Session 7

Question 1

Incentives for distortions

Answer 1

1. Taxes
2. Executive compensation e.g.. stock options profit related bonuses
3. Profit storing in order to smooth volatile earnings in bed years
4. Taking a bath and blaming predecessors
5. IPOs, takeovers, LBOs and MBOs
6. Minimising capital costs&avoidance of breached debts covenants

Question 2

What is a sale?

Answer 2

Order revived 
Good received 
Invoice issued 
Cash received 
Goods returned

Question 3

Potential red flags

Unexplained/unusual/unexpected

Answer 3

• Unexplained changes in accounting policy
• Unexplained transactions that boost profits
• Unusual increases in trade receivables w/o changes in sales
• Unusual increases in inventory in relation to sales
• Unexpected large write offs and impairments

Question 4

Potential red flags

Answer 4

• Increasing gap between reported profit and cash flow from operations
• Excessive use of special purpose entities, joint ventures and sale of receivables with resources
• Large year end adjustments
• Qualified audit opinions, or chnage in auditors that is not wel justified
• Poor internal governance mechanisms
• Too many related party transactions inflating net income/profit

Question 5

Checking for red flags - changes in accounting policy

Answer 5

Check statement of accounting policy

• compare with previous year
• recognition of sales
• asset valuation methods

Question 6

Checking for red flags - unexplained transactions

Answer 6

If complex - why?
Asset swaps
Debt for equity swaps
ENRONS shareholders weren’t shown all liabilities from subsidiary companies

Question 7

Provision for bad debt

Answer 7

• account receivables - credit sales - not received
• generous credit terms may increase sales
• sales recognised in the income statement should be adjusted by a provision for bad debtors
• unexplained changes in inventory

Question 8

Off-balance sheet items

Distortion of liabilities

Answer 8

Leases and IAS17 
Operating leases are not capitalised 
Finance leases are capitalised 
SPEs and JVs 
Sale and leaseback arrangements

Question 9

Distortion of liabilities

Accounts receivables

Answer 9

A source of financing that increases cash flow is:
Factoring with resources
Non-resource factoring
May reduce the profit margin
Increase the profit margin
Increase the heating if there is doubt about collectability of receivables factored with resource

Question 10

Impairments

Amortisation and impairment

Answer 10

Hugh book value of asset base has an effect on

• Cash flow return on assets
• Return on assets
• Return on equity
• total assets/total equity ie gearing

Question 11

Predicting impairment - warning signs

Answer 11

Asset turnover less then expected
ROA < WACC
ROE < cost of equity
Decline in market value of similar assets

Question 12

Large year-end adjustments

Answer 12

Interim reports not audited
If there are short term incentives to flatter interim figures
Adjustments are likely to appear in the audited annual figures

Question 13

Qualified audit or change in auditors

Answer 13

• Qualified audits are not always that easy to spot due to:
  Overly legalistic/boiler plate language
  Need to read carefully and think about what is / not said
• Change in audits
  Could signal opinion shopping
  Also recommend to rotate auditors periodically

Question 14

Poor internal governance mechanisms

Answer 14

• Chairman is also CEO
  incestuous board lacking independence
• Chairing/attending remuneration committees when own remuneration is being discussed
• Dual class shares

Question 15

Related party transactions

Answer 15

Distortion of reported sales
Do these inflate / create profits?
When should a sale be recognised?

Question 16

Manipulating sales

Answer 16

Channel stuffing
Sales/returns
What if distributors is a joint venture
Acceleration of sales
Warning sign may be large increase in sales in the final quarter for non-seasonal business
Over generous and unsustainable credit terms - increase in debtor >sales