Moody’s credit analysis focuses on the fundamental factors and key business drivers relevant to an issuer’s long-term and short-term risk profile. The foundation of Moody’s methodology rests on two basic questions:
- What is the risk to the debtholder of not receiving timely payment of principal and interest on this specific debt security?
- How does the level of risk compare with that of all other debt securities?
Actions to reduce earnings management and accounting fraud - What are some key actions done in the last decades to reduce earnings management and accounting fraud?
Key mechanisms introduced after 2001 have been to tighten regulations – came after the IT bubble and Enron scandal:
1) More detailed accounting rules, and the discussion of ‘true and fair’ view
2) Improved enforcement and oversight boards
3) Stricter regulation of auditors
4) Increased requirements for corporate governance, some hard law and
others soft law
Assets consist of operating non-current and current assets, and financing assets. What are the different sources of financing these?
Equity, non-current and current financing (interest-bearing) liabillities and operating liabilities
By what ability is a firm’s liquidity risk influenced by?
Its ability to generate positive net CF in both the short and long term.
Define accounting quality by the two fundamental questions
Is the financial reporting a faithful representation: complete, neutral, and free from error
Relevant information for users: information about the firm’s underlying economic position and performance’
There are different ways for defining accounting quality. The most common is Gaynor and it also depends on the audience (users) “more complete, neutral and free from error and provides more useful predictive or confirmatory information about the firm’s underlying economic position and performance’” Gaynor et. al. (2016)
Define accounting quality from the analysts
“the extent to which an issuer’s reported historical performance is a sound basis for forecasting its future financial performance.”
Describe the course of the rating process, a Moody’s analyst
- Gathers information sufficient to evaluate risk to investors who might own or buy a given security, - evaluate the risk
- Develops a conclusion in committee on the appropriate rating,
- Monitors the security on an ongoing basis to determine whether the rating should be changed, and
- Informs the marketplace of Moody’s actions.
DuPont model– three categories when you grow EVA
Changes in core business: operations, investments in existent businesses, and investments in new business segments
- Transitory items: country changes its tax rate, accounting principles, accounting estimaties
- Financial items (WACC): capital structure, interest rate, risk, and tax rate
Example of financial performance measures (incentive plans) and what are the issues with them?
• Revenue growth • EBITDA • EBIT • Consolidated Profit • eps (earnings per share) Issues • Change in accounting • ”Extra-ordinary” items • Alignment, example EPS and share buy-backs (that impacts the EPS)
Example of non-financial performance measures (incentive plans) and the issues?
- Customer satisfaction
- Customer retention
- Employee satisfaction
- Specific activities (for example Selling Russian operation)
Issues
• How to measure
• Judgments (based on judgements)
Example of stock returns measures (incentive plans)
- Absolute returns
- Relative returns
* to market
* to comparable - Short and long-term
Explain the normal, flat, and inverted yield curve
Normal - increasing interest rate over time
Flat - no difference between time and interest rates
Inverted - the long-term interest rate is lower than the short-term interest rate
FFO (funds from opeations) formula (S&P)
EBITDA - net interest expense - current tax expense (plus or minus all applicable adjustments)
– here you have paid the interest and the tax, but you have not made any investments yet so it is a proxy for recurring CF.
Formula for cost of equity (re)
re = rf +Be ( rm - rf )
How can you distinguish from the SML if an asset is under- or overvalued
Any asset above the SML is undervalued, and any asset below the SML is overvalued
How is earnings management defined?
”Earnings management occurs when managers intentionally use judgement in financial reporting and in structuring transactions to alter financial reports to mislead some stakeholders about the underlying economic performance of the firm or to influence contractual outcomes that depend on reported accounting numbers.”
WACC formula
WACC = E/V * re + D/V * rd* (1-tax rate)
What are the choices of performance measures for incentive plans?
Stock returns, financial performance measures, and non-financial performance measures
What are the events/circumstances when earnings management is more frequent?
- Financial distress
- Capital market events – if you were to acquire another company using your own shares then it is beneficial if your shares are valued high
- Change of management – management want to take out all losses and make provisions when there is a new management entering
- Change of auditors
- Changes in rules and regulations
- Implementation of incentives for managements
