Financial Reporting Quality

I am having a hard time with questions from “Evaluating Financial Reporting Quality and Other Applications”. If all of the options look suspicious how can I decide which one is the yellow flag and which one is red?

For example this question below:

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. Nonoperating and nonrecurring gains recorded as revenue.

C. The declining LIFO reserve.

The correct answer is A

The only thing that springs to mind is that the first three bullet points are not sustainable, whereas the fourth is.

Did they give any explanation in the answer?

Yes, here is the explanation but I still don’t get it:

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 they will artificially boost sales growth. Each 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.

Does it make sense to anyone?

Seems a bit light: the author glossed over the gains-recognized-as-revenue boondoggle.

If you’re using the equity method to account for an investment, your share of the earnings of the investee company are recorded on your P&L. However, there is no cash flow backing these earnings (say your P&L says you made $100 on your 20% investment in a company - your earnings will increase by $100 but your cash flow doesn’t change) for as long as you’re using the equity method to account for the investment. Earnings from investments that don’t pay dividends which are accounted for using the equity method are of poor quality.

I remember this question from last year’s QBank and I hated it. Having nearly finished my studying for L2, I now understand it.

EDIT: I defer to S2000 for all things CFA whenever he makes an appearance in a thread…