Block 2: Question block created by wizard

Question
1 of 6

Which of the following is most likely a warning sign of deteriorating earnings quality? The new policy relating
to:
compensation using stock grants.
warranty expenses.
revenue recognition.

Bogdan Andrei, an independent equity analyst, is working on his analysis of Galaxy Electronics Ltd. Galaxy is a
manufacturer and distributor of foldable smartphones that focus on security, encryption, and identity protection. The
company prepares its financial statements in accordance with US GAAP. From its inception in 2009, the company grew
rapidly to 2013, but in early 2014 sales growth slowed significantly. Andrei is reviewing recent changes in the
companys financial reporting to assess the companys quality of financial reporting and earnings.
Andrei starts with the notes he made following an update issued by Nadeen Bhatty, Galaxys vice president of finance,
on financial reporting changes Galaxy implemented in 2014.

Galaxy produces its smart phones based on orders received. A 25% deposit is required for all
orders, and then Galaxy manufactures and usually ships the units in two to four weeks. Some
orders are placed even further in advance, and some shipments may not occur for up to two
months following an order. Galaxy had been recording a sale when the product was shipped, but
under Bhattys revised policy, the revenue recognition point now occurs when the deposit is
received. If the products are made to order, then the critical event is the receipt of the order, she
had explained.

As of 31 August 2014, Galaxy received deposits of $3 million for orders yet to be shipped.

Andrei compares the descriptions of warranty expenses from the 2013 and 2014 management
discussion and analysis (MD&A), shown in Exhibit 1, and observes that similar information is
included among the notes to the financial statements.
Exhibit 1
Excerpts from Galaxys MD&A
($ thousands)
2013 Warranties
The company provides a one-year
warranty on its products and records it
as a selling and administrative expense
at the time of sale. The 2013 warranty
expense recognized is $5,000

2014 Warranties
The company provides a one-year warranty
on its products. After five years of
experience the company has realized that
the actual claims experience has been less
than the amounts accrued and has revised
our warranty estimation rate.

The company also believes its production

process has become very reliable.
Therefore, in 2014 warranty expense
($2,000) is included in non-operating
expenses.
Andrei next reviews the comparative financial information for Galaxy in Exhibit 2
Exhibit 2
Galaxy Electronics Ltd.
(U.S. $ thousands)
Condensed Income Statement
Year Ended 31 August
2014

2013

2012

$100,000

$95,000

$65,000

Gross profit

53,000

47,500

31,200

Operating expenses

32,000

38,000

28,000

4,400

2,700

3,000

16,600

6,800

200

$11,122

$4,556

$134

Sales

Non-operating expenses
Earnings before taxes
Net Income

Excerpts from Galaxt's Balance Sheet, 31 August

2014

2013

Cash & investments

$21,122

$25,000

Accounts receivable

25,000

13,500

Inventories

9,000

6,500

Prepaids and deferrals

4,000

2,000

$59,122

$47,000

$131,122

$127,000

$15,000

$11,000

Assets

Total current assets

Total Assets

Liabilities
Accounts payable
Unearned revenue
Warranty provision

4,000
2,000

4,000

Current portion of long

term debt

5,000

5,000

Total current liabilities

$22,000

$24,000

Long term debt

35,000

40,000

Total liabilities

$57,000

$64,000

Andrei prepares a Beneish Model analysis, shown in Exhibit 3, to assess the likelihood that Galaxy is
manipulating its earnings. He recalls that an M-score of 1.78 corresponds to a probability of earnings
manipulation of 3.8%.
Exhibit 3
Galaxy 2014 Beneish Model M-Score Determination
Variabl
e

Value of
Variable

Beneish Model
Coefficient

Days sales in receivables

index

DSRI

1.759

0.92

1.619

Gross margin index

GMI

0.943

0.528

0.498

Asset quality index

AQI

0.814

0.404

0.329

Sales growth index

SGI

1.053

0.892

0.939

Depreciation index

DEPI

0.932

0.115

0.107

Sales, general, and

administrative expenses
index

SGAI

0.95

0.172

0.163

Accruals

0.107

4.67

0.499

LEVI

0.861

3.270

2.815

Variable Name

Accruals
Leverage index

Contribution

Intercept
M-score

4.840
3.83

Finally, Andrei reviews his notes on Galaxys executive compensation. Since 2011, annual executive compensation has
included stock options on the companys stock. On 1 September 2014, the company introduced a restricted stock grant
program for all non-executive employees who had worked at the company for three years or more:
The fair value of the companys stock at the grant date was $4.2 million.
For the shares to vest, it requires a three-year service periodthat is, the employee has to remain with
the company for another three years.
The average volatility of the companys stock had been in the range of 38%42% during 20092011, but
since 2012, it has declined to the 19%24% range.
Correct.
The change in revenue recognition to an earlier point, before the product has been produced or delivered, is
an aggressive accounting policy that would lower the companys quality of earnings.

CFA Level II
Evaluating Quality of Financial Reports, Jack T. Ciesielski, Jr., Elaine Henry, and Thomas I. Selling.
Sections 2.2.1, 3.1
Question
2 of 6

The amount which the new revenue recognition policy contributed to gross profit in fiscal 2014 ($-millions)
is closest to:
6.4 million.
1.6 million.
4.8 million.

Incorrect.
Deposits received
Deposit as percentage of
order
Revenue recognized on
receipt of order
Gross profit margin

Increment to gross profit from

early recognition policy

$3 million
25%
$3 million/0.25 = $12 million

53% $12 million = $6.36 million

CFA Level II
Evaluating Quality of Financial Reports, Jack T. Ciesielski, Jr., Elaine Henry, and Thomas I. Selling.
Section 4.2.1
Integration of Financial Statement Analysis Techniques, Jack T. Ciesielski Jr.
Section 1
Question
3 of 6

The best conclusion Andrei can make about the classification of warranty expenses in 2014 is that Galaxys:
earnings quality is lower.
financial reporting quality is lower.
return on sales is improved.
Incorrect.
The classification of warranty expense as a non-operating item reduces Galaxys earnings quality. High-quality earnings
allow investors to identify core or recurring earnings and Galaxys core earnings are overstated when an operating cost,

like warranties, are classified as non-operating. The company disclosed the change in classification in both the MD&A
and Notes to the financial statements, thereby exhibiting high financial reporting quality.
CFA Level II
Evaluating Quality of Financial Reports, Jack T. Ciesielski, Jr., Elaine Henry, and Thomas I. Selling.
Sections 2.1, 2.2.2, 3.1, 4.1.1
Question
4 of 6

Which of the following from Andreis Beneish M-score determination is the best indicator that Galaxy could be
manipulating earnings?
The total M-score
The leverage index
The days sales in receivable index
Correct.
A DSRI (Days sales in receivable index) greater than 1 indicates an inappropriate relationship between
accounts receivable and revenue recognition and is a potential signal of earnings manipulation. For Galaxy it
is the largest positive contributor (DSRI = 1.619) that would increase the M score. Larger values for the Mscore (and contributors) are more indicative of earnings manipulation. Increasing leverage could predispose
a company to manipulate earnings but here the leverage index is negative indicating that leverage has
decreased.
CFA Level II
Evaluating Quality of Financial Reports, Jack T. Ciesielski, Jr., Elaine Henry, and Thomas I. Selling.
Section 3.2.1

Question
5 of 6

The fiscal year 2015 stock-based compensation expense from the stock grant program will be closest to:
4.2 million.
0.
1.4 million.

Correct.
The compensation expense for restricted stock grants is the fair market value of the shares on the grant date and this
amount is allocated over the three-year service period because of the three-year vesting period: $4.2 million/3 = $1.4
million
CFA Level II
Employee Compensation: Post-Employment and Share-Based, Elaine Henry and Elizabeth A. Gordon
Section 3.1
Question

6 of 6

If the recent changes in the volatility of the companys stock persist, it will most likely affect the companys
compensation expense for:
executives only.
both non-executive employees and executives.
non-executive employees only.

Incorrect.
Only the executive stock option plan is affected by volatility of the companys stock. The volatility affects the
initial valuation of the stock options granted, for example through the use of the Black-Scholes model to
determine the fair value of the options. The initial valuation of the options determines the expense
recognized. Compensation expense for stock grants is based on the fair market value of the stock on the day
of the grant and is not affected by the stocks volatility.
CFA Level II
Employee Compensation: Post-Employment and Share-Based, Elaine Henry, and Elizabeth A. Gordon
Sections 3.1, 3.2
Option Markets and Contracts, Don M. Chance
Section 7.3.5