FT11105 FSAV Take Home Test

1. Using information in financial statements as originally reported in Exhibits 5.27 to 5.29; compute the value of Beneish¶s manipulation index for fiscal year 5 and 6. Answer: Beneish developed a statistical model to identify the financial characteristics of companies which are likely to engage in earnings manipulation. The Beneish model used here uses 8 factors to measure the likelihood of the firm manipulating its financial statements. Using these 8 factors Beneish manipulation score is calculated. Using the manipulation score, we calculate the probability of manipulation using the NORMSDIST function of excel. For Millennial technologies, Beneish score for year 5 is -0.21 and probability of manipulation is 41.5%. Therefore with a high level of confidence we can say that Beneish might have worked its financial statements. For year 6, the Beneish score is 0.94 and probability of manipulation is 82.52% indicating that there is a high risk that Millennial could have indulged in earnings manipulation. S.No Index Formula Year 5 Index value 1.56 Year 6 Index value 1.04

1

Days sales in receivables index Gross margin index Asset quality index Sales growth index Depreciation index Selling and Administrative expense index Leverage index

ratio of accounts receivable to sales for current year/ratio of accouns receivable to sales for previous year Gross margin as a percentage of sales last year/gross margin as a percentage of sales for current year proportion of lower quality assets during current year/proportion of lower quality assets during the preceding year sales of current year / sales of previous year ratio of depreciation expense to PPE for previous year/ratio of depreciation expense to PPE for current year ratio of SGA to sales for current year/ratio of SGA to sales for previous year proportion of total financing comprising currnet liabilities and long-term debt for the current year relative to the proportion for the preceding year Accruals (net income - operating cash flow) as a percentage of total assets for current year

2

1

1.2

3

0.99

0.09

4 5

1.52 1.1

3.04 1.68

6

1.18

0.45

7

2.12

0.54

8

Total accruals to total assets

0.36

0.32

9 10

Beneish's manipulation y value Probability of Manipulation

-0.21 41.50%

0.94 82.52%

However. This indicates that the firm is financing most of its debt . Since the future benefits of these assets is less certain. Or.9 in year 4 to 4. indicate possible signals that millennial technologies might have been manipulating its financial results. y The long term debt ratio of the company is very low at 0. a higher proportion of ³other assets´ will raise some doubts.30. Other assets usually include categories like Good will or capitalized costs. y Accounts receivable turnover has decreased from 6. This would mean that some of its account receivables are fictious or bad debts have increased. Using information from Beneish¶s manipulation index and financial ratios in Exhibit 5. there has been a steady increase in the gap between accrual based profit and operating cashflows.Aditya Goel FT11105 FSAV Take Home Test 2. which have not been disclosed. This indicates that the quality of the assets is not that high. which is very abnormal. This means the company will need lot of funding.1% in year 6. This drastic reduction will raise doubts whether expenses are being capitalized. y Accounts receivable and inventories make up 60% to 70% of the total assets. This is a very strong signal that there could be some earnings manipulation which needs to be probed further. its long term debt to equity ratio is less than 1% where as its short term notes payable is pretty high. Beneish index helps to identify the financial characteristics of companies which are likely to engage in earnings manipulation. the Beneish index predicts a 41% probability of earnings manipulation in year 5 and 82% probability of manipulation in year 6. y Days account payable has halved from 63 in year 5 to 39 in year 6. This means that company is taking more time to convert its receivables to cash. y The firm is growing very rapidly at around 230% and will therefore need lot of funds. This might indicate that suppliers are demanding their money to be paid faster because they might have an indication of the problems with the company. Apart from the Beneish index.8%. y Selling and general administrative expenses as a percentage of sales has decreased from 27% in year 5 to 12.6 in year 6. For Millennial technologies. This might mean that the company is not confident of paying interest on debt on a regular basis (probably because it knows the status of its operations) and is therefore preferring equity. y A significant portion of the assets are classified as ³other assets´. Sales are growing at a rate of 230%. Also. This should indicate that the firm could be resorting to some manipulation of accrual profit. y Operating cashflows are negative for all the years. management has included certain other items in accounts payable. This means that the company is having lots of uncollectible accounts or outdated inventory and is not writing them off properly. the below mentioned issues raise doubts about the accuracy of the financial statements: y A significant increase in accounts receivable as a percentage of sales in both year 5 and year 6 indicate that there might be some fictious sales or some relaxation of credit terms to push sales. but most of funding is through equity even though equity is costly compared to debt.

3. No change Manipulating inventory balances by including dummy boxes y Effect on balance sheet: a. No change Failure to write down inventory for product obsolescence y Effect on balance sheet: a. III. . y Effect on cash-flow statement: a. Higher assets II. Answer: The effects of the accounting irregularities are discussed I. V. Higher assets due to increase in accounts receivable b. No change Capitalization of costs y Effect on balance sheet: a. IV. Higher than actual assets due to increase in inventory b. income statement and statement of cashflows.Aditya Goel FT11105 FSAV Take Home Test through short term borrowing. Higher revenues for the current period at the expense of next period y Effect on cash-flow statement: a. This might be because there is no long term borrower willing to lend since they are not convinced about the firms sustainability. Describe the effect of each of the eight accounting irregularities on balance sheet. Higher assets due to increase in inventory y Effect on income statement: a. Higher share holder equity due to increased retained earnings (retained earnings increase due to higher profit reported) y Effect on income statement: a. Higher profits because of lower cost of goods sold. Higher share holder equity due to increased retained earnings (retained earnings increase due to higher profit reported) y Effect on income statement: a. Higher profits because the losses in inventory are not accounted for y Effect on cash-flow statement: a. Lower inventories because inventories are converted as sales c. Recording of invalid sales transactions y Effect on balance sheet: o Higher assets because of increase in accounts receivable o Higher share holder equity due to increased retained earnings (retained earnings increase due to higher profit reported) y Effect on income statement: o Higher revenues y Effect on cash-flow statement: o No change Recording of revenues from bill and hold transactions y Effect on balance sheet: a.

33. 4.27 2. VIII. Higher profits because losses on investments are not booked y Effect on cash-flow statement: a.53 Year 5 1.61 0. Higher profits because some of the costs are not included Effect on cash-flow statement: a. Most important of these are the liquidity and solvency figures of the firm. and the information provided in the case. No change Failure to write-down investments even after the investments have lost significant value y Effect on balance sheet: a.18 2. would you as a commercial banker be willing to offer millennial technologies a line of credit as of July 31. Manipulation of prepaid licenses as advances y Effect on balance sheet: a.31 to 5. No change VI. Higher profits because of lower amortization costs y Effect on cash-flow statement: a.34. No change Failure to provide adequately for uncollectible amounts in accounts receivable y Effect on balance sheet: a. year 7? State the conditions that would induce you to offer such a line of credit? Answer: A number of factors need to be considered before a lending decision is made. Higher assets due to overvalued accounts receivable account y Effect on income statement: a. No change VII. y Effect on income statement: a.20 0. Higher revenues because lower y Effect on cash-flow statement: a. Change in composition of assets ± the ³prepaid asset´ account is undervalued where as ³notes receivable´ account is overvalued.25 Year 6 4.74 Year 4 5.Aditya Goel FT11105 FSAV Take Home Test y y b. the financial ratios is Exhibit 5. Higher assets shown on balance sheets y Effect on income statement: a. Using information in the restated financial statements in Exhibits 5. Higher share holder equity due to increased retained earnings (retained earnings increase due to higher profit reported) Effect on income statement: a.55 . Some of the important liquidity and solvency ratios for Millennial technologies are given below: Ratio Liquidity ratios Current ratio = quick ratio= Year 7 1.

17 -2. Accounts receivable and inventories turnover ratios are pretty high and have been increasing from year to year as shown above.55 -78.00 0. Circumstances leading to the need for loan: Millennial technologies needs cash to finance its working capital needs.Aditya Goel Operating cash flow to current liabilities ratio = Accounts receivable turnover = Days receivables outstanding = Inventory turnover = Days inventory held = Solvency ratios Long term debt ratio = Debt to equity ratio = Liabilities to assets ratio = Interest coverage ratio = Interest coverage ratio based on cashflows = Operating cashflows to total liabilities ratio = -0.20 4.01 0.00 0.76 47.63 0.01 0.00 0.44 -108. It is not able to move its inventories or collect cash promptly.23 FT11105 FSAV Take Home Test 7.56 3. Also. .46 -3.08 -88. Collateral: Most of the firm¶s assets are made up of accounts receivable and inventories. Therefore.57 -58. Therefore there is significant credit risk involved. there is considerable risk involved in liquidating the collateral. Given the firms problems with collection of receivables the value of the receivables on book might be overstated and difficult to liquidate if need be.02 3.14 0. Cashflows: y y y The firm has significant negative cashflows from operations.40 82.11 -21.94 6.55 0.23 Let us look at each factor affecting the lending decision one by one.22 -10.03 0. The line of credit will be used to finance accounts receivable and inventories.45 -3. Also.04 0. However. the firm has significant operational problems.03 -3.51 -1.04 0. There are no marketable securities as of year 7.81 5.50 -0.15 59.31 -1.13 116.14 -2.36 108.39 107.15 4.71 63.00 0. Operating cashflows to total liabilities and operating cashflows to current liabilities is still negative but has improved in year 7. the firm has been unable to monetize its inventories or collect cash promptly from customers. the firm is a fast changing industry and its inventory could turn obsolete very soon.92 -2.75 76.68 3.

S. Contingencies: The firm faces huge contingency risk from unresolved class action law suits and other penalties that might be imposed by regulators. Having said that. It uses five factors to calculate the Z score. 5. receivable and inventory turnovers. Year 7. while Z-scores above 3 indicate a low probability of bankruptcy. Scores between 1.21111853 0.089241767 -1.Aditya Goel FT11105 FSAV Take Home Test Capacity for debt: The firm¶s long term debt to equity ratio looks good because there is no long term debt.255716866 Weight of the factor 1 2 3 4 5 (Net working capital / total assets) Retained earnings/total assets EBIT/total assets Market value of equity/Liabilities Sales/Total assets Altman Z score 1. I would insists on y y y y Significant restructuring of operations. Compute Altman z-score for fiscal year ending on March 31. Higher collateral and interest margins New equity infusion into the company.840911754 2. Answer: Altman Z score can be used to predict the likelihood of bankruptcy for the firm under consideration.81 indicate a high probability of bankruptcy.047501856 -0. The firm has been unable to generate cash from its operations and has been sustaining itself on cash raised from share holders in Year 6. Debt covenants which keep a tight leash on cash available.4 3.3 0. Can millennial technologies avoid bankruptcy as of mid year 7? Why did not Altman model signal the financial difficulties earlier than they do? Answer: .81 and 3 are in the gray area. This indi cates that the probability of bankruptcy is very high. If I were to lend. The Z-score for Millennial technologies as on 31st March. Considering these adverse factors. Year 7 is -2.No Factor Value of the factor as on March 31st. I would be very sceptical about providing a line of credit to Millennial technologies. Year 7 0.552033283 -2. the firm¶s debt to equity ratio is 44% indicating that there is some scope for raising long term debt if the firms operations improve in the future.26. Z scores below 1.2 1.6 1 6. This is because the firm is in distress and no one is willing to lend. Character of management and corporate governance structures: Recent events show that the management is not trustworthy and the firm lacks adequate control structures.

the Z score was high and could not predict the possibility of bankruptcy. it does not have quality assets to put as collateral and raise loans. it is difficult for the firm to avoid bankruptcy. Altman score was using many accrual based ratios. it would not be able raise fresh equity. Because of the fraud committed.Aditya Goel FT11105 FSAV Take Home Test The chances of Millennial technologies avoiding bankruptcy as on mid year 7 is very low. Also. Altman Z-score was not very effective in predicting bankruptcy early on because y Altman score uses accrual basis income statements and balance sheet data instead of cash-flow data. . Had the model included some cash-flow based ratios. But accrual based statements are more easily subject to manipulation compared to cash flow statements. Since the equity valuations were very high (because of manipulated financial statements). y Also. market value of equity is a critical factor in calculating Altman Z score. but all these ratios were manipulated to present a rosy picture of the firm. it could have predicted the possibility of bankruptcy earlier (because the cash-flow are more difficult to manipulate). The firm is unable to generate cash from operations. So. In millennial technologies case.