Level I Review: Financial Reporting Quality

Study session ten in the Level I CFA Program curriculum concludes the material on FSA with reporting quality and some applications in three readings (33-35). Towards the end of the week, after you’ve read through the study session, it would be a good idea to take a small mock-exam over the FSA topic area. Use the end-of-chapter problems or a question bank to work through 100-200 questions. If you do not score at least 65% or better, you may want to build in some FSA review over the next couple of weeks. The topic is probably the most important in the curriculum and to your career.

Financial Reporting Quality

The reading, and much of the curriculum in FSA, revolves around your ability to understand aggressive and questionable accounting practices. Companies using more conservative accounting practices are more likely to surprise on the upside while those using aggressive assumptions may be signaling weakness.
A lot of the aggressive practices are highlighted elsewhere in the curriculum but are reiterated here. Motivation to artificially increase earnings could be to meet expectations, meet debt covenants or to improve incentive compensation. Understand that management might have an incentive to manipulate earnings lower as well, possibly to smooth higher earnings in the current quarter into weaker quarters.
The list material behind red flags is fairly testable so understand the risks. The curriculum describes the ‘Fraud Triangle’ and three conditions that are generally present when it occurs.

  • Incentives and pressures include pressure on management to meet expectations, financial targets, debt covenants, and their own financial well-being
  • Opportunities include the nature of the industry, a complex organizational structure, ineffective monitoring, a significant number of estimates build into the accounting system, high turnover or ineffective audit staff
  • Attitudes and rationalizations include the use of inappropriate accounting, poor communication channels, failure to correct reportable conditions, and a history of violations

The most important material is the specific warning signs and the measures to spot them.

  • aggressive revenue recognition (bill-and-hold sales, sale-leaseback, swaps and barter to generate sales)
  • operating cash flow out of line with earnings, i.e. if earnings are increasing or positive while operating cash flow is decreasing or negative may be an indication that management is manipulating earnings (CFO/Net Income)
  • Classification of expenses as extraordinary or nonrecurring
  • LIFO liquidations occur when management uses the LIFO method and runs the balance lower to year-end. Watch the LIFO reserve for clues of LIFO liquidation.
  • Margins significantly out of line with peers without other explanations – overstatement of inventory or capitalization of costs is a clue that management is using aggressive accounting with expenses. Check the company’s margins against prior years and quarters as well.
  • Assumptions behind depreciation – using a longer life estimate for machinery than peers will lower depreciation expense and increase earnings but may not appropriately match costs with sales.
  • Assumptions used in pension accounting – Using a higher discount rate or higher expected return on plan assets will decrease pension expense but may lead to a problem down the road when the assumptions are corrected. As with most of the warning signs, compare assumptions with peers in the industry
  • Fourth quarter surprises that cannot be attributable to seasonality
  • Excessive use of operating leases or other off-balance sheet financing – the company may be guaranteeing some contracts or receiving financing that is not accounted for on the balance sheet, this reduces liabilities relative to peers and makes the balance sheet look more healthy than reality.

Accounting Shenanigans on the Cash Flow Statement

Understand that the cash flow statement is less easily manipulated but management can still distort the various accounts.

  • Stretching out payables (look for a trend in days sales payable) – accounts payable increases and may indicate problems paying suppliers
  • Using a third-party to pay payables and then accounting for payment as a financing cash outflow in subsequent periods – this is basically taking out a loan to pay for current expenses. The problem is that it does not appropriately match expenses with sales and later quarters will be affected
  • Securitization of receivables and whether it is through a bankruptcy-remote VIE – The problem here, and with many of the other questionable accounting tactics, is sustainability. Securitizing (selling off your receivables) increases cash flow for the current quarter but the company may still be responsible for collecting those sales. The company may have to pay back some of the proceeds in subsequent periods if default on receivables is higher.
  • Treatment of tax benefit on the cash flow statement and sustainability as an increase in cash from operations
  • Stock buybacks to offset dilution – Since buybacks are listed under financing cash flows, analysts need to reclassify net cash paid to buyback shares from financing outflow to operating cash outflow.

Financial Statement Analysis: Applications

Really nothing new in this reading, just a review of the previous material. The reading gets into a little more detail but remember that the Level 1 exam is all about the basic ideas and reasons. Start with understanding the processes for evaluating past performance and projecting financial performance then move on to ratios.
Remember what accounts you use as the denominator for pro forma financial statements (sales and total assets), using the ratios from past periods is how you will estimate going forward. Remember the accounts and rationale behind analyst adjustments (FIFO balance sheets, LIFO income statements), adjustments to PP&E, goodwill and bringing off-balance sheet financing on the books.
Four general categories for quantitative credit analysis:

  • Scale and diversification: purchasing power from scale and product/geographic diversification
  • Tolerance for leverage:
    • Retained cash flow (RCF)/total debt
    • (RCF – capex)/total debt
    • Total debt/EBITDA
    • (EBITDA – capex)/interest
    • EBITDA/interest is the most well known and used formula of the four
  • Operational efficiency leads to lower costs and higher margins
    • EBITDA margin
    • Operating margin
  • Margin stability is measured through average % change in EBITDA margin

Remember the basic screens for different equity strategies, i.e. growth versus value investing, and the limitations of back-testing.
We are going to skip over some topics and begin our coverage of Equity Investments next week. The topic area is covered in two study sessions and will become increasingly important in the next two exams. Building a good base of knowledge from Level 1 material is absolutely critical to doing well on the other exams.
Only a few months left to the December exam. If you haven’t already, assess how you are doing with a mock exam or some practice problems over the material you have covered. If you are not through at least a few study sessions or are not retaining much of the information, you may need to step up your schedule. Stay strong, we’ll get there.
‘til next time, happy studyin’
Joseph Hogue, CFA

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