Level 1 CFA® Exam:
Issues and Red Flags
CFA Exam: Presentation and Accounting Methods Used to "Manage" Financial Statementsstar content check off when done
Lesson 3 of the financial reporting quality module discusses a set of accounting measures and management choices that may influence the analyst's perception of the company.
The choices to be made by the management that are within the boundaries of the accounting standards are abundant. Analysts need to be able to overcome this challenge of abundance and deal with the complexities of how companies can report their performance. Particularly, analysts need to be able to constructively challenge the judgments and estimates used within the financial reports to appropriately assess both the quality of financial reporting and earnings quality.
We differentiate between accounting choices that increase a company’s performance in the current reporting period (aggressive choices) and accounting choices aimed at increasing the performance in the subsequent period (conservative):
|Aggressive accounting choices||Conservative accounting choices|
|premature revenue recognition||deferring current income to the subsequent period|
|recognition of non-recurring transactions (i.e., one-offs like a sale of real estate)||premature recognition of the expenses|
|deferring expenses||undervaluation of assets and overvaluation of liabilities|
|overvaluation of assets and undervaluation of liabilities|
Let’s move on to the presentation methods used by the management to influence analysts' perception of the company.
Historically, we observed that companies tried various methods to distract from their performance:
Let’s now investigate how the management may influence specific components of the financial report in detail.
CFA Exam: Influencing Specific Financial Statement Componentsstar content check off when done
Before we delve into the accounting details, it is worth mentioning that the management does not necessarily need to use “gaps” in the accounting standards to manage the revenues and costs. It is possible to influence the business process through, e.g., the shipment terms (i.e. INCOTERMS).
While not directly connected with the accounting rules, the selection of favorable incoterms defines the moment when the control over the goods changes. This might define the moment when the revenue is recognized.
So, companies interested in premature recognition of the revenue might select incoterms that transfer the control over the goods at the moment when they leave the warehouse (e.g., before the end of the quarter, which triggers recognition in the current period). On the other hand, companies that defer the transfer of the control over the goods to the moment when the goods are delivered to the customer (e.g., post the quarter-end) might be able to defer the moment of the revenue recognition.
Impact on Earnings and Balance Sheetstar content check off when done
Let’s have a couple of examples where the accounting practice might alter the company's performance in line with the management’s will:
Inventory valuation method
One of the most common methods to adjust earnings is connected to inventory valuation and inventory cost recognition. Under the majority of accounting regimes, companies are allowed to apply at least two differentiation methods of accounting for inventory cost, namely first-in-first-out (FIFO) or weighted average cost basis.
The application of the FIFO method requires the company to recognize the cost of the goods sold to the customer at the prices of the acquisition or production of the oldest batch of inventory. This means that the inventory still owned by the firm is valued at the most recent prices, therefore the inventory valuation presented in the balance sheet will reflect the current market conditions.
The weighted average cost method averages the cost of the inventory recognized for the products sold, therefore it is a blend of the old prices and most recent prices weighted by the volume.
Let’s consider an example to demonstrate how the selection of the inventory cost method can impact the company’s revenues, costs, and balance sheet.
A company can account for the inventory and relevant cost of sales under either the FIFO or weighted average cost method and operates in an inflationary environment. How does the selection of the inventory cost method impact the company’s revenues, costs, and balance sheet?
Company ABC Inc. operates in the furniture industry and purchases vast volumes of timber. Current inflationary market conditions resulted in a significant increase in the price of timber during the last six months as illustrated in the table below:
|Timber Purchase Date||Units (cubic meters)||Price per cubic meter (USD)||Cost (USD)|
Note: An average weighted cost of timber per cubic meter amounted to USD 146.29.
Assuming that Company ABC Inc. generated USD 800,000 in revenues and used 5,000 cubic meters of timber and no other costs were incurred, calculate operating profit under the FIFO and weighted average cost method.
Analysts need to be cognizant of the fact that while the choice of the inventory cost method by the management inflates the operating profit in the current period, it will negatively impact the operating profit when the inflation decreases (under the FIFO method, the cost of the old inventory is higher than the current market prices indicate).
Estimating the customer return
The management can also greatly influence the company’s financial performance by using estimates.
Under GAAP, the financial reporting is based on accrual accounting (rather than cash-based accounting). That is why there is an inherent judgment embedded into how transactions are accounted for in the financial records.
Let’s look at the sales and goods returns.
Under accrual accounting, the company’s managers need to estimate and record a provision at the moment when the sale is made to reflect the potential rate of goods returned by customers. From the revenue perspective, the revenue will be recognized in the full value of the sales, but the provision created to account for the returns will be booked against those revenues. The net effect will be the total positive impact on the operating profit for the firm.
Let’s now imagine that the management is under pressure to quickly increase the operating profit by the end of the year to be granted a sales bonus. There might be a temptation to temporarily decrease the estimate of the goods returned by the customers (e.g., from 6% to 3%) to report a significantly higher operating profit.
Deferred tax asset valuation adjustment
The depreciation method used by the company is another example where the management’s estimates play a vital role. According to the commonly applied standards, the company can choose one of the three depreciation methodologies:
- straight-line basis,
- accelerated method, or
- activity-based method.
The straight-line method assumes that the depreciation charge is equal in each period.
The accelerated method (double-declining balance) allows the company to apply higher depreciation charges during the first years of asset life.
The activity-based method is based on the actual usage of the asset in time.
Apart from the choice of the method, depreciation charges will also depend on the management’s estimates of the salvage value (the estimated value of an asset at the end of its useful economic life) and the useful economic life of an asset.
The intuition is simple here.
If the management is willing to recognize less depreciation (lower cost means higher profit) in the early life of the asset, the straight-line basis might be selected vs the accelerated method. Additionally, the management might estimate a high salvage value which will additionally decrease the depreciation charge in the current period.
Capitalization of expense payments
The estimates-making process is inherent in the acquisition and takeover processes.
The management needs to provide an estimate of the fair value of the assets of the firm acquired, which might have a great impact, e.g., on the depreciation charges. If the management dampens the value of the assets acquired, the deprecation charges will be lower, which will positively impact the operating profit reported.
Additionally, there will be an impact on the value of the goodwill recognized (goodwill is the difference between the price paid for the company taken over vs the total fair value of the identifiable assets acquired). Goodwill is not subject to depreciation or amortization, but it is periodically tested for impairment. If – in the subsequent periods – it is disclosed that the management has overestimated the value of the goodwill (e.g., through artificially dampening the value of the assets acquired), an impairment charge might be required, which will negatively impact the future period results.
Impact on Cash Flow Statementstar content check off when done
Some biased management choices may also be applied to manage the results of the statement of cash flows. Cash flows are one of the most important components of the company’s financial report and are very useful for the analyst and investors both in the company valuation process and to better understand the underlying performance and liquidity position of the firm.
Let’s see how the management might influence the cash flow positions by focusing on the key element of the cash flow statement, namely cash flow from operations.
There are two presentation methods allowed by the accounting standards for the operating cash flow section:
- direct method, and
- indirect method.
Under the direct method, companies present key cash receipts and cash outflows in line with their nature and meaning. However, while transparent and simple, this method is not the one that companies use most often.
Companies usually use the indirect method.
The indirect method adjusts the net income by non-cash related positions to arrive at the cash flow generated from operations.
Regardless of the method used, the management might use certain techniques discussed below to create an impression that the cash flow generated from operations is better than it is in reality.
The management might influence the cash flow from operations by delaying the moment when the accounts payable are due. If the credit period is extended and the company settles the payments after the reporting date, the cash flow from operations will be higher for the current period and the cash outflow will be reported in the subsequent period.
In 2021, Company ABC reported USD 2.4 million of net cash generated by operating activities within its statement of cash flow. The financial auditors who validated the financial statement have noted that in December 2021 the company was reminded by one of its main suppliers to settle the invoice due in October 2021, but the company did not respond to the reminder. The invoice amounted to USD 3 million and was paid in January 2022. Comment on the company’s behavior and assess how the net cash generated by operating activities reported by Company ABC would change if the invoice was paid on time.
Misclassification of cash flows
Operating cash flow is an area of interest for both investors and analysts and it is very often used to compare the company under analysis with its industry peers (not only in direct terms but also thanks to comparing the performance metrics that are based on cash flow from operations such as the ratio of cash flow from operations to net income, interest paid, expenditures or dividends).
The management might misclassify cash flows between cash flow from operations, cash flow from investment activities, or cash flow from financing activities.
Note that certain flexibility in this area is allowed by the accounting standards, e.g., IAS 7 allows non-financial institutions to classify interest paid and interests and dividends received as operating cash flows, investing cash flows, or financing cash flows. Similarly, the same standard gives a possibility to classify dividends paid as either financing or operating cash flows.
CFA Exam: Effect on Financial Reporting and Warning Signsstar content check off when done
Finally, let’s enumerate the key areas where the management’s accounting choices and estimates might impact the financial reports and name the typical warning signs that investors and analysts should pay attention to.
- The choice of shipment terms affects the moment when the control over the product is transferred and will therefore dictate when the revenue is recognized.
- Channel stuffing through aggressive sales (e.g., using significant discounts) to record high revenues in the current reporting period. This might lead to significant returns (which will be charged against the revenues of the subsequent periods) or result in a drop in future demand and revenue as customers would not need to replenish their orders.
- Over- or under-estimating the rate of customer returns charged against the revenue recognized in the current period.
- Bill-and-hold transactions, where the customers purchase the goods but ask that the goods be kept in the company’s warehouse until a future date. This effectively transforms the end-of-year inventory into sales that generate revenue and very often involves falsification of the sales documents.
Inventory cost method:
The selection of the method used to report inventories offers a possibility of managing the results. Companies can choose from 3 basic inventory cost methods:
- LIFO (allowed only under U.S. GAAP), and
- weighted average cost basis.
Deferred tax asset valuation adjustments:
Estimating how much of the positive deferred tax assets could be utilized is left to the management’s discretion. The management estimates the valuation adjustment.
Goodwill that is recognized during the company acquisition process depends heavily on the assets’ fair value estimate. Underestimating the fair value of the assets acquired vs the price paid for the acquired company will overestimate the goodwill. If such overestimation is observed during the annual goodwill impairment testing in subsequent periods, the correcting decrease will be charged against the future results.
The management can use its discretion when estimating the value of the reserves required to cover the future warranty claims made by the customers. The management might be induced to underestimate such reserves, not in line with the actual costs, to decrease the costs in the current period (e.g., artificially decreasing the warranty reserves due to a change in the management estimate would benefit the operating income).
Companies might transact with other companies within the capital group or individuals running the company at terms that are favorable to one of the sides only. This might be used by the management to transfer profits or costs between the companies or use private wealth (e.g., of the founder) to cover for the companies’ mismanagement.
Identifying Warning Signsstar content check off when done
As we can see, there is a multitude of methods of how the management might influence the reported performance or try to distract analysts’ attention from the problems in the company.
Analysts should have a robust framework aimed at the identification of warning signs in the accounting practices to be able to assess independently both the quality of financial reporting and earnings quality.
For revenue recognition, analysts should:
For inventory, analysts should:
- look for growth in the inventory positions against the revenue, especially if the levels are higher than those reported by the market peers. It might indicate that the company is not able to sell its products (e.g., might not be competitive in the market), which might require write-downs and markdowns in the future. The analysis of the inventory turnover ratio might be helpful as a decrease in the measure might indicate that products are obsolete.
- review the inventory sales costs accounting method. A change in the method of accounting for the inventory sold (i.e., FIFO, LIFO under U.S. GAAP, and weighted-average basis) might indicate the management’s will to alter the results.
For long-lived assets, analysts should:
- review company assets capitalization methods against the methods used by the competitors. Any material difference between the market and the company concerning the capitalization of interest costs might be perceived as a warning sign.
For cash flows and net income, analysts should:
- focus on the relationship between cash flow from operations and net income generated across multiple periods. The goal is to understand whether the company can turn the income accounted for under the accrual assumption into cash. Any material differences might indicate that the company is using aggressive accrual accounting methods to defer expenses into subsequent periods.
Analysts should also focus on some other typical warning signs observed in the business and accounting practice:
It is worth noting that:
- firms that had been on a fast-paced growth path for several years (e.g., start-ups) might be willing to influence their financial statements whenever the growth is at risk as they still want to demonstrate progress,
- companies that try to limit the volume and quality of the disclosures within the financial statements (e.g., not disclosing all the reportable segments or providing limited commentary in the notes to the financial statements) pose a higher risk for the analysts and investors (analysts might find it challenging to assess the overall quality of the financial statements and reported results),
- executives who are overly focused on financial reporting (e.g., excessive usage of the non-GAAP measures) might miss the true drivers of the company’s performance, which may be a limiting factor on the future performance and growth,
- analysts should be cognizant of the overall culture demonstrated by the company and how it might affect the quality and accuracy of the financial statements. The management that demonstrates high motivation and ambition might be willing to manipulate the financial reporting, especially if competition in the market is tough.
Level 1 CFA Exam Takeaways: Issues and Red Flagsstar content check off when done
- Accounting choices can be divided into those that increase the company’s performance in the current reporting period (aggressive choices) and the ones aimed at increasing the performance in the subsequent period (conservative).
- Key aggressive accounting choices are premature revenue recognition, recognition of non-recurring transactions, deferring expenses, overvaluation of assets, and undervaluation of liabilities.
- Key conservative accounting choices are deferring current income to subsequent periods, premature recognition of the expenses, undervaluation of assets, and overvaluation of liabilities.
- Analysts should consider and assess the extent to which non-GAAP financial measures are a true representation of the company’s performance as those metrics are especially susceptible to the management’s adjustments and exclusions.
- The main accounting areas where the management might be willing to apply biased accounting choices are inventory valuation methods, estimates on customer return rates, valuation adjustments to the deferred tax asset, depreciation methods, capitalization of expense payments, and acquisitions.
- The application of the FIFO inventory valuation method means that the inventory still owned by the company is valued at the most recent prices. Therefore, the inventory valuation presented in the balance sheet will reflect the current market conditions.
- The application of the weighted average cost method averages the cost of the inventory recognized for the products sold (it is a blend of the old prices and most recent prices weighted by the volume).
- Analysts and investors should investigate the customer return rate estimates provided by the management to ensure that they are in line with the market standards and past customer behavior.
- Valuation adjustments to the deferred tax assets position should be scrutinized by analysts and investors because of the risk of the management’s bias that the company can benefit from the DTA in the subsequent period.
- The choice of the assets’ depreciation method between straight-line basis, accelerated method, or activity-based method can be an easy way for the management to manage current or future periods results.
- There is a great deal of judgment applied to the capitalization of the payments made to cover multi-year costs. Capitalization methods and choices might significantly impact the performance reported in the current period and should be investigated.
- Acquisitions processes create a good opportunity to manage results both in the current and subsequent periods. Estimates of the fair value of assets acquired impact the depreciation charges and goodwill recognized.
- The statement of cash flow from operations is presented either in direct or indirect method. Regardless of the method, the management might influence how the cash flows are presented in the financial statements.
- Key areas where the management’s choices impact the cash flows from operating areas are accounts payable and the misclassification of cash flows between operating, financing, and investing activities.
- Key warning signs for the analyst that indicate possible management bias in the financial statements regarding revenue recognition are the application of non-standard shipment terms, channel stuffing, non-standard assumptions on customer returns, and bill-and-hold transactions.
- Key warning signs for managing long-lived assets positions are the application of non-standard depreciation charges, estimates on the useful economic lives, or salvage values.
- Estimates and policies on R&D capitalization rules, provisions for doubtful debts, warranty reserves are the ones that analysts should review and assess because those are prone to management bias.
- Analysts should also review whether the company engages in related-party transactions as such transactions might be used to alter the company’s performance, e.g., by transacting on non-market conditions for the benefit of the reporting entity.