FIN 4370 FSA Quiz 2(Ch5-8, 13)

1. What is depreciation and what is the objection to the relevance of depreciation when calculating earnings?

- Depreciation: an accounting process that 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. relevance: relevance to earnings is hard because it is malleable. Companies can raise or lower its reported earnings by using the latitude of assuming shorter or longer average lives for its depreciable assets.

What are some of the complications preferred stock introduces in the financial leverage calculations?

- It is legally equity - failure to pay interest doesn't constitute a default - it's dividends are cumulative - it has a sinking fund provision - sometimes can be transformed into debt

Lessons learned form Krispy kreme case and generally consistent earnings growth:

- Lessons learned are that consistent beating of earnings are signs of fraud - related party transactions and deceptive reporting go hand and hand - when companies offer explanations for decreased earnings that don't withstand scrutiny, they're probably using financial reporting tricks to cover up the true causes.

Lessons from Haliburtion:

- auditor's seal of approval doesn't mean much - immateriality is used to justify a lot of things - prestigious individuals in control of things doesn't mean they're done right.

What are some of the reasons profits hold such an exalted place in the business world and economic theory?

- imposes order and discipline on the business organization - it fosters cost reducing innovations - promotes efficient use of scarce resources - it encourages saving and risk taking - is the yardstick by which business people measure their achievements and justify their compensation

1. Would a loss of value occur for an apparel manufacturer whose management guesses wrong about the fashion trend and is holding inventory that can be sold, if at all, only at knockdown prices?

1. According to accounting standards, they should. Management may argue that they don't need to write off the loss. Rather than selling the inventory at significantly discounted prices, a company may decide to retain them in finished goods inventory.

Under what circumstances, if any, can companies book revenue before billing their customers?

Companies engaged in long term contracts such as construction companies

Why are the calculation of financial leverage ratios less simple than they may appear?

1. Aggressive borrowers frequently try to satisfy the letter of maximum leverage limit imposed by lenders without fulfilling the conservative spirit behind it. These ratios are more meaningful when compared across time and against peer averages.

1. Why do companies welcome the migration towards less variable measures of performance?

1. Because investors reward stability with high price earnings multiples.

1. 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?

1. Change in working capital, where WC is AR+INV-AP, was added.

1. What inspired the attack on the accrual accounting treatment of depreciation?

1. Companies can raise or lower its reported earnings by using the latitude of assuming shorter or longer average lives for its depreciable assets.

Why is the Total Debt to Equity ratio important?

1. Creditors use it to gauge the amount of equity that is beneath them which gives creditors more cushion.

Other than operating leases, what are other ways companies try to obtain the benefits of debt without suffering the associated penalties imposed by credit analysts?

1. Entering into joint ventures or forming partially owned subsidiaries. In some cases, the affiliate's operations are critical to the parent's operations.

1. How can a rising debt-to-capital ratio confirm an adverse credit trend revealed by operating cash flow?

1. If a company does not finance the bulge in inventories and receivables by extending its payables or drawing down cash, it must add to its borrowing, which would lead to a rise in debt to capital ratio.

Regarding non-convertible and convertible debt, what is the ultimate objective of the credit analyst?

1. It is not to calculate ratios but to assess credit risk. Analysts should count convertible in total debt but also consider the possibility of debt conversion when comparing a borrower's financial leverage with its peer groups.

1. What did Bernstein's findings reinforce?

1. It reinforced 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 is the risk when all preferred stock is treated as equity?

1. It understates risk because some preferred stock can be turned into debt, raising the risks.

1. What problems are signaled by a surge in accounts receivable?

1. Management may be trying to prop up sales by liberalizing credit terms to existing customers, or it may result from extension of credit to new, less creditworthy customers that pay their bills comparatively slowly without an increase in bad debt write-offs.

Accounting rules distinguish between capital and operating leases. Should the user of financial statements be satisfied with this treatment?

1. No, because The two financing vehicles frequently differ little in economic terms. One is just left off the BS and the other is not. Capital leases must reflect on the BS separately as a liability or part of long term debt. In addition to including capital leases in the total debt calculation, credit analysts should also take into account operating leases which are reported as rental expenses in the notes to financial statements.

For the analysis of financial statements, what is the most important distinction to understand?

They must know what are genuine revenues and distinct costs

What is the assumption that if not true weakens the argument for favoring the EBITDA-based over EBIT-based fixed charge coverage

1. The assumption is that 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. Capital spending may exceed depreciation.

What is the most immediate danger faced by a lender and how can this condition arise?

1. The danger is that the borrower will suffer illiquidity, an inability to raise cash to pay its obligations. It can arise from a loss of ability to borrow new funds to pay off existing creditors.

What were the lessons learned from the wave of LBO-related bond defaults of the 1980s

1. The lesson learned was that depreciation was not available as a long run source of cash for interest payments.

1. What is the rational explanation of the phenomenon of an investment increasing in value while generating losses?

1. The rate at which the tax code allows owners to write off property over states actual wear and tear. Thus there is a difference between economic depreciation and tax depreciation. Due to MACRS

From a firm's standpoint, what are the two risks inherent in depending on debt with maturities of less than one year?

1. The two risks are potential illiquidity to renew their loans because credit is tight or unwillingness to renew, and is the exposure to interest rate fluctuations.

What distinguishes the preceding liabilities from other kinds of hidden liabilities?

1. These items are exclusively in furtherance of business objectives, such as attracting and retaining capable employees. A large or growing underfunded liability can be significantly negative in assessing a deteriorating credit.

Why would a creditor calculate financial leverage ratios?

1. They are used to figure out how many assets can be used for liquidation purposes.

1. How can management mask problems related to inventory or receivables?

1. They can do it by pumping up the third component of working capital requirements, AP.

How can a firm insulate itself from floating interest rate fluctuations?

1. They can limit the risk by using financial derivatives (interest rate swaps, forward rate agreements, Eurodollar cd futures market).

What types of off-balance sheet obligations do SFAS No. 87 and SFAS No. 106 cover?

1. They cover pension liabilities related to employee's service to date, and postretirement healthcare benefits.

What are some of the reasons why analyzing a company's financial statements may not be sufficient to determine its credit quality?

1. borrower's credit may be supported, formally or informally, by another entity. Some muni bonds are backed by bond insurance. A thorough analysis may not include a check of the subjects past record of repayment which is not part of a standard financial statement. Borrowers must consider the competitive environment and strength of the local economy in which the borrower operates.

Are corporate budget systems designed to reward lies and punish the truth?

1. they are. They do this because budget systems are tied to employee compensation, essentially motivating them to do whatever they can to meet budget.

1. What is "channel stuffing"?

Accelerates future revenues for the current period by over forcing products into a channel they can't sell

1. What is one of the most abused features of financial reporting?

Accruals is one of the most distorted features in financial reporting

For financial analysts, what is the practical definition of accounting profit?

An accounting profit is whatever the account rules says it is.

1. What is the difference between this abused feature and a payable?

An accrual is a payment in the future for goods and services that have already been received but not yet billed. Payables are ongoing expenses that are short-term debt and must be paid in a certain time frame to avoid default and is supported by an invoice.

1. Why was diverting analyst's focus away from traditional fixed charge coverage and toward EBITDA coverage of interest particularly beneficial during the 1980s?

Because having a ratio above one is very comforting to lenders, and in the 80s, buyouts were so highly leveraged that EBIT wouldn't cover interest expense even in a good year.

1. Why would it be seem paranoid to a novice analyst to consider every company's income statement with suspicion?

Because they have never been blind sided by restatements and revisions of financial statements

1. Why must the simple formula of revenues minus costs not be taken at face value?

Because they're malleable and subject to manipulation.

1. What happens to firms that spend the minimum on property, plant, and equipment, year after year?

Companies would lose their competitive advantage.

What are telltale danger signals?

Conspicuous surges in unbilled recievables and deferred income are telltale danger signals.

1. Why and how will the way Salsa Meister International converts losses into profits end?

Eventually owners will realize this and stop lending money, thus killing the process.

What did accounting rules (in 2001-2005) state regarding rebates?

If 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 tan booked immediately.

1. How does the major risk of analytical error in the reporting of depreciation expense arise?

It arises when depreciation can be used to hide profits. From the possibility that economic depreciation will exceed reported dep expense and reported dep expense will exceed economic dep.

1. What did Altman's model demonstrate?

It has demonstrated that no single financial ratio predicts bankruptcy as accurately as properly selected combination of ratios.

1. What is the incentive for "new economy" firms to break free from the focus of after-tax earnings as a basis for valuation?

It is because of the minimal net profits in new economy companies. These companies PE makes their stock look expensive.

What are some after-the-fact explanations for excesses in income reporting?

Misjudgments, bookkeeping errors, deliberate misrepresentation by rogue managers, or some combination of the three.

What does the liability account "Deferred Income Taxes" represent and what does it reflect?

It 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.

What do financial statements tell about a borrower's ability and willingness to repay a loan?

It shows a lot about a borrower's ability to pay a loan but little about their willingness to pay a loan

1. What are some of the reasons that capital spending may exceed depreciation over time?

It will exceed dep over time as the company expands its productive capacity to accommodate rising demand, and newly acquired equipment may be costlier than the old equipment being written off.

Under what circumstances does it make sense for management to delay revenue recognition?

Management might delay revenue recognition when they are doing well and save it for a time when they're not doing as well, in order to disguise the fact that they aren't doing well.

What are some of the ways companies downplay expenses?

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

What is the treatment of membership refunds under GAAP?

Membership fees should be spread over the full membership period. If a company offered refunds, it could not book any revenue until the refund period expired.

Regarding the liability account "Deferred Income Taxes," what is the argument many credit analysts make and how do they adjust for this?

Net worth is understated by the amount of the deferred tax liability, since it will in all likelihood never come due and is therefore not really a liability at all. They adjust for it by adding deferred taxes to the denominator in the total debt to total capital calculation.

1. 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.

1. What do accounting rules say about setting profits aside?

Profits can only be set aside for foreseeable and quantifiable liabilities.

What is the important take away from the Nortel case?

Seemingly small items can prove highly significant.

Under what conditions is there a universally agreed upon definition of profit?

The agreed definition is only at the extremely rudimentary level of revenue - costs = profit

Why should the astute analyst be troubled by the way Salsa Meister International converts losses into profits?

The astute analyst is troubled because wealth hasn't increased

cookie-jar strategies?

The cookie Jar strategy involves over stating losses creates a cookie jar reserve that can be taken into profits in later years.

What is the litmus test that a calculation of bona fide profits must pass?

The litmus test is weather owners are wealthier now than before.

What must financial analysts do to benefit from the insights provided by the careful scrutiny of financial statements?

They must be disciplined enough to disbelieve the innocent explanations that companies routinely provide for abnormalities that point to trouble down the road.

1. What is the fine line that financial analysts must walk?

They must not lose touch with economic reality by hewing to accounting orthodoxy, but on the other hand, they must not accept the version of reality that seekers of Cheap capital would like to foist on them.

1. Aside from seasonal variations, what should analysts suspect when inventories or receivables increase materially as a percentage of sales?

They should suspect that earnings are overstated, even though management will invariably offer a more benign explanation. The amount of working capital need to run a business represents a fairly constant percentage of a company's sales. If inventories or receivables increase materially as a percentage of sales, analysts should strongly suspect earnings are over stated.

1. 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?

They will set easy targets and do their best to meet them even if it means damaging the company

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 would have substantially different total enterprise value. They could produce similar levels of income to cover interest but have dissimilar levels of risk. Long before the dot com companies began seeking alternatives to net income, user noticed two companies could have substantially different total enterprise value

1. Under what conditions are the physical wear-and-tear of plant, property and equipment not considered an expense in the calculation of profits?

When a capital intensive business is marginally unprofitable. Land, land rights with indefinite lives, site preparation, grading and land scaping, excess plant and equipment, when an assets salvage value is => the cost of the asset, reserve construction equipment, PPE in the process of construction until the facility or segment thereof, is replaced in service.

1. Can companies with similar interest rate coverage have a substantially different default risk? Explain.

Yes they can, because some can be less capital intensive, thus depreciation has more or less of an effect on them. If a company loses profitability, they could still have the cash on hand to cover interest expense if they have high depreciation.

1. Is it common to take liberties with booking expenses?

Yes, corporate managers are just as creative with minimizing and slowing down the recognition of expenses as they are in maximizing revenues.

1. How can EBITDA help credit analysts discriminate between two similar-looking credit risks?

depending on the EBITDA and the amount of depreciation and amortization they have, they can figure out how much cash the company will have to cover interest expenses if they start to lose margins and revenue. Simply add back depreciation and Interest.

How can the riddle of a franchiser's profits and franchisee's losses be resolved?

sell stock to the public and then lends the proceeds to the franchisees. The franchisees send the cash right back to the franchiser under the rubric of fees. Franchiser take the fees which exceed the cost of running headquarters, and names it revenue.

What are the "big bath" and cookie-jar strategies?

the big bath strategy is premised on the belief that magnifying an annual loss will not hurt stock prices as much as magnifying an annual profit will help it.