Financial statement analysis workbook

P1: OTA/XYZ P2: ABCJWBT510-fm JWBT510-Fridson May 23, 2011 7:24 Printer: Yet to Come Additional Praise for Financial Statement Analysis, Fourth Edition “This is an illuminating and insig

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Additional Praise for

Financial Statement Analysis, Fourth Edition

“This is an illuminating and insightful tour of financial statements, how theycan be used to inform, how they can be used to mislead, and how they can

be used to analyze the financial health of a company.”

—Jay O Light, Dean Emeritus, Harvard Business School

“Financial Statement Analysis should be required reading for anyone who

puts a dime to work in the securities markets or recommends that others dothe same.”

—Jack L Rivkin, Director, Neuberger Berman Mutual Funds and Idealab

“Fridson and Alvarez provide a valuable practical guide for understanding,interpreting, and critically assessing financial reports put out by firms Theirdiscussion of profits—‘quality of earnings’—is particularly insightful giventhe recent spate of reporting problems encountered by firms I highly rec-ommend their book to anyone interested in getting behind the numbers as ameans of predicting future profits and stock prices.”

—Paul Brown, Associate Dean, Executive MBA Programs,Leonard N Stern School of Business, New York University

“Let this book assist in financial awareness and transparency and higherstandards of reporting, and accountability to all stakeholders.”

—Patricia A Small, Treasurer Emeritus, University of California;Partner, KCM Investment Advisors

“This book is a polished gem covering the analysis of financial statements

It is thorough, skeptical, and extremely practical in its review.”

—Daniel J Fuss, Vice Chairman, Loomis, Sayles & Company, LP

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Financial Statement Analysis Workbook

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Founded in 1807, John Wiley & Sons is the oldest independent ing company in the United States With offices in North America, Europe,Australia and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding

publish-The Wiley Finance series contains books written specifically for financeand investment professionals as well as sophisticated individual investorsand their financial advisors Book topics range from portfolio management

to e-commerce, risk management, financial engineering, valuation and nancial instrument analysis, as well as much more

fi-For a list of available titles, visit our Web site at www.WileyFinance.com

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Financial Statement Analysis Workbook

Step-by-Step Exercises and Tests to Help You Master Financial Statement Analysis

Fourth Edition

MARTIN FRIDSON FERNANDO ALVAREZ

John Wiley & Sons, Inc.

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Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc.,

222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created

or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a

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of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com

ISBN 978-0-470-64003-6 (paperback); ISBN 978-1-118-09749-6 (ebk);

ISBN 978-1-118-09747-2 (ebk); ISBN 978-1-118-09748-9 (ebk)

Printed in the United States of America.

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In memory of my father, Harry Yale Fridson, who introduced me to accounting, economics, and logic,

as well as the fourth discipline essential to the creation of this book—hard work!

M F.

For Shari, Virginia, and Armando.

F A.

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PART TWO

Answers

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JWBT510-Preface JWBT510-Fridson May 9, 2011 14:31 Printer: Yet to Come

Preface to Fourth Edition Workbook

This fourth edition of Financial Statement Analysis, like its predecessors,

seeks to equip its readers for practical challenges of contemporary ness Once again, the intention is to acquaint readers who have alreadyacquired basic accounting skills with the complications that arise in apply-ing textbook-derived knowledge to the real world of extending credit andinvesting in securities Just as a swiftly changing environment necessitatedextensive revisions and additions in the second edition, new concerns andchallenges for users of financial statements have accompanied the dawn ofthe twenty-first century

busi-For one thing, corporations have shifted their executive compensationplans increasingly toward rewarding senior managers for “enhancing share-holder value.” This lofty-sounding concept has a dark side Chief executiveofficers who are under growing pressure to boost their corporations’ shareprices can no longer increase their bonuses by goosing reported earningsthrough financial reporting tricks that are transparent to the stock market.They must instead devise more insidious methods that gull investors intobelieving that the reported earnings gains are real In response to this trend,

we have expanded our survey of revenue recognition gimmicks designed todeceive the unwary

Another innovation that demands increased vigilance by financial lysts is the conversion of stock market proceeds into revenues In terms ofaccounting theory, this kind of transformation is the equivalent of alchemy.Companies generate revenue by selling goods or services, not by selling theirown shares to the public

ana-During the Internet stock boom of the late 1990s, however, clever erators found a way around that constraint Companies took the moneythey raised in initial public offerings, bought advertising on one another’sweb sites, and recorded the shuttling of dollars as sales Customers weresuperfluous to the revenue recognition process In another variation on thetheme, franchisers sold stock, lent the proceeds to franchisees, then immedi-ately had the cash returned under the rubric of fees By going out for a shortstroll and coming back, the proceeds of a financing mutated into revenues.The artificial nature of these revenues becomes apparent when read-ers combine an understanding of accounting principles with a corporate

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finance perspective We facilitate such integration of disciplines throughout

Financial Statement Analysis, making excursions into economics and

busi-ness management as well In addition, we encourage analysts to considerthe institutional context in which financial reporting occurs Organizationalpressures result in divergences from elegant theories, both in the conduct offinancial statement analysis and in auditors’ interpretations of accountingprinciples The issuers of financial statements also exert a strong influenceover the creation of the financial principles, with powerful politicians some-times carrying their water

A final area in which the new edition offers a sharpened focus involvessuccess stories in the critical examination of financial statements Wherever

we can find the necessary documentation, we show not only how a

corpo-rate debacle could have been foreseen through application of basis analytical

techniques, but also how practicing analysts actually did detect the problembefore it became widely recognized Readers will be encouraged by theseexamples, we hope, to undertake genuine, goal-oriented analysis, instead ofsimply going through the motions of calculating standard financial ratios.Moreover, the case studies should persuade them to stick to their guns whenthey spot trouble, despite management’s predictable litany (“Our finan-cial statements are consistent with generally accepted accounting principles.They have been certified by one of the world’s premier auditing firms Wewill not allow a band of greedy short-sellers to destroy the value created byour outstanding employees.”) Typically, as the vehemence of management’sprotests increases, conditions deteriorate and accusations of aggressive ac-counting give way to revelations of fraudulent financial reporting

The principles and theories put forth in the University Edition of cial Statement Analysis, fourth edition, are reinforced through the questions

Finan-and exercises in this workbook Part One, Questions, provides chapter fill-in-the-blank questions, financial statement exercises, and com-putational exercises They are designed to be thought-provoking exercisesrequiring analysis and synthesis of the concepts covered in the book Inshort, these questions do not call for “regurgitation of information.”The answers to all questions can be found in Part Two Answers are pro-

chapter-by-vided in boldfaced, italic type in order to facilitate the checking of answers

and comprehension of the material

Financial markets continue to evolve, but certain phenomena appearagain and again in new guises In this vein, companies never lose their re-sourcefulness in finding new ways to skew perceptions of their performance

By studying their methods closely, analysts can potentially anticipate thevariations on old themes that will materialize in years to come

MARTINFRIDSON

FERNANDOALVAREZ

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Acknowledgments

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Questions on Each Chapter

2 The true purpose of financial reporting is

3 Corporations routinely because the appearance of

4 According to the , reversals of the excess write-offsoffer an artificial means of in subsequent periods

5 The following are some of the powerful limitations to continued growthfaced by companies:

movement of the 1960s However, by the 1980s,

8 is one of the ways that the notion of diversification as

a means of maintaining is revived from time to time

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9 The surprise element in Manville Corporation’s 1982 bankruptcy was,

C H A P T E R 2 : T H E B A L A N C E S H E E T

1 A study conducted on behalf of Big Five accounting firm Arthur

the stock market value of public companies in the United States

2 As noted by Baruch Lev of New York University, two examples of howtraditional accounting systems are at a loss to capture most of what isgoing on today are:

a

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3 In the examples in Question 2 there is no accounting event because

5 Some financial assets are unaffected by the difficulties of evaluating

6 Under the compromise embodied in SFAS 115, financial instruments are

7 If a company wrote off a billion dollars worth of goodwill, its ratio ofassets to liabilities would Its ratio of

would not change, however

8 Through stock-for-stock acquisitions, the sharp rise in equity pricesduring the late 1990s was transformed into , despite

9 Unlike , goodwill is not an asset that can be readily

to raise cash Neither can a company enter into a

of its goodwill, as it can with its plant and equipment

In short, goodwill is not that management can either

or to extricate itself from a financialtight spot

10 A reasonable estimate of a low-profit company’s true equity value would

13 A limitation of the peer-group approach to valuation is that

and therefore one major benefit ofusing as a gauge of actual equity value

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14 Instead of striving for theoretical purity on the matter, analystsshould adopt a , using the measure of equity value

15 Historical-cost-based balance sheet figures are the ones that matter in

that a company will violate requiring

16 Users of financial statements can process only , and

17 Deterioration in a company’s financial position may catch investors by

C H A P T E R 3 : T H E I N C O M E S T A T E M E N T

1 Students of financial statements must keep up with

2 In the , each income statement item is expressed

as (sales or revenues), which is represented as

3 Besides facilitating comparisons between a company’s present andpast results, the can highlight important facts

4 Even within an industry, the breakdown of expenses can vary

5 Percentage breakdowns are also helpful for comparing a single

6 In essence, Peet’s is more of and Starbucks is more

7 Costs as percentages of sales also vary among companies within an

8 The more widely diversified pharmaceutical manufacturers can be

as percentage expenses, than industry peers that focus

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9 Analysts must take care not to mistake difference that is actually

as evidence of A subtler tion may be available at the modest cost of

explana-10 Executives whose bonuses rise have a strong incentive

11 On a retrospective basis, a surge or

12 Along with , another major expense category that can

ratios of its industry peers may indicate that management is being alistic in acknowledging the pace of wear and tear on fixed assets Un-derstatement of and overstatement of

unre-would result

15 One way persuading investors that a major development that hurt

suggest that any suffered by the company was

16 An extraordinary item is reported on an basis, below

17 The accounting rules prohibit corporate officials from displaying tain hits to earnings “above the line,” that is, , andfrom using the label Accordingly they employ des-

18 In recent years, has become a catchall for charges thatcompanies wish analysts to consider , but which do not

19 Corporate managers commonly perceive that will be

if they take (for sake of argument) a $1.5 billion off than if The benefit of exaggerating the damage isthat in subsequent years,

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20 The most dangerous trap that users of financial statements must avoidwalking into, however, is inferring that the term “restructuring” con-

21 The purpose of providing pro forma results was to help analysts

to convey a misleading impression

22 Computer software producers got into the act by fromthe expenses considered in calculating

23 Unlike operating income, a concept addressed by FASB standards,

is a number that subjectively manythat lack any standing under GAAP

24 In fact, analysts who hope to forecast future financial results accurately

25 Analysts must exercise judgment when considering pro forma earnings;however, they must make sure to examine , instead of

26 An older, but not obsolete, device for beefing up reported income is

is another sign of potential trouble

28 Management can through techniques that more erly fall into the category of

prop-29 One way to increase profitability through involves

30 A corporation can easily accelerate its sales growth by

and Creating genuine value for shareholders through

is more difficult, although unwary investors sometimesfail to recognize the distinction

31 Analysts need to distinguish between internal growth and externalgrowth consists of sales increases generated from acompany’s existing operations, while represents incre-mental sales brought in through

32 If Company A generates external growth by acquiring Company B andneither Company nor its new subsidiary increases its profitability, then

sum of the two companies’ values

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33 In general, the the combining businesses are,the it is that the hoped-for economies of scope

35 A company with relatively large has a

breakeven level Even a modest economic downturn will reduce

below the rate required to keep the companyprofitable

36 Deals that work on paper have often foundered on

a

b

c

d

37 Financial statements cannot capture certain that may

be essential to These include

a

b

c

C H A P T E R 4 : T H E S T A T E M E N T O F C A S H F L O W S

1 The present version of the statement that traces the flow of funds

in and out of the firm, the statement of cash flows, became tory, under , for issuers with fiscal years ending after

manda-

2 For financial-reporting (as opposed to ) purposes, apublicly owned company generally seeks to maximize ,which investors use as a basis for valuing its shares

3 A privately held company, unlike a , which shows oneset of statements to the public and another to the Internal RevenueService, a private company typically prepares of state-ments, with foremost in its thinking Its incentive is

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thereby its tax bill as well

4 In a classic LBO, a group of investors acquires a business by

5 The amount attributable to depreciation in the rent year Rather, it is a bookkeeping entry intended to represent the

6 Viewed in terms of cash inflows and outflows, rather than earnings,

7 Analysts evaluating the investment merits of the LBO proposal wouldmiss the point if they focused on rather than

best information about a highly leveraged firm’s financial health

10 Among the applications and uses of the Statement of Cash Flows are:a

b

c

its asset value, as a result of havinglagged the of the company’s operations

12 Revenues build gradually during the phase, during

13 Growth and profits accelerate rapidly during the

phase, as the company’s products begin to penetrate the market and

14 During the period, growth in sales and earnings

opportunities are limited to the replacement of products previously sold,

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15 Price competition often intensifies at this stage, as companies

The stage does not automaticallyfollow maturity, but over long periods some industries do get swept

16 Sharply declining sales and earnings, ultimately resulting in

, characterize industries in decline

17 are typically voracious cash users

18 are start-ups that survive long enough to reach thestage of entering the public market

19 For a company at , it may take several years for sales

21 are in a less precarious state in terms of cash flow thantheir emerging growth counterparts

22 Reflecting the of its business, Kimberly-Clark

, giving them the opportunity to it

They either launch or acquire businesses with Theolder businesses become for funding the neweractivities

25 are past the cash strain faced by growth companies

26 struggle to generate sufficient cash as a consequence

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occasionally befall the business world, is unavailable

33 A company with a strong balance sheet can fund much of that cash need

by increasing its (credit extended by vendors) Externalfinancing may be needed, however, if accumulation of unsold goods

Similarly, if customers begin paying more slowly than formerly, can

34 One typical consequence of violating or striving tohead off is that management reduces discretionary ex-

35 Overinvestment has unquestionably led, in many industries, toprolonged periods of , producing in turn chroni-cally In retrospect, the firms involved would haveserved their shareholders better if they had or

36 Keeping cash “trapped” in marketable securities can enable a

37 Another less obvious risk of eschewing financial flexibility is the

occasioned by recessions

38 The income statement is a dubious measure of the success of a

company that is being managed torather than , reported profits

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39 The cash flow statement is the best tool for measuring ,which, contrary to a widely held view, is not merely a security blanket

40 In the hands of an aggressive but prudent management, a cash flowcushion can enable a company to when competitorsare forced to cut back

C H A P T E R 5 : W H A T I S P R O F I T ?

1 Profitability is a yardstick by which businesspeople can measure their

2 When calculating profits, the analyst must take care

to consider only genuine revenues and deduct all relevant costs

3 There can be no bona fide profit without Bona fideprofits are the only kind of profits in financial analysis

4 Merely , it is clear, does not increase wealth

5 An essential element of genuinely useful financial statement analysis is:

6 The issuer of the statements can or

its reported earnings simply by using its latitude to assume shorter or

2 Under intense pressure to maintain their stock prices, companies

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3 To seasoned investors, by a senior manager represents

4 Bonus-seeking managers may initially veer off the straight-and-narrow

to the following year, but they instead fall furtherand further behind Eventually, the gap between and

grows too large to sustain

5 Even when an independent accounting firm certifies that a company’sfinancials with generally accepted accounting princi-ples; the analyst must stay alert for evidence

6 Staying alert to evidence of flawed, , reporting is tial, even when the auditors

essen-7 As a rule, distorting one section of the financial statements

Assiduous tracking of a variety ofshould raise serious questions about a company’s reporting, at aminimum

8 The explanation for the sudden drop in projected earningswas that in 2001 Bristol-Myers to induce them

9 “ ” is a security analysts’ term for the financial reporting

gimmick that Bristol-Myers employed

10 Along with other pharmaceutical producers, Bristol-Myers was feelingprofit pressures due to to replace sales of products

11 Haydon was known for speaking candidly about Bristol-Myers’sdeclining sales prospects Consequently, his reassignment was

12 Also suspect was Bristol-Myers’s repeated practice of

13 The Bristol-Myers Squibb case study nevertheless illustrates the value of

14 According to Take-Two management, the adjustment arose because the

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15 to the lesson taught by many other cases of financialmisreporting, it paid to accept the Take-Two assur-ances that the company’s business prospects

16 Take-Two shipped hundreds of thousands of video games to

17 Encouragingly for users of financial statements, managers

18 In layaway sales, customers reserve goods , and thenmake additional payments over a specified period,

when they have paid in full

19 Prior to the change in accounting practice, which FAS 101 made tory, Wal-Mart booked layaway sales Under the newand more conservative method, the company began to recognize the

20 On the whole, Bally’s reported profit margins benefited from the increase

in as a percentage of total revenues The reportedearnings, however, rested on assumptions regarding the percentage of

21 As in any sales situation, aggressive pursuit of new business couldresult in On average, the newer members mightprove to be or less committed to physical fitness than

22 There was no change in the accounting principle, namely

In the case of a health club, members’ upfront feesrepresent Club operators should therefore recognizethe revenue over the period in which

23 Under GAAP, the general requirement was to spread membershipfees If a company offered refunds, it could not

until the refund period expired, unless there was

with reasonable confidence

24 Under certain circumstances, a company engaged in long-term contractwork can This result arises from GAAP’s solution to

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25 GAAP addresses the problem through the , which mits the company to recognize revenue in , rather than

per-in lper-ine with its billper-ing

26 As is generally the case with , taking liberties with thepercentage-of-completion borrows , making a surprise

28 The SEC also claimed that management at Sequoia Systems profited

29 Loading the distribution channels consists of to acceptlarger shipments of goods than

30 Loading does not boost , but merely shifts the timing

31 Inevitably, the underlying trend of final sales to consumers slows down,

at least temporarily At that point, the manufacturer’s growth in ported revenue will maintain its trend only , rela-tive to their sales If the distributors balk, , forcing

re-a , of previously recorded profits

32 Krispy Kreme revised its senior executive compensation plan.1 forth, officers would receive unless the company

33 In essence, according to the Wall Street Journal’s story, Krispy Kreme

The catch is that an asset is supposed to be Terminated stores would not seem

appeared to have come from a

1SEC v Scott A Livengood, John W Tate, and Randy S Casstevens SEC Complaint against Scott A Livengood, John W Tate, and Randy S Casstevens, May 4, 2009.

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36 Krispy Kreme increased the size of the corrections to its fiscal 2004results The previously undisclosed problems involved ,

39 A second lesson of the Krispy Kreme case is that and

often go hand in hand

40 It is impossible to assess the quality of an internal investigation without

41 Users of financial statements should not be intimidated bycorporate that denounce allegedly irresponsible

42 In 2001, Halliburton adopted an even more aggressive approach

to For some projects, Halliburton began reportingsales Previously, the policy was to book revenues

In addition, the company began keeping some puted bills on the books The previous policy was torefrain from a write-off only

dis-43 Halliburton became more aggressive about , a classic

44 If earnings look suspiciously during a

for the company’s industry, users of financial statements should

explains the disparity

45 A stock’s value is a function of expected , which partlydepend on the vis- `a-vis its competitors’

46 Generally, the initial response of corporate executives caught in a lie is

, but gratifyingly often,

47 Analysts who strive to go beyond routine canprofit by seeking of corporate disclosure, even when

48 Sometimes, management revenue recognition in order

to short-run profits The motive for this paradoxical

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behavior is a desire to report the sort of that equity

49 Grace executives reckoned that with earnings already meeting WallStreet analysts’ forecasts, a windfall the company’sstock price Such an inference would have been consistent with in-vestors’ customary that they perceive to be generated

50 Grace’s 1998 statement that its auditors had raised no objections toits accounting for the Medicare reimbursement windfall was true only

that Price Waterhouse issued clean financials, based

on materiality considerations As a spokeswoman for the auditing firmpointed out, such an opinion

51 According to Michael Jensen: “Tell a manager that he will get a bonuswhen targets are realized and two things will happen”:

a

b

52 All too often, companies wouldn’t be able to accomplish the frauds

53 According to Jensen, almost every company uses a budget system that

He proposes reforming the system by severing the

54 Even in the case of the bluest of the blue chips, watching for rising levels

should be standard operating procedure

55 When the revenues derived from fail to materialize, themanagers may resort to The positive mental attitudethat overstates revenues in the early stage , however,

C H A P T E R 7 : E X P E N S E R E C O G N I T I O N

the recognition of as they are in maximizing and

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2 Investors attach little significance to profits and losses

in valuing stocks Therefore, a public company has a strong incentive to

into a one-time event and to curring into smaller pieces and

nonre-3 Nortel Networks illustrated , one of the most

of financial reporting

4 Between September 2000 and Nortel’s market

capi-talization sank by 99%, devastating that were heavilyinvested in its shares

6 In addition to dashing hopes , Nortel rattled the

Gollogly

for producing definitive

8 Nortel’s investigation, which previously had focused on

10 Nortel followed a strategy of in its money-losing

11 Nortel’s experience shows that if a company , it will

12 An important takeaway from the Nortel case is that

General Motors’s fiddling with this device

in the integrity of financial reporting.

14 At issue in GM’s restatement was and

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15 GM said that some cash flows from that should havebeen classified among its were instead booked as

16 This revelation puzzled accounting experts because the applicable

21 Freddie Mac’s manipulation did not end there Another ploy to

consisted of ceasing to use

22 Companies can follow a variety of approaches in downplaying expensessuch as:

1 The impetus for trying to redirect investors’ focus to

or other variants has been recorded by many “neweconomy” companies

2 Users of financial statements had discovered certain limitations in netincome as a They observed that two companies in thesame industry could report similar , yet have substan-

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3 Net income is not, to the disappointment of analysts, a standard bywhich every company’s can be compared

4 The accounting standards leave companies considerable discretion

same applies to amortization schedules for

5 For some companies, the sum of net income, income taxes, and interestexpense is not equivalent to EBIT, reflecting the presence of such factors

6 Shifting investors’ attention away from traditional fixed-charge erage and toward was particularly beneficial dur-ing the 1980s, when some buyouts were so that

cov-would not cover pro forma interest expense even in agood year

7 Capital spending is likely to exceed depreciation over time as the

rea-son that capital spending may run higher than depreciation is that newlyacquired equipment may be than the old equipmentbeing written off, as a function of

8 Delaying equipment purchases and repairs that are butnot , should inflict no lasting damage on the company’s

quarters

9 Depreciation is not available as a long-run source of cash for

This was a lesson applicable not only to the tremely deals of the 1980s, but also to the more

ex-capitalized transactions of later years

10 Beaver’s definition of cash flow was more stringent than

since he did not add back either or

to net income

11 Beaver did not conclude that analysts should rely solely on the

, but merely that it was the single best

12 Some investment managers consider that the single ratio of

bankruptcy better than all of quantitative and tative considerations combined

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13 Aside from , the amount of working capital needed torun a business represents a fairly constant of a com-pany’s sales Therefore, if inventories or receivables

materially as a percentage of sales, analysts should strongly suspectthat the earnings are , even though management willinvariably offer a explanation

14 If a company resorts to stretching out its payables, two other ratios thatwill send out warning signals are:

a

b

15 Merrill Lynch investment strategist Richard Bernstein points out that

earnings tend to be more stable thanearnings, EBIT tends to be more stable than earnings,and tends to be more stable than EBIT

16 Strategist Bernstein found that by attempting to ent in companies’ earnings, investors reduced the oftheir stock selection

inher-C H A P T E R 9 : T H E R E L I A B I L I T Y O F D I S inher-C L O S U R E

A N D A U D I T S

1 Fear of the consequences of breaking the law keeps corporate managers

in line the law is another matter, though, in the minds

of many executives If their bonuses depend on , theycan usually see their way clear to adopting that course

2 Technically, appoints the auditing firm, but

is the point of contact in hashing out the details ofpresenting financial events for

3 At some point, becomes a moral imperative, but in thereal world, accounting firms must be

4 It is common for front-line auditors to balk at an

proposed by a company’s management, only to be overruled by

5 is an unambiguous violation of accounting standards,

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6 Extremely clever scamsters may even succeed in undermining the ditors’ efforts to select a procedure designed to foilconcealment of fraud

au-7 When challenged on inconsistencies in their numbers, companies

8 Seasoned followers of the corporate scene realize that companies are

9 According to president and chief executive of Trump World’s FairCasino Hotel, the firm’s focus in 1999 was threefold:

11 Abundant evidence has emerged over the years of corporate managers

to paint as rosy a picture as possible

12 To say that , however, is quite different from sayingthat

14 Systematic problems in the audit process arise not only

15 In the 1990s, emerged as a means of keeping a lid

on costs Instead of focusing on , they identified theareas that in presented the greatest risk of error orfraud, such as Incredibly, these judgments in some

16 In WorldCom’s early days, Arthur Andersen audited the company in

As the company grew, however, Andersen migratedtoward If a question arose about controls or proce-dures, Andersen relied on the

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17 Congress’s unwillingness to give the SEC reflected

18 One final line of defense for users of a company’s financial statements is

This protection has over the years

19 In one of the few encouraging notes of recent years, the SEC has imposed

a requirement on audit committee members

Rather than laying down the law (or GAAP), the auditors typicallywind up to arrive at a point where they can convincethemselves that have been satisfied

21 Given the observed gap between and

in financial reporting, users of financial statements must provide

but merely of Nevertheless, the diversified facturer responded in the ; Tyco angrily denouncedMeyer’s report, stating that

manu-3 Alert analysts had suspected something was going on behind the scenes.They questioned why in the most recent fiscal year,

to Tyco’s doubled to $21.6 billion even though thecompany reported $4.8 billion .

4 Swartz acknowledged that the amount spent on wasnot determinable from Tyco’s financial statements because it reported

and did not disclose the

5 The investigators concluded that Tyco repeatedly used aggressive,

, including immediately before sition, in order to generate Company officials referred

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