soverby

In measuring earnings quality, which of the following statements is most appropriate?

A) The higher the accruals ratio, the higher the earnings quality.

B) Accruals can be measured as the change in net operating assets (NOA) over a period of time.

C) Accruals can be measured as net income less cash flows from operations (CFO) less cash flows from financing (CFF).

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Using the balance sheet, we can measure accruals as the change in net operating assets (NOA) over a period of time. 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). In summary, the formula for balance sheet based aggregate accruals is:

AccrualsBS = NOAEND − NOABEG

We 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:

AccrualsCF = NI − CFO − CFI

The lower the accruals ratio, the higher the earnings quality.

anshultongia

With regard to specific measures to analyze in detecting manipulation in the financial reporting process, which of the following statements is the least accurate?

A) An increasing days’ inventory on hand (DOH) measure may be indicative of obsolete inventory.

B) A decreasing days’ sales outstanding (DSO) measure may be an indication of lower quality revenue.

C) Negative nonrecurring or non-operating items may be indicative of misclassifying an operating expense.

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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 the accounts receivable turnover ratio. 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.
Days’ inventory on hand (DOH) is equal to the number of days in the period divided by inventory turnover ratio and it measures the number of days it takes to sell inventory. An increasing DOH may be indicative of obsolete inventory.
Analysts should compare changes in the core operating margin over time and look for negative nonrecurring (e.g., restructuring charges, asset impairments, and write-downs) or non-operating items that occurred when the ratio increased. This may be the result of misclassifying an operating expense.

anshultongia

Analyst Jane Kilgore is worried that some of Maxwell Research’s accrual accounting practices will lead to excessive operating earnings recognition in the near-term. Examples of Kilgore's concerns include the following:

• Accelerated revenue recognition of service agreements.
• Classification of recurring revenue as nonrecurring revenue.
• Understated inventory obsolescence.

Which of Kilgore’s concerns is least likely to overstate current operating earnings?

A) Classification of recurring revenue as nonrecurring revenue.

B) Accelerated revenue recognition of service agreements.

C) Understated inventory obsolescence.

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Classification of recurring revenue as nonrecurring revenue will understate current operating earnings. The other two items act to overstate revenue and understate expenses.

anshultongia

Frank Brill, CFA, is concerned that Moses Aviation is overstating its profits. The best indicator of such action would be Moses Aviation’s:

A) sales-growth rate of nearly twice the industry average.

B) rising inventory.

C) recognition of revenue from barter transactions.

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While an unusually high sales-growth rate may indicate fraud, it could also indicate good management. It’s a yellow flag, but not the best indicator of accounting shenanigans. Rising inventory is also a dual signal. It could be meant to overstate profits, or it could simply reflect an actual buildup of inventory in response to market forces or corporate operations. However, companies should not recognize revenue from barter transactions. The additional revenue is likely to improperly boost profits.

anshultongia

Marcel Schulte is analyzing various retailing firms. Which of the following items is least indicative of a potential problem with revenue recognition and earnings quality?

A) Use of barter transactions.

B) Disproportionate revenues in the last quarter of the calendar year.

C) Implementing a “bill and hold” arrangement.

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Disproportionate revenues in the last quarter may be an indication of aggressive revenue recognition to meet analyst forecasts but it is much more likely if the firm is a non-seasonal one. A retailing firm presumably has a disproportionate amount of sales during the busy Christmas season in the last quarter of the calendar year so this point alone would not be indicative of a potential problem.
In a barter transaction, two parties exchange goods or services. The main issue is whether: (a) a sale transaction has actually occurred in substance; (b) it is not a “sham” transaction; and (c) the transaction amount is overstated.
Bill and hold occurs when the retailer (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.

anshultongia

Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the year-end financial statements of Zartner Canneries. In those statements he sees a sharp increase in inventories well above the sales-growth rate, and an increase in the discount rate for its pension assets. To determine whether or not Zartner Canneries is cooking the books, what should Nicholls do?

A) Calculate Zartner’s turnover ratios and review the footnotes of its competitors.

B) Check Zartner’s cash-flow statement and review its footnotes.

C) Analyze trends in Zartner’s receivables and consider the changing characteristics of its work force.

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To assess the meaning of the inventory increase, look for declines in industry turnover. And if Zartner changes its pension assumptions, Nicholls should see how those new assumptions compare to those found in the footnotes of financial statements from other companies in the same industry.