- 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).
- 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.
- 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).
- 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).
- 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.
- 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.
- 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.
- 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.
- A is correct. The DSR (days’ sales receivable index) variable in the Beneish model is related positively to the Beneish model M-score. Therefore, a year-over-year increase in DSR from 0.9 to 1.20 would lead to an increase in the M-score, which implies an increase in Miland’s likelihood of manipulation.
B is incorrect because the LEVI (leverage index) variable in the Beneish model is related negatively to the Beneish model M-score. Therefore, a year-over-year increase in LEVI from 0.75 to 0.95 would lead to a decrease in the M-score, which implies a decrease (not increase) in Miland’s likelihood of manipulation.
C is incorrect because the SGAI (sales, general, and administrative expenses index) variable in the Beneish model is related negatively to the Beneish model M-score. Therefore, a year-over-year increase in SGAI from 0.60 to 0.75 would lead to a decrease in the M-score, which implies a decrease (not increase) in Miland’s likelihood of manipulation.
- 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.
- 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.
- A is correct. Based on the principle of mean reversion, the high ROE for both firms should revert toward 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.