Enron: Underreported balance sheet longterm debt

1. Enron: Underreported balance sheet longterm debt.

Underreporting debt affects balance sheet quality. Solvency risk ratios using some measure of long-term debt in the numerator incorrectly indicate lower solvency risk. Generally speaking, longterm debt is recorded at present value. As time passes, interest expense should be reported on the income statement. If the long-term debt is incorrectly omitted from the balance sheet, interest expense will be omitted from the income statement, thus impairing earnings quality.

2. WorldCom: Capitalized rather than expensed expenditures to maintain transmission lines.

Incorrectly reducing long-lived assets' estimated useful lives slows depreciation, which overstates long-lived assets and net income. Balance sheet quality is impaired because the investment public believes PP&E is newer than it is (i.e., the ratio of accumulated depreciation to original cost is too low). Also, the collateral value of PP&E is potentially overstated, affecting risk assessment. Earnings quality is affected because the firm appears more profitable than it is

The WorldCom and Waste Management scandals are similar in that both involve the overstatement of an asset and the understatement of expenses

3. AIG: Booked debt as revenue.

Booking debt as revenue decreases debt and increases revenue. Balance sheet quality is impaired because, if the debt is long-term, solvency risk measures (those ratios using some measure of debt in the numerator) indicate lower risk. If the debt is short-term, the current
and quick ratios are overstated, falsely indicating lower liquidity risk. Earnings quality is seriously impaired. Earnings are overstated by this transitory amount, leading the investment public to believe that profitability is higher.

4. Lehman Brothers: Sold toxic asset (i.e., financial investments) to other banks with a buyback agreement, removing the toxic assets from its books.

Claiming to have sold any asset, toxic or not, when an agreement to buy it back exists causes the asset to be removed from the balance sheet and replaced by cash (or possibly a receivable). Balance sheet quality is impaired because the firm appears to be more liquid than it is remember that noncash assets are in essence statements that future cash will probably be received, not that cash has been received or shortly to be received and is available to pay other claims). The problem is particularly significant for toxic assets with a far lower probability of collection. Earnings quality is also impaired. Toxic assets should probably be reported at lower amounts on the balance sheet with associated charges to earnings. (A mitigating factor for this earnings quality impairment exists if the toxicity is a one-time writeoff and, thus, not expected to persist).

5. Saytam: Created fictitious revenue recognition journal entries.

Creating fictitious revenue impairs earnings quality. Earnings are overstated by the fraudulent transaction, leading the investment public to believe that profitability is higher. Also, revenue projections are critical in developing forecasted financial statements used for
valuation. The false growth implied by the revenue inflation will likely lead to upwardly biased revenue forecasts and valuation errors. Balance sheet quality is also impaired. The current ratio is overstated by the inflated accounts receivable, and liquidity risk appears to be lower when it is not.

6. A company may try to paint a favorable picture of itself by accelerating the timing of revenues or estimating the collectible amounts too aggressively. In these cases the quality of accounting information declines because it does not represent the company's true economic condition and may not be sustainable. List two conditions which might suggest that a company is recognizing revenues too early?

1. Large and volatile amounts of uncollectible accounts receivable.
2. Unusually large amounts of returned goods.
3. Excessive warranty expenditures.
4. A significant increase in days accounts receivable are outstanding.

7. Briefly define and give an example for accrual manipulation and real activities manipulation. What is the main difference between the two methods of manipulation?

Accrual manipulation: manipulating accruals to meet certain earnings thresholds. Examples include changing accounting methods (i.e., depreciation method), changing estimates (e.g., bad debt expense, useful lives, salvage value, ...), delaying write-offs.
Real activities manipulation: "management actions that deviate from normal business practices, undertaken with the primary objective of meeting certain earnings thresholds". Examples include cutting R&D expense, cutting advertisement expense, and selling assets.
The main difference is that accrual manipulation has no effect cash flow. It only affects the timing of earnings recognition. Real activities manipulation affects the real economic activities of the firm (R&D, advertisement,...) and therefore has implications for future performance.

8. Discuss the economic characteristics of firms that have the following mix of profit margin and asset turnover. In addition, provide an example of an industry that would have the relevant profit margin asset turnover mix: A. High profit margin and low asset turnover

A. Firms and industries characterized by heavy fixed capacity costs and lengthy periods required to add new capacity operate under a capacity constraint. There is an upper limit on the size of assets turnover achievable. In order to attract sufficient capital, these firms must generate a relatively high profit margin. Some of the industries in this space are oil and gas extraction, hotels, and utilities.

9. . Discuss the economic characteristics of firms that have the following mix of profit margin and asset turnover. In addition, provide an example of an industry that would have the relevant profit margin asset turnover mix: B. Low profit margin and high asset turnover

Firms whose products are commodity-like in nature, where there are few entry barriers, and where competition is intense, operate under a competitive constraint. There is an upper limit on the level of profit margin for ROA achievable. In order to attract sufficient capital, these firms must strive for high assets turnovers. Some of the industries in this space are retailers and wholesalers.

10. Condition A: Increasing cost of goods sold to sales percentage, coupled with an increasing inventory turnover.

Condition A: Firm lowers prices to sell inventory more quickly. Firm shifts its product mix toward lower margin, faster moving products. Firm outsources the production of a higher proportion of its products, requiring the firm to share profit margin with the outsourcer but reducing the amount of raw materials and work-in-process inventories.