Level 2 SS7

Capital Structure

a firms capital structure must be able to support management's strategic objectives as well as to allow the firm to honor its future obligation

Discretion in Revenue Recognition

◦much discretion is involved with recognizing revenue. Manipulation techniques include misstating revenue, accelerating revenue, and misclassifying nonrecurring or non-operating revenue.

Cash Flow Statement

◦net income is easily manipulated because of accrual accounting and the many estimates involved. ◦On the other hand, cash flow is unaffected by estimates. However, firms can still manipulate the cash flow statement by misclassifying cash flows, ignoring cash flows, and managing cash flows.

LOS 23.d: Describe earnings quality and measures of earnings quality, and compare the earnings quality of peer companies.

◦the term earnings quality usually refers to the persistence and sustainability of a firm's earnings; that is, more persistent and sustainable earnings are considered higher quality ◦focusing on accruals and deferrals is a more effective way of measuring earnings quality

Other revenue issues (abnormal sales growth as compared to the economy, industry or peers) and disproportionate fourth quarter revenues for a nonseasonal firm.

...

Deferred Expenses

deferred expenses are costs that will benefit future periods. These costs usually involve noncurrent assets and prepaid assets.

Understating Expenses

focus is on the allocation of capitalized costs, primarily costs associated with fixed assets and inventory. depreciation and cogs/inventory.

Revenue Recognition

manipulation techniques include misstating revenue, accelerating revenue, and misclassifying nonrecurring or nonoperating revenue.

Detecting Expense Recognition Problems

manipulation techniques include understating expenses, delaying expenses, and misclassifying ordinary expenses as nonrecurring or nonoperating.

Fourth Lesson: Check for Cash Flow: LOS 22.b: Explain how trends in cash flow from operations can be more reliable than trends in earnings

◦operating cash flow is generally more reliable than earnings because it is less subject to estimates and judgments. ◦However, over time there should be a fairly stable relationship between the growth of operating cash flow and earnings. ◦if not, the firm may be engaging in earnings manipulation. Also, earnings growth is not sustainable without the support of operating cash flow over the long run. ◦in the case of enron, there were wide differences in operating cash flow and operating income. Operating cash flow was often negative while operating income was positive. Also, earnings growth significantly exceeded the growth in operating cash flow.

Concerns

◦potential earnings manipulation as evidenced by increasing accrual rations. However, this concern is reduced due to thunderbirds strong cash flow. ◦thunderbird may be over allocating capital resources to the lower margin segment (specialty products). Future monitoring will be required. ◦Recent acquisitions may result in losses from goodwill impairment in the future.

Cash Flow Statement (Misclassifying Cash Flow)

◦the effects of misclassifying cash flow can be eliminated by including operating cash flow and investing cash flow when assessing earnings quality. This is exactly what was done in the cash flow accrual ratio discussed earlier

First Lesson Learned: Read It All

◦the financial footnotes and the management discussion and analysis (MD&A) section are where most of the detail and explanations are found. ◦The footnotes provide information about the firm's accounting principles, estimates, and assumptions, as well as other details. ◦MD&A provides information about the firm's liquidity, capital resources, and results of operations. also some firms use this to discuss their critical accounting policies.

Off-Balance-Sheet Financing

◦there are numerous contractual obligations that are not reported on the balance sheet as liabilities. The most popular one is an operating lease. ◦a lease is a contractual arrangement whereby the lessor, the owner of the asset, allows the lessee to use the asset for a specified period of time. A lease can be treated as a capital lease or an operating lease. ◦a capital lease transfers all of the risks and rewards of ownership to the lessee. According to US GAAP, if any one of the following is met at inception, the lessee must capitalize the lease: ‣ ownership of the leased asset is transferred to the lessee at the end of the lease. ‣ the lease contains a bargain purchase option ‣ the lease term is 75% or more of the asset's economic life ‣ the present value of the lease payments is 90% or more than the fair value of the leased asset. ◦with a capital lease, the lessee treats the lease an an asset purchase assuming debt financing. asset is depreciated and interest expense is recognized on the liability. thus, capital lease treatment affects the lessee's leverage and profitability. ◦an operating lease just has rent expense. want this, more favorable balance sheet treatment

Support for Investments in thunderbird

◦thunderbird earnings growth has been generated internally from operations, through acquisitions, and by investment income from eagle. ◦thunderbird's roe is positive and trending upward. Investment income from eagle has improved thunderbirds ROE. ◦earnings quality appears to be good as operating earnings are confirmed by cash flow. ◦cash flow is sufficient to support capital expenditures and an increase in debt if necessary. ◦thunderbird is growing through acquisitions and its cash return on assets continues to increase. ◦after eliminating thunderbirds pro-rata share of eagles market value and equity income, Thunderbird appears to be undervalued based on its implied P/E multiple relative to that of the S&P index

Understating Expenses

◦firms must disclose the depreciation methods used as well as broad summaries of useful lives. Comparing depreciation expense (relative to gross plan and equipment) to other companies can be useful in determining the conservatism of the firm's estimates. ◦detecting understated expenses involves focusing on the related balance sheet accounts such as fixed assets and inventory. Like revenue recognition, large changes in these accounts are suspect. ◦increasing inventory is often an indication of obsolescence. Analysts often focus on the firm's day's inventory on hold (DOH) to uncover obsolete inventory. ‣ DOH is equal to the number o days in the period divided by inventory turnover, and it measures the number of days it takes to sell inventory. An increasing DOH may be indicative of obsolete inventory. If the firm does not recognize the obsolete inventory, its earnings are overstated. ‣ also check for a lifo liquidation- involves selling more goods than are replaced; thus, the firm penetrates the older, lower cost layers of inventory thereby increasing profit. • the profitability is not sustainable, however, because the firm will eventually run out of older, cheaper inventory. For analytical purposes, the profit from the liquidation shoud be removed from the income statement

Other - Receivable sale with recourse

‣ although the transaction is recorded as a sale, thereby decreasing accounts receivable, and increasing operating cash flow, the buyer usually has limited exposure (because the risk of not collecting a receivable is borne by the seller) ‣ therefore, the transaction is nothing more than a collateralized borrowing arrangement that remains off balance sheet.

Equity method

◦ under the equity method, investor recognizes its pro rata share of the investees earning on the income statement. Eliminating the equity income from the investor's earnings permits analysis of the investors performance resulting exclusively from its own asset base. Assuming investee is profitable, this adjustment will decrease both the investor firm's earnings and net profit margin. ◦under equity method, the firm's investment is reported as a balance sheet asset, total assets should be reduced by the carrying value of investment. This will increase total asset turnover (smaller denominator). We can use the extended dupont euqation to dermine the overall effect on ROE

Net investment hedge of a foreign subsidiary:

◦a firm with a foreign subsidiary may enter into foreign exchange contracts and other transactions in order to offset the effects of fluctuating foreign currency on its net investment in the subsidiary. ◦the gains and losses from the foreign currency transactions bypass the income statement and are reported in shareholders' equity as a part of other comprehensive income. ◦this treatment offsets the gain or loss recognition in equity from translating the financial statements of the foreign subsidiary using the current rate method.

Persistency of accrual and cash flow methods

◦accrual component of income is less persistent than cash component. ◦by persistent we mean the income is sustainable, that is, a dollar of earnings today implies a dollar of earnings in future periods. ◦lower persistency is partially due to the estimates involved with accrual accounting. ◦thus, an analyst would apply a lower weighting to the accrual component of income than the cash component when evaluating company performance. ◦lower persistency is not always the result of strategic manipulation

Misclassifying Cash Flow

◦firms can misrepresent their cash-generating ability by classifying investing activities as operating activities and vice versa. ◦for example, under US GAAP, the cash flow statement reconciles the changes in cash and cash equivalents. Cash equivalents include short term, highly liquid investments. ◦some firms "park" cash in longer-term investments such as marketable debt and equity securities. Typically the acquisition and disposal cash flows from these longer-term investments are reported as investing activities in the cash flow statement.

Delaying Expenses

◦delaying expenses involves deferring recognition to a future period ◦delaying expense is the result of capitalizing a cost instead of immediately recognizing the cost in the income statement. ◦the result is higher profit in the current period. Improperly capitalized costs usually involve noncurrent assets such as plant and equipment and intangible assets

Misclassifying Operating Expenses as Nonrecurring or Nonoperating

◦one method of detecting misclassification involves calculating the firm's core operating margin. ◦Core operating margin measure the pretax return on sales from the firm's normal operations and is calculated as follows: • Core operating margin = Sales - COGS - SG&A / SALES • analysts should compare changes in the core operating margin over time and look for negative nonrecurring or nonoperating items that occurred when the ratio increased. this may be the result of misclassifying an operating expense.

Accelerating Revenue

◦firms must wait to recognize revenue until it is earned.

Other - Revaluing deferred tax assets:

◦firms periodically revalue deferred tax assets to reflect the likelihood of use. Revaluing a deferred tax asset is done through a valuation allowance account. Decreasing the valuation allowance will increase deferred tax assets and results in higher earnings.

Goodwill

◦firms that are involved in acquisitions can report significant amounts of goodwill on the balance sheet. ◦goodwill is not amortized. Instead, it is tested for impairment at least annually or more often if circumstances warrant. ◦impairment occurs when the carrying value exceeds the fair value. However, measuring the fair value of goodwill is complicated by the fact that goodwill cannot be separated from the business.

Accrued expenses

◦expenses that have been incurred but not yet paid.

Accrued Revenue

◦occurs when revenue has been earned but it has not yet been collected.

ROE equation

◦Roe = NI/EBT x EBT/EBIT x EBIT/REV x REV/AVG ASSETS x AVG ASS/AVG Equity ◦ROE= tax burden x interest burden x ebit margin x total asset turnover x financial leverage

Goodwill

◦a discussion of a firm's goodwill is often found in the footnotes. ◦Analysts should examine the year-over-year changes in goodwill and also consider the lack of impairment given overall economic conditions. this is especially true for a firm with a book value that is greater than its market capitalization

Mechanisms to Deter Strategic Manipulation

◦an independent audit: the auditor expresses an opinion as to whether the financial statements conform to GAAP, the estimates are reasonable, and the data includes no material errors. The auditor also examines the firm's internal control system and reports any weaknesses to the audit committee of the board of directors. ◦The board of directors: through the audit committee and the firm's internal auditors, the board can discourage unwanted behavior. ◦certification by senior management: in the US, the CEO and CFO must certify the financial statements, which increases their personal risk. ◦Class action litigation: lawsuits serve as a deterrent to manipulating results. ◦regulators: regulators can use fines as well as criminal prosecution as a deterrent. ◦general market scrutiny: business journalists, financial analysts, short sellers, and unions are constantly trying to identify manipulative behavior.

Asset Base

◦analysis of the asset base requires an examination of changes in the composition of balance sheet assets over time. Presenting balance sheet items in a common-size format (as a proportion of total assets) is a useful starting point. big goodwill - acquisitions.

Cash Flow Statement (Managing Cash Flow)

◦analysts should be on alert for a decrease in discretionary spending, especially near the end of the year.

Cash Flow Statement (Ignoring Cash Flow)

◦analysts should compare the growth of operating leases with the firm's asset growth. ◦since an operating lease is maintained off-balance sheet, an increase in operating lease activity is excluded from the accrual amounts used to analyze earnings quality

Balance Sheet

◦because of the relationship between the balance sheet and the income statement, how items are treated on the balance sheet can affect earnings quality. Specifically, we will examine the effects of off-balance-sheet financing and goodwill.

Other revenue issues that may impact earning quality (implementing a bill and hold arrangement)

◦bill and hold occurs when the seller invoices the customer but does not ship the goods until a later date. Alternatively, the seller may ship the goods to a location other than the customer's. In either case, the seller may be recognizing revenue prematurely.

Capital Allocation Decisions

◦calculate the ratio of proportional capital expenditures to proportional assets for each segment. ◦a ratio greater than one indicates the firm is growing the segment by allocating a greater percentage of its capital expenditures to a segment than that segment's proportion of total assets. ◦ratio of less than one indicates the firm is allocating a smaller percentage of its capex to a segment than its proportion of total assets. ◦by comparing the EBIT margin contributed by each segment to its ratio of capital expenditure proportion to asset proportion, we can determine if the firm is investing its capital it its most profitable segments.

Measuring Earnings Quality (Cash Flow statement approach)

◦can also derive the aggregate accruals by subtracting cash flow from operating activities (CFO) and cash flow from investing activities (CFI) from reported earnings as follows: ‣ accruals = NI - CFO - CFI ‣ must also be scaled for different sizes ‣ accruals ratio = ((NI - CFO - CFI) / (NOAend + NOA beg)/2) ‣ interpretation of both accruals ratio is the same; the lower the ratio, the higher the earnings quality.

LOS 23.c: Explain opportunities and motivations for management to intervene in the external financial reporting process and mechanisms that discipline such intervention.

◦capital markets: security prices are affected as the capital markets digest reported financial information. there is an incentive for firms to meet or exceed the markets expectations. ‣ studies have shown that more firms report small profits as compared to firms that report small losses. ‣ difference in a firm's reported earnings and the consensus sell-side earnings forecast is known as forecast error. The consensus sell-side forecast is a benchmark the firm is trying to meet. Firms periodically communicate their earnings expectations to the market in order to move the benchmark. ◦contractual provisions ‣ there are numerous contracts that are based on accounting data ‣ lending covenants are often used to maintain the risk profile of the debt. ‣ lenders want protection from actions of the borrower that would negatively affect their claims to the borrower's assets and earnings. ‣ another popular contract is involving an executive compensation plan.

Other revenue issues (channel stuffing)

◦channel stuffing involves pushing more goods into the distribution channel than the channel can sell.

Fifth Lesson: Understand the Risks

◦common risks: ‣ interest rate risk ‣ foreign exchange risk ‣ accounts receivable risk ‣ price risk of raw materials and other inputs ◦uses hedges where the firm will use the fair values or cash flows from derivative instruments to offset the changes in fair values or cash flows of the at-risk assets or liabilities. ◦derivatives are reported on the balance sheet at fair value. if the firm is using a derivative to speculate, all gains and losses (both realized and unrealized) from the derivative are recognized in the income statement. ◦If the derivative is used for hedging purposes, gain or loss recognition depends on the type of hedge (fair value, cash flow, and net investment of a foreign subsidiary)

Detecting Accelerated Revenue

◦detecting accelerated revenue involves focusing on accounts receivable and unearned revenue. Large changes in these accounts should be investigated. ◦also should compare revenue to the actual cash collected from the customer. In order to reconcile revenue with cash collections, we need to adjust revenue for the change in receivables and the change in unearned revenue as follows: ‣ cash collection = revenue - increase in receivables + increase in unearned revenue ◦normally, the relationship between revenue and cash collections is relatively stable. If not, the firm may be manipulating revenue ◦when analyzing revenue, analysts should be on higher alert when: ‣ senior management owns a significant number of vested options that are "in the money" ‣ the firm is trying to maintain exponential sales growth ‣ the firm is attempting to raise additional financing.

Detecting Delayed Expense

◦detecting improperly capitalized cost involves comparing asset growth to sales growth ◦not only should this analysis be conducted on the firm but also on its sector group. ◦when excess capacity is available and margins are declining, a growing asset base may be indicative of improperly capitalized costs (bad asset growth) ◦on the other hand, a growing asset base when little capacity is available and margins are attractive is indicative of good asset growth. Because evaluating the quality of asset growth is a difficult task, analysts should view all asset growth with a degree of skepticism ◦to eliminate the effects of capitalizing costs, it is necessary to increase expenses by the change in the net fixed assets for the period. ◦capitalizing costs can also affect cash flow from operations. Capitalizing a cost is usually reported on the cash flow statement as outflow from investing activities. Immediately expensing a cost is reported as an outflow from operating activities. Thus, a firm that capitalizes costs will report higher cash flow from opreations

Detecting Misstated Revenue

◦detecting misstated revenue involves focusing on the related balance sheet accounts. ◦revenue is related to the balance sheet through accounts receivable and unearned revenue. ◦large changes in these accounts are suspect. When a large portion of revenue is attributed to an increase in receivables or decrease in unearned revenue, the revenue is considered lower quality ◦analysts should also pay attention to ratios such as accounts receivable turnover or days sales outstanding. DSO measures the number of days it takes to convert receivables into cash and is calculated by dividing the number of days in the period by accounts receivable turnover. an increasing DSO (decreasing receivables turnover) may be an indication of lower quality revenue; that is, the longer it takes to collect from customers, the more likely the receivables will turn into bad debt. CAn expand terms to gain market share... also selling (Factoring) or securitizing receivables will result in a lower DSO, However, the result is a one-time increase in cash that is not sustainable

LOS 23.b: Describe the relation between the level of accruals and the persistence of earnings and the relative multiples that the cash and accrual components of earnings should rationally receive in valuation

◦differences are the result of unearned revenue, accrued revenue, deferred expense, and accrued expense.

Third Lesson: Evaluate the disclosures. LOS 22.a: Distinguish among the various definitions of earnings (e.g., EBTDA, operating earnings, net income, etc.)

◦earnings and net income are often used synonymously. ◦EBITDA: EBITDA is often used as a proxy for operating cash flow, although it is still an earnings based measure. EBITDA does not consider the changes in operating accounts on the balance sheet and is subject to the many estimates and judgments involved with accrual accounting. ◦Operating earnings or earnings before interest and taxes (EBIT): EBIT is often referred to as operating income, or operating profit. It excludes the effects of financing and taxes. ◦Income from continuing operations: This subtotal is equal to the firm's earnings before any "below the line" items are considered. ◦discontinued operations and extraordinary items are reported "below the line", net of tax. Without any "below the line" items, income from continuing operations and net income would be the same. ◦net income: Net income is the bottom line of the income statement. Net income includes all revenues, expenses, gains, losses and below the line items.

LOS 23.e Explain mean reversion in earnings and how the accrual component of earnings affects the speed of mean reversion

◦earnings at extreme levels tend to revert back to normal levels over time. ◦the competitive marketplace corrects poor performance; thus, losses are eliminated as firms abandon negative value projects. Conversely, capital is attracted to successful projects thereby increasing competition and lowering returns. ◦when earnings are largely comprised of accruals, mean reversion will occur even faster

Measuring Earnings Quality

◦earnings have a cash flow component and an accrual component ◦by measuring the difference in cash flow and earnings, we can capture the accrual component ◦we can disagregate reported earnings into cash flow and accruals using a balance sheet approach or a cash flow statement approach. it is often difficult to identify the specific account that has been manipulated; thus, we will focus on the aggregate accruals.

Earnings Quality and Cash Flow Analysis

◦earnings quality refers to the persistence and sustainability of a firm's earnings. ◦earnings that are closer to operating cash flow are considered higher quality ◦of course, earnings are subject to accrual accounting events that require numerous judgments and estimates. as a result, earnings are more easily manipulated than cash flow. ◦we can disaggregate earnings into their cash flow and accruals components using their a balance sheet approach or a cash flow statement approach ‣ with either approach, the ratio of accruals to average net operating assets can be used to measure earnings quality. ‣ the interpretation of both ratios is the same: the lower the ratio, the higher the earnings quality. ‣ see high accruals... sooo we want to look at operating cash flow to its operating income. we want to see whether operating income is confirmed cash flow. ‣ in order to compare the two measures, it is necessary to eliminate cash paid for interest and taxes from operating cash flow by adding them back. Operating ash flow deducts interest and taxes while operating income does not. • be careful when making the cash interest and tax adjustment to operating cash flow. IFRS have the choice of reporting cash paid for interest as an operating cash flow or as a financing. if it is financing, no interest adjustment is necessary. • ratio of operating cash flow to operating income confirms that operating cash flow has exceeded operating income over the past three years. the results reduce our concerns • to analyze recent acquisitions - we examine the cash return on total assets. ◦if it has increased over the period, is a good thing ◦can also calculate cash flow to reinvestment, cash flow to total debt, and cash floor interest coverage ratios.

Managing Cash Flow

◦firm can manipulate earnings by delaying or accelerating the expenditure to a different period. ◦For example, under U.S. GAAP, research and development costs are generally expensed as incurred. In order to increase current period earnings, the firm can delay the expenditure until the next period.

Detecting Balance Sheet Problems: Off-Balance Sheet Financing

◦focus on operating leases ◦for analytical purposes, it is recommended that operating leases be treated as capital leases. ◦this will increase leverage and decrease asset turnover. ◦in addition, the rent expense should be removed from the income statement and replaced with depreciation expense and interest expense. ◦The lessee's footnote disclosure provides some, but not all, of the data necessary to make the adjustments. ◦lessees are required to disclose useful information about capital leases and operating leases in the financial statements or in the footnotes. For example, the lessee must disclose the lease payments that are due in each of the next five years. Lease payments due after five years are usually aggregated. ◦Unfortunately, the interest rate used in the lessee's calculations is not always disclosed. thus, it may be necessary for any analyst to derive the interest rate in order to make adjustment for analytical purposes. ◦the interest rate is simply the internal rate of return (IRR) of the future lease payments; that is, the interest rate that equates the present value of the lease and the future lease payments.

Second Lesson: Be Skeptical

◦if the financial results are too good to be true, they probably are. ◦earnings growth is not sustainable in the long run without growth in operating cash flow. ◦over the short run, earnings growth can be financed with debt; however, the debt markets can quickly dry up, and so will the growth without the support of internally generated cash flow. Happened at enron.

Other balance sheet that may impact earnings:

◦immediate write-off of purchases in-process research and development (IPR&D). By expensing the IPR&D immediately, earnings are overstated in the future. In this case, there is no matching of future revenues with the expenses incurred to generate the revenues.

Other revenue issues (use of barter transactions)

◦in a barter transaction, two parties exchange goods or services. The main issue is whether a sale transaction has actually occurred and whether the transaction amount is overstated.

Cash Flow Hedge

◦in a cash flow hedge, the firm uses derivatives to hedge exposure to variable cash flows. ◦for example, a firm might use a forward contract to hedge the future cash flows of an anticipated transaction. ◦like a fair value hedge, the firm reports the derivative instrument at fair value on the balance sheet. ◦however, the unrealized gains and losses from the derivative bypass the income statement and are reported in shareholders' equity as a part of other comprehensive income. ◦the accumulated gains and losses are eventually recognized in the income statement when the anticipated transaction affects earnings

Fair Value Hedge

◦in a fair value hedge, the firm uses derivatives to hedge exposure to changes in the fair value of recognized assets or liabilities. ◦for example, a firm might use a put option to hedge an equity investment. ◦if perfectly hedged, the gain or loss on the derivative will exactly offset the gain or loss of the hedged asset or liability. ◦the firm reports both the derivative and the hedged asset or liability on the balance sheet at fair value. In addition, the unrealized gains and losses from the derivative and from the hedged asset or liability are recognized in the income statement.

Other- use of special purpose entities (SPE)

◦income can be overstated if assets are transferred to an SPE at inflated amounts. Once transferred, assets and liabilities remain off-balance sheet

Misclassifying Operating Expenses as Nonrecurring or Nonoperating

◦investors typically focus more on operating income than nonrecurring and nonoperating income. Thus, firms may have an incentive to increase operating income by misclassifying an operating expense as a nonrecurring or nonoperating item. ◦firm might understate depreciation expense by assuming longer useful lives and/or higher salvage values for its fixed assets. ◦if too little depreciation is recognized, the asset will be impaired eventually and will recognize a loss. if the firm reports this loss as a nonrecurring item, investors may discount the loss in their earnings forecasts. if so, the firm has successfully reclassified an operating expense as nonrecurring and increased its operating profit. ◦said another way, had the firm recognized sufficient depreciation expense, an impairment would not have been necessary. Of course, higher depreciation expense would have resulted in lower operating income.

Misclassifying Nonrecurring or Nonoperating Revenue

◦investors typically focus more on operating income than on nonrecurring and nonoperating income. ◦Thus, firms may have an incentive to misclassify transactions as a part of normal operations. For example, a firm might sell a noncurrent asset ad include the gain as a part of operating income. nonrecurring and nonoperating revenue do not typically self-correct like deferrals and actuals thereby providing an even greater manipulation benefit to the firm

Expense Recognition

◦like revenues, much discretion is involved with recognizing expenses. Manipulation techniques include understating expenses, delaying expenses, and misclassifying ordinary expenses as nonrecurring or nonoperating

Detecting Misclassified Nonrecurring or Nonoperating Revenue

◦look for inconsistencies in the firm's definition of operating income. for example, the analyst should compare reported income and pro-forma income that are provided each quarter. Excluding certain items form proforma earnings may be an indication of revenue misclassification.

Ignoring Cash Flow

◦noncash investing and financing activities are not reported in the cash flow statement since they do not result in an inflow or outflow of cash. ◦for example, a capital lease is both and investing and financing decision in that the transaction is the equivalent of borrowing the purchase price. However, since no cash is involved, the transaction has no net impact on the cash flow statement at the inception of the lease. ◦operating leases also suffer from a lack of cash flow recognition at inception. ◦the accrual amounts are also affected by acquisitions. Under the purchase method, the price paid is reported as an investing activity in the cash flow statement, and the method of financing is reported as a financing activity. in return for the price paid, the investor reports the individual assets and liabilities of the acquired firm. Since the acquired assets and liabilities were not included on the investor's balance sheet at the beginning of the period, analysts must be careful when computing the changes in accruals.

Unearned revenue

◦occurs when payment is received in advance of providing goods or services. ◦unearned revenue is reported as a liability on the balance sheet. ◦once the revenue is earned, the liability decreases.

Off balance sheet financing on the income statement

◦on the income statement, it is necessary to replace the rental expense (payment) for the operating lease with depreciation expense (on the lease asset) and interest expense (on the lease liability). ◦Recall that in early years of a finance lease, depreciation expense and interest expense will exceed the lease payment. As a result, net income will be lower in the early years for a finance lease compared to an operating lease. ◦in addition, by recognizing interest expense in the lessee's income statement, the interest coverage ratio will likely decline (higher denominator)

Off-Balance-Sheet Financing

◦recall that an operating lease is simply a rental arrangement; that is, the lessee reports neither an asset nor a liability related to the lease on its balance sheet, even though the lessee may have a contractual obligation under the lease agreement. The lessee only reports rental expense, equal to the periodic lease payment, on the income statement. ◦finance lease is treated as a purchase of an asset financed with debt. Thus, the lessee reports an asset and a liability on its balance sheet. On the income statement, the lessee reports depreciation expense and interest expense instead of rental expense. ◦for analytical purposes, an operating lease should be treated as a finance lease, increasing assets and liabilities by the present value of the remaining lease payments. since assets and liabilities are initially increased by the same amount, stockholders' equity is not affected by this adjustment. Capitalizing an operating lease will increase financial leverage because of the increase in liabilities

LOS 23.f: Explain potential problems that affect the quality of financial reporting, including revenue recognition, expense recognition, balance sheet issues, and cash flow statement issues, and interpret warning signs of these potential problems.

◦relevant financial reporting measures vary across firms. ◦For example, depreciation methods and assumptions are relevant for capital intensive firms and inventory measures are relevant to retailing and manufacturing firms. ◦financial reporting measure also vary across time, making it easier to hide manipulation when a firm is growing. thus, financial reporting measures should include year over year comparisons as well as comparisons with the firms sector (industry) group. ◦subtracting the mean or median sector group ratio from the target firm is called sector neutralizing. a useful tool in examining earnings quality but comparability may be limited because of a lack of homogeneity (firms may have divisions operating in different industries) and because firms change over time through acquisitions and divestitures.

Common estimates:

◦revenue recognition including the timing of revenue recognition, bad debt expense, warranty expense, and returns and allowances. ◦depreciation estimates such as useful lives and salvage values. Firms also have choices of different depreciation methods (e.g. straight-line, accelerated). ◦inventory cost flow assumptions (e.g. LIFO, FIFO, average cost) and obsolescence issues. ◦Forecasting cash flows in order to test for impaired assets such as plant and equipment and goodwill. ◦valuation allowances for deferred tax assets ◦pension assumptions such as the discount rate, compensation, growth rate, and expected rate of return. ◦stock option valuation models used to compute compensation expense.

Example analysis focuses on the following

◦source of earnings and return on equity ◦asset base ◦capital structure ◦capital allocation decisions ◦earnings quality and cash flow analysis ◦market value decomposition ◦off balance sheet financing ◦anticipating changes in accounting standards

Anticipating Changing Accounting Standards

◦users must be aware of proposed changes in accounting standards because of the financial statement effects and the potential impact on a firms valuation. ◦looking to eliminate the operating lease treatment in financial statements. if enacted, firms would be required to capitalize operating leases. could increase leverage. lease capitalization will also affect the firm's compliance with its bond covenants based on financial leverage calculated in accordance with US GAAP. ◦to avoid the increase in leverage from capitalizing a lease, the firm could raise additional equity, which would dilute existing investor's ownership interests. ◦FASB no longer permits exception for qualified special purposes entities (QSPE). In the past, firms could avoid consolidating asset securitizations (primarily receivables) by creating a QSPE.

Measuring Earnings Quality (Balance Sheet Approach)

◦using the balance sheet, we can measure accruals as the change in net operating assets over a period. ◦net operating assets (NOA) is the difference in operating assets and operating liabilities. ◦Operating assets are equal to total assets minus cash, equivalents to cash, and marketable securities. ◦Operating liabilities are equal to total liabilities minus total debt (both short-term and long-term). ◦Accruals = NOA(end) - NOA(beg) ◦for difference in size: ‣ Accruals ratio = (NOA(end) - NOA(beg)) / (NOA(end)+NOA(beg)/2)

Market Value Decomposition

◦when a parent owns an associate - it may be beneficial to determine the standalone value of the parent; that is, the implied value of the parent without regard to the value of the associate. the implied value is equal to the parent's market value less the parent's pro-rata share of the associate's market value.

Misstating Revenue

◦with accrual accounting, revenue is recognized when realized and earned. ◦revenue is realized when the seller can measure the amount of cash, or other assets, it ultimately will receive. ◦revenue is earned when the seller no longer has an obligation to provide goods or services. because of these requirements, recognizing revenue involves a number of estimates including bad debt expense, warranty expense and sales returns and allowances.

LOS 23.a: Contrast cash-basis and accrual-basis accounting, and explain why accounting discretion exists in an accrual accounting system

◦with the cash basis of accounting, revenues are recognized when cash is collected and expenses are recognized when cash is paid. ◦cash flows may occur in different periods than when the revenues are actually earned or when the expenses are actually incurred. ◦accrual basis of accounting: revenues are recognized when earned, and expenses are recognized when incurred, regardless of the timing of cash flow. ◦accrual accounting provides more timely and relevant information to users

Other- Use of the equity method when substantial ownership exists

◦with the equity method, the investor reports its pro rate share of the net assets of the investee. ◦the separate assets and liabilities of the investee are not reported. In addition, the investor reports its pro-rata share of the investee's earnings, not the separate revenues and expenses.