Reading 27: Evaluating Financial Reporting Quality-LOS f 习题 2011, including, interpret, potential, reporting

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Session 7: Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis
Reading 27: Evaluating Financial Reporting Quality

LOS f: Discuss problems with 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.

 

 

Junior analyst Xander Marshall sends an e-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is manipulating its results to artificially inflate profits. He cites four reasons for his conclusion:

• The LIFO reserve is declining. 
• Earnings are much higher in the September quarter than in other quarters.
• Many nonoperating and nonrecurring gains are being recorded as revenue.
• Much of Peterson’s earnings come from equity investments not reflected on the cash-flow statement.

Jacobs is less concerned about Peterson’s earnings than Marshall is, though she does resolve to check out one of his concerns. Which of Marshall’s observations best supports his conclusion?

A) Nonoperating and nonrecurring gains recorded as revenue.

B) The declining LIFO reserve.

C) Equity investment earnings not reflected on the cash-flow statement.

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On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and disclosed the LIFO liquidation in its footnotes. When unusual gains are recorded as revenue they will artificially boost sales growth. Each of the above issues are potential danger signs, but can also be easily explained in a manner beyond reproach. However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further examination.

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During Parlex Chemicals’ media day, four executives spoke. Here are excerpts from all four executives speeches.

Calvin Baynard, CEO: “I’ve been a scientist all my life, but I want to assure shareholders that as CEO I am actively involved in both managing operations and setting accounting policy.”
Kristan Lenz, CFO: “I work closely with our auditors to make sure we are always on the same page.”
Melvin Jackson, COO: “In the past I have told you that Parlex would meet aggressive growth targets. I am proud to say that we have met those targets.”
Sally Yu, compliance director: “All of our executives are required to review Parlex’s ethics policy every year.”

Reporter John Bustard, CFA, is concerned that three of the executives are exhibiting attitudes or rationalizations that can lead to accounting fraud. Bustard should be least concerned about:

A) Jackson.

B) Lenz.

C) Yu.

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Working closely with auditors is a good thing. All of the other statements reflect behavior that can lead to fraudulent accounting. Jackson made a commitment to the media that the company would meet targets – that promise could spark a rationalization to falsify numbers to meet the target. Yu said all executives must review Parlex’s ethics policy, but what about everybody else? Most of the employees are not executives, and if the rank and file, including those in the accounting department, are not familiar with the firm’s ethical standards, it could breed ethical problems throughout the organization.

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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.

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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.

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Based on her analysis of Maxwell Research’s internal operations and business climate, analyst Jane Kilgore is concerned about management’s opportunities to commit fraud. Which of the following characteristics should worry Kilgore least?

A) More than half of Maxwell’s revenue is generated in emerging markets.

B) Maxwell’s market penetration gives it the ability to dictate terms to vendors.

C) More than a third of Maxwell’s total sales go to its own consolidated subsidiaries.

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High levels of related-party transactions are worrisome, particularly when those parties are not audited. But transactions within the company between subsidiaries consolidated in a company’s audited financial statements are neither unusual nor a particularly fertile ground for fraud. Both remaining characteristics are legitimate risk factors.

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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.

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The failure to recognize inventory obsolescence is an example of ___________.

A) Understating expenses.

B) Delaying expenses.

C) Misclassifying expenses.

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Inventory must be tested for obsolescence using the lower-of-cost-or-market method. Obsolete inventory must be written down (expensed) in the income statement which results in lower earnings. Thus, failure to recognize obsolescence understates expenses and overstates earnings.

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. This is not the same as failing to recognize inventory obsolescence.

Investors typically focus more on operating income than nonrecurring and non-operating income. Thus, firms may have an incentive to increase operating income by misclassifying an operating expense as a nonrecurring or non-operating item. Therefore, failure to recognize obsolescence is not an example of misclassification.

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Fero Inc. (Fero) is a successful computer consulting services firm that has an established policy of investing its excess cash in short-term, virtually riskless, and highly liquid money market securities. However, it has recently deviated from this policy by investing in commercial paper and medium-cap domestic equities. As well, Fero entered into a $1.0 million lease with Pasquale Inc. (Pasquale) for some specialized computer equipment on December 28, 2008 that will be shipped at the very start of its next fiscal period on January 1, 2009. In exchange for the lease, Fero agrees to provide consulting services to Pasquale. Which of the following activities is one in which Fero is least likely involved?

A) Managing cash flow.

B) Misclassifying cash flow.

C) Ignoring cash flow.

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Fero is ignoring cash flow, most likely misclassifying cash flow, but there is no evidence that Fero is managing cash flow. Firms can misrepresent their cash generating ability by misclassifying investing activities as operating activities and vice versa. For example, under U.S. 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.

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 an investing and financing decision in that the transaction is the equivalent of borrowing the purchase price. However, since no cash is involved, the transaction is not reported (it is ignored) on the cash flow statement throughout the life of the lease.

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

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

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.

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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.