CFA L2 FSA (Part 2/2) Flashcards
1
Q
Two ways foreign currency can affect a multinational firm’s financial statements:
A
- The firm may engage in business transactions that are denominated in another currency.
- The firm may invest in subsidiaries that maintain their books and records in a foreign currency. In both cases, special accounting treatment is required.
2
Q
Local currency
A
The currency where the foreign subsidiary is located.
3
Q
Functional currency
A
The currency of the primary economic environment where the firm operates.
- This is the currency where the firm spends its cash.
- The functional currency may or may not be the local currency.
4
Q
Presenting currency/reporting currency
A
The currency that the parent company presents its financial statements.
5
Q
Three risks in multinational operations:
A
Translation risk= Tends to affect bigger, multinational firms. This is the risk where the subsidiary must convert their currency into the parent’s currency at the date of consolidation and it’ll cause a loss.
Transaction risk= The risk that the exchange rate can move between entering a FX contract and settling the contract.
Economic risk= The risk that movements in exchange rates will affect imports/exports.
6
Q
True or false: Foreign currency risk occurs when the transaction date and payment date are the same?
A
False, when they differ.
Ex: A US firm sells goods to a firm located in Italy for $10,000 when the spot exchange rate is $1.60 per Euro. The payment is due in 30 days and when the payment is actually received the exchange rate is now $1.50. On the transaction date, the US recognizes a sale of ($10,000 * $1.60) = $16,000. On the payment date, the US firm receives ($10,000 * $1.50)= $15,000 … so the US firm must record a $1,000 loss in the IS and thus a $1,000 decrease in RE.
7
Q
Transaction exposure example when the settlement date is after the b/s date:
Ex: A US firm sells goods to a firm located in Italy for $10,000 when the spot exchange rate is $1.60 per Euro on Dec. 15. The payment is due in 30 days on Jan. 15 and when the payment is actually received the exchange rate is now $1.50. Obviously, the settlement date is in the next accounting period. At Dec. 31, the exchange rate was $1.56.
A
On the transaction date, Dec. 15, the US recognizes a sale of ($10,000 * $1.60) = $16,000. The B/S reflects a $16,000 increase to assets. At Dec. 31, The US recognizes a loss of $10,000 * ($1.56 - $1.60) = $400 to the IS and thus a $400 decrease to RE. The B/S reflects the $400 reduction to assets. At Jan. 15, The US recognizes another loss of $10,000 * ($1.50 - $1.56) = $600 to the IS and thus a $600 decrease to RE. The B/S reflects the $600 reduction to assets.
8
Q
True or False: IFRS and GAAP provide guidance to where transaction gains/losses should be recognized in the IS?
A
False, IFRS and GAAP both say that transaction gains/losses must be reported in the IS but not where within the IS.
9
Q
Process of translation of foreign currency of financial statements.
A
- Identify the subsidiary’s local currency.
- Convert the local currency balances into the functional currency.
- Convert the functional currency balances into the parent’s reporting currency using closing rates.
- Some of these may be the same but it is possible that all 3 are different.
10
Q
Remeasurement/ Temporal method/ nonmonetary method
A
Converting the local currency into functional currency.
- Use the temporal method when the functional current is the same as the parent’s presentation currency.
- Subsidiaries reporting their results in the local currency that is NOT the functional currency use the temporal method.
11
Q
Translation/ Current rate/all-current method
A
Converting the functional currency into the parent’s presentation/reporting currency.
- Use the current rate method when the functional currency and the parent’s presentation currency differ.
- Self-contained, independent subsidiaries reporting their results in the local currency that is also the functional currency use the current method.
12
Q
IASB guidance on which currency should be the functional currency:
A
The currency that influences sale prices of goods/services. Currency of the country whose competitive forces and regulations determine the sale prices of goods/services. The currency that influences labor, material, & other costs. The currency from which funds are generated. The currency in which receipts from operating activities are usually retained.
13
Q
True or false: In a case where the local currency, functional currency, and presentation/reporting currency all differ, both the temporal method and current rate method are used?
A
TRUE
14
Q
In a situation with hyperinflation, how do we account for translation of currencies?
A
Under GAAP, the functional currency is considered to be the parent’s presentation currency and the temporal method is used.
Under IFRS, the subsidiary’s financial statements are restated for inflation and then translated using the current exchange rate.
15
Q
Current rate vs average rate vs historical rate
A
Current rate/Closing exchange rate= The exchange rate on the b/s date
Average rate= The average exchange rate over the reporting period
Historical rate/actual rate= The actual rate that was in effect when the original transaction occurred.
16
Q
Applying the Temporal Method
A
On the b/s, monetary assets & liabilities are restated using the current exchange rate. All other assets are considered to be non-monetary and are restated at the historical exchange rate. Any nonmonetary assets or liability measured on the b/s at FV is restated at the current exchange rate. Capital stock is restated at the historical exchange rate. On the IS, common stock and dividends paid are restated at the historical exchange rate. Expenses related to nonmonetary assets (ex: COGS, D&A) are restated at the historical exchange rate. Revenues and all other expenses are translated at the average rate. Any remeasurement gain/loss is recognized in the IS. This leads to a more volatile NI compared to the current rate method because there the translation gain/loss is reported in equity.
17
Q
Monetary assets & liabilities
A
Assets & liabilities that are fixed in the amount of currency to be received or paid.
Ex: Cash, receivables, payables, short-term debt, and long-term debt.
Ex of nonmonetary assets & liabilities: inventory, fixed assets, intangible assets, deferred revenue.
18
Q
True or false: Inventory valuation methodologies (LIFO, FIFO, etc.) play a major role in the temporal method?
A
True, when restating items using the historical method, FIFO and LIFO can play a large role. For example, FIFO COGS consists of costs that are older, thus the exchange rates used to remeasure COGS are older compared to LIFO.
19
Q
Applying the Current Rate Method
A
Start w/ the IS with this method. On the IS, all accounts are translated at the average rate. Dividends are also translated at the historical exchange rate. Any translation gain/loss is reported in shareholders’ equity as part of the cumulative translation adjustment (CTA). CTA is a part of OCI. When CTA is disposed, it passes through the IS. On the b/s, all accounts are translated at the current rate except for common stock which is translated at the historical exchange rate.
- Taxes are reported at the average rate under both the current rate method and the temporal method.
20
Q
How to calculate ending RE:
A
Beginning RE + NI - dividends paid
21
Q
Example of how to calculate CTA under the Current Rate Method given:
Assets= $1,000
Liabilities= $600
Common Stock= $150
Beginning RE= $175
Current NI= $50
Dividends paid= $25
A
First, we need to calculate ending RE= $175 + $50 - $25 = $200
Now we can back into CTA: $1,000 (assets) - $600 (liabilities) = $400.
Given that ending RE= $200 and CS = $150, we know that $400 - $200 - $150 = $50.
22
Q
True or false: Under the temporal method, all of the parent company’s assets are exposed to changing rates?
A
False, only the net monetary assets = (monetary assets - monetary liabilities) position is exposed to changing rates. If a firm is balanced, meaning monetary assets = monetary liabilities, there is no exposure under the temporal method.
23
Q
COGS calculation
A
Beginning inventory + purchases - ending inventory
24
Q
True or false: pure b/s ratios and pure IS ratios are affected by the temporal method and current rate method?
A
False, they are unaffected.
Pure means that all of the components of the pure b/s ratio are from the b/s or all of the components from the pure IS ratio are from the IS.
25
Mixed ratio
A ratio the combines inputs from the IS and b/s.
## Footnote
* These ratios are affected by the temporal and current rate methods. Ex: ROA
26
True or false: If accounts receivable turnover increases, receivables collection period will decrease?
True
Accounts receivable turnover= net sales ÷ accounts receivable.
27
True or false: If the foreign currency is depreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be smaller than the original ratio?
False, if the foreign currency is depreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be larger than the original ratio.
28
True or false: If the foreign currency is appreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be larger than the original ratio?
False, if the foreign currency is appreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be smaller than the original ratio.
29
How to compare impact of the current rate method vs the temporal method on ratios?
1. Determine if the local currency is appreciating or depreciating.
2. Determine which rate (historical, current, or average) is used to convert the numerator under both methods.
3. Determine whether the numerator will be smaller, the same, or larger under the temporal or current rate method.
4. Determine which rate (historical, current, or average) is used to convert the denominator under both methods.
5. Determine whether the denominator will be smaller, the same, or larger under the temporal or current rate method.
6. Determine whether the ratio will increase, decrease, or stay the same based on the direction of the change in the numerator and denominator.
30
True or false: In a hyper-inflationary environment, a local currency will rapidly appreciate against the presentation currency?
False, depreciate
31
Hyperinflation
3 year cumulative inflationary environment w/ an inflation rate > 100% (GAAP). In a hyper-inflationary environment, the current rate will result in significantly lower assets/liabilities of the subsidiary.
## Footnote
* Nonmonetary assets/liabilities are not affected by hyperinflation.
* Under IFRS, firms can adjust for inflation but under GAAP they cannot. The temporal method is used under GAAP in a hyperinflationary environment.
32
How to adjust for hyperinflation under IFRS:
Nonmonetary assets & liabilities are restated for inflation using a price index. Since most nonmonetary items are reported at historical cost, simply multiply the by the quotient of the price index for the b/s date divided by the acquisition date. Monetary assets/liabilities are generally not restated. The components of equity (other than RE) are restated by applying the change in the price index from the beginning of the period. Simply multiply the by the quotient of the price index for the b/s date divided by the acquisition date. RE will be used as a plug figure. The income statement items are restated by multiplying by the quotient of the price index for the b/s date divided by the average rate (assuming that purchases were made evenly throughout the year). The net purchasing power gain or loss is recognized in the IS based on the net monetary asset/liability exposure. This is mostly a plug figure to ensure that revenues - expenses = NI.
33
Similarities between the temporal method and current method when adjusting for inflation:
Under the temporal method, monetary assets/liabilities are exposed to exchange rate risk, whereas under the current rate method they are exposed to inflation risk. Purchasing power gains/losses are the same concept as exchange rate gains/losses when the foreign currency is depreciating. Any gain/loss from remeasurement is recognized in the IS just like net purchasing power gains/losses are recognized in the IS.
34
True or false: In a hyperinflationary environment, under IFRS, monetary assets will result in purchasing power gains and monetary liabilities will result in purchasing power losses?
False, in a hyperinflationary environment, under IFRS, monetary assets will result in purchasing power losses and monetary liabilities will result in purchasing power gains?
35
Effective tax rate
The percent of income that an individual or corporation owes/pays in taxes. A disclosure must be made that reconciles the difference between the effective tax rate and the statutory tax rate.
Calculation: Tax expense ÷ pretax profit
## Footnote
* Statutory and effective tax rates will differ if a firm has overseas subsidiaries.
36
Statutory tax rate
The tax code of the home country.
## Footnote
* Changes in the effective tax rate on account of foreign operations can be due to changes in the mix of profits from different countries w/ varying tax rates and changes in tax rates.
37
True or false: When evaluating a company's sales, most of the time we want to strip out a company's exchange rate gains/losses?
True, we want to see organic growth in sales not the effects of currencies. Currency effects distort sales growth.
38
True or false: Analysts can use disclosures to evaluate the impact of changes in currency values on a company's business?
TRUE
39
3 ways financial institutions differ from regular companies:
* Systemic importance
* More heavily regulated.
* Types of assets
40
True or false: Global regulatory bodies coordinate to determine rules for oversight of banks and to prevent regulatory arbitrage?
TRUE
41
Basel Committee on Banking Supervision
A committee under the Bank of International Settlements that develops a worldwide regulatory framework for banks. The current framework is called Basel III.
42
3 pillars of Basel III's framework:
* Minimum capital levels: the riskier the bank's assets, the more required capital.
* Liquidity: Banks must hold enough liquid assets for a 30-day stressed scenario.
* Stable funding
43
Primary other global organizations that coordinate bank regulations:
* Financial stability board
* International Association of Deposit Insurers: Seek to improve effectiveness of deposit insurers.
* IOSCO: Maintains fair and efficient security markets.
* International Association of Insurance Supervisors (IAIS): Regulates the insurance industry.
44
True or false: The FDIC alone determines how risk weightings are applied to bank assets?
False, risk-weighting is specified by the individual regulators.
45
Tier 1 Capital
Tier 1 capital is a bank's primary form of capital. Tier 1 capital is made up of: CE Tier 1 Capital: common stock, additional paid-in capital, RE, and OCI minus intangibles and DTA.
Other Tier 1 Capital: Subordinated instruments w/ no specified maturity and no contractual dividends (ex: PS w/ discretionary dividends)
Total capital = Tier 1 capital + Tier 2 capital
46
Basel III guidelines regarding CE tier 1 capital, tier 1 Capital, and total capital as a % of risk weighted assets:
CE tier 1 capital must = 4.5% of RWA
Tier 1 capital must = 6% of RWA
Total capital must = 8% of RWA
## Footnote
* Individual regulators can make these restrictions tighter.
47
Asset quality
The process of generating assets, managing them, and controlling overall risk. Analysis of AQ involves measuring credit risk. Loans are the main asset and generally carried at amortized cost net of allowances.
48
Reverse repurchase agreements
Bank loans advanced under a repurchase agreement.
## Footnote
* Reverse repo is when a firm sells an asset with an obligation to buy them back later at a higher price.
49
Assets held for sale
Bank assets that the b/s assumes disposition. These are classified as discontinued operations.
50
Allowance for loan losses
A contra account that is a provision for loan losses. This is an expense subject to mgmt discretion. When an actual loss occurs (assuming no recovery), these are written off against the ALLL.
51
What are the 3 ratios used to evaluate ALLL:
1. ALLL: non-performing loans
2. ALLL: net loan charge-offs
3. Provision for loan losses: net loan charge-offs
## Footnote
* Provision for loan losses: net loan charge-offs
52
How to value the FV of banks assets?
We use the FV hierarchy based on types of inputs used in determining FV:
Level 1 inputs are the market price of identical assets.
Level 2 inputs are observable but not market prices of identical assets. We look at similar assets or interest rate spreads or implied volatility.
Level 3 inputs are non-observative and therefore objective (Ex: DCF)
53
What are high quality earnings?
return on equity > cost of capital. We want earnings to be sustainable, on a positive trend, unbiased estimates, and come from recurring sources.
54
Primary sources of earnings for a bank
* Net interest income
* Service income:
* Trading income: most volatile year-to-year
## Footnote
* Higher #1 and #2 will lead to more sustainable earnings.
55
Minimum liquidity ratios under Basel III
Liquidity coverage ratio (LCR)
Calculation: highly liquid assets ÷ expected cash outflows
* Expected cash outflows are estimated one-month cash requirements in a stressed scenario.
* Banks need a minimum LCR of 100%
Net stable funding ratio (NSFR)
Calculation: Available stable funding (ASF) ÷ required stable funding
* Banks need a minimum NSFR of 100%.
* Available stable funding is the composition and maturity distribution of a bank's funding sources.
* Required stable funding is the composition and maturity distribution of a bank's assets.
56
Interest rate risk
The result of differences in maturity, rates, and repricing frequency between the bank's assets and its liabilities.
57
Besides CAMELS, what other factors should analysts consider when analyzing a bank?
* Government support: (ex: deposit insurance).
* Government ownership: government ownership increases public faith in the banking system.
* The bank's mission: community banks are more likely to have asset concentrations.
* Culture: (ex: risk averse vs risk taking). Too risk averse means insufficient returns, whereas too much risk can lead to failure.
* The competitive environment the bank is in.
* Off b/s items (ex: derivatives, LOCs, etc.)
* Currency exposure
58
How to evaluate culture of banks
* Are losses stemming from narrow-focused investment strategies or too much risk?
* Are there internal control issues?
* Is mgmt's compensation excessively tied to stock price performance?
* How quickly does the bank adjust loan loss provisions to actual loss behavior?
59
Types of insurance companies
* Property and casualty (P&C)
* Life and health (L&H)
60
Types of revenues for insurance companies
* Income on premiums
* Income on float= Premiums not paid out in claims
61
Property & Causality (P&C) insurers
Property insurance deals w/ properties and causality insurance (a.k.a liability insurance) protects against a legal liability. Main source of income is premiums. To be profitable, P&C insurers need to have good underwriting, charge enough premiums for the risk, and diversify their risk (by selling policies to many customers and selling different types of insurance). Typically, P&C policies are short-term and renegotiated frequently. The main expenses for P&C firms are claims and the cost of writing new policies. These firms also make money off of investing premiums. P&C margins are cyclical. During a soft pricing period- a period of losses and shrinking capital bases due to increased competition, more P&C firms will leave the industry. This will lead to higher profits (hard pricing period), and then more firms will enter.
62
Direct writers vs agency writers
Direct writers are insurance firms w/ their own sales and marketing staff. Higher fixed costs.
Agency writers are insurance firms that use insurance agents. Higher variable costs due to commissions paid to the agent.
63
Multiple peril policy
A policy that covers property insurance and liability insurance.
64
Underwriting loss ratio/loss and loss adjustment expense
A profitability ratio for insurers. Measures the relative efficiency of the firm's underwriting standards- whether the policies are priced appropriately relative to risks.
Calculation: (Claims paid + $ in loss reserves) ÷ net premium earned
* Lower is better
65
Expense ratio/underwriting expense ratio.
A profitability ratio for insurers. Measures the efficiency of the firm's operations.
Calculation: Underwriting expenses including commissions ÷ net premium written
* Lower is better
* GAAP uses net premium earned for the denominator.
66
Combined ratio calculation
Expense ratio + Underwriting loss ratio
* A ratio > 100% indicates an underwriting loss.
67
Life and Health (L&H) insurers
Insurance for people's health and for life/death. These firms also derive their revenue primarily from premiums. These are typically longer-term policies than P&C. L&H insurers have a longer contract period, higher float, and higher IRR than P&C insurers.
68
Loss reserve
An estimated value of unpaid claims. This ratio is subject to mgmt discretion. Mgmt may manipulate these reserves for earnings purposes.
69
Net premiums written
Premiums earned over the period of coverage (net of reinsurance)
70
Net premiums earned
Premiums earned over a relevant accounting period
71
True or false: Longer obligation periods make it easier to estimate loss reserves?
False, more difficult.
72
Dividends to policyholders ratio
This is a liquidity measure that measures cash outflow of dividends relative to premium income.
Calculation: Dividends to policyholders ÷ net premiums earned
73
Combined ratio after dividends calculation
Combined ratio + dividends to policyholders ratio
74
Total investment return ratio
Used to evaluate the performance of an insurer's investment operations.
Calculation: Total investment income ÷ invested assets
75
What is a way analysts gauge the liquidity of an insurer's investment portfolio?
By looking at the FV hierarchy reporting. Level 1 assets are tend to be the most liquid and Level 3 tend to be the least liquid.
76
True or false: The GICS are the global insurance capital standards?
False, there are no global risk-based capital requirements for insurers. The NAIC sets the standards in the U.S. and the E.U has adopted the Solvency II standards.
77
What are the primary considerations when analyzing L&H insurance companies?
* Revenue diversification
* Earnings characteristics
* Investment returns: Since L&H insurers have a longer float period than P&C insurers, investment returns are a key component of profitability.
* Liquidity
* Capitalization
78
Cost ratios for L&H insurers:
* Total benefits paid ÷ (net premiums written + deposits
* (Commissions + expenses) ÷ (net premiums written + deposits)
79
Earnings quality/Results quality
1/2 ways to view the quality of financial reports. Earnings quality refers to the persistence, sustainability, and level of earnings (is ROE > COE). Earnings that are close to CFO are high quality. Earnings can be high and sustainable or low and unsustainable. High earnings quality increases a company's value, while low earnings quality decreases company value.
80
Reporting quality
1/2 ways to view the quality of financial reports. Reporting quality is an assessment of the info disclosed in the financial reports. High-quality reports will contain information that is relevant, complete, neutral, and accurate. High-quality reporting provides decision-useful info.
81
Decision-useful information
Info that is accurate and relevant
82
True or false: It's possible to have low-quality reporting and high quality earnings?
False, high-quality earnings assumes high quality reporting.
83
True or false: It's possible to have high quality reporting but low quality earnings?
TRUE
84
Measurment and timing issues
1/2 potential problems that affect the quality of financial reports. These errors affect multiple financial statement elements (ex: aggressive revenue recognition practices increase reported revenues, profits, equity, and assets).
## Footnote
* Errors that affect multiple financial statement elements are more likely to arise from measurment and timing issues than classification issues.
85
Classification issues
1/2 potential problems that affect the quality of financial reports. These issues refer to how an item is categorized within financial statements (ex: classifying an expense as operating or nonoperating). Typically, classification issues only affect one element.
86
Common classification issues
| !!! ***Learn These*** !!!!
1. Removing accounts receivable by selling or transferring receivables to a related entity or by treating them as long-term receivables.
2. Reclassifying inventory as other (long-term) assets.
3. Reclassifying non-core revenues as revenues from core continuing operations.
4. Reclassifying expenses as non-operating.
5. Treating investing cash flows (e.g., sale of long-term assets) as operating cash flows.
87
Biased accounting
Seeks to further a specific agenda- sell a story.
88
Mechanisms to misstate profitability
* Aggressive revenue recognition
* Lessor use of financial lease classification
* Classifying non-operating revenue as operating or vice versa.
* Channeling gains through net income and losses through OCI
89
Warning signs of misstated profitability
* Revenue growth higher than peers'.
* Receivables growth higher than revenue growth.
* High rate of customer returns.
* Most of the year's revenue is recognized in the final quarter.
* Unexplained boost to operating margin.
* CFO < operating income
* Inconsistency in operating vs non-operating classification over time.
* Aggressive accounting assumptions
90
Mechanisms to misstate assets/liabilities
* Choosing inappropriate models and/or model inputs.
* Reclassification from current to non-current.
* Overstating or understating allowances and reserves.
* Understating identifiable assets in acquisition method.
91
Warning signs of misstated assets/liabilities
* Inconsistency in model inputs
* Typical current assets being classified as non-current.
* Allowances/reserves differ from those of peers and fluctuate a lot over time.
* High goodwill relative to total assets/Use of SPEs.
* Large fluctuations in DTAs/DTLs.
* Large off b/s liabilities.
92
Mechanisms to overstate CFO
* Managing activities to affect CFO
* Misclassifying CFI as CFO.
93
Warning signs of overstated CFO
* Increase in payables combined with decrease in inventory and receivables.
* Capitalized expenditures.
* Increases in bank overdrafts.
94
True or false: Restructuring provisions and impairment losses provide opportunities to time the recognition of losses?
TRUE
95
Steps to understanding the quality of financial reports
1. Describe the company, industry, and accounting principles being used.
2. Understand mgmt's structure of compensation.
3. Identify accounting areas that require subjectivity and/or estimates.
4. Make cross-sectional and time series comparisons of financial statements and important ratios.
5. Check for warning signs.
6. If a firm is multinational or has multiple business lines, make sure that one area isn't improving while the rest is not improving.
7. Use quantitative tools to evaluate the likelihood of misreporting.
96
Beneish Model
A quantitative tool for estimating misreporting. This is a regression model that uses 8 independent variables. Higher values indicate higher probability of misreporting. The output (dependent variable) is called the M-score.
## Footnote
* Lower M-scores are better.
97
Limitations of the Beneish Model
* The model relies on accounting data, which does not always reflect the economic reality.
* If managers are aware that the model is being relied on to detect manipulation, they can play to the model.
* Cannot determine cause and effect between model variables.
98
Altman Model
A quantitative tool for estimating the probability that a firm will file for bankruptcy. The model generates a Z-score using 5 variables: net working capital: TA, RE: TA, operating profit: TA, MVE: BV of liabilities, sales: TA. Each variable is positively related to the Z-score (has a plus sign). Higher output is better- less likelihood of bankruptcy.
99
Limitations of the Altman Model
It DOES NOT capture the variables over time. Also, it only uses accounting data.
100
What are the two elements of high quality earnings?
* Sustainability
* Adequacy (ROE > COE)
## Footnote
* Sustainable earnings are mostly driven from the CF aspect.
101
Regression model to determine if earnings are persistent:
Earnings = à + ? * earnings + î
102
Accrual based accounting
Revenues are recognized when earned and expenses are recognized when occurred regardless of the timing of CF. Revenues are expenses are usually recognized in the same period under accural accounting versus different periods under cash-based accounting.
## Footnote
* Requires subjectivity to determine which period some earnings should be recognized.
* Differs from cash-basis accounting.
* Compared to the cash basis of accounting, the accrual basis of accounting provides more timely information about future cash flows.
103
True or false: It's a major red flag when a company reports positive NI with negative CFO?
TRUE
104
True or false: It's a red flag when a company meets or barely meets consensus estimates each quarter?
TRUE
105
External indicators of low-quality earnings:
* Enforcement actions by regulators.
* Restating financial statements
* External indicators are not as useful because they are after-the-fact.
106
True or false: Mean reversion does not typically happen in earnings?
False, mean reversion is typical and can be explained through basic economics- the competitive marketplace corrects poor performance.
107
True or false: When earnings are largely comprised of accruals, mean reversion will occur slower?
False, faster, and even faster when the accruals are largely discretionary.
108
Days of sales outstanding calculation
(average accounts receivable ÷ revenue) * 365
109
Receivables turnover calculation
Net sales ÷ average accounts receivable
110
Steps in the analysis of revenue recognition:
1. Understand the overview
2. Evaluate and question ageing receivables.
3. Evaluate the proportion of earnings that are cash-based versus accruals-based.
4. Evaluate level and trend of revenue.
5. Check for related party transactions: ex: a firm might claim a big gain on a sale to an affiliated entity.
111
True or false: Capitalizing an expense is a common way to misreport earnings and make them look better?
TRUE
112
Steps in the analysis of expense recognition:
* Understand the basics.
* Trend and peer analysis
* Related party transactions: ex: shifting resources to a privately held company owned by a senior manager.
113
High quality cash flow
High quality CF is when CF is high and from sustainable sources (good economic performance) and adequate to cover CAPEX, dividends, and debt repayments. Reporting quality will also be high.
## Footnote
* High quality CF usually refers to CFO.
* CF quality should be dependent on the individual firm. Ex: startup firms are likely to have negative CFO.
114
True or false: Significant differences or widening over time between earnings and CFO suggests potential earnings manipulation?
TRUE
115
True or false: CFs are more susceptible to manipulation than the IS?
False. However, the cash flow statement can still be manipulated by management. Management may use strategic timing or shift positive CFs from CFI or CFF into CFO.
116
Steps to evaluating the cash flow statement:
1. Check for extraordinary items.
2. Check revenue quality: aggressive revenue recognition typically leads to an increase in inventories, and thus a decrease to CFO.
3. Check for strategic provisioning: provisions for restructuring charges show up as an inflow in the year of the provision and then an outflow in later years.
117
High quality b/s
High quality b/s reporting is evidenced by completeness, unbiased measurement, and clarity of presentation. ***Completeness= the existence of off b/s liabilities.***
118
Primary assets/liabilities where there is subjectivity in measurement:
* Value of pension liability
* Value of an investment (where FV isn't available)
* Impairment value for goodwill, inventory, and PP&E
119
Sources of info about risk within a company
* Financial statements
* Auditor's report
* Notes to financial statements
* SEC form 'NT': this is a report filed when a firm cannot file reports in a timely manner.
120
Framework for financial statement analysis:
1. Establish the objectives
2. Collect data
3. Process data
4. Analyze data
5. Develop & communicate conclusions
6. Follow up
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DuPont analysis
This analysis allows us to derive return on equity. This enables us to identify the firm's performance drivers and expose effects of weaker areas of the business that are being masked by the effects of stronger areas. For example, a firm could offset a declining EBIT margin by increasing asset turnover or increasing leverage.
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Extended Dupont calculation
ROE = (net income / EBT) * (EBT / EBIT) * (EBIT / revenue) * (revenue / AVERAGE assets) * (AVERAGE assets / AVERAGE equity)ROE= Tax burden * interest burden * EBIT margin * asset turnover * financial leverage
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True or false: When performing DuPont analysis financial analysts should remove the equity income from associates?
True, since firms do not have control over associates (only influence), we want to strip associate earnings out of our DuPont analysis. We also want to remove the proportionate assets from the associate when doing DuPont analysis. This is the next step of DuPont analysis in L2 compared to L1.
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Do we adjust financial leverage when performing DuPont analysis if there is an investment in an associate?
It depends. If we have info about how the investment was financed (stock, cash, debt, etc.) then we could but w/o this info we do not adjust equity or assets.
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True or false: Common size financial statements is a good way to compare companies of significantly different asset sizes?
TRUE
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Why are some liabilities more burdensome than others?
Liabilities such as bonds can be placed in default if not paid on time and that can affect a firm's credit rating. Employee benefit obligations, DTLs, and restructuring provisions are less burdensome forms of liabilities.
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Purchases calculation
COGS + ending inventory - beginning inventory
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Estimated CF calculation
EBITDA
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Business segment
A portion of a larger company that accounts for more than 10% of the company's revenues or assets, and is distinguishable from the company's other line(s) of business in terms of risk and return characteristics. Segments must report revenues, operating profit, assets, liabilities, CAPEX, D&A
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What analysts look at with business segments:
* Revenue by segment
* EBIT by segment
* Assets by segment
* CAPEX by segment
* EBIT margin by segment
* CAPEX ÷ assets by segment (as a %)
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How to disaggregate earnings into CF and accruals:
* B/S approach (accruals ratio)
* CF statement approach
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Accruals ratio/ BS approach
We can measure accruals as the change in net operating assets (NOA) over a period. In this ratio, we scale the denominator to account for differences in size. This is done because accruals can be distorted if a firm is growing or contracting quickly.
Calculation: Accruals = [ (NOA at EOP) - (NOA at BOP) ] ÷ [ ((NOA at EOP) - (NOA at BOP)) ÷ 2 ]
* Lower ratio = higher quality earnings
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Net operating assets (NOA) calculation
operating assets - operating liabilities
OR
(TA - cash) - (TL - total debt)
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Accruals calculation
(NOA at end of period) - (NOA at beginning of period)
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Cash flow statement approach
We can derive the aggregate accruals by subjecting CFO and CFI from NI.
Calculation: Accruals = (NI - CFO - CFI) [÷ ((NOA at EOP) - (NOA at BOP)) ÷ 2 ]
* Lower ratio = higher quality earnings
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True or false: The b/s approach and the CF statement approach will give the same result?
False, they will be similar but may not be exactly the same. Acquisitions/divestures, exchange rate gains/losses, and inconsistent treatment of items in the two financial statements can lead to differences.
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True or false: When calculating accruals using the b/s approach or CF statement approach, wide fluctuations in results YOY may indicate earnings manipulation?
TRUE
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If we detect earnings manipulation when disaggregating earnings into CF and accruals, what can we use?
We can compare CF to operating income, however we DO NOT use CFO as a proxy for CF. We use cash generated from operations (CGO).
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Cash generated from operations (CGO)
This is the cash-based version of EBIT.
Calculation= EBIT + non-cash charges - increases in working capital
OR
CFO + cash interest + cash taxes
## Footnote
* If CGO ÷ EBIT is close to 1, then operating income is mostly backed by cash.
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Cash flow return on assets
CFO ÷ average assets
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Operating earnings quality
CGO ÷ EBIT
## Footnote
* If CGO > EBIT, and the ratio is greater than 1, the earnings are backed by cash. If < 1, they are not backed by cash.
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Cash flow to reinvestment
Looks at whether core operations generate sufficient cash to cover capital expenditures.
Calculation: CGO ÷ CAPEX
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Cash flow interest coverage
Looks at whether core operations generate sufficient cash to cover interest payments on debt.
CGO ÷ cash interest
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Cash flow to total debt
CGO ÷ total debt
* The higher this ratio, the more room there is for the company to borrow in the future.
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True or false: When evaluating P/E ratios, many times firms strip out earnings from associates because they don't have control over associate firms?
TRUE
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How to calculate the implied value of the parent firm excluding the value of the associate
Implied value of the parent = Market cap of the parent (share price * shares outstanding) - parent's share of the associates' market cap
* It may be necessary to convert the associates' market cap to the parent's reporting currency.
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How to calculate the implied P/E of the parent excluding the associates' income
(Implied value of the parent excluding the associate) ÷ (NI - parent's share of associates' earnings)
* It may be necessary to convert the associates' earnings to the parent's reporting currency using the average exchange rate.
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How to determine whether a company is growing its investment in a segment or reducing it?
Look at CAPEX ÷ total assets
## Footnote
* A value greater than 1 indicates growing a segment while a value less than 1 indicates shrinking a segment.
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True or false: A foreign currency translation loss will reduce net sales growth?
True. Net sales growth is sales growth minus the effects of acquisitions, divestures, and FX.
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True or false: Typically, the ratio of revenue to cash collections is relatively stable for a firm?
True
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LIFO liquidation
When a company sells its newest inventory first. This will result in older lower costs being used to calculate COGS. Compared to following regular purchase policies, this will reduce COGS, reduce inventory, and artificially increase gross and net margins.
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True or false: The lessor use of sales-type finance lease classification can be used in a bias way that results in the Lessor recognizing the gross profit at inception of the lease and is a mechanism to overstate profitability?
True
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What does aggressive revenue recognition practices increase in the financial statements?
Aggressive revenue recognition practices would increase accounts receivable, revenues, expenses, income and stockholder's equity. Ending inventory would decline but by less than the increase in accounts receivable resulting in increase in total assets. Early recognition of revenues also accelerates recognition of expenses (COGS).
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True or false: Capitalizing/finance leases decreases earnings quality while operating leases increase earnings quality
False, a finance (capital) lease is reported on the balance sheet as an asset and as a liability. In the income statement, the leased asset is depreciated and interest expense is recognized on the liability. Thus, capitalizing a lease enhances earnings quality. An operating lease lowers earnings quality.
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True or false: Increased selling expenses are consistent with an investment in building brand loyalty, which is an appropriate response to a threat of substitutes and intra-industry competition?
True
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True or false: Capitalizing R&D enhances earnings quality?
False, this is an aggressive assumption since it's deferring expenses.
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True or false: Using capital leases will not appear on the CF statement and thus can be considered ignoring CFs?
True
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Stretching payables
When accounts payable is increasing as a % of NI
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True or false: Cash is an operating asset?
False, operating assets = TA - cash
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What are the effects of aggressive revenue recognition?
Increase in sales, cogs, expenses, NI, assets, and equity.
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True or false: If you ignore minority interest, the acquisition method, proportionate consolidation method, and equity method all report the same level of equity?
True
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