CFA Level 1 (2009) - 3

Srwly Session 10

Cross-Referencc lO CFA Institute Assigned Reading #39 - Financial Analysis Tcchniqucs

A.The following table lists IJartiallinancial SLltenKnl dal~l for Alpha Cou!iJany:

Calculate the following ralios for Alpha Company:

•Invcn tory turnovcr.

•Days of invcntory on hand.

•Reccivables turnover.

•Days of sales outstanding.

•Payables turnovcr.

•Number of days of payablcs.

•Cash conversion cycle.

Use the following information for problems B through E,

Beta Co. has a loan covenant rcquiring it w maintain a current ratio of 1.5 or hcner. As Beta approaches year-end, current assets are $20 million ($1 million in cash, $9 million in accounts receivable, and $10 million in inventory) and current liabilities arc $13.5 million,

B.Calculate Beta's current ratio and quick ratio.

c. Which of the foJlowing transactions would Beta Co. most likely enter to meet its loan covenant?

•Sell $1 million in inventory and deposir the proceeds in the company's checking accounr.

Srudy Session 10

Cross-Reference to CFA Institute Assigned Reading #39 - Pinancial Analysis Techniques

D.If Beta sells $2 million in inventory on credit, how will this affect its current

Study Session 10

Cross-Refercnce to CFA Institute Assigned Rcading #39 - Financial Analysis Tcchniqucs

.ANSWERS - CONCEPT CHECKERS . .;,

I.B \X1irh a vertical common-size income statel1lCllt, all income statemellt aecoul1ts arc divided by des.

2.A Compally alld industry data are Willrly avaiiJ.bk from numerollS private and public sources. The other sratemellts describe limilaliolls of financial ralios.

3.C hxed charge coverage is a solvency ratio. Return on total capital is a measure of profitability and the defensive interval ratio is a liquidity measure.

4.B Payables turnover ~ (purchases / avg. AP) ~ 100/ 12 ~ 8.33. Payables payl1lcnt period ~

365 / 8.33 ~ 43.8 days

5.B total asset turnover, (S;lleS / lOtal assets) ~ 150/ 7') ~ 2 limes

8.A Quick ratio = (cash + AR) I AP. If cash decreases, the quick ratio will also decrease. The denominator is unchanged.

12.C This is the correct formula for the three-ratio DuPont model for ROE.

13.C return on equity = (net incorneJ( sales 'J(ass~ts J = (0.12)(1.2)(1.2) = 0.1728 = 17.28%

15.C (ROA)(inrerest burden)(tax retention rate) is not one of the DuPont models for calculating ROE.

16.A Tax burden = 1- 0.35 = 0.65.

ROE = 0.65 x 0.7 x 0.11 x 1.2 x 1.5 = 0.0901.

fi~S,W;ERS~ COMP~EHENSIVEPROBLEMS

A.inventory turnover ~ COGS / avg. inventory ~ 2500/600 = 4.167 times

Quick ratio = (cash + marketable securities + receivahles) / current liabilities

= (I + 9) / 13.5 = 10/ 13.5 = 0.74 times

C.Selling $1 million in inventory and payoff some of its short-term creditors would increase the current ratio: (20-1) / (13.5 -I) ~ I') /12.5 = 1.52.

Selling $1 million in inventory and depositing the proceeds in the company's checking account would Icave the ratio unchanged: (20 + 1 - I) / 13.5 = 1.48. Borrowing $1 million short term and depositing the funds in their checking account would decrease the current ratio: (20 + I) / (13.5 + I) = 21 / 14.5 = 1.45.

D.If inventory goes down and receivables rise by the same amount, current assets would be unchanged.

E.QR = (cash r AR) / AP. AP will decrease without any change to the numerator, thus increasing the overall ratio.

The following is a review of the financial Reporting and Analysis principles designed to address the learning outcome statements set fonh by CFA InstitUle@. This topic is also covered in:

FINANCIAL REPORTING QUALITY: RED FLAGS AND ACCOUNTING WARNING SIGNS

Study Session 10

EXAM Focus

LOS 40.a: Describe incentives that might induce a company management to ovcrreport or underreport earnings.

firms are motivated to manage earnings because of the potential benefits.

Management may be motivated to o/Jerstate net income to:

•Meet earnings expectations.

•Remain in compliance with lending covenants.

•Receive higher incentive compensation.

Managing earnings can also involve understating net income. Management may be motivated to underreport earnings to:

• Obtain trade relief in the form of quotas or protective tariffs.

•Negotiate favorable terms from creditors.

•Negotiate favorable labor union contracts.

Firms may also be motivated to manage the balance sheet. For exam pie, by overstating assets or understating liabilities, the firm appears more solvent. Conversely, a firm

might understate assets or overstate liabilities to appear less solvent in order ro negotiatc concessions with creditors and other interested parties. A firm may also manage its balance sheet in ordcr to enhance performance ratios. For example, lower assets will result in a higher return on assets ratio and a higher assct turnover ratio.

Srudy Session 10 Cross-Referc:nce to CFA Institute Assigned Reading #40 - Financial Reporting Quality: Red Flags and Accounting Warning. Signs

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LOS 10.b: Descrihe activities that will result in a low quality of earnings.

CenL'rally accqHcd accounring principles (CAAP) can be exploited by a firm ro achiL've a specific OlltCOI1lL' whik meL'ting thL' lettL'r, bllt not the spirit, of the accounting standards; however, earnings quality will usually deteriorate. Low lJualiry earnings are rhe result of:

Sell'l'til/g (/((eptab!,' rlaO/lIlting prinnjJles that misrepre.(cllt the economics ofrl

trill/SrICtion. For example, a fIrm mighr choose rhe units-of-producrion merhod of depreciation in periods when rhe consumption of rhe asser is betrer measured hy rhe srraighr-line or accelerared methods. If the units-of-producrion method resulrs in lower depreciation than the srraight-line method early in the asset's life, earnings will be accelerared ro the early years of rhe asset's life.

•Structuring transactiom to rlchieue a desired outcolJle. For example, a firm might structure the terms of a lease to avoid capital kase recognition, resulting in lower liabilities, lower leverage ratios, and lower fixed assns.

Using rzggressiIJe or unrr·rzlistic estimatr's (/nd aHIln/ptiow. For example, lengthening rhe lives or depreciable assets or increasing the salvage value will result in lower

depreciation expense and higher earnings.

L"-jJloitiny, the illtent oIrlll accounting principle. For namplc, some hnlls havL' applied a narrow rule regarding unconsolidated special purposes entities (SPE) to a broad range of transactions, because leveragc is lower if the firm docs not consolidate the SPE.

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1.0S10.c: Describe [he "fralld triangle."

Users of financial information should becomc familiar with the risk factors and warning signs of fraud. StatcmeI1l on Auditing Standards No. 99,

Finrlilcia! Statement Audit (SAS No. 99), issued by rhe American Institute ofCerrified Public Accountants (AICPA), identifies threc conditions that arc usually prcsent when fraud occurs. These conditions, known as the fraud triangle, are illustrated in Figure 1.

Note that not all of these conditions need to be present for fraud to occur.

Figure 1: "fraud Triangle"

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Ani Illdcs/Ral iOl1,d i'l.;1rioD

S[lldy Session 10

Cross-Reference to CFA Insti[Ute Assigned Reading #40 - Financial Reporting Quality: Red Flags and Accounting Warning Signs

•Incentive or pressure is the motive that exists to commit fraud. For example, management may want to meet earnings expectations because their compensation depends the firm's stock price.

• Opportunity exists when there is a weakness in internal controls.

•Attitudes or rationalization is a mindset that fraudulent behavior is justified.

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LOS /to.d: Describe the risk l'actors related to incelllives and pressures dlat Illay lead to Fraudulent accoullling.

SAS No. 99 identified four risk facrors related to the incentives or pressures (motive) that may lead to fraudulent reponing.

I. Threats to financial stabili~)' or jJr~fitabili~y as a result of economic, industry, or firm conditions such as:

Intense competition or market saturation, along with declining margins.

Vulnerability to rapid ch:lIlges in technology, rates of product ohsolescence, or

II1tcrest rates.

•Declining cusromer demand or increasing business failures.

• Operating losses that may result in bankruptcy, foreclosure, or a hostile takeover.

•Recurring negative operating cash Aow or inability to generate positive cash Row while reponing earnings or earnings growth.

Rapid growth or unusual profitability.

New accounting standards, laws, or regulatory requirements.

2. Excc,rsive third party p resJII res on management from:

•Aggressive or unrealistic profitability or trend expectations.

• Debt or equity financing requirements in order to stay competitive.

•Stock exchange listing requirements.

•Debt covenants and repayment requirements.

•Impact of real or perceived effects of poor financial performance on a pending transaction, such as a business acquisition.

3.Personal net worth o/management or the board o/directors i,r thrCtltened because of:

•A significant financial interest in the firm.

•A significant amount of contingent compensation based on achieving aggressive targets for stock price, operating profit, or cash flow.

•Personal guaran tees of the firm's debt.

4.Excessive pressure on management or operating per,ronnel to meet internal financial goals, including sales and profitability targets.

SruJy Session 1() Cross-Reference to CFA Institute Assigned Reading #40 - Financial Reporting Quality: Red Flags and Accollnting Warning Signs

I.OS 40.<:: Describe the risk factors related to opportunities that may lead to fraudulcllt accounting.

SAS No. 99 idel1lif1ed four risk berors related (() the opponunities (() commit fraud in f1nancial reponing.

I.The I/rllure of tlJ(: f!'nUJ' iJ/{/lIStly or operations might involve:

SignifIcant relared pany transaerions, panicularly when those panies arc unaudited, or ~lUditcd by another firm.

•Ability (Q dictate terms and conditions lO suppliers and CUSlOmers that may result in rransactions that are not at arm's length.

Signif1canr estimates and judgments in accounring for assets, liabilities, revenues, and expenses.

Unusual or complex rransactions, especially ncar year-end, such as rransactions that present "subsrance over form" issues.

Operations that exist or transactions rhar occur illlernarionally where cultures and husiness practiccs n1;lY difTer.

Bank accounts or operations locatcd in Llx-!l;\Vcns withour clear bu.'>incs.'> justif1cation.

2. Ille/fi:cti1!e management monitoring as a result of:

•Managemenr being dominated by a single person or small group.

Ineffective oversight by the board of directors or audit commirree.

3. A compLex or ltllStabLe organizationaL structure as evidenced by:

•Difficulty in determining who is in conrrol.

Organizational structure that involves unusual legal enrities or unusual lines of authority.

High turnover :llllong management, legal counsel, or board members.

4.Deficient internaL controLs that can result from:

•Inadequate monitoring controls.

•High turnover rates of accounting and information technology personnel. Ineffective accounting and information systems.

Professor's Note: The Last three fitctors reLate to corporate governance. In firms with more effectioe corporate g01!ernance systems, the opportunities to commit fraud

are Limited. See the topic review ofcorporate governance in the Study Session on

COlporate Finance for more details.

LOS 40.f: Describe the risk factors related to attitudes and rationalizations that may lead to fraudulent accounting.

SAS No. 99 identified the following risk factors related (Q attitudes and rationalization to justify fraudulent behavior:

1.Inappropriate ethicaL standards or failure to effectively communicate or support a firm's ethical standards.

Study S~ssion 10

Cross-Reference to efA Institute Assigned Reading #40 - Financial Reponing Quality: Red Flags and Accoullting Warning Signs

2.F'CCfHi!Jt prlrlieipation hy lIonfillrlflcirll fl/rlllllfl,0nCllt ill IIlc scltaioll o(ilccoullting

:). Known history or ;dkgations of'lJiollltiolls ofIII/os illld regulatiolls 1))1 mrl!lllgclllCllt or

hOllrtf l'Ili'lllhc}J.

4. J1 /llilllilK 1'111 I' III ol)sc.rsion lUith IIlrlilltrll"illg or illcrc".rillg Ihtfinll~' .r/oe/': pril'l' or cill'llillgr

I rclid.

5. Milking eommitmCllts to third partil's to tlthicuc tlf,..l!,rcssil)c rcmlts.

G.}-i/l,/illg 10 correct 1000/il1l rtpOrlrlUC (()nrliliol!S in a timely manner.

7.Illtippropriatcl)' millilllizing ('(/millgs lor tax j!lnjJIIJCS.

H.i\1anagcl11cnt's conlinlll:d lise Or/llrllailrlil)' 1/\ a IMSis IOjllsti(jr illil/'/JI'ojJ;'irl!c or iFlc.rlio)liIUe 11((OllillinK IlJc!/;orl.r.

9./1 .i/rtfincr! rcltltio/lSf,ip l)elll'c(,11 llltlllaf!,1' III I'll I dnd the OIl'J'oll or prc7Iio/./s tfuditor as evidenced by any of the following:

frcquenr disputes on accolilHing, auditing, and n:porring issues. Unreasonable demands on the auditor, such as unreasonabk time constraints. Restricting the auditor's access to people and information.

Limiting the auditor's abilit), to effectively communicate v",ith the board of directors and audit committee.

Domineering management behavior roward rhe auditor.

lOS /to.g: Describe common ;)cccuming warning signs :l11rl methods or detecting each.

Aggressive revenue recognition. '1'he most common earnings manipulation rechnique is recognizing revenue Ion soon, Recall thar revenllc is recognized in rhe income statement when it is earned and paymelH is reasonably assured. Usually revenue is recognized

at delivery but, in some cases, revenue can be recognized before delivery takes place. Firms are required to repon their revenue recognition policies in the financial statement footnotes. It is important to understand when revenue recognition takes place,

Some examples of aggressive recognition include:

BilJ-and-hold arrangements whereby revenue is recognized before the goods are shipped.

Holding the accounting period open past year-end.

Sales-type leases wherehy the lessor recognizes a sale, and proht, at the inception of [he lease, especially when the lessee does not capitalize the lease.

Recognizing revenue before fulhlling all of [he terms and conditions of sale.

Recognizing revenue from swaps and barter transactions with third parties.

Different growth rates of operating cash flow and earnings. Over time, there should

be a fairly stable relationship between the growth of operating cash flow and earnings. If

5mdy Session 1()

Cross-Referenc~ to CFA Institute Assigned Reading #40 - Financial Reporting Quality: Red Flags and Accounting Warning Signs

not, earnings manipulation may be occurring. A 11rm that is reponing growing earnings, but negative or declining operating cash flow, may be recognizing revenue roo sol)n and/or delaying the recognition of expense.

The relationship of operating cash lJow and earnings can bc measurcd with the cash flow earnings index (operating cash lJow/nct incomc). An index that is cOllsisteIllly less than one or that is declining over time is suspect.

Abnormal sales growth as compared to the economy, industry, or peers. Abnotmal growth may be the result of superior management or products, but may also indicate accoul1ling irregularities. Receivables that arc growing faster than sales, as indicated by an increasing average coUection period, may be evidence of aggressive revenue recognIrlon.

Abnormal inventory growth as compared to sales growth. Increasing inventory may he an indication of obsolete products or poor inventory management, but it could also result from overstating invelHory, decreasing the cost of goods sold and therebv increasing gross profit and nct profit. This can be dncLtcd hy looking ;1 declining InvelltOry turnovC[" rallo.

~'. Professor's Note: Recall that ending inventory is equal to beginning illUeJl. tory plus

~~ purchases minl/S cost ofgoods sold (COGS). Ifending inuCIltory is too high, COGS ·_~.t< will b{' too loUl, all else equal. .

Boosting revenue with nonoperating income and nonrecurring gains. Some hrms try to reclassify nonoperating income and nonrecurring gains as revenue, in effect, moving these items "up" the income statemcnt. Net income is the samc but revenue growth is higher.

Delaying expense recognition. By capital izing opcrati ng expend itu res, the fl rl11 d days expcnse recognition to future periods. Watch for an increase in assets with unusual sounding names such as "deferred marketing charges" or "deferred customer acquisition costs. "

Abnormal use of operating leases by lessees. Operating leases afe common in most hrms. However, some firms use this off-balance-sheet financing technique to improve ratios and reduce perceived leverage. Analysts should compare the firm's use of leasing, as a financing source, to its industry peers. l~or analytical purposcs, consider treating operating leases as capital leases.

Hiding expenses by classifying them as extraordinary or nonrecurring. The result is to move expenses "down" the income statement and boost income from continuing

opcratlons.

LIFO liquidations. When a LIFO hrm sells more inventory than it purchases or produces during a period of rising prices, it reduces the cost of goods sold and increases proht, although taxes are higher as well. Such profits are not sustainable because the firm will eventually run out of inventory. A declining LIFO reserve is an indication of a LIFO liquidation. Firms should disclose the effects of a LIFO liquidation in the hnancial statement footnotes.