Study session ten in the Level I CFA Program curriculum curriculum concludes the material on FSA with reporting quality and some applications in three readings (33-35).
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 practices are going to have higher earnings quality because the doubt will be on the side of more favorable accounts.
A lot of the aggressive practices are highlighted elsewhere in the curriculum but are reiterated here. Understand that management might manipulate earnings to the downside as well as to the downside.
The list material behind red flags is fairly testable so understand the risks.
- 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 (CFO/Net Income)
- Classification of expenses as extraordinary or nonrecurring
- LIFO liquidations
- Margins significantly out of line with peers without other explanations
- Assumptions behind depreciation
- Assumptions used in pension accounting
- Fourth quarter surprises that cannot be attributable to seasonality
- Excessive use of operating leases or other off-balance sheet financing
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)
- Using a third-party to pay payables and then accounting for payment as a financing cash outflow in subsequent periods
- Securitization of receivables and whether it is through a bankruptcy-remote VIE
- Treatment of tax benefit on the cash flow statement and sustainability as an increase in cash from operations
- Stock buybacks to offset dilution
Financial Statement Analysis: Applications
Really nothing new in this reading, just a review of the previous material. Remember what accounts you use as the denominator for pro forma financial statements (sales and total assets). Remember the accounts and rationale behind analyst adjustments (FIFO balance sheets), adjustments to PP&E, goodwill and bringing off-balance sheet financing on the books.
Study session eleven in the Level I CFA Program curriculum is an extremely lengthy (six readings) on Corporate Finance. Much of it is fairly basic and will be a repeat of your intermediate finance courses from college. If your background is not in finance then you will need to spend some extra time because the concepts will be revisited in the second exam as well.
‘til next time, happy studyin’
Joseph Hogue, CFA