Page 98 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

READING 18: EVALUATING QUALITY OF FINANCIAL REPORTS
Answer:
1. The M-score for PPI is given as –1.53 which is higher than –1.78,
indicating a higher-than-acceptable probability of earnings manipulation.
The estimated probability of earnings manipulation is 9.58%.
2. Both DSRI and DEPI (as well as SGI) have a value greater than 1. A
DSRI value greater than 1 may indicate that the firm is accelerating
revenue recognition. A DEPI value greater than 1 indicates that the
depreciation rate was lower than in the previous year. PPI may have used
aggressive estimates for estimated useful lives or estimated salvage
values or may be adopting more income friendly methods of depreciation.
MODULE 18.2: EVALUATING EARNINGS QUALITY, PART 1
Limitations of the Beneish Model
1. Relies on accounting data, which may not reflect economic reality.
Deeper analysis of underlying relationships may be warranted to
get a clearer picture.
2. As managers become aware of the use of specific quantitative
tools, they may begin to game the measures used. This concern
is supported by evidence indicating that the predictive power of
the Beneish model is decreasing over time.
Altman Model
Developed to assess the probability that a firm will file for bankruptcy.
Relies on discriminant analysis to generate a Z-score using five
variables:
• net working capital as a proportion of total assets,
• retained earnings as a proportion of total assets,
• operating profit as a proportion of total assets,
• market value of equity relative to book value of liabilities, and
• sales relative to total assets.
Each variable is positively related to the Z-score, and a higher Z-score
is better (less likelihood of bankruptcy).
Limitation?
1. It is a single-period static model and, hence, does not capture the
change in key variables over time.
2. Similar to the Beneish model, Altman’s model mostly uses
accounting data. Other market based data sources may provide
more meaningful information for evaluation of default risk.