FSA Quiz 2
What lessons can users of financial statements draw from this case?
An exceptionally long record of beating guidance or posting year-over-year gains in quarterly earnings is a reason to suspect earnings management. Related-party transactions and deceptive financial reporting often go hand in hand. When management offers an excuse for deteriorating earnings that does not stand up to scrutiny, as krispy kreme did by citing the low-carb craze, it may be using financial reporting tricks to try to conceal the true causes.
What were the lessons learned from the wave of LBO-related bond defaults of the 1980s?
Depreciation was not, after all, available as a long-run source of cash for interest payments.
What role was played by Halliburton's CEO identity under whose watch the accounting controversy occurred?
Dick Cheney was CEO and VP of the USA under Bush who was advocated for a tougher prison sentence for corporate officials engaging in fraud. A 1998 change in accounting policies enabled Halliburton to book more than $100 mm of disputed costs as revenue.-Halliburton did not disclose the change in its treatment of cost overruns until more than a year later-By the time this disclosure became public knowledge, CEO Dick Cheney was VP of U.S.
How is the line of business used to define a peer group?
Different industries have different financial characteristics. Cross-sectional analysis requires a peer group with virtually identical products. (SIC, NAICS)
How are Major repairs in CapEx treated?
Major repairs will take on the characteristics of the long cycle Replacement CapEx because the repair is designed to extend the life of the asset for many years.
According to Michael C. Jensen, what two things must one expect when a manager is told he or she will get a bonus when targets are realized?
Managers will attempt to set easy targets and once these are set, they will do their best to see that they are met even if it damages the company Monetary incentives can cause unintended consequences.
What are some of the reasons why analyzing a company's financial statements may not be sufficient to determine its credit quality?
May have to include a check of subject's past record of repayment which is not part of the financial statement. To assess the creditworthiness the banks must also consider the competitive environment and strength of the local economy in which the borrower operated. The borrower's credit may be supported, formally or informally, by another entity (SBA, FHA, VA as legal guaranties and there are informal guaranties who stand behind subsidiary debt). (Municipalities obtain cost savings by having their debt payments guaranteed by bond issuers)
How are Repair and Maintenance CapEx treated?
Minor repairs and maintenance costs that extend an asset's life for another year are usually expensed in the Income Statement. Major repairs to critical assets that extend the asset's life for more than one year will be capitalized.
What happens to firms that spend the minimum on property, plant, and equipment, year after year?
Most companies would lose their competitive edge if they spent only the bare minimum on PPE year and year.
What happened in the Entrasys Networks' overstating of revenues?
Revenue booked in wrong period Inflated valuation of stock received as payment for products Expected payments that were booked as revenue but failed to materialize
What was central to Kendall Square's difficulties?
Revenue recognition controversies Booking future sales before they occur Their booked sales were dubious.
What is the important take away from the Nortel case?
Seemingly small items can prove highly significant (By paying little attention to a few hundred million dollars of reserve related losses in the context of a total of $34 billions of losses recorded from 2000-2004, these additions, added to reserves, added to accrued liabilities that grew to $5 billion by the summer of 2002, giving management a vast opportunity to manipulate earnings to enhance its bonuses.)
In 2003, what did Nortel introduce as a special bonus plan? What classic red flag did Nortel disclose on March 10, 2004?
Senior executives' bonuses were tied to profit Delaying the filing of its 2003 financial reports.
What is funded CapEx?
Since debt is the primary funding source, these expenditures are not a drag on primary cash flow. - means funded with external debt
What did the SEC charge Take-Two with?
Systematically booked revenue from approximately 180 separate "parking arrangements." the company shipped hundreds of thousands of video games to distributors who were under no obligation to pay for them, fraudulently booked the shipments as if they were sales, then accepted returns of the products in later periods. Management created fraudulent invoices to disguise the returns as "purchases of assorted product", Instead of reducing sales returns increased COGS.
What did accounting rules (in 2001-2005) state regarding rebates?
That if the rebates involved not only current business but were upfront inducements to place large orders over several years, they should be taken into earnings over time rather than booked immediately. Rebates should be taken over time
What does the Step Transaction Doctrine say?
The IRS can collapse a series of apparently unrelated transactions into one transaction to determine the tax consequences (Example; where a corporation sells property to an unrelated purchaser who subsequently resells the property to a wholly-owned subsidiary of the corporation. "strawman transaction") (Transactions that occur more than 12 months apart are presumed to be independent)
What does the Substance-Over-Form Doctrine "smoke and mirrors" say?
The IRS can look through the legal formalities to determine the economic substance (if any) of a transaction. A transaction must be real and bona fide (If the substance differs form the form, the IRS will base the tax consequences of the transaction on reality rather than illusion. Enron Special Purpose Entitites.)
Aside from seasonal variations, what should analysts suspect when inventories or receivables increase materially as a percentage of sales?
The amount of WC needed to run a business represents a fairly constant percentage of a company's sales. If Inventories or AR increase materially as a percentage of sales, analysts should strongly suspect that the earnings are overstated
How did analyst Steven Tighe derive his estimate for wholesale inventories and what was his conclusion?
The analyst derived his estimate of wholesale inventories for Bristol Myers's 10 major drugs, representing 50% of pharmaceutical revenues from price and prescription statistics of IMS Health, a vendor of health care data which is the external source to verify financial statements. His conclusion is that inventory could total $500 million to $800 million which would approximate 2.42 times average weekly sales which is an abnormally high level,
According to the Beaver study, what was the single best predictor of bankruptcy and how was it calculated?
The best single predictor of bankruptcy was a declining trend in the ratio of cash flow to total debt. Cash flow = Net Income + Depreciation, Depletion, and Amortization
Why and how will the way Salsa Meister International converts losses into profits end?
Investors will come to the realization that there is no growth in this way of generating profit. the company will lose its ability to manufacture accounting profits by raising new funds in the stock market and the stock price will then fall to 0 (intrinsic value).
How does the major risk of analytical error in the reporting of depreciation expense arise?
It arises from the possibility that economic depreciation will substantially exceed reported depreciation expense.
What is EBITDA apart from its acronym?
It is an earnings-based, modified cash flow metric and a crude approximation of pre-tax interest, pre-tax Operating Cash Flow.
What is the fixed-charged coverage ratio?
It measures the ability of a company's earnings to meet the interest payments on its debt, the lender's most direct concern: ((net income + income taxes + interest expense) / interest expense))
What are some of the complications preferred stock introduces in the financial leverage calculations?
It must contractually pay a fixed dividend vs. interest on debt Failure to pay a dividend does not constitute an event of default An issuer can omit its preferred dividend but not without also omitting common dividend. A preferred dividend is typically cumulative (insurer repays all preferred dividend arrearages before resuming CS dividend). A preferred stock may have a sinking fund provision that requires redemption of a substantial portion of the outstanding par amount prior to final maturity. (Such provision implies less financial flexibility than is the case for a perpetual preferred stock which requires no principal repayment at any time) Exchangeable preferred stock can be transformed into debt at the issuer's option
What is the risk when all preferred stock is treated as equity?
It would understate financial risk. (Analysts must recognize the heightened level of risk implied by the presence of preferred stock in a company's capital structure.)
When is the Step Transaction Doctrine applied?
It's applied in instances when each transaction viewed separately has one overall result but considering the transactions together yields a different result.
When did Nortel finally file its 2003 financial statements and what unusual step did twelve senior executives take?
January 10, 2005. 12 senior executives agreed to return $8.6 million in bonuses they received based on erroneous accounting.
What are cycle-to-cycle comparisons and why should they be used instead of year-to-year comparisons?
Bond-rating agencies focused on cycle-to-cycle because their notion was that a cycle-to-cycle pattern of similar highs and similar lows did not imply a true impairment of financial strength. Deterioration was indicated only when a company displayed a trend of successively lower highs and lower lows.
What is Deferred Tax Liability?
They are not liabilities in the purest sense because they do not impose any obligation on the business to pay taxes. All the deferred tax liability suggest is the actual tax payments will be proportionally higher in the future because tax payments were proportionally lower in the past.
What problems are signaled by a surge in accounts receivable?
management may be trying to prop up sales by liberalizing credit terms to its existing customers. The company may be carrying financially strained businesses by giving them more time to pay up their accounts (If so average AR will be higher than in the past) A buildup in AR may result from extension of credit to new, less creditworthy customers that pay their bills comparatively slowly (reserve for bad debts increases)
What is the incentive for "new economy" firms to break free from the focus of after-tax earnings as a basis for valuation?
minimal net profits recorded by New Economy companies their P/E multiples make their stocks look expensive
When can companies book revenue before billing their customers?
revenue is recognized in proportion to amount of work completed
What are the types of long-term debt?
secured and unsecured debt, and preferred and common stock
What is secured debt, according to Fletcher's graph?
for senior they get primary claim on assets pledge, for junior they get secondary claim on assets pledged. All remaining assets are distributed between unsecured debt and lower priority claims (equity).
Why is Cash Flow from Operations to capital expenditures a key ratio to analyze in capital-intensive manufacturers and utilities? How does this ratio vary with the capital spending cycle?
it explains the financial flexibility (High ratio = greater financial flexibility) A company that reduced its capital budget will appear to increase its financial flexibility based on the ratio. But cutting back on outlays, may impair their long-run competitiveness by sacrificing market share or causing the company to fall behind in technological terms.
What are disadvantages to EBITDA according to Fletcher's ppt?
- It ignores changes in working capital and overstates cash flow in periods of working capital growth - It can be a misleading measure of liquidity - It does not adjust for a variety of non-cash or non-operating items of revenue, gains, expenses or losses - It does not consider the amount of required CapEx reinvestment - It does not include federal income taxes, state income taxes, dividends or owners' withdrawals - The avoidance of changes in the balance sheet causes it to be an imperfect measure of cash flow - It ignores distinctions in the quality of cash flow resulting from differing accounting policies
What can cause the rise of deferred tax liability?
1. Depreciation methods 2. Installment sales 3. Long-term contracts 4. Leases 5. Warranties 6. Service contracts
What does the ratio of capital expenditures to depreciation capture?
A ratio of less than 1.0 over a period of several years raises a red flag, since it suggests that the company is failing to replace its Plant and Equipment. Underspending on capital replacement amounts to gradual liquidation of the firm
What are some of the issues associated with the size of a company when comparing it to a peer group?
A smaller bank with less sales but similar financial ratios as a bigger company would be a higher credit risk because they have less economies of scale and less leverage with suppliers than a bigger company would. A big company can spread the risks of obsolescence and competitive challenges over a wide range of products and customers, whereas a smaller competitor's sales are likely to be concentrated on a few products and customers. A company with just a single manufacturing facility is vulnerable because an unexpected loss of production could prove fatal to such an enterprise. Lack of depth in management is another problem with smaller companies. (Statistical models confirm that, on average, big corporations meet their obligations with greater regularity.)
What was in the Business Purpose Doctrine (1935)?
A transaction will not be effective for income tax purposes unless it is intended to achieve a genuine business purpose. If the transaction has no substantial business purpose other than the avoidance or reduction of tax, the IRS will disregard the transaction.
For financial analysts, what is the practical definition of accounting profit?
An accounting profit is whatever the accounting rules say it is.
What is the difference between accruals and a payable?
Accruals are earned revenues and incurred expenses that have yet to be received or paid. Accounts payable are short-term debts, representing goods or services a company has received but not yet paid for
What is one of the most abused features of financial reporting?
Accruals, their distorting power.
What is the assumption that if not true weakens the argument for favoring the EBITDA-based over EBIT-based fixed charge coverage?
Adding depreciation to the numerator is appropriate only for the period over which a company can put off a substantial portion of its capital spending without impairing its future competitiveness.
What are some of the reasons that capital spending may exceed depreciation over time?
Additional outlays are required for the replacement of obsolete equipment. Exceeds depreciation as the company expands its productive capacity to accommodate rising demand. Newly acquired equipment may be costlier than the old equipment being written off, as a function of inflation.
What is the litmus test that a calculation of bona fide profits must pass?
After a company earns a bona fide profit, its owners are wealthier than they were beforehand.
What must financial analysts do to benefit from the insights provided by the careful scrutiny of financial statements?
Analysts must be disciplined enough to disbelieve the innocent explanations that companies routinely provide for abnormalities that point to trouble down the road.
What does the Assignment of Income Doctrine "fruit and tree" say?
As long as a taxpayer retains control over the source of the income (the tree), he or she will be taxed on the receipt of that income (the fruit) even though he or she has assigned all the rights to the income to someone else. (Example: where a self-employed person, who receives a $20,000 check in payment for services rendered on behalf of a client, cannot avoid reporting the $20,000 as income by endorsing the check to his adult son. Who would then claim this as income.)
How is Bally's situation different from the situation at BJ's Wholesale Club?
BJ's member fees were paid in cash and lasted for about 12 month and only about .5% of members asked for a refund.
Why do companies welcome the migration towards less variable measures of performance?
Because investors reward stability with high price-earnings multiples.
Why were investors unwilling to accept Bally's earnings increases at face value?
Because of the company's growing reliance on memberships fees that it financed as opposed to selling for cash
Why must the simple formula of revenues minus costs not be taken at face value?
Because those basic measures of corporate performance are far too subject to manipulation and distortion to be taken at face value. Because of the malleability of accounting based revenues and expenses.
Why would it be seem paranoid to a novice analyst to consider every company's income statement with suspicion?
Being critical of human nature Didn't the accounting firm that audited the company's financial statements issue a clean opinion? Aren't most people honest?
Why was diverting analyst's focus away from traditional fixed charge coverage and toward EBITDA coverage of interest particularly beneficial during the 1980s?
Beneficial when some buyouts were so highly leveraged that projected EBIT would not cover (1.0x) pro forma interest expense even in a good year. Debt coverage ratios: - Interest coverage ratio = EBIT/ interest expense. - CMLTD coverage ratio - Interest coverage ration on an operating CF= OCF/interest expense - Principal and interest coverage ratio - OCF
How can management mask problems related to inventory or receivables?
By pumping up the third component of WC requirements, AP. But this can cause potential repercussions on operations and suppliers might view a slowdown in payments as a sign of financial weakness
How can a firm insulate itself from floating interest rate fluctuations?
By using financial derivatives. Interest rate swaps, forward contracts, Eurodollar CD Futures market.
What is the fine line that financial analysts must walk?
Cannot lose touch with economic reality by hewing to accounting orthodoxy. Must not accept the version of reality that seekers of cheap capital would like them to accept. They should be skeptical of claims that a business's alleged costs are mere accounting conventions
What is Unfunded CapEx?
Cash flow is the primary funding source - means it is funded internally
What are some after-the-fact explanations for excesses in income reporting?
Companies variously attribute excesses in reporting to misjudgment, bookkeeping errors (WITTB), deliberate misrepresentation by rogue managers, or some combination of the three
What are telltale danger signals?
Conspicuous surges in unbilled receivables (Exclude these ineligible receivables from the BB) deferred income
What are some of the ways companies downplay expenses?
Corporate managers make liberal assumptions about costs that may be capitalized, pile up unjustified accruals, dilute expenses with one-time gains, and jump the gun in booking rebates from suppliers.
How can EBITDA help credit analysts discriminate between two similar-looking credit risks?
EBITDA can discriminate among companies that look similar when judged in terms of EBIT. It Adds back Amortization And Depreciation (2 companies could be perfectly matched on DFL and one of the company's Total-debt-to-total-capital ratio could be higher thus riskier than the other, but when bringing EBITDA into the analysts it could reveal that the risker company is better able to keep up its interest payments in the event of a business downturn. Because by adding back DA the noncash charges to EBIT shows that the company keeps its head above water)
What signs began to surface in 2005 that GM's corporate culture had changed?
Erroneous booking credits from suppliers. Bond ratings had slid down to the speculative grad rating. (BB-) They disclosed that the SEC was investigating their accounting aspects. They had to restate earnings. Changed accounting for retirements.
What is the rational explanation of the phenomenon of an investment increasing in value while generating losses?
Explained by the Tax code that allows owners to write off property that essentially overstates the property's wear and tear There are no salvage values in tax reporting. MACRS (Modified Accelerated Cost Recovery System tax depreciation) with different asset classes. (When non cash depreciation is recorded on paper it looks like the company is suffering losses so they don't have to pay that much in taxes but when the building is sold it is worth more than it was bought at so in the end they come out a lot wealthier)
What is unsecured debt, according to Fletcher's graph?
For example, debentures and notes. They are divided between senior and subordinated. Subordinated debenture holders will not receive payment unless designated senior debenture holders are paid in full.
Explain Deferred Tax Liability in terms of GAAP income:
GAAP income was greater than taxable income in the past; past tax payments were relatively (as a % of GAAP income) lower; and therefore future tax payments are expected to be relatively (as a % of GAAP) higher.
What lessons can be learned from Halliburton's case?
If earnings look suspiciously strong during a rough patch for the company's industry, users of financial statements should never automatically rule out the possibility that manipulative accounting explains the disparity. Do a peer analysis
Profits and resulting cash flow ultimately sustain a company's liquidity and asset values. What are the most commonly used profit margin ratios?
Gross margin important when analyzing retailers, measures management's skill in buying and selling at advantageous prices. ((Sales - COGS) / sales) Operating margin shows how well management has run the business in terms of buying and selling wisely and controlling selling and admin expenses before taking in to account company's capital and tax structure.(Operating income / sales) ((net income + income taxes + interest expense - interest income - other income) / sales) Pretax Margin ((net income + income taxes) / sales) Net margin includes all factors whether under management's control or not. (Net income/ sales)
What did Altman's model demonstrate?
He introduced a multivariate model composed of five ratios. His models demonstrated that no single financial ratio predicts bankruptcy as accurately as a properly selected combination of ratios
What is the example of Ikon Office Solutions facilitating revenue recognition fraud?
Hybrid Networks had inventory that they couldn't sell, so they made an agreement with Ikon to purchase these items, and gave them a side letter which said they could exercise the option to return the items for all of their money back. These sales accounted for over one-third of their 4 quarter revenues that year. Later, when Hybrid sent the letter to their auditor, the SEC sued them and made them restate their 4th quarter earnings and eliminate the nominal sale of modems to Ikon
How can a rising debt-to-capital ratio confirm an adverse credit trend revealed by operating cash flow?
If a company resorts to stretching out its payables thus increase debt (numerator) other ratios will send out warning signals. Also, if companies do not finance the bulge in inventories and AR by extending its payables or drawing down cash, it must add to its borrowings.
Under what conditions are the physical wear-and-tear of plant, property and equipment not considered an expense in the calculation of profits? (depreciation/ depletion)
Land, land rights with indefinite lives, site preparation, grading, and landscaping Excess plant and equipment When an assets salvage value = the cost of the asset Reserve construction equipment PPE in the process of construction until the facility or segment thereof is placed in service
Why is the Total Debt/ Equity ratio important?
Lenders gauge the amount of equity beneath them by comparing it with the amount of debt outstanding
Explain why a drop in the stock price accompanied the apparent good news of increasing revenues at Wal-Mart?
Linked to an accounting change that was expected to reduce the following third quarter's earnings. The retailer's management advised analysts to lower their earnings per share estimates to reflect a shift in the company's method of accounting for layaway sales. Prior to the change, they booked layaway sales as soon as it placed the merch on layaway but under the new and more conservative method the company began to recognize the sales only when customers completed the required payments
What are at the bottom of Fletcher's Types of Long-Term Debt chart?
Lower Priority Claims, which are the Preferred stock and Common stock.
Under what conditions can the use of net interest expense in the denominator of the fixed-charge coverage ratio overstate the level of protection implied by this coverage?
Net interest expense is difference between interest expense and income derived from interest-bearing assets. They portray the two items (interest expense and income) as offsetting, with operating earnings having to cover only the portion of interest expense not automatically paid for by interest income.
Can most users of financial statements replicate the analysis of Steven Tighe and C.J. Sylvester?
No because it is very costly, 10s of thousands of dollars.
Explain why net income may be (or not) a standard by which every company's value and risk can be compared.
No single measure could capture financial performance comprehensively enough to fulfill such a role.
Is EBITDA a cash flow that is available to investors (creditors and stockholders)?
No!
Was Krispy Kreme a case of massively fictitious earnings?
No, it was a case of nickel and diming to beat earnings guidance by $0.01 in every single quarter
Did Beaver advocate the method that practitioners have institutionalized? Explain.
No, never. The method has also shown to be fatally flawed. Beaver did not conclude that analysts should rely solely on the ratio of cash flow to debt ratio, but merely that it was the single best bankruptcy predictor.
What did Nortel announce on April 28, 2004? Under Canadian Law, what does it mean to be terminated for cause?
Nortel dropped a bombshell in the form of a 50% cut in its previously announced 2003 earnings of $732 million. Under Canadian law the phrase also included "incompetence", so the dismissal did not necessarily imply any criminal acts.
What are the "big bath" and cookie-jar strategies and how did Nortel use them?
Nortel took a big bath in its money-losing period of 2001-2002. Overstating losses created cookie-jar reserves that could be taken into profits later years. The big bath is premised on the belief that magnifying an annual loss will not hurt the stock price as much as magnifying an annual profit will help it in a subsequent year.
Elaborate on how Nortel abused the accrual treatment of contractual liabilities.
Nortel's management raided the cookie jar, taking reserves off its balance sheet without legitimate triggers for doing so and they overstated the reserves to create a bigger cookie jar into which it could dip. (Ex: if they missed a deadline, and estimated a 500,000 refund, they would charge that as an expense in that period. But later, if it was only a 200,00-300,000 refund, the rest would be considered profit in the year the refund was paid.)
What needs to be considered even if the ratio of capital expenditures to depreciation consistently exceeds 1.0?
Persistent inflation means that a nominal dollar spent on plant and equipment today will not buy as much capacity as it did when the depreciating asset was acquired. Depreciation may be understated with respect either to wear and tear or to obsolescence. Capital outlays may be too low even if they match in every sense the depreciation of existing plant and equipment.
From a firm's standpoint, what are the two risks inherent in depending on debt with maturities of less than one year?
Potential illiquidity: If debt comes due at a time when lenders are either unable because credit is tight, or unwilling to renew because they perceive the borrower as less creditworthy than before, the borrower may be unable to meet its near-term obligations. Exposure to interest-rate fluctuations: If a substantial amount of debt is about to come due, and interest rates have risen since the debt was incurred the borrower's cost of staying in business may skyrocket.
Since EBITDA is an earnings-based measure, what type of creative accounting problems does it suffer from, (the same that plague net income)?
Premature or fictitious revenue recognition Aggressive cost capitalizations Understated accruals, etc.
What are some of the problems with quantitative default models?
Quantitative models tend to classify as troubled credits not only most of the companies that eventually default but also many that do not default. Credit analysts must also bear in mind that companies can default for reasons that a model based solely on reported financial data cannot pick up.
Why are the calculation of financial leverage ratios less simple than they may appear?
Ratios are most meaningful when compared across time (historical trends) and across borrower. And against peer averages (cross- sectional analysis.)
What is depreciation and what is the objection to the relevance of depreciation when calculating earnings?
Recognizes certain types of property decline in value over time due to wear and tear or obsolescence and recognizes this property must eventually be replaced. Match expenses with revenue Its preferable for the investor to obtain earnings before depreciation and to make his/her own estimate of depreciation in arriving at approximate net earnings
What is the added level of analysis (beyond sources and uses of cash) that prompted FASB to prescribe a more comprehensive definition of operating cash flows?
Recognizing the need of AP to generate an offsetting amount of cash because of AR and inventories typing up increasing amounts of cash this caused FASB to prescribe a more comprehensive definition of operating cash flow: (OCF = Net Income + Depreciation + changes in WC requirements. WC = AR + Inventory - AP)
What do accounting rules say about setting profits aside?
Sometimes management delays revenue recognition to understate short-run profits in order to report the sort of smooth year-to-year earnings growth that equity investors reward with high price-earnings multiples.
What are Growth CapEx?
These expenditures are asset purchases for territorial expansion or new lines of business. Depending on what's acquired, these expenditures may be covered by debt, cash on hand, equity injections of a combination of these. ("As a rule, Acquisition CapEx will not reduce cash flow before debt service.")
What distinguishes the preceding liabilities (pension plan) from other kinds of hidden liabilities?
These items arise exclusively in furtherance of a business objective (attracting and retaining capable employees), rather than as a surreptitious means of leveraging shareholders' equity.
What did the failure of W.T. Grant bankruptcy show?
The department store chain's collapse showed that reliance on earning + depreciation measure could cause analysts to overlook weakness at a company with substantial WC needs.
What is the treatment of membership refunds under GAAP?
The general requirement was to spread membership fees over the full membership period. Revenue could not be booked until the refund period expired. "percentage completion" has room for hanky-panky
Why is the ratio of depreciation to Cash Flow from Operations considered forward-looking?
The higher the percentage of cash flow derived from depreciation, the more predictable a company's cash flow and the less dependent its financial flexibility on the vagaries of the marketplace. (Will this give us a better idea of stable CF?)
What did Bernstein's findings reinforce?
The message that instead of seeking an alternative to net income that summarizes corporate performance in its entirety, analysts of financial statements should examine a variety of measures to derive maximum insight.
What does Replacement CapEx represent? When do these certain types occur?
The money spent to replace broken, worn or outdated equipment. Certain types of these expenditures can occur every year or be staggered across two or three years. These expenditures then take on the characteristics of Mandatory Recurring CapEx.
What are some of the reasons profits hold such an exalted place in the business world and economic theory?
The necessity of producing profits imposes order and discipline on business organizations. It fosters cost-reducing innovations, which in turn promote the efficient use of scarce resources and also encourages savings and risk taking (which are two indispensable elements of economic development) profitability is a yardstick by which businesspeople can measure their achievements and justify their claims to compensation.
How can Salsa Meister International show a profit when the franchised restaurants consistently lose money?
The restaurants' operations are not part of Salsa Meister International, their revenues are not its revenues, and their costs are not its cost, their income consists of franchise fees.
What is the most immediate danger faced by a lender and how can this condition arise?
The risk that the borrower will suffer illiquidity meaning inability to raise cash to pay its obligations. It can arise for many reasons one of which is a loss of ability to borrow new funds to pay off existing creditors and also inadequate cash flows.
What role, if any, did the treatment of layaway sales at Wal-Mart have on the paradoxical drop in stock prices after an announcement of sales increasing?
The stock price was an overreaction because the changing accounting method did not alter the amount of cash received by the retailer nor the timing of its receipt.
What inspired the attack on the accrual accounting treatment of depreciation?
The world of privately owned real estate, where the logic of managing a public company is turned upside down. Private owners of real estate strive to minimize reported income thus income taxes.
Regarding non-convertible and convertible debt, what is the ultimate objective of the credit analyst?
Their objective is not to calculate ratios but to assess credit risk, the best practice is to count convertible debt in total debt but to consider the possibility of conversion when comparing the borrower's leverage with that of its peer group.
Regarding the liability account "Deferred Income Taxes," what is the argument many credit analysts make and how do they adjust for this?
They argue that net worth is understated by the amount of the deferred tax liability, since it will in all likelihood never comes due and is therefore not really a liability at all. (this statement is true as long as the company continues to pay taxes at less than the statutory rate) Proponents of their view adjust for the alleged understatement of net worth by adding deferred taxes to the denominator in the total-debt-to-total-capital calculation. (Total debt/ total debt+ deferred taxes + minority interest + total equity)
What role did carb-consciousness play in Krispy Kreme's faltering profits?
They blamed that for their 10% drop in earnings than it previously expected. But the real problem was suspected to be over-expansion.
Do improving or deteriorating financial ratios always have the same implications for different companies?
They can be different. This Ratio analysis is an effective technique for assessing relative credit risk.
What did Bristol-Myers executives strenuously deny regarding their accounting policies?
They denied that its accounting policies were geared toward managing earnings or maximizing the compensation of senior executives whose compensation was linked to the company's stock price. They did the cookie jar SEC said restructuring reserves must be used for specified purposes "receivable and justifiable" Divesting lines for EPS.
What classic red flag appeared the day after the SEC launched an investigation of Take-Two accounting practices?
They disclosed that the SEC had launched an investigation of its accounting. Also, the company's CFO resigned.
What accounting practice did the SEC allege Krispy Kreme Doughnuts employed as its store openings stalled?
They manipulated certain expense accruals to produce EPS at least one penny above the guidance. They also improperly recorded questionable transactions involving company purchases of franchised stores
What did users of financial statements and credit analysts notice in regard to the reports of two companies in the same industry reporting similar income?
They observed that two companies in the same industry could report similar income yet have substantially different TEV. They also realized that in a given year, two companies could generate similar levels of income to cover similar levels of interest expense yet represent highly dissimilar risks of defaulting on their debt in the future
What disclosures did GM make in March 2006 regarding their classification of cash flows?
They said that some cash flows from its mortgage subsidiary that should have been classified among its investing activities were instead booked as operating activities. (According to GAAP extending a loan or receiving principal repayment is an investing activity. Interest payments are operating. Repurchase of metals in following year is financing rather than a sale They overestimated the salvage value of cars.)
How can the riddle of a franchiser's profits and franchisee's losses be resolved? Why should the astute analyst be troubled by the way Salsa Meister International converts losses into profits?
They sell stock to the public and then lend the proceeds to the franchisees who then send that cash right back to them under the rubric of fees. Resolved by cutting through the form of the transactions to the substance of the transactions Their wealth does not increase it is merely the circulation of funds.
What do financial statements tell about a borrower's ability and willingness to repay a loan?
They tell much about a borrower's ability to repay a loan but disclose little about the equally important willingness to repay.
What did Bristol-Myers offer as an explanation for the sudden drop in projected 2002 earnings?
They told analysts and investors that the company was cutting back shipments and that 2002 profits would depend on how quickly the wholesalers' inventory levels could be reduced
How did Bristol Myers use channel stuffing?
They used it to accelerate future revenues to the current period. Drug wholesalers were happy to hold more inventory than they needed, as long as the discounts they received were large enough to cover the related carrying costs. They do this because wholesalers could absorb only so much redundant inventory and sooner or later, the scheme would have to end, making it apparent that the company had overstated earnings by borrowing sales from periods.
What are the distinct benefits of quantitative models of credit quality?
They were developed by objectively correlating financial variables with events of defaults (EDF). The record of quantitative models is excellent from the standpoint of classifying as troubled credits most companies that subsequently defaulted
What does the liability account "Deferred Income Taxes" represent and what does it reflect?
This item represents the cumulative difference between taxes calculated at the statutory rate and taxes actually paid. The difference reflects the tax consequences, for future years, of the differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes
For the analysis of financial statements, what is the most important distinction to understand?
To consider only genuine revenues and to deduct all relevant costs
Why would a creditor calculate financial leverage ratios?
To test liquidity. Analysis of current assets and current liabilities provide warnings about impending illiquidity. Creditors also wish to know how much asset value will be available for liquidation to pay off their claims. (The greater the amount by which asset values could deteriorate, the greater the equity cushion and the greater the creditor's sense of being protected)
What are the dangers of attempting to create homogenous peer groups?
Too zealous an effort to create homogeneous peer groups narrows the field to such an extent that ratio comparisons begin to suffer from having too few data points.
What is SFAS 34 and what refinement in the fixed-charge coverage ratio is required by it?
Under SFAS 34, companies may be required to capitalize, rather than expense a portion of their interest costs. It adds "capitalized interest" in the denominator of the fixed-charged coverage ratio.
What types of off-balance sheet obligations do SFAS No. 87 and SFAS No. 106 cover?
Under SFAS 87 balance sheet recognition is now given to pension liabilities related to employees' service to date. SFAS 106 requires recognition of post-retirement health care benefits as an on-balance-sheet liability. Projected future wage increases are still not recognized, although they affect the calculation of pension expense for income statement purposes.
When does Mandatory Recurring CapEx apply? Is this common? How should it be treated?
When a business is obligated to continuously purchase new fixed assets for the purpose of maintaining its existing revenue base. Particularly common among businesses involved in leasing, but it can also be present in manufacturing and other types of companies. Should be treated as an operating expense in the cash flow statement.
Under what circumstances does it make sense for management to delay revenue recognition?
When net profit happens to be running above expectations, managements stows part of it in a rainy day reserve, then later, when the income is needed to boost results to targeted levels, management pulls the earnings out of storage.
What happens when the Replacement cycle of CapEx is long? Or short?
When the replacement cycle is long, the total amount of Replacement CapEx shouldn't be deducted from cash flow because a single year's recurring cash flow is not going to support that purchase. Examples are HVAC or a roof that needs to be replaced every 10 or 20 years. When the replacement cycle is short, cash flow will be the primary source of funding. Replacement CapEx starts to resemble Mandatory Recurring CapEx.
When should Repair and Maintenance be charged to recurring cash flow?
When they are one-time cost, except if they are abnormally large.
Did FASB conclude that the deferred tax liability was a legitimate liability representing a future economic sacrifice?
Yes
Are corporate budget systems designed to reward lies and punish the truth? Explain.
Yes, almost every company uses a budget system that rewards employees for lying and punishes them for telling the truth. Linked between budget targets and compensation.
Can companies with similar interest rate coverage have a substantially different default risk? Explain.
Yes, similar to companies with similar net income and interest coverage ratios can have substantially different TEV.
Is it common to take liberties with booking expenses?
Yes, to minimize expenses.
Under what conditions is there a universally agreed upon definition of profit?
profit is equal to revenues minus costs
What were some of the risks associated with Bally's increased reliance on customers who had to borrow in order to join?
could result in acceptance of more marginally qualified customers, the newer members might be less financially capable or less committed to physical fitness if more members failed on their payments than management assumed, Bally would prove in hindsight to have been too aggressive in recognizing revenue and would have to rescind previously reported income.
What pathology did GM illustrate as its fortunes deteriorated in the early 2000s?
that culture may change if profitability starts to end
Why would Krispy Kreme try to recover the store-closing costs and overdue interest only to pay it right back?
the extra money paid out to Dough-Re-Mi became part of an intangible asset (reacquired franchise rights) which would not be amortized When the very same dollars came back to Krispy Kreme they would be recorded as interest income they manufactured earnings by taking money out of one pocket and putting it into another a. Krispy Kreme and its Michigan franchisee to absorb the cost of closing two underperforming stores and repay all the past due interest that was owed. KK also agreed to increase purchase prices of the two stores Warning sign of cash inflow - it's from sale-leaseback's. They overpaid and over expanded
