5. Evaluating Quality of Financial Reports - EOC

Ioana Matei is a senior portfolio manager for an international wealth management firm. She directs research analyst Teresa Pereira to investigate the earnings quality of Miland Communications and Globales, Inc.

Pereira first reviews industry data and the financial reports of Miland Communications for the past few years. Pereira then makes the following three statements about Miland:

Statement 1	Miland shortened the depreciable lives for capital assets.
Statement 2	Revenue growth has been higher than that of industry peers.
Statement 3	Discounts to customers and returns from customers have decreased.

Pereira also observes that Miland has experienced increasing inventory turnover, increasing receivables turnover, and net income greater than cash flow from operations. She estimates the following regression model to assess Miland’s earnings persistence:

Earnings_t+1 = α + β₁Cash flow_t + β₂Accruals_t + ε

Pereira and Matei discuss quantitative models such as the Beneish model, used to assess the likelihood of misreporting. Pereira makes the following two statements to Matei:

Statement 4	An advantage of using quantitative models is that they can determine cause and effect between model variables.
Statement 5	A disadvantage of using quantitative models is that their predictive power declines over time because many managers have learned to test the detectability of manipulation tactics by using the model.

Pereira concludes her investigation of Miland by examining the company’s reported pre-tax income of $5.4 billion last year. This amount includes $1.2 billion of acquisition and divestiture-related expenses, $0.5 billion of restructuring expenses, and $1.1 billion of other non-operating expenses. Pereira determines that the acquisition and divestiture-related expenses as well as restructuring expenses are non-recurring expenses, but other expenses are recurring expenses.

Matei then asks Pereira to review last year’s financial statements for Globales, Inc. and assess the effect of two possible misstatements. Upon doing so, Pereira judges that Globales improperly recognized EUR50 million of revenue and improperly capitalized EUR100 million of its cost of revenue. She then estimates the effect of these two misstatements on net income, assuming a tax rate of 25%.

Pereira compares Globales, Inc.’s financial statements with those of an industry competitor. Both firms have similar, above-average returns on equity (ROE), although Globales has a higher cash flow component of earnings. Pereira applies the mean reversion principle in her forecasts of the two firms’ future ROE.

Question

Which of Pereira’s statements describes an accounting warning sign of potential overstatement or non-sustainability of operating and/or net income?

1. A.Statement 1

2. B.Statement 2

3. C.Statement 3

B is correct. Higher growth in revenue than that of industry peers is an accounting warning sign of potential overstatement or non-sustainability of operating income. Shortening the depreciable lives of capital assets is a conservative change and not a warning sign. An increase (not a decrease) in discounts and returns would be a warning sign.

Which of Pereira’s statements about Miland Communications is most likely a warning sign of potential earnings manipulation?

1. A.The trend in inventory turnover

2. B.The trend in receivables turnover

3. C.The amount of net income relative to cash flow from operations

C is correct. Net income being greater than cash flow from operations is a warning sign that the firm may be using aggressive accrual accounting policies that shift current expenses to future periods. Decreasing, not increasing, inventory turnover could suggest inventory obsolescence problems that should be recognized. Decreasing, not increasing, receivables turnover could suggest that some revenues are fictitious or recorded prematurely or that the allowance for doubtful accounts is insufficient.

Based on the regression model used by Pereira, earnings persistence for Miland would be highest if:

1. A.β₁ is less than 0.

2. B.β₁ is greater than β₂.

3. C.β₂ is greater than β₁.

B is correct. When earnings are decomposed into a cash component and an accruals component, research has shown that the cash component is more persistent. A beta coefficient (β₁) on the cash flow variable that is larger than the beta coefficient (β₂) on the accruals variable indicates that the cash flow component of earnings is more persistent than the accruals component. This result provides evidence of earnings persistence.

Which of Pereira’s statements regarding the use of quantitative models to assess the likelihood of misreporting is correct?

1. A.Only Statement 4

2. B.Only Statement 5

3. C.Both Statement 4 and Statement 5

B is correct. Earnings manipulators have learned to test the detectability of earnings manipulation tactics by using the model to anticipate analysts’ perceptions. They can reduce their likelihood of detection; therefore, Statement 5 is correct. As a result, the predictive power of the Beneish model can decline over time. An additional limitation of using quantitative models is that they cannot determine cause and effect between model variables. Quantitative models establish only associations between variables, and Statement 4 is incorrect.

A is incorrect because quantitative models cannot determine cause and effect between model variables. They are capable only of establishing associations between variables. Therefore, Statement 4 is incorrect.

Based on Pereira’s determination of recurring and non-recurring expenses for Miland, the company’s recurring or core pre-tax earnings last year is closest to:

1. A.$4.3 billion.

2. B.$4.8 billion.

3. C.$7.1 billion.

C is correct. Recurring or core pre-tax earnings would be $7.1 billion, which is the company’s reported pre-tax income of $5.4 billion plus the $1.2 billion of non-recurring (i.e., one-time) acquisitions and divestiture expenses plus the $0.5 billion of non-recurring restructuring expenses.

After adjusting the Globales, Inc. income statement for the two possible misstatements, the decline in net income is closest to:

1. A.EUR37.5 million.

2. B.EUR112.5 million.

3. C.EUR150.0 million.

B is correct. The correction of the revenue misstatement would result in lower revenue by EUR50 million, and the correction of the cost of revenue misstatement would result in higher cost of revenue by EUR100 million. The result is a reduction in pre-tax income of EUR150 million. Applying a tax rate of 25%, the reduction in net income would be 150 × (1 − 0.25) = EUR112.5 million.

Pereira should forecast that the ROE for Globales is likely to decline:

1. A.more slowly than that of the industry competitor.

2. B.at the same rate as the industry competitor.

3. C.more rapidly than that of the industry competitor.

A is correct. Based on the principle of mean reversion, the high ROE for both firms should revert towards the mean. Globales has a higher cash flow component to its return than the peer firm, however, so its high return on common equity should persist longer than that of the peer firm. The peer firm has a higher accruals component, so it is likely to revert more quickly.

Emmitt Dodd is a portfolio manager for Upsilon Advisers. Dodd meets with Sonya Webster, the firm’s analyst responsible for the machinery industry, to discuss three established companies: BIG Industrial, Construction Supply, and Dynamic Production. Webster provides Dodd with research notes for each company that reflect trends during the last three years:

Note 1	Operating income has been much lower than operating cash flow (OCF).
Note 2	Accounts payable has increased, while accounts receivable and inventory have substantially decreased.
Note 3	Although OCF was positive, it was just sufficient to cover capital expenditures, dividends, and debt repayments.

Note 4	Operating margins have been relatively constant.
Note 5	The growth rate in revenue has exceeded the growth rate in receivables.
Note 6	OCF was stable and positive, close to its reported net income, and just sufficient to cover capital expenditures, dividends, and debt repayments.

Note 7	OCF has been more volatile than that of other industry participants.
Note 8	OCF has fallen short of covering capital expenditures, dividends, and debt repayments.

Dodd asks Webster about the use of quantitative tools to assess the likelihood of misreporting. Webster tells Dodd she uses the Beneish model, and she presents the estimated M-scores for each company in Exhibit 1.

Exhibit 1:

Beneish Model M-scores

Company	2017	2016	Change in M-score
BIG Industrial	−1.54	−1.82	0.28
Construction Supply	−2.60	−2.51	−0.09
Dynamic Production	−1.86	−1.12	−0.74

Webster tells Dodd that Dynamic Production was required to restate its 2016 financial statements as a result of its attempt to inflate sales revenue. Customers of Dynamic Production were encouraged to take excess product in 2016, and they were then allowed to return purchases in the subsequent period, without penalty.

Webster’s industry analysis leads her to believe that innovations have caused some of the BIG Industrial’s inventory to become obsolete. Webster expresses concern to Dodd that although the notes to the financial statements for BIG Industrial are informative about its inventory cost methods, its inventory is overstated.

The BIG Industrial income statement reflects a profitable 49% unconsolidated equity investment. Webster calculates the return on sales of BIG Industrial based on the reported income statement. Dodd notes that industry peers consolidate similar investments. Dodd asks Webster to use a comparable method of calculating the return on sales for BIG Industrial.

Question

Which of Webster’s notes about BIG Industrial provides an accounting warning sign of a potential reporting problem?

1. A.Only Note 1

2. B.Only Note 2

3. C.Both Note 1 and Note 2

B is correct. Only Note 2 provides a warning sign. The combination of increases in accounts payable with substantial decreases in accounts receivable and inventory are an accounting warning sign that management may be overstating cash flow from operations. Note 1 does not necessarily provide a warning sign. Operating income being greater than operating cash flow is a warning sign of a potential reporting problem. In this case, however, BIG Industrial’s operating income is lower than its operating cash flow.

Do either of Webster’s Notes 4 or 5 about Construction Supply describe an accounting warning sign of potential overstatement or non-sustainability of operating income?

1. A.No

2. B.Yes, Note 4 provides a warning sign

3. C.Yes, Note 5 provides a warning sign

A is correct. Neither Note 4 nor Note 5 provides an accounting warning sign of potential overstatement or non-sustainability of operating income.

Increases in operating margins can be a warning sign of potential overstatement or non-sustainability of operating and/or net income. In this case, however, operating margins for Construction Supply have been relatively constant during the last three years.

A growth rate in receivables exceeding the growth rate in revenue is an accounting warning sign of potential overstatement or non-sustainability of operating income. In this case, however, Construction Supply’s revenue growth exceeds the growth rate in receivables.

Based on Webster’s research notes, which company would most likely be described as having high-quality cash flow?

1. A.BIG Industrial

2. B.Construction Supply

3. C.Dynamic Production

B is correct. High-quality OCF means the performance is of high reporting quality and also of high results quality. For established companies, high-quality operating cash flow would typically be positive; be derived from sustainable sources; be adequate to cover capital expenditures, dividends, and debt repayments; and have relatively low volatility compared with industry peers. Construction Supply reported positive OCF during each of the last three years. The OCF appears to be derived from sustainable sources, because it compares closely with reported net income. Finally, OCF was adequate to cover capital expenditures, dividends, and debt repayments. Although the OCF for BIG Industrial has been positive and just sufficient to cover capital expenditures, dividends, and debt repayments, the increases in accounts payable and substantial decreases in accounts receivable and inventory during the last three years are an accounting warning sign that management may be overstating cash flow from operations. For Dynamic Production, OCF has been more volatile than other industry participants, and it has fallen short of covering capital expenditures, dividends, and debt repayments for the last three years. Both of these conditions are warning signs for Dynamic Production.

Based on the Beneish model results for 2017 in Exhibit 1, which company has the highest probability of being an earnings manipulator?

1. A.BIG Industrial

2. B.Construction Supply

3. C.Dynamic Production

A is correct. Higher M-scores indicate an increased probability of earnings manipulation. The company with the highest M-score in 2017 is BIG Industrial, with an M-score of −1.54. Construction Supply has the lowest M-score at −2.60, and Dynamic Production also has a lower M-score at −1.86. The M-score for BIG Industrial is above the relevant cutoff of −1.78.

Based on the information related to its restatement, Dynamic Production reported poor operating cash flow quality in 2016 by understating:

1. A.inventories.

2. B.net income.

3. C.trade receivables.

A is correct. The items primarily affected by improper revenue recognition include net income, receivables, and inventories. When revenues are overstated, net income and receivables will be overstated and inventories will be understated.

Webster’s concern about BIG Industrial’s inventory suggests poor reporting quality, most likelyresulting from a lack of:

1. A.completeness.

2. B.clear presentation.

3. C.unbiased measurement.

C is correct. Webster is concerned that innovations have made some of BIG Industrial’s inventory obsolete. This scenario suggests impairment charges for inventory may be understated and that the inventory balance does not reflect unbiased measurement.

In response to Dodd’s request, Webster’s recalculated return on sales will most likely:

1. A.decrease.

2. B.remain the same.

3. C.increase.

A is correct. The use of unconsolidated joint ventures or equity-method investees may reflect an overstated return on sales ratio, because the parent company’s consolidated financial statements include its share of the investee’s profits but not its share of the investee’s sales. An analyst can adjust the reported amounts to better reflect the combined amounts of sales. Reported net income divided by the combined amount of sales will result in a decrease in the net profit margin.

Mike Martinez is an equity analyst who has been asked to analyze Stellar, Inc. by his supervisor, Dominic Anderson. Stellar exhibited strong earnings growth last year; however, Anderson is skeptical about the sustainability of the company’s earnings. He wants Martinez to focus on Stellar’s financial reporting quality and earnings quality.

After conducting a thorough review of the company’s financial statements, Martinez concludes the following:

Conclusion 1	Although Stellar’s financial statements adhere to generally accepted accounting principles (GAAP), Stellar understates earnings in periods when the company is performing well and overstates earnings in periods when the company is struggling.
Conclusion 2	Stellar most likely understated the value of amortizable intangibles when recording the acquisition of Solar, Inc. last year. No goodwill impairment charges have been taken since the acquisition.
Conclusion 3	Over time, the accruals component of Stellar’s earnings is large relative to the cash component.
Conclusion 4	Stellar reported an unusually sharp decline in accounts receivable in the current year, and an increase in long-term trade receivables.

Question

Based on Martinez’s conclusions, Stellar’s financial statements are best categorized as:

1. A.non-GAAP compliant.

2. B.GAAP compliant, but with earnings management.

3. C.GAAP compliant and decision useful, with sustainable and adequate returns.

B is correct. Stellar’s financial statements are GAAP compliant (Conclusion 1) but cannot be relied upon to assess earnings quality. There is evidence of earnings management: understating and overstating earnings depending upon the results of the period (Conclusion 1), understated amortizable intangibles (Conclusion 2), and a high accruals component in the company’s earnings (Conclusion 3).

Based on Conclusion 2, after the acquisition of Solar, Stellar’s earnings are most likely:

1. A.understated.

2. B.fairly stated.

3. C.overstated.

C is correct. Martinez believes that Stellar most likely understated the value of amortizable intangibles when recording the acquisition of a rival company last year. Impairment charges have not been taken since the acquisition (Conclusion 2). Consequently, the company’s earnings are likely to be overstated because amortization expense is understated. This understatement has not been offset by an impairment charge.

In his follow-up analysis relating to Conclusion 3, Martinez should focus on Stellar’s:

1. A.total accruals.

2. B.discretionary accruals.

3. C.non-discretionary accruals.

B is correct. Martinez concluded that the accruals component of Stellar’s earnings was large relative to the cash component (Conclusion 3). Earnings with a larger component of accruals are typically less persistent and of lower quality. An important distinction is between accruals that arise from normal transactions in the period (called non-discretionary) and accruals that result from transactions or accounting choices outside the normal (called discretionary accruals). The discretionary accruals are possibly made with the intent to distort reported earnings. Outlier discretionary accruals are an indicator of possibly manipulated—and thus low quality earnings. Thus, Martinez is primarily focused on discretionary accruals, particularly outlier discretionary accruals (referred to as abnormal accruals).

What will be the impact on Stellar in the current year if Martinez’s belief in Conclusion 4 is correct? Compared with the previous year, Stellar’s:

1. A.current ratio will increase.

2. B.days sales outstanding (DSO) will decrease.

3. C.accounts receivable turnover will decrease.

B is correct. Because accounts receivable will be lower than reported in the past, Stellar’s DSO [Accounts receivable/(Revenues/365)] will decrease. Stellar’s accounts receivable turnover (365/days’ sales outstanding) will increase with the lower DSO, giving the false impression of a faster turnover. The company’s current ratio will decrease (current assets will decrease with no change in current liabilities).

Maxine Thorsell Case Scenario

Maxine Thorsell, a financial analyst, is examining the most recent annual financial report of Coleridge Ltd., a mature U.K.-based company that complies with IFRS. Thorsell wants to evaluate the quality of the company's financial reports for the purpose of making an investment recommendation to her firm. To begin her analysis, Thorsell observes the following:

• Observation 1: Increases in operating margin occurred during each of the past 3 years.

• Observation 2: Average depreciation lives on assets were reduced by two years from that of preceding years.

• Observation 3: The growth in revenues has exceeded the growth in receivables during the past 3-year period.

Next, Thorsell notes that Coleridge's receivables turnover ratio, inventory turnover ratio, and Beneish M-scores have all increased each year during the preceding 3-year period. She also notes that consistent with past years, Coleridge has generated only accounting losses when it sells any one of its long-term assets. The losses are presented on the income statement after operating income, and when they occur they are significant in amount.

Thorsell next examines Coleridge's underfunded defined benefit pension plan and observes that the plan's discount rate assumption is 0.5% higher than its industry competitors' discount rates. For comparison purposes, Thorsell adjusts Coleridge's financial statements before computing the company's financial ratios.

Question

Which of the following Thorsell's observations most likely indicates a potential accounting warning sign?

1. A.Observation 1

2. B.Observation 2

3. C.Observation 3

Solution

1. Correct because according to the Accounting Warning Signs in the reading, a trend of increasing operating margins indicates a potential accounting warning sign.

2. Incorrect because according to the Accounting Warning Signs in the reading, it is an increase in depreciation lives rather than a decrease in depreciation lives that indicates a potential accounting warning sign. In the case of Coleridge, average depreciation lives on assets were reduced.

3. Incorrect because according to the Accounting Warning Signs in the reading, it is an increasing trend of receivables growing faster than revenues that indicates a potential accounting warning sign. In the case of Coleridge, revenues are growing faster than receivables.

Evaluating Quality of Financial Reports

• explain potential problems that affect the quality of financial reports

An indicator of low earnings quality is most likely evidenced by the trend in Coleridge's:

1. A.M-score.

2. B.inventory turnover ratio.

3. C.receivables turnover ratio.

Solution

1. Correct because higher M-scores (i.e., less negative numbers) indicate an increased probability of earnings manipulation.

2. Incorrect because a declining (not increasing) inventory turnover ratio could suggest obsolescence problems.

3. Incorrect because a declining (not increasing) receivables turnover ratio could suggest that some revenues are fictitious or recorded prematurely or that the allowance for doubtful accounts is insufficient.

Evaluating Quality of Financial Reports

• describe how to evaluate the quality of a company’s financial reports

With respect to the sale of its long-term assets, Coleridge most likely displays:

1. A.low earnings quality only.

2. B.low financial reporting quality only.

3. C.both low earnings quality and low financial reporting quality.

Solution

1. Incorrect because this also displays low financial reporting quality.

2. Incorrect because this also displays low earnings quality.

3. Correct because a consistent pattern of recognizing accounting losses when any long-term assets are sold demonstrates that depreciation expense is being understated during the periods that the assets are in use.

   An understatement of depreciation expense will cause operating income to be higher than what it otherwise would be if there was no management bias in the depreciation expense estimate. Although the accounting losses are properly displayed on the income statement, there is an intentional lag in time (perhaps many years) as to when that ultimate cost is recognized. A biased accounting decision to understate depreciation expense does not faithfully represent the economic circumstances of the accounting periods in which it occurs because operating income and the carrying value of the long-term assets are both overstated. This is a clear indication of low financial reporting quality. Financial reports can range from those that contain relevant and faithfully representational information to those that contain information that is pure fabrication.

   Earnings quality will also be low because operating incomes are higher than what they should be each and every year because of the deliberate understatement of depreciation expense. Operating income infers sustainable income whereas net income does not (since net income also includes the non-recurring recognition of accounting gains and losses that are generated from the occasional disposal of long-term assets and settlement of long-term liabilities). Earnings (results) quality can range from high and sustainable to low and unsustainable.

Evaluating Quality of Financial Reports

• demonstrate the use of a conceptual framework for assessing the quality of a company’s financial reports

With respect to the defined benefit pension plan assumption, which of the following will decrease after Thorsell's adjustment?

1. A.Debt-to-equity ratio

2. B.Book value per share

3. C.Financial leverage ratio

Solution

1. Incorrect because the debt-to-equity ratio (total debt ÷ total shareholders' equity) will increase since total debt will increase and total stockholders' equity will decrease after Thorsell makes the pension discount rate adjustment by reducing the discount rate by 0.5%.

2. Correct because the book value per share (common stockholders' equity ÷ total number of common shares outstanding) will decrease once Thorsell makes the pension discount rate adjustment. After reducing the discount rate by 0.5%, (a higher discount rate assumption results in a lower estimated pension obligation) the underfunded plan obligation will increase (that is, become even more underfunded) and total shareholders' equity (via accumulated other comprehensive income) will decrease. The number of common shares outstanding is not affected.

3. Incorrect because the financial leverage ratio (average total assets ÷ average shareholders' equity) will increase since total assets will remain unchanged and total shareholders' equity will decrease after Thorsell makes the pension discount rate adjustment by reducing the discount rate by 0.5%. Total shareholders' equity (via accumulated other comprehensive income) will decrease.

Evaluating Quality of Financial Reports

• describe indicators of balance sheet quality

Marcio Bruno Case Scenario

Marcio Bruno is an equity analyst studying the earnings quality of Libra S.A., a Colombian publicly-traded company that reports under IFRS. Bruno computes some financial ratios for Libra in Exhibit 1.

Exhibit 1:

	Most Recent Year	Previous Year	Two Years Ago
Receivables turnover ratio	9.0	6.3	6.2
Inventory turnover ratio	2.5	4.1	4.2

Libra competes in a very mature industry with a 3% annual rate of revenue growth. In the last three years, Libra’s revenue growth was the same as the industry’s average, which allowed the company to maintain its market share. Libra had no significant change in its sales, collection, purchases or inventory policies.

Bruno realizes that most of Libra’s competitors are US companies, which report under US GAAP. When reviewing Libra’s cash flow statement, he notices that the only difference in cash flow classification relates to interest paid. To improve comparability with those competitors, Bruno reclassifies interest paid in Libra’s cash flow statement.

Bruno believes that Libra's management significantly underestimates the environmental risks of its business. To investigate the issue, Bruno refers to different information sources.

Question

The trend in the receivables turnover ratio most likely indicates that, in the most recent year, Libra engaged in:

1. A.channel stuffing.

2. B.the sale of receivables.

3. C.bill-and-hold revenue practices.

Solution

1. Incorrect because channel stuffing refers to inducing customers to order more goods than they would normally through offers of discounts and other incentives. Often customers also have return rights on their purchases. If Libra had engaged in such a practice in the most recent year, both receivables and revenues would have increased by the same amount (the amount of sales generated by channel stuffing). As a result, and since the receivables turnover ratio (revenues/receivables) is higher than one, the ratio would have decreased.

2. Correct because the receivables turnover ratio shows a significant jump in the most recent year. This means that receivables as a percentage of revenues decreased significantly. Since Libra had no significant change in its sales or collection policies, the trend in the receivables turnover ratio could be an indication that, in the most recent year, Libra engaged in the practice of selling receivables to third parties. According to the reading, a company may focus on accounts receivable because it wants to hide liquidity or revenue collection issues. Choices include removing the accounts receivable from the balance sheet by selling them externally.

3. Incorrect because under the practice of bill-and-hold revenue is recognized when the invoice is issued while the goods remain on the premises of the seller. If Libra had engaged in such a practice in the most recent year, both receivables and revenues would have increased by the same amount (the amount billed). As a result, and since the receivables turnover ratio (revenues/receivables) is higher than one, the ratio would have decreased.

Evaluating Quality of Financial Reports

• evaluate the earnings quality of a company

The trend in the inventory turnover ratio most likely indicates that, in the most recent year, Libra has aggressively:

1. A.liquidated inventory.

2. B.delayed payments to suppliers.

3. C.reduced the obsolescence allowance.

Solution

1. Incorrect because if Libra had aggressively liquidated inventory, inventory would have decreased and cost of goods sold would have increased by the same amount. As a result, the inventory turnover ratio (cost of goods sold/inventory) would have increased in the most recent year.

2. Incorrect because if Libra had aggressively delayed payments to suppliers, neither the inventory nor the cost of goods sold would have been affected. As a result, the inventory turnover ratio (cost of goods sold/inventory) would not have been affected in the most recent year.

3. Correct because the inventory turnover ratio shows a significant decrease in the most recent year. This means that inventory as a percentage of cost of goods sold increased significantly. Since Libra had no significant change in its purchase or inventory policies, the trend in the inventory turnover ratio could be an indication that, in the most recent year, Libra may have aggressively reduced its obsolescence allowance. Management may use items such as reserves and allowances to manage or smooth earnings.

Evaluating Quality of Financial Reports

• explain potential problems that affect the quality of financial reports

Bruno’s adjustment to Libra’s cash flow statement will result in a higher cash flow from:

1. A.operating activities.

2. B.investing activities.

3. C.financing activities.

Solution

1. Incorrect because Bruno’s adjustment will result in a reclassification of interest paid from financing activities to operating activities thus making cash flow from financing activities higher, cash flow from operating activities lower, and cash flow from investing activities the same.

2. Incorrect because Bruno’s adjustment will result in a reclassification of interest paid from financing activities to operating activities thus making cash flow from financing activities higher, cash flow from operating activities lower, and cash flow from investing activities the same.

3. Correct because Bruno’s adjustment to Libra’s cash flow statement will result in a reclassification of interest paid from financing activities to operating activities. IFRS permits companies to classify interest paid either as operating or as financing. In contrast, US GAAP requires that interest paid, be classified as operating cash flows. Since the only classification difference between Libra’s cash flow statement and its US competitors’ is the classification of interest paid, Bruno will have to reclassify the interest paid from cash flow from financing activities to cash flow from operating activities. This adjustment will make cash flow from financing activities higher, cash flow from operating activities lower, and cash flow from investing activities the same.

Evaluating Quality of Financial Reports

• describe indicators of cash flow quality

Which of the following information sources is least useful for Bruno’s investigation?

1. A.Financial press

2. B.Auditor’s report

3. C.Management commentary

Solution

1. Incorrect because the financial press can be a useful source of information about risk, when for example, a financial reporter uncovers financial reporting issues that had not previously been recognized.

2. Correct because to investigate risks, Bruno can turn to several sources. However, an auditor’s opinion is unlikely to be an analyst’s first source of information about a company’s risk. The auditor’s report indicates if the financial statements fairly reflect the financial position and results of the company’s business activities, but it does not list nor completely explain the company’s environmental risks.

3. Incorrect because one purpose of the commentary is to help users of the financial reports in understanding the company's risk exposures, approach to managing risk, and effectiveness of risk management.

Evaluating Quality of Financial Reports

• describe sources of information about risk

Cooper Creek Cable Case Scenario

Hannah Treadway is an analyst at Knight Investment Management (Knight). Knight holds Cooper Creek Cable Limited (CCCL) as part of its AFE (Australian and Far East) investment portfolio. CCCL is a diversified cable and communications company operating in Western Australia. The company consists of three divisions:

• Cable: Provides subscription television services and high speed internet to residential customers.

• Media: Owns and operates a group of radio stations and publishes several magazines.

• Wireless: Is engaged in wireless voice and data communications services.

Treadway is just starting her annual review of the company based on its most recent financial statements, excerpts of which are in Exhibits 1 and 2. The financial statements for CCCL are prepared in accordance with Australian Accounting Standards (AASB), which comply with IFRS. All figures are in Australian dollars ($).

Exhibit 1:

Cooper Creek Cable Limited Statement of Earnings for Years Ending December 31 (all figures in $ thousands)

	2016	2015
Revenue	711,200	674,600
Programming and communication expenses	312,900	317,000
Gross margin	398,300	357,600
Depreciation expense	98,750	78,650
Amortization of intangibles	7,250	8,150
Reversal of impairment loss	–12,500	---
Gain on sale of assets held for sale	–14,400	---
Operating costs	185,900	173,000
Interest expense	64,100	65,900
Income from investments in associates	1,200	850
Profit before tax	70,400	32,750
Tax benefit (expense)	17,600	–8,187
Net profit for the year	88,000	24,563

Exhibit 2:

Cooper Creek Cable Limited Balance Sheet as of December 31 (all figures in $ thousands)

	2016	2015
Cash	95,600	74,400
Accounts receivable, net	35,700	33,500
Assets held for sale	---	23,500
Total current assets	131,300	131,400
Investments in associates	42,700	42,300
Capital assets, net	221,800	241,200
Intangible assets, net	43,250	24,500
Goodwill	11,000	6,500
Deferred tax assets	185,500	169,900
Total assets	635,550	615,800
Trade payables	92,100	104,200
Interest bearing loans	49,700
Short-term unearned revenue	12,500	21,250
Other liabilities	23,800	23,000
Total current Liabilities	178,100	148,450
Interest bearing debt	703,800	814,300
Long-term unearned revenue	6,500	13,500
Total liabilities	888,400	976,250
Issued capital	556,400	536,800
Accumulated losses	–809,250	–897,250
Total equity	–252,850	–360,450
Total liabilities and equity	635,550	615,800

CCCL sustained substantial losses in its start-up period (2001–2005) (from which it is still benefiting for tax purposes) but has been profitable since 2005, reporting a record profit after tax in 2016. However, Treadway is wondering if CCCL’s revenues in general are supported by cash flows and if the company might be trying to increase the appearance of profitability in order to increase the share price, which remains low.

The Wireless division was acquired by CCCL in a share purchase in late 2015. Treadway wants to review the accounting policies CCCL has adopted for both revenue and expenses incurred on long-term wireless contracts (Exhibit 3).

Exhibit 3:

Excerpts of Accounting Policy Notes (all figures in thousands)

Note 1 d) Long-Term Wireless Contracts

Customers who enter into long-term service contracts for wireless services can obtain their mobile devices for a nominal amount. Commencing in 2016, the discount offered on the devices, relative to the regular price, is capitalized as a customer acquisition cost and amortized straight-line over the life of the contract, or a minimum of three years. Previously this amount was recognized in income immediately.

Note 1 g) Unearned Revenue

Unearned revenue for subscriptions, or for services paid in advance, was historically recognized on a straight-line basis over the term of the contract or subscription, which was typically three years. After reviewing the historical pattern of usage and cancellations for service contracts in 2016, the pattern of recognition was changed to recognize the majority of the revenues in the first 12 months after the service contract is signed with the remainder recognized in the following year.

Note 12) Broadcast Licenses

During 2016, the company successfully disposed of broadcast licenses that were held for sale for $37,900 (net book value of $23,500). Based on the successful completion of that sale the impairment losses taken in 2014 on other licenses have been reversed, restoring those intangible assets to their amortized historical cost. Broadcast licenses are amortized over a period of 15 to 25 years.

On reading the note about the rapid reversal of the impairment loss related to the Broadcast licenses (Exhibit 3, Note 12) Treadway strongly believes that it arose as an attempt by management to manage earnings. She realizes that both her 2014 and 2015 analyses were impacted by these actions and now need to be reconsidered.

As part of her annual review, Treadway determines the Altman’s Z-scores for CCCL. The results for the current and past years are reported in Exhibit 4.

Exhibit 4:

Cooper Creek Cable Limited Altman Z-Scores

	2016	2015
Altman Z-score*	2.14	1.82
* Critical values: 1.81 and 3.0

Finally, Treadway noted that during 2016 CCCL acquired 100% of MusicMusic (MM), a specialty cable music channel in an all-stock deal. At the time of the acquisition MM reported intangible assets for broadcast licenses at a value of $2,500. CCCL estimated the fair value of those licenses to be $5,500 at that date and estimated the value of the MusicMusic brand name to be $2,000, all figures in thousands. The acquisition did not give rise to any goodwill.

Question

The change in which of the following items most likely indicates that CCCL might be recognizing revenue early?

1. A.Unearned revenue

2. B.Deferred tax assets

3. C.Days sales in receivables

Solution

1. Correct. In the past, revenue from service contracts had been recognized on a straight-line basis over the (typical) three-year period of the contract (Note 1 g in Exhibit 3). Under the new policy, most of the revenue is recognized in the first year and all of it within the two-year time frame. This represents a much more aggressive revenue recognition policy.

   An increase in DSO could be an indicator of early revenue recognition but for CCCL the ratio did not change significantly (18.1 days in 2015 to 18.3 days in 2016 using year-end receivables).

   Deferred tax assets (Exhibit 2) can arise from differences in revenue recognition for taxes and financial statement purposes (they would rise with increases in unearned revenue), but there is no indication here that revenue is the reason for the increase in deferred tax assets DTA (in fact, unearned revenue decreased). The deferred tax assets most likely arise from the loss carry forwards generated from earlier losses.

2. Incorrect. Deferred tax assets can arise from differences in revenue recognition for taxes and financial statement purposes (they rise with increases in unearned revenue), but there is no indication here that revenue is the reason for the increase in DTA (in fact, unearned revenue decreased). They most likely arise from the loss carry forwards arising from earlier losses.

3. Incorrect. An increase in DSO could be an indicator of early revenue recognition but for CCCL the ratio did not change substantially (18.1 days to 18.3 days using yearend receivables).

   2016: 711,200/35,700 = 19.9× ≥ 18.3 days

   2015: 674,600/33,500 = 20.1× ≥ 18.1 days

Evaluating Quality of Financial Reports

• describe indicators of earnings quality

The new accounting policy adopted in 2016 for the customer acquisition cost related to long-term wireless contracts (Exhibit 3, Note 1 d) most likely increases CCCL’s:

1. A.debt to asset ratio.

2. B.quality of earnings.

3. C.cash from operations.

Solution

1. Incorrect. The total assets would increase by the amount capitalized (as opposed to expensed) (be higher) hence the D/A ratio would decrease.

2. Incorrect. Capitalizing decreases the quality of earnings because it would be more conservative and closer to cash flow to expense the losses in the period. The future benefit and the ability to match these costs to revenues are uncertain, particularly given CCCL’s new policy to accelerate the recognition of revenue on long-term contracts.

3. Correct. In 2016, CCCL started capitalizing the discount offered (from selling the mobile devices at a lower price) instead of recording it in the period it is incurred. This change in the policy would increase net income (by lowering expenses) and cash from operations. The amounts capitalized would be recorded as cash outflows for investing activities, compared to cash from operations if they were expensed.

Evaluating Quality of Financial Reports

• evaluate the cash flow quality of a company

If Treadway’s belief about management’s motivation behind the 2014 treatment of the broadcast licenses is correct, compared to the actual economic results in 2015, her original 2015 analysis would most likely have:

1. A.understated ROA.

2. B.overstated net profit margin.

3. C.understated fixed asset turnover.

Solution

1. Incorrect. In 2015 the intangible assets were understated and net profit was overstated (due to the lower amortization expense), so ROA would have been overstated in 2015, not understated.

2. Correct. The broadcast licenses were written down in 2014, but the write-down was reversed in 2016. Therefore, during 2015 the intangible assets were understated, which would have understated amortization expense for the year and increased profit. Thus in 2015, net profit margin was overstated.

3. Incorrect. In 2015 the intangible assets were understated, which would have increased asset turnover (Sales/Average total assets), so it would have been overstated during the year.

Evaluating Quality of Financial Reports

• describe how to evaluate the quality of a company’s financial reports

From her Altman Score results, Treadway is most likely to conclude that the probability of bankruptcy for CCCL has:

1. A.decreased.

2. B.remained uncertain.

3. C.increased.

Solution

1. Incorrect. The Altman score has increased, which might suggest less bankruptcy risk, but it is still in that zone of uncertainty.

2. Correct. Altman scores in excess of 3.0 indicate low probability of bankruptcy; those below 1.81 indicate a high probability of bankruptcy. Scores within the 1.81 to 3.0 range do not provide a clear indication of bankruptcy.

3. Incorrect. The Altman score has increased, which might suggest less bankruptcy risk, but it is still in that zone of uncertainty.

Evaluating Quality of Financial Reports

• evaluate the earnings quality of a company