common issues with financial ratio analysis

Welcome To

Common Issues WithFinancial Ratio Analysis

Course Overview

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Common Issues with Financial Ratio AnalysisWelcome

Welcome to the Course! • The course has two purposes: 1. Provides CPE credit. 2. Reviews content tested in Part 2, Section A of

the Certified Management Accountant (CMA) exam.

If you are already certified but not a CMA, it can serve both purposes!

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CMA Part 2 Exam Sections and Weightings

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Section Name % A Financial Statement Analysis 20%B Corporate Finance 20%C Decision Analysis 25%D Risk Management 10%E Investment Decisions 10%F Professional Ethics 15%

Common Issues With Financial Ratio AnalysisCourse Overview

CMA Part 2 Section A: Financial Statement Analysis

• 20% of the CMA Part 2. • Covered in two courses:

1. Financial Statement Analysis Using Ratios.2. Common Issues with Financial Ratio Analysis

(this course).

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Common Issues With Financial Ratio AnalysisCMA Part 2 Exam

Course Modules• Module 1: Limitations of Financial Ratio Analysis.• Module 2: Earnings Quality. • Module 3:Impact of Changes in Accounting

Treatments. • Module 4: Impact of Foreign Exchange

Fluctuations.

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Enjoy the Course• Enough of the overview, hope that you enjoy the course.

• If you are going to take the CMA exam, best of luck!

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Welcome To

Common Issues With Financial Ratio Analysis

Limitations of Ratio Analysis

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Limitations of Ratio Analysis Key Learning Objectives

1. Identify major limitations of ratio analysis. 2. Distinguish between accounting profit and

economic profit.3. Distinguish between book value and market

value.

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Common Issues With Financial Ratio AnalysisLimitations of Ratio Analysis

Major Limitations of Ratio Analysis (1 of 2) • Major limitations include:

1. Use of past data. 2. Use of historical cost.3. Different accounting standards.4. Changes in accounting treatments. 5. Operational changes. 6. Seasonal factors.

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Major Limitations of Ratio Analysis (2 of 2) • Major limitations include (continued) :

7. Inflation.8. Window dressing.9. Fraud may not be detected.

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Limitation #1: Use of Past Data • Ratio analysis by its nature is retrospective, using past data.• Forecasts are prospective (forward looking).• Firms can not include future projections in public filings.

• Past performance does not necessarily represent future performance.

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Limitation #2: Use of Historical Cost• Asset ratios are developed using accounting

data, which is based on historical cost. • Consider the treatment of these assets. • A landholding purchased 50 years ago. • Coca Cola trademark and formula.

• Other profit and business value perspectives may be more appropriate to predict future performance.

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Perspectives of Profit• Accounting profit ‐ Revenue less historical costs.• Economic profit ‐ accounting profit less implicit costs, including opportunity costs. • Opportunity cost ‐ the value given up when making a choice between two or more alternatives. • Every decision has an opportunity cost.• Cost of capital is an opportunity cost.

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Perspectives of Business Value • Accounting book value ‐ assets less liabilities = equity.

• Market cap of public companies– number of shares outstanding multiplied by the price per share.

• Market value of private companies – appraisal.• Ultimate market value of any company ‐ what someone is willing to pay to acquire it.

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Limitation #3: Different Accounting Standards • Firms in different parts of the world may use

different accounting standards.• International Financial Reporting

Standards (IFRS) –required in approximately 90 countries.

• US GAAP – used in 1 country – USA. • As of early 2020, efforts to converge US

GAAP with IFRS appear to have ceased. 15


Limitation #4: Changes in Accounting Treatments

• Changes in accounting treatments include: 1. Change in an accounting principle.2. Change in accounting estimate.3. Correction of an error.

• Any of these may alter past and future reporting. Information changes in treatments is generally found in the notes to the financial statements.

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Limitation #5: Changes In Operations• Operational changes: A company may significantly change its operational structure, impacting period to period comparisons.

• For example:• Product portfolio – new products or services, exit existing products or services.

• Impact of acquisitions or divestments. • Supply chain changes.

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Limitation #6: Seasonal Factors• Ratios can be affected by seasonal factors.• Inventory build up in advance of peak selling

season.• Accounts receivable increase following peak

selling season. • Higher levels of returns following peak

selling season.

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Limitation #7: Inflation (1 of 2)• Financial statements are released according to the company’s fiscal calendar irrespective of external economic conditions.

• Financial statements use nominal, not real values. • Nominal values ‐ unadjusted for inflation.• Real values –adjusted to take out the impact of inflation.

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Limitation #7: Inflation (2 of 2)• Common size analysis (horizonal analysis) can partially mitigate the impact of inflation when analyzing multiple periods. • Balance sheet – percent of assets. • Income statement – percent of revenue.

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Limitation #8: Window Dressing (1 of 2)• Window dressing occurs when firms make short‐term adjustments at the end of a period to improve revenues or balance sheet. • Improve revenue: Heavier than usual discounts in the final days of a reporting period. For example: • US automotive business.• Enterprise software

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Limitation #8: Window Dressing (2 of 2)• Short‐term adjustments (continued): • Improve balance sheet: Pay down current liabilities at the end of a quarter to increase current ratio, making it in compliance with debt covenants.

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Limitation #9: Fraud May Not Be Detected • For a variety of reasons, financial statements may be manipulated by the company’s management and/or employees, unbeknownst to the company.

• Fraudulent misrepresentation of information is not easily detected by ratio analysis.• Collusion – one or more perpetrators, more difficult to detect than a single perpetrator.

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Limitations of Ratio Analysis Wrap Up

You should be able to: • Identify the major limitations of ratio analysis.• Distinguish between accounting profit and

economic profit.• Distinguish between book value and market

value.

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Welcome to


Earnings Quality

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Earnings QualityKey Learning Objectives (1 of 2)

1. Identify the determinants and limitations of earnings quality.

2. Demonstrate an understanding of the relationship between revenue and receivables.

3. Demonstrate an understanding of the relationship between revenue and inventory.

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Common Issues With Financial Ratio AnalysisEarnings Quality

Earnings QualityKey Learning Objectives (2 of 2)

4. Explore the relationship between earnings and cash flow.

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Earnings Quality• Earnings quality is stability, persistence, and lack of variability in reported earnings.

• Factors in evaluating earnings quality: 1. “Conservative” vs. “aggressive” accounting

practices. 2. Relationships between revenue and

receivables, revenue and inventory. 3. Correlation of earnings and cash flows.

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Key Relationship: Revenue and Receivables• In general, the relationship between revenue and receivables should remain consistent.• Revenue is a leading indicator of receivables.

• Potential causes of receivables growing faster than revenue: • Change in credit terms.• Change in credit policies.• Receivables collection issues.• New markets.

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Key Relationship: Revenue and Inventory• Companies prepare for future revenue streams by increasing inventory levels. Inventory growth should be followed by revenue growth.• In general, inventory is a leading revenue indicator.

• Potential causes of inventory growing faster than revenue: • Unanticipated reduction in market demand.• Inventory management issues. • Change in inventory valuation methods.

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Key Relationship: Earnings and Cash Flow• Increased earnings should correlate to increases in cash flow from operations. • Income statement earnings are on an accrual basis, which ignores cash flow.

• The cash flow from operations section of the cash flow statement is essentially the cash basis of accounting.

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An Underappreciated Ratio• Positive cash flows follow earnings. • For companies with increasing earnings, a consistent slower rate of growth of cash from operations is a red flag to be analyzed.

• A simple ratio to monitor is: • Quality of earnings ratio: Cash flow from operations / Net income.

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Earnings vs. Cash Flow• Harold Williams, Chair of Securities and

Exchange Commission (1977‐1981).• “If I had to make a forced choice between earnings information and cash flow information, I would take the latter.”

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Case Study: Lucent Technologies (1 of 5)• Lucent was spun off of AT&T in 1996.• The $3.025 billion Initial Public Offering (IPO) was the largest ever at the time.

• The initial results after the IPO were stellar. • Lucent’s net income increased from $470 million in FY 97 to $1.06 billion in FY 98 to $4.79 billion in FY 99.

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Case Study: Lucent Technologies (2 of 5)• Lucent became a "darling" stock of the investment community. By late 1999: • Split‐adjusted IPO price of $7.56/share was over $84.

• Market capitalization was over $258 billion.• Over 5.3 million shareholders made it the most widely held US firm.

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Case Study: Lucent Technologies (3 of 5)• While revenue increased, net income and operating cash flow did not follow.

• How stable are the earnings and cash flow?

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$ Millions FY 00 FY 99 FY 98Revenue $33,813 $30,617 $24,367Net Income $1,219 $4,789 $1,065Operating cash flow $304 $(962) $1,452Average receivables $9,998 $8,689 $6,156

Case Study: Lucent Technologies (4 of 5)• 2 key ratios has negative trends.

• Cash flow ratio: For every $ of earnings, there was $1.36 of cash flow in FY 98, $(.20) of cash flow in FY 99, and $.25 in FY 00.

• DSO: Should remain constant if processes are good. 37


FY 00 FY 99 FY 98Cash flow ratio (Operating cash flow / net income)

.25 (.20) 1.36

Days sales outstanding (DSO)

108 days 104 days 92 days

Case Study: Lucent Technologies (5 of 5)• In May 2004 the SEC charged Lucent and 10 individuals with fraudulent reporting for fiscal year 2000.• $511 million revenue prematurely recognized.• $637 million of revenue was fictitious• Improper and fraudulent accounting actually started in 1996, perhaps earlier.


Earnings QualityWrap Up (1 of 2)

You should be able to: • Identify the determinants and limitations of

earnings quality. • Demonstrate an understanding of the

relationship between revenue and receivables. • Demonstrate an understanding of the

relationship between revenue and inventory. 39


Earnings QualityWrap Up (2 of 2)

You should be able to (continued): • Identify the relationships between earnings and

cash flow.

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Welcome To


Impact of Changes in Accounting Treatments

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Impact of Changes in Accounting TreatmentsKey Learning Objectives

1. Describe the three types of changes in accounting treatments (principles, estimates, and errors).

2. Describe how to adjust financial statements for changes in accounting treatments.

3. Explain how adjustments for changes in accounting treatments impact financial ratios.

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Common Issues With Financial Ratio AnalysisImpact of Changes in Accounting Treatments

Accounting Policies and Estimates • Firms establish unique accounting principles (policies) for consistent reporting. • Inventory valuation – Lifo vs. Fifo. • Fixed asset depreciation.

• Estimates are inherent in accrual accounting.• Allocations of revenue and expenses, fixed asset lives, future liabilities, etc.

• Can change based on business conditions. 43


Accounting ErrorsErrors can result from a number of situations: • Unintentional mistakes. • Transpositions.• Misunderstanding. • Noncompliance with GAAP. • Fraud.• Collusion.

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Changes in Accounting Treatments • This module discusses the following 3

accounting treatments: 1. Change in accounting principle. 2. Change in an accounting estimate. 3. Correction of an error.

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Relevant US GAAP 1. Accounting Principles Board, Opinion #20

“Accounting Estimates” (Issued in 1971).• APB 20.

2. FASB Statement No. 154, “Accounting Changes and Error Corrections” (Issued in 2005).• FASB 154.

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APB Opinion 20 vs. FASB 154• Difference is in how changes in estimate and error correction are handled.

• APB 20 had a “catch‐up” approach; the cumulative changes were reported on the current year’s income statement.

• FASB Statement 154 requires retrospective application of voluntary changes in accounting principles to prior periods’ financial statements.

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FASB Statement 154 (1 of 2)• Retrospective “application of change in accounting principle” approach eliminated all cumulative adjustments to current income.

• In addition, requires presentation of pro forma information before change and after change.

• The purpose was to enhance the consistency and comparability of financial information over time and between companies.

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FASB Statement 154 (2 of 2)• Part of a broader FASB effort to improve the analysis of cross‐border financial reporting.

• At the time, the FASB and the International Accounting Standards Board (IASB) were working towards US adoption of International Financial Reporting Standards (IFRS).

• As of 2020, US efforts to adopt IFRS have stalled.

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Treatment # 1: Changes in Accounting Principle• Example of change in accounting principle: • Change inventory valuation from LIFO to FIFO.

• Companies must retrospectively apply all changes in accounting principle to previous‐period financial statements unless impracticable.• Impracticable ‐ unable to apply new principle to previous periods after making “every reasonable effort”.

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Making a Change in Accounting Principle (1 of 3)• Approach: Adjust prior financial statements by applying a “different accounting principle to prior accounting periods as if that principle had always been used”.

• Need to disclose: 1. Description and reason for the change. 2. Explanation of why the new principle is

preferable. 51


Making a Change in Accounting Principle (2 of 3)Disclosures (continued): 3. Description of the prior‐period information

that was retrospectively adjusted. 4. Present the effect of the change on income

from continuing operations, net income, and per‐share amounts for the current period and any prior periods retrospectively adjusted.

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Making a Change in Accounting Principle (3 of 3)Disclosures (continued): 5. Disclose the cumulative effect of the change

on retained earnings as of the earliest period.

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Treatment #2: Change in Accounting Estimate

• Changes in estimate include: • Change in calculation of allowance for doubtful accounts.

• Change in asset life.• Change in calculation of warranty reserve.

• Approach: Always treated prospectively ‐current and future periods, not past periods.

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Disclosures of Changes in Accounting Estimate

• If material, disclose the nature and amount of that the change has in the current period or is expected to have an effect in future periods.

• If immaterial, do not disclose the alteration.• Most changes in reserves and allowances are immaterial.

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Changing Depreciation Methods • Changing depreciation methods is treated as a change in accounting estimate. For example: • Making a change from double declining balance to straight line method of depreciation expense is a change in estimate.

• Changing depreciation methods is not a change in accounting principle.

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Treatment #3: Error Corrections (1 of 2)• Can result from unintentional accounting errors, fraud, and noncompliance with GAAP.

• Materiality of error must be considered. • If material, need to restate previously issued financial statements. • Negative restatement often shakes investors' confidence and causes the stock's price to decline.

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Treatment #3: Error Corrections (2 of 2)• Companies must report the correction of errors in previously issued financial statements as retroactive prior‐period adjustments, restating the prior‐period financial statements.

• The carrying value of balance sheet accounts is adjusted for the cumulative effect of the error for periods before the earliest restated period.

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Impact on Financial Statement Users From Changing Prior Period Results

• Any time a company restates its financial results, it raises a red flag and prompts stakeholders to dig deeper.

• Users of the financial statements may have difficulty understanding the differences between the two types of changes to prior period statements.

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Both Change Prior Periods: Are They the Same?

1. Retrospective applications for changes in principle, also called revision restatements• “little r”

2. Retroactive restatements for error corrections, also called reissue restatements.• “Big R”.

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Restatements in 2018 • According to Audit Analytics (www.auditanalytics.com) 471 public companies amended their 10‐K SEC filings in 2018. • Of these, 70% were retrospective applications (revisions or “little r”).

• The other 30% were retroactive restatements (reissue or “Big R”).

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Summary of Changes to Financial Statements

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Type Description Financial Statement Impact

Changes in principle

Retrospectiveapplication

Adjust prior periods “as if” the principal had been in place.

Changes in estimate

Prospective change

Change basis for financial statements going forward.

Errors Retroactive restatement

Restate prior periods to remove impact of error.


Impact on Ratio Analysis

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Type Impact on Financial RatiosChanges in principle

Need to revise all ratios that used the old information.

Changes in estimate

Be aware that comparability of statements before and after may affected.

Errors • Need to revise all ratios that used the old information.

• Is a deeper dive necessary, especially with a major restatement or fraud?


Impact of Changes in Accounting TreatmentsWrap Up

You should be able to: • Describe the three types of changes in

accounting treatments. • Describe how to adjust financial statements for

changes in accounting treatments. • Explain how adjustments for changes in

accounting treatments impact financial ratios64


Welcome to


Impact of Foreign Exchange Fluctuations

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Impact of Foreign Exchange Fluctuations Key Learning Objectives (1 of 2)

1. Define functional currency, reporting currency, and transaction currency.

2. Identify differences between foreign currency translations and foreign currency transactions.

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Common Issues With Financial Ratio AnalysisImpact of Foreign Exchange Fluctuations

Impact of Foreign Exchange Fluctuations Key Learning Objectives (2 of 2)

3. Identify issues in the accounting for foreign operations. • Historical rate vs. current rate.• Treatment of transaction and translation gains and losses.

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Foreign Currency Accounting• 3 keys in accounting for foreign currency

exchange fluctuations are: 1. Type of foreign currency exchange ‐

translation or transaction. 2. Time frame ‐ end of period or over a period. 3. Exchange rate to use ‐ depends on type and

time frame.

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Functional Currency• An entity’s functional currency is the currency of the primary economic environment in which the entity operates. • The principal currency the business uses to generate and expend cash.

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Reporting Currency• Multi‐national companies consolidate foreign

subsidiaries from the subsidiary’s functional currency to the parent’s reporting currency. • This currency is the reporting currency.

• A company has to report consolidated financial statements in one currency, no matter how many functional currencies its subsidiaries have.

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Financial Statement Impacts • Foreign currency exchange differences impact financial statements 2 different ways: 1. Currency translations – translating financial

statements from functional currency to the reporting currency.

2. Currency transactions – a business transaction uses a currency different than the functional currency.

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Foreign Currency Translations • If the functional and reporting currencies are different, the functional currency financial statements are translated to the reporting currency as part of the consolidation process.

• Translation adjustments are reported in the other comprehensive income section of equity as a “Cumulative Translation Adjustment (CTA)”.

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Recording Foreign Currency Translations• Balance Sheet translations – use the exchange rate on the balance sheet date.• Last date of the reporting period.

• Income Statement translations ‐ use the average rate over the reporting period.

• Foreign currency translations are not realized(unrealized) and have no cash flow impact.

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Cumulative Translation Adjustments (CTA) • Recorded in the equity section of a translated balance sheet.

• Summarize the cumulative unrealized gains/losses resulting from exchange rate fluctuations.

• Help external indirect users to differentiate between actual operating gains/losses and those generated via translation.

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Foreign Currency Transactions (1 of 2)• Foreign Currency Transactions – a transaction not denominated in an entity’s functional currency. 1. Functional currency – currency business

generates and expends cash.2. Transaction currency – specific to the

situation.

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Foreign Currency Transactions (2 of 2)• Foreign currency transactions are realized

and have cash flow impacts. • Typically are the settle up of payables and receivables.

• Difference between accrual and cash paid or received is a gain or loss on the income statement.

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Foreign Currency Transaction Example (1 of 4)• A US company provides services to a Canadian client, and invoices in Canadian dollars at the client’s request on March 1. • Invoice for $1,100,000 Canadian dollars (CAD).• The exchange rate on the sale date is $1 USD

= $1.10 CAD. • The transaction is recorded in United States dollars (USD) on the selling company’s books.

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Foreign Currency Transaction Example (2 of 4)• March 1 ‐ journal entry to record sale (USD)

Debit: Accounts receivable $1,000,000.Credit: Revenue: $1,000,000

• On June 1 the receivable is collected. The exchange rate is $1 USD = $1.20 CAD.

• The $1,100,000 CAD collected is exchanged into $916,667 USD. ($1,100,000 CAD/ $1.20 CAD)

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Foreign Currency Transaction Example (3 of 4) • The $916,667 USD collected is $83,333 less than the $1,000,000 USD receivable.

• How is the $83,333 recorded? It is a realized foreign exchange loss.

• June 1 ‐ journal entry to record collection (USD)Debit: Cash $916,667Debit: Exchange loss $83,333

Credit: Accounts receivable $1,000,000 79


Foreign Currency Transaction Example (4 of 4)• There is always a foreign exchange gain or loss if the exchange rates on the date of the sale and the date the receivable is collected are different.

• Exchange gains and losses are recognized in the continuing operations section of the income statement.• Hedging is a strategy to mitigate foreign currency exchange rate risk.

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Impact of Foreign Exchange Fluctuations Wrap Up

You should be able to: • Define functional, reporting, and transaction currencies. • Identify accounting differences between foreign currency translations and foreign currency transactions.

• Identify issues in the accounting for foreign operations. • Historical costs vs. current rate.• Treatment of translation and transaction gains and losses.

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common issues with financial ratio analysis

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