New Lecture 4 Spr 09

Spring 2009

NBA 5060 Lecture 4 – Accounting Analysis

1. Why accounting analysis is important 2. Conducting an accounting analysis:

Step 1.Identifying key accounting policies Step 2.Identifying incentives to manage earnings Step 3.Identifying where managers have flexibility Step 4.Assessing the likelihood of earnings management Step 5.Adjusting financial statements

Additional Notes (not discussed in class): 3. A note on capitalizing operating leases 4. Checklists for detecting earnings management

This checklist provides guidance on the questions to ask when you think the firm might be managing its earnings.

For 2/3: Read Harnischfeger Case. Come to class prepared to discuss case questions, which will be handed out in class today. Both the case and the discussion questions will be handed out today. Also, compute the basic profitability ratios (ROE and its components) for CBRL. Lecture 3

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Why is Accounting Analysis Important? Provides an understanding of the degree to which a firm’s accounting captures its underlying business reality. • How do key business activities and business risks affect the financial statements? • Does management have incentives to manage earnings? • Does evidence of earnings management exist? Answering these questions is essential if we want to use the financial statements to evaluate the firm’s current performance and forecast the firm’s future profitability. F Account ing Strategy B A u Choice ic of accounting s policies c n i Choice o a of accounting u estimates n e Choice n c of reporting f ormat s itChoice of supplementary is disclosures a ln E S A g tn c S rv E tS i n y a r v ts tio e n rtg e m iy o m e S e M n cn s m te t o O e a s L p sn M te u a b rC n o e a tfr p g i a e m tb rn u g a sd ’lsr ik rA cn m se te a p u ris o p rkvsC e i:a rte Lecture 3 Page 2 of 23 itp i o t rse tsa l rID e e n cu

n ra te r se u io k rte m n fie t n cC o fs g ro P cn m r d tA o a rcio tn tvd isa This step involves evaluating how well the financial statements reflect the ciu e o tvrceffects of key business activities. q n ist u ti n e o ** Revenue recognition is always important. ifm g n ia ce scrBeyond this, use what you learned about key business activities and a e b k a F sn u business risks facing the company from your industry and strategy analysis ite sd tto identify key accounting policies. in s o a g n n o e vcKey accounting policies for CBRL: so i sfe rn Reflects S g n b economic T a u yp A sn Key Activity Accounting Policy reality? icp a tl e cn i A te e iscvo vscifr ts io id u ta e icn tsv e sie rC vn E u sig tis irft io e m cm sg a e a tu iltr is a o to n in C o e o rn C rsm p T o m e ra sxtp ie D t ia i sn v* If all else fails, go down the income statement and balance sheet, line-bytd e o line, and make sure you understand the economic activities that affect rf sthose accounts. tip B o in Lecture 3 Page 3 of 23 su a o is n scti in e o fa s rln

Step 1. Identify Key Accounting Policies

m n r g :e m g a cu n cl a a o g t C u e i o rn sto ’itn s n l g e Yahoo Gets Pinched After Profits Miss by a Penny la By Will Swarts id April 18, 2007 e n a ckrThe Company sYahoo (YHOO1) ca hShare price as of Tuesday's close: $32.09 g o i Share price now: $28.31 e u spPercent change: -11.8% n Volume: 127.1 million shares, daily average 19.3 million tT ih The News i n A penny saved is a penny earned, but a penny short was bad news for Yahoo (YHOO2). Shares of the r g Internet behemoth plunged 12% after quarterly per-share earnings fell one cent short of Wall Street's D d expectations. c-i fYahoo, a portal and search engine that has in effect become one of the largest online advertising players p h fon the planet, reported first-quarter earnings of 10 cents a share, down from 11 cents a share in the yeara o ago period, and a penny shy of analysts' consensus estimate of 11 cents, according to Thomson ire ctrFinancial. Revenue came in at $1.18 billion, up 9% from a year earlier but short of the $1.21 billion yexpected by analysts. e sn The company warned late Tuesday that second-quarter revenue would be just $1.2 billion to $1.3 billion, tpotentially a bit out of sync with the average Street estimate of $1.28 billion. The company reiterated its a ifull-year revenue and earnings guidance, saying it expects revenues of $4.95 billion to $5.45 billion and u a d earnings before interest, taxes, depreciation and amortization, or Ebitda, of $1.95 billion to $2.2 billion. itThat prompted Deutsche Bank analyst Jeetil Patel to note Wednesday that management "only" reiterated tiearlier projections, making its performance in the second half of the year particularly important. io Yahoo completed its conversion to its Panama advertising platform during the first quarter, a much n anticipated move that's designed to boost its search-based ad revenue. Despite the profit shortfall senior K g management said the strategic shift was moving according to plan. e L y"Our first-quarter financial results reflect solid execution against our plan," Chief Financial Officer Susan e Decker said on a conference call. "We maintained strong profitability and cash flow, while remaining g sfocused on building innovative products and services for our large and growing base of users, advertisers a and publishers." lu cNeedham & Co. analyst Mark May downgraded the stock to Hold from Buy, saying it was fully valued and scthat core display ad growth was slowing. ye "Our estimates are in-line with guidance, but we increasingly believe the [second half of 2007] sacceleration implied in consensus revenue forecasts could be difficult to exceed given the recent tsslowdown in display ad growth," May wrote Wednesday. e f m a fc t o ro r s a c c& o Page 4 of 23 rLecture 3 u i n ts ik s n g

Step 2. Identify managers’ reporting incentives

d i s p u t e s

Discontinuities in the distribution of earnings

Around zero:

Earnings increases:

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Analysts’ forecasts:

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Meeting earnings benchmarks: What managers have to say (from Graham, Harvey, and Rajgopal, Journal of Accounting and Economics 2005)

Benefits of meeting earnings benchmarks:

Consequences of missing earnings benchmarks:

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Step 2. Identify managers’ reporting incentives (cont’d) O Debt M T S C R covenants t o a e xn m ra p g The strongest and most pervasive incentives arise from capital markets ka ip u and management compensation. cg e lto e to rh a At a minimum, check whether: r m in o tla tlse o - 1. Earnings are barely positive ’ 2. Earnings are barely better than prior year earnings in d e rm t 3. Earnings are equal to or barely better than analysts’ forecasts vd e ya (quarterly and annually) over the past year (two years, if available) a rce r cko caCBRL EPS n e o 2008 Q1 2008 Q2 2008 Q3 2008 Q4 08 Annual mAnalysts to n uActual ip srn n se ico t lin o d 4. The company has a policy of issuing regular earnings guidance si d n e n 5. Top management had large option exercises during the year a rsce rtg 6. Top management has significant performance-related compensation io a (options, restricted stock, stock appreciation rights, bonuses) i a n td c to ie h in re o so a n i stn isc e o s n s

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-

Step 3. Identify areas of management flexibility Delta and Pan-Am Property, Plant, and Equipment Delta Airline June 30, 1990 Depreciation and Amortization – Substantially all the Company’s flight equipment is being depreciated on a straight-line basis to residual values (10% of cost) over a 15-year period from dates placed in service. Ground property and equipment are depreciated on a straight-line basis over their estimated service lives, which range from three to thirty years. Pan Am Corp. Dec 31, 1989 G. Property and Depreciation Operating property and equipment is depreciated to estimated residual value on a straight-line basis over the estimated useful lives of the equipment, as follows: Aircraft Type B747-100 B747-200 B727-200 A310-200

Useful Life 21-25 years 22-25 years 22-25 years 18 years

Residual Value 15% 15% 15% 15%

Other property and equipment, primarily of Pan Am, is depreciated over a period of 4 to 20 years without residual value. During 1987, the lives of B727-200 aircraft were extended by an average of five years, decreasing 1987 depreciation expense by $12,914,000.

Is Pan Am too aggressive, Delta too conservative, or could both be correct?

-

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Summary of areas of managerial flexibility: Accounting Methods

Managerial Choice Over Accounting Structuring & Estimates Timing of Events

Revenue Recognition

When is revenue earned?

Special expense items: R&D Advertising Expense Exploration Costs Receivables

Software development costs

Inventory

LIFO vs FIFO

Oil and Gas exploration costs Allowance for Doubtful Accounts

Property, Plant, & Equipment and Intangibles

Straight line vs. accelerated

Leases

Capital vs Operating

Pensions & OPEBs

Cost allocation between COGS and Inventory for manufacturers.

Timing of write-offs & amortization if capitalized ‘Real’ earnings management

Timing of LIFO purchases Overproduction in current period

Est. useful life

Write-offs Timing of write-offs

Est. salvage value

Restructuring charges

Impairment test Residual value of asset (90% test)

Expected rate of return on assets Warranty expense Insurance company liability reserves

Pooling vs. Purchase (Pooling has been abolished under SFAS 141)

Environmental Liabilities In-process R&D writeoffs. Allocating purchase price Impairment amount

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Favorable credit terms

Rate assumptions

Commitments and contingencies

Business Combinations

‘Substantial performance’ and ‘reasonably collectible’ criteria Amount of directresponse advertising to capitalize

Sales discounts

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Restructuring charges

Goodwill impairment test

Step 4. Is it likely that the company has engaged in earnings management? This is usually impossible to know with certainty. The point is to critically evaluate the company’s exercise of discretion in light of the company’s incentives to achieve a particular reporting outcome. Does the company have an incentive to achieve a particular reporting objective, and did the company make accounting choices consistent with achieving that objective?

**We will return to this topic later and examine how to use cash flow information and ratio analysis to identify accounting distortions.

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Step 5: Adjusting Financial Statements When should you adjust financial statements? 1. To promote comparability across companies •

Differences in income statement/balance sheet classification

• Differences in accounting methods •

Differences in fiscal periods

2. To promote comparability over time • Non-recurring gains/losses • Changes in accounting methods • Changes in accounting estimates 3. To evaluate effects of off-balance sheet assets/liabilities • Operating versus capital leases • Capitalizing investment in R&D or advertising • Joint ventures/equity method investments

How should you adjust financial statements?

Goal is to eliminate as many accounting distortions that cause differences in ratios over time/across firms as possible. In this way, your comparisons are more meaningful. Unfortunately, some distortions are unavoidable. In this case, keep those distortions in mind when you interpret the ratios as possible explanations for differences you observe. Lecture 3

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General Issues in Computing Net Income One of the primary objectives of analyzing the income statement is to get a sense of the relative permanence of a firm’s earnings. Items Affecting Earnings Permanence and the Prediction of Future Earnings Income from continuing operations: Should include only the normal, recurring, relatively sustainable, ongoing economic activities of the organization. The one exception is often termed ‘Special Items’ Special items or unusual items include any relatively infrequent or non-recurring items that nevertheless tend to arise from a firm’s on-going, continuing operations. Some frequent special items to consider when assessing the permanence of earnings: • Gains and losses on sale of securities. • Restructuring charges. • Gain or loss on sale of PPE. Items excluded from income from continuing operations (all are reported net of tax): Discontinued Operations includes the income as well as the gain/loss from a discontinued business segment. Extraordinary Items include items that meet the ‘unusual nature’ and ‘infrequent occurrence’criteria. Changes in Accounting Principletypically involves an adjustment for the cumulative effect on all prior periods. To provide comparable numbers, income from continuing operations are usually recomputed

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Cracker Barrel Income Statement What adjustments would you make to this income statement?

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Income Statement For the Fiscal Period Ending Currency Units Revenues Total Revenues Expenses Cost of Goods Sold Labor and Other Related Expenses General and Administrative Expenses Other Store Operating Expenses Impairment and Store Closing Charges Interest Expense Interest Income Earnings before Taxes Taxes and Other Expenses Provision for Income Tax Earnings of Discontinued Operations Net Income (Loss)

12 months Jul-28-2006 USD Thousands

12 months Aug-03-2007 USD Thousands

12 months Aug-01-2008 USD Thousands

2,219,475.0

2,351,576.0

2,384,521.0

(706,095.0) (832,943.0) (128,830.0) (384,442.0) (5,369.0) (22,205.0) 764.0 140,355.0

(744,275.0) (892,839.0) (136,186.0) (410,131.0) (59,438.0) 7,774.0 116,481.0

(773,757.0) (909,546.0) (127,273.0) (422,293.0) (877.0) (57,445.0) 185.0 93,515.0

(44,854.0) 20,790.0 116,291.0

(40,498.0) 86,082.0 162,065.0

(28,212.0) 250.0 65,553.0

3. A Note on Operating versus Capital Leases Operating Leases: Accounting treatment: Recognize rental (or lease) expense on an annual basis. Include financial statement disclosure in notes for future liability. No asset or liability recognized. Provide a source of off-balance sheet financing. Lower leverage and increase ROA. The primary criteria for classification as an operating lease is that minimum lease payments do not exceed 90% of the fair value of the leased asset. Capital Leases: Accounting treatment: Capitalize and expense both the interest payments and depreciation expense. Lower the current ratio. Lower ROA and increase the leverage of the firm. A Simplified Approach to Making Financial Statements Comparable:

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1. Ignore Income statement effects. For mature firms there often isn’t a material difference as both methods tend to have equal expense amounts at the mid-point of the lease period. 2. For the balance sheet, the most straightforward approach is to capitalize the leases of all companies. The liability that appears on the balance sheet is the discounted present value of the minimum lease payments. To compute this you need (1) a discount rate, and (2) annual payments in the later years. A typical lease footnote disclosure taken from the SBUX 2007 annual report looks as follows: Fiscal Year 2008 2009 2010 2011 2012 Later Years Net Minimum Lease Payments

Minimum Operating Lease Payments (in thousands) 691,011 671,080 629,696 582,509 526,684 1,915,603 5,016,583

To obtain a discount rate, use the following if available: (1) The discount rate actually used might be disclosed in the lease footnote; (2) If there is no discount rate in the lease footnote, use the discount rate disclosed in the long-term debt footnote; (3) If the firm carries no debt, use the discount rate for debt on a comparable company. For the company above, we will use a discount rate of 6.25% (taken from their debt footnote). Estimating annual payments: For the ‘Later Years’ payments that are aggregated, simply use straight-line depreciation if the time horizon is given. If not, estimate the time horizon using the last available annual lease payment (2012in the above example). The time horizon is determined as: Minimum Op. Lease Paymentsafter 2012 1,915,603 = = 3.63 years 2012 annual payment 526,684 We’ll round this up to 4 years (always round up), for annual payments of $1,915,603 / 4= $478,901 per year. Now that we have the payment schedule, simply discount the stream of payments at a rate of 6.25% annually to get the present value of the lease obligation: PV of Lease = (691,001*0.9412) + (671,080*0.8858) + (629,696*0.8337) + (582,509*0.7847) + (526,684*0.7385) + (487,901*3.6607*0.6951) = $ 3,834,359 To adjust the balance sheet:

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Simplest approach – increase lease obligation (liability) and long-term leases (asset) each by $3,834,359. Use the adjusted numbers for ratio calculations. Assume interest expense at the discount rate multiplied by the computed value of the asset – this is required for EBI when computing ROA. Treat the capitalized lease as long term debt for solvency ratio calculations, etc. If you want more accurate guidance, see any intermediate accounting textbook such as Revsine, Collins, and Johnson, Financial Reporting and Analysis, Prentice-Hall (1999).

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4. Checklists for Detecting Earnings Management (from The Financial Numbers Game) Checklist to Detect Premature or Fictitious Revenue A. What is the company's revenue recognition policy? 1. Before delivery or performance? a. Is it really earned? 2. At delivery or performance? a. Is there a right of return or price protection? i. Has the company provided adequately for returns or price adjustments? b. Does the company offer side letters offering a right of return or price protection not contained in the actual sale contract? i. Do side letters effectively negate the sale? 3. After delivery or performance and full customer acceptance? B.

Was there a change in the revenue recognition policy? l. Did the change result in earlier revenue recognition?

C.

Are there any unusual changes in revenue reported in recent quarters? 1. What is revenue for each of the last four to six quarters? 2. Does anyone quarter show unusual activity not explained by seasonal factors'! 3. How do quarterly changes in revenue compare with the industry or selected competitors? a. For companies with a strong seasonal effect, changes in quarterly revenue should be calculated using amounts taken from the same quarter of the previous year. b. If quarterly data are not available, or if quarterly data give misleading signals, annual data can be used. Three or more years of data should provide a sufficient number of data points to get a meaningful indicator of potential problems.

D.

Review disclosures of related-party transactions. 1. Is there evidence of significant related-party revenue? a. Is this revenue sustainable?

E.

Does the company have the physical capacity to generate the revenue reported? 1. What is revenue per appropriate measure of physical capacity for each of the last four to six quarters? 2. How do the measures compare with the industry or with selected competitors? a. Possible measures of revenue per physical capacity: i. Revenue per employee ii. Revenue per dollar of property, plant, and equipment iii. Revenue per dollar of total assets iv. Revenue per square foot of retail or rental space

F.

Are there signs of overstated accounts receivable or other accounts that might be used to offset premature or fictitious revenue? 1. Compare the percentage rate of change in accounts receivable, property, plant, and equipment, and other assets with the percentage rate of change in revenue for each of the last four to six quarters.

G.

a. What are the implications of differences in the rates of change in these accounts and revenue? 2. Consider whether unexplained changes in other asset or liability accounts might be explained by premature or fictitious revenue. 3.Compute A/R days for each of the last four to six quarters. a. What are the implications of changes noted in A/R days over the last four to six quarters? b.How does the absolute level of A/R days and changes therein compare with the industry and selected competitors? Does the company use the percentage-of-completion method for long-term contracts? 1. Is management experienced in applying the method? 2. Has the company reported losses in prior years from cost overruns?

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3.Depending on data availability, compare the percentage rate of change in unbilled accounts receivable with the percentage rate of change in contract revenue for each of the last four to six quarters. a. If unbilled accounts receivable is increasing faster than contract revenue. it implies that amounts recognized as revenue are not being billed. i. Is there a particular reason why amounts recognized as revenue are not being billed? ii. Note that for some contractors, quarterly data may give misleading signals. Certain key contract benchmarks may not have been met during the quarter, limiting amounts billed over that short of a time frame. In these cases, annual data should be used. Checklist to Detect Aggressive Capitalization Policies A. For cost capitalization generally: 1. What are the company's policies with respect to cost capitalization? a. Is the company capitalizing costs that competitors or other companies in the industry expense? b. Does the company expense more, taking a more conservative approach? c. Are capitalized costs increasing faster than revenue over lengthy periods? d. What do capitalized costs represent? i. An identifiable asset with an ascertainable market value? ii. Not an identifiable asset, whose market value, if any, is tied to the general fortunes of the company? 1. Can the benefit to future periods be determined? 2. What is the materiality of the asset to total assets and shareholders' equity? 2. Do capitalized costs exceed market value? B.

For companies incurring software development costs:

1.What proportion of software development costs incurred is being capitalized? 2. How does this percentage compare with competitors or other companies in the industry? C.

For companies capitalizing interest costs: 1. Should capitalization of interest costs be discontinued? a. Is the asset under construction complete and available for its intended use? b. Do costs incurred on the asset under construction give an indication of exceeding net realizable value? i. Have there been construction delays? ii. Have there been cost overruns?

D.

For companies capitalizing direct-response advertising and related expenditures such as customer acquisition or subscriber acquisition costs: 1. Is persuasive historical evidence available that would permit formulation of a reliable estimate of future revenue to be obtained from incremental advertising or customer/subscriber acquisition expenditures? 2. Is the company an insurance company that is properly capitalizing policy acquisition costs?

E. For companies incurring oil and gas exploration expenditures: 1. Does the company use the successful efforts method (expensing option) or the full cost method (capitalization option) to account for exploration expenditures? 2. Are petroleum prices declining, suggesting capitalized costs may be value impaired? F. A policy of capitalizing the following costs should be considered at odds with generally accepted accounting principles: 1. Costs of start-up activities, including organizational costs and preopening costs 2. Advertising, marketing, and promotion costs, excluding direct-response advertising and general and administrative expenses

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3. Costs incurred on internally conducted research and development activities and purchased in-process research and development a. Software development is excluded and can be capitalized i. For software written for sale or lease-capitalization begins after technological feasibility has been reached ii. For software written for internal use-capitalization begins after the preliminary project stage is complete G. Has the company shown evidence in the past of being aggressive in its capitalization policies? 1. Is there an example of a prior year write-down of capitalized costs that. in hindsight, should not have been capitalized? 2. Has a regulator, such as the SEC, forced a change in accounting policies in the past? H. Has the company capitalized costs in stealth? 1. Examine unusual changes in and relationships with revenue of the following: accounts receivable, inventory, property, plant, and equipment, and other assets Checklist to Detect Extended Amortization Policies A. Has the company selected extended amortization and depreciation periods for capitalized costs? 1. As data permit, how does the calculated average amortization period for long-lived assets compare with competitors or other firms in the industry? B. Be particularly alert for extended amortization periods in the following situations: 1. Company's industry is experiencing price deflation 2. Company is in an industry that is experiencing rapid technological change 3. Company has shown evidence in the past of employing extended amortization periods a. Is there an example of a prior year write-down of assets that became value impaired? C. For companies taking restructuring charges, examine activity in the restructuring liability or reserve account 1. Is there reason to believe that normal operating expenses are being charged to the reserve? Checklist to Detect Overvalued Assets A.

Accounts receivable 1. Compare the percentage rate of change in accounts receivable with the percentage rate of change in revenue for each of the last four to six quarters. a. What are the implications of differences in the rates of change? 2. Is the allowance for doubtful accounts sufficient to cover future collection problems? a. Compute A/R days for each of the last four to six quarters i. Is the trend steady, improving, or worsening? ii. Is the overall level high when compared with competitors or other firms in the industry? 3. Have economic conditions for the company's customers worsened recently? a. Are company sales declining? b. Are there other general economic reasons to expect that customers are, or may be. having difficulties? 4. Are sales growing rapidly? a. Has the company changed its credit policy? i. Is credit being granted to less creditworthy customers? b. Have payment terms been extended?

B. Inventory 1. Are inventories overstated due to inclusion of nonexistent inventories or by the reporting of true quantities on hand at amounts that exceed replacement cost?

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a. Compute gross margin and inventory days for the last four to six quarters i. Is the trend steady, worsening, or improving? ii. How do the statistics compare with competitors and other firms in the industry?

I. Before making comparisons with competitors, make sure that the same inventory methods (LIFO, FIFO, etc.) are being used b. Do ongoing company events and fortunes suggest problems with slackening demand for the company's products? i. Are sales declining? ii. Have raw materials inventories declined markedly as a percentage of total inventory? c. Are prices falling, suggesting general industry weakness and an increased chance that inventory cost may not be recoverable? d. Is the company in an industry that is experiencing rapid technological change, increasing the risk of inventory obsolescence? e. Has the company shown evidence in the past of inventory overvaluation? i. Is there an example of a prior year write-down of inventory that became value impaired? 2. Does the company use the FIFO method? a. Companies that use FIFO run a greater risk that inventory costs may exceed replacement costs 3. Does the company employ the LIFO inventory method for at least a portion of its inventory? a. Are LIFO adjustments being made for interim periods? i. Has the LIFO reserve account remained unchanged during interim periods? ii. If the LIFO reserve account has been adjusted during interim periods, does the estimate of inflation used appear reasonable? iii. How does gross margin for interim periods compare with prior years' annual results? b. Was there a decline in LIFO inventory? i. Have the effects of a LIFO liquidation been disclosed? ii. What were the effects on gross profit and net income? 4. What is the nature of the company's environment with respect to inventory controls? a. Do controls to guard against theft seem adequate? b. When a physical inventory is taken, how does the amount compare with the books? i. Do the books consistently exceed the physical count by a significant amount? ii. Are the books adjusted or are differences dismissed as errors in taking the physical inventory? C.

Investments 1. For debt securities held until maturity, and nonmarketable equity securities: a. Is there evidence of a nontemporary decline in fair value? 2. For debt securities and marketable equity securities that are available for sale: a. Are investment losses included in stockholders' equity that might be taken to income in the future? i. Might the designation of these losses be changed to other-than-temporary? ii. Is sale of one or more investments imminent? b. Has stockholders' equity been buoyed by substantial write-ups to market value that may disappear in a market decline? 3. For investments accounted for under the equity method: a. Is there evidence of a non temporary decline in fair value?

Checklist to Detect Undervalued Liabilities A.

Accrued expenses payable

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1. What is the trend in accrued expenses payable? 2. Compare the percentage rate of change in accrued expenses payable with the percentage rate of change in revenue for each of the last four to six quarters. a. What are the implications of differences in the rates of change?

3.Does an improvement in selling, general. and administrative expense as a percentage of revenue reflect true operating efficiencies? B.

Accounts payable

1.Compute A/P days for each of the last four to six quarters a. Is the trend steady, worsening, or improving'! b. How docs the statistic compare with competitors' and other firms in the industry? 2. Was there an unexpected improvement in gross profit margin? 3. How does the percent change in accounts payable compare with the percent change in inventory? C.

Tax-Related Obligations 1. What is the effective tax rate and how does it compare to the statutory tax rate? a. Review the reconciliation of the statutory to the effective tax rate or statutory to actual tax expense and identify nonrecurring items 2. What is the valuation allowance, if any, for deferred tax assets? a. Does it seem reasonable after carefully considering the prospects for future taxable income?

D.

Contingent Liabilities 1. What unrecognized contingencies are noted in a careful reading of the footnotes? 2. Given an understanding of the company's business dealings, is there reason to believe that an unrecognized contingent liability exists?

Checklist for Using Operating Cash Flow to Detect Creative Accounting Practices A. Isolate nonrecurring cash inflows and outflows and adjust reported cash provided by operations, including: 1. Cash flow resulting from the operating income component of discontinued operations 2. Income taxes paid or recovered on transactions classified as investing or financing activities, including: a. Gain or loss on sale of assets, investments, or businesses b. Gain or loss on disposal of discontinued operations c. Extraordinary items, especially early retirement of debt d. Changes in accounting principle, if any e. Tax benefits of nonqualified employee stock options 3. Cash flow from the purchase and sale of trading securities

4.Capitalized expenditures that other companies expense as incurred a. In particular, capitalized software development costs 5. Nonrecurring cash income and expense a.

Cash receipts arising from nonrecurring income

b.

Cash payments arising from nonrecurring charges

6. Significant isolated events leading to changes in operations-related assets and liabilities, including: a. Factoring or securitization of receivables b. Special inventory reduction sale outside normal channels B.

Compute adjusted cash flow provided by continuing operations 1. Adjust reported cash flow provided by operating activities for identified nonrecurring cash flow items

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C.

Compute adjusted income from continuing operations

I.

Adjust reported income from continuing operations for nonrecurring items of income and expense Compute the adjusted cash flow-to-income ratio

D.

1. Adjusted cash flow provided by operating activities divided by adjusted income from continuing operations. a. Compute for several years and quarters and examine results for discernible trend

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