This week is a little different than the past two weeks. Complete discussion 3 using the financial statements from the firm you have chosen for your AAER paper. Then choose one of the earnings management techniques we have read about (chapters 12 through 18 in the text). Ideally it would be a technique used by your AAER firm but that is not required. You should choose a ratio that would be impacted by the earnings management technique you chose.
First calculate a time series of your ratio using the financial statements as reported.
Second you should recalcuate your ratio using either (A, B or C)
- restated financial statements if available,
- adjusting the financial statements based on reports in the AAER that indicate by how much the firm misreported a particular account, or
- making your own adjustment assuming your firm misreported one or more of its accounts by $100 million.
You will have to choose option C if you chose an earnings management technique that your AAER firm is NOT using. For example, if a firm is reporting bogus revenue of $100 million then accounts receivable would be $100 million to high and revenue would be $100 million to high.
Complete steps 1-7 of the ratio analysis using the as reported numbers and the adjusted numbers and compare them.
Step 1
Find the company or companies on the Securities and Exchange Commission (SEC) website. I recommend that you analyze only one of the two companies but the choice is up to you. For some students doing two companies and being able to compare and contrast the companies helps them to focus their analysis. However, for most students the additional work of calculating the ratios for two companies causes them to do a superficial analysis. The quality of the analysis will influence your grade much more than the quantity of your analysis. Go to the website www.sec.gov to find the financial statements. In the top right corner click on ‘Company Filings’. In the box under ‘Company Name’ Type in the company name exactly as I have listed it. That should get you close enough to see what company to select. I will assign the companies and the fiscal quarters you should focus on. The financial statements you want are under filing type 10-Q and 10-K. If you type in 10-Q or 10-K under the filing type box and then search it will bring up all of the financial statements for the firm. I would recommend using the 10-Q because quarterly statements are simpler and it is easier to find the financial statements but it is up to you.
Step 2
Calculate several ratios—I would suggest at least one from each of the categories (profitability, liquidity, solvency, and activity/efficiency) from chapter 4 (chapter 11 in Marshall) in the text plus at least one ratio that you have found somewhere else or even made up. You should examine these ratios over a 4 year period (No need to look at every quarter). For example you might look at quarter 2 every year for 4 years—including the quarter that I have chosen. Once you are used to looking up financial statements–if you do this strategically you should be able to examine 4 years of data by looking at only two separate years of financial statements. Please do not discuss all of these ratios. Your goal in calculating a number of ratios is to increase your chances of finding a ratio that is interesting and important.
Step 3
Choose a primary ratio to discuss. This is a critical choice. To score above 92 on the discussion posts I expect you to impress me. You need to point out interesting relations between your ratio and other ratios that help provide insight into one of the companies or insight in comparing the two companies. A poor choice of your primary ratio makes it difficult to have an impressive discussion. For example if you choose the current ratio and that ratio has not dramatically changed over the time period you are analyzing (say it fluctuates between 1.5 and 1.7) and it is above 1.2—then this ratio is not capable of providing significant insight into the firm. Choosing an insightful primary ratio is part of the analysis. That is why you may want to calculate a number of ratios before you choose the one you think is most interesting. Do not choose more than one primary ratio to discuss. It is not uncommon for students to try and discuss and analyze several primary ratios. In this case I choose the ratio that students have analyzed the best—and completely ignore the rest. These students often get a mediocre score because it is a lot of work to thoroughly analyze one ratio and because they are trying to do several ratios they end up doing a superficial analysis on all of them. The quality of the analysis will influence your grade much more than the quantity of your analysis.
PROHIBITED RATIOS
There are some ratios that either do not provide a lot of information or are almost always misinterpreted by students. Consequently some ratios are banned from your analysis.
Cash Ratio—use the current ratio or acid-test ratio if you want to analyze liquidity
Working Capital—use the current ratio or acid-test ratio if you want to analyze liquidity
Earnings Per Share
Earnings Quality if it is a negative value.
Debt-to-Equity—use the debt ratio instead (total liabilities divided by total assets)
Ratios where the values are negative during the entire time-series you are analyzing.
Any ratio where the denominator is negative
I also strongly recommend that you do not use market ratios such as dividend yield and the P/E ratio. These tend to be much more complicated and in 6 semesters of teaching this class I have only seen a few excellent discussion posts that have used a market based ratio for their primary ratio. Nevertheless if you really want to examine these ratios and are sufficiently confident in your understanding of them then I do not want to restrict you.
Step 4
Explain your definition for your primary ratio. Provide one sample calculation for one of the quarters you are examining. For example you might say
—I chose the current ratio. It is defined as current assets divided by current liabilities. For Quarter 2 in 2010 the ABC Company has a current ratio of 2.0. Current assets are 40,250,800. Current liabilities are 20,125,400. So the current ratio is 40,250,800/20,125,400 = 2.0. No need to provide this much detail for every quarter you analyze. Once is enough for your audience to see your definition and how you calculate it.
Step 5
Discuss why you chose your primary ratio. What can this ratio tell about the company? Are their particular values that are significant for this ratio? For example, a ratio of 1.0 for the current ratio is generally considered significant because ratios below one usually point to a lack of sufficient liquidity. Convince me that your primary ratio is providing insight about the company.
Step 6
Provide a time-series analysis of your primary ratio—at least 4 years (using the same quarter each year). You should be able to do this by examining two sets of financial statements. If you are examining quarter 2 for the period from 2000 through 2003 you could look at the financial statements for 2001 and 2003 and that would provide you the information to make calculations for quarter 2 for each year from 2000 to 2003. Explain what is happening with your primary ratio over the time period you are examining. Is your ratio increasing—decreasing—trending—describe what is happening to your ratio over this time period. Everyone should be able to complete steps 1-5. You are just following my instructions. This step—step6 and the remaining steps will give each student the opportunity to demonstrate their analyzing abilities and creativity in discussing something interesting and significant about the company and its situation.
Step 7
Examine the numerator and denominator of your primary ratio. Step 7 and especially step 8 is where each student has the opportunity to demonstrate their analyzing abilities and creativity in discussing something interesting and significant about the company and its situation. Describe the numerator and denominator. Describe whether they are increasing or decreasing, trending, or scattered or just what is happening with them over time. Just like you did with the primary ratio by itself in step 6. How much of the variation in your primary ratio is explained by the numerator or denominator? Is one or the other the dominant reason for the value and/or the changes in the value of the primary ratio. This is where your choice of a primary ratio becomes critical. If you choose a primary ratio that has not varied over time and neither the denominator nor the numerator are varying then you will not have a very interesting analysis.
