FSA Quiz 2

What are the two approaches to including rent expense for operating leases in the fixed- charge coverage ratio?

-Add total current year to numerator and denominator however a portion of those represent interest so do below where you take 1/3rd -Add 1/3 on the numerator and denominator theory that 1/3 of a lease payment = interest of the asset purchased with debt and 2/3 = principal repayment

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 and they show too much sympathy

Why were investors unwilling to accept Bally's earnings increases at face value?

-Because the company's growing reliance on memberships that it financed as opposed to selling for cash -Rather than taking upfront membership fees in cash, financed its growing reliance on membership fees that were financed with promissory notes from members

What were some of the risks associated with Bally's increased reliance on customers who had to borrow in order to join?

-Because the risk with expanding to new customers is high because they are less likely to pay than old members -Even under new members let their membership lapse despite paying an initial fee

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 only appropriate for the period which a company can put off a substantial portion of its capital spending without impairing its future competitiveness -EBITDA is not for cash flows -But it does reduce federal income taxes this assumes the firm has federal tax liability (point is basically that D&A are noncash expenses)

What signs began to surface in 2005 that GM's corporate culture had changed?

-Bond ratings had slid down to the speculative grad rating -The SEC was investigating their accounting aspects -They had to restate earnings -Changed accounting for retirements -Credits were erroneously booked

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

-Additional outlays are required for the replacement of obsolete equipment/replacement costs -As the company expands its productive capacity to accommodate the rising demand -Newly acquired equipment may be costlier than the old equipment that is being written off

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

-Because it will increase their PE ratios -Minimal net profits are recorded by many "new economy" companies

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

- misjudgment, bookkeeping errors (WITTB: what it takes to balance), deliberate misrepresentation by rogue managers

What are some of the issues associated with the size of a company when comparing it to a peer group?

(1)Big companies can spread risk over a wide range of products (2)Bigger companies have better credit rating regardless of ratios (3)Particularly vulnerable is a company with just one manufacturing facility (4)Lack of depth in management is another problem commonly associated with smaller companies -Statistical models confirm that on average big corporations meet their obligations with greater regularity

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 asset's salvage value → the cost of the asset -Reserve construction equipment -PP&E in the process of construction until the facility or segment thereof is placed in service

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

- Because of the malleability of accounting based revenues and expenditures

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

- Depreciation is not available as a long-term source of cash for interest payments and never will be

What classic red flag did Nortel disclose on March 2004?

- It delayed the filing of its financial reports - A revision of past earnings

What is the objection to the relevance of depreciation when calculating earnings?

- Wear and tear and new fixed assets are two types that are hard to differentiate -Traditional cash flows where some companies suggest financial analysts to add back depreciation to net profit rather than calculating bona fide profits - not the best way

What are telltale danger signals?

-surges in receivables that have not been billed and offsetting deferred income (deferred income is on the liabilities side) -surges in receivables that have been billed but not shipped -watch for rises of A/R or inventory relative to sales

What did Nortel announce on April 28, 2004? Under Canadian Law, what does it mean to be terminated for cause?

-A cut in its previously announced earnings of 50%, also delayed reporting its results for Q1 to 2003 -The phrase includes incompetence so these dismissals did not necessarily imply any criminal acts

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

-Accruals are expenses incurred but not yet billed, -A payable is supported by a received invoice/billing statement

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

-Add deferred taxes to denominator in total-debt to total equity ratio -Net worth is understated by amount of deferred tax liability (true if the company pays taxes at less that statutory rate)

How can management mask problems related to inventory or receivables?

-By pumping up 3rd component of working capital requirements, accounts payable (riding the payables) -When payables go down it's a "use of cash"

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

-By using financial derivatives (Interest rate swaps, forward rate agreements, euromarkets CD future 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 -Understand that they are always seeking cheap capital

What is SFAS 34 and what refinement in the fixed-charge coverage ratio is required by it?

-Companies can capitalize some portion of interest costs -Interest accrued must be in the denominator -Don't add capitalized interest to the numerator -SFAS 34 requires companies to capitalize rather than expense a portion of their interest costs -Whether interest expensed or capitalized - all accrued interest must be covered by earnings and should appear in denominator of the fixed charge coverage ratio -Do not include capitalized interest in the numerator because this would result in double counting -Previous years current maturities of long term debt are included in EBIT + lease payments

When companies book revenue before billing customers

-Companies engaged in long-term contracts; construction companies can do this as a solution to mismatches between revenue and expenses -Revenue is recognized in proportion to the amount of work completed (percentage of completion method) -These estimates can entail considerable subjectivity which allows management to speed up revenue recognition

How does this ratio vary with the capital spending cycle?

-Companies will go through capital spending cycles -If they continue to cut back on CapEx they will lose competitive edge

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

-Cumulative difference between taxes calculated at a stationary rate and taxes actually paid -Reflects tax consequences in future years, cash recaptured by the firm never to be paid in full by the firm -Differences between the tax basis of asset and liabilities their carrying amount for financial reporting purposes

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 -Income taxes and interest expense are not added back

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: the amount of sales taking cogs (best for retailers) -Operating margin: how much sales is from operating before taxes/capital structure

What aspect of management's effectiveness does each ratio reflect?

-Gross profit margin measures management's skill in buying and selling at advantageous prices -Operating profit margin shows how well management has run the business in terms of buying/selling wisely and controlling selling and admin. Expenses before taking into account the company's capital structure and effective tax rate -Net profit margin reflects all factors whether under management's control or not that influence profitability

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

-If a company does not ride payables or draw down cash to pay its payables it must borrow money -Borrowing incurs interest expense -Ask for an A/P aging and listing and the payable terms

What does the ratio of capital expenditures to depreciation capture?

-If it is greater than 1 then it's a red flag that they are not replacing their equipment and will lose competitive edge -Underspending on replacement (maintenance) cap ex is the equivalent to a gradual liquidation of the firm = Capex/ depreciation

When did Nortel finally file its 2003 financial statements and what unusual step did twelve senior executives take?

-In January of 2005 -12 Executives agreed to return 8.5 million in bonuses from erroneous accounting errors

What explains the behavior of Freddie Mac's stock price when it announced in January 2003 an unexpected increase in reported earnings?

-In some instances it manipulated its earnings to match the Wall Street earnings forecasts -Know that no one could understand their complicated accounting

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

-Inability to raise cash to pay obligations (Inadequate cash flow, inability to borrow new funds to pay off existing creditors, the risk that the borrower will suffer illiquidity)

What needs to be considered even if this ratio consistently exceeds 1.0?

-Inflation (means a nominal dollar spent on p&e today will not buy as much as it did when the depreciating asset was purchased) -Depreciation may be understated with respect to wear and tear or obsolescence cash outlays may be too slow as well -Capital outlays may be too low even if they match in every sense the depreciation of existing plant and equipment

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?

-Investigate inventories and a/r were tying up increases in taxes -Statement of cash flows FASB 95 was not formally required until 1988!

How is the line of business used to define a peer group?

-It can be misleading -Because different industries have different financial characteristics, ratio comparisons -Only works if companies sell same exact thing, requires "a peer group with virtually identical products" to do cross-sectional analysis

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

-It fosters cost reducing innovations, which promote the efficient use of scarce resources - Encourages savings and risk taking - Is a yardstick by which businesspeople can measure their achievement and justify their claims to compensation

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

-It is explained by the Tax Code that allows owners to write-off property that essentially overstates the property's wear and tear, do this with MACRS - different asset classes -Do not have salvage values in tax reporting

Explain why a drop in the stock price accompanied the apparent good news of increasing revenues at Wal-Mart?

-It was due to an accounting change that was expected to reduce the following quarters earnings -They were booking layaway sales as soon as it was placed as a layaway and under conservative methods these aren't supposed to be recorded until cash is received

What is the risk when all preferred stock is treated as equity?

-It would understate financial risk -The analyst must recognize the heightened level of risk implied by the presence of preferred stock in a company's capital structure

What role did carb-consciousness play in Krispy Kreme's faltering profits?

-Krispy Kreme blamed its drop in earnings on people having carb-conscious diets -It was used as an excuse but analysts suspected the real problem was over expansion

What are some of the ways companies downplay expenses?

-Liberal assumptions about costs that may be capitalized -Pile up unjustified accruals -Dilute expenses with one-time gains -Jump the gun in booking rebates from suppliers / booking rebates from suppliers in advance

What accounting practice did the SEC allege Krispy Kreme Doughnuts employed as its store openings stalled?

-Management was manipulating certain expense accruals to produce a higher EPS -It improperly recorded transactions involving company purchases of franchise stores

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

-May have a sinking fund provision -Pays a dividend rather than interest -From a legal standpoint- preferred stock is equity but in liquidation it is subordinated by debt -It must contractually pay a fixed dividend vs interest on debt -Failure to pay a dividend does not constitute an event of default -Preferred stock issuer can omit dividend but not without omitting common stock dividend -Preferred stock dividends are cumulative -It may have sinking fund provisions that require redemption -Exchangeable preferred stock can be converted to debt at issuers option

What is the treatment of membership refunds under GAAP?

-Membership fees could not be booked as revenue until the refund period was expired -Membership fees should be spread throughout the entire membership period -Companies can book revenue before billing customers

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

-More meaningful compared across time and against peers -These ratios are more meaningful when compared across time (historical or trend analysis) and against peer averages (cross-sectional analysis)

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 -Only appropriate when the companies strategy is to in marketable securities

Did Beaver advocate the method that practitioners have institutionalized? Explain.

-No because no one measure should be used to predict -He did not advocate the sole measure of EBITDA to total debt

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

-Overstating losses created CJ reserves that could be taken into profits -Big bath 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

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

-Pension liabilities related to employees service to date, post retirement benefits -87: recognizing pension liabilities -106: recognizing health care and retirement costs

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 time when lenders are unavailable (potential debt coming due within less than one year) -Exposure to interest rate fluctuations

What was central to Kendall Square's difficulties?

-Revenue recognition controversies -Revenue rebates based on future sales

What complications arise in connection with incorporating operating 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

What is the important take away from the Nortel case?

-Seemingly small items can prove highly significant -Investors were not paying attention to a few hundred million dollars of reserves related to loss. These reserves were added to accrued liabilities which gave management an opportunity to manipulate earnings

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

-Should suspect that earnings are overstated -The amount of WC needed to run a business represents a fairly constant percentage of a company's sales -If inventories/receivables increase materially as a % of sales analysts should suspect that earnings are overstated

What disclosures did GM make in March 2006 regarding their classification of cash flows?

-Some of their investing activities from mortgages were recorded as operating activities -Gain on sale of precious metals in inventory and agreed to repurchase the metals in the following year -Overestimated the salvage value of the rental cars coming back in

What did the failure of W.T. Grant bankruptcy show?

-That neither EBITDA nor net income + depreciation was a valid proxy for cash flow -2 years before bankruptcy Grant reported a positive net income and also had a positive stable cash flow (NI + depreciation + depletion + amortization)

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

-The borrowers may be supported formally or informally by another entity (guaranty of owner, joint & s.)/Legal (SBA, FHA, VA) vs informal (where company is dependent on raw materials) guarantees -Thorough credit analysis may not include check of subjects past repayments which is not part of financial statements -To assess creditworthiness the bank must consider the competitive environment and strength of the local economy in which the borrower operates

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

-The distinction between bona fide profits and accounting profits -What is revenue -What costs count now and which costs count later

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 the cash flows will be in the future = Deprecation / cffo, proxy for replacement in maintenance but not for growth capex

What are the dangers of attempting to create homogenous peer groups?

-There is not enough data to compare to -They may look good compared to their peer but against industry as a whole they may suck -It narrows the field to such an extent that ratio comparisons begin to suffer from having too few data points

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 did not imply impairment -Deterioration is indicated when a company displayed successively lower highs and lower lows

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

-They arise exclusively in furtherance of a business objective -A large or growing under funded liability can be significantly negative in assessing a deteriorating credit -Defined benefit plans (work for a company for X amount of years and you get X amount a month until you die - risk is on company) vs. defined contribution plans (401K, 403B, traditional IRA - risk is on you)

Why would Krispy Kreme try to recover the store-closing costs and overdue interest only to pay it right back?

-They asked their Michigan franchisee to absorb the cost of closing down two underperforming stores and repay all of the past due interest that was owed -"Straw man - insider," they then agreed to increase it purchase price of these two stores by these additional costs

What did Bristol-Myers offer as an explanation for the sudden drop in projected 2002 earnings?

-They gave wholesalers discounts to induce them to buy its products much faster than necessary to fill prescriptions at pharmacies -Under intense pressure to maintain stock prices companies like to show rapid growth

What problems are signaled by a surge in accounts receivable?

-They may be liberal with credit terms to prop up sales -May also result from extension of credit to new, less creditworthy customers who pay their bills comparatively slower -From extension of credit to new less credit worthy customers that pay bills slowly

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 innocent explanations that companies routinely provide for abnormalities -Be careful about believing simple explanations

What are the distinct benefits of quantitative models of credit quality?

-They were developed by objectively correlating financial variables with events of default (EDF) -The record of quantitative models is excellent from the standpoint of classifying as troubled credits most companies that subsequently defaulted

What did Bristol-Myers executives strenuously deny regarding their accounting policies?

-They were making one time gains look like revenues and pumped up their earnings -They denied that its accounting policies were geared toward managing earnings or by extension, maximizing compensation of executives whose compensation was related to stock prices -Executives pumped up the bottom line by taking portions of restructuring reserves created in earlier periods into earnings "cookie jar" - now must be "perceivable and quantifiable" according to GAAP -Beating EPS by 1 or 2 cents

Elaborate on how Nortel abused the accrual treatment of contractual liabilities.

-They were taking reserves off the balance sheet without legitimate triggers for doing so -Management overstated reserves to create a bigger cookie jar into which it could dip - CJ example -Management was generating money from reserves

Why is Cash Flow from Operations to capital expenditures a key ratio to analyze in capital-intensive manufacturers and utilities?

-This measures the financial flexibility of the company -The higher the ratio, the more flexible -= CFFO / Capex, don't have to calculate but do need to know what ratio tells you (3 of these questions on QUIZ)

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

-To assess credit (the ability to repay) in addition to calculate financial leverage ratios -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

Why is the Total Debt to Equity ratio important?

-To gauge how much debt they already owe and the amount of equity they have beneath them (cushion)

Why would a creditor calculate financial leverage ratios?

-To know how much asset value will be available for liquidation to pay off their claims -Recognizing that one day creditors may find themselves holding defaulted obligations, lenders want to know how much asset value will be available during liquidation to pay their claims (deb ratio and 1- debt ratio = equity ratio)

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

-When buyouts were so highly leveraged that projected EBIT would not cover the Pro Forma interest expense even in a good year -EBIT / interest expense

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

-Yes -Only way to reform the system is by separating the link between budget targets and compensation -it forces managers to do whatever it takes

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?

-Yes but people may leave them in finished goods inventory -A company may decide to retain them in finished goods inventory rather than selling the inventory at significantly discounted prices

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

-Yes. Because it doesn't take into account depreciation and amortization -Companies with similar interest coverage ratios have substantially different default risks

What lessons can be learned from Halliburton's case?

-auditors seal of approval does not guarantee financial reports are reliable -users should not be complacent just because a prestigious individual has ultimate responsibility for integrity of numbers (Dick Cheney) -prior to '98 Halliburton recognized income from the recover of cost overruns in the quarter it resolved the claims -if earnings look suspiciously strong during a rough patch for industry, look into it

What happened in the Entrasys Networks' overstating of revenues?

-blamed accounting errors for a revenue drop of 11% -it was all booked in the wrong period -inflated valuations of stock received as payment for products -also accepted payments that were booked as revenue yet failed to materialize

How did analyst Steven Tighe derive his estimate for wholesale inventories and what was his conclusion?

-excessive inventory -inventory in wholesale distribution chain for the companies top 10 core retail brands (drugs) could total 500-600 million aka 50% revenue -that would be a 2.42 times average weekly sales aka HUGE

What is "channel stuffing"?

-forcing customers to buy products before the end of the period to make earnings look more desirable -Borrows sales from future periods and is indicative of a short-term cure for a long-term problem that is not sustainable -Accelerates future revenues to the current period

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

-from the possibility that economic depreciation will exceed reported depreciation expense and reported depreciation expense will exceed depreciation -Economic depreciation > reported depreciation expense OR reported economic depreciation expense > depreciation

Was Krispy Kreme a case of massively fictitious earnings?

-it beat earnings by 1 penny every quarter - so no it was a process of nickel and diming -was a process of nickel and diming through a wide range of etc.

What lessons can users of financial statements draw from Krispy Kreme case?

-long record of year over year gains (beating guidance) quarterly is a sign of earnings management -Related party transactions and deceptive financial reporting go hand in hand -Excuse for deteriorating earnings ask if it passes the "smell test" because could be using tricks to conceal the true causes

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 set easy targets -they will literally do whatever it takes to meet their targets whether it damages the company or not (once targets are set) -incentives can sometimes cause unintended consequences

Can most users of financial statements replicate the analysis of Steven Tighe and C.J. Sylvester?

-no because in order to make this type of analysis you must make an annual subscription to data (IMS health is required which = thousands of dollars) -this is an example of using an external report to validate a company aka use 3rd party information

What are some of the problems with quantitative default models?

-not only show you which ones they predict to go into bankruptcy 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

What is the example of Ikon Office Solutions facilitating revenue recognition fraud?

-the buy back agreement Ikon agreed to purchase materials for end of the quarter then return it back to improve quarter earnings -basically a repurchase agreement permitting Ikon to return modems without paying for them

What did the SEC charge Take-Two with?

-they had to pay a penalty charge of 500,000 and prejudgment interest of 3.1 million representing bonuses based on the originally reported earnings -Systematically booked revenue from approximately 180 separate "parking arrangements" which is like essentially a consignment of goods where you send it back if you don't like it (thousands of games shipped to distributors who were under no obligation to pay for them, also no documentation) -Instead of reducing sales, returns were booked as COGS

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

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 before hand

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

An accounting profit is whatever the accounting rules say it is

Explain why net income may be (or not) a standard by which every company's value and risk can be compared.

Because no single value can determine the financial performance of a company

4 IRS doctrines

Business purpose, substance-over-form, step transaction, and assignment of income

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

By adding depreciation and amortization (which are non cash expenses) it shows that a company can keep its head above the water given its current non cash debts

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

By cutting through the form of the transaction to get to the substance of the transaction

Business Purpose Doctrine

a transaction will not be effective for income tax purposes unless it is intended to achieve a genuine business purpose (a high tax bracket individual taxpayer contributes an asset 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)

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

Companies can raise or lower its reported earnings (financial vs tax reporting) by using at the latitude of assuming shorter or longer average lives for its depreciable assets

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

GAAP states if rebates involved not only current bus but were upfront inducements to place larger orders over several years, they should be taken into earnings over time rather than immediately

What is depreciation?

Depreciation 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 eventually be replaced

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

Distorting the power of accruals

What was the purpose of Freddie Mac's structuring interest rate swaps with nil net economic benefit?

Interest rates fro them would rise and fall at the same time, interest rate swaps to make income look better in the next year: no true economic benefit to this

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

Investors reward stability with high PE multiples

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

It tells a lot about the ability to pay but very little on their willingness to repay a loan

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

It will end badly

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

Merely circulating the same funds does not increase wealth

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

Profit = revenue - cost

In 2003, what did Nortel introduce as a special bonus plan?

Senior executives bonuses were tied to profits

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

They lose their competitive advantage

What pathology did GM illustrate as its fortunes deteriorated in the early 2000s?

They may start to break the rules when earnings don't go their way

What are the two fundamental issues that credit analysts face and are addressed in Altman's Z-score model and Zeta model?

These models are not perfect, cannot capture everything

Is it common to take liberties with booking expenses?

Yes, companies are creative at minimizing and slowing down expenses recognition as they are speeding up revenues

Assignment of income doctrine, "fruit and tree"

as long as a taxpayer retains control over the source (tree) of income, he will be taxed on the receipt (fruit) of that income even though he has assigned all the rights to the income to someone else (self-employed person receives $20 check in payment for services, cannot avoid reporting this $20 as income by endorsing the check to his adult son)

Wear and tear

can develop a proxy where depreciation shows up in the income statement (maintenance)

Deferred income taxes

cash recapture by the business, never to be repaid in for the firm

Experience teaches us that it can be dangerous to accept reported revenues at ______ ________ if they have been audited

face value

Often outward signs of exceptional success indicate in reality a ______ probability of __________ revisions of previously reported revenues

high; downward

What do accounting rules say about setting profits aside?

it must be foreseeable and quantifiable liabilities

"Requirement of franchise rights"

red flag - make sure debits and credits make sense if you see this because they can hide a lot of things in here!

Step transaction doctrine "piercing the veil"

the IRS can collapse a series of apparently unrelated transactions into the transaction to determine the tax consequences. Needs "whiskers" if transactions occur are not more than 12 months apart. Instances where transactions are viewed separately has one overall result but considering the transactions together yields a different result (a corporation sells property to an unrelated purchaser who subsequently resells the property to a wholly-owned subsidiary of the corporation)

Substance-over-form Doctrine, "smoke and mirrors"

the IRS can look through the legal formalities to determine the economic substance of a transaction. Transaction must be real and bona fide (if the substance differs from the from the IRS will base the tax consequences of the transaction on reality rather than illusion)

What classic red flag appeared the day after the SEC launched an investigation of Take-Two accounting practices?

the company's CEO Albert Pastino resigned the following day

New fixed assets

to meet growth - but have to really ask management about this one aka no proxy for this

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

to smooth year to year earnings growth (to get a higher P/E ratio), and understate short term profits

Free cash flows determine the _______ of the firm. The ability to sell its production determines the _____ of the firm. The distribution process of the free cash flow itself does not determine the ______ or ______ of the firm.

value; risk; value or risk