Test 2

Question 1

Define the statement of cash flows

Answer 1

The only financial statement showing cash inflows and outflows over the accounting period. Evaluates cash flows in the groups of operating, investing, and financing.

Question 2

What does it show to analysts regarding the business?

Answer 2

Shows business ability to generate future cash flows, meet obligations requiring cash, obtain/need for future financing, manage investing activities, and develop and manage financing strategies.

Question 3

What are the groupings of cash inflows and outflows that appear on the statement of cash flows?

Answer 3

Operating, Investing, Financing

Question 4

What are Operating cash flows?

Answer 4

Cash flows from transactions related to producing and selling goods and services

Question 5

What are Investing cash flows?

Answer 5

Buying, selling, disposing of non-cash assets, not cash equivalent securities, productive long term assets

Question 6

What are Financing cash flows?

Answer 6

Borrowing from creditors and repaying principle and interest to creditors, raising capital from owners

Question 7

What are the two methods that can be used to develop the statement of cash flows?

Answer 7

Direct, Indirect

Question 8

What is the direct method for Operations?

Answer 8

Cash received from sale of goods and services-cash spent on operating expense=net cash flow from operations

Question 9

What is the direct method for Investing?

Answer 9

Cash received from sales of investments, property, equipment, and intangible assets-cash invested in investments, property, equipment and intangibles=net cash flow from investing

Question 10

What is the direct method for Financing?

Answer 10

Cash received from the sale and debt of equity securities-purchases of equity securities, retiring debt instruments, paying dividends

Question 11

What is the indirect method?

Answer 11

A=L+SE, Cash+NCA=L+Se,

1. Change in cash=change in L-Change in NCA+change in SE
2. Net cash flow-reorder changes in these balance sheet accounts as from operations, financing, and investing
3. Adjustments: substitute net income and dividends for retained earnings, add back depreciation and amortization to net income, remove non-recurring/non-operating cash flows from net income

Question 12

What are the general opportunities which management has to influence reported earnings in a manner that is not truly reflective of the firm?s performance or financial health?

Answer 12

Earnings Management

Question 13

Be familiar with and understand the checklist of areas to examine order to evaluate the quality of reported earnings or financial statements.

Answer 13

Key Metrics

Question 14

What is Earnings Management?

Answer 14

Manipulation of a companies financial statement to make them look more desirable

Question 15

What are Key Metrics?

Answer 15

Ratio analysis, deals with inventory more than assets. Manipulation of the ratios.

Question 16

What are sources of information available to analyst?

Answer 16

Proxy Statements, Auditior’s Report, Management Discussion and Analysis, Supplimental Schedules, Forms 10-K and 10-Q

Question 17

What are Proxy Statements?

Answer 17

Statement required by a firm when soliciting shareholder votes. Contains useful information about the board of directors, director and executive compensation, option grants, audit related matters, related party transactions, and proposals to be voted on by shareholders. Important in assessing who manages the firm and how it is managed, potential conflict of interest issues

Question 18

What is an Auditor’s Report?

Answer 18

Contains the expression of opinion as to the fairness of the financial statement presentation. Many reports are unqualified meaning that in the opinion of the auditor the financial statements present the financial statements fairly. If it is qualified it means they believe there is unethical behavior within the firm.

Question 19

What is Management Discussion and Analysis?

Answer 19

Section of the annual report required by SEC, discusses qualitative aspects of the business that may not be represented in financial statements. Included projections

Question 20

What are Supplimental Schedules?

Answer 20

Provide breakdown of key financial figures by operating segment if business is involved in many different areas of the business and this may not be clearly represented elsewhere

Question 21

What are 10-K and 10-Q Forms?

Answer 21

10-K-annual document filed with SEC by companies that sell securities to the public, similar to the annual report issued to shareholders. 10-Q-less extensive, provides quarterly financial information

Question 22

What are Creditors?

Answer 22

Want to know the health of the company in order to be reassured that they will be paid back (concerned with how much debt compared to assets)

Question 23

What are Investors?

Answer 23

Want to know if it is a good investment and if they will make money (Each investor is unique so areas of interest can be different, but most are concerned with the ratios)

Question 24

What is Management?

Answer 24

What can they improve on (concerned with the overall big picture)

Question 25

What are Regulators?

Answer 25

Concerned that the business is being run legally

Question 26

What are the tools and techniques used by the analyst (e.g., common-sized financial statements, financial ratios)?

Answer 26

Create ratios and understand common size financial statements (using percentage comparisons with industry average)

Question 27

Financial ratios can be divided into six groups. What are they? (Ratio, not formula)

Answer 27

liquidity ratios, cash conversion cycle, activity ratios, leverage ratios, profitability ratios, and market ratios

Question 28

What is the Cash Conversion Cycle?

Answer 28

The normal operating cycle of a firm that consists of buying or manufacturing inventory with some purchases on credit and the creation of accounts payable: selling inventory with some sales on credit and the creation of accounts receivable: and collecting the cash. The amount of days it takes to get the cash converted from credit

Question 29

What is the financial leverage index and how is it calculated and used?

Answer 29

Indicates whether a firm is employing debt successfully. Return on equity/adjusted return on assets

Question 30

What is the Du Pont system? What does it do, how is it used and interpreted?

Answer 30

Du Pont looks at the interrelationships among the ratios, the ultimate goal is to see the influences on return on equity, benefits: identification of strengths and weaknesses, traces cause and effect, and allows you to do what if analysis. Analytical technique used to evaluate the profitability and return on equity. Net profit margin*total asset turnover=ROA, ROA*financial leverage=ROE

Question 31

What is the role of accrual accounting and earnings management via revenue and expense recognition?

Answer 31

Accrual basis of accounting: method of earnings determination where revenues and expenses are recognized in the period when earned regardless of when cash is received. Makes you more susceptible to earnings management because it allows for revenues or expenses to be recorded when they have not actually happened

Question 32

What is the general approach of manipulating earnings through the recognition of revenues and expenses?

Answer 32

a. Recording earnings too soon
i. Record sale before contractual obligations are satisfied
ii. Expand the number of days in the month
b. Record revenue in excess of percent completed
i. Long term contract/project capture revenue in excess of percent completed
c. Record revenue before buyer acceptance
d. Record bogus revenue
i. Release money from reserve accounts and treat it like revenue (called transactions lacking economic substance)
ii. Transactions lacking arms length (trading partners have a relationship)
e. Recording receipts from non-revenue transactions
f. Inflating revenue
g. Report revenue from one time or unsustainable transactions as operational revenue
i. Sales of property plant and equipment
h. Classifying expenses and assets inappropriately on the balance sheet
i. Shifting operating expenses below the line (out of operations)
i. Write off inventory and equipment
ii. Take restructuring charges
j. Record investment income as operational
k. Shift current expenses to future time periods
l. Hide or not recognize expenses
m. Shift current income to later periods
n. Shift future expenses to earlier periods

Question 33

How can manipulations be discovered?

Answer 33

a. Cash flow from operations (CFFO) lags net income
b. Shift cash inflows to operations
i. Take out bank loan secured by own asset (often inventory)
ii. Loan proceeds cash inflow in operations payments cash outflow in financing
iii. Use special entities by parent firm-cosign loans for the entity. The entity purchases goods from parent. These purchases increase cash flows from operations for parent and expenses of loan are in financing
c. Sell off accounts receivable before collection date
i. Quick increase in CFFO

Question 34

What is the general approach of manipulating cash flows?

Answer 34

Earnings Management

Question 35

How can manipulations be discovered?

Answer 35

Audit or Whistle Blower