c


 
 

c

à Y Using information in financial statements as originally reported in Exhibits 5
 to 5


compute the value of Beneish¶s manipulation index for fiscal year 5 and 6

c


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
à and probability of manipulation
is 4à 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 4 and probability of manipulation is 8
5
% indicating
that there is a high risk that Millennial could have indulged in earnings manipulation


    
  

     
 
 Days sales in ratio of accounts receivable to sales à 56 à 04
receivables for current year/ratio of accouns
index receivable to sales for previous year
 Gross margin Gross margin as a percentage of sales à à

index last year/gross margin as a percentage
of sales for current year
 Asset quality proportion of lower quality assets 0  0 0
index during current year/proportion of
lower quality assets during the
preceding year
 Sales growth sales of current year / sales of à 5
3 04
index previous year
 Depreciation ratio of depreciation expense to PPE àà à 68
index for previous year/ratio of depreciation
expense to PPE for current year
 Selling and ratio of SGA to sales for current à à8 0 45
Administrative year/ratio of SGA to sales for previous
expense index year
 Leverage index proportion of total financing
à
0 54
comprising currnet liabilities and
long-term debt for the current year
relative to the proportion for the
preceding year
 Total accruals Accruals (net income - operating cash 0 36 0 3

to total assets flow) as a percentage of total assets for
current year
  
!
 "#
$ %& &

& '
((#$
)* "#
 &+ +
c
  
 

c

Y Using information from Beneish¶s manipulation index and financial ratios in Exhibit
5 30, indicate possible signals that millennial technologies might have been manipulating
its financial results

Beneish index helps to identify the financial characteristics of companies which are likely
to engage in earnings manipulation For Millennial technologies, the Beneish index
predicts a 4à% probability of earnings manipulation in year 5 and 8
% probability of
manipulation in year 6 This is a very strong signal that there could be some earnings
manipulation which needs to be probed further

Apart from the Beneish index, 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
Y A significant portion of the assets are classified as ³other assets´ This indicates that
the quality of the assets is not that high Other assets usually include categories like
Good will or capitalized costs Since the future benefits of these assets is less certain,
a higher proportion of ³other assets´ will raise some doubts
Y Accounts receivable and inventories make up 60% to 0% of the total assets, which is
very abnormal This means that the company is having lots of uncollectible accounts
or outdated inventory and is not writing them off properly
Y Accounts receivable turnover has decreased from 6  in year 4 to 4 6 in year 6 This
means that company is taking more time to convert its receivables to cash This
would mean that some of its account receivables are fictious or bad debts have
increased
Y Selling and general administrative expenses as a percentage of sales has decreased
from
% in year 5 to à
à% in year 6 This drastic reduction will raise doubts
whether expenses are being capitalized
Y Operating cashflows are negative for all the years Also, there has been a steady
increase in the gap between accrual based profit and operating cashflows This should
indicate that the firm could be resorting to some manipulation of accrual profit
Y Days account payable has halved from 63 in year 5 to 3 in year 6 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 Or, management has
included certain other items in accounts payable, which have not been disclosed
Y The long term debt ratio of the company is very low at 0 8% Sales are growing at a
rate of
30% This means the company will need lot of funding, but most of funding
is through equity even though equity is costly compared to debt 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 The firm is growing very rapidly at around
30% and will therefore need lot of funds
However, its long term debt to equity ratio is less than à% where as its short term
notes payable is pretty high This indicates that the firm is financing most of its debt
 c
  
 

c

through short term borrowing This might be because there is no long term borrower
willing to lend since they are not convinced about the firms sustainability
3 Y Describe the effect of each of the eight accounting irregularities on balance sheet, income
statement and statement of cashflows

c


, ))-#

)# --
 # ..#

-



IY Recording of invalid sales transactions

Y Effect on balance sheet:
?Y Higher assets because of increase in accounts receivable
?Y Higher share holder equity due to increased retained earnings (retained
earnings increase due to higher profit reported)
Y Effect on income statement:
?Y Higher revenues
Y Effect on cash-flow statement:
?Y No change
II Y Recording of revenues from bill and hold transactions
Y Effect on balance sheet:
a Y Higher assets due to increase in accounts receivable
b Y Lower inventories because inventories are converted as sales
c Y Higher share holder equity due to increased retained earnings (retained
earnings increase due to higher profit reported)
Y Effect on income statement:
a Y Higher revenues for the current period at the expense of next period
Y Effect on cash-flow statement:
a Y No change
III Y Manipulating inventory balances by including dummy boxes
Y Effect on balance sheet:
a Y Higher assets due to increase in inventory
Y Effect on income statement:
a Y Higher profits because of lower cost of goods sold
Y Effect on cash-flow statement:
a Y No change
IV Y Failure to write down inventory for product obsolescence
Y Effect on balance sheet:
a Y Higher than actual assets due to increase in inventory
b Y Higher share holder equity due to increased retained earnings (retained
earnings increase due to higher profit reported)
Y Effect on income statement:
a Y Higher profits because the losses in inventory are not accounted for
Y Effect on cash-flow statement:
a Y No change
VY apitalization of costs
Y Effect on balance sheet:
a Y Higher assets
 c
  
 

c

b Y Higher share holder equity due to increased retained earnings (retained

earnings increase due to higher profit reported)
Y Effect on income statement:
a Y Higher profits because some of the costs are not included
Y Effect on cash-flow statement:
a Y No change

VI Y Manipulation of prepaid licenses as advances

Y Effect on balance sheet:
a Y hange in composition of assets ± the ³prepaid asset´ account is undervalued
where as ³notes receivable´ account is overvalued
Y Effect on income statement:
a Y Higher profits because of lower amortization costs
Y Effect on cash-flow statement:
a Y No change

VII Y Failure to provide adequately for uncollectible amounts in accounts receivable

Y Effect on balance sheet:
a Y Higher assets due to overvalued accounts receivable account
Y Effect on income statement:
a Y Higher revenues because lower
Y Effect on cash-flow statement:
a Y No change

VIII Y Failure to write-down investments even after the investments have lost significant value
Y Effect on balance sheet:
a Y Higher assets shown on balance sheets
Y Effect on income statement:
a Y Higher profits because losses on investments are not booked
Y Effect on cash-flow statement:
Y No change

4 Y Using information in the restated financial statements in Exhibits 5 3à to 5 33, the

financial ratios is Exhibit 5 34, and the information provided in the case, would you as a
commercial banker be willing to offer millennial technologies a line of credit as of July
3à, year  State the conditions that would induce you to offer such a line of credit

c


A number of factors need to be considered before a lending decision is made Most important
of these are the liquidity and solvency figures of the firm Some of the important liquidity
and solvency ratios for Millennial technologies are given below:

/#
   
01#$#


2 ##
3 à
0 4 à8 à 6à 5

1-4#
3 0
5
53 0 4
55
c
  
 

c

Œ"# .-
 -0 56 -3 à5 -

0 -à
3
)
#
- #
(#
#
3
c--
 #
 3 36 4 5 4 40  6
-(#

3
5$
-(
 à08 68 6 8à 8
4 4 0

#
#  .3
  #
$#
 3 à3 5 à 6 à5 3 3
3
5$
  #
$ àà6 46 63 
5 3à à0 63
3

 -$#


0
.#(# 0 00 0 0à 0 04 0 00
#
3
5(##
1#$#
 0 00 0 0à 0 04 0 00
3
0(#
#


#
 0 44 0

0 55 0 à
#
3
 #
#-
. -à08 àà -à0 5 -8 08 -
03
#
3
 #
#-
. -
à 50 -58 45 -88 à4 -3 5à
#
(


-
)

3
Œ"# . -0 55 -3 03 -
à4 -à
3
-
)

#
#
#
(#
#
3

Let us look at each factor affecting the lending decision one by one

ircumstances leading to the need for loan: Millennial technologies needs cash to finance its
working capital needs The line of credit will be used to finance accounts receivable and
inventories However, the firm has significant operational problems It is not able to move its
inventories or collect cash promptly Therefore there is significant credit risk involved

ashflows:

Y The firm has significant negative cashflows from operations

Y Also, the firm has been unable to monetize its inventories or collect cash promptly
from customers Accounts receivable and inventories turnover ratios are pretty high
and have been increasing from year to year as shown above
Y Operating cashflows to total liabilities and operating cashflows to current liabilities is
still negative but has improved in year 

ollateral: Most of the firm¶s assets are made up of accounts receivable and inventories
There are no marketable securities as of year  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 Also, the firm is a fast changing industry and its inventory could turn obsolete
very soon Therefore, there is considerable risk involved in liquidating the collateral
c
  
 

c

apacity for debt: The firm¶s long term debt to equity ratio looks good because there is no
long term debt This is because the firm is in distress and no one is willing to lend Having
said that, 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

ontingencies: The firm faces huge contingency risk from unresolved class action law suits
and other penalties that might be imposed by regulators

haracter of management and corporate governance structures: Recent events show that the
management is not trustworthy and the firm lacks adequate control structures

onsidering these adverse factors, I would be very sceptical about providing a line of credit
to Millennial technologies 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 If I were to lend, I
would insists on

Y Significant restructuring of operations

Y Debt covenants which keep a tight leash on cash available, receivable and inventory
turnovers
Y Higher collateral and interest margins
Y New equity infusion into the company

5 Y ompute Altman z-score for fiscal year ending on March 3à, Year 

c


Altman Z score can be used to predict the likelihood of bankruptcy for the firm under
consideration It uses five factors to calculate the Z score Z scores below à 8à indicate a high
probability of bankruptcy, while Z-scores above 3 indicate a low probability of bankruptcy
Scores between à 8à and 3 are in the gray area

The Z-score for Millennial technologies as on 3àst March, Year  is -

6 This indi cates that
the probability of bankruptcy is very high 


-#
 6
)#  8. #
)
)-#


 # )-#

*- 
#7

 (Net working capital / total assets) 0 08
4à6 à

 Retained earnings/total assets -à 0450à856 à4
 EBIT/total assets -0 840àà54 33
 Market value of equity/Liabilities

àààà853 06
 Sales/Total assets 0 55
033
83 à
 c# 9
-
 %

6 Y an millennial technologies avoid bankruptcy as of mid year  Why did not Altman
model signal the financial difficulties earlier than they do

c

c
  
 

c

The chances of Millennial technologies avoiding bankruptcy as on mid year  is very low
The firm is unable to generate cash from operations Also, it does not have quality assets
to put as collateral and raise loans Because of the fraud committed, it would not be able
raise fresh equity So, it is difficult for the firm to avoid bankruptcy

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 But accrual based statements are more easily subject to manipulation
compared to cash flow statements In millennial technologies case, Altman score was
using many accrual based ratios, but all these ratios were manipulated to present a
rosy picture of the firm Had the model included some cash-flow based ratios, it could
have predicted the possibility of bankruptcy earlier (because the cash-flow are more
difficult to manipulate)

Y Also, market value of equity is a critical factor in calculating Altman Z score Since the
equity valuations were very high (because of manipulated financial statements), the Z
score was high and could not predict the possibility of bankruptcy