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When companies use different accounting methods or estimates relating
to areas such as inventory accounting, depreciation, capitalization, and
off-balance-sheet financing, analysts must adjust the financial
statements for comparability.LIFO ending inventory can be adjusted to a
FIFO basis by adding the LIFO reserve. LIFO COGS can be adjusted to a
FIFO basis by subtracting the change in LIFO reserve.When calculating
solvency ratios, analysts should estimate the present value of operating
lease obligations an
Threats to the firm's financial stability or profitability.Excessive
third-party pressures on management.Threats to the personal net worth of
management or board members.Excessive pressure on management and
employees to meet internal targets.
The "fraud triangle" consists of:-Incentives and pressures: the motive
to commit fraud-Opportunities: the firm has weak internal control
system.-Attitudes and rationalizations: the mindset that fraud is
justified.
Management may be motivated to overstate earning to meet analyst
expectations, remain in compliance with debt covenants, or because
higher reported earnings will increase their compensation. Management
may be motivated to understate earnings to obtain trade relief,
renegotiate advantageous repayment terms with existing creditors,
negotiate more advantageous union labor contracts, or "save" earnings to
report in a future period.
A company's future income and cash flows can be projected by
forecasting sales growth and using estimates of profit margin and the
increases in working capital and fixed assets necessary to support the
forecast sales growth.
Common warning signs of earning manipulation include:-Aggressive
revenue recognition-Different growth rates of operating cash flow and
earnings.-Abnormal comparative sales growth.-Abnormal inventory growth
as compared to sales.-Moving nonoperating income ad nonreocurring gains
up the income statement to boost revenue.-Delaying expense
recognition.-Excessive use of off-balance-sheet financing arrangements
including leases.-Classifying expenses as extraordinary or nonreocurring
and moving them down the income
Low earnings quality can result from selecting accounting principles
that misrepresent the economics of transactions, structuring
transactions primarily to achieve a desired effect on reported earnings,
using aggressive or unrealistic estimates and assumptions, or
exploiting the intent of an accounting standard.
The nature of the industry.Ineffective monitoring of
management.Complex or unstable organizational structure.Deficient
internal controls.
Credit analysis uses a firm's financial statements to assess its
credit quality. Indicators of a firm's creditworthiness include its
scale and diversification, operational efficiency, margin stability, and
use of financial leverage.
-Inappropriate or inadequately supported ethical standards-Excessive
participation by non-financial management in selecting accounting
methods.-A history of legal and regulatory violations by management or
board members.-Obsessive attentions to the stock price or earnings
trend-Aggressive commitments to third parties.-Failure to correct known
compliance problems.-Minimizing earnings inappropriately for tax
reporting.-Continued use of materiality to justify inappropriate
accounting.-A strained relationship w
Potentially attractive equity investments can be identified by
screening a universe of stocks, using minimum or maximum values of one
or more ratios. Which (and how many) ratios to use, what minimum or
maximum values to use, and how much importance to give each ratio all
present challenges to the analyst.
Trends in a company's financial ratios and differences between its
financial ratios and those of its competitors or industry average ratios
can reveal important aspects of its business strategy.
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