Session 7 Flashcards
Incentives for distortions
- Taxes
- Executive compensation e.g.. stock options profit related bonuses
- Profit storing in order to smooth volatile earnings in bed years
- Taking a bath and blaming predecessors
- IPOs, takeovers, LBOs and MBOs
- Minimising capital costs&avoidance of breached debts covenants
What is a sale?
Order revived Good received Invoice issued Cash received Goods returned
Potential red flags
Unexplained/unusual/unexpected
- 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
Potential red flags
- 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
Checking for red flags - changes in accounting policy
Check statement of accounting policy
- compare with previous year
- recognition of sales
- asset valuation methods
Checking for red flags - unexplained transactions
If complex - why?
Asset swaps
Debt for equity swaps
ENRONS shareholders weren’t shown all liabilities from subsidiary companies
Provision for bad debt
- 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
Off-balance sheet items
Distortion of liabilities
Leases and IAS17 Operating leases are not capitalised Finance leases are capitalised SPEs and JVs Sale and leaseback arrangements
Distortion of liabilities
Accounts receivables
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
Impairments
Amortisation and impairment
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
Predicting impairment - warning signs
Asset turnover less then expected
ROA < WACC
ROE < cost of equity
Decline in market value of similar assets
Large year-end adjustments
Interim reports not audited
If there are short term incentives to flatter interim figures
Adjustments are likely to appear in the audited annual figures
Qualified audit or change in auditors
- 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
Poor internal governance mechanisms
- Chairman is also CEO
incestuous board lacking independence - Chairing/attending remuneration committees when own remuneration is being discussed
- Dual class shares
Related party transactions
Distortion of reported sales
Do these inflate / create profits?
When should a sale be recognised?
