FSA QUIZ 2
What is the fine line that financial analysts must walk?
They must not lose touch with economic reality by hewing orthodoxy. They must not accept the version of reality that seekers of cheap capital would like to foist on them
What is the difference between accrued expense and a payable?
-An accrued expense is an expense that has been incurred, but not yet billed by the vendor -A payable is supported by a received by a received invoice or billing statement
What are the "big bath" and cookie-jar strategies?
-By overstating loses when the occurred, they were able to create cookie-jar reserves that could be taken into profits in later years. -The big bath strategy 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.
What did Nortel announce on April 28, 2004? Under Canadian Law, what does it mean to be terminated for cause?
-Nortel announced a 50% cut in its previously announced 2003 earnings of $732 million. -Under Canadian law, terminated for cause includes incompetence, so the dismissal did not necessarily imply any criminal acts.
When did Nortel finally file its 2003 financial statements and what unusual step did twelve senior executives take?
-On January 10, 2005, Nortel finally filed their 2003 financial statements. -12 of the senior executives agreed to return $8.6 million in bonuses they received based on erroneous accounting. Also, 5 directors said they would not seek reelection, although they were not charged with any wrongdoing.
Elaborate on how Nortel abused the accrual treatment of contractual liabilities.
-The accruals that Nortel abused arose from contractual liabilities. -If the company missed a deadline on a $5 million contract and reasonably estimated the failure would cost it $500,000 through a customer refund. The amount of the expected refund would be booked as an expense, reducing current year profits, and would be recorded as a liability until it was paid. If the customer subsequently agreed to accept a refund of only $300,000, the remaining $200,000 would be recognized as a profit in the period which the refund was paid. -The investigation by Nortel's board found that in 2003 management raided the cookie-jar, taking reserves off its balance sheet without legitimate triggers for doing so. Furthermore, management overstated the reserves to create a bigger cookie jar into which it could dip.
some of the issues associated with the size of a company when comparing it to a peer group
1. bigger companies can enjoy economies of scale and have greater leverage with suppliers 2. big company can spread risk of obsolescence and competitive challenges over a wide range or products and customers whereas smaller competitors are more ocncentrated 3. company with one manufacturing facility is particularly vulnerable 4. lack of depth in mgmt is another problem with smaller companies
what types of off balance sheet obligatiosn do SFAS no 87 and SFAS no 106 cover?
87 - pension liabilities related to employers service to date -- requires BS recognition for pension liabilities that are related to employee service to date 106 - post retirement basis --recognition of post retirement health care benefits as BS liability
what two things must one expect whena manager is told he or she will get a bonus when targets are realized
managers will attempt to set easy targets they will do their best to meet them even if it harms the company
why is CF from operations
measures the financial flexibility of a company, higher the ratio implies higher flexibility
What pathology did GM illustrate as its fortunes deteriorated in the early 2000s?
A long-established company with a strong balance sheet and a lengthy record of stable earnings may have a corporate culture that includes going by the book on accounting matters, but that culture may change if profitability starts to erode.
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 numerator is only appropriate for the period over which a company can put off substantial portion of capital spending without impairing future competitiveness. On a permanent basis, the cash flow represented by depreciation is not truly available for paying interest, but it does reduce federal income tax. The assumes the firm has a federal tax liability.
What are some of the reasons that capital spending may exceed depreciation over time?
Additional outlays are required for replacement of obsolete equipment A company must expand its production capacity to accommodate rising demand Newly acquired equipment may be costlier than old equipment that being written off.
What is SFAS 34 and what refinement in the fixed-charge coverage ratio is required by it?
Allows companies to capitalize some portion of interest costs interest accrued must be in the denominator dont add capitalized interest to the numerator - would result in double counting
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.
Regarding non-convertible and convertible debt, what is the ultimate objective of the credit analyst?
Assess credit risk (the ability to repay) 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 group
What are the distinct benefits of quantitative models of credit quality?
They were developed by objectively correlating financial variables with events of default The record of quantitative models is excellent rom the standpoint of classifying as troubled credits most companies that subsequently defaulted
why would it seem paranoid to a novice analyst to consider every company's income statement with suspicion
Because the novice analyst is inherently trusting of people Novice analyst hasn't been blind sided Accounting firm that audited company issued a clean opinion
How can management mask problems related to inventory or receivables?
By pumping up the payables Look at DSO, credit terms and see if they're going outside those terms By pumping up the third component of working capital requirements by riding the payables
how can a company show a profit if its franchised restaurants consistently lose money?
Company's income consists entirely of franchise fees, don't coincide with how the restaurant is doing. Company would sell stock and use that money to lend back to franchises.
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 in advance.
What was the purpose of Freddie Mac's structuring interest rate swaps with nil net economic benefit?
Freddie Mac bet on a rise in interest rates at the same time that it bet on a decline in interest rates. The only justification for the swaps was altering the timing of profits. Freddie Mac structured the swaps such that it made its payments in one month and received payment for the offsetting trade in the following month. That reduced net income for one year and raised it the next.
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?
Not if loss is not recognized, could persuade auditors it is stylish and hold in finished goods inventory instead of recognizing loss in value Rather than selling inventory at heavy discount, a company could retain them in finished goods inventory
According to the Beaver study, what was the single best predictor of bankruptcy and how was it calculated?
Declining trend in ratio of cash flow to total debt
How can EBITDA help credit analysts discriminate between two similar-looking credit risks?
Differ in probabilities of defaulting on interest payments also useful ensuring comparability of companies with dissimilar depreciation policies when estimating total enterprise value. adding back non-cash expense
How is the line of business used to define a peer group?
Different industries have different financial characteristics, ratio comparison Carrying this principle to its logical conclusion, cross sectional analysis requires a peer group with virtually identical products.
What signs began to surface in 2005 that GM's corporate culture had changed?
Disturbing signs began to surface that an aggressive approach to financial reporting had become embedded in GM's corporate culture.
Aside from seasonal variations, what should analysts suspect when inventories or receivables increase materially as a percentage of sales?
Earnings are overstated. 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 % of sales, analysts should strongly suspect that earnings are overstated.
How can a rising debt-to-capital ratio confirm an adverse credit trend revealed by operating cash flow?
If a company does not ride the payables or draw down cash it must borrow the money Ask for current AP aging and listing and payable's terms
What are some of the problems with quantitative default models
Not only do quantitative default models tend to classify as troubled credits most of the companies that eventually default, but also many companies that do not default Credit analysts must also bear in mind that companies can default for a variety of reasons that a model based on reported financial data cannot pick up
business purpose doctrine
Individual tax payer contributes an aset to a newly formed C corporation solely to take advantage of the lower marginal tax rate afforded to corporations on the sale or disposition of assets. IRS can look through legal formalities to determine the economic substance of the transaciton.
Why do companies welcome the migration towards less variable measures of performance?
Investors are going to reward stability with high P/E multiples
What are the dangers of attempting to create homogenous peer groups
It narrows the field to such an extent that ratio comparisons begin to suffer from having too few data points
What happens to firms that spend the minimum on property, plant, and equipment, year after year?
Lose competitive edge...lose their competitive advantage is they spent the bare minimum
Did Beaver advocate the method that practitioners have institutionalized? Explain.
No, he didn't conclude that analysts should rely solely on ration of cash flow to total debt.
What are some after the fact explanations for excesses in income reporting?
misjudgement bookkeeping errors deliberate misinterpretation by rogue managers
What problems are signaled by a surge in accounts receivable?
Management may be trying to prop up sales by liberalizing credit terms It may also result from the extension of credit to new, less credit worthy customers who pay their bills comparatively slower
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 firms, P/E Multiples make stocks expensive
Explain why net income may be (or not) a standard by which every company's value and risk can be compared.
No because no single measure could capture financial performance comprehensively enough.
What did Altman's model demonstrate?
No single financial ratio predicts bankruptcy as properly selected combination of ratios. in 1968 Altman developed a multivariate model composed of five ratios that demonstrated no single financial ratio predicts bankruptcy as accurately as a properly selected combination of ratios
What were the lessons learned from the wave of LBO-related bond defaults of the 1980s?
Projections were aggressive, depreciation was not available as long run source of cash for interest payments. Depreciation, after all, was not available as a long-term source of cash for interest payments.
Why are the calculation of financial leverage ratios less simple than they may appear?
more meaningful compared across time against peers
What did the failure of W.T. Grant bankruptcy show?
Reliance on earnings and deprecation measure could cause analysts to overlook weakness of a company with substantial working capital needs that neither EBITDA or Net Income + Depreciation was a valid proxy for cash flow Two years before its bankruptcy, W.T. Grant reported positive net income. It also enjoyed positive and stable cash flow as defined by Beaver (Net Income +Depreciation + Depl. + Amort.)
what complications arise in connection with incorporating lease payments in the fixed charge coverage ratio?
SEC does not require companies to report rental expense retailers negotiate with leases that are semi-fixed, tie to revenue of the leased store
In 2003, what did Nortel introduce as a special bonus plan?
Senior executive's bonuses were tied to profits
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?
Similar income but different total enterprise value and dissimilar risks of defaulting on future debt
Why was diverting analyst's focus away from traditional fixed charge coverage and toward EBITDA coverage of interest particularly beneficial during the 1980s?
Some buyouts were so highly leveraged that EBIT would not cover 1x pro forma interest expense even on a good year.
What is the important take away from the Nortel case?
That 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.
What did accounting rules (in 2001-2005) state regarding rebates?
The accounting rules stated that 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 than booked immediately.
What disclosures did GM make in March 2006 regarding their classification of cash flows?
The company said that some cash flows from its mortgage subsidiary that should have been classified among investing activities were instead booked as operating activities.
What is one of the most abused features of financial reporting?
The distorting power of accruals. Accrual anomaly
What explains the behavior of Freddie Mac's stock price when it announced in January 2003 an unexpected increase in reported earnings?
The explanation was the concern that the announcement raised among investors about the reliability of the financial statements of the government-sponsored enterprise (GSE) officially known as the Federal Home Loan Mortgage Corporation. Even before the news, investors were apprehensive about the complexity of Freddie Mac's accounting. Anxiety increased when the company's auditor raised questions about the way the company treated past accounting for certain hedging transactions. Investors were apprehensive over its accounting complexity.
What classic red flag did Nortel disclose on March 2004?
They delayed their filing of their 2003 financial reports. revised past earnings
What are cycle-to-cycle comparisons and why should they be used instead of year-to-year comparisons?
They are used for cyclical companies. Pattern of similar highs and lows do not imply impairment. Deterioration is indicated when a company displayed successively lower highs and lower lows
Do improving or deteriorating financial ratios always have the same implications for different companies?
This ratio is an effective technique for assessing relative credit analysis In some cases a declining trend over several years signals a company has genuinely fallen to a lower level of credit quality
why is total debt to equity ratio important?
To gauge how much debt they already owe and the amount of equity they have beneath them
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?
Whether inventory and A/R were tying up increasing amounts of cash, determine whether company could generate offsetting amount of cash by expanding A/R The statement of cash flows (FASB 95) was not formally required until 1988 OCF = Net Income + Depr. - Changes in Working Capital Requirements Working Capital Requirements = Accounts Receivable + Inventory - AP Therefore, an increase in working capital requirements reduces OCF
Can companies with similar interest rate coverage have a substantially different default risk? Explain.
Yes, deprecation, PPE Assets, and other figures distort default risk Yes, as in the preceding total enterprise value examples, companies with similar interest coverage ratios can have substantially different default risks.
Is it common to take liberties with booking expenses?
Yes. Corporate managers are just as creative in minimizing and slowing down the recognition of expenses as they are in maximizing and speeding up the recognition of revenues.
step transaction doctrine
a. An example is where a corporation sells property to an unrelated purchaser who subsequently resells the property to a wholly owned subsidiary of the corporation. b. Doctrine is applied tin instances when transaction viewed separately has one overall result but considering the transactions together yields a different results c. Transactions that occur more than 12 months apart
assignment of income doctrine
a. an example is where a self employed person who receives a 20 g check in payment for services rendered on behalf of a client, cannot avoid reporting the 20 as income by endorising the check to his adult son
What is channel stuffing
accelerating future revenues to the current period by offering discounts that encourage buying in the current period
practical definition of accounting profit?
accounting profit is whatever the accounting rules say it is
what do accounting rules say about setting profits aside?
accounting rules clearly states that profits can be set aside for forseeable and quantifiable liabilities GAAP does not give companies any discretion to create rainy day funds
what is the litmus test that a calculation of bona fide profits must pass
after a company earns bona fide profits, its owners are wealthier than they were beforehand
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 third party transactions and deceptive reporting go hand in hand. when mgmt offers an excuse for deteriorating earnings that does not stand scrutiny, the company may be using financial reporting tricks to conceal true causes.
What lessons can be learned from the Halliburton case?
auditors seal of approval does not guarantee that a company's financial reporting is reliable Immateriality is often misused users of financial statements should not trust prestigious individuals responsibility of the numbers dont trust high earnings of a company if their industry is having a rough patch
Are corporate budget systems designed to reward lies and punish the truth? Explain.
because of budget targets, managers are rewarded by cooking the books to meet targets to achieve bonuses. When they do not by telling the truth, they are punished by not receiving the bonus must severe the link between budget targets and compensation
what are some of the reasons why analyzing a company's financial statements may not be sufficient to determine its credit quality?
borrowers credit may be supported formally or informally by another entity thorough credit analysis may not include check of subjects past repayments which is not part of financial statements does not look at competitive environment Legal guarantees by suppliers**
How does this ratio vary with the capital spending cycle?
companies will go through capital spending cycles Company that sharply reduces its capital budget will appear to increase its financial flexibility, but cutting back on capital outlays may impair the company's long term competititveness by sacrificing market share or causing the company to **
what is depreciation and what is the objection of the relevance of depreciation when calculating earnings
depreciation is the writing down of assets over time. Can be manipulated to change net earnings numbers is an accounting procedure that recognizes certain types of property decline in value over time due to wear and tear or obsolescence and recognizes this property must be eventually replaced
what are ways companies try to obtain the benefits of debt without suffering the associated penalties imposed by credit analysts?
employ leverage yet avoid reflecting debt on its consolidated BS by entering in joint ventures or forming partially owned subsidaries -analyst should attribute to the company its proportional liability for the debt of such ventures some cases the affiliate operations are critical to the parent's operations**
what does liability account "deferred income taxes" represent and what does it reflect?
file on canvas "deferred tax liability" cumulative difference between taxes calculated at a stationary rate and taxes actually paid reflects tax consequences in future years or the difference between the tax basis of asset and liabilities and their carrying amounts for financial reporting purposes
how can firm insulate itself from floating interest rate fluctuations
financial derivatives - interest rate swaps -forward rate agreements - euromarket CD future market
most commonly used profit margin ratios
gross profit margin -revenue - cogs --good measure for retailers measures mgmt skill in buying and selling at advantageous prices operating margin - how much sales is from operating before taxes/capital structure -- how well mgmt has run the business in terms of buying and selling wisely and controlling and selling and administtrative expenses before capital structure and tax rate NP margin - reflects all factors, managements control or not.
why is ratio of depreciation to CF from operations so forward looking
higher the % of CF derived from depreciation the more predictable a company's CF and less dependent its financial flexibility on the vagaries of the market place
treatment of membership refunds under GAAP
if a company offered refunds, it could not book any of the revenue until the refund period expired, unless there was a sufficiently long history for management to estimate future experience with reasonable confidence.
what does ratio of capital expenditures to depreciation capture
if it is greater than one it is a red flag that they are not replacing their equipment and will lose competitive adv. under spending on replacement**
what is most immediate danger faced by a lender and how can this condition arise?
inadequate cash flow inability to borrow new funds to pay of existing creditors the risk that the borrower will suffer illiquidity
what needs to be considered even if this ratio consistently exceeds 1
inflation depreciation may be understated with respect to wear and tear or obsolescence - cash outlays too low capital outlays may be too low even if they match in every sense the depreciation of existing plant and equipment
what do financial statements tell about a borrowers ability and willingness to repay a loan?
it can show ability but it doesn't show willingess
what conditions are the physical wear and tear of PP&E not considered an expense when calculating profits?
land, land rights with indefinite lives, site preparation, grading and landscaping excess plant and equipment. assets salvage value> cost of the asset reserve construction equipment PP&E in the process of construction until the facility, or segment thereof is placed in service.
what distinguishes the preceding liabilites form other kinds of hidden liabilities
large or growing under funded liability can be significantly negative in assessing a deteriorating credit
what are some complications PS introduces in financial leverage calculations
legal standpoint, PS is equity but in liquidation it is subordinated to debt Unlike CS dividends, must contractually pay a fixed divident vs interest on debt failure to pay dividend does not constitute an event of default PS issuer can omit its dividend but not without also omitting CS dividend PS dividends are typically cumulative which means issuer must repay all PS dividends that are in arrears resuming CS dividends may have a sinking fund provision that requires redemption of a substantial portion of the oustanding par amount prior to final maturity vs perpetual PS exchangeable PS can be converted into debt at the issuer option
how far can the major risk of analytical error in the reporting of depreciation expense arise?
major risk does not arise from the possibility that reported depreciation expense will substantially exceed economic depreciation, but opposite *double check
What are some of the reasons profits hold such an exalted place in the business world and economic theory?
necessity of producing profits, fosters cost reducing innovations for the efficient use of scarce resources encourages savings and risk taking Yardstick by which business people can measure achievement and claims to compensation
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 this is only appropriate when a company's strategy is to invest a substantial portion indefinitely in marketable securities
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 amount of deferred tax liability - true if company pays taxes at less than a statutory rate add deferred taxes to denominator in total debt to total equity ratio
two approaches to including rent expense for operating leases in fixed charge coverage ratio
one approach simply adds total annual rent expenses in the numerator and denominator, but not all of these rent payments represent interest Only include 1/3 of the rent expenses based on the theory that 1/3 of a lease payment typically represents interest if the asset was purchased with debt and 2/3 is equivalent to principal repayment
under what circumstances does it make sense for management to delay revenue recognition?
only allowed for unforeseen future events or if the amount is immaterial. to understand short term profits and report smooth year to year earnings growth that equity investors will reward with high P/E multiples
from a firm's standpoint, what are the two risks inherent in depending on debt with maturities of less than one year?
potential illiquidity - substantial debt due at a time when lenders are unavailable to renew borrowers loan or unwilling to renew the borrowers loan - borrowers may be unable to meet its short term obligations exposure to interest rate fluctuations - if substantial debt is coming due and interest rates have risen sharply since debt was incurred, the borrowers cost of staying in business may skyrocket overnight
what inspired the attack on accrual accounting and treatment of depreciation
privately owned real estate where owners would attempt to minimize reported income and therefore income taxes by maximizing depreciation
what conditions is there a agreed definition of profit
revenue - costs
Why must the simple formula of revenues minus costs not be taken at face value?
revenues may be improperly recognized . How depreciation is accounted for can distort actual expenses and therefore profit
what are telltale danger signals?
rising levels of A/R and inventory relative to sales, conspicuous surges in un-billed receivables offsetting deferred income are danger signs conspicuous surges in receivables from the borrowing base
what is rational explanation of the phenomenon of an investment increasing in value while generating losses
tax savings produced by non cash depreciation expense can contribute to a rise in wealth. even on an asset that does not earn a profit. ** ask maddy
what is risk when all PS is treated as equity?
tendency to understate financial risk -analyst must recognize the heightened level of risk implied by presence of PS in a company's capital structure
For the analysis of financial statements, what is the most important distinction to understand?
the difference between bona fide profits and accounting profits
What did Bristol-Myers executives strenuously deny regarding their accounting policies?
they denied their accounting policies were geared toward managing earnings. Or maximizing the compensation of senior executives whose compensation was linked to stock price
Why would a creditor calculate financial leverage ratios?
to know how much asset value will be available for liquidation to pay off their claims