FSA Exam 2

Why do we use accrual accounting? Is it better than the cash basis?

• Matches revenues with expenses for better performance measurement

• More useful for forecasting and valuation than cash-basis

• Reflects economic activity, not just cash movement

What are the rules for revenue and expense recognition under accrual accounting?

• Revenue: recognized when earned and realizable

• Expenses: recognized when incurred, regardless of cash timing

How does accrual accounting alter the economic recognition of the timing of cash flows?

• Income and expenses may be recorded before or after related cash is received/paid

• Improves matching, but adds estimation uncertainty

Can the cash basis method of accounting be manipulated by evil managers?

Yes—delaying payments or accelerating receipts can shift reported income

How does the use of accrual accounting help us in forecasting?

• Provides a clearer view of ongoing operations and performance trends

• Helps predict future earnings better than volatile cash flows

What are the general limitations of accounting? Are all sources of economic value recognized under GAAP?

• No—many economic assets (e.g., brand value, internally generated intangibles) are not recognized

• Some liabilities are excluded if not probable or estimable

What is the difference between an economic asset and an accounting asset? What is the difference between an economic liability and an accounting liability? Be able to give an example of specific economic assets/liabilities that are not recognized under GAAP rules.

• Economic asset: brand loyalty, skilled workforce

• Accounting asset: inventory, equipment

• Economic liability: reputation damage risk

• Accounting liability: accounts payable

What is the market to book ratio? Know how to calculate the M/B ratio and its interpretation.

• M/B = Market value ÷ Book value

• 1 means market sees more value than what’s on the books (e.g., Apple’s brand)

Why are M/B ratios generally greater than one? What does this tell us about economic assets and liabilities vs. accounting assets and liabilities? Know the specific example of Apple and the economic assets and liabilities that might be excluded from accounting recognition (see P6-1).

• Greater than one

  • Market value includes economic assets not captured on the balance sheet (e.g., brand, R&D, customer loyalty).

  • Book value omits internally developed intangibles due to GAAP limitations.

• What does this tell us?

  • GAAP doesn’t recognize all economic assets/liabilities.

  • Accounting numbers are conservative and incomplete representations of firm value.

• Apple Example

  • High M/B due to unrecognized brand value, innovation, customer base.

  • These are economic assets but not accounting assets.

What is earnings management? What are the three major categories of earnings management that we discussed? Be able to explain each one and give an example.

• Intentional manipulation of earnings to achieve desired financial outcomes.

• Three Categories:

  • Accrual-based manipulation

    • Changing estimates (e.g., overstating bad debt reserve)

  • Presentation manipulation

    • Using non-GAAP numbers to paint a better picture

  • Real activities manipulation

    • Cutting R&D or delaying expenses to boost income

Even though accrual accounting is generally superior to cash basis accounting, it still has its weaknesses. What are the two big reasons why accrual estimates may not turn into cash flows? How to these reasons relate to “noise” (symmetric errors) and “bias” (asymmetric errors)?

• Two reasons accruals don’t turn into cash:

  • Noise (symmetric errors) – honest estimation errors

  • Bias (asymmetric errors) – deliberate manipulation

• These contribute to unreliable accruals, reducing earnings quality.

How does conservatism affect the extent to which GAAP accounting reflects economic reality?

• Effect:

  • GAAP recognizes losses more quickly than gains.

  • Leads to understatement of firm value, but increases reliability.

What is the “accrual anomaly”? How does it relate to the quality of accruals? How does it relate to the wise saying, “A cash flow in the hand is worth two accruals in the bush”?

• What is it?

  • Market overestimates earnings driven by accruals, underestimates earnings from cash.

• Quote meaning:

  • “A cash flow in the hand is worth two accruals in the bush” → accrual-based income is less persistent than cash-based income.

How can we calculate total “accruals” for a given year? What is the relation between Net Income and CFO? Why do we have to adjust net income before comparing it to CFO? How do we interpret our results from accruals analysis? What qualifies as a “red flag”?

• Formula:

  • Accruals = Net Income – CFO

  • Accrual % = (NI – CFO) ÷ |NI|

• Interpretation:

  • Positive = income-increasing accruals

  • Negative = income-decreasing accruals

• Red flags:

  • Accruals growing faster than sales

  • NI much higher than CFO

What are “income-increasing” and “income-decreasing” accruals? Be able to give an example of each.

• Income-increasing example:

  • Lowering the bad debt reserve to boost income

• Income-decreasing example:

  • Accelerating depreciation to reduce taxable income (big bath)

How can we identify any specific problematic accruals (see P6-3, a-c)? What is the expected relation between growth and accruals?

• Indicators:

  • A/R or Inventory growing faster than sales

  • NOA increases not justified by revenue

  • Low cash flow relative to income

• Expected relation:

  • Accruals should grow in line with sales—faster growth suggests manipulation

What is the basic idea behind abnormal accrual models? What is the modified Jones model (also known as the discretionary accruals model)? What is the Dechow-Dichev model? How do these models identify suspicious accruals (think conceptually)?

• Abnormal accrual models estimate the portion of accruals not explained by normal business activity, helping detect potential earnings manipulation.

• Modified Jones Model:

  • Predicts “normal” accruals based on changes in revenue and PP&E

  • Residuals = discretionary (potentially bad) accruals

• Dechow-Dichev Model:

  • Regress accruals on past, present, future cash flows

  • Poorer fit (high residuals) = lower quality accruals

Where do we usually find information about a company’s accounting methods and its key estimates and assumptions?

• Footnote 1 in the 10-K (Summary of Significant Accounting Policies)

• Also other relevant footnotes (e.g., revenue recognition, depreciation, impairment)

What are “non-GAAP” or “pro-forma” earnings? Why are they used by managers, investors, and analysts? What are the pros and cons of non-GAAP earnings?

• Why used:

  • Managers argue they better reflect “core” performance by excluding non-recurring items

• Pros:

  • Removes distortions, aids comparability

• Cons:

  • Can be misleading, often excludes recurring “bad” items

Understand each of Chairman Levitt’s five “hocus pocus” techniques: big baths, creative acquisition accounting and IPR&D, cookie jar reserves, materiality manipulation, and misapplication of the revenue recognition principle.

• Big Baths – Write-offs in a bad year to clean the slate

• Creative Acquisition Accounting / IPR&D – Manipulate post-acquisition results

• Cookie Jar Reserves – Build up reserves in good years to smooth bad years

• Materiality Manipulation – Misuse of thresholds to hide misstatements

• Misapplication of Revenue Recognition – Prematurely booking revenue

Know how to identify the most important accounting estimates and assumptions for a company (e.g., inventory is a pretty important accounting item for Walmart).

• Focus on material items—the more impactful an account is, the more critical its assumptions (e.g., inventory for Walmart, A/R for a bank).

• Start with Footnote 1 in the 10-K and explore other footnotes based on account size.

What are the five “creative accounting policies” from P7-1?

• Aggressive revenue recognition

• Capitalizing costs that should be expensed

• Manipulating reserves or allowances

• Improper classification of items (e.g., operating vs. non-operating)

• Use of off-balance-sheet entities or financing

How might managers abuse the revenue recognition principles?

• Managers may:

  • Recognize revenue too early (e.g., before delivery or completion)

  • Bundle or split contracts strategically

  • Manipulate performance obligation timing

• Vulnerable steps: setting the transaction price, allocating to obligations, recognizing revenue

What is the most common type of accounting fraud? How does revenue recognition relate to the most risky current operating accruals of AR and inventory? Know the basic details of the Boston Market example (e.g., their strategy for showing rapid growth without the immediate start-up costs associated with new franchises).

• Revenue manipulation is the most common

• Risky accruals = A/R and Inventory

• Boston Market strategy:

  • Rapid franchise expansion using related party financing

  • Booked franchise revenue before operations started → inflated growth

Why does the “gross versus net” revenues distinction matter if the bottom line is unchanged? Know the basic facts about GroupOn’s revenue reporting change.

• Why it matters:

  • Gross: Includes full amount of sales

  • Net: Reports only the portion the company keeps

• Groupon overstated revenue by reporting gross instead of net; restatement cut revenue in half but profit was unchanged

Know how to analyze AR (see P7-3). I demonstrate two basic tools: 1) AR turnover or the growth in AR relative to the growth in Sales and 2) the allowance for bad debts as a percentage of gross AR. How does the firm’s credit policy affect how we interpret AR and the allowance?

• Compare A/R growth to Sales growth

  • If A/R grows faster = possible collection issues or aggressive revenue recognition

• Allowance for Bad Debts ÷ Gross A/R

  • Low % = possibly underestimating uncollectibles

• Credit policy impacts interpretation: looser credit → higher A/R and possibly higher bad debt allowance

Know how to analyze inventory (see P7-4). What is the relationship between the inventory turnover ratio and the gross profit percentage? Why is a declining inventory turnover ratio (COGS/end inv) combined with a declining gross profit margin (gross profit/Sales) such a huge red flag? Did this signal have predictive value for Cisco?

• Inventory Turnover = COGS ÷ Ending Inventory

• Gross Profit Margin = Gross Profit ÷ Sales

• Red flag: Both declining = possible obsolete inventory or margin pressure

• Cisco example: Combo of declining turnover and margin was an early warning before large inventory write-offs

What is the general rule for capitalizing advertising (see P7-5)? What did AOL do with its direct-response advertising? Know the basic facts of the AOL situation and how it relates to aggressive capitalization policies.

• General rule: Advertising is expensed as incurred

• AOL capitalized direct response advertising (e.g., sending free disks)

  • Treated marketing as an asset, inflating earnings in 1995–1997

  • These “assets” had questionable future benefits → aggressive practice

Know how to calculate the average life and the average age of PP&E.

• Average Life = Gross PP&E ÷ Depreciation Expense

• Average Age = Accumulated Depreciation ÷ Depreciation Expense

• Use these to assess:

  • Whether PP&E is outdated

  • If depreciation rates are reasonable

How does a company’s strategy affect the forecasting process? Where can we learn about a company’s strategy?

• Strategy affects assumptions about margins, growth, capital needs, etc.

• Learn about strategy via:

  • 10-K (especially MD&A section)

  • Earnings calls and press releases

  • Analyst reports

Describe the forecasting framework we discussed in class. What is the general order in which you should tackle the forecasting process? Why do we start with the sales forecast? Why do we forecast the balance sheet before the income statement?

• Order:

  • Forecast sales

  • Forecast balance sheet (driven by sales)

  • Forecast income statement

  • Plug & reconcile cash flows

• Why sales first?

  • Sales drive most other forecasted items (assets, expenses, income)

• Why B/S before I/S?

  • Asset/liability forecasts determine expenses (e.g., depreciation, interest)

After forecasting turnover ratios and leverage ratios (and hence the levels of all assets and liabilities) comprehensive income, and retained earnings we do not explicitly forecast the level of “Paid in Common Capital, net” (net stock repurchases). Why not? What does it mean that net stock repurchases is the “plug”? Why do we need a “plug”?

• Not explicitly forecasted because it’s a balancing item

• "Plug" maintains A = L + SE

• Net stock repurchases = cash dividends + stock repurchases – stock issuance

Note that net stock repurchases is usually expressed as a positive number in the Valuation Workbook. It is equal to the change in “Paid in Common Capital, net” multiplied by minus one. For example, if “Paid in Common Capital, net” increases, then we must have issued stock and net stock repurchases would be negative.

• Positive = stock repurchased (Paid-in Capital decreased)

• Negative = stock issued (Paid-in Capital increased)

How should we forecast “non-recurring” items? How does this relate to non-GAAP earnings? How does this relate to Unusual Items, Discontinued Operations, and Other Comprehensive Income (OCI)?

• Non-recurring items (e.g., restructuring, gains/losses) should not be forecasted

• Aligns with non-GAAP earnings (which often exclude these items)

• Also applies to:

  • OCI (often assumed to be 0)

  • Discontinued operations

  • Special items from Compustat

After forecasting the income statement and the balance sheet, how are cash distributions to common equity holders calculated? Know both the direct and indirect ways to calculate cash distributions.

• Direct method:

  • Cash Dividends + Net Stock Repurchases

• Indirect method (via Clean Surplus):

  • Distributions = Income – Change in Equity

What is the clean surplus relation? How does it relate to comprehensive income and the “all inclusive principle”? How can the formula be rearranged to solve for cash distributions? Be able to explain this formula in your own words and how it makes sense on an intuitive level.

• Comprehensive Income = Ending Equity – Beginning Equity + Distributions

• Rearranged:

  • Distributions = Comprehensive Income – Change in Equity

• It links accounting income with shareholder value changes

After forecasting the financial statements, we have determined the net cash distributions to equity holders for each period (dividends + net stock repurchases). Generally speaking, how do we use this series of cash distributions to find the “intrinsic value” of the stock? What can we say when comparing the intrinsic value of the stock to the actual market price of the stock?

• Intrinsic Value = Present value of forecasted cash distributions

• Compare to market price:

  • Intrinsic > Market → stock undervalued

  • Intrinsic < Market → stock overvalued

What is the "forecast horizon"? How should we choose the length of the forecast horizon? What firm or industry characteristics determine the length of the forecast horizon?

• Number of years you forecast explicitly

• Should be long enough to:

  • Reach steady-state conditions (e.g., competitive equilibrium)

  • Allow temporary distortions (e.g., rapid growth) to fade

What is the "terminal period"? What terminal period assumptions are reasonable for sales growth and ROE? Why does the terminal sales growth have to be less than the cost of capital? What is the “terminal value”?

• Terminal period = first year after explicit forecast ends

• Assumes stable ROE, margins, and growth

• Reasonable assumptions:

  • Sales growth ≤ nominal GDP (~5%)

  • ROE = cost of equity

• Terminal value = PV of perpetuity starting in terminal year

Know the default forecast assumptions built into our valuation workbook. What is the default assumption for sales growth? Why is the default terminal growth rate set at 5.0%? How about margins, turnovers, leverage, and the dividend payout ratio? What is "straight-lining"?

• Sales growth: usually aligned with nominal GDP (5%)

• Margins, turnovers, leverage: held constant = straight-lining

• Dividend payout ratio: based on recent historical average

What are some sources of information that can help us improve on these default forecast assumptions? What are some factors that determine future sales growth for a firm? What is the price elasticity of demand? What are normal versus inferior goods?

• Sources:

  • 10-K, 8-K, earnings calls, industry reports, macro data

• Sales drivers:

  • New products, stores, advertising, R&D

  • Price elasticity of demand:

    • Normal goods → sales rise with income

    • Inferior goods → sales fall with income

What is top-down versus bottom-up forecasting?

• Top-down: Start with industry/macroeconomic data → allocate to firm

• Bottom-up: Use firm-specific metrics like store openings, R&D, pricing

What are the two big problems with forecasting EPS in our valuation workbook? Also note that we are forecasting GAAP EPS, but analysts might be forecasting non-GAAP numbers.

• EPS = Net Income ÷ Shares Outstanding

  • Share count is hard to forecast (repurchases, issuance)

  • We forecast GAAP EPS, analysts may use non-GAAP

Know how to calculate compound sales growth rates (see P8-2). What is year-over-year growth versus sequential growth?

• Compound growth = [(1+g₁)(1+g₂)...] – 1

• Year-over-year growth = Current Q vs. same Q last year

• Sequential growth = Current Q vs. previous Q

How can segment data help us in our forecasting? Know how to break down sales growth by segment to calculate an overall sales growth number (see P8-2).

• Break down by business/geographic segment

• Apply specific growth rates to each

• Aggregate based on sales weights

Know the perpetuity formula (for both a constant and a growing perpetuity). You should be able to do all of the problems in P8-5 (using any TVM formulas basic time value equations).

• Constant perpetuity: PV = C / r

• - Growing perpetuity: PV = C / (r – g)

  • C = cash flow in first terminal year

  • r = discount rate

  • g = growth rate

Know how to calculate the two adjustments shown in P8-6.

• Why do we move the cash flows forward 6 months?

• How do we adjust the valuation to the current date?

• Assumes even cash flow throughout the year

• Use: multiply value by (1 + r/2)

• Multiply value by (1 + r × (days since fiscal year-end ÷ 365))