D describe common accounting warning signs and methods for detecting each. Flashcards
Describe common accounting warning signs and methods for detecting each
Aggressive Revenue Recognition
Recognizing rev. before fulfilling all of the terms and conditions of sales
Recognizing revenues from swaps and barter transactions w/ 3rd parties
Bill-and-hold: Rev. is recognized before the goods are shipped
Sales-type leases: lessor recs a sale, and a profit, at the inception of the lease, especially when the lessee does not capitalize the lease.
Different Growth Rates of Operating Cash Flows and Earnings
Gen. princip. for the growth of op. CF and earnings - there should be a fairly stable relationship between the growth of op. CF and earnings
Growing earnings but neg or declining Op. CF’s may indicate that revs are recognized too soon and/or delaying the recognition of expense
Op. CF and earnings relationship measured w/ ‘CF earnings index’ (Op CF/NI) - if index is consistently less than one or that is declining over time = suspicious
Abnormal sales growth as compared to the economy, industry, or peers
May be the result of superior management or products, may also indicated accting irregularities. Receivables that grow faster than sales, as indicated by an increasing avg. collection period, may be evidence of aggressive revenue recognition.
Abnormal inventory growth as compared to sales growth
Increasing inv. may be an indication of obsolete products or poor inventory management, but it could also result from overstating inventory, decreasing the COGS and thereby increasing GP or Net Profit
- Ending Inv = beg. inv + purchases - COGS
- If EI too high, COGS will be too low ceteris paribus
Boosting revenue with non-operating income and non-recurring gains
Reclassify nonoperating income and nonrecurring gains as revenue, in effect, moving these items ‘up’ in the income statement. NI is the same but rev. growth is higher.
Delaying expense recognition
Capitalize operating expenditures to delay expense recognition to future periods. Watch for an increase in assets w/ unusual sounding names such as ‘deferred marketing charges’ or ‘deferred customer acquisition costs’
Abnormal use of operating leases by lessees
Operating leases are common in most firms. However, some firms use this off-balance sheet financing technique to improve ratios and reduce percieved leverage. Analysts should compare the firms use of leading, as a financing source, to its indutry peers. For analytical purposes, consider treating operating leases as capital leases.
Hiding expenses by classifying them as extraordinary or nonrecurring
The result is to move expense ‘ down’ the IS and boost inc from cont. ops.
LIFO Liquidations
When a LIFO firm sells more inventory than it purchases or produces during a period of rising prices, it reduces the COGS and increases profit, although taxes are higher as well. Such profits are not sustainable because the firm will eventually run out of inventory. A declining LIFO reserve (the diff. between LIFO inv. and what it would be under FIFO, which must be disclosed by firms that use LIFO) is an indication of a LIFO liquidation. Firms should disclouse the effects of a LIFO liquidation in the financial statement footnotes.
Abnormal Gross Margin and Operating Margin as compared to industry peers
Abnormal margins may be the result of superior management or cost controls; however, they may be an indication of accting irregularities. Determine the firms conservatism by comparing the firms accting principles, as disclosed in the goodnotes, to those of its industry peers.
Extending the useful lives of long-term assets
Depreciating or amortizing the cost of an asset over more periods results in higher reported 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 expectd rate of teturn on pension assets will results in lower penison expense and gifher reported earnings. Compare these asuumotions witho indutry peers.
Year-end surprises
Higher earnings win the 4th Q that cannot be explained by seasonality may be an indication of manipulation.
Equity method investments and off-balance-sheet special purpose entitites
Equity method investments are not consolidated. however, the pro-rata share of the ivnestee’s warnings are included in net income. Watch for frequent use of nonconsolidated SPE
Other off-balance-sheet financing arrangements including debt guarantees
Firms must disclose these arrangements in the financial statement footnoes. For analytical purposes, consider increasing BS L’s for these arragements.
