Reading 23 - Evaluating Financial Reporting Quality

Question 1

What is earnings quality mean ?

Answer 1

referes to the persistence and sustainability of a firm’s earnings

Question 2

How is Net Operating Assets calculated?

Answer 2

• Operating assets - Operating liabilities
• Operating assets ( = total assets - cash, cash equivalents & marketable securities)
• Operating liabilities ( = total liabilities - total debt (lt &st))

Question 3

What are 2 manipulation techniques involved with the balance sheet?

***keep

Answer 3

1. Off-balance-sheet financing
2. Goodwill

Question 4

Define what **Reporting Quality **is……

Answer 4

pertains to the information disclosed in financial reports

high quality reporting provides decision-useful information

Question 5

Define Earnings Quality….

Answer 5

the earnings and cash generated by the company’s actual economic activities and resulting financial condition relative to expectations of current and future financial performance

**high quality earnings reflect and adequate level of return on investment **

Question 6

What are the 2 questions an analyst needs to consider in regards to the Quality of Financial Reporting?

Answer 6

1. Are the financial reports GAAP compliant and decision-useful
2. Are the results of high quality? In other words, do they provide an adequate level of return, and are they sustainable?

Question 7

Define what **“Earnings Management” **is….

Answer 7

When earnings are “smoothed” to understate earnings volatility relative to the volatility if earnings were faithfully represented

Question 8

What are 4 issues that can affect the quality of Financial Reports?

Answer 8

1. Reported Amounts and Timing of Recognition
2. Classification
3. Quality issues and Mergers & Acquisitions
4. Financial Reporting that diverges from Economic Reality despite compliance with Accounting rules

Question 9

What are 3 ways that operating income and/or net income can be overstated?

Answer 9

1. Overstated or accelerated revenue recognition
2. Understated expenses
3. Misclassification of revenue, gains, expenses, or losses

Question 10

What are some things a firm can do to overstate operating income and/or net income?

Answer 10

• contingent sales
• channel stuffing
• bill & hold sales

Question 11

What are some _warning signs _that is firm is overstating operating income and/or net income?

Answer 11

• growth in revenue higher than industry peers
• increases and discounts to and returns from customers
• higher growth rate of receivables than revenue
• cash flow from operations is much lower than operating income
  *

Question 12

What are 3 ways that a firm can mistate balance sheet items to improve their financial results?

Answer 12

1. Over-or-Understatement of assets
2. Over-or-Understatment of liabilities
3. Misclassification of assets and/or liabilities

Question 13

What are some things a firm can do to mistate balance sheet items to improve their financial results?

Answer 13

1. Choice of models and model inputs to measure fair value
2. Classification from current to non-current
3. Over- or understating reserves and allowances
4. Understanding identifiable assets and overstating goodwill

Question 14

What is the Beneish Model?

Answer 14

Assesses the likelihood of misreporting by identifying quantitative indicators of earnings manipulation

Question 15

Is the Beneish model a logit or probit model?

Answer 15

Probit

Question 16

What is the equation for the Beneish Model?

Answer 16

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)

Question 17

Does a low Beneish M-score mean there is an increased chance of earnings manipulation?

Answer 17

No, the higher the number the more likely earnings manipulation is

Question 18

What are two external indicators of poor earnings quality?

Answer 18

1. Enforcement actions by regulatory authorities
2. Restatements of previously issued financial statements

Question 19

What is Tunneling?

Answer 19

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.

Question 20

What is Propping?

Answer 20

The practice of transferring managerowned entity’s resources to the public company to ensure its economic viability is referred to as Propping

Question 21

What is the Altman Model?

Answer 21

A model that assess the probability of bankruptcy

Question 22

What is the equation for the Zaltman Model?

Answer 22

Question 23

What are 2 shortcoming of the Zaltman model?

Answer 23

1. It is a single period model, taken at a point in time
2. That financial statements measure past performance and incorporate the going conern assumption

Question 24

What are 4 characteristics of high quality cash flow that established companies have?

Answer 24

1. Postive OCF (Operating Cash Flow)
2. OCF derived from sustainable sources
3. OCF adequate to cover capital expenditures,dividends and debt repayment
4. OCF with relatively low volatility (relative to industry participants)

Question 25

What is a Clean Audit Opinion?

Answer 25

States that the financial statements present the information fairly and in conformity with the relevant accounting principles