financial reporting quality: red flags and accounting warning signs(Reading 33)

Exercise Problems:

1. An analyst is assessing a company’s quality of earnings by looking at the cash flow earnings index. Potential problems would most likely be indicated if the ratio were consistently:

A. equal to 1.0.

B. less than 1.0.

C. greater than 1.0.

Ans: B.

cash flow earnings index=

A cash flow earnings index consistently below 1.0 could indicate potential problems in a company’s quality of earnings.

2. An analyst is analyzing two companies in the same industry and believes that they have similar strategies regarding the use of property, plant, and equipment (PP&E). He also thinks that the PP&E assets of the two companies are roughly of the same age and have the same expected useful lives remaining. Company A uses the LIFO method of inventory valuation, and Company B uses the FIFO method. The following additional information is available from the companies’ financial statements:

In the analyst’s opinion, which of the following conclusions is most appropriate? Compared with Company A, Company B:

A. is more liquid.

B. has a higher quality of earnings.

C. uses more aggressive accounting estimates related to PP&E.

Ans: C.

The analyst believes the two companies’ PP&E are of the same age; however, the useful life remaining for Company B’s assets is 15 years compared with 10 for Company A, implying B is using a longer useful life or more aggressive accounting policies.

The more aggressive PP&E estimates combined with the use of FIFO indicate that Company B has a lower quality of earnings, not higher. The adjusted current ratio for Company A (adjusted to include the LIFO reserve to convert the balance sheet to FIFO for comparison) is higher than the current ratio for B, indicating that A is more liquid.

3. An analyst has made three observations in his worksheets about a company that he is reviewing. Which of the observations most likely reduces the quality of earnings of the company? The company:

A. reported for the first time an asset titled “Deferred customer acquisition costs.”

B. has reduced its estimate of the expected useful life of computer equipment from 8 years to 5 years.

C. entered into long-term leases for its manufacturing equipment instead of purchasing it and recorded the leases as capital leases.

Ans: A.

An asset such as “deferred acquisition costs” could indicate the company is deferring current period expenses to future periods, which is a warning sign and an indication of lower quality earnings.

B is incorrect. Reducing its estimate of the expected useful life of computer equipment from 8 years to 5 years is not an activity that will reduce the quality of earnings of the company.

But using aggressive or unrealistic estimates and assumptions is. For example, lengthening the lives of depreciable assets or increasing the salvage value will result in lower depreciation expense and higher earnings.

C is incorrect. Entering into long-term leases for its manufacturing equipment instead of purchasing it and recording the leases as capital leases is not an activity that will reduce the quality of earnings of the company.

Structuring transaction to achieve a desired outcome is. For example, a firm might structure the terms of a lease to avoid capital lease recognition, resulting in lower liabilities, lower leverage ratios and lower fixed assets.

4. Which of the following is least likely to be a warning sign of low quality earnings?

A. Greater use of operating leases than peer companies.

B. Use of a higher discount rate in pension plan assumptions.

C. A ratio of operating cash flow to net income greater than 1.0.

Ans. C.

A ratio of operating cash flow to net income below 1.0 (not above 1.0) can be a warning sign of low quality earnings.

A is incorrect. Abnormal use of operating leases is a warning sign of low quality of earning. Operating leases are common in most firms. However, some firms use this off-balance-sheet financing technique to improve ratios and reduce perceived leverage.

B is incorrect. Aggressive pension assumptions are a warning signs of low quality of earning. Aggressive assumptions such as a high discount rate, low compensation growth rate, or high expected rate of return on pension assets will results in lower pension expense and higher reported earnings.

5.A pharmaceutical company has been very successful for the past several years, increasing its sales many-fold over that of its competition. It has been able to meet or beat analysts’ optimistic quarterly earnings estimates and consistently registers very high sales towards the end of each quarter. Most of the company’s sales are to two of its major wholesalers. The firm covers the carrying costs for these two wholesalers and guarantees them a return on investment until the wholesalers sell the products.

Which of the three risk factors related to fraudulent financial reporting would best explain the behavior of this company?

A. Opportunities

B. Incentives/Pressures

C. Attitudes/Rationalizations

Ans: B.

Incentives/Pressuresis the motive that exists to commit fraud.

The company is recognizing revenue for sales on shipment while the risks and rewards of ownership have not yet been transferred to the wholesalers. The motivation behind the activity is most likely the pressure to meet the expectations of investment analysts to meet ever increasing sales growth forecasts.

A is incorrect. Opportunity exists when there is a weakness in internal controls.

C is incorrect. Attitudes/Rationalizationsis a mindset that fraudulent behavior is justified.

6. Which of the following accounting warning signs was evident in the Enron accounting scandal?

A. Recording revenue from contingent sales.

B. Accelerating sales from later periods into the present quarter.

C. Classifying financing cash flows as operating cash flows to increase operating cash flows.

Ans: C.

Enron classified financing cash flows as operating cash flows.

7. Which of the following is least likely a condition present in a “fraud triangle”?

A. Constraining debt covenants.

B. Adding independent members to the Board of Directors.

C. Management’s belief that a decline in performance is due to temporary economic conditions.

Ans: B.

The “fraud triangle” requires incentives (e.g., debt covenants), opportunities, and management’s ability to rationalize (temporary economic conditions). Adding independent members to the Board of Directors should improve corporate governance and hence decrease the opportunity for fraud.

A is incorrect. This is an example of incentives and pressures: excessive third-party on management from debt covenants and repayment requirements.

C is incorrect.  This is an example of attitudes and rationalizations.

8. Which of the following will most likely be an incentive for management to underreport earnings?

A. Meeting analysts’ expectations.

B. Contract negotiations with unions.

C. Meeting restrictive debt covenants.

Ans: B.

Management is most likely to try and report lower earnings when negotiating concessions from a union.

A is incorrect. This is an example of excessive third-party pressures on management from aggressive or unrealistic profitability or trend expectations, which is an incentive for management to overreport earnings.

C is incorrect. This is an example of excessive third-party pressures on management from debt covenants and repayment requirements, which is an incentive for management to overreport earnings.

9. Zhan Wang, CFA, issues a “sell” recommendation on S Company because she suspects accounting fraud. Wang writes, “S has an unstable and complex organizational structure with unclear lines of authority. Rapid turnover of key employees in its information systems and accounting units have made S’s internal monitoring controls ineffective.” Which condition of the “fraud triangle” has Wang detected at S?

A. Opportunity.

B. Incentives and pressures.

C. Attitudes and rationalizations.

Ans: A.

Complex or unstable organizational structures and ineffective internal controls over accounting and information technology are among the risk factors related to opportunities for fraud.

10. While motive and opportunity both can lead to accounting fraud, a third important contributing factor is:

A. poor financial controls.

B. a justification of the fraudulent actions.

C. pressure to meet earnings expectations.

Ans: B.

A mindset that alloes rationalization or justification of the fraud is the third important condition underlying accounting fraud.

A is incorrect. Poor financial controls are an example of opportunity for fraud.

C is incorrect. Pressure to meet earnings expectations us a possible motive.

11. The ratio of operating cash flow to net income (the cash flow earnings index) would least likely be an “accounting red flag” when it is:

A. less than one.

B. declining over time.

C. highly variable.

Ans: C.

Operating cash flow that is less than net income (ratio less than one) or declining over time may indicate low quality earnings from aggressive accounting or accounting irregularities. A ratio that is consistently above one, but highly variable, is not necessarily indicative of accounting irregularities.

12. A manager whose compensation is tired to improving the firm’s inventory turnover most likely has an incentive to:

A. overstate assets.

B. understate earnings.

C. overstate working capital.

Ans: B.

Inventory turnover = .

A manager who wishes to manipulate earnings or the balance sheet to show improvement in this ratio can either understate inventories, which would understate working capital and total assets, or overstate COGS, which would understate earnings.