Lecture #7 (#6) Flashcards
What are Referral arrangements and Principal Protected Notes (PPNs)
Referral arrangements: Payments service providers make to third parties in return for recommending their services or sending customers to them
Principal Protected Notes (PPNs): guarantee your original investment will be returned after a set period (usually 3–10 years), regardless of market performance. If the market does well, you share in the gains.
- PPNs protect your principal by using insurance and invest in underlying assets like indexes, mutual funds, or hedge funds.
- They’re typically sold by insurance companies and are costly to purchase.
What are Hedge Funds and Mortgage-Backed Securities (MBS)
Hedge Funds – pool money from accredited investors and are managed by professionals. Unlike mutual funds, they face fewer regulations, can’t advertise, and their managers don’t need to be registered advisors.
- They take high risks—using strategies like short selling, options, futures, margin trading, and currency bets (which mutual funds can’t do).
- They charge high fees: typically 20% of profits plus 1–2% annual management fees.
Mortgage-Backed Securities (MBS) – Bonds backed by bundled home loans, where investors receive payments as borrowers repay their mortgages.
What are Limited Partnerships (LPs) and Exchange-Traded Notes (ETNs)
Limited Partnerships (LPs) – Business structures with general partners (who manage and assume liability) and limited partners (who invest but have liability only up to their investment).
Exchange-Traded Notes (ETNs) – Unsecured debt securities issued by banks, tracking an index or asset, but with no ownership of underlying securities and subject to issuer credit risk.
What are Charitable Donation Funds
Charitable Donation Funds: (like donor-advised funds) let individuals or organizations donate assets to support specific charities.
- Donors get immediate tax benefits but can’t be the beneficiaries.
- Professional managers handle the funds.
- Donors give up ownership of contributions but can advise on investments and which charities receive the funds.
- These funds are heavily regulated.
Whata are violations an employee can make when leaving a company?
Leaving a Company can be a difficult situation. While still employed and paid, the employee must continue acting in the company’s best interest.
Violations of loyalty include:
- Misusing confidential info
- Taking trade secrets
- Soliciting clients
- Copying client lists
- Taking company data
There’s often confusion over what belongs to the company vs. the departing employee.
What is the source of accounting distortions: ?
“Accurals”
- Accruals are accounting adjustments for revenue or expenses recorded before cash changes hands. For example, income earned in December but paid in January is still recorded in December.
- Self-reversing means these entries must be undone in future periods—timing can shift, but the total amount stays the same.
- Example: A company may report extra revenue in Q4 to boost results, but it must reverse it in Q1, so the boost is temporary.
- Why it matters: Managers may use accruals to make earnings look better short-term, but the true numbers eventually surface.
why do managers have incentives to manipulate accounting earnings? Whats the general reason and the specifc reasons?
sometimes making them look better (up) or worse (down) (!)—depending on their goals
- Accounting-based bonuses: Managers may boost earnings to hit bonus targets.
- Equity-linked compensation: If managers are paid in stock, they may raise earnings to increase the stock price (as long as the market is “fooled” by the numbers).
- Debt contracts: Some loans require the company to maintain certain earnings levels—so managers might inflate profits to avoid breaking those rules.
- Union contracts: Managers might lower earnings to appear weaker during union negotiations.
- Management buyouts: If managers plan to buy the company, they may deflate earnings to make the company look cheaper.
what are the ways managers can do to manage/manipulate earnings ?
Managers can manipulate earnings through various tactics, such as:
- Recording revenue too early (e.g., before payment is due or services are complete)
- Booking one-time gains by selling undervalued assets
- It means a company makes a quick profit by selling something it owns for more than it’s worth on paper
- Delaying expenses by wrongly capitalizing them
- a company hides costs by recording them as assets instead of expenses, making profits look higher than they really are
- Stretching out expense amortization over too many years
- Ignoring or underestimating future liabilities
- Using mergers and acquisitions to mask asset revaluations or create hidden reserves
- to quietly change asset values or stash extra profits
What is Jones (1991) Model
Developed by Jennifer J. Jones, the model is a way to spot earnings manipulation by estimating what a company’s normal (honest) accounting adjustments should look like.
- It uses a formula that looks at changes in sales and property, plant & equipment (PP&E) to predict what accruals (non-cash accounting adjustments) should be.
- Different-sized companies naturally have different revenue, expenses, and asset levels. To make fair comparisons across companies, we standardize the data by dividing each variable (like revenue change or PP&E) by total assets.
- Widely used to detect earnings management by comparing actual accruals to expected ones.
What are Cookie Jar Reserves and a Big Bath?
Cookie Jar Reserves are accounts set up to cover future expenses, often during M&A or restructuring.
- Example: A company reserves for 10,000 layoffs but only lays off 5,000—later reversing the excess reserve to boost future earnings.
Big Bath is a strategy where a company intentionally reports a large loss in one period
- usually during a bad year or major event (like a new CEO, restructuring, or acquisition). The idea is to “clear the decks” by dumping all the bad news into one period
- After the “bath,” future periods look cleaner and more profitable
What is Aggressive Revenue Recognition and Channel Stuffing
Aggressive Revenue Recognition involves recording revenue earlier than allowed to inflate earnings.
- Channel Stuffing: Shipping products likely to be returned just to book revenue now.
What is Special Purpose Entity?
Special Purpose Entity (SPE)
is a separate legal entity a company creates to move assets or liabilities off its own books, often to hide debt or risk.
- The debt used to finance the SPE stays off the parent’s books, but earnings still flow back to the parent.
- This hides risk and inflates performance—example: Enron.
What are Quality of Earnings? Also what is Earnings Response Coefficients (ERCs)
Quality of Earnings refers to how sustainable and repeatable a company’s earnings are.
- Analysts rely on past earnings to predict future performance.
- If investors believe the earnings growth is long-term, the stock price reacts more positively.
Earnings Response Coefficients (ERCs) measure how strongly the market reacts to earnings surprises—indicating whether the market trusts the earnings quality.
What is the Beneish (1999) Model
Beneish (1999) Model
- Created by Messod D. Beneish, this model detects earnings manipulation by analyzing financial ratios.
- It looks beyond earnings to spot red flags like:
- Growing Days Receivable compared to Sales
- Slowing earnings growth
- Declining profitability
- Increased capitalization of expenses
