Financial Reporting “Red Flags” and Key Risk Factors Red Flags Complex business arrangements not well understood and appearing to serve little practical purpose. Large last-minute transactions that result in significant revenues in quarterly or annual reports. Changes in auditors over accounting or auditing disagreements (i.e., the new auditors agree with manage and the old auditors do not). Overly optimistic news releases or shareholder communications, with the CEO acting as an evangelist to convince investors of future potential growth.

Financial Reporting Red Flags (Cont.) Financial results that seem “too good to be true” or significantly better than competitors - without substantive differences in operations. Widely dispersed business locations with decentralized management and a poor internal reporting system. A consistently close or exact match between reported results and planned results – for example, results that are always exactly on budget, or managers who always achieve 100 percent of bonus opportunities. Hesitancy, evasiveness, and/or lack of specifies from management or auditors regarding questions about the financial statements Frequent instances of differences in views between management and external auditors. A pattern of shipping most of the month’s or quarter’s sales in the last week or last day. Internal audit operating under scope restrictions, such as the director not having a direct line of communication to the audit committee.

Risk Factors Relating to Management Characteristics A failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. A significant portion of management’s compensation represented by bonuses, stock options, or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results or financial position. An excessive interest n maintaining or increasing the entity’s stock price or earnings trend through the use of unusually aggressive accounting practices. Nonfinancial management’s excessive participation in, or preoccupation with, the selection of accounting principles or the determination of significant estimates.

Risk Factors Relating to Industry Conditions New accounting, statutory, or regulatory requirements that could impair the financial stability or profitability of the entity. High degree of competition or market saturation, accompanied by declining margins. Declining industry with increasing business failures. Rapid changes in the industry, such as significant declines in customer demand, high vulnerability to rapidly changing technology, or rapid product obsolescence.

Risk Factors Relating to Operating Characteristics and Financial Stability Significant pressure to obtain additional capital necessary to stay competitive considering the financial position of the entity – including need for funds to finance major research and development or capital expenditures. Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm. Overly complex organizational structure involving numerous or unusual legal entities, managerial line of authority, or contractual arrangements without apparent business purpose. Difficulty in determine the organization or individual(s) that control(s) the entity.

Net Present Value The difference between the present value of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return. For example, an investment of $1,000 today at 10 percent will yield $1,100 at the end of the year; therefore, the present value of $1,100 at the desired rate of return (10 percent) is $1,000. A positive net present value means a better return, and a negative net present value means a worse return, than the return from zero net present value.

Net Present Value Advantages Tells whether the investment will increase t he firm’s value Considers the time value of money Considers the risk of future cash flows through the cost of capital

Net Present Value Disadvantages Requires estimates of cost of capital Expressed in terms of dollars instead of a percentage or rate A primary issue with gauging an investment’s profitability with NPV is that NPV relies heavily upon multiple assumptions and estimates, so there can be substantial room for error.

Future Value Example The value of a sum after investing over one or more periods. Calculate the future value (or compound value): The initial capital investment is $85,000 The estimated value of the investment is expected to be $91,000 one year from now If the money is invested in the bank, next year they would have: FV = Cash Flow Today X (1 + r) $85,000 X (1 + 0.1) = $93,500 Using only money as a determining factor, you would have more money by investing.

Present Value Present value: The amount of money that should be put in the alternative investment (the bank) in order to obtain the expected amount next year. PV = Estimated Future Value / (1 + r) PV = $91,000/1.10 = $82,727 The initial investment costs $85,000, you would only need to invest $82,727 to get the same result It is better to invest the money

Net Present Value The net present value can also be determined by: NPV = Present Value – Initial Investment NPV = $82,727 - $85,000 = -$2,273 When the NPV is < 0, the investment option is better

Multiple Periods Future Value Where: r is the interest rate t is the number of periods FV = Initial Investment X (1 + r) 𝑡

Future Value Example What is the future value of $1,000 invested at 10% (compounded annually) for 5 years? 𝐹𝑉 = $1,000 𝑋 1 + .10 5 𝐹𝑉= $1,610.51

Multiple Periods Present Value Where: r = interest rate t = time periods PV = F𝑉 1+𝑟 𝑡

Present Value Example How much must I invest today at 10% interest, compounded annually to have $1,000 at the end of 5 years? 𝑃𝑉 = $1,000 1 + .10 5 𝑃𝑉= $620.92

Net Present Value Formula Where: Ct = net cash inflow during the period t Co= total initial investment costs r = discount rate, and t = number of time periods 

Net Present Value Example 𝑁𝑃𝑉 = $91,000 1 + .10 1 − $85,000 𝑁𝑃𝑉= −$2,273

Internal Rate of Return Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

Internal Rate of Return Formula The IRR can be found by setting the Net Present Value (NPV) equation equal to zero (0) and solving for the rate of return (IRR).

Internal Rate of Return Example