FSA Quiz 1 (Chapters 1, 2, 3, 9, 11)

What is the goal when analyzing an income statement?

To determine whether the story it tells is good, bad, or indifferent. Watch for large increases in Accruals!!

In addition to the suspicious financial items, to what else should readers pay attention?

To the behavior of senior managers as the validity of their stated profits is challenged.

Why should analysts keep track of senior management turnover?

Unexpected turnover in senior management is a classic warning sign of financial misrepresentation.

What does Warren Buffett have to say about footnotes to financial statements?

"If you cannot understand the footnotes, it is because management does not want you to."

Who was the person who achieved the greatest renown for early recognition of Parmalat's fraud? What was his occupation? What advantage did he have over the average citizen?

A comedian, Beppe Grillo, was the one who recognized the fraud. Prior to becoming a comedian, he had a degree in accounting.

What are several different ways a company can increase revenues before the end of a quarter?

A company could borrow sales from the next quarter by offering customers discounts if they place orders early. They could make an acquisition (can do so even 5 days before the period ends) to incorporate the acquired company's profits into their own. Channel stuffing.

What role, if any, did insider trading have in the uncovering of HealthSouth's financial reporting fraud?

A large stock sale by Scrushy 3 months before that precipitous drop aroused SEC's suspicions on insider trading.

How can the new way of looking at the firm explain why firms would overstate earnings; i.e., reporting depreciation for a period longer than can be justified?

A more sophisticated and realistic way of looking at firms show overstating earnings to appear as self-defeating in the long term. Long term interests of firms' owners are not equal to short term interest of their salaried managers. (Agency problem)

How can an analyst detect artificial expansion of revenues on a retrospective basis? On a current basis?

A surge in credit losses or an unexpected shortfall in revenues may indicate that revenues were inflated in an earlier period. Analysts should take notice if a company posts a substantially greater sales increase than its competitors.

What is highest level of financial statement an accountant can prepare?

Audited Financial Statements! The auditor's report must accompany the financial statements when they are issued to the intended recipients

What are some of the approaches used by non-accountants to establish the value of real assets?

Capitalization of rentals (in footnotes, cap net operating income as a way to value it), inferring a value based on sales of comparable properties, and estimating the value a property would have if put to its highest and best use.

In addition to accounting rules, cash flows, and analytical techniques, what must a complete financial analysis include?

Consider the motivations of corporate managers, and dynamics of the organization. Ask, does the judgement reflect a flawed analysis on a higher-level management decision to override an analyst's recommendation.

What is another reason why candid reporting is not consistent with management self-interest?

Corporate executives have their own agenda.

What is the dark side of aligning management and shareholder interests?

Corporate executives who want to satisfy their self-interests and not want to be detectable by investors, devise better-hidden gambits that are harder to spot by analysts.

How do credit analysts use the concept of fixed and variable costs to assess risk?

Credit analysts generally perceive greater risk in a high-fixed-cost pattern. High VC is subject to inflation shocks that increases input prices and/or expenses so if the company has low variable costs its earnings will rise dramatically following a recession.

What is the difficulty encountered in valuing an actively traded commodity such as oil reserves?

Crude oil reserves, which is frequently bought and sold and has an easily agreed-on valuation, cannot be properly valued. There are no means of directly measuring oil reserves and it also has a lot of uncertainty.

What items were apart of Interpublic's misreporting?

Double counting of revenue, estimate of not-yet-realized insurance proceeds, write-off of AR and WIP, understated liabilities at other subsidiaries.

What is a sale-leaseback?

Enables a company to sell an asset to raise capital, then lets the company lease that asset back from the purchaser.

What are some of the reasons that the financial statements will not reflect a fair picture of the company's financial performance?

Executives falsify their results, audits do not invariably catch fraud. Auditors rely on sampling rather than reviewing every transaction and inventory because that would be costly. Companies also blame "error" regarding any inconsistencies in their numbers rather than any intention to mislead the uses of financial statements. Haggling between the company's managers and auditors will not present a fair picture of performance.

What hint about Enron's deceptive methods emerged as the company was attempting to save itself through sale to Dynegy?

FASB Emerging Issues Task Force received a rush question: The question was may a hypothetical company report profits earned in one subsidiary but not report losses incurred at the other?

How is an acquired intangible asset recognized?

Fair value

What are the rules Statement of Financial Accounting Standards/SFAS No.142 about?

Goodwill and Other Intangible Assets It was issued in June 2001 and it supersedes APB Opinion No. 17, "Intangible Assets".

What is a major difference between inventories or accounts receivables and goodwill?

Goodwill is not an asset that can be readily sold or factored to raise cash nor can a company enter into a sale-leaseback of its goodwill. Cannot raise cash.

How can the firm lower the rate it must pay to obtain financing?

Have a higher credit rating

What is Reasonable Assurance?

High level of confidence of Financial Statements that they are fairly stated in all material aspects.

What is the main advantage of using historical cost as the basis of a system to value assets? What are some of its disadvantages?

Historical cost has the greatest advantage of competing theories because the cost of acquiring or constructing an asset is the best verifiable figure. It is objective too. Disadvantages include basing valuation on transactions means that no asset can be reflected on the balance sheet unless it has been involved in a transaction, the most familiar difficulty being goodwill. A company's intangible value is not recognized until it is acquired by another company, then they are shown on the financial statements which shows the company to have more value.

How can one tell if a company's earnings are sensitive to fluctuations in interest rates?

If the company borrows heavily and has debt outstanding. Debt ratio, debt/tangible net worth ratio, times Interest Earned (EBIT/Interest Exp), interest coverage (operating cash flow/ interest paid) DOL DCL

What are some of the non-quantitative factors essential for an evaluation that are not found in financial statements?

Industry conditions, corporate culture, and management's ability to anticipate change and respond effectively.

What is the average cost inventory method?

It calculates the average cost of all units in the inventory irrespective of which units are sold first. This method attempts to smooth out these variances (inflation) on the balance sheet accounts by averaging the cost of all units held in inventory. Net income under this inventory valuation method will tend to vary depending on the number of inventory purchases made during an accounting period. Large purchases of higher-priced inventories added to current on-hand inventory amounts can increase the inventory's cost of goods sold reported on the income statement.

What is the environment created by institutional investors and why is it far from ideal?

It operates in a mechanical fashion, and also assume that as long as stock stack up well by Price-earnings multiples then it represents an attractive investment. This is the expense of evaluating the quality of a company's earnings. Outright fraud is not tolerated, disclosure that shades economic realities without violating law requires impressive ingenuity.

What are the some of the advantages of using market capitalization as a measure of equity?

It represents the consensus of large numbers of analysts and investors who constantly monitor companies' future earnings prospects as the basis for their evaluations. An up-to-the-minute market cap can be calculated on any day that the stock exchange is open

What role did the Sarbox provision play in the HealthSouth fraud?

It required CFOs and CEOs to attest to the accuracy of financial statements.

What is Fair Value Accounting?

It uses current market values as the basis for recognizing certain assets and liabilities. Fair value is the estimated price at which an asset can be sold or a liability settled in an orderly transaction to a third party under current market conditions.

What new SEC rules went into effect in the early 2000s and what effect did it have on Interpublic's financial reporting?

Made CEOs and CFOs subject to fines/ imprisonment if they certified false financial statements. Interpublic had to restate their financial statements because they booked the same revenue more than once between two different offices.

What actions did Enron's management take once it conceded that it was overly indebted?

Management tried to restructure existing debt, arrange additional borrowings, obtain equity infusions, and raise cash by selling overseas assets.

What does it mean to "make the numbers talk?"

Means to put the I/S in context by comparing it with I/S of earlier period and those of other companies.

What was behind HealthSouth success in its early years?

Medicare reimbursements to hospitals. The business provided physical rehabilitation. But Congress cut back Medicare reimbursements to hospitals, so they responded by slashing salaries and divesting unprofitable sidelines, when that failed to revive profits, he then tightened operations, cutting average patient's stays

According to security analysts, how did Enron make money?

No one knew how they made money. They took liberties with mark-to-market accounting rules to inflate its earnings. Under GAAP, it was legitimate to include in current earnings the profits on energy-related contracts and other derivatives that it expected to earn over future periods that could be as long as 20 years. At the end of each quarter, the company estimated the fair value of each open contract to buy or sell electricity or natural gas at a stated price. A change in the value of a contract would be added to or subtracted form earnings.

What is the relationship between operating leverage and breakeven level of sales?

Operating leverage is the rate at which net income escalates once sales volume rises above the breakeven rate.

Primary stages of an audit

Planning and risk assessment, internal controls testing, substantive procedures

How has a firm been traditionally portrayed? How is a firm viewed now?

Profit-maximizing firms that if possible would overstate their earnings to boost equity market valuation. Today, they are an aggregation of individuals with diverse motivation (behavioral finance).

What are some of the useful, albeit limited observations one can make from observing an income statement in its raw form?

Reader can make useful observations whether the company is profitable or not, and it provides some sense of the firm's cost structure. Major sources of revenue Major sources of expenses How sensitive is the company to changes in revenue and various expenses?

What are the inferences drawn from "behavioral finance" regarding market capitalization as a measure of equity?

Research conducted by behavioral finance can support an inference the dynamics of the stock market which affects shifts in aggregate value of a company's market shares. Behavioral finance shows that market prices frequently overreact to news events. The behavioralists find that the stock market is far more volatile than the variability of dividends can explain

What do audit cost considerations preclude?

Reviewing every transaction or counting every piece of inventory. Auditors use random sampling methods.

How can management reduce a sudden jump in profits and why would they want to do so?

Smooth their earnings to make profit look as if it rose at a consistent increasing rate rather than a sudden jump. This is done for a higher price-earnings multiple.

Who prepares Compiled financial statements?

The CPA prepares these statements with information provided to them by the business client. A compilation doesn't normally include footnotes explaining deviations from (GAAP), but it is still a very good idea to do so. Also, the accountant isn't examining every transaction, thus they cannot provide an assurance that the statements are accurate and complying with the rules of GAAP

What are some of the limitations of financial statement analysis highlighted by Enron's success in sustaining its fraud over a long period?

The auditors' failure to curb flagrant abuses of GAAP, The company did its best to make its financial reports unfathomable

How did Enron raise the bar for financial statement analysts?

The secretive management kept many of the most important sources of reported earnings off the balance sheet and did its best to intimidate anyone who complained about inadequate disclosure. They filed for bankruptcy a little more than a year after being ranked among the 25 most admired companies in the world.

How did Enron address the difficulties resulting from not having market prices for long-dated contracts?

They were allowed to generate its own valuations, using undisclosed assumptions and pricing models. The CAO (Causey) maintained that the unrealized gains were not heavily concentrated in long-term contracts, where uncertainty regarding valuation was greatest

How does "negative equity" dramatize the contrast between the economist and accountant's notion of equity?

a. Under accounting terms, there is no reason to consider either suspending payment to creditors or filing for bankruptcy with negative equity but with economist negative equity it means bankruptcy.

When does genuinely valuable analysis begin?

after all the usual questions have been answered and raising questions that are not on the checklist

Why is tenacity so essential to the analysis of financial statements?

because financial statements conceal more than they reveal

What is impairment?

impairment is a loss of value arising from a clear indication that the obligor will be unable to satisfy the terms of the obligation. Delay goodwill impairments, to temporarily inflating earnings and stock prices.

What can derail mergers and acquisitions that appear to work on paper?

incompatible information systems, disparate distribution channels, clashes of personality among senior executives, and contrasting corporate cultures.

In related party situations, what are the required footnote disclosures?

nature of the relationship, description of the transaction including amounts, amounts due from or to related parties at year-end, the effects of any change in terms; and, manner of settlement.

What is Cross-selling?

one division's services to the customers of another, an attempt to diversify as a means of higher future earnings growth.

What is in a financial statement review?

the accountant performs those procedures necessary to provide a reasonable basis for obtaining limited assurance that no material changes are needed to bring the financial statements into compliance with the applicable financial reporting framework

What are some examples of earnings discontinuities financial analysts should look for?

unrealizable synergies, and company-furnished projections of cost ratios that incorporate management's assumptions regarding sales volume.

Since a corporation exists for the benefit of its shareholders, what can be said about the purpose of financial reporting?

to obtain cheap capital

What was the actual reason for Trump Hotels & Casino Resorts reported year-over-year rise?

$17.2 million of the period's revenue came from a bankrupt restaurant operator's abandonment of its lease on the café at Trump's casino

What is a subsidiary?

A company of which more than 50% of the voting shares are owned by another corporation, termed the Parent Company. A subsidiary is always, by definition, an affiliate, but subsidiary is the preferred term when majority control exists.

What are some of the challenges one encounters when attempting to calculate fixed vs. variable costs?

A company's published I/S provides only limited insight into its operating leverage, and this is unfortunate because breakout of fixed and variable costs would be immensely helpful in quantifying the economies of scale potentially achievable through a merger. Break out fixed vs VC to determine the VC ratio based on management discussion.

Elaborate on the way the response to the 2001-2002 scandals illustrates the way lobbying functions to block reforms.

Advocates for the users of financial statements are outgunned by corporate and auditing interests, as these groups commit substantial resources to participate in hearings and requests for comments that influence the deliberations of FASB and SEC. With attention diverted from reform of the accounting system, persistent lobbying by corporations and auditor's waters down the original sweeping proposals.

When did skilled analysts identify some of the famous frauds?

After the schemes became unsustainable and the company collapsed.

What is the Common Form Balance Sheet and what are its uses?

Also known as the percentage balance sheet, the common form balance sheet converts each asset into a percentage of total assets and shareholders' equity. Use common form BS and IS to look for any red flags, this is the first step before taking a dive in to analyzing the financial statements.

What happens when a company's earnings and cash flow diverge to an extent that becomes unsustainable?

An abrupt adjustment to the financial statements of previous periods. Worse, company runs out of cash to maintain its operations and declares bankruptcy.

The law of one price states that identical items must sell at identical prices. Explain how this law may be violated in the context of SFAS 115.

An asset may be valued on one company's balance sheet at a substantially different value than an identical asset is valued on another company's balance sheet, all based on the different companies' representations of their intentions. And they can be violated if they have bad intentions.

Under Fair Value Accounting, how can companies value large amounts of financial assets that do not have continuously quoted prices determined in deep, liquid markets?

An asset of this sort is valued at the amount at which it "currently could be bought or sold" in a transaction between willing parties, not including a liquidation sale. If no active market for the asset exists, the company can determine its balance sheet value based on quoted prices for similar assets that do trade actively but the company need to make assumption about how the market adjusts for assets that do and do not actively trade because they are not identical

What are the rules for Amortization of Intangible assets under SFAS No. 142 say?

An intangible asset with a finite useful life is amortized over its useful life. The useful life is not limited by legal, economic or other factors, and is indefinite (not infinite). Amount to be amortized = Cost - residual value If the pattern of economic benefits can be determine, then Amortization method should reflect that pattern BUT if it cannot be determined then Straight-Line amortization

What are two assumptions that misconstrue the motives that frequently underlie financial reporting?

Analysts should trust their instincts and managers may be pursuing their own agenda.

On 11/15/2000 what caused Lernout & Hauspie Speech Product's auditor to withdraw its clean opinion of the company's 1998 and 1999 financial statements?

Belgian producer of speech-recognition and translation software made an announcement stating an internal investigation has uncovered accounting irregularities and errors

In the past, why was it difficult for securities analysts to incorporate legal risks into their earnings forecasts?

Because it relied on microeconomic and macroeconomic variables. It is difficult for managers to testify persuasively in the company's defense while acknowledging to investors that the Plaintif's claims may prevail. Settlements are cheaper than a lawsuit. Also bankruptcy can be a result from legal claims.

Why should users of financial statements provide themselves with an additional layer of protection through tough scrutiny of the numbers?

Because of the gap between theory and practice in financial reporting

Elaborate on the conditions that result in the wide gap between theory and practice when it comes to why the system is supposed to work for the benefit of financial statement users.

Bending the law is different than breaking the law in the minds of executives. They can negotiate with auditors on limits of stretching the accounting standards so large gap when it comes to relying on legal mechanisms to protect shareholders and lenders. Fear of the consequences when breaking the law keeps corporate managers in line.

How did HealthSouth exaggerate its earnings? How did it affect its Balance Sheet? How did they avoid detention?

By understating the gap between the cost of a treatment and the amount that the patient's insurance would cover. This enabled the company to set aside an unrealistically small allowance for uncollectible accounts, and each time the company overstated its net revenue and earnings in this way, it made a corresponding balance sheet adjustment, raising the value of an asset such as PPE. To avoid detention, HealthSouth made no large, concentrated adjustments but instead spread them over several different categories, including inventory, intangible assets, and PPE. HealthSouth propped up profits by failing to write off receivables with little chance of being collected which accounted for the $500 million. The company also did not recognize losses when it sold a depreciated asset, and they treated arm and leg braces that had their logo as inventory.

What is the cornerstone of GAAP?

Comparability. Compare financial statements with those of prior years and periods average with those of other companies. There is a problem with believing that financial statements are prepared in accordance with GAAP and that they are reliable.

Outside the financial statements, where else can one find evidence of financial reporting manipulation? Is this method more accurate than a model based on discretionary accruals?

Conference calls that corporate senior executives make in connection with quarterly earnings releases are a source to identify verbal cues of financial reporting hank-panky. Judgment based on the words used by CEOs and CFOs are more accurate than a model based on discretionary accruals.

What is economies of scale?

Cost structure and the base of sales over which to spread the costs for each company in the merger or acquisition.

How does Beneish define manipulation of financial statements?

Defines manipulation to include both actual fraud and the management of earnings or disclosure within GAAP. He developed a model for identifying companies that are likely to manipulate their earnings, based on numbers reported in their financial statements.

What are two crude examples of Enron's fraudulent activities? What does the record indicate about analysts' ability to detect Enron's fraud?

Enron borrowed $500MM form a bank and bought TBills, then sold them and repaid bank with proceeds and reported this as operating cash. Enron kept debt of an affiliate off its balance sheet and Andersen said that Enron failed to disclose to its auditor that "it had guaranteed half of a 3% investment by a financial institution in its special purpose entity." Not even diligent scrutinizers of Enron's financial statements recognized the depths of the fraud.

What are some of the criticisms leveled at traditional accounting systems?

Financial reporting practices rooted in an era more dominated by heavy manufacturing grossly understated the value created by research and development outlays, which GAAP was resistant to capitalizing. Traditional accounting generally permitted assets to rise in value only if they were sold, thus this traditional system is at a loss to capture much of what goes on.

What are the two fundamental shortcomings of using the Balance Sheet to summarize the values of all assets owned by an enterprise?

First, a summary of the values of all the assets owned by an enterprise are frequently proven elusive in practice. Second, many kinds of things have value and could be construed as assets. Not all of them can be assigned a specific value and recorded on a balance sheet.

What were the reasons given by Trump Hotels & Casino Resorts for its reported year-over-year rise in its third-quarter earnings in October 1999?

First, to increase operating margins at each operating entity, second to decrease marketing costs, and third to increase their cash sales from their non-casino operations.

What are two distinct approaches to financial statement analysis?

Follow a prescribed routine and the relentless pursuit of accurate financial profiles of the entities being analyzed.

What are options to include regarding SFAS 115 (1993)

If the company intends to hold a debt security to maturity, it records the value at amortized cost less impairment. If the company intends to sell a debt or equity security in the near term, hoping to make a trading profit, it records the instrument at fair value and includes unrealized gains and losses in earnings. The company could classify a debt or equity security as neither held-to-maturity or a trading security, but instead in the noncommittal category of available for sale. The instrument is recorded at fair value but unrealized gains and losses are excluded from earnings and instead reported in other comprehensive income. (Trading account is always recorded as current asset.) Available for sale (for Debt and equity securities not classified as either Held-To-Maturity or Trading Account Securities) it is Reported at FMV with unrealized gains and losses excluded from net income (can be current or longer term).

Under what conditions is the valuation of non-exchange-traded derivatives subject to violent swings? And why is this of great concern to financial institutions?

In a financial market crisis the price at which they would be bought or sold is subject to violent swings. Companies would prefer that investors do not see nor consider such losses in value as they characterize it as temporary. No liquidity! For a financial institution it is a larger worry because its regulator will declare the institution insolvent, based on the market induces and temporary decline in the Balance Sheet value of its derivatives

What is the definition of an affiliate?

In general, two companies are affiliated when one owns less than a majority of the voting stock of the other, or when both are subsidiaries of a third company. In everyday use, affiliate is the correct word for inter-company relationships, however indirect, where the parent-subsidiary relationship does not apply.

What are three ways corporations can use financial reporting as a means to enhance value?

Lower borrowing rate, a high P/E ratio thus high stock price, dividend growth.

According to Beneish, what are the five factors whose presence increases the probability of earnings manipulation? Does the presence of any of these factors provide irrefutable evidence of accounting malfeasance?

Increasing days' sales in receivables, deteriorating gross margins, decreasing rates of depreciation, decreasing asset quality (defined as an increase in the ratio of non-current assets other than PP&E to total assets), and growing sales. He does not characterize these indicators as irrefutable evidence of accounting malfeasance. A review does not require the accountant to obtain an understanding of internal control or to assess fraud risk or other types of audit procedures.

What is the definition of Related Parties?

Interaction between two parties, one of whom can exercise control or significant influence over the operating policies of the other. A special relationship may exist, for example, between a business enterprise and its principal owners

What is "restructuring" and what is the dangerous trap that users of financial statements must avoid?

It has a positive connotation implying that the corporation has cast off its money-losing operations and positioned itself for significantly improved profitability. It's a catchall of charges that companies wish analysts to consider outside the normal course of business but that do not qualify for below-the-line treatment its reflected above operating earnings. The most dangerous trap that must be avoided, is inferring that the term restructuring connotes finality. Over charges can be adjusted in future years.

What is channel stuffing?

It is a deceptive and fraudulent business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public. It is usually done in an attempt to hit compensation targets or increase/prevent a decrease in the value of its common stock.

Explain what is reviewed financial statements and what they do not provide now require.

It is a service under which the accountant obtains limited assurance that there are no material modifications that need to be made to an entity's financial statements for them to be in conformity with the applicable financial reporting framework such as GAAP or IFRS. It does not require the accountant to obtain an understanding of internal control or to assess fraud risk or other types of audit procedures. It does not provide the accountant with assurance that he has become aware of all the significant matters that would normally have been discovered and disclosed in an audit.

What is the tension that exists for the auditing firm?

It is between standards of professional excellence and fear of the consequences of losing a client.

Why do corporations seem to have an interest in facilitating cookie-cutter analysis?

It is convenient. For example EPS does not explain the quality of earnings.

What are the two objections one may raise regarding the "Purpose of Financial Reporting"?

It is fraudulent to obtain capital at a less than fair rate by presenting an unrealistically bright financial picture - are they cooking the books. Misleading the users of financial statements is not a sustainable strategy.

What are the rules for Goodwill under SFAS No. 142 say?

It is not amortized, but tested for impairment. Impaired when the fair value is less than carrying amount. Test for impairment on an annual basis. If certain events would reduce fair value below carrying amount, then test for impairment is done between annual tests.

What is "synergy" and what are some examples?

It is the effect of external growth increasing shareholders' wealth. For examples if mergers and acquisitions lead to improvements in profitability or improving profitability through economies of scope.

What is LIFO?

It is the inventory method where the last units received are the first units sold. With inflation, It may result in lower inventory amounts reported on the balance sheet since the cheapest inventory remains in the account and the higher priced goods are sold first. This method may result in lower net income since newer items are sold first. Older inventory, items under this method may actually be obsolete or worthless, meaning that the company is unable to sell this inventory at current market value. This distortion will maintain high inventory balances on the company's financial statements until the obsolete inventory is written off. Obsolete inventory write-offs can create significant losses on a company's income statement

How did Scrushy's indictment in 2003 make history?

It made Scrushy the first CEO accused of violating the Sarbox because he had signed the financial statements.

What was the most dismaying action of HealthSouth's auditor? Would the standard auditing practice have uncovered the fraud?

It was EYs failure to challenge a sudden, large increase in cash. Yes, Auditors were supposed to confirm cash balances by obtaining a sample. Internal Auditor told EY that she could not get full access to the company's books. Watch for big jumps in cash. Negative confirmation.

What is a prepaid swap and how did Enron use it to disguise the magnitude of its debt burden?

It's a derivatives trade, its cash flows replicated a floating rate loan. Therefore, instead of treating it as a loan, Enron treated it as a swap. Unlike an ordinary swap, this transaction required Enron's counter-party to make its payments upfront, while Enron's payments were spread over a multiyear period

What is Cookie jar accounting?

It's a disingenuous accounting practice in which periods of good financial results are used to create reserves that shore up profits in lean years. It is used by a company to smooth out volatility in its financial results thus giving investors the misleading impression that it is consistently meeting earnings targets.

What are Reasons for Inventory write-downs?

Lower of cost or market inventory valuation, lack of demand (Cannibalism created by newer products, one timer purchases where new sales only come from replacements, seasonality), Excess inventory caused by overly optimistic management assumptions, Obsolete inventory that is at the end of its product lifecycle, Shrinkage (evaporation, fire or water damage, fraud, and theft), physical inventory counts (poor inventory controls, inaccurate inventory systems).

What could a company do to keep from having a higher-than trendline growth and volatility of growth rate when borrowing sales from the next quarter?

Management could run up the company's expenses (BDE) in the current period.

Under what circumstances, if any, can an asset be carried at two different values in a single balance sheet?

Many deals can be shared by multiple private equity firms. For example, a university endowment fund or pension plan sponsor might be a limited partner in a privately owned company held by two or more private equity funds that placed different values on the company.

What two factors, identifiable from the financial statements, led Off Wall Street Consulting group to recommend a short sale of Enron in May 2001?

Mark-to-market on non-traded assets and related-party transactions with private partnerships

Would a careful reading of the Notes to Financial Statements disclose whether a company is exaggerating revenues? Provide examples.

No, Reduction of credit standards without commensurate increase in reserve for bad debts. A manufacturer may institute short-term discounts that encourage its dealers or wholesalers to place orders earlier than they otherwise would.

What are some of the commonly heard rationalizations for declining growth?

Our year-over-year comparisons were distorted (freak weather conditions and shipment delays). New products will get growth back on track. We're diversifying away from mature markets.

What were some of the inconsistencies in Enron's financials spotted by McCullough Research?

Overstated revenue, a discrepancy between reported earnings less dividends and additions to retained earnings, negative cash flow.

Why would a naïve observer consider it overkill to scrutinize a company's financial statements for signs that management is presenting anything less than a candid picture?

Publicly traded corporations are already compelled by extensive regulations to disclose material events affecting the value of their securities. Investors' second line of defense: auditors annual certification and SEC's corporation finance and enforcement divisions.

What are the powerful continued growth limitations faced by corporations?

Saturation in sales (no new buyers so probably must rely on replacement goods), entry of competition, (Law of Diminishing Returns) an increasing base (growth can not be greater than GDP and all growth will come to an end), and market share constraints)

How can the careful study of financial statements raise red warning flags regarding risk in mergers and acquisitions driven by stock-for-stock transactions?

Segregate ongoing growth through purchased growth.

What are some of the tensions that exist between the desire to book credit and the need to make sound credit decisions that exist in commercial lending?

Temporary strain, is it a young struggling company (despite financial ratios, startups have higher risk of default), and remember that loan officers must meet budgeted loan production numbers, loan losses cost against them. The promotions/bonuses/stock options are based on loan officer's loan and interest income production.

What would make intense analysis of financial statements superfluous?

The combined impact of corporate disclosure requirements, external audits, and regulatory backup

What event caused Enron's investors to become alarmed about the lack of clarity regarding the partnerships?

The company terminated its relationship with the partnerships and the associated write-down of a promissory note produced a $1.2 billion DECLINE in shareholder's equity. Their CEO, Lay, later alluded to the write-down in a conference call with analysts, and investors became alarmed. His response when questioned about Enron's complex transactions was that the questions were getting way over his head. Their auditor also was guilty of obstruction of justice for shredding documents related to the Enron audit.

What reason did Merrill Lynch's analysts cite as their rationale for downgrading Parmalat to a SELL? What turned out to be the explanation for Parmalat's behavior? What signs of trouble surfaced in the last two months before the bankruptcy?

The company was reporting high cash balances, but actually their large cash balance was negative. They argued that maintaining vast amounts of debt while holding cash that generated a lower interest rate, rather than using the cash to reduce debt, represented "inefficient balance sheet management" and it turned out that the cash was fictitious. Classic danger signs were senior management turnover and also the resignation of the CFO. Also, the company had to sell its stake in a hedge fund based in the Cayman Islands and the proceeds were not recoverable.

Which items in Parmalat's financial statements showed evidence of the fraud? How much advanced notice did investors have before Parmalat's collapse?

The company's revenues were exaggerated, they recorded lower net debt than reality, and EBITDA was lower than was reported and their actual assets. Until 9 days before the bankruptcy filing, the company's debt carried an investment grade rating.

What was the reasoning behind Scrushy's overstatement of the impact of changes in Medicare reimbursement?

The cost was overstated because they wanted to downplay earnings. It lowered security analysts' expectations.

How does the existence of a secondary market influence P/E multiples?

The disparity in P/E multiples is justified by the private company's owners' opportunity to exchange an illiquid investment for public stock

When examining a company's financial statements, is one interested in the past of the future? Explain.

The document is less important for what it tells about the past than for what is implies about future years. For example, last year's earnings have no direct impact on a company's stock price. An equity investor is interested in a company's income statement from the preceding year primarily as a basis for forecasting future earnings.

What are the some of the drawbacks of using market capitalization as a measure of equity?

The objectivity of a price quotation established in a competitive market is obtainable only for corporations with publicly traded stocks. also public companies are subjected to systematic and unsystematic risk. For private companies proponents of market cap generates a proxy for true equity through reference to industry-peer public companies. Short-run changes in Dow jones, for example, of large magnitude raise caution for market cap

What enabled Enron to make itself less debt-laden than it really was?

The off-balance-sheet vehicles, combined with nontransparent disclosures.

What can be said about the existing provisions for issuing financial accounting standards?

The present system was not made by expert analysis who's driven solely by a desire to provide accurate and transparent financial statement to the public, and auditing firms are profit-maximizing businesses that face conflicts between retaining clients and upholding professional standards. A systematic component perpetuates financial misreporting. Accounting standards lag most current innovations in the business world.

What is the fallacy of "cross selling"?

The question of how is paying premium acquisition prices for the two companies to work under the same corporate roof more profitable than simply having one independent company that pays a fee to reach the other's company. How is new growth going to camp out?

What is the real scandal involving major financial reporting violation when they come to light?

The real scandal involves what is not forbidden. GAAP tolerates much inaccurate information and measurement in the short run. Neither fear of antifraud statutes nor enlightened self-interest invariably deters corporations from cooking the books.

Compare and contrast the answers given by truthful executives to those given by deceptive executives during conference calls made in connection with quarterly earnings releases.

The replies of deceptive executives contain more references to general knowledge (like phrases "you know"), fewer non-extreme positive emotions ("solid" or "respectable"), and fewer references to shareholder value and creating value. They also make fewer references to themselves and more to impersonal third parties, saying "the team" or "the company" rather than "I". More positive rather than negative emotions are used my deceptive executives as well.

What is the trick that will allow investors to understand sudden changes in value in both the Old and New Economies?

The trick is to understand the relationship between the accounting conventions and reality of not assuming that the balance sheet figures invariably corresponding to the current economic worth of the assets they represent and the expectation that the numbers have been calculated in accordance with GAAP.

Using the example of Lehman Brothers, elaborate on how internally inconsistent valuations can affect the balance sheet of an enterprise.

Their bankruptcy found that each trading desk within the investment bank had its own methodology for pricing assets, they differed within a single asset class and Product Control Group was understaffed to enforce standardization in valuation. Some of the methodologies were dubious.

What was a major red flag of Parmalat's impending collapse? What was the CFO's response when challenged on this point?

Their voracious appetite for debt, despite claiming to have a huge cash balance. The CFO (Tonna) consistently replied that the company was on the acquisition trail and that its liquid balances were earning good returns.

Using the example of specialized machinery, illustrate some of the difficulties encountered in the quest for true value.

There are problems with purchased machinery if it is customized and cannot be used by many manufacturers which will cause the lender difficulty to monitor value in the future without compairables and harder to sell it especially if the manufacturer has a foreclosure. Need to understand the specialized machinery equipment from a liquidation value.

Why can it be said that some financial assets can be valued with objectivity and accuracy?

These assets are traded daily and actively in well-organized markets such as the NY Stock Exchange thus its feasible to value such assets on the basis of market quotations at the end of the financial reporting period to achieve objectivity and accuracy. Make sure the market is liquid

What standing do the terms "nonrecurring" and "unusual" have under GAAP? How and why do firms use these terms?

These terms have no official standing under GAAP, but they foster the impression that the highlighted items are exceptional in nature. These terms are used instead of "extraordinary" because it not as prohibited nor as difficult to have the permission to use that term on the financial statements. These terms give investors the impression it was just a hiccup and the company has moved beyond that loss.

What quality are internally prepared financial statements?

They are considered the "lowest" quality of financial statements in the hierarchy of GAAP.

What are the rules for Intangible assets not specifically identifiable under SFAS No. 142 say?

They are not recognized as an asset on the balance sheet and the cost of internally developing intangible assets are recognized as an expense when incurred.

What are some of the conditions that provide economies of scale?

They become available due to technological advances that can make a sizable portion of existing capacity redundant, Increase worker productivity, and Consolidation of a mom-and-pop business, that is, an industry characterized by many small companies operating within small market areas.

Under Fair Value Accounting how can companies value large amounts of financial assets that do not have comparables? Also, elaborate on the answer.

They can use their own assumptions about the assumptions market participants would use to offer or bid for that asset. Users of financial statements can reasonably expect that some companies' assumptions about assumptions will be on the liberal side, inflating the value of non-actively traded assets. (Enron Fraud)

What is risk-based-audits? When did they emerge? And what incredible feature did they include?

They emerged in the 1990s as a means of keeping a lid on costs. they identified the areas that in their judgment presented the greatest risk of error or fraud, like complex derivatives. Firms abandoned their traditional bottom-up approach of examining all components of the financial statements and the details of individual transactions

What happens when the measure of achievement becomes more important than the accuracy of the measure itself?

They move the Goal Post. Corporations may try to block the intro of new account standards that might hurt their earnings.

What must a conscientious analyst do?

They must determine how accurately the statement reflects the issuer's revenues, expenses, and earnings. "How Accurate Are the Numbers?" documents indefatigability of issuers in devising novel gambits for exploiting these vulnerabilities

What did HealthSouth do to meet analysts' expectations?

They stretched the truth. By overstating earnings, incorrect accounting for goodwill and other acquisition-related items. They changed auditors.

What would have been the consequences of Enron's debt being downgraded to speculative grade?

They would be compelled to issue tens of millions of shares of stock to cover the $3.3 billion of loans it had guaranteed thus driving down its share price through dilution and this would induce other traders to cease doing business with.

What were the doctrinal disputes over accounting for assets that intensified during the late 1990s?

They're over accounting for assets intensified as intellectual capital came to represent growing proportions of many major corporations' perceived value. Between 1978 and 1999 book value fell from 95% to 71% of the stock market value of public companies un the US

IN which way should the analyst consider the issuers of financial statements as adversaries?

View them just like how one would temporarily demonize their opponents in a basketball game. Understand gamesmanship of financial reporting.

What is the "big bath" hypothesis, and how was it corroborated?

When a company suffers a large quarterly profit decline that cannot be offset by discretionary items, they take a big bath to maximize the reported setback. It is a strategy of manipulating a company's income statement to make poor results look even worse to make future results better. It is often implemented in a bad year for a company to enhance the next year's earnings in an artificial manner. This is corroborated by showing that large declines to earnings are more common than large increases.

What's the implication of the finding that corporations post small increases in quarterly profits more frequently than they post small declines?

When companies are in danger of sowing small negative earnings comparisons, they find enough discretionary items to squeeze out marginally improved results".

Is the evidence of criminal misrepresentation obvious after the fact?

Yes

Was the information omitted from the Trump Hotels & Casino Resorts October 1999 report detectable?

Yes, because it is a mysteriously large amount of revenues. The cutback in disclosure could have been due to trying to conceal that their year-over-year revenue gain was solely attributable to a nonrecurring event.

Fully explain the compromises embodied in SFAS 115 (1993).

financial instruments are valued according to their intended use by the company issuing the financial statements. Financial assets that have readily determinable FMVs are valued according to their intended use by the company issuing the financial statements.

What are the three common types of inventory valuation methods used in business?

first-in first-out (FIFO), last-in first-out (LIFO) and average cost

What is FIFO?

the first units of inventory received by a company are the first units sold. This inventory valuation may increase the company's balance sheet inventory amount due to increasing inflation, because economic inflation causes prices to rise on the most recent inventory purchases. This method also may result in higher net income since cheaper inventories are sold first. Warning this method may distort the actual value or importance of a company's inventory.

Is it common for senior managers of accounting firms to overrule the frontline auditors?

yes