Reading 11 - Evaluating Financial Reporting Quality Flashcards
What is good earnings quality mean ?
- Return on equity
- Sustainable (vol = risk)
How is Net Operating Assets calculated?
- Operating assets - Operating liabilities
- Operating assets ( = total assets - cash, cash equivalents & marketable securities)
- Operating liabilities ( = total liabilities - total debt (lt &st))
What are 2 manipulation techniques involved with the balance sheet?
***keep
- Off-balance-sheet financing
- Goodwill
What is good reporting quality?
- Decision useful information
- Accurate (GAAP compliant) and relevant
- Enables assessment
high quality reporting provides decision-useful information
Define what **“Earnings Management” **is….
When earnings are “smoothed” to understate earnings volatility relative to the volatility if earnings were faithfully represented
What are 4 issues that can affect the quality of Financial Reports?
- Measurement and Timing of Recognition
- Classification
- Misstating profitability
- Financial Reporting that diverges from Economic Reality despite compliance with Accounting rules
What are 3 ways that operating income and/or net income can be overstated?
- Overstated or accelerated revenue recognition
- Understated expenses
- Misclassification of revenue, gains, expenses, or losses
What are 3 things a firm can do (special names) to overstate operating income and/or net income?
- contingent sales
- channel stuffing
- bill & hold sales
What are some _warning signs _that is firm is misstating profitability?
- growth in revenue higher than industry peers
*higher rate of customer returns - higher Q4 revenues
- higher growth rate of receivables than revenue
- cash flow from operations is much lower than operating income/earnings
- unexplained boost in operating margins
- inconsistent classifications
- aggressive accounting assumptions
- exec comp tied to financial results
What are 3 ways that a firm can mistate balance sheet items to improve their financial results?
- Over-or-Understatement of assets
- Over-or-Understatment of liabilities
- Misclassification of assets and/or liabilities
What are some things a firm can do to mistate balance sheet items ?
- Choice of models and model inputs affecting ets. values
- Classification from current to non-current
- Over- or understating reserves and allowances
- Understanding identifiable assets and overstating goodwill in business combinationd
Warning signs of misstated asstes/liabilites:
- inconsitency of model inputs for valuation of assets/liabs
- typical current assets treated as noncurrent
- Allowances/reserves out of line with peers or fluctuating
- High GW relative to total assets
- Use of SPEs
- Off b/s liabs
Fluctuating DTA/L
Mechanisms to overstate CFs
Warning sings of overstated CFs
Business combo issues
What is the Beneish Model?
Assesses the likelihood of misreporting by identifying quantitative indicators of earnings manipulation
Is the Beneish model a logit or probit model?
Probit
What is the equation for the Beneish Model?
M-score = -4.84 + 0.92(DSR)+0.528(GMI)+0.404(AQI)+0.892(SGI)+0.115(DEPI)-0.172(SGAI)+4.67(ACRRUALS)-0.327(LEVI)
Does a low Beneish M-score mean there is an increased chance of earnings manipulation?
No, the higher the number the more likely earnings manipulation is
What are two external indicators of poor earnings quality?
- Enforcement actions by regulatory authorities
- Restatements of previously issued financial statements
What is Tunneling?
The practice of t_ransferring public company resources_, e.g. through excessive compensation, direct loans, or guarantees, t_o managers and/or shareholders_ is referred to as tunneling.
What is Propping?
The practice of transferring managerowned entity’s resources to the public company to ensure its economic viability is referred to as Propping
What is the Altman Model?
A model that assess the probability of bankruptcy
What is the equation for the Zaltman Model?
