CFA Level 1 (2009) - 3

Study Session 10

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

Abnormal gross margin and operating margin as comparcd to industry peers. Abnormal margins may be the resulr of suptrior management or cost controls; however, lhcy may be an indication of accouI1ling irregularitics. DetCl"mine the firm\ conservatism by comparing tlte firm's accounting principles, as llisclosed in the footnotes, to those of its industry peers.

Extcnding the usefullivcs of long-tcrm asscts. Depreciating or amortizing the cost of an asset uwr more periods results in higher reponeel earnings. Compare the useful lives of the firm's assets with those of its industry peers.

Aggressive pension assumptions. Aggressive assumptions such as a high discount rate, low compensation growth rate, or high expected rate of retllrn on pension assets will result in lower pension expense and higher reponed earnings. C:omp:ue these assumptions with those of its industry peers.

Year-end surprises. Higher earn ings in the fourth quarter that cannot be expl:1 ined by seasonality may be an indication or manipulation.

Equity method invcstments and off-balance-sheet special purpose entities. Equity mcthod investments are not consolidated. However, the pro-rata share of the investee's earnings are included in net income. Watch for frequent usc of nonconsolidated special purpose entities.

Othcr off-balance-shect financing arrangements including debt guarantees. Firms must disclose these arrangemeIlts in the financial statemeI1l footnotes. For analytical purposes, consider increasing balance sheet liabilities for these arrangements.

~;~:'Sj\ ProfrHor's Note: Keep ill mind tlJtlt these are uwmillg sigllS a/low quali~y

·<,"Lc 9 earnings. jhcy rur not ru:ccssari0' indications that fraud has occurred or willoal/I'.

LOS 40.11: Describe the accounting warning signs related to the EnrOll

accoun1 iup ~;calldal.

"

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A study of Enron indicates numerous warning signs to investors, analysts, and creditors. Following is a brief discussion of some of the ted flags in Enron's financial statemen ts for the fiscal year 2000.

•Insufficient operating cash flow. Although Enron's operating cash flow exceeded net income, certain transactions were classified as operating activities when, in substance, the transactions were more like financing activities. In addition, Enron did not generate sufficient operating cash flow to fund irs investing activities. Financing activities made up the difference

•Pressure to support stock price and debt ratings. If Enron's stock price declined by a certain amount, or if Enron's debt rating dropped below investment grade, additional collateral in the form of Enron stock was required by its lenders. These

provisions provided an incentive for Enron to manipulate earnings in order to boost its srock price and debt ratings. Recall that one of the motivations for overreporting earnings is to remain in compliance with lending covenants.

Study Session 10 Cross-Refercnce to CFA Institutc Assigned Rcading #40 - Financial Rcporting Quality: Red Flags and Accounting Warning Signs

Revenucs reported usin p mark-to-market accounting. Mark-tn-markct revenue accounting is allowed in very limited situations, mostly involving commodities. Enron applied this accounting mcthod to a number of differcnt types of contracts. [n some cases, there were no established market prices to valuc the underlying contract; thus, market value was simply cstimated by huon. As a result, Enron could recognize revenue before the contracts were even operational.

•Excessive revenues reported in the last half of the year. Revenues reportcd ill the third and fourth quarters were disproponionate with Lnron's seasonal t1Tnd (rom prevIous years.

•Inflated sales to SPEs. Enron securitized assets and sold the securitizations at inAated values to special purposes entities. In some cases, Enron protected the SPF investors from the risks involved in the transactions.

Usc of mark-to-market accounting for equity method investments. Recall that equity method investments arc not consolidated; rather, the \1fo-rata earnings o( the investee arc reponed in net income. In somc cases, Enron reponed mark-to-market gains on equity investmeI1ls, rather than simply their GAAP incomc.

Usc of barter transactions. In some l';ISl'S, Fnron would s<:I1 cable capacity to ;1 !XUIY

and simultancously 11urchase capacity (rom the same party.

eSignificant use of related party transactions. Probably the mOSl egregious irregularities occurred using limited partnerships whereby an Enron employee served as general partner. The limited partnerships engaged in billions of dollars in derivatives transactions with Enrol1. The primary assets of the partnerships included

receivables from Enron and Enron securities.

•Senior management compensation and turnover. Senior management's compensation was based most1y on bonus and stock awards. In addition, during the

year 200 I, several key top managers resigned.

! US iiO.i: Describe the ;lccollntil1F. ,-,varning signs rehted 1<.: tl1\' Slinlw;111l

:1"e':)II)lrl!lg';clnd;ll.

As previously noted, the most common earnings manipulation technique is recognizing revenue too soon. Sunbeam Corporation's 1996 and 1997 financial statements provide an excellent case study in earnings manipulation through aggrt'ssive revenue recognition. Sunbeam was a financially distressed company and, as pan of Sunbeam's turnaround, management engaged in a number of questionable transactions. Following is a brief discussion of some of the warning signs found in Sunbeam's financial statements:

•Created "cookie jar" reserves. As a pan of its turnaround, Sunbeam recognized restructuring charges aud created reserves by recognizing losses in its 1996 income statement. For example, writing off inventory results in a reponed loss; however, this

loss turns into a profit when the inventory is sold in subsequent periods.

•Receivables increased faster than sales. In 1997, Sun beam's receivables increased faster than sales. Sales without collections may be an indication that both sales and

receivables are of poor qual ity.

•Generated negative operating cash flow. In 1997, Sunbeam reported a record level of earnings but operating cash flow was negative. The negative cash flow was

primarily the result of increasing inventories and receivables.

•Engaged in bill-and-hold sale arrangements, In 1997, Sunbeam changed its revenue recognition policy and began recognizing some sales under bill-and-hold arrangements, whereby revenue was recognized before (he goods were shipped.

Study St:ssioll 10

Cmss-Reference to eFA Institute Assigned Reading #40 - Financial Reponing Quality: Red Flags and Accounting Warning Signs

•Inappropriately reduced bad debt expensc. In 1997, bad debt expense rdatn! to receivables decreased even though sales and receivables increased significantly.

•Increased fourth quarter revenucs. The I1nancial statement footnotes indicate rhat Sunbeam's products are nor seasonal, yet the footnotes reveal that Sunbeam initialed an early buy program for certain produCls. Accordingly, the pLTcenrage of Sunbeam's lOlal revenue was highest in the fourth quarter. An increase in fourth quarter revenue of a nonseasonal business is a red flag.

Study Session 10

Cross-Reference to CFA Institutc Assigncd Rcading #40 - Financi;11 Rcponing Quality: Rcd Flags and Accounting Warning Signs

JOSH!.;!

Managcment 1ll:IY he motivatL,d to ovcrstare carnings to men alLtlyst expeLlations, re/1lain in complianu: with elL-bt covenaIllS, or hecallsL' higher repont:ll L'arnings will increase their ulm[Knsation. Managclllellt nL1Y bL' 1l1lltiv;IlL'd to UndnSLllL' carnings to ohtain tLlde relief, renegotiate adV;ll\tageolls repayment telms with existing creditors, negotiate more advantagcous union labor contracts, or "save" earnings to report in a future period.

IOS·jO.h

I,ow earnings quality ell] result from selecting ,IL:coullling principles that misrepresem the economics or transactions, structuring tLlI1s:1crions primarily to achieve a desirt:ll dTcL·t on reponed earnings, using aggressivc or unrealistic estimates and assum[1rions, or nploil illg thl' ilHL'nt or :In ;\cL'ounting standard.

The "(raud triangle" consists of:

IJlCCJltilJC / prl'HllrL·-the Illative ro commit fraud.

OpportIlJlitil's--the linn has a weak ilHcma) conrrol system.

Atti/Tidl' / mtioJlizlizfl/iolJ-the minc!scr that framl is justified.

lOS -1(l.ll

Risk (actors rdared to incelHives and pressurcs for traud include:

Threats ro rhe 11rm\ financial stability OJ' profitahiliry.

Excessive rhird-party pressures 011 management.

Threars to the personal ncr worth of managemcnt or board mcmbers.

•Excessive pressure on management and emplo)"ees to meet internal targets,

LOS ,H!.,~

Risk facrors rclared to opponunities for (raud include:

• The nalllJ'c of the industry or operalions.

•I neffecrivc 1110nirori ng of managemen r.

Complex or unstable organizarional srrucrure. Deficient inrcrnal controls.

l.OS10.r

Risk facrors related ro arrirudes and rationalizations for fraud include:

•Inappropriate or inadequately supponed ethical srandatds.

Excessive parricipation by nonfinancial management in selecring accounting merhods.

A hisrory of legal and regulatory violations by management or board members.

Obsessive ;]rrention to the srock price or earnings trend.

•Aggressive commitments 1'0 rhird panics. Failure ro correct known compliance problems.

Minimizing earnings inappropriately for rax reponing. Continued usc of matcrialiry to jusriFy inappropriare accounting. A strained relationship with the currenr or previous audiror.

Study Session 10

Cross-Rcfercncc to CFA Institutc Assigncd Rcading #40 - Financial Rcporting Quality: Rcd Hags and Accounting Warning Signs

LOS 40.g

Common warning signs of earnings manipulation include:

Aggressive revenue recognition.

• Different growth rates of operating cash How and earnings.

•Abnormal comparative sales growth.

•Abnormal inventory growth as compan:d to sales.

•Moving non-operating income and nonrecurring gains up the income sratemelH to boost reven ue.

•Delaying expense recognition.

• Excessive use of off-balance-sheet financing arrangemenrs including leases.

•Classifying eXIJenses as extraordin:Hy or nonrecurring and moving them down the income statement to boost income frol11 continuing operations.

•UFO liquidations.

•Abnormal comparative margin ratios.

•Aggressive assumptions and estimates.

•Year-end surprises.

Equity method invcstlllents with link or no cash now.

lOS 'lOh

Accounting warning signs related to the Enron scandal included:

•Insufficient operating cash flow.

•Pressure to support the stock price and debt ratings.

•Mark-to-market accounting for equity method investments.

• Disproportionately high revenues in the third and fourth quarters.

•Inflated sales of financial assets to special purpose enti tics. Significant barrer and related-party transactions.

High senior management turnover.

LOS 40.i

Accounting warning signs related to the Sunbeam scandal included:

•"Cookie jar" reserves.

•Receivables increasing faster than sales.

•Negative operating cash How.

•InHating revenue with bill-and-hold sale arrangements.

•Lower bad debt expense despite growing receivables.

•Outsized fourth quarter revenue for a business described as non-seasonal.

Study Session 10 Cross-Reference to CI:A Institute Assigned Reading #40 - Financial Reporting Quality: Red Flags allll Accounting Warning Signs

1.Which of the following is least likely to be a motivation to overrepon net income?

A.Meet earnings expectations.

B.Negotiate labor union contracts.

C. Remain in compliance with bond covenants.

2, Which of the following is most likely an example of accoullting fraud?

A.Using aggressive pension assumptions.

B.Booking revenue from a fictitious customer.

C, Selecting an acceptable depreciation method rhar misrepresenrs the economics of the transaction.

3.The "fraud triangle" consists of:

A. incenrive or pressure, 0PI)orrunity, and attitudes or rationalization.

n, ineffective Il1dnage11ll'nr, unsrable organizational srructure, and ddiL'ienl intnna\ controls.

C, inappropriare ethical standards, violations of laws or regulations, and failing to correct known reportable conditions.

4.Competitive threats to the profitability or financial srability of a firm are IJI'.fI categorized as an accounting fraud risk factor related to:

A.opportunities.

B.incentives and pressures.

C. attitudes and rationalizations.

A.Significant related parry transactions.

B.High turnover among accounting and information systems personnel.

C.Aggressive or unrealistic profitability expectations from third panies.

6.Accounting fraud risk factors related to attitudes and rationalizations are Leas! likely to include:

A.Management has a strained relationship with the current or previous auditor.

B.The firm does not effectively communicate an appropriate set of ethical standards.

C.A high proportion of management's compensation depends on the firm exceeding targets for earnings or the srock price.

7.Which of the following actions is least likely to immediately increase earnings?

A.Selling more inventory than is purchased or produced.

B.Lowering the salvage value of depreciable assets.

C. Holding the accounting period open past year-end.

Swdy Session 10

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

8.Accounting warning signs related to the Enron scandal least likely include:

R.relatcd-parry transactions.

C.inHated sales to special purposc cmitics.

9.Which of the following Jctions was lemf likely a warning sign of potcntia! carnings manipulation discloscd in Sunbeam's financial staternCIH footnotes?

A.Significant use of barter transactions.

B.Receivables wcre increasing, but bad debt cxpense was decrcasing.

C. A record lcvel of earnings, yct opcrating cash How was negative.

Study Session 10

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

I.13 Negotiating labor union contracts would be a reason to underreport, not ovetreport, earnings. The other choices are motivations to overreport earnings.

2, B Booking revenue from a lictitious CllSltlmlT is rrauJ.

5.A The three components of the fraud triangle arc incenrive or presslll'e, opportunity, and altitudes or rationali,.ation.

4.B Risk factors related to incentives and pressures include threats to the firm's financial stability or profitability from economic, industry, or firm-specific operating conditions.

'i. C Unrealistic profitallility expectations from third parties is a risk faeror related (() incentives and pressures. The other choices arc risk factors related to man:lgellH:nt's opportunities to commit fraud.

(). c: Significallt thrl'ats to the pl'l'sollal wcalth or IlLlllagns anJ /Hl.lrJ members due to the

linn Ilut IllCctillg its financiall.,rgcts arc a risk hctor tela ted to incentives and prcsslll'cs. The other choices are risk fanors rl'lateJ to attillldl's and rationali,.ations.

7.B Lowering the salvage value will result in higher depreciation expense, and thlls, lower earnings. The other choices will immediately increase earnings. Selling more inventory than is purchaseJ or produced will incrl'ase rCVl'nue without increasing cost or goods sold, which will increase earnings. Holding the accounting period 0pl'n past Yl'ar-end is an aggrl'ssive revenue recognition method that will boost earnings.

8.A Enron engaged in significant related party transacrions and had high asset sail's [0 spl'cial purpose entities. Cookie-jar reserves were used by Sunbeam, but not Enron.

9.A Sunbeam was not involved in significant barter transactions, The other choices are warning signs related to Sunbeam's accounting sC;lnJal.

The following is a review of the Financial Reporting and Analysis principles designed to address the learning outcome statements set forth by CfA Institute@. This topic is also covered in:

ACCOUNTING SHENANIGANS ON THE CASH FLOW STATEMENT

Study Session 10

EXAM Focus

CASH FLOW MANIPULATION

Accrual accounting is easily manipulated because of the many estimates and judgments involved. Operating cash How is usually unaffected by estimates and judgments. However, firms can still create the perception that sustainable operating cash tlow is greater than it actually is.

One technique is to misrepresent a firm's cash generating ability by classifying financing activities as operating activities and vice-versa. Additionally, management has discretion over rhe timing of cash flows. An analyst should take care to investigate the quality

of a company's cash flows and determine whether increases in operating cash flow arc sustainable. Management also has discretion over where to report cash flows, and the analyst should be aware that the difference in treatment among companies may make comparisons of cash flow less useful, particularly for valuation.

[OS 41: Analyze ano discu,;s the follovving ways to manipulate \ he cash !low statement: strctchillg otH payables; financing of payables; securitization of receivables; and using stock buybacks 10 offset dilution of earnings.

Stretching Accounts Payable

Transactions with suppliers are usually reported as operating activities in the cash flow statement. A firm can temporarily increase operating cash flow by simply stretching accounts payable; that is, delaying payments to its suppliers. By delaying payment, the firm effectively receives no-cost financing. However, stretching payables is not a

sustainable source of increased cash flows, since the firm's suppliers may eventually refuse to extend credit because of the slower payments.

One way to determine whether a firm is stretching its payables is to examine the number of days in accounts payable. Days' sales in payables is calculated by dividing accounts payable by COGS and multiplying the result by the number of days in the period.

Study Session I () Cross-Referencc to CFA Institutc Assigncd Rcading #41 - Accounting Shenanigans on thc Cash Flow Statcmcnt

Example: Calculating days sales in accounts payable

At year-end, Silver Creek Company reported cost of goods sold of $250 million. Ending accounts payable is $50 million. Assuming there are 365 days in a year, calculate the number of days on average it takes Silver Creek to pay its suppliers.

Answer:

days' sales in accounts payable = ( $50 Jx 365 = 73 days $250

Financing Accounts Payable

Delaying the cash flows associated with payables can also be accomplished by entering into a financing arrangement with a third party, usually a financial institution. Such an arrangement allows the firm to manage the timing of the reponed operating cash Bows.

Consider a manufacturing firm's credit purchases of raw materials. In an indirect cash How statement, the increase in inventory decreases operating cash flow and the increase in accounts payable increases operating cash How. 'J(Jtal operating cash Bow does not change.

When the account payable is due, a financial institution makes payment to the supplier on behalf of the firm, and the firm reclassifies the account payable to shon-term debt. The decrease in accounts payable decreases operating cash How, and the increase in short-term debt increases financing cash flow. At this point, operating cash How is lower and financing cash How is higher, but total cash How is still unaffected. The firm might time the arrangement so that the lower operating cash How is offset by higher operating cash Hows from other sources, such as seasonal cash Hows or cash Hows from receivable sales or securitizations. In effect, the firm times the operating cash outHow to occur when other operating cash inflows are higher.

Finally, when the firm repays the financial institution, the firm reports the outHow of cash as a financing activity and not an operating activity. Ultimately, the firm

has delayed the outHow of cash. Of course, the financial institution will charge a fee (interest) to handle the arrangement.

Securitizing Accounts Receivable

Firms can immediately convert accounts receivable to cash by borrowing against the receivables, or by selling or securitizing the receivables. When a firm borrows with its