adjustments)
– here you have paid the interest and the tax, but you have not made any investments yet so it is a proxy for recurring CF.

Question 14

Formula for cost of equity (re)

Answer 14

re = rf +Be ( rm - rf )

Question 15

How can you distinguish from the SML if an asset is under- or overvalued

Answer 15

Any asset above the SML is undervalued, and any asset below the SML is overvalued

Question 16

How is earnings management defined?

Answer 16

”Earnings management occurs when managers intentionally use judgement in financial reporting and in structuring transactions to alter financial reports to mislead some stakeholders about the underlying economic performance of the firm or to influence contractual outcomes that depend on reported accounting numbers.”

Question 17

WACC formula

Answer 17

WACC = E/V * re + D/V * rd* (1-tax rate)

Question 18

What are the choices of performance measures for incentive plans?

Answer 18

Stock returns, financial performance measures, and non-financial performance measures

Question 19

What are the events/circumstances when earnings management is more frequent?

Answer 19

1. Financial distress
2. Capital market events – if you were to acquire another company using your own shares then it is beneficial if your shares are valued high
3. Change of management – management want to take out all losses and make provisions when there is a new management entering
4. Change of auditors
5. Changes in rules and regulations
6. Implementation of incentives for managements