FSA Quiz 1
How did Scrushy react to the SEC charges?
"Im not an accountant," he later stated in a civil trial related to these allegations.
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?
"Our focus in 1999 was threefold" "First to increase our operating margins at each operating entity; second, to decrease our marketing costs; and third, to increase our cash sales from our non-casino operations. We have succeeded in achieving positive results in each of these three categories.
What are some of the commonly heard rationalizations for declining growth?
"Our year over year comparisons were distorted" "New products will get growth back on track" "We're diversifying away from Mature Markets"
What was Enron's equivalent of saying: "trust me"?
"Ultimately they're telling you what they think the answer is, but they're not telling you how they got to that answer."
How did Enron's president J. Skilling respond to those who questioned the veracity of the firm's reported earnings?
"Well thank you very much, we appreciate that.."
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?
- audited by trained professionals -finance and enforcement -disclose events that affect statement
How does the existence of a secondary market influence P/E multiples?
A closely-held company may sell out to a publicly-held company at a lower P/E multiple to gain liquidity from the purchasing company's shares
Using the example of specialized machinery, illustrate some of the difficulties encountered in the quest for true value.
A company would not pay more for a piece of equipment if it is perceived as worth less If a potential purchaser is located hundreds of miles away, the machinery's value in a liquidation would be further reduced by the costs of transporting and reinstalling it
What elaborate financial engineering technique was disclosed in the footnotes of Parmalat's Brazilian unit? How did it affect shareholder's equity? How is this technique an example of hedging?
A disclosure that on January 18th, 2002, the subsidiary issued a 500 million security convertible into company shares. Selling debt in one unit and buying it in another, the company increased its shareholders' equity They were said to be engaging with related parties in currency hedges
What role, if any, did insider trading have in the uncovering of HealthSouth's financial reporting fraud?
A large stock sale by Scrushy three months before that precipitous drop aroused the SEC's suspicions of insider training. Led tin unexpected direction of financial reporting.
What is impairment?
A loss of value arising from a clear indication that the obligator will be unable to satisfy the terms of the obligation
How much advanced notice did investors have before Parmalat's collapse?
A month Until 9 days before the bankruptcy filing, the company's debt carried and investment grade rating
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 with the techniques described early. Analysts should take notice if a company posts a substantially greater sales increase than its competitors.
Under what circumstances, if any, can an asset be carried at two different values in a single balance sheet?
A university endowment fund or pension plan sponsor might be a limited partner in two private equity funds that own the same privately-held company Each private equity fun places a different value on the company
Which accounting firm was Enron's auditor, and how did they respond to the firm's violation of basic accounting standards?
According to GAAP, a stock sale cannot be recorded as equity until the issuing company receives cash Arthur Anderson agreed to waive the requirement on the grounds this transaction was immaterial
What is the main advantage of using historical cost as the basis of a system to value assets? What are some of its disadvantages?
Advantage: Its an objective and verifiable figure and compatible with accountants' traditional principle of conservatism Disadvantage: goodwill is not recorded clearly because it's not in a transaction
Elaborate on the way the response to the 2001-2002 scandals illustrate the way lobbying functions to block reforms.
Advocates for the users of financial statements, such as the chartered financial analysts institute, are outgunned by corporate and auditing interests. Those groups commit substantial resources to participate in hearings and requests for comments that influence the deliberations of the Financial Standards Board and the SEC.
Where does genuinely valuable analysis begin?
After all the initial questions have been answered. Value is added when the questions are asked that aren't even on the checklist.
What caused Lernout and Hauspie Speech Product's auditor to withdraw its clean opinion in the financial statements?
After the Belgium producer of speech-recognition and translation software that an internal investigation had uncovered accounting errors for those two years.
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. In the worst case, the company runs out of cash to maintain its operations and declares bankruptcy
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?
An analyst of financial statements may be confronted by special pleasing on behalf of a loyal, long-established client may argue that a loan request ought to be approved, despite substandard financial ratios, on the grounds that the applicant is a young, struggling company with potential to grow into a major client
In addition to accounting rules, cash flows, and analytical techniques, what must a complete financial analysis include?
Analyst must consider the motivations of corporate managers, which could differ from stockholders
Arthur Andersen was forced out of the accounting business as a result of what actions as Enron's auditor?
Arthur Anderson was convicted of obstruction of justice for shredding documents related to the Enron audit
What were some of the conventional tactics employed by Scrushy's defense?
Attacking one government witness for marital infidelity. His lawyers hammered at the light sentences meted out to HealthSouth executives who confessed and testified against Scrushy.
Why should users of financial statements provide themselves with an additional layer of protection through tough scrutiny of the numbers?
Because of the observed gap between theory and practice in financial reporting.
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?
Beppe Grillo, a comedian. He said anyone could have seen the holes in Parmalat's balance sheet, given the financial reports were easily accessible. He had a degree in accounting.
How did HealthSouth exaggerate its earnings? How did it affect its Balance Sheet?
By understanding the gap between the cost of a treatment and the amount that the patient's insurance would cover. Each time the company overtstaed its net revenue and earnings in this way, it made a corresponding balance sheet adjustment, raising the value of an asset such as property, plant, and equipment "The Cookie Jar"
What new SEC rules went into effect in the early 2000s and what effect did it have on the interpublic's financial reporting?
CFO could be subject to fines or prison sentences if they certified false financial statements.
What are some of the approaches used by non-accountants to establish the value of real assets?
Capitalization of net rentals, inferring a value based on sales of comparable properties, and estimating the value of a property Estimating the value of a property if is put to its highest and best use
What are some of the challenges one encounters when attempting to calculate fixed vs. variable costs?
Companies do not generally break out their fixed and variable costs A company with relatively high variable costs is subject to inflation shock that increase input prices and/or expenses A company with relatively high fixed costs has a higher breakeven level
How and why do firms use these terms?
Company officials not only encourage financial statement users to disregard these losses, but ask them to ignore certain hits to earnings because management pronounces them aberrant
What is the cornerstone of GAAP?
Compatibility. Compare standard financial ratios (historical/trend analysis)
What event in 1997 caused HealthSouth's operating margins and profits to plummet? How did Scrushy respond?
Congress cut back Medicare reimbursements to hospitals. He responded by slashing salaries and diverting unprofitable sidelines. When that failed, he tightened operations, cutting average patients' stays from 21.5 to 17.5 days.
Common Form Balance Sheet: What is it and what are its uses?
Converts each assets and each liability or component of equity into a percentage of total liabilities plus shareholders equity To check whether something like inventory is increasing significantly as a percentage of total assets
How far back did the Enron restatements announced in late 2001 go
Covered annual reports beginning in 1997
How can one tell if a company's earnings are sensitive to fluctuations in interest rates?
Debt ratio. Debt/Tangible Net Worth Ratio, Times Interest Earned, Interest Coverage, and DFL
What did prosecutors disclose in July 2003 that compounded Scrushy's legal problems?
Disclosed in July 2003 that they had uncovered evidence of tax fraud, obstruction of justices, witness intimidation, money laundering, and public corruption.
What does it mean to "make the numbers talk?"
Draw a few conclusions, then puts the income statement into context by comparing it with income statements of earlier periods, as well as statements of other companies.
Using the example of Lehman Brothers, elaborate on how internally inconsistent valuations can affect the balance sheet of an enterprise.
Each trading desk within the investment bank had its own methodology for pricing assets The investment bank based its second quarter 2008 prices for one group of assets on a morgan stanley research not published in the first quarter of that year
How does "negative equity" dramatize the contrast between the economist and accountant's notion of equity?
Economist: equity of less than zero is synonymous with bankruptcy because when a company's liabilities exceed the PV of all future income, it is not rational for the owners to continue paying off liabilities Accountant: if a company records net losses for several years and writes off selected operations, the book value of its assets can exceed liabilities
What are two crude examples of Enron's fraudulent activities?
Employees claimed that in 1998, management took them to an empty trading floor and had them pretend to be salespeople busily engaged in selling energy contracts, all to impress visiting securities analysts. Scheme in which Enron reportedly borrowed $500 million from a bank and bought Treasury bills. A few days later, it sold the Treasury bills and repaid the bank, reporting the process from the meaningless transaction as operating cash flow.
Compare and contrast Enron's method of booking revenue with the method employed by a brokerage firm.
Enron booked revenue from its energy-related derivatives contracts at their gross rather than net values
How did Enron address the difficulties resulting from not having market prices for long-dated contracts?
Enron was allowed to generate its own valuations, using undisclosed assumptions and pricing models.
What were some of the inconsistencies in Enron's financials spotted by McCullough Research?
Enron's quarterly earnings report for the nine months ending September 30, 2001, claimed $544 billions of notional revenue, yet its federal energy regulatory commission filing for the same period showed only $693 million of energy purchases and sales. Discrepancy between reported earnings less dividends and additions to retained earnings. Firm noted that Enron's reported cash flow included customer deposits in California that had to be repaid at a later point. Cash flow was negative.
What is the goal when analyzing an income statement?
Essentially determine whether the story it tells is good, bad, or indifferent
In addition to double counting of revenue, what other items were part of Interpublic's misreporting?
Estimate of not-yet-realized insurance proceeds, write-offs of accounts receivables and work in progress, and understand liabilities at other interpublic subsidiaries datings as far back as 1996. consolidate FS can hide powerful information
What is "synergy" and what are some examples?
External growth leads to improved profitability through operating expenses In general, the less closely related the combined businesses are, the less certain the economics of scale
How can the careful study of financial statements raise red warning flags regarding risk in mergers and acquisitions driven by stock-for-stock transactions?
Financial analysts should segregate ongoing operations from purchased earnings growth
Parmalat was founded in 1961; became internationally known by 1970; went public in the 1990s; and filed for bankruptcy in 2003. How long was Parmalat falsifying financial statements?
For at least a decade
What are some of the criticisms leveled at traditional accounting systems?
Generally permitted assets to rise in value only if they were sold.
What is a major difference between inventories or accounts receivables and goodwill?
Goodwill is not a separable asset that management can convert into cash or use to raise cash to extricate itself from a financial tight spot
How did Scrushy capitalize on the prosecutor's decision not to seek a change in venue from Birmingham?
He capitalized on the confident prosecutors' decision not to seek a change in venue from Birmingham, where he was admired as a local boy who made good. Pushed this advantage by hosting a new television series on a Birmingham station.
What was CEO Lay's response when questioned about Enron's complex transactions?
He replied that the questions were getting way over his head
What are some of the useful, albeit limited observations one can make from observing an income statement in its raw form?
How sensitive is the company to changes in revenue and various expenses What is/are major sources of expenses and how much control does the company have other this/these expense What is/are the major sources of revenue Whether the company was profitable vs. unprofitable
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 too.
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 Its regulator will declare the institution insolvent, based on a market-induced and genuinely temporary decline in the balance sheet value of its derivatives
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 cultures.
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 DSO Deteriorating gross margins Decreasing rates of depreciation Decreasing asset quality (defined as an increase in the ratio of noncurrent assets other than property, plant, and equipment to total assets) Growing sales
What was the eventual outcome of Scrushy's legal problems?
Indicted of charges of bribing the former governor of Alabama to appoint him to the state board responsible for approving hospital construction. He faced a shareholder suit and SEC civil charges arising from the accounting fraud. Eventually he was convicted of the bribery charge and sentenced 10 year and 6 months in prison
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 are risk-based-audits? When did they emerge? And what incredible feature did they include?
Instead of focusing on details of individual transactions, they identified the areas in their judgement presented the greatest risk of error or fraud, such as complex derivatives. Risk based audits emerged as a means of keeping a lid on costs. These judgements in some cases were based on management's advice.
What were the doctrinal disputes over accounting for assets that intensified during the late 1990s?
Intellectual capital came to represent growing proportions of many major corporations' perceived value Book value fell from 95% to 71% of the stock market value of public companies in the United States
When examining a company's financial statements, is one interested in the past of the future? Explain.
Is less important for what it tells about the past than for what it implies about future years. Last year's earnings, have no direct impact on a company's stock price.
What is the relationship between operating leverage and breakeven level of sales?
It indicates the rate at which EBIT and therefore net income increase once sales volume rises above the breakeven point
What is "restructuring" and what is the dangerous trap that users of financial statements must avoid?
It is a catchall for changes companies want analysts to consider outside the normal course of business. i. These expenses do not qualify for below the line treatment The trap for financial analysts is inferring restructuring charges connote finality i. These overcharges can be "adjusted" in future years to supplement and smooth earnings
What are the two objections one may raise regarding the above?
It is fraudulent to obtain capital "cooking the books" Misleading the users of financial statements is not a sustainable strategy over the long run
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 capitalization can be calculated on any day that the stock exchange is open Adjusts instantaneously to news
Why should analysts keep track of senior management turnover?
It's a classic warning sign of financial misrepresentation.
What was the most dismaying action of HealthSouth's auditor? Would the standard auditing practice have uncovered the fraud?
It's failure to challenge a sudden, large increase in cash. No, the auditing firm concluded that the company's accounting was legitimate.
What are the some of the drawbacks of using market capitalization as a measure of equity?
It's obtainable only for corporations with publicly traded stocks Publicly traded stocks are also subject to systematic risk in addition to unsystematic risk
How did HealthSouth respond when auditors questioned some of the accounting entries related to the fraud?
Knowing that the auditors would question an addition to fixed assets only if it was greater than a certain dollar amount, the company officials were careful not to exceed that threshold.
Elaborate on the use of assumptions about assumptions that users of financial statements must consider.
Liberal Side
How did Scrushy's indictment in 2003 make history?
Made him the first CEO accused of violating Sarbanes-Oxley Act because he had signed financial statements.
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. On 11/19/01, Enron told its investors 9.15B in debt was due at the end of 2002 and only had 1.75b in cash and availability under its existing lines of credit lines
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 nontraded assets and related-party transactions with private partnerships.
What would have been the consequences of Enron's debt being downgraded to speculative grade?
Might compel it to issue tens of millions of shares of stock to cover $3.3 billion of loans it had guaranteed, driving down its share price through dilution.
What must a conscientious analyst do?
Must determine how accurately the statement reflects the issuer's revenue, expenses, and earnings.
Would a careful reading of the Notes to Financial Statements disclose whether a company is exaggerating revenues? Provide examples.
No A company might lower the credit standards it applies to prospective customers without simultaneously raising the percentage of reserves it establishes for losses on receivables. A manufacturer may institute short-term discounts that encourage its dealers or wholesalers to place orders earlier than they otherwise would.
Did Parmalat actually engage in currency hedging?
No Since Parmalat units engaged in currency hedges with related parties, the economic impact of such transaction does not truly constitute a hedge
What standing do the terms "nonrecurring" and "unusual" have under GAAP?
No official standing under GAAP
Since a corporation exists for the benefit of its shareholders, what can be said about the purpose of financial reporting.
Obtain cheap capital
What other reasons existed for questioning whether HealthSouth's board was sufficiently independent?
On director earned $250,000 a year in consulting fees from the company, and another received a $5.6 million contract to install glass at a hospital constructed by HealthSouth. They would go along with whatever he wanted them to do Directed more than 174 million in business
What was the reasoning behind Scrushy's overstatement of the impact of changes in Medicare reimbursement?
Other HealthSouth executives were worried that under the newly enacted Sarbanes-Oxley Act, the requirement to certify the company's false financial statements meant they might face prison sentences.
What was a major red flag of Parmalat's impending collapse? What was the CFO's response when challenged on this point?
Parmalat's voracious appetite for debt, despite claiming to have a huge cash balance. CFO replied the company was on the acquisition trail and its liquid balances were earning good returns
What happens when the measure of achievement becomes more important than the accuracy of the measure itself?
People attempt to move the yardstick Corporations may try to block the introduction of new accounting standards that might reduce their reported earnings
What classic and other dodges accounted for most of the $500 million of Enron's questionable accounting practices?
Propped up profits by failing to write off receivables with little chance of being collected. Which accounted for most of the $500 million of questionable accounting uncovered by an internal investigation. In addition, the company did not recognize losses when it sold assets that had declined in value. Arm and leg braces bearing HelahtSouth's logo were treated as inventory although these did not generate revenue since they were free at its medical centers.
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?
Rather than a liquidation value, this type of asset is valued at the amount in which it can be bought or sold in a transaction between willing parties If no active market for the asset exists a company can determine its balance sheet value on the basis of quoted prices for similar assets that are actively traded The basis of quoted prices for similar assets that do trade actively or use its own assumptions about the assumptions market participants would use to offer or bid for the asset it is valuing
What are two distinct approaches to financial statement analysis?
Routine- filling in the boxes with no real analyzation. Plug and Chug Proactive Approach- relentless pursuit of accurate financial profiles of the entities being analyzed. Continue to be skeptical while looking and asking questions.
What is the environment created by institutional investors and why is it far from ideal?
Sacrificing analytical comprehensiveness to the operational objective of maintaining up-to-date earnings estimates on vast number of companies
What are the powerful, continued growth limitations faced by corporations?
Saturation- sales that grow at astronomical rates at a time entry of competition- increasing base- it is arithmetically possible for volume to increase indefinitely market share constraints- basic economics and compounded interest tables assure the financial analyst all growth stories will come to an end
Contrast and compare Scrushy's statements in a 60 Minutes interview and in a congressional hearing.
Scrushy disavowed any culpability in an interview on the 60 minutes network television program, but when asked to repeat his declaration of innocence in a congressional hearing, he invoked his fifth amendment right against self-incrimination. Later during his trial, Scrushy said that if acquitted, he would try to regain his position as CEO of HealthSouth.
What is the dark side of aligning management and shareholder interests?
Sometimes corporate executives put their own interests ahead of their shareholders' welfare. They will beef up their own bonuses by overstating profits, game the system need to work harder than ever to spot hidden gambits
What were the danger signs that something was amiss in Parmalat's financial statements?
Suspiciously high profitability. Should have operating margin of 6 to 7 percent, but they had 12. Lack of transparency. Lack of transparency in financial reporting
What are some of the conditions that provide economies of scale?
Technological advances Increase worker productivity Consolidation of mom-and-pop business, manufacturing facilities
What was behind HealthSouth success in its early years?
Thanks to a large measure to a generous Medicare reimbursement policy for physical rehabilitation of an arguing population keen on sports and exercise.
What does the record indicate about analysts' ability to detect Enron's fraud?
That not even diligent scrutinizers of Enron's financial statements recognized the depths of the fraud. Management successfully concealed the worst of its misdeeds until most of the investors' money had been lost.
What disturbing statement did HealthSouth's internal auditor make? What was Ernst & Young's response?
That she could not get full access to the company's books. The independent auditor took no action in response to that disturbing statement, according to another partner.
What signs of trouble surfaced in the last two months before the bankruptcy?
The Italian stock market regulator requested details on how Parlamat had invested 3.5 billion and how it planned to pay back bonds schedules to mature by the end of 2004.
What role did the Sarbox provision play in the HealthSouth fraud?
The Sarbox provision requiring CFOs and CEOs to attest to the accuracy of financial statements gave prosecutors a powerful weapon to wield against falsifiers, but HealthSouth's fraud dispelled any notion that the ough new law would end financial misreporting altogether,
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 posed a huge obstacle to analysts. The company did its best to make its financial reports unfathomable. Analysts should be especially wary when a strong likelihood of financial manipulation, as indicated by tools such as the Beneish model, coincides with nontransparent financial reporting.
What would make intense analysis of financial statements superfluous?
The combined impact of corporate disclosure requirements, external audits, and regulatory backup.
Which items in Parmalat's financial statements showed evidence of the fraud?
The company had net debt of approximately $18 billion, almost $16 billions of which had not been disclosed previously. The company's revenues for the nine months ended. Revenue was lower. Actual assets were down.
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?
The company's frequent recourse to the bond market, while reporting high cash balances, threw into question its cash-generating ability. Turned out to be that the cash was fictitious They also argues that maintaining vast amounts of debt while holding cash, that generated a lower interest rate, rather than paying down debt represented "inefficient balance sheet management."
What is another reason why candid reporting is not consistent with management self-interest?
The corporate executives who lead the battles against FASB have their own agenda and want to maximize their own wealth.
What are several different ways a company can increase revenues before the end of a quarter?
The corporation simply borrows sales from the next quarter by offering customers special discounts to place orders earlier than they had planned channel stuffing, illegal and fraudulent
What hint about Enron's deceptive methods emerged as the company was attempting to save itself through sale to Dynegy?
The day before the company forced out Chief Financial Officer Andrew Fastow, the Financial Accounting Standard's Board Emerging Issues Task Force received a rush question: A hypothetical "Big Energy Corporation" has a natural pipeline subsidiary and an energy trading subsidiary. May the company report profits earned in one subsidiary but not report losses incurred at the other?
How has a firm been traditionally portrayed? How is a firm viewed now?
The first model is inclined to overstate their earning if they can do legally and if they believe it will boost their equity market valuation. Now, the corporation is viewed more realistically as an aggregation of individuals
What is documented in the section "How Accurate Are the Numbers?"
The indefatigability (seemingly incapable of being fatigued) of issuers in devising novel gambits for exploiting these vulnerabilities.
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?
The long terms interests of the firm's owners, in other words, may not be consistent with the short-term interests of their agents, their salaried managers.
How can the firm lower the rate it must pay to obtain financing?
The lower the interest rater at which a corporation can borrow the interest rate at which it can sell stock to new investors, the greater the wealth of its shareholders.
What enabled Enron to make itself less debt-laden than it really was?
The off-balance-sheet vehicles combined with nontransparent disclosures Off-balance-sheet entities were used to keep debt off Enron's books based on accounting rules which Enron could asset it did not exert
Why is tenacity so essential to the analysis of financial statements.
The often conceal more than they reveal.
What is the real scandal involving major financial reporting violation when they come to light?
The real scandal involves what is not forbidden, flexibility in GAAP interpretation
What is the fallacy embodied in the conclusion that a company can improve its credit quality by making stock-for-stock acquisitions at excessive prices?
The receivables, inventories, and machinery available to be sold to satisfy creditors claims are no greater in scenario II than in scenario I Since the total-assets-to-total-liabilities ratio is lower at Consolidator than Amalgamator, the combined companies' ratio logically should be lower than at Amalgamator. Amalgamator shouldn't have a better credit quality if it overpays for Consolidator than if it acquires the company at a fair price
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 know knowledge, fewer nonextreme positive emotions, and fewer references to shareholder value and creating value. Deceptive CEOs make fewer references to themselves and more to impersonal third parties. They use more extreme positive emotions and fewer extreme negative emotions, as well as certainty and hesitation words.
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 di its best to intimidate anyone who complained about inadequate disclosure.
What is the tension that exists for the auditing firm?
The tension exists between standards of professional excellence (when it must be acknowledged, matter a great deal to most accountants) and fear of the consequences of losing a client.
What are the two fundamental shortcomings of using the Balance Sheet to summarize the values of all assets owned by an enterprise?
The values frequently prove elusive in practice Many kinds of things have value and could be constructed as assets, but not all of them can be assigned a specific value
What is a prepaid swap and how did Enron use it to disguise the magnitude of its debt burden?
These transactions required Enron's counterparties to make their payments upfront while Enron's payments were spread over a multiyear period
How did HealthSouth avoid detention of its financial fraud? How did this avoidance affect its Balance Sheet?
They created fake documents
What event caused Enron's investors to become alarmed about the lack of clarity regarding the partnerships?
They feared that Enron might have used them to hide losses in its core trading business. 1.2 decline in shareholder's equity
What are the inferences drawn from "behavioral finance" regarding market capitalization as a measure of equity?
They find it hard to believe that the one-day erasure of billions of market capitalization must automatically be a truer representation of the company's change in equity value than a figure derived from financial statement data The stock market is far more volatile than the variability of dividends can explain
According to security analysts, how did Enron make money?
They has no idea how Enron made money, Enron manufactured savings through fraud
How can management reduce a sudden jump in profits? Why would they want to do so?
They run up expenses in the current period by scheduling training programs and plant maintenance, that would ordinarily be undertaken in a later quarter Because a sudden jump produces volatility, which is regarded as evil and to be avoided
Why do corporations seem to have an interest in facilitating cookie-cutter analysis?
They spend a lot of money to spread the information about their financial performance. They want it to be easy for analysts to monitor their progress.
Why can it be said that some financial assets can be valued with objectivity and accuracy?
They trade daily and actively so it's feasible to value such assets on the basis of market quotations at the end of the financial reporting period
On 11/15/00, what caused Lernout & Hauspie Speech Product's auditor to withdraw its clean opinion of the company's 1998 and 1999 financial statements?
They withdrew after the announcement by the Belgium producer of speech-recognition and translation software that an internal investigation had uncovered accounting errors for those two years
How does Beneish define manipulation of financial statements?
To include both actual fraud and the management of earnings or disclosure within generally accepted accounting principles. In either case, his definition specified that the company subsequently must have been required to restate results, write off assets, or change its accounting estimates or policies at the behest of its auditors, and internal investigation, or a SEC probe.
What can be said about the existing provisions for issuing financial accounting standards?
To say that no perfect system can be designed, however is quite different from saying that existing provisions for issuing financial accounting standards, conducting audits and policing fraud are as good as real-world conditions permit. The present system in not the product of objective analysis by panels of experts driven solely by a desire to provide accurate and transparent financial statements to the public.
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 couldn't shareholder and bondholders "vote with their feet" and close their positions in HealthSouth once the scandals came to light? How large were the losses?
Trading in the company's securities was suspended The convertible subordinated bonds closed at 20 from 98 earlier in the week
What is the difficulty encountered in valuing an actively traded commodity such as oil reserves?
Transactions are based on estimates of eventual production from unique geological formations Estimates rely heavily on judgement and inference
Explain how Enron took liberties with mark-to-market accounting rules to inflate its earnings.
Under GAAP is was legitimate to include in current earnings the profits of energy-related contracts and other derivatives that it expected to earn over future periods that could be as long as 20 years. The potential for abuse arose when the quoted prices were only available for contracts that extended a few years out
What is the trick that will allow investors to understand sudden changes in value in both the Old and New Economies?
Understand the relationship (gap) between these accounting conventions and reality
What are some examples of earnings discontinuities financial analysts should look for?
Unrealizable synergies and company-furnished protections of cost ratios that incorporate management's assumptions regarding sales volume.
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?
Verbal cues of financial reporting hanky-panky by analyzing the question-and-answer sections of the transcripts of 29,663 conference calls.
What is the "big bath" hypothesis, and how was it corroborated?
When a large corporation suffers a quarterly profit decline too larger to erase through discretionary items
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 showing slightly negative earning comparisons, they locate enough discretionary items to squeeze out marginally improved results
What are two assumptions that misconstrue the motives that frequently underlie financial reporting?
When some aspect of a company's disclosure does not meet the smell test, readers should trust their instincts Managers may be pursuing their own agendas
When did skilled analysts identify some of the famous frauds?
When they became unsustainable, and the companies collapsed. May turn out to be a case of almost no bona fide assets supporting the claims of creditors and shareholders. After the companies have collapsed
Was the information omitted from the Trump Hotels & Casino Resorts October 1999 report detectable?
Yes, bond analyst Tom Shandell noticed the company's press release reported mysteriously large revenues for the Trump Taj Mahal. Revenue increased $4.9 million over the comparable 1998 quarter, even though there was a decline in revenue.
Is the evidence of criminal misrepresentation obvious after the fact?
Yes, but not even the most skilled analysts definitively identified some of the most famous frauds until the schemes became unsustainable and the companies collapsed.
When did the analysts proclaim that Enron's financial statements were unreliable? When did Enron file for bankruptcy?
but not until a few days before Enron's collapse did security analysts openly proclaim that the company's financial statements were unreliable.
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.
fear of the consequences of breaking the law keeps corporate managers in line. Bending the law is a different matter. executive bonuses negotiations with auditors over the limits to which the accounting standards can be stretched
What are the three ways corporations can use financial reporting as a means to enhance value?
increase dividends, reduce rate of return, increase growth
In the context of rationalization for declining growth, what is the fallacy of "cross selling"?
it is not clear why paying a premium for a company should be more profitable than having one company pay a fee to use another companies mailing list
In the past, why was it difficult for securities analysts to incorporate legal risks into their earnings forecasts?
managers have a clear interest in downplaying risks that threaten the value of their stock holdings and stock options
Was this the entire picture?
no, contained no mention of another important contributor to the third-quarter surge in revenues and, by extension, net income,
What are some of the reasons that the financial statements will not reflect a fair picture of the company's financial performance?
the outcome of haggling between the company's manager and auditors will not necessarily present a fair picture of performance cost considerations preclude reviewing every transaction of examining every bin to see whether it contains the inventory attributed to it Auditors rely on sampling
In which way should the analyst consider the issuers of financial statements as adversaries?
understand the gameship of financial reporting
Is it common for senior managers of accounting firms to overrule the frontline auditors?
yes, they believe everything in life is negotiation
