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14 Cards in this Set
- Front
- Back
Quality |
Reporting quality-high quality reporting provides decision useful information, information that is accurate as well as relevant. High-quality earnings refers to a high level of earnings, meets the required return on Investments, as well as sustainability of earnings. What cannot have both low-quality reporting and high-quality earnings. |
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Problems affecting quality |
Measurement and timing issues Classification issues Timing / measurement issues affect multiple financial statement elements, classification issues typically affect just one element. |
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Biased accounting |
Misstating profitability-aggressive Revenue recognition. Channel stuffing, which is aggressively selling products distributors on generous terms such as lax return policies. Bill and hold sales, where economic title may not truly past to the customers. Lessor use of finance lease classification Making non-operating Revenue operating Channeling gains through net income and losses through oci Misstated profitably? Revenue growth higher than peers, receivables growth higher than Revenue growth, High rate of customer returns, High proportion of Revenue received in 4th quarter, unexplained boost to operating margin, operating cash flow lower than operating income, inconsistency and operating versus non-operating classifications over time, aggressive accounting assumptions, executive compensation tied to results Misstating assets and liabilities? Inconsistent valuation model Imports for assets vs. liabilities, typically current assets classified as non-current, allowances and reserves differ from peers and fluctuates, hi Goodwill, use of spes, large fluctuation in deferred tax assets liabilities, large off-balance-sheet liabilities Overstating operating cash flows-managing activities to affect cash flow operations, stretching payables, misclassifying investing cash flow as cash flow from operations Warning signs of overstated cash flows Increase in payables combined with decreases in inventory and receivables, capitalized expenditures, which flow through investing activities, increases in Bank overdraft |
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Acquisition method accounting |
Companies with declining operating cash flow may be motivated to acquire other cash generating entities. Paying for an acquisition in stock would bypass the cash flow statement all together. Management May pursue aggressive Accounting in order to inflate their stock price prior to acquisition. And I just pursue Acquisitions to hide pre-acquisition accounting irregularities. Acquiring companies often underestimate the value of identifiable net assets there by overestimating Goodwill on acquisition. Fair value adjustments for identifiable net assets typically result in excess depreciation which reduces profits for future reporting. |
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Steps in evaluating the quality of reports |
Understand the company its industry and accounting principles Understand management, Fair compensation, Insider trades and related-party transactions Identify areas of accounting vulnerable to subjectivity A cross-sectional and time series comparisons Check for warning signs Check for shifting of profits and revenues to specific parts of the business a firm wants to highlight Evaluate the likelihood of misreporting using quantitative tools |
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Beneish model |
Probit regression model that estimates the probability of earnings manipulation using 8 dependent variables. The end score determines the possibility of manipulation higher values indicating higher probabilities. M score > -1.78 higher than acceptable possibility of manipulation Days sales receivable index, ratio of days sales receivable in year t relative to year T minus one. A large increase could be Revenue inflation. Gross margin index, ratio of prior-year to that of current year. When this ratio is greater than 1 the margin has a deteriorated, making earnings manipulations more likely. Asset Quality Index, ratio of non-current assets other than pp&e to total assets in year relative to Prior year. This could indicate excess capitalization. Sales growth index, ratios of sales in current year relative to Prior year period growth companies tend to find themselves Under Pressure to manipulate. Depreciation index, ratio of depreciation rate in prior-year to current year. Greater than one suggest assets are being depreciated slower to manipulate earnings Sg&a expenses, ratio as a percentage of sales in current year relative to Prior year. Increases might predispose manipulation Accruals-income before extraordinary items less cash flow from operations over total assets. Leverage index, ratio of total debt to total assets and current year to Prior year. |
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Altman model |
Probability of bankruptcy Generate the Z score using five variables Net working capital as a proportion of total assets, retained earnings as a proportion of total assets, operating profit at the proportion of total assets, market value of equity relative to book value of liabilities, and sales relative to total assets. Each variable is positively related to the z-score, and a higher z-score is better, less likelihood of bankruptcy. It is a single. Static model and does not capture changes over time |
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Revenue recognition issues |
Concerned by quantity and quality Channel stuffing and Bill in a hold should be considered Higher growth rate of receivables relative to the growth rate of revenues is a red flag Increasing Day sales outstanding indicates poor quality |
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Expense capitalization |
Understand the companies capitalization policies and depreciation policies Evaluate changes in non-current assets over time. Civil are improving profit margins coupled with a buildup of non-current assets is a warning sign. Rising Revenue coupled with declining asset turnover is another warning sign Check for related-party transactions. The company may be shifting resources to privately held companies |
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Cash flow quality |
Consider the corporate life cycle and Industry norms. Early-stage startups have negative operating and investing cash flows in high financing in flows. Mature form negative cash flowcoupled with positive financing cash flow would be problematic High-quality cash flow is characterized by positive ocf drive from sustainable sources and is adequate to cover Capital expenditures dividends and debt repayment. It is also characterized by lower volatility than firm peers. Wide differences between ocf in earnings is a red flag |
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Evaluating the cash flow quality of a company |
Check for any unusual items that have not shown up in Prior years The rest of Revenue recognition results in an increase in receivables reducing operating cash flow. An increase in inventories and reversals of sales Provisions for restructuring charges show up as an inflow, a non-cash expense in the year of the provision and then as an outfit when ordinary operating expenses are Channel through such Reserves. Interest paid, interest received and dividends received have to be treated as offering cash flow under gaap. Interest paid can be classified as either operating or financing under IFRS. Also interest / dividend received can be classified as either operating or investing under IFRS Cash flows from the sale of available-for-sale Securities are treated as investing cash flows, I'll cash flows from the sale of trading Securities are treated as operating. |
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Completeness |
Compromise by existence of off-balance-sheet liabilities, such as in correct operating lease classification or purchase agreement structured as take-or-pay contracts. Take-or-pay contractual Provisions obligate a party to either take delivery of goods or pay a specified amount ie a penalty |
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Unbiased measurement |
Balance sheet subjectivity: value of a pension liability based on Actuarial assumptions, value of investment of debt or equity for which market value is not readily available, Goodwill value, inventory valuation, impairment of pp&e and other assets, overstatement of asset values |
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Sources of information about risk |
Financial statements contain information about leverage cash flows in earnings and are used by quantitative models Auditor's report provides only historical information so it is limited, look for changes involuntary infirm and lack of Independence Notes to the financial statements disclose certain risk related things. Both standards require companies to disclose risks related to pension benefits contingent obligations and financial instruments. Disclosures about contingent liabilities include description of the liability as well as estimated amounts and timing of payments. Pensions include information about actuary assumptions. Disclosures about financial instruments include information about credit risk liquidity risk and Market risk Md&a should include principal risks unique to business SEC form NT is filed when a firm is unable to file required reports in a timely manner Financial press |