week 24

Question 1

what are the four categories of accounting ratios

Answer 1

measures of performance
measures of working capital
measures of solvency and liquidity
measures of return on investment and risk

Question 2

what are measures of performance

Answer 2

measures how the company is performing financially
profits generated

Question 3

what are measures of working capital

Answer 3

indicates the ability of the company to manage elements of working capital effectively

Question 4

what are measures of solvency and liquidity

Answer 4

indicates the ability of the company to pay its liabilities as they fall due

Question 5

what are measures of return on investment and risk

Answer 5

indicates the ability of the company to generate returns for shareholders and the level of company risk

Question 6

what are the limitations of ratio analysis

Answer 6

no true comparator peer company
many companies operate in more than one industry
different accounting policies/estimates

data limitations
historical data
missing data
non-financial info not considered

ratios identify where you need to find additional info
meaningful interpretation requires understand of circumstance

Question 7

how do you compare financial statements

Answer 7

express each line item as a percentage
common size income statement expressed as % of revenue
common size B/S expressed as % of total assets
useful for identifying major changes

Question 8

how can you identify a company using financial ratios

Answer 8

consider characteristics of company/industry
does it have high levels of inventory?
is it capital intensive? (large non-current assets, alternatively labour intensive)
if the industry associated with high profit margins?

Question 9

when identifying companies from tables, what ratios do you focus on

Answer 9

profit margin %
inventory turnover times - how quickly you sell inventory
receivables turnover times - how many times a year receive payment from customers
current ratio and quick ratio - difference is the value of inventory

Question 10

what is a company’s financial reporting process

Answer 10

transactions and events
selection of accounting policies
application of accounting policies
estimates and judgements involved
disclosures about transactions, events, policies estimates and judgements

Question 11

what is creative accounting

Answer 11

accounting practices that follow the rules but make the most of loopholes in accounting standards to falsely portray a better financial image of the company

Question 12

does it matter that firms engage in creative accounting

Answer 12

yes - want a level playing field for all investors and investors and other market participants rely on the reported accounting numbers
no - if earnings management is observable at low cost to market participants, published information enables investors to adjust for earnings management

Question 13

what are the motives for creative accounting

Answer 13

to get around restrictions
to avoid gov action
to hide poor management decisions
to achieve sales or profit target
to attract new share capital or loan capital
to satisfy demands of major investors
to cover up fraud

Question 14

what are the methods of creative accounting

Answer 14

depreciation
inventory and COGS
provisions
capitalisation of costs
intangible non-current assets
front end revenue recognition

Question 15

how is depreciation used in creative accounting

Answer 15

choice of method
adjust expected economic lives, scrap values etc to achieve the depreciation charge desired

Question 16

how is inventory and COGS used in creative accounting

Answer 16

change between FIFO/weighted average to affect COGS figure as desired
remember changes of policies must be disclosed

Question 17

how are provisions used in creative accounting

Answer 17

estimate a lower or higher figure for warranties etc
overestimate provisions for reorganisation
underestimate provisions for bad debts

Question 18

how is capitalisation of costs used in creative accounting

Answer 18

rather than treating certain debits as expenses, treat them as assets eg research and development

Question 19

how are intangible non-current assets used in creative accounting

Answer 19

balance sheet not healthy looking enough
capitalise your brand name
goodwill on acquisition of one company by another

Question 20

how is front-end revenue recognition used in creative accounting

Answer 20

company’s revenues derive from sales of software plus three years worth of updates
when should income be recognised
why not recognise all the revenue when the software is sold, rather than over the three year period

Question 21

how can you use accruals and prepayments for creative accounting

Answer 21

move profits from one period to another
understate accruals and overstate prepayments - increase this years profit, decrease next years profit
understate prepayments and overstate accruals - decrease this years profit, increase next years profit

Question 22

what is real earnings management

Answer 22

practice of structuring transactions to meet financial reporting targets
decrease profits by - accelerating research and development and delaying sales
increase profits by - postponing research and development and accelerating sales

Question 23

what is fraudulent accounting

Answer 23

clear violations of GAAP with an intent to mislead users
includes: recording sales before they are realisable, recording fictitious sales, backdating sales invoices, overstating inventory by recording fictitious inventory

Question 24

what are health checks on financial statements

Answer 24

compare reported profits and operating cash flows
look at tax charge in relation to reported profits
check notes for changes in accounting policies and estimates
audit report