Module I - Readings Flashcards
Summarize four key points from Blackwell’s article on “The Value of Auditor Assurance Evidence from Loan Pricing”
(1) Private firms are not required to purchase audits so their demand for auditor assurance is driven by the expected net benefits of the services purchased
(2) Auditor association leads to reduced interest rates on revolving credit agreements (used instead of term loans because they are relationship driven as opposed to transaction driven)
(3) Benefit of an audit decreases non-linearly as firm size increases (banks perceive larger firms as less risky borrowers so interest rate benefit of audit should decrease as firm size increases)
(4) Audited firms pay lower interest rates (25 basis points lower than those of unaudited firms), have higher total assets, and represent lower credit risks.
Summarize key points from Chaney’s article on “Shredded Reputation: The Cost of Audit Failure”
(1) Article investigates the impact of auditor reputation on market prices of an auditor’s clients around an audit failure
(2) Enron failure shredded AA rep and AA’s other clients experienced a neg. market reaction, suggesting investors downgraded the quality of audits performed by AA
(3) After AA admitted to shredding docs at Enron, its other clients lost on average $31.6m to $37.1m in the days following the announcement
In Magrath’s article on “Abusive Earnings Management and Early Warning Signs,” what did the earnings management schemes start out as? Why do some management teams believe it is good to manage earnings?
(1) ALL started by engaging in earnings management schemes designed to smooth earnings to meet internally or externally imposed earnings forecasts and analyst expectations
(2) Some management teams believe good business practice requires managers to manage earnings like the strategic timing of investments, sales, expenses, and financing decisions to maximize s/h value (volatile earnings streams typically lead to lower market valuations)
In Magrath’s article on “Abusive Earnings Management and Early Warning Signs,” what are five warning signs of abusive earnings management? Why do these warning signs stand out?
(1) Big bath restructuring charges
(2) Creative acquisition accounting
(3) Cookie jar reserves
(4) Immaterial misapplications of accounting principles
(5) Premature recognition of revenue
-These warning signs stand out because these forms of earnings management typically require pre-meditated use of sophisticated accounting techniques
In Magrath’s article on “Abusive Earnings Management and Early Warning Signs,” how does the SEC define earnings management?
-SEC documents refer directly to managers’ attempt to meet analysts’ expectations
In Magrath’s article on “Abusive Earnings Management and Early Warning Signs,” how would one go about detecting earnings management?
(1) Cash flows that are not correlated with earnings
(2) Receivables that are not correlated with revenues (could be a sign management is engaging in abusive earnings management by recording fictitious sales or inflating revenues and A/R)
(3) Allowance for uncollectible accounts that are not correlated with receivables (both Lucent and Cendant decreased their reserves for uncollectible accounts at times when revenues and A/R were rising)
(4) Reserves that are not correlated with B/S items (both Lucent and Cendant manipulated or overstated acquisition and purchase reserves)
(5) Questionable acquisition reserves
(6) Earnings that consistently and precisely meet analysts’ expectations (particularly growth expectations)
In Magrath’s article on “Abusive Earnings Management and Early Warning Signs,” whose job is it to understand the difference b/w good management and deceptive business practice?
- Auditors and investors need to be vigilant in their attempts to uncover abusive earnings management by understanding the difference b/w good management and deceptive business practices.
- SEC’s job is just to inform auditors on existing GAAP and auditing procedures.
In Bogoslaw’s article on “Earnings: Watch for These Red Flags,” what are two key areas that companies may fiddle with to manage earnings?
(1) Revenue Recognition - like premature recognition, or booking sales before prices have been fixed, contracts have been finalized, or goods and services have been delivered to customers
(2) Asset Impairment - watch for companies that have been very active in acquiring assets from other companies - you would start off expecting to see impairments and then would need to be convinced there’s good reason why a company has not booked an impairment esp. in this distressed economy
In Colter’s article on “Accrual Accounting Can Be Costly,” why can accrual accounting be costly?
Firms booking aggressively are 4x more likely to be sued by shareholders than less-aggressive peers
In Colter’s article on “Accrual Accounting Can Be Costly,” how do co. who accrue aggressively perform overall?
- Co. that use more accruals underperform companies with fewer accruals
- Those using the most accruals had poorer forward earnings and stock returns
- Also had more earnings restatements and SEC enforcement actions
From ASC 450-20 “Contingencies,” when shall a contingent liability be recognized?
(1) Info available prior to audit-report date indicates it’s probable that a liability had been incurred as of the B/S date, AND
(2) The amount of the loss is reasonably estimable
Define contingent liabilities.
Probable future sacrifices of economic benefit that result from past transactions or events.
From ASC 450-20 “Contingencies,” when a range of estimates is available but no amount within the range is a better estimate, what do you do?
Accrue the minimum
What is the interpretation of probable under ASC 450?
Probable = likely to occur
What is the interpretation of probable under ASC 410?
Probable = high degree of expectation
