Earnings Manipulation - Not convinced!!!

Ok I just wanna see what people respond with for the following two questions… personally i feel shweser answers are conflicting and not convinving enough…maybe it’s just me… 1. Junior analyst Xander Marshall sends an e-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is manipulating its results to artificially inflate profits. He cites four reasons for his conclusion: The LIFO reserve is declining. Earnings are much higher in the September quarter than in other quarters. Many nonoperating and nonrecurring gains are being recorded as revenue. Much of Peterson’s earnings come from equity investments not reflected on the cash-flow statement. Jacobs is less concerned about Peterson’s earnings than Marshall is, though she does resolve to check out one of his concerns. Which of Marshall’s observations best supports his conclusion? A) Equity investment earnings not reflected on the cash-flow statement. B) The declining LIFO reserve. C) High September-quarter earnings. D) Nonoperating and nonrecurring gains recorded as revenue. 2. Frank Brill, CFA, is concerned that Moses Aviation is overstating its profits. The best indicator of such action would be Moses Aviation’s: A) recognition of revenue from barter transactions. B) rising inventory. C) rising ratio of operating cash flow to earnings. D) sales-growth rate of nearly twice the industry average.

D and B But Im 50% on both

  1. D 2. A ??

for #1, B sounds like a lifo liquidation, which is definitely a sign of earnings manipulation so i say B, A

  1. D 2. A

Oh yea, LIFO liquidation…I like B as a better answer now. So 1. B 2. A

I think D and A

D A would be my guesses.

Lifo liquidation can be a manipulation method, but I would think booking non-operating gains and non-recurring stuff as regular old sales is a more severe.

What about A for #1. If you have an equity investment you book the proportionate share of earnings on your IS. But if it is not in the cash flow, that means you did not receive any dividends or any real cash…it’s just an entry on your books.

The equity method doesn’t always mean you’ll have cash flows coming in, so it’s possible you had earnings but no CF.

i’ll try D and B

Do we know the actual answers?

Ok…I don’t feel so bad anymore… Schweser’s Answers 1. A 2. A Answer for 1. The correct answer was A) Equity investment earnings not reflected on the cash-flow statement. On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and disclosed the LIFO liquidation in its footnotes. When unusual gains are recorded as revenue rather than income, they will boost sales growth, but have no effect on net income. High September-quarter earnings could simply be a result of seasonality. All three of the above issues are potential danger signs, but can also be easily explained in a manner beyond reproach. However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further examination. Answer for 2. The correct answer was A) recognition of revenue from barter transactions. While an unusually high sales-growth rate may indicate fraud, it could also indicate good management. It’s a yellow flag, but not the best indicator of accounting shenanigans. Rising inventory is also a dual signal. It could be meant to overstate profits, or it could simply reflect an actual buildup of inventory in response to market forces or corporate operations. Cash flow is growing faster than earnings, which is not a sign of earnings enhancement. However, companies should not recognize revenue from barter transactions. The additional revenue is likely to improperly boost profits. why oh why??? For the first one…I feel either B could be possible answers. Because a declining LIFO reserve, means the company will have a lower COGS, basically meaning higher profits. C is out - the company could have seasonal revenues D could be out - whether the company reports the non operating/recurring items as revenue or further down the IS - it will affect Net Income. I guess just because they record as revenue - Earnings don’t get boosted… but A just doesn’t make sense!!?

wanderingcfa - care to elaborate please!!

Here is what I was thinking. For equity investments we report on our income statement our proportionate share in our investments earnings right? Lets say our equity investment was for 30% of company X. For each dollar of income that company x earns, we get to report $0.30 on our income statement. If company X is earning $100,000,000 per year, then we get to report an additional $30,000,000 but if company x does not pay out any dividends (e.g. nothing reported on our cash flow statement), we never actually received any of that $30,000,000 and thus our earnings are overestimated. Now that I look back at the question, it stated "Much of Peterson’s earnings come from equity investments "…so if Petersons earnings totaled $50,000,000 but $30,000,000 was from our 30% equity investment then Peterson had much higher earnings stated than if they did not have the equity investment.

hmmm…i hate that you make sense… i just wish the cfa/schweser was wrong sometimes!!! thanks though …

I can get on board with those answers but I’m still a little confused about how non-operating and non-recurring gains will affect only revenue. Wouldnt these have to flow down and affect NI??

nerdattax… recording non operating/recurring on your income statement will affect your net income - but whether you record it as sales or further down the income statement i.e. after operating income, is irrelevant… just because you record it as revenue - it will not make your net income look higher or lower… feel like i’m repeating what i said…dunno if this is a better explanation…

Damn…I was so sure that the first one was B.