case_study - week5

8/4/2019 Case_Study - Week5

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CASE STUDY - WEEK 5 1

Week 5 Case StudyFinancial Statement Analysis


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Chapter 10with focus on credit rating agencies

One of the course objectives is to evaluate earnings analysis. I believe another objective

could be to evaluate the impact of credit ratings. The U.S. Government was recently

downgraded by S&P for its level of sovereign debt. We will explore the credit ratings that apply

to individual companies and debt (bond) securities. Subramanyam (2009) notes that bond credit

ratings are an expression of judgment about the creditworthiness of the bond issuer and the

quality of the specific debt security. They are issued by a variety of credit rating agencies. They

provide investors with a sense of the probability that the bond issuer will make payments on the

bond and ultimately return the original invested amount. The credit rating agencies use security-

specific information, industry factors, market trends as well as analysis of the debt-issuing firm

itself to determine their ratings.

Ratings for publically traded bonds are required by the OCC (Office of the Comptroller of

the Currency). Wearden (2011) notes that Fitch, Moodys and S&P became the first three

companies recognized as rating agencies. Today there are 10 rating agencies approved by the

SEC (Securities and Exchange Commission). We can easily understand that debt (bond) ratings

provide a benefit to individual investors who want to know the creditworthiness of the issuer and

the particular security before they execute their purchase. What benefit do the ratings provide to

businesses?

Banks and other financial institutions utilize credit ratings to in their calculations of

regulatory reserve capital requirements. The FCIC (Financial Crisis Inquiry Commission of

2010) notes that risk capital requirement weights for bonds rated AAA or AA securities are

lower than the weights for lower-rated securities: BBB securities require typically five times


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greater reserve capital to guard against losses. BB securities typically require ten times the

capital requirements of AAA or AA securities.

Benner (2011) relates that Moody recently agreed to rate a recent mortgage-backed security

with its AAA rating only if the company holding that security provided a 10% subordination

level (reserve commitment) to ensure a protective cushion should the mortgages in the pool

begin to sour. The company ultimately went with Fitch which provided a AAA rating and only

required a 7.5% subordination level. We see from this example that a relatively minor variation

in a credit rating may require a company owning that security to tie up more money in capital

reserves.

Rating agencies also apply ratings to companies that hold large amounts of debt securities

such as the bank where I am employed. Moodys documents their rating methodology on their

corporate website: It includes determining the bank Financial Strength Rating (BFSR) by

analyzing the banks credit profile. It includes determining the probability that the institution

will receive support from external sources to prevent a default and it considers foreign currency

risks as well. What is the purpose of focusing so heavily on banks and other financial

institutions? The answer is that these companies use leverage to increase the money available

for their financial operations. Banks that are careless with managing credit risk are at higher risk

themselves of default and bankruptcy.

Wearden (2011) relates that a AAA-rated bank can secure loans at lower interest rates. The

AAA rating indicates that there is less risk that the money will not be repaid. (It represents that

there is less chance of default than a lower rated company or debt-instrument). Lower ratings

result in higher borrowing costs and force banks that hold lower-rated securities to post more


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collateral. Aspan (2011) notes that Moodys has considered cutting the credit ratings of large

U.S. banks (such as the one I work at) out of concern that the Dodd-Frank law eliminates the

certainty of U.S. governmental support. We can conclude from this that credit ratings applied to

banks have a significant impact on both their ability to borrow money and on the money they are

required to keep in reserve to guard against losses.


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Chapter 11with focus on 10-Q SEC Interim Report

One of the course objectives is to assess limitations of accounting data. Let us explore

limitations with 10-Q filings that public companies submit to the SEC. Subramanyam (2009)

notes that the SEC requires quarterly 10-Q form submissions as well as other interim reports.

What is the purpose of the 10-Q? It allows an investor to look at the performance of a company

on a quarterly basis. Some may assume that quarterly earnings report may serve this purpose.

Krantz (2009) notes the distinction that earnings reports typically do not list cash flows whereas

10-Q filings include a statement of cash flows.

Investors should understand that 10-Q numbers are reviewed by the SEC but are not

audited by an audit firm. This means that the numbers should not be assumed to be under the

same level of scrutiny as the annual 10-K filing or the annual report. (The annual report is

essentially a glorified, printed version of the 10-Q or 10-K SEC filings.) Investors should also

know that companies have 40 days from the end of the quarter to submit the 10-Q. (In contrast,

the annual 10-K must be submitted within 90 days of the end of the fourth quarter.) That means

that there is a rush each quarter in order to compile the accounting data for the prior quarter and

submit the 10-Q to the SEC.

Where can one obtain the 10-Q? An SEC press release in 2008 unfurled a new online tool

for looking up filings: They are available on the SECs Interactive Data Electronic Applications

(IDEA) database. I was able to easily browse to my companys balance sheet, income statement

and statement of cash flows from the May 2011 10-Q filing. The SEC also allows the reader to

view the data in Excel format. Financial analysts have quarterly financial statements literally at

their fingertips.


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Unfortunately quarterly financial statements are subject to the same manipulation as year-

end financial statements. A savvy investor, however, can scan for red flags in the quarterly

reports that are harbingers of problems to come. Schilit (2010) notes various kinds red flags in

10-Q statements:

1. A notice about a revenue recognition change which allows revenue to berecognized earlier is a red-flag. Investors should take note if sales growth remains

flat despite the revenue recognition change. It may be a tip that management of the

company is desperate to mask revenue problems.

2. Companies that report surging receivables in one quarter only to be forced torepurchase product at a later time is similarly an indication of managements

attempt to record revenues early and mask operational problems. It is likely that the

revenues should not have been recognized in the first place.

3. Comments in a 10-Q about purchasing inventory at above-market prices is a redflag for the company selling the product. The selling company may be attempting

to understate one-time gains and overstate a revenue stream. (This highlights the

importance of occasionally reading 10-Q statements from multiple companies in

order to uncover the truth behind financial statements.)

Although quarterly financial reports may mask problems, they are still of tremendous value

for investors. Olstein (2002) maintains that it is preferable to review reports submitted to the

SEC than to hear glossy predictions from management.

I believe that my greater understanding of the topics I researched this week will help me

become a more valuable employee in my field of work. I appreciate the need for appropriate


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credit risk management at banks. I can conclude that lack of expertise with analyzing interim

financial statements puts an investor at a great disadvantage.


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References

Subramanyam, K.R. (2009). Financial Statement Analysis.

Benner, Katie (2011). Mortgage Bond Ratings Return with Scrutiny. Retrieved from

http://finance.fortune.cnn.com/2011/02/18/lets-try-this-again-mortgage-bond-ratings-

return-with-scrutiny.

Wearden, Graeme (2011). AAA Ratings Explained. Retrieved from

http://www.guardian.co.uk/business/2011/jul/27/triple-aaa-credit-ratings-explained.

Aspan, Maria (2011). Moody's may cut BofA, Citi, Wells ratings. Retrieved from

www.reuters.com/article/2011/06/02/us-moodys-debt-idUSTRE75153020110602.

Moodys Global Bank Rating Methodology. Retrieved from

http://www.moodys.com/newsandevents/topics/global-bank-rating-methodology/-

/007005/-/-/0/0/-/0/-/-/en/global/rr.

Krantz, Matt (2009). Fundamental Analysis for Dummies.

SEC Announces Successor to EDGAR Database. Retrieved from

www.sec.gov/news/press/2008/2008-179.htm.

MacDonald, Elizabeth. Breaking Down the Numbers on Wall Street. Retrieved from

www.forbes.com/2002/06/06/0606olstein.html.

Goodman, Jordan (2003). Reading Between the Lies: How to Detect Fraud and Avoid

Becoming a Victim of Wall Streets Next Scandal.

Schilit, Howard (2010). Financial Shenanigans.
http://www.forbes.com/2002/06/06/0606olstein.htmlhttp://www.forbes.com/2002/06/06/0606olstein.html

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