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Red Flags that might affect analysts' decisions.

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One step in assessing the quality of earnings is to look for red flags. An example of a red flag is a significant increase in accounts receivable without commensurate growth in sales (that is, accounts receivable turnover decreases). can you list and discuss at least five other red flags the astute analyst might look for, explain why each is a red flag, and identify where the analyst might find this information

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Operating an investment where the project's cost of capital is higher than the internal rate of return (IRR). IRR is the project's expected rate of return. If this return exceeds the cost of the funds used to finance the project, then the excess goes to the firm's stockholders (Brigham & Houston, 2007). Therefore, when IRR is less than the cost of capital, the project will not generate enough revenues to provide stockholders with enough returns. The analyst may find this information in the analysis of capital budgeting.

A shorter payables deferral period with an increase in days sales outstanding (DSO) is another red flag. A longer period of days' sales outstanding with shorter payables deferral period will cause cash ...

Solution Summary

This solution is comprised of events that may result in red flags impression in financing that may cause a change in the analysts' decisions.

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Jackson Daniels graduated from Lynchberg State College two years ago. Since graduating from the college, he has worked in the accounting department of Lynchberg Manufacturing. Daniels was recently asked to prepare a sales budget for the year 2011. He conducted a thorough analysis and came out with projected sales of 250,000 units of product. That represents a 25 percent increase over 2010.

Daniels went to lunch with his best friend, Jonathan Walker, to celebrate the completion of his first solo job. Walker noticed Daniels seemed very distant. He asked what the matter was. Daniels stroked his chin, ran his hand through his bushy, black hair, took another drink of scotch, and looked straight into the eyes of his friend of 20 years. 'Jon, I think I made a mistake with the budget.'

What do you mean? Walker answered.
You know how we developed a new process to manufacture soaking tanks to keep the ingredients fresh?
Yes, Walker answered.
Well, I projected twice the level of sales for that product than will likely occur.
Are you sure, Walker asked.
I checked my numbers. I'm sure. It was just a mistake on my part, Daniels replied.
So, what are you going to do about it, asked Walker.
I think I should report it to Pete. He's the one who acted on the numbers to hire additional workers to produce the soaking tanks, Daniels said.
Wait a second, Walker said. How do you know there won't be extra demand for the product? You and I both know demand is a tricky number to project especially when a new product comes on the market. Why don't you sit back and wait to see what happens?
But what happens if I'm right and the sales numbers were wrong? What happens if the demand does not increase beyond what I now know to be the correct projected level, Daniels asks.
Well, you can tell Pete about it at that time. Why raise a red flag now when there may be no need?� Walker states.
As the lunch comes to a conclusion, Walker pulls Daniels aside and says, Jack, this could mean your job. If I were in your position I'd protect my own interests first.

Questions

1. What should an employee do when he or she discovers that there is an error in a projection? Why do you suggest that action? Would your answer change if the error was not likely to affect other aspects of the operation such as employment? Why or why not?

2. Identify the stakeholders potentially affected by what Daniels decides to do. How might each stakeholder be affected by Daniels's action and decision? Use ethical reasoning to support your answer.

3. Assume Daniels is both a CPA and holds the Certified Management Accountant (CMA) certification granted by the IMA. Use the ethical standards of these two organizations to identify what Daniels should do in this situation.

Case 1-8 A Faulty Budget

Jackson Daniels graduated from Lynchberg State College two years ago. Since graduating from the college, he has worked in the accounting department of Lynchberg Manufacturing. Daniels was recently asked to prepare a sales budget for the year 2011. He conducted a thorough analysis and came out with projected sales of 250,000 units of product. That represents a 25 percent increase over 2010.

Daniels went to lunch with his best friend, Jonathan Walker, to celebrate the completion of his first solo job. Walker noticed Daniels seemed very distant. He asked what the matter was. Daniels stroked his chin, ran his hand through his bushy, black hair, took another drink of scotch, and looked straight into the eyes of his friend of 20 years. 'Jon, I think I made a mistake with the budget.'

What do you mean? Walker answered.
You know how we developed a new process to manufacture soaking tanks to keep the ingredients fresh?
Yes, Walker answered.
Well, I projected twice the level of sales for that product than will likely occur.
Are you sure, Walker asked.
I checked my numbers. I'm sure. It was just a mistake on my part, Daniels replied.
So, what are you going to do about it, asked Walker.
I think I should report it to Pete. He's the one who acted on the numbers to hire additional workers to produce the soaking tanks, Daniels said.
Wait a second, Walker said. How do you know there won't be extra demand for the product? You and I both know demand is a tricky number to project especially when a new product comes on the market. Why don't you sit back and wait to see what happens?
But what happens if I'm right and the sales numbers were wrong? What happens if the demand does not increase beyond what I now know to be the correct projected level, Daniels asks.
Well, you can tell Pete about it at that time. Why raise a red flag now when there may be no need?� Walker states.
As the lunch comes to a conclusion, Walker pulls Daniels aside and says, Jack, this could mean your job. If I were in your position I'd protect my own interests first.

Questions

1. What should an employee do when he or she discovers that there is an error in a projection? Why do you suggest that action? Would your answer change if the error was not likely to affect other aspects of the operation such as employment? Why or why not?

2. Identify the stakeholders potentially affected by what Daniels decides to do. How might each stakeholder be affected by Daniels's action and decision? Use ethical reasoning to support your answer.

3. Assume Daniels is both a CPA and holds the Certified Management Accountant (CMA) certification granted by the IMA. Use the ethical standards of these two organizations to identify what Daniels should do in this situation.

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