FSA: Financial Reporting Quality Flashcards
Incentives to Manipulate Earnings =
Overstate net income: meet earnings expectations, remain in compliance with lending covenants, higher incentive compensation
Understate net income: obtain trade relief (quotas, protective tariffs), favourable terms from creditors, favourable labor union contracts
Managing BS: manipulate appearance of solvency (less or more through adjusting assets/liabilities), performance ratios (lower assets = higher ROA, asset turnover)
Low Quality Earnings =
firm exploits GAAP to ‘meet the spirit, not the letter’ of the standards - earnings quality usually deteriorates. Activities:
- Selecting acceptable accounting principles that misrepresent a transaction
- Structuring transactions to achieve a specific outcome
- Using aggressive or unrealistic estimates and assumptions
- Exploiting the intent of an accounting principle
3 Conditions for Fraud =
SAS #99, by AICPA
Opportunity (weakness in internal controls), Incentives & Pressure, Attitudes/Rationalization
Incentives and Pressures (x4) =
- Threats to financial stability or profitability (as a result of economic, industry, or firm conditions)
- Excessive third party pressures on management
- Personal net worth of management or the BOD is threatened
- Excessive pressure on management or operating personnel to meet internal financial goals
Opportunities for Fraud (x4) =
- The nature of the firm’s industry or operations involve: grey areas around transactions, auditing, terms and conditions, estimates, overseas transactions/bank accounts/related parties
- Ineffective manageent monitoring from: ineffective oversight by BOD/audit committee, single person/group dominates management.
- Complex/unstable organizational structure (including unusual legal entities/authority lines, high turnover)
- Deficient internal controls (ineffective systems, high turnover of relevant personnel)
Attitudes and Rationalizations (x9) =
- inappropriate ethical standards
- Excessive infuence of nonfinancial management in the selection of accounting standards/estimates
- History of being a badass (BOD/mgmt)
- Mgmt obsession with increasing stock price
- Making commitments to third parties to achieve agressive results
- Failing to correct known reportable conditions in a timely manner
- inappropriately minimizing earnings for tax purposes
- Mmgt’s use of MATERIALITY to justify questionable accounting methods
- Strained rship between management and auditors
Agressive revenue recognition =
recognizing revenue too soon.
including:
- bill-and-hold arrangements - RR before goods are shipped
- Sales-type leases whereby the lessor recognizes sale/profit at the start of the lease
- RR before fulfilling all terms of sale
- RR from swaps/barter transactions from third party
Different growth rates of OCF and earnings =
relationship should be STABLE.
Growing earnings and negative/declining OCF may show RR too soon or delayed expense recognition.
Rship can be measured with CASH FLOW EARNINGS INDEX (OCF/Net Income) - consistently less than 1 or declining over time is fuckin suspicious.
Abnormal sales growth =
compared to peers, industry, economy.
may be from superior management or products, or accounting irregularities.
Receivables growing faster than sales, indicated by an increasing average collection period, may be a sign of agressive revenue recognition.
Abnormal Inventory growth (compared to sales growth) =
may indicate obselete products or poor inventory management, or overstating inventory, decreasing COGS and thus increasing increasing gross and net profit.
note: ending inventory = starting inventory + purchases - COGS
So if it is too high either purchases are overstated or COGS is understated
Boosting Rev w/ non operating income and nonrecurring gains =
some firms try and classify these as revenue - moving them ‘up’ the income statement.
net income is the same BUT revenue growth is higher
Delaying expense recognition =
by capitalizing operating expenditures the firm delays expense recognition.
Increase in assets with unusual names like ‘deferred marketing charges’ or ‘deferred customer acquisition costs’
*Abnormal use of leases by lessees =
can be used to reduce ratios and reduce perceived leverage (through off balance operating leases)
compare use of leasing as a financing source to industry peers - consider treating operating leases as capital leases.
Hiding Expenses by classifying them as extraordinary or non recurring =
this moves expenses down the balance sheet - boosting income from continuing operations.
LIFO Liquidations =
If a LIFO firm sells more inventory than it purchases when prices are rising = COGS decreases, profit increases, taxes increase.
These profits are not sustainable as the firm will RUN OUT OF INVENTORY
LIFO Reserve : difference in inv. between FIFO and LIFO - if declining this signals Lifo Liquidation.
This must be disclosed by LIFO firms, and should disclose the effects of liquidation in footnotes.
