chapter 02 - financial reporting and analysis

Chapter 02 - Financial Reporting and Analysis

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Financial Reporting and

Analysis

REVIEW

Financial statements are the most visible products of a company’s financial reporting process. The financial reporting process is governed by accounting rules and standards, managerial incentives, and enforcement and monitoring mechanisms. It is important for a user of financial information to understand the financial reporting environment along with the accounting information presented in financial statements. In this chapter, the concepts underlying financial reporting are discussed with special emphasis on accounting rules. Next the purpose of financial reporting is discussed – its objectives and how these objectives determine both the quality of the accounting information and the principles that underlie the accounting rules. The relevance of accounting information for business analysis and valuation is also discussed and limitations of accounting information are identified. Last, accrual accounting is discussed including the strengths and limitation of accruals, and the implications of accruals for financial statement analysis.

OUTLINE

• Financial Reporting Environment

Statutory Financial Reports

Financial Statements

Earnings Announcements

Other Statutory Reports

Factors Affecting Statutory Financial Reports

Generally Accepted Accounting Principles

GAAP Defined

Setting Accounting Standards

Role of the Securities and Exchange Commission

International Accounting Standards

Managers

Monitoring and Enforcement Mechanisms

Securities and Exchange Commission


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Auditing

Corporate Governance

Litigation

Alternative Information Sources

Economic, Industry, and Company Information

Voluntary Disclosure

Information Intermediaries

• Nature and Purpose of Financial Accounting

Objectives of Financial Accounting

Stewardship

Information for Decisions

Desirable Qualities of Accounting Information

Primary Qualities: Relevance and Reliability

Secondary Qualities: Comparability and Consistency

Important Principles of Accounting

Double-Entry

Historical Cost

Accrual Accounting

Full Disclosure

Materiality

Conservatism

Relevance and Limitations of Accounting

Relevance of Financial Accounting Information

Limitations of Financial Statement Information

Relevance and Limitations of Accrual Accounting

Relevance of Accrual Accounting

Conceptual Relevance of Accrual Accounting

Empirical Relevance of Accrual Accounting

Accruals Can Be a Double-Edged Sword

Analysis Implications of Accrual Accounting

Myths and Truths About Accruals and Cash Flows

Accruals and Cash Flows – Myths

Accruals and Cash Flows – Truths


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Should We Forsake Accruals for Cash Flows?

• Concept of Income Economic Concept of Income Economic Income Permanent Income Operating Income Accounting Concept of Income Revenue Recognition and Matching Analysis Implications

• Fair Value Accounting Understanding Fair Value Accounting Considerations in Measuring Fair Value Hierarchy of Inputs Analysis Implications

• Introduction to Accounting Analysis Need for Accounting Analysis Accounting Distortions Accounting Standards Estimation Errors Reliability versus Relevance Earnings Management

Analysis Objectives Comparative Analysis Income Measurement Earnings Management Earnings Management Strategies

Increasing Income Big Bath

Income Smoothing Motivations for Earnings Management

Contracting Incentives Stock Price Effects

Other Incentives Mechanics of Earnings Management

Income Shifting Classificatory Earnings Management

Analysis Implications of Earnings Management Process of Accounting Analysis Evaluating Earnings Quality Steps in Evaluating Earnings Quality Adjusting Financial Statements

Appendix 2A: Auditing and Financial Statement Analysis

• Relevance of Auditing to Analysis Credibility and Competence of the Audit Firm Relevance and Limitations of the Audit Report

• Audit Process

Generally Accepted Auditing Standards Auditing Procedures

• Audit Report Types of Audit Qualifications

“Except for” Qualification Adverse Opinion Disclaimer of Opinion

• Analysis Implications from Auditing Analysis Implications of the Audit Process Audit Risk and Its Implications Analysis Implications of Auditing Standards Analysis Implications of Auditor Opinions Analysis Implications of Explanatory Language for Uncertainties Analysis Implications of the SEC

Appendix 2B: Earnings Quality

• Determinants of Earnings Quality Accounting Principles

• Income Statement Analysis of Earnings Quality Analysis of Maintenance and Repairs Analysis of Advertising Analysis of Research and Development Analysis of Other Discretionary Costs

• Balance Sheet Analysis of Earnings Quality Conservatism in Reported Assets Conservatism in Reported Provisions and Liabilities Risks in Reported Assets

• External Factors and Earnings Quality


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ANALYSIS OBJECTIVES

• Explain the financial reporting and analysis environment

• Identify what constitutes generally accepted accounting principles (GAAP)

• Describe the objectives of financial accounting, and identify primary and secondary qualities of accounting information

• Define principles and conventions that determine accounting rules

• Describe the relevance of accounting information to business analysis and valuation

• Identify limitations of accounting data a nd their importance for financial statement analysis

• Understand alternative income concepts and distinguish them from cash flows

• Understand fair value accounting, its advantages, limitations and analysis implications

• Explain the importance of accrual accounting and its advantages and limitations

• Describe the need for and techniques of accounting analysis

• Explain the relevance of auditing and th e audit report (opinion) for financial statement analysis (Appendix 2A)

• Analyze and measure earnings quality and its determinants (Appendix 2B)

Chapter 02 - Financial Reporting and Analysis Edited by: Sazzad Hossain, MBA, CSCA™

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QUESTIONS

The users of financial reporting information include investors, creditors, analysts, and other interested parties.

There are several sources of information available to users. These include statutory financial reports and

alternative information sources such as economic information and industry information. Statutory financial

reports are prepared according to the set of generally accepted accounting principles (GAAP). A regulatory

hierarchy that includes the Securities and Exchange Commission, the American Institute of Certified Public

Accountants, and the Financial Accounting Standards Board promulgates these principles. GAAP is also

influenced in some industries by specialized industry practices. Managers prepare the statutory financial

reports. Thus, the reports are subject to manipulation based on incentives of managers to present the

company in its best light. However, the ability of managers

2-1. to manipulate the financial reports is limited by several monitoring and enforcement mechanisms including

the SEC, internal and external auditors, corporate governance, and the possibility of litigation against the company

and/or the managers.

2-2.

Earnings announcements provide summary information about the company’s performance and financial

position during the quarter and/or year just ended. The earnings announcement contains much less detail than

the financial statements, which are only released after they are prepared and audited. Although the earnings

announcement contains few details, it does contain important summary data such as the results of operations. By

making an earnings announcement, the company conveys important information to the market in a timely manner.


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2-3.

The Securities and Exchange Commission SEC serves as an advocate for investors. As such, the SEC requires

registrant companies to file periodic standard reports. These reports allow the SEC to oversee the financial

reporting activities of the company and allow the SEC to make key financial information available to all investors.

Some of the reports required by the SEC are summarized in Exhibit 2.1. The Form 10-K is a filing that includes

audited annual financial statements and management discussion and analysis. The Form 10-Q is filed on a

quarterly basis and contains quarterly financial statements and management discussion and analysis. The Form

20-F is an annual filing by foreign issuers of financial securities. This report reconciles reports that were prepared

using non-U.S. GAAP to reports prepared using U.S. GAAP. The Form 8-K is a report of current activities that

must be filed within 15 days of the occurrence of any of the following events: change in management control,

acquisition or disposition of major assets, bankruptcy or receivership, auditor change, or resignation of a director.

Regulation 14-A is commonly called the Proxy Statement. The Proxy Statement contains details of directors,

managerial ownership, managerial compensation, and employee stock options. The Prospectus contains audited

statements and other information about proposed project or share issues.

2-4.

Contemporary generally accepted accounting principles (GAAP) is the set of rules and guidelines of financial

accounting that are currently mandated as the acceptable rules and guidelines for preparing financial reports

for the external users of financial information. These rules are comprised of the following: Financial

Accounting Standards Board (FASB) Statements of Financial Accounting Standards; Accounting Principle Board

Opinions; Accounting Research Bulletins issued by the Committee of Accounting Practices; Pronouncements of

the American Institute of Certified Public Accountants such as Statements of Position regarding issues not yet

addressed by the FASB; and Industry Audit and Accounting Guidelines for any industry-specific matters. The

FASB also issues Emerging Issues Task Force (EITF) Bulletins that contain guidance regarding emerging issues

that will be on the agenda of the FASB in the near future. GAAP is also influenced by generally accepted practices

in certain industries.

2-5. The accounting profession currently establishes accounting standards. The Financial Accounting

Standards Board is currently the primary rule making body. The SEC and the AICPA oversee the activities of

the FASB. The FASB proposes rules by first issuing a discussion memorandum. Interested parties are asked to

render an opinion regarding the proposal by the FASB. Next, the FASB issues an Exposure Draft of the proposed

rule and invites additional comment. Finally, based on input received via the exposure and comment process, the

FASB issues the new rule.


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2-6. Managers have the main responsibility for ensuring fair and accurate financial reporting by

a company.

2-7. Managers have discretion in financial reporting in most cases. This discretion may result from either of two

sources. First, managers often have a choice between alternative generally accepted rules in accounting for

certain transactions. Second, managers often have to make estimates of uncertain future outcomes. Each

of these managerial judgments creates managerial discretion.

2-8. Monitoring and control mechanisms include SEC oversight, internal and external auditor review, corporate

governance such as Board of Director subcommittees assembled to oversee the audit and financial reporting, and

the omnipresent threat of litigation.

2-9. Statutory financial reports are not the only source of information about a company that is available to interested

parties outside of the organization. Other sources include forecasts and recommendations of information

intermediaries (analysts), general economic information, general information about the company’s industry,

and news about the company. Also, management will often provide voluntary disclosure of information that is

not required by GAAP or other regulatory mandate.

2-10. Financial intermediaries (analysts) play an important role in capital markets. They are an active and

sophisticated group of users that provide useful information to market participants. Tasks performed by

intermediaries include collecting, processing, interpreting, and disseminating information about the financial

prospects of companies. The outputs of analysts include forecasts, stock buy or sell recommendations, and/or

research reports that investors can use to make investment decisions.

2-11. Under the historical cost model, asset and liability values are determined on the basis of prices obtained

from actual transactions that have occurred in the past. Under the fair value accounting model, asset and

liability values are determined on the basis of their fair values (typically market prices) on the measurement

date (i.e., approximately the date of the financial statements).

Under historical cost method, when asset (or liability) values subsequently change, continuing to record value at

the historical cost—i.e., at the value at which the asset was originally purchased—impairs the usefulness of the

financial statements, in particular the balance sheet. Because of this the historical cost model has come under a

lot of criticism for various quarters, resulting in the move toward fair value accounting.


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2-12. In accounting, conservatism states that when choosing between two solutions, the one that will be least

likely to overstate assets and income should be selected. The two main advantages of conservatism are that (1)

it naturally offsets the optimistic bias on the part of management to report higher income or higher net

assets; and (2) it is important for credit analysis and debt contracting because creditors prefer financial

statements that highlight downside risk.

2-13. The two types of conservatism are unconditional and conditional conservatism. Unconditional

conservatism understates assets (or income) regardless of the economic situation. An example is writing-off

R&D irrespective of the nature of the research. Conditional conservatism understates assets conditioned on the

economic situation. An example is an asset impairment charge that occurs when changed economic circumstances

lower an asset’s economic value below its carrying value. Of the two, conditional conservatism is more useful

for analysis because it reflects current economic information in a timely, albeit in an asymmetric, manner.

2-14.

Finance and accounting researchers have established that accounting information is indeed relevant for decision

making. For example, researchers have shown that accounting earnings explain much (50% - 70%) of the

fluctuation in stock price changes. This is some of the most important empirical research about accounting

earnings. Accounting earnings are shown repeatedly to explain stock prices better than other available measures

such as cash flows or EBITDA. Simply put, if you can predict whether accounting earnings per share will

increase or decrease, you can, on average, predict whether the stock price will increase or decrease. Also,

book value does a reasonable job in explaining market value changes.

2-15.

Financial statement information has several limitations. First, financial statements are released well after the end

of the quarter and/or fiscal year. Thus, they are not entirely timely. Second, they are only released on a

quarterly basis. Investors often have a need for information more often than just on a quarterly basis. Thus,

financial statements are limited by the relative infrequency of their release. Third, financial statements have little

forward-looking information. Investors must use the largely backward looking financial statements to generate

their own beliefs about the future. Fourth, financial statements are prepared using rules that are promulgated

with a relevance and reliability trade-off. The need for reliability causes the relevance of the information to

be, in certain instances, compromised. Fifth, the usefulness of financial statement information may also be

limited by the bias of the managers that prepare the statements. For example, managers in certain instances

may have incentives to overstate or understate earnings, assets, liabilities, and/or equity.


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2-16.

Timing and matching problems make short-term performance measurement difficult and often less meaningful.

Timing problems arise because cash is often not received in the period that the revenues are earned and

cash is often not paid in the period that the expenses are incurred. To the extent that the timing of cash receipt

does not occur in the period that the goods or services are delivered, a timing problem is created in performance

measurement. Likewise, a matching problem can arise because the expenses incurred to generate the revenues

may be paid in a different period than the revenue was recorded (earlier period or later period). As a result,

performance is not measured appropriately because the economic efforts required to generate the revenues are not

appropriately matched against the revenues to measure the net benefit of the activities.

2-17. Accrual accounting calls for recognizing revenue when the revenue is both earned and realizable. Revenues

are earned when the company delivers the products or services. Revenues are realized when cash is received.

Revenues are realizable when an asset is acquired for the products or services delivered that is convertible into

cash or cash equivalents. The asset received is usually an account receivable that is collectible.

2-19. Accrual accounting requires that the economic efforts required to generate revenues be matched against the

related revenues. As a result, product costs are recognized in the period the related goods are sold. Period costs

are matched with revenues of the same period.

2-19. Short-term accruals arise because of the timing differences between income and cash flows. For example, the

accrual of revenues before or after cash is received and the accrual of expenses before or after cash is paid are

short-term accruals. Long-term accruals arise from the capitalization of assets that will provide benefits to

the company for more than one year.

2-20. Cash flow measures of performance almost always suffer from the timing and matching problems that

accrual accounting was developed to mitigate. For example, cash often is not received in the accounting period

when it is earned. Further, expenses are often not paid in the period that the cash of the sale that the expense helped

to generate was received. As a result, cash flow measures of performance can be very misleading. Consider for

example, a company that increases inventory levels substantially in the fourth quarter of the current year. This

company will likely report a negative cash flow from operations. However, they may have had an excellent year

and are increasing inventories because they expect continued strong sales.


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2-21. Accrual accounting is a superior measure of performance and financial position relative to cash flows. The

factors that give rise to this superiority are the more appropriate timing of revenue recognition and the more

precise matching of costs against these revenues. Also, these accruals create a balance sheet that is a more

precise indication of the current financial position of the company. As a result, accrual-based income

information is more relevant for assessing a company's present and future cash generating ability and

accrual-based balance sheets are a better measure of the financial position of the company.

2-22. Accrual-accounting based income measures repeatedly out-perform cash flow-based measures such as

operating cash flow or free cash flow at explaining changes in stock price. That is, increases or decreases in net

income have been shown to have a much higher positive relation to increases or decreases in the stock price.

Increases or decreases in cash flow measures are much less likely to have corresponding increases or

decreases in the stock price.

2-23. Cash flows are highly reliable because the receipt or payment of cash measures the cash flows. Accounting

net income is less reliable than cash flows because calculating net income often requires estimations of future

outcomes. Analysts' forecasts are the least reliable because they are simply an estimate by one or a few

individuals. However, in terms of relevance the ranking reverses. Analysts' forecasts are highly relevant

because the forecasts can impound additional information and are timelier than accounting income or cash

flows. Accounting income is more relevant than cash flows because net income contains the additional information

contained in accruals. Cash flow is the least relevant of the performance information alternatives because of timing

and matching problems between cash flow and revenues and expenses.

2-24. Income (also referred to as earnings or profit) summarizes, in financial terms, the net effects of a business’s

operations during a given time period. Economic income differs from cash flow because it includes not only

current cash flows but also changes in the present value of future cash flows. Similarly, accounting income

considers not only current cash flow but also future cash flow implications of current transactions.

2-25. The two basic income concepts are economic income and permanent income. Economic income is

typically determined as cash flow during the period plus the change in the present value of expected

future cash flows, typically represented by the change in the fair value of the business’s net assets.

Permanent income (also called sustainable income or recurring income) is the stable average income

that a business is expected to earn over its life, given the current state of its business conditions.

Economic income measures change in shareholder value and is useful in evaluating the total shareholder


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value created during a period. Permanent income is proportional to shareholder value and is useful in

valuing firms using pricing multiples.

2-26.

Economic income measures the net change in shareholder value during a period. We cannot use economic

income to directly value a company. In contrast, permanent income is a measure of the stable income that the

firm is expected to generate over the long run. We can get an estimate of firm value by merely multiplying

permanent income with an appropriate multiplier. Because of this, economic income measures change in value

while permanent income is proportional to value.

2-27. Accounting income is the excess of revenues and gains over expenses and losses measured using accrual

accounting. As such, revenues are recognized when earned and realized and expenses are matched against

the recognized revenues to generate income.

2-28. Economic income is a measure of the change in shareholder value over a period of time. Permanent

income is the normal, recurring amount of income that a company is able to earn each period. Accounting

income has aspects of both. For example, fair value accounting for investment securities recognizes the change

in the value of certain financial assets during the period. This is reflective of economic income. Accrual

accounting also measures the operating profit related to ongoing operations which is especially reflective of

permanent income.

2-29. The permanent component of accounting income is the portion of total earnings that is expected to

persist indefinitely (recur). Revenues and cost of goods sold components are largely permanent income

components. The transitory component of accounting income is the portion of total earnings that is not

expected to recur. Onetime gains or losses on the sale of operating assets are transitory income items for most

companies.

2-30. Value irrelevant income components have no economic content and, as the name suggests, have no effect

on the value of the company. They are accounting distortions that arise from the imperfections in

accounting. An example of a value irrelevant income component is the gain or loss related to a change in

accounting principle.


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2-31. Core income refers to a current period’s recognized income from which all transitory components have

been removed. Typically one-time items such as extraordinary items, gain and loss on sale of business

units, asset impairments and restructuring charges are removed from net income to estimate core income.

Determining core income is an important first step in estimating permanent income, because it provides a

measure of income created from the ongoing operating activities for the current period.

2-32. Some of the major adjustments to net income for determining economic income are including various

unrealized gains and losses that are included in other comprehensive income, such as unrealized

gains/losses on marketable securities or net pension assets.

2-33. Accounting principles can, in certain cases, create differences between financial statement information and

economic reality. The principles are promulgated to strike a balance between relevance and reliability.

In certain cases, this creates problems. For example, accounting principles require that long-lived assets be

recorded on the books at historical cost because this is a reliable number that can be verified by examining

documents related to the acquisition of the asset. Economic reality is represented by the current market

value of the long-lived asset. Unfortunately, fair market value, while more relevant, is often difficult to

determine. Thus, any market value measure might not be entirely reliable. As a result, economic reality is

often not reflected in the reported value of long-lived assets like land and buildings.

Another example is internally generated goodwill and the value of the work force. Each comprises a

significant portion of the overall value of many companies. However, quantifying that value would be difficult.

Thus, while relevant, the amount is not reliable enough to formally record and report on the financial

statements.

2-34. Under the historical cost model, asset and liability values are determined on the basis of prices obtained from

actual transactions that have occurred in the past. Under the fair value accounting model, asset and liability values

are determined on the basis of their fair values (typically market prices) on the measurement date (i.e.,

approximately the date of the financial statements). The key difference is the fair value accounting periodically

updates asset/liability values even in the absence of explicit transactions.

Historical Cost Model Fair Value Accounting Model

Asset and liability values are determined on the

basis of prices obtained from actual transactions

that have occurred in the past.

Asset and liability values are determined on the

basis of their fair values (typically market prices)

on the measurement date (i.e., approximately

the date of the financial statements).


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The fair value accounting periodically updates

asset/liability values even in the absence of

explicit transactions.

2-35. Under historical cost accounting, income is the accountants estimate of what an enterprise has “earned”

during a period. Under fair value accounting, income is merely the residual amount that measures the

net change in the fair values of assets and liabilities.

2-36. Formally, SFAS 157 defines fair value as exchange price, that is, the price that would be received from

selling an asset (or paid to transfer a liability) in an orderly transaction between market participants on the

measurement date. There are five key elements to this definition: (1) the fair value is determined on the

measurement date, i.e., date of the balance sheet; (2) it is based on a hypothetical, and not actual, transaction;

(3) the hypothetical transaction must be orderly; (4) fair values are market based and not entity specific

measurements; and (5) fair values are based on exit, and not entry, prices.

2-37. Consider a cab service that operates in an area without competition and charges very high rates, and is

extremely profitable. Therefore, the present value of future net cash flows from the use of each automobile

over its normal life in this enterprise is $ 85,000. However, the blue book value is only $ 20,000. For fair

value purposes we will use $ 20,000, i.e., the market value, and not $ 85,000, i.e., the entity-specific value,

when valuing the automobiles.

2-38. Two types of inputs are recognized: (1) observable inputs, where market prices are obtainable from sources

independent of the reporting company—for example, from quoted market prices of traded securities; and

(2) unobservable inputs, where fair values are determined through assumptions provided by the reporting

company because the asset or liability is not traded. They are divided into three levels: Level 1 Inputs.

These inputs are quoted prices in active markets for the exact asset or liability that is being valued,

preferably available on the measurement date. Level 2 Inputs. These inputs are either (1) quoted prices

from active markets for similar, but not identical, assets or liabilities or (2) quoted prices for identical

assets or liabilities from markets that are not active. Level 3 Inputs. These are unobservable inputs and

are used when the asset or liability is not traded or when traded substitutes cannot be identified. Level 3

inputs reflect manager’s own assumptions regarding valuation, including internal data from within the

company. Level 3 inputs are the least reliable and therefore least useful for valuation.


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2-39. Financial assets/liabilities are easier to fair value. This is because they are more homogenous and usually

have liquid markets with traded quotes. Because of this, financial assets/liabilities can be valued using Level

1 or Level 2 inputs. In contrast, most operating assets are not traded in liquid markets and therefore will

need to be valued using Level 3 inputs.

2-40. Market approach: As the name implies, this approach directly or indirectly uses prices from actual market

transactions. Sometimes, market prices may need to be transformed in some manner in determining fair

value. This is approach is applicable to most of the Level 1 or Level 2 inputs.

Income approach: Under this approach fair values are measured by discounting future cash flow (or

earnings) expectations to the current period. Current market expectations need to be used to the extent

possible in determining these discounted values. Examples of such an approach is valuing intangible assets

based on expected future cash flow potential or using option pricing techniques (such as the Black-

Scholes model) for valuing employee stock options.

Cost approach: Cost approaches are used for determining the current replacement cost of an asset, i.e.,

determining the cost of replacing an asset’s remaining service capacity. Under this approach, fair value is

determined as the current cost to a market participant (i.e., buyer) to acquire or construct a substitute asset

that generates comparable utility after adjusting for technological improvements, natural wear and tear and

economic obsolescence. Income and cost approached apply to Level 3 inputs.

2-41.

The major advantages are: Reflects current information; Consistent measurement criteria; Comparability; No

conservative bias.

The major disadvantages are: Lower objectivity; Susceptibility to manipulation; Use of Level 3 Inputs; Lack

of conservatism; Excessive income volatility.

2-42. Historical cost model generates more reliable accounting information, since all numbers are based on actual

transaction, i.e. the exact price paid by the company at acquisition; Fair value model is more relevant, as

it reflects market participant (e.g., investor) assumptions about the present value of expected future cash

inflows or outflows arising from an asset or a liability.

2-43. Some of the issues that the analyst needs to consider when evaluating fair value accounting are: (1) balance

sheet and not income statement is the most important statement under fair value accounting; (2) income

under fair value accounting measures change in net assets, it is not a measure of profitability and cannot


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be used for directly valuing an enterprise; (3) use of fair value assumptions, especially for Level 3 inputs

is suspect and must be evaluated for reliability.

2-44. Preparers of financial statements must make certain estimates of uncertain outcomes and make judgments

about other uncertainties. For example, the company must estimate the amount of accounts receivables that

will ultimately prove uncollectible and must assess the probability and amount of losses that are contingent

upon some event or outcome. To the extent that these estimates or judgments are not exactly correct, the

financial statements can depart from economic reality.

2-45. Accounting analysis is the process of evaluating the extent to which a company’s accounting numbers

reflect economic reality. The process involves a number of different tasks, such as evaluating a

company’s accounting risk and earnings quality, estimating earning power, and making necessary

adjustments to financial statements to both better reflect economic reality and assist in financial analysis.

2-46. Accounting analysis involves several interrelated processes and tasks. First, the analyst must evaluate the

quality of the financial information. To do this, the analyst should identify and assess key accounting policies,

evaluate the extent of accounting flexibility that the preparers had, determine the reporting strategy used by the

preparers, and identify and assess any red flags of potential misstatements. Second, the analyst must adjust the

financial information based on the findings in the evaluation of the quality of the financial information.

Adjustments, while rarely perfect, enhance the quality of the financial information that will be used in the analyst’s

models of financial analysis.

2-47. Accounting distortions are deviations of reported information in financial statements from the underlying

business reality. These distortions arise from accounting policy choices, errors in estimation, the trade-

off between relevance and reliability, and the latitude in application.

2-48. Managers have several potential incentives to manage earnings. First, managers that earn bonus payments

as a function of reported earnings may manage earnings to maximize their bonus. Second, if the company

is subject to debt contract constraints (debt covenants) such as minimum net income, minimum working

capital, minimum net worth, or maximum debt levels then the manager might have incentive to manage

earnings to minimize the probability that the company will violate any of the debt covenant constraints.

Third, the company might choose to manage earnings because of potential stock price implications. For

example, managers may increase earnings to temporarily boost company stock price for events such as a


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forthcoming merger or security offering, or plans to sell stock or exercise options. Managers also smooth

income to lower market perceptions of risk and to decrease the cost of capital. Still another stock price

related incentive for earnings management is to beat market expectations. Fourth, the company might

manage earnings downward to reduce political costs from scrutiny from government agencies such as anti-

trust regulators and the IRS. It is very possible that Microsoft employed such a strategy when U.S. officials

were contemplating anti-trust charges.

2-49. There are several popular earnings management strategies. First, managers often adhere to a strategy of

increasing income where latitude exists. The motivation is to portray the success of the company more

favorably. Second, managers might take a big bath. This strategy involves taking all discretionary losses

in the current period. As a result, net income in the current period is very low but future income is

increased. The period chosen to take a bath is usually one with poor performance even before recognition

of the additional losses. Third, managers might follow a strategy of income smoothing in which slightly

higher than usual earnings are reduced in line with the trend of earnings and slightly lower than usual

earnings are increased in line with the trend of earnings.

2-50. Earnings management is the “purposeful intervention by management in the earnings determination process,

usually to satisfy selfish objectives” (Schipper, 1989). Incentives to manage earnings are created by

contracts tied to accounting numbers, stock price effects of reported accounting numbers, and

government scrutiny based on reported accounting numbers.

2-51. Different persons use accrual accounting information and cash flow information to varying degrees in their

valuation models. Accrual accounting information is often used in valuation models based on price to

earnings multiples, market to book multiples, and abnormal accounting earnings-based valuation models.

Cash flow information is used in such models as discounted dividend and discounted cash flow models.

2-52. Accounting concepts and standards are subject to individual judgments and incentives in the promulgation

process. Accounting regulation is proposed by accounting regulators and then commented upon by the

financial reporting community. Respondents have incentives to get the final standard to conform to their

economic desires. As a result, the standards themselves are ultimately a product, at least in part, of these

incentives. Likewise, when statements are prepared the preparer has certain choices among alternative


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accounting policies and has to make estimates of uncertainties. All of these choices and estimates can be

influenced by incentives faced by the parties making the choices.

2-53. An investor would not be willing to pay as much for a stock, on average, when the accounting information

provided to him/her about the firm is unaudited. The reason is that the investor must price protect

him/herself against the integrity of the information. That is, the investor must be conservative since he/she

is assuming the risks inherent in the business and the risk that the information that they are using is not fairly

presented in conformity with generally accepted accounting principles (and specifically portrays a more

favorable performance and financial position than economic reality).

2-54. Auditing standards are broad generalizations that come in three sets:

(1) General standards define the personal qualities required of the independent CPA.

(2) Standards of fieldwork cover the actual execution of the audit and cover the planning of the work,

evaluation of the client's system of internal control, and the quality and sufficiency of the evidence

obtained.

(3) Reporting standards govern the preparation and presentation of the auditor's report. They are intended

to insure that the auditor's position is clearly and unequivocally stated and that the degree of

responsibility taken is made clear to the reader.

2-55. Auditing procedures are tests applied to a company’s accounts to develop evidence to support or refute

the hypothesis that the reported numbers are prepared according to generally accepted accounting principles and

are fairly presented. The basic objective of the financial audit is the detection of errors and irregularities

that, if undetected, would materially affect the fairness of presentation of financial summarizations or their

conformity with generally accepted accounting principles.

To be economically feasible and justifiable, auditing can aim only at a reasonable level of assurance about the

data under review. This means that, under a testing system, assurance can never be complete and that the final

audit conclusions are subject to this inherent probability of error.

2-56. The auditor's opinion deals with:

(a) The fairness of presentation of the financial statements,

(b) Their conformity with generally accepted accounting principles, and

(c) Disclosure when a material change in accounting principles has occurred.


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2-57. Auditing is based on a sampling approach to the data under audit. Statistical sampling, while lending itself

to many applications in theory, is more limited in actual practice. Thus, most audit tests are based on

"judgmental" samples of the data-samples derived by feel, judgment, and evaluation of many factors. Often the

size of the sample is necessarily limited by the economics of the accounting practice.

The reader must realize that the auditor does not aim at, nor can ever achieve, complete certainty. Even a review

of every single transaction--a process that would be economically unjustifiable--would not achieve complete

certainty.

Auditing is a developing art. Even its basic theoretical underpinnings are far from fully understood or resolved.

There is, for instance, no clear relation between the auditor's evaluation of the effectiveness of the system of

internal controls, which is a major factor on which the auditor relies, and the extent of audit testing and the

nature of audit procedures employed. If we add to that the fact that the qualities of judgment among auditors

can vary greatly, we should not be surprised to find that the history of auditing contains many examples of

spectacular failures.

On the other hand, the percentage of failure to the total number of audits performed is very small. The user of

audited financial statements can, in general, be reassured about the overall results of the audit function but must

remember that there is risk in reliance on its results. Such risks are due to many factors including the auditor's

inability to detect fraud at the highest level and the application of proper audit tests to such an end, the auditor's

conception of the range of responsibilities to probe and disclose, and the quality of the audit.

While the audit function will generally justify the reliance which analysts place on audited financial statements,

such reliance cannot be a blind one. The analyst must be aware that the entire audit process is a probabilistic

one subject to many risks. Even its flawless application may not necessarily result in complete assurance and

most certainly cannot insure that the auditor has gotten all the facts, especially if there is high-level management

collusion to withhold such facts. The heavy dependence of the auditing process on judgment will, of necessity,

result in a wide range of quality of performance.

2-58.

The auditor maintains that s/he expresses an opinion on management's statements. Auditors are very insistent

on this point and attach considerable importance to it. It means that, normally, the auditor did not prepare the

financial statements nor did the auditor choose the accounting principles embodied in them. Instead, the auditor

reviews the financial statements presented by management and ascertains that they are in agreement with the

books and records that are audited. The auditor also determines that acceptable principles of accounting have

been employed in the preparation of the financial statements, but that does not mean that they are the best

principles that could have been used. It is a well-known fact that management will rely on the auditor, as an


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expert in accounting, to help them pick the principle which, while still acceptable, will come nearest to meeting

their reporting objectives. Finally, the auditor will determine that the minimum standards of disclosure have

been met so that all matters essential to a fair presentation of the financial statements are included in them.

2-59. One could well ask what difference it makes whether the auditor prepared the statements or not so long as it

expresses an unqualified opinion on them. The accounting profession has never clearly explained what the

implications of this really mean to the user of the financial statements. However, a number of such possible

implications should be borne in mind by the analyst:

(a) The auditor's knowledge about the financial statements is not as strong as that of the preparer who was in

more intimate contact with all the factors which gave rise to the transactions. The auditor knows only what it

can see on the basis of a sampling process.

(b) Since many items in the financial statements are not capable of exact measurement, the auditor merely

reviews such measurements for reasonableness. These are not the original determinations and unless the

auditor can successfully prove otherwise, as in the case of estimates of useful lives of property, management's

determination will prevail. Thus, the auditor's opinion contains no reference to "present exactly" or "present

correctly" but rather states that the statements "present fairly."

(c) While the audit firm may be consulted on the use of accounting principles it, as an auditor rather than as

preparer of such statements, does not select the principles to be used. Moreover, it cannot insist on the use of

the best available principle any more than it is likely to insist on a degree of disclosure above the minimum

considered as acceptable.

(d) While the preparer must, under the rules of double-entry bookkeeping, account for all items, large or small,

the auditor is held to less exacting standards of accuracy. Thus, the error tolerances are wider. The auditor

leans on the doctrine of materiality which in its basic concept simply means that the auditor need not concern

itself, in either the auditing or the reporting phases of its work, with trivial or unimportant matters. What is

important or significant is a matter of judgment and the profession has neither defined the concept nor set

limits nor established criteria to govern the application of the concept of materiality.

The auditor's reference to "generally accepted accounting principles" in its opinion should be well understood

by the user of the financial statements. Such reference means that the auditor is satisfied that such principles

have authoritative support and that they have been applied "in all material respects." Aside from

understanding the operation of the concept of materiality, the analyst must understand that the definition of

what constitutes "generally accepted accounting principles" is often vague and subject to significant latitude

in interpretation and application. Moreover, not all important areas of accounting are covered by authoritative

pronouncements that define acceptable practice.


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2-60. Following are some of the circumstances that can point to areas of high audit risk:

(a) Growth industry or company with need for continuing earnings growth to justify high market price or to

facilitate acquisitions.

(b) Company in difficult financial condition requiring financing urgently and frequently.

(c) Company with high market visibility issuing frequent progress reports and earnings estimates.

(d) Management dominated mostly by one or a few strong-willed individuals.

(e) Personal financial difficulties of members of management.

(f) Deteriorating operating performance.

(g) Excessively complex capital structure.

(h) Management which has displayed a propensity for earnings manipulation.

(i) Problem industry displaying weaknesses, in such areas as receivable collection, inventories, contract cost

overruns, dependence on few products, etc.

(j) Dealings with insiders on related parties or stockholder lawsuits.

(k) Turnover of key officers, legal counsel or auditors.

(l) Audit conducted by a firm which has experienced a higher than normal incidence of audit failures.

It should be noted, however, that while none of the above situations can be taken for granted to always indicate

situations of higher audit risk, they have been shown by experience to have appeared in a sufficient number of

problem cases to warrant the analyst's close attention.

2-61. KPMG is paid by Citigroup management to perform the audit and render an independent opinion

regarding the fairness of the financial disclosures made by Citigroup. KPMG is providing assurance to all users

of the financial statements. Should users be confident that KPMG performed the audit in the interests of the

users? A couple of market forces dictate that users can use the information with some confidence. First, KPMG

faces substantial litigation risk if they do not perform the audit in conformity with generally accepted auditing

standards. Second, KPMG places its professional reputation at stake when it issues an opinion. Many public

accounting organizations have been forced to fold because their reputation was injured by a high-profile audit

that was found to not be in conformity with generally accepted auditing standards. These firms were forced to

fold because there was no longer any demand for their services.


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2-62. A penny per share misstatement is usually not significant to the user of the financial statements. As

a result, correction of such problems is routinely passed upon. However, a penny per share misstatement can,

in certain instances, be very significant. For example, if the earnings of the company are very near zero then

such a change can be a significant percentage of the reporting earnings or loss. Also, a penny misstatement

might allow a company to report earnings that exceed the market’s expectation by a penny. The market appears

to value such results. As a result, misstatements that cause the company to meet or beat expectations should be

considered significant and worthy of correction during the audit process.

2-63. The "quality" of earnings of an enterprise is a measure of the degree of care and unbiased judgment with

which they are determined, the extent to which all important and necessary costs have been provided for

and the variability which industry conditions subject these earnings to. Analysts must assess the quality of

earnings in order to render them comparable to those of other enterprises.

The quality of earnings depends, among other factors, on:

(1) The degree of conservatism with which the estimates of present and future conditions are arrived at. That

is, the degree of risk that real estimates or assumptions may prove over-optimistic or downright

unwarranted and misleading.

(2) Management's discretion in applying GAAP. This requires the analysis of discretionary and future directed

costs.

(3) The relation between earnings and business risk. The stability and the growth trend of earnings as well as

the predictability of factors that may influence their future levels.

2-64. Discretionary costs are outlays which management can vary to some extent from period to period in

order to conserve resources and/or to influence reported income. Two important categories of discretionary

costs are repairs and maintenance and advertising.

Discretionary costs are readily subject to manipulation by management who may desire to present a good earnings

picture when operational performance is poor in fact. The analyst should realize that an excessive "savings" in the

discretionary costs in the current year will inevitably affect future earnings adversely.

2-65. The carrying amounts of most assets appearing in the balance sheet ultimately enter the cost streams of

the income statement. Therefore, whenever assets are overstated, the income, both present and cumulative,

is overstated because it has been relieved of charges needed to bring such assets down to realizable value. The

converse should also hold true, that is, to the extent to which assets are understated, the income, current and

cumulative, is also understated.


2-22

For similar reasons as above, an overstatement of income can occur because the latter is relieved of charges

required to bring the provision or the liabilities up to their proper amounts. Conversely, an overprovision of present

and future liabilities or losses results in the understatement of income or in the overstatement of losses.

2-66. The assets and liabilities of an enterprise hold important clues to an assessment of both the validity and the

quality of its earnings. Thus, the analysis of the balance sheet is an important complement to the other

approaches of income analysis discussed in the book.

The importance we attach to the amounts at which assets are carried on the balance sheet is due to the fact that,

with few exceptions such as cash and land, the cost of most assets enters ultimately the cost stream of

the income statement. Thus, we can state the following as a general proposition: Whenever assets are

overstated the income, both present and cumulative, is overstated because it has been

relieved of charges needed to bring such assets down to realizable values. Similarly, an

understatement of provisions and liabilities will result in an overstatement of income because the latter is

relieved of charges required to bring the provision or the liabilities up to their amounts. For example, an

understatement of the provision for income taxes, product warranties, or pension costs means that income, current

and cumulative, is overstated.

Conversely, an overprovision for present and future liabilities or losses results in the understatement of

income or in the overstatement of losses. Provisions for future costs and losses which are excessive in amount

represent attempts to shift the burden of costs and expenses from future income statements to that of the present.

Bearing in mind the general proposition regarding the effect on income of the amounts at which assets and liabilities

are carried in the balance sheet, the critical analysis and evaluation of such amounts represents an important check

on the validity of reported income.

2-67. The concept of earnings quality is so broad that it encompasses many additional factors that can make

earnings more reliable or more desirable. These external factors include:

• The effect of changing price levels on the measurement of earnings. In times of rising price levels the

inclusion of "inventory profits" or the understatement of expenses such as depreciation lowers in effect the

reliability of earnings and hence their quality.

• The quality of foreign earnings is affected by factors such as difficulties and uncertainties regarding the

repatriation of funds, currency fluctuations, the political and social climate as well as local customs and

regulation. With regard to the latter, the inability to dismiss personnel in some countries in effect converts

labor costs into fixed costs.


2-23

• Regulation provides another example of external factors that can affect earnings quality. For example, the

regulatory environment of a public utility can affect the quality of its earnings if an unsympathetic or even

hostile regulatory environment causes serious lags in obtaining rate relief.

• The stability and reliability of earnings sources also affect earnings quality. Defense-related revenues

can be regarded as nonrecurring in time of war and affected by political uncertainties in peacetime.

• Finally, some analysts regard complexity of operations and difficulties in their analysis (e.g., highly

diversified companies) as factors that negatively affect the quality of earnings.

2-68. Analysts must be alert to accounting distortions. Some of the most common and most pervasive

manipulative practices in accounting are designed to affect the presentation of earnings trends. These

manipulations are based on the assumptions, generally true, that the trend of income is more important than its

absolute size, that retroactive revisions of income already reported in prior periods have little, if any, market effect

on security prices and that once a company has incurred a loss, the size of the loss is not as significant as the fact

that the loss has been incurred. These assumptions and the propensities of some managers to use accounting as a

means of improving the appearance of the earnings trend has led to techniques which can be broadly described

as "earnings management."

The earnings management process so as to distinguish it from outright fraudulent reporting must meet a number

of requirements. This process is a rather sophisticated device. It does not rely on outright or patent falsehoods and

distortions, but rather uses the wide leeway existing in accounting principles and their interpretation in order to

achieve its ends. It is usually a matter of form rather than one of substance. Consequently, it does not involve a

real transaction (e.g., postponing an actual sale to another accounting period in order to shift revenue) but only a

redistribution of credits or charges among periods. The general objective is to moderate income variability over

the years by shifting income from good years to bad years, by shifting future income to the present (in most cases

presently reported earnings are more valuable than those reported at some future date) or vice versa.

2-69. Earnings management may take many forms. Listed here are some forms to which the analyst should be

particularly alert:

• Changing accounting methods or assumptions with the objective of improving or modifying reported results.

For example, to offset the effect on earnings of slumping sales and of other difficulties, Chrysler Corp. revised

upwards the assumed rate of return on its pension portfolio, thus increasing income significantly. Similarly,

Union Carbide improved results by switching to a number of more aggressive accounting alternatives.

• Misstatements, by various methods, of inventories as a means of redistributing income among the years.


2-24

• The offsetting of extraordinary credits by identical or nearly identical extraordinary charges as a means of

removing an unusual or sudden injection of income that may interfere with the display of a growing earnings

trend.

2-70. There are powerful incentives at work, which motivate companies and their employees to engage in income

smoothing. Companies in financial difficulties may be motivated to engage in such practices for what they see

and justify as their battle for survival. Successful companies will go to great lengths to uphold a hard-earned and

well-rewarded image of earnings growths by smoothing those earnings artificially. Moreover, compensation plans

or other incentives based on earnings will motivate managers to accelerate the recognition of income by

anticipating revenues or deferring expenses.

Analysts must appreciate the great variety of incentives and objectives that lead managers and, at times, second-

tier management without the knowledge of top management, to engage in practices ranging from smoothing to the

outright falsification of income.

It has been suggested that smoothing is justified if it can help a company report earnings closer to its true "earning

power" level. Such is not the function of financial reporting. As we have repeatedly seen in this work, the analyst

will be best served by a full disclosure of periodic results and the components which make these up. It is up to the

analyst to average, smooth, or otherwise adjust reported earnings in accordance with specific analytical purposes.

The accounting profession has earnestly tried to promulgate rules that discourage practices such as the smoothing

of earnings. However, given the powerful propensities of companies and of their owners and employees to engage

in such practices, analysts must realize that, where there is a will to smooth or even distort earnings, ways to do so

are available and will be found. Consequently, particularly in the case of companies where incentives to smooth

are likely to be present, analysts should analyze and scrutinize accounting practices in order to satisfy themselves

to the extent possible, regarding the integrity of the income-reporting process.


2-25

EXERCISES

Exercise 2-1 (10 minutes)

a. Perhaps the most important disadvantage of complete uniform accounting is that it would be inflexible and, if

nationally or internationally adopted, it would be exceedingly difficult to change and to utilize new ideas. In

short, total uniformity might freeze the state of accounting at its current level of development. Second,

complete uniformity might stifle new approaches and ideas. This would be particularly true from the technical

approach to accounting (as contrasted with the economic and business approaches). Third, entirely uniform

accounting might not be appropriate for all industries and all countries. Different countries have different

economic objectives. For example, uniformity in accounting is more desirable in France where economic

planning is important than in Germany, where the long-term trend in accounting has been toward less

uniformity. Furthermore, the same accounting system may not be appropriate for the utility industry as opposed

to railroads. Accounting must in some respects be tailored to the nature of the business. Fourth, an additional

problem is that total uniformity in accounting would be difficult and expensive to implement. Accountants

and regulatory authorities would disagree on the standardized form, and small firms would have difficulty

shouldering the cost of adopting the full standardized form.

b. Uniform accounting does not necessarily mean comparability. Uniform accounting can mean (a) uniform

classification of accounts (a classification system), (b) a uniform plan (a system of procedures), or (c) total

uniformity. The latter would not seem to be desirable in view of the different characteristics of different

businesses. For example, different pieces of equipment may have different lives and should be depreciated

accordingly. Different mines have different expected reserves and should be depleted accordingly. Different

lists of receivables have different quality, and bad debts reserves should accordingly vary. It would seem very

unfair and inadvisable to apply the same depreciation rate, the same depletion rate, and the same bad debts

reserves for all companies regardless of the nature of their businesses. Thus, comparability might include

uniform classification of accounts and a uniform plan but not total uniformity.


a. Market prices usually will appropriately increase or decrease in advance of an earnings announcement. For

example, stock prices usually rise in advance of a strong earnings report and fall in advance of a weak earnings

report. This happens as the market receives information that suggests strong or weak earnings.

b. There are many types of information that might be received in advance of earnings announcements. For

example, the market can receive signals about the strength of macroeconomic conditions, conditions in the


2-26

industry, and the relative strengths or weaknesses of sales of the company’s products. All of these indicators

can contain information about the ultimate strength of the company’s earnings. Of course, there are a limitless

number of such signals available that can be used to predict earnings with some accuracy.

c. The relatively small reaction after the formal announcement represents the market updating

the price to account for the difference between the expected earnings based on prior

information and the actual earnings report.


a. Summary earnings information is released well in advance of release of the annual report. As a result, when

the financial statements are released, the market via the earlier earnings announcement already knows the

bottom-line earnings number.

b. Release of the income statement does contain additional information for the market because the income

statement has much more line item revenue and expense detail than does the earnings announcement.


Quarterly financial reports are subject to seasonal differences. It is not always meaningful to compare for example,

the third and fourth quarters for a couple of reasons. (1) Companies might have seasonal sales (consider retailers

and the holiday season for example). (2) Companies tend to make most of their large, annual accruals and

adjustments in the fourth quarter of the fiscal year. These are the two factors to keep in mind when using quarterly

financial information.


a. Form 10-K (Annual Report)

b. Regulation 14-A (Proxy statement)

c. Regulation 14-A (Proxy statement)

d. Regulation 14-A (Proxy statement)

e. Form 10-Q (Quarterly Report)


2-27

f. Form 8-K (Current Report)

g. Prospectus


Several penalties can be imposed upon a manager that contemplates or perpetrates fraudulent revenue recognition.

First, the auditors may identify the fraudulent revenue and refuse to issue an unqualified opinion on the financial

statements. When this occurs, the managers often relent and correct the misstatement. If the auditor is unable to

force a correction, the auditor will either quit or be forced to issue an adverse opinion. Second, the Securities and

Exchange Commission may force the manager to restate the financials. This action often results in a stock price

drop and questions about the integrity of the manager in the managerial labor market. The SEC may also fine the

manager or even prosecute the manager criminally. Third, corporate governance exists to limit the ability of

managers to misstate the financial statements. For example, the Board of Directors will form an audit committee

that will oversee the audit of the firm. In addition, the Board of Directors will usually hire and oversee internal

auditors that should search for such misstatements. Last, but certainly not least, the manager and/or the firm may

face litigation as a result of misstatements.


a. Yes, the manager is likely to voluntarily disclose this early to lessen the probability of a resulting lawsuit.

b. Yes, the manager is likely to voluntarily disclose this early to adjust earnings expectations downward.

c. The manager is less likely to voluntarily disclose this early because it is good news. Usually managers would

prefer to simply exceed expectations with the actual announcement of unexpectedly favorable news.

d. Yes, the manager is likely to voluntarily disclose this to adjust earnings expectations downward in line with

his/her lower expected earnings.

e. Management might voluntarily disclose this under the signaling hypothesis. The signal that the manager would

hope to convey via voluntary disclosure is that the market appears to be undervaluing the firm.


a. The primary advantage of financial statements over analysts’ forecasts is that financial statements are reliably

prepared according to a known set of generally accepted accounting principles. The analysts’ forecasts are


2-28

the result of the analysts’ individual beliefs and calculations. Thus, they can be arrived at using an infinite

number of models. For example, analysts’ forecasts are believed to be biased towards understating earnings.

b. Analysts’ forecasts have advantages over financial statement information. First, they are timelier. The analyst

can revise the forecast as soon as news is received. Financial statements will only reflect this information the

next time they are issued. Also, analysts’ forecasts can consider additional signals that aren’t captured by

financial accounting such as the hiring of talented employees or changing economic conditions. Last, analysts’

forecasts are forward looking. Financial statements are only backward looking.

c. Analysts’ forecasts and financial statements are interrelated because financial statements are usually a major

input into the analysts’ forecasting process. Analysts use the backward looking financial statements to help

them predict future results and financial position. Also, since analysts are a significant user group, the input of

analysts is important when accounting principles are formulated. Thus, analysts have a role in the generation

of financial statements.


a. Historical cost accounting measures assets and liabilities at the original cost at which they were transacted at.

Fair value accounting measures assets and liabilities at their fair value (market value) on the date of the balance

sheet. Under historical cost accounting entries are made only when an actual transaction arises, under fair value

accounting measurements are updated on periodically even in the absence of explicit transactions.

b. Advantages of fair value accounting are: it reflects more current valuation of assets/liabilities, uses a consistent

measurement criteria for all assets and liabilities, enhances comparability across firms and time and is useful

for equity analysis because it eschews conservatism. The disadvantages of fair value accounting are that it is

less reliable and objective and increases susceptibility to manipulation especially when Level 3 inputs are

used, it is less useful for credit analysis since it removes conservatism, and income under fair value accounting

is excessively volatile and does not reflect underlying operating profitability.

c. Financial assets and liabilities more readily lend themselves to fair value accounting. This is because they

are homogenous and are generally traded in liquid markets with observable prices. It is more difficult to

visualize a situation when operating assets, especially fixed assets and intangible assets are measured at

fair value. For such assets it is necessary to use Level 3 inputs to a large extent, and such usage will decrease

the reliability and objectivity of accounting information.


2-29

d. Under fair value accounting, income largely becomes a number that represents the net change in the fair value

of assets and liabilities. This number will be very volatile because of movements in the fair value of long-term

assets and liabilities. Because of this, income measured under fair value accounting will cease to measure the

underlying profitability of an enterprise, which is one of the central quests in financial statement analysis.


a. Accrual accounting income statements are more useful for analyzing business performance than cash flow

based statement for a number of reasons. The reasons pertain to the matching and timing problems

inherent in cash flow based statements. Accrual based information attempts to recognize revenues when

earned and match the related costs against the revenues. This is a reflection of the performance for the

month. Cash inflows may or may not occur in the period that the benefits are earned. Likewise, cash

outflows may or may not occur in the appropriate period to be matched against the related revenues. As a

result, performance measures can be greatly skewed and misleading. Also, accruals have some

information value. We can gain some insight by assessing management’s estimate of future losses such as

bad debts. Last, cash flow performance can be manipulated easily by management. For example, if the

manager wants to show better performance on a cash basis, he/she will simply delay the payment of expenses

until the first day of the next accounting period.

b. The asset side of a cash flow based balance sheet would simply be cash. This is because we make no

accruals. As a result, fixed assets would be expensed when paid for rather than being capitalized and

depreciated. Likewise, accounts receivables would not be accrued. We would simply recognize revenue

when cash is received. The cost of inventory would also be expensed in the period that the inventory is

purchased. The asset side of an accrual balance sheet is, of course, much more informative. It would contain

items of value like inventory, accounts receivable, and fixed assets.

c. Cash flow information is reliable because it involves no estimates, judgments, or choices by the preparer of

the information. Instead, the amounts are based on verifiable cash receipts and cash payments. However,

this cash flow based information is not always relevant for decision-making purposes. For example, a

measure of performance based on cash flows is highly variant and not a great indicator of future cash flows.

However, performance measures using accrual accounting such as net income are more relevant. These

measures, with revenues recognized when earned and costs matched to the revenues, are useful data for

assessing past performance and predicting future cash generating capacity. Thus, the information is more

relevant than cash flow information.


2-30


a. Analysts’ forecasts are often more relevant than financial statement information for a couple of reasons. First,

the forecasts are more timely in that they are often updated based on new information. Financial statements are

only issued quarterly. Also, analysts’ forecasts can impound information not impounded in financial statements

such as beliefs about future macroeconomic changes. Last, analysts’ forecasts are forward looking. Financial

statement information is backward looking.

b. Analysts’ forecasts are generally not as reliable as financial statements for a couple of reasons. First, financial

statement information is based on verifiable transactions and economic events. Second, financial statements

are prepared based on a known set of generally accepted principles. Analysts’ forecasts are the product of the

analyst’s model, which may or may not be known to the user. Also, empirical research has shown that, on

average, analysts’ forecasts are often biased down. That is, actual earnings are, on average, higher than analysts’

forecasts creating positive earnings surprises.


First, the principles underlying accounting information may not be entirely reflective of economic reality. For

example, long-lived assets are reported at historical cost less accumulated depreciation. Asset value appreciation

is not recognized. As a result, the carrying value of long-lived assets is often not reflective of fair value (economic

reality). Also, accounting standards do not allow for the recognition of internally generated goodwill. As a result,

the company can be worth far more than the reported book value due to internally generated goodwill that is not

recorded in the accounts.

Second, preparing accounting information requires certain judgments and estimates. The actual outcome may

or may not equal the estimate. As a result, economic reality may differ from the reported accounting information.

For example, a company estimates the amount of obsolescence present in inventory at the end of an accounting

period. The actual obsolescence (economic reality) may be greater or less than the amount estimated.

Third, the relevance / reliability trade-off causes differences between reported accounting information and

economic reality. For example, consider a firm that is facing a large lawsuit. The amount of the loss will be

estimated and disclosed if the probability of loss is high, the amount of the potential loss is significant, and the

amount of the ultimate loss can be estimated. If the amount of a loss cannot be estimated, the liability will not be

reported on the balance sheet. As a result, economic reality is not reflected in the accounting information.


2-31

A fourth reason why accounting information might deviate from economic reality is the latitude that managers

have in preparing the information. Managers often use this latitude opportunistically. For example, firms often

overstate the amount of certain liabilities such as restructuring charges. These overstated liabilities are then used

in the future to increase net income. The overstated liabilities cause differences between economic reality and

reported accounting information.


a. A “cookie-jar” reserve is created in the reserve for bad debts and obsolete inventory by overstating the

expected amount of future uncollectible accounts and inventory that is not salable. Overstating the

amount of future loss creates hidden reserves in certain liabilities.

b. In future periods, these overstated reserves can be used to increase earnings. For example, in a period of soft

sales, net income can be increased by making a smaller than necessary accrual for bad debts or obsolete

inventory. Some past accrual can even be reversed. Likewise, these certain liabilities can be reversed or simply

debited for certain expenses rather than an expense account.


a. Overstated loan loss reserves can be used to manage earnings in the future. As a result, banks often choose to

overstate future losses as part of a “big bath” accounting strategy.

b. In future years, if net income is somewhat less than expected, it can be increased by recognizing less loan loss

expense than usual. This is possible because the reserve will still be adequately large since it was overstated in

an earlier year.


2-32

PROBLEMS

Problem 2-1 (15 minutes)

The standard setting process is of great relevance to the financial analyst because it provides insight into the final

product of this process, i.e., accounting standards.

The financial analyst, in order to analyze financial statements intelligently, must have a sound understanding of the

standards that underlie the preparation of these financial statements. Since financial accounting standards are the

result of the standard setting process, the nature of this process affects the soundness and the lack of ambiguity of

the standards. The standard-setting process is at risk to subversion by special interests and by standard setters trying

to accommodate all. For example, if standards are written in such a way so as to satisfy different conflicting

interests then they are likely to be "soft," i.e., subject to a wide variety of interpretations. That, in turn, can lead to

practice that avoids the letter as well as the spirit of the standard.


a. Neutrality lies at the heart of reliability--it implies accounting devoid of ulterior motives and devoid of

interests other than that of objective and fair presentation and reporting. It is even-handed with respect to the

impact of the information on user's behavior.

b. Examples are when accounting slants presentations so as to make financial statements present a financial

position in a way superior to that which exists or to present results of operations more favorable than were in

fact achieved. The motives for such presentations that lack in neutrality relate to the parties’ self-interests.

Cases can be readily drawn from news media such as Business Week.


a) Under current generally accepted accounting standards, measurement means determination of the cost or

net realizable value of an asset or liability.

Determining the original cost of an asset, say, in the purchase of land, involves little more than recording the

purchase price in most cases. Measuring the fair value of accounts receivable, however, involves estimating how

much will ultimately be collected. Here we deal with probabilities based on experience, and this is a different level

of precision in measurement.


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b) Many analysts seem to be offended by the precision implied in the accountant's use of the word

"measurement." Equity analysts want the measurement to have a link to or relevance to the ultimate

valuation by the market place. This is, however, an altogether different level of measurement and estimation.

Analysts may start with accounting measurements but they must build on their assessments of how the

market will (1) adjust these accounting measurements to its perceptions of relevant valuation factors and

(2) value these, e.g., determine what price-earnings ratios they will accord to the adjusted earnings.

c) The two measurement objectives are different. Accountants lay no claim to engaging in valuation. They

merely provide the raw material for this process. Accounting measurements aim to estimate the most

probable cash flows that will ultimately be realized from an asset or be devoted to the repayment of a

liability. Measurement is only selectively concerned with the time value of money.

Analysts seek measurements that are relevant to the valuation of the aggregate business enterprise in the context

of the market place. Measurement is concerned with the timing of these cash flows and their valuation. In many

cases, as a practical matter, it is concerned with the capitalization of the most relevant earnings number. The

analyst's measurement starts with that of the accountant and builds on it.


a. Pure rules of measurement are possible only when the process of measuring is scientific, objective, and

generally incontrovertible. In accounting, rules of measurement cannot be "sold" to those who have to live with

them solely on that basis. These rules must be made acceptable to a majority of those who must abide by them.

It is this requirement that gives them the character of rules of conduct to be abided by. To many, abiding by

such rules may involve sacrifices. Hence, the need for acceptability as well as fairness.

b. The process by which acceptability is secured is basically a political process. It requires that those whose

concurrence is sought be involved in the decision process, have a voice in the consideration of alternatives, be

persuaded that compromises which have to be reached are fair, and recognize the theoretical soundness of the

proposed solution.

Purists would argue that accounting is a science and that solutions to questions of accounting standards should be

arrived at by the "scientific method" of observation, experimentation, and verification. In the final analysis,


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accounting is more of a service activity than a service governed by natural law. To the extent that accounting is a

science, it is a social science subject to the mores of the society of which it is part.


a. Society has brought increasing pressure to bear on accountants in its desire to improve the efficiency with which

its assets are priced and its capital investment directed. It has also chosen to exploit the notion that corporation

activity is an appropriate point at which to extract taxes from the economy and control economic activity.

Aspects of pressure on accountants include the increasing role of securities commissions requiring "full

disclosure," the emergence of class action suits, the growing taxation bureaucracy, and the increasing literacy

of the populace, including the press, corporate clients, and securities analysts. Indeed, society's developing

objectives have made the practice of accounting and auditing increasingly demanding, if not hazardous.

Recent reports and hearings by congressional committees are part of society's pressures on accountants so that

it is better served.

b. Accountants' accommodation consists mainly of educating the profession and the public and enlarging the

professional membership. Standards boards and research committees are sometimes viewed as devices to

protect accountants by providing them an authority with which to counter and modify the thrusts of society.

The accounting profession can enhance its position and at the same time improve its service to society by

insisting that, while numbers are not possible without definitions, by recognizing the uniqueness of each

enterprise, qualifications and descriptions enhance meaning and reduce possibilities for abuse of numbers and

generally applied definitions.

The organized profession's response to congressional action has been to organize politically as well as to

promote and promise self-reform. Among these measures are the establishment of a Public Oversight Board by

the AICPA, and the establishment of Peer Review as well as the institution of continuing Professional

Education.

(CFA Adapted)


a. In accounting, conservatism states that when choosing between two solutions, the one that will be least

likely to overstate assets and income should be selected. The two main advantages of conservatism are

that (1) it naturally offsets the optimistic bias on the part of management to report higher income or

higher net assets; and (2) it is important for credit analysis and debt contracting because creditors

prefer financial statements that highlight downside risk.


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b. The standard setters’ opinion arises because conservatism violates the “neutrality” requirement of

accounting and therefore purportedly reduces reliability. However, one could argue that neutral standards

suffer from an optimistic bias because of managers’ propensity to overstate income and/or net assets. By

counteracting this inherent optimistic bias one could argue that conservatism actually increases neutrality in

financial reporting.

c. An equity analyst may prefer a neutral accounting model, like fair value accounting, because equity

analysis seeks to also determine upside potential that is not reported in conservative statements. Credit

analysts, however, obviously prefer conservative presentation of financial statements.

d. Many analysts and investors (Warren Buffet) believe that conservative accounting is high “quality”

accounting. However, conservatism can reduce accounting quality in many instances. For example,

many managers write-off assets through aggressive use of one-time charges. This reduces the information

content of the financial statements and allows managers to report excessively higher income in future

periods.

e. The two forms of conservatism are unconditional conservatism and conditional conservatism.

Unconditional conservatism refers to understatement of assets without regard to the underlying

economics, such as not capitalizing R&D. Conditional conservatism refers to a conservative

presentation of economic events by recognizing the future effects of bad news

immediately but deferring the recognition of good news. For example, an asset impairment is

immediately recognized but an increase in asset values is only gradually recognized through future revenues

and cash flows as they arise.


a. The business observer's view is certainly skeptical, bordering on cynical. Also, there is a good deal of

misunderstanding regarding the function of general purpose financial reports in what he says. It also appears

that the observer is confusing the function of the corporate controller (management accountant) with that of the

independent public accountant whose function it is to probe and to reveal.

While we have come a long way from the time when almost any financial disclosure was viewed as the giving

away of competitive information, there remains a great deal that is not disclosed primarily for competitive

reasons. Present-day financial disclosure requirements do not require details about the physical composition of


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inventories or the identification of specific slow-paying customers. Much additional information which analysts

may view as essential need similarly not be disclosed. It is this lack of requirements rather than the accountant's

subservience to management that represents the main reason why such information is rarely found in published

financial reports. That independent public accountants, whose primary function it is to serve the public interest,

are sometimes unduly influenced by management's desires is well known and a problem much in the forefront

of public discussion today. (See examples in Appendix 2A and elsewhere in the book.) However, the degree of

public disclosure necessary is a matter of public policy, which is importantly influenced by the SEC. The day

is long past when accountants were the sole setters of disclosure policy.

For reasons of competition, cost, and other considerations, it is unlikely that all information desired by financial

analysts will ever be provided in general purpose public reports. Consequently, this will remain an area where

analysts will have to exercise their information-gathering ingenuity to the fullest extent. Much additional

information of a statistical nature is often available on request.

b. The omitted information which the business observer is referring to is the type every serious financial analyst

would like to get as much as possible of to assess the risks inherent in a business enterprise as well as the

rewards which can be expected from it. Such quantified data as product sales breakdowns, inventory

composition, and customer-paying records are indeed data needed by any good management in the conduct and

planning of business operations. While analysts will not find these data in most financial statements, they

attempt to obtain them, if they need them, from management or from other sources.

In a report based on a survey of financial reports, the Financial Analysts Federation's corporate information

committee listed the following most prevalent problem areas:

• Lack of detail in production costs and marketing types of information.

• Lack of non-statement detail, such as labor costs or contracts, pension information, regulations, etc.

• Limited discussion on economic and industry developments that represent current or recent problems,

unusual developments or facts not generally available to average investors or shareholders.

• A need for more disclosure of operating statistics already on file with regulatory agencies.

A very important source of narrative as well as quantified information which is available is "Management's

Discussion and Analysis of Financial Condition and Results of Operations" which, because of specific SEC

requirements, must contain significant and meaningful information.


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The logic underlying the “new paradigm” argument is intuitively appealing. Indeed, the future earning potential

of many of these companies is based on assets that aren’t recognized on accounting balance sheets under GAAP.

For example, these companies invest heavily in research and development, which is expensed. As a result, net

income and assets are quite low. Since the market is valuing the stock highly, both the price to earnings and price

to book ratios are high. However, new paradigm proponents would argue that this is because the base is too low.

The future earning potential is very high.

Opponents argue that valuations must ultimately be supported by positive earning ability and they don’t believe

that these great earnings will materialize given the competitive nature of the high-tech business environment.

Further, they argue that “new paradigm”-type arguments are not new. Similar statements were made with all of

the great financial “bubbles” of the past. The valuations of these firms is simply momentum investing that is far

beyond the fundamental value of the firm given future earnings potential and probabilities of future earnings.

Who is right? At the time of this writing, that is the most debated question on Wall Street and Main Street. There

are certain intuitively appealing aspects to arguments on both sides. There is some historical data that supports the

view of opponents. Future empirical researchers will spend great energy answering, in retrospect, which argument

was more correct. For now, one person’s opinion is no better than another.


a. While the above argument appeals to intuition, it is unworkable. We need a method of profit determination on

a periodic basis and we cannot liquidate the business every time a profit measurement is needed.

b. The most practical solution is the diligent and impartial application of the accrual method of accounting

measurement. The assumptions underlying accrual accounting are important to bear in mind as one uses accrual

accounting information. For example, accrual accounting assumes that the company can continue as a going

concern so that the business will be around to realize the conversion of accrued amounts to cash.


The production company will be providing accounting information in this special setting. The information that is

provided should be useful in deciding whether the movie investment is worthwhile and must be somewhat reliable.

a. The film makers should provide a description of the story or even make the script available. The name of the

key production personnel such as producers and directors should be disclosed along with information about

past work. Key employees should also be listed including any signed cast members. Also, investors should


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receive reliable cost projections related to the movie production. This information would enable potential

investors to make assessments about the revenue potential of the movie and the expected cost of production.

b. The prospectus should provide information to enhance the credibility of the information. For example, a

complete list of the relevant past works of the producers, directors, and cast members should be provided. Any

relevant education and training history for the producers and directors would be useful as well. If available,

revenue figures from the past works of the producers, directors, and prominent actors and actresses (the

individuals who are most directly related to the revenue potential of the movie) should be provided. This is

some evidence to support claims that the production team is able to produce work that produces revenues. The

movie cost projections should be classified by major cost type to lend credibility to the overall cost projections.


a. Discussion of the role the following parties should play in standard setting:

1. The FASB should be the most important component of the guideline promulgation process. The Board has

the knowledge to produce rules that are the best solution to information needs of the capital markets. Their

conclusions must be grounded in accounting and finance theory and produced independent of political or

other pressures.

2. The SEC should oversee the FASB to ensure that the Board is continuing to successfully fulfill its role as

an independent rule-making body working in the best interests of the accounting profession.

3. The AICPA should ensure that the FASB is comprised of highly qualified professionals and is continuing

to successfully fulfill its role as an independent rule-making body working in the best interests of the

accounting profession.

4. Members of Congress are subject to great pressures from important constituencies. Thus, Congress should

be kept largely out of the rule-making process. However, this is difficult given the hierarchy that empowers

the SEC, the AICPA, and ultimately the FASB to make the rules.

5. Company CEO’s should continue to diligently provide input to the FASB regarding existing rules and

regarding proposed new rules. The FASB, in turn, should value the input of the CEO’s greatly and use this

input as they finalize the rules.

6. Much like the executives of companies, accounting firm partners should remain active in the rule-making

process by providing the FASB valuable input on existing rules and proposed new rules. Again, the FASB

should heed the input of the accounting firms.


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7. Investors should play an active, if not the most active, role in accounting standard setting. Investors are the

‘end-users’ of financial accounting reports, and, as such, should have the most input into the promulgation

of standards. However, investors’ knowledge of the ramifications of accounting standards and the cost to

implement new standards may not be of the best quality.

b. Company executives diligently pressured Congress to intervene and ensure the FASB does not pass a rule

requiring the expensing of the fair value of stock options. The pressure apparently worked. In the end, the

FASB passed a compromise rule that suggests but does not require expensing the value of options.


a.

Yr 9 Yr 8 Yr 7 Yr 6 Yr 5 Yr 4

1. Net income per share 1.04a 2.07 1.57 0.91 1.04 1.22

a: (31.2/30.1)

b: (74.3/30.1)

c: (0.03/30.1)

d: (27.5/30.1)

Price per share 32.375 39.312 28.375 14.625 16.125 24.375

2. Operating cash flow per share 2.47b -0.86 3.76 1.23 0.99 0.62

Price per share 32.375 39.312 28.375 14.625 16.125 24.375

3. Net cash flow per share 0.00c -2.79 2.34 0.35 -0.46 -0.03

Price per share 32.375 39.312 28.375 14.625 16.125 24.375

4. Free cash flow per share 0.91d -2.41 3.19 0.82 0.07 0.14

Price per share 32.375 39.312 28.375 14.625 16.125 24.375

b. The net income per share figure best explains stock price. As you can see from your graph, the graph of

these two values across time is almost parallel.

c. Solutions depends on the company and data collected.


The wording in management’s discussion and analysis of Marsh suggests that the company decided to “take a big

bath” in conjunction with the recognition of the large charge related to the implementation of FAS 121.

Marsh believes that the additional charges taken in the quarter will be perceived less unfavorably by the market

than if they had each been recorded in separate quarters. Now the company has recognized all of its losses. These

items are no longer looming as losses that need to be recognized. Thus, in the future, net income will be higher.


2-40


a. Earnings smoothing.

b. The earnings record of Emerson reflects primarily a core business that is very stable in nature. Also,

excellent management has contributed to the ability of the company to report this impressive string of

earnings increases. Lastly, earnings management has had to be used to report the unfailing string of

earnings increases. Despite the solid management team and the stable core businesses, it would be very

difficult for a company to achieve this record without some earnings management.

c. In good years, Emerson likely records especially large expense accruals related to estimate future losses. In

bad years, the company simply records an amount of expense accrual at the lower end of the acceptable range.

By doing this, the company is able to manage earnings to some extent.

d. In Y5, the company barely beat Y4 earnings (less than 1% increase). It is possible that the company needed to

draw upon hidden reserve to beat the Y4 total. Again, in Y8, the company only beat the prior year by 1.9%.

The company may have needed to use earnings management to bring earnings above the Y7 total. In Y13, the

company beat the previous year by about 3%. Again, earnings management may have been needed to lift

earnings that year. There are several years when earnings were much higher than the previous year (e.g., 2, 6,

11, 16, 17, 18, 19, and 20). In these years, the company likely created hidden reserves by recognizing larger

loss estimates.


The “nail soup” analogy is attention grabbing and uses imagery to make an interesting point. However, most

do not agree with the fundamental point asserted. It is true that accruals have a discretionary component and other

estimation errors built into it.

To the extent that managers use this discretion opportunistically, the accruals can create some distortion in financial

reporting. However, the positive information provided by accruals is of much greater benefit than the distortion

created by accruals. To illustrate this, see the graphs in Problem 2-11.


2-41


a. Most agree with the statement. Accruals do, in fact, have disadvantageous properties such as providing an

opportunity for some manipulation. However, to ignore them because of a slight imperfection is not prudent.

b. Accrual accounting information provides a better measure of performance because accruals eliminate the

timing and matching problems of revenues and expenses. As a result, accrual-based net income is very useful

in assessing the performance of the company and predicting future cash flows.

c. Many accruals such as interest expense are largely non-discretionary. As a result, the amount of the accrual is

reliable and verifiable. The imperfections of accrual accounting arise from the discretionary nature of

certain accruals. These accruals involve predictions about the future that are slightly less reliable because

of uncertainty about the future. Thus, accrual-based information may not exactly depict “economic reality.”

However, the information is closer to economic reality than if no accruals were recorded.

d. The prudent approach to analysis using accrual accounting information is to review the nature of the accruals

for a company. If the company’s management appears to have had many discretionary accruals than this should

be considered in the analysis. Discretionary accruals lead to the possibility of lower quality financial reporting.

The quality of the information can be enhanced via accounting analysis and recasting certain disclosures to

more closely reflect accounting reality.


The quarter ended September 30, 20X9 contains two unusual items. First, the company recorded the effect of a

change in the accounting rules related to software development. This change resulted in additional income totaling

$68 million (approximately $44 million after tax). Second, the company recorded a gain on sale of receivables

totaling $36 million after incremental tax expense. If reported net income is reduced by these amounts, net income

is actually less than the third quarter of the previous year.

After these adjustments are made, earnings per share is approximately equal to the prior year. Return on equity as

reported is 25.3%. This suggests equity totaling approximately $2,561 ($648/.253). If net income is reduced by

the $80 million of unusual items, return on equity falls to 22.2%. Again, this would suggest that performance in

the current quarter was worse than that of the same quarter in the prior year. Thus, while 22% return on equity is

quite good, it is not as good as the reported 25%. Also, the trend would be much less positively sloped.


2-42

CASES

Case 2-1 (15 minutes)

a. The management of Dell, Inc. is responsible for the preparation and integrity of the consolidated financial

statements and related notes that appear in the annual report. This is stated in the letter of Management’s

Responsibility for Financial Statements.

b. Note #1: Description of Business and Summary of Significant Accounting Policies

c. The international accounting firm of PriceWaterhouseCoopers LLP issued an unqualified (clean) opinion on

the Dell financial statements.

d. Yes, estimates are used. The company discusses this in note #1 (Use of Estimates).

Case 2-2 (30 minutes)

a. Political influences on accounting are, and remain, strong. The SEC's resistance to the adoption of the preferred

successful accounting method was strongly influenced by pressure not only from affected oil companies but

also by congressmen from oil-producing states.

The bending of rules was narrowly avoided when the commission stood up to the companies and to its staff.

Had the SEC acquiesced to this bending of rules in time of stress, accounting integrity would have suffered

another blow.

b. Tenneco's change in accounting method seems designed to avoid a write-off to income of capitalized production

costs that exceed the SEC-defined ceiling which are affected by dropping oil prices.

Tenneco had demonstrated how companies could use accounting rules to their advantage. Tenneco's past

drilling expenses would be offset against past reported results and would never appear on a current income

statement. Those costs will now be matched against revenues earned at a time when oil prices were much higher

than at present.


2-43

While analysts may be able to adjust for the effects of Tenneco's accounting strategy their task in assessing the

company's real earning power will be rendered more difficult.

Case 2-3B (60 minutes)

(1) The tonnage-of-production method provides an especially good matching of depreciation expense against

revenues for Canada Steel's highly cyclical business. A unit-of-production method effectively makes

depreciation a variable rather than a fixed cost and, therefore, tends to stabilize earnings. Casting metals is not

a high technology business, and actual wear and tear on the equipment is more relevant to replacement need

than technological obsolescence.

A switch to straight-line would not eliminate the deferred tax liability as this difference is caused by accelerated

methods and shorter lives rather than the difference between the tonnage-of-production and straight-line

methods. Moreover, Canada Steel should not attempt to extinguish this liability since it is an interest-free loan

from the government, which may never have to be repaid as long as new assets are acquired.

A switch to straight-line would leverage profits on any production increase (or decrease) because depreciation

expense would be a direct function of time rather than units produced. However, the quality of earnings could

be reduced by a switch to straight-line inasmuch as this method would accentuate the highly cyclical nature of

our business and result in an increased net income volatility.

(2) The reasons for adopting the LIFO method--reducing taxes and increasing cash flow--are still valid. Inflation

usually declines during recessions, but this does not mean its recurrence is improbable. Maximizing cash flow

remains important to the corporation and shareholders. A return to FIFO would relinquish the tax savings of

prior years, although it is true that the balance sheet and income statement would be strengthened by the change.

The quality of earnings is likely to be affected adversely by the lack of consistency in inventory method (two

changes in a period of several years) and a perception that the motive in making the change was to increase

book value per share, avoid two consecutive unprofitable years, and escape violation of a loan covenant. The

$4 million upward adjustment in working capital is a result of increasing the inventory account by this amount,

which has the effect of increasing the current ratio as shown below:

LIFO FIFO

Current Assets ............................................... $10.5 $14.5


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Current Liabilities .......................................... $ 4.5 $ 4.5

Current Ratio ................................................. 2.3 3.2

The $0.5 million increment to net income will offset an operating loss of $0.4 million, which would not be

unexpected on a sales decline of 31%.

In addition, the $2.0 million addition to shareholders' equity from prior years' profits is likely to be far less

significant than current profit trends, as Canada Steel has had to disclose regularly in the footnotes to its

financial statements the difference in inventory values resulting from the use of LIFO versus FIFO.

Case 2-3B—continued

(3) The inventory change will enable Canada Steel to meet the minimum current ratio requirements. However, the

stock repurchase program should not be recommended for the following reasons:

a. The proposed repurchase price of $100 per share is well above book value and recent market prices,

suggesting dilution for remaining shareholders.

b. The potential dividend savings are outweighed by interest costs of $118,800 ($2.0 million x 11% x (1-0.46

marginal tax rate)) to finance the purchase--in other words, leverage is negative.

c. The debt-to-equity ratio is increased significantly from 10% ($2.0 million long-term debt/$17.7 million

equity + $2.0 million long-term debt) to 35% ($6.1 million long-term debt/$11.4 million equity + $6.1

million long-term debt). An additional $2.0 million of stock repurchased would raise this ratio to 41% ($8.1

million long-term debt/$11.5 million equity + $8.1 million long-term debt). The increased financial risk is

particularly inappropriate for an industry with significant sensitivity to the business cycle. Shrinking

shareholders' equity under present circumstances is prudent only by sale of fixed assets, not the incurrence

of additional debt.

In summary, each of the foregoing would have a negative impact on the quality of Canada Steel's earnings.


2-45

QUESTIONS [Superscript A (B) denotes assignments based on Appendix 2A (2B).]

2–1. Describe the U.S. financial reporting environment including the following:

a. Forces that impact the content of statutory financial reports

b. Rule-making bodies and regulatory agencies that formulate GAAP used in

financial reports

c. Users of financial information and what alternative sources of information are

available beyond

statutory financial reports

d. Enforcement and monitoring mechanisms to improve the integrity of statutory

financial reports

2–2. Why are earnings announcements made in advance of the release of

financial statements? What information

do they contain and how are they different from financial statements?

2–3. Describe the content and purpose of at least four financial reports that must

be filed with the SEC.

2–4. What constitutes contemporary GAAP?

2–5. Explain how accounting standards are established.

2–6. Who has the main responsibility for ensuring fair and accurate financial

reporting by a company?

2–7. Describe factors that bring about managerial discretion for preparing

financial statements.

2–8. Describe forces that serve to limit the ability of management to manage

financial statements.

2–9. Describe alternative information sources beyond statutory financial reports

that are available to investors

and creditors.

2–10. Describe tasks that financial intermediaries perform on behalf of financial

statement users.


2-46

2–11. Explain historical cost and fair value models of accounting. What explains

the move toward fair value accounting?

2–12. What is conservatism? What are its advantages?

2–13. What are the two types of conservatism? Which type of conservatism is more

useful for analysis?

2–14. Describe empirical evidence showing that financial accounting information

is relevant for decision

making.

2–15. Describe at least four major limitations of financial statement information.

2–16. It is difficult to measure the business performance of a company in the short

run using only cash flow measures because of timing and matching problems.

Describe each of these problems and cite at least

one example for each.

2–17. Describe the criteria necessary for a business to record revenue.

Chapter Two | Financial Reporting and Analysis 123

2–18. Explain when costs should be recognized as expenses.

2–19. Distinguish between short-term and long-term accruals.

2–20. Explain why cash flow measures of performance are less useful than accrual-

based measures.

2–21. What factors give rise to the superiority of accrual accounting over cash

accounting? Explain.

2–22. Accrual accounting information is conceptually more relevant than cash

flows. Describe empirical

findings that support this superiority of accrual accounting.

2–23. Accrual accounting information, cash flow information, and analysts’

forecasts are information for

investors. Compare and contrast each of these sources in terms of relevance and

reliability.


2-47

2–24. Define income. Distinguish income from cash flow.

2–25. What are the two basic economic concepts of income? What implications

do they have for analysis?

2–26. Economic income measures change in value while permanent income is

proportional to value itself.

Explain this statement.

2–27. Explain how accountants measure income.

2–28. Accounting income has elements of both permanent income and

economic income. Explain this statement.

2–29. Distinguish between the permanent and transitory components of income.

Cite an example of each, and

discuss how each component affects analysis.

2–30. Define and cite an example of a value irrelevant component of income.

2–31. Determining core income is an important first step to estimating permanent

income. Explain. What

adjustments to net income should be made for estimating core income?

2–32. What adjustments would you make to net income to determine economic

income?

2–33. Explain how accounting principles can, in certain cases, create differences

between financial statement

information and economic reality.

2–34. What are the key differences between the historical cost and the fair value

models of accounting?

2–35. Describe what income purports to represent under the historical cost and

the fair value accounting

models. How is income determined under either model?

2–36. Provide a formal definition for fair value. What are the key elements of this

definition?


2-48

2–37. Fair values are market-based measurements not entity-specific

measurements. Explain with an example.

2–38. Explain the hierarchy of inputs used in determining fair values. The use of

which level of input lowers the

reliability of fair value estimates?

2–39. Which types of assets/liabilities lend themselves more easily to fair value

measurements: financial or

operating? Explain with reference to the hierarchy of inputs.

2–40. Describe the three basic valuation approaches for estimating fair values.

Relate the valuation

approaches to hierarchy of inputs.

2–41. Discuss the advantages and disadvantages of fair value accounting.

2–42. In your opinion does historical cost or fair value model generate more (a)

relevant and (b) reliable

accounting information? Argue your case.

2–43. What are the major issues that an analyst needs to consider when analyzing

financial statements

prepared under the fair value accounting model?

2–44. Explain how estimates and judgments of financial statement preparers can

create differences between

financial statement information and economic reality.

2–45. What is accounting analysis? Explain.

2–46. What is the process to carry out an accounting analysis?

2–47. What gives rise to accounting distortions? Explain.

2–48. Why do managers sometimes manage earnings?

2–49. What are popular earnings management strategies? Explain.

2–50. Explain what is meant by the term earnings management and what

incentives managers have to engage


2-49

in earnings management.

124 Financial Statement Analysis

2–51. Describe the role that accrual accounting information and cash flow

information play in your own models

of company valuation.

2–52. Explain how accounting concepts and standards, and the financial

statements based on them, are

subject to the pervasive influence of individual judgments and incentives.

2–53. Would you be willing to pay more or less for a stock, on average, when the

accounting information provided

to you about the firm is unaudited? Explain.

2–54A. What are generally accepted auditing standards?

2–55A. What are auditing procedures? What are some basic objectives of a

financial statement audit?

2–56A. What does the opinion section of the auditor’s report usually cover?

2–57A. What are some implications to financial analysis stemming from the audit

process?

2–58A. An auditor does not prepare financial statements but instead samples and

investigates data to render a

professional opinion on whether the statements are “fairly presented.” List the

potential implications of

the auditor’s responsibility to users that rely on financial statements.

2–59A. What does the auditor’s reference to generally accepted accounting

principles imply for our analysis of

financial statements?

2–60A. What are some circumstances suggesting higher audit risk? Explain.

2–61A. Citigroup is currently audited by KPMG. Who pays KPMG for its audit of

Citigroup? To whom is KPMG


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providing assurance regarding the fair presentation of the Citigroup financial

statements? List two

market forces faced by KPMG that increase the probability that the firm

effectively performed an audit

with the interests of financial statement users in mind.

2–62A. Public accounting firms are being implored to assess a company’s

reported earnings per share relative

to the market expectation of earnings per share (e.g., consensus analysts’

forecast) when establishing

the level of misstatement that is considered acceptable (the materiality

threshold). Explain

why a 1 cent misstatement can be insignificant for one firm but significant to

another otherwise

comparable firm.

2–63B. What is meant by earnings quality? Why do users assess earnings quality?

What major factors determine

earnings quality?

2–64B. What are discretionary expenses? What is the importance of discretionary

expenses for analysis of

earnings quality?

2–65B. What is the relation between the reported value of assets and reported

earnings? What is the relation

between the reported values of liabilities, including provisions, and reported

earnings?

2–66B. How does a balance sheet analysis provide a check on the validity and

quality of earnings?

2–67B. What is the effect of external factors on earnings quality?


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2–68B. Explain how earnings management affects earnings quality. How is

earnings management distinguished

from fraudulent reporting?

2–69B. Identify and explain three types of earnings management that can reduce

earnings quality.

2–70B. What factors and incentives motivate companies (management) to

engage in earnings management?

What are the implications of these incentives for financial statement analysis?

EXERCISES Some financial statement users maintain that despite its intrinsic intellectual appeal, uniformity

in accounting seems unworkable in a complex modern society that relies, at least in part, on

economic market forces.

Required: a. Discuss at least three disadvantages of national or international accounting uniformity. b. Explain whether uniformity in accounting necessarily implies comparability. (CFA Adapted)

EXERCISE 2–1 Uniformity in Accounting

Chapter Two | Financial Reporting and Analysis 125 Announcements of good news or bad news earnings for the recently completed fiscal quarter EXERCISE 2–2 usually create fairly small abnormal stock price changes on the day of the announcement.

Required: a. Discuss how stock price changes over the preceding days or weeks help explain this phenomenon. b. Discuss the types of information that the market might have received in advance of the earnings announcement. c. How does the relatively small price reaction at the time of the earnings announcement relate to the price changes that are observed in the days or weeks prior to the announcement? Earnings

Announcements and Market Reactions

EXERCISE 2–3 Timeliness of


Some financial statement users criticize the timeliness of annual financial statements.

Required: a. Explain why summary information in the income statement is not new information when the annual report is issued. b. Describe the types of information in the income statement that are new information to financial statement users

when the annual report is issued. EXERCISE 2–4 Reliability of

Quarterly Reports

The SEC requires companies to submit statutory financial reports on both a quarterly and an

annual basis. The quarterly report is called the 10-Q.

Required: What are two factors about quarterly financial reports that can be misleading if the analyst does

not consider them when performing analysis of quarterly reports?

EXERCISE 2–6 Mechanisms to Monitor Financial Reporting

Managers are responsible for ensuring fair and accurate financial reporting. Managers also have

inside information that can aid their estimates of future outcomes. Yet, managers face incentives

to strategically report information in their best interests.

Required: Assume a manager of a publicly traded company is intending to recognize revenues in an

inappropriate and fraudulent manner. Explain the penalty(ies) that can be imposed on a manager


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by the monitoring and enforcement mechanisms in place to restrict such activity.

EXERCISE 2–5 Information in

SEC Reports

The SEC requires various statutory reports from companies with publicly traded securities.

Required: Identify which SEC report is the best place to find the following information.

a. Management’s discussion of the financial results for the fiscal year. b. Terms of the CEO’s compensation and the total compensation paid to the CEO in the prior fiscal year. c. Who is on the board of directors and are they from within or outside of the company? d. How much are the directors paid for their services? e. Results of operations and financial position of the company at the end of the second quarter. f. Why a firm changed its auditors. g. Details for the upcoming initial public offering of stock.


Incentives for

Voluntary Disclosure

There are various motivations for managers to make voluntary disclosures. Identify whether you

believe managers are likely to release the following information in the form of voluntary disclosure

(examine each case independently):

a. A company plans to sell an underperforming division for a substantial loss in the second quarter of next year. b. A company is experiencing disappointing sales and, as a result, expects to report disappointing earnings at the

end of this quarter. c. A company plans to report especially strong earnings this quarter. d. Management believes the consensus forecast of analysts is slightly higher than managers’ forecasts. e. Management strongly believes the company is undervalued at its current stock price. EXERCISE 2–7 Analyst Forecasts versus Financial Statements

Analysts produce forecasts of accounting earnings along with other forward-looking information.

This information has strengths and weaknesses versus financial statement information.

Required: a. Discuss whether you believe analysts forecasts are more relevant for business decision making than financial statement information. b. Discuss whether you believe analysts forecasts are more reliable than financial statement information. EXERCISE 2–11 Accrual Accounting versus Cash Flows

a. Identify at least two reasons why an accrual accounting income statement is more useful for analyzing business performance than a cash flow based income statement. b. Describe what would be reported on the asset side of a cash flow based balance sheet versus the asset side of

an accrual accounting balance sheet. c. A strength of accrual accounting is its relevance for decision making. The strength of cash flow information is its reliability. Explain what makes accrual accounting more relevant and cash flows more reliable. EXERCISE 2–10 Historical Cost versus Fair Value

Financial statements are inexorably moving to a model where all assets and liabilities will be measured

on the basis of fair value rather than historical cost.

Required: a. Discuss the conceptual differences between historical cost and fair value. b. Discuss the merits and demerits of the two alternative measurement models. c. What types of assets (or liabilities) more readily lend themselves to fair value measurements? Can we visualize a scenario where all assets are measured using fair value? d. What are the likely effects of adopting the fair value model on reported income? EXERCISE 2–9 Financial Statement Information versus

Analysts Forecasts

Financial statements are a major source of information about a company. Forecasts, reports, and

recommendations from analysts are popular alternative sources of information.

Required: a. Discuss the strengths of financial statement information for business decision makers. b. Discuss the strengths of analyst forecast information for business decision makers. c. Discuss how the two information sources in (a) and (b) are interrelated. EXERCISE 2–8


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Chapter Two | Financial Reporting and Analysis 127

PROBLEMS PROBLEM 2–1 Financial Statement

Analysis and

Standard Setting

Financial statement users often liken accounting standard setting to a political process. One user

asserted that: My view is that the setting of accounting standards is as much a product of political action

as of flawless logic or empirical findings. Why? Because the setting of standards is a social decision. Standards

place restrictions on behavior; therefore, they must be accepted by the affected parties. Acceptance

may be forced or voluntary or some of both. In a democratic society, getting acceptance is an exceedingly

complicated process that requires skillful marketing in a political arena. Many parties affected by

proposed standards intervene to protect their own interests while disguising their motivations as

altruistic or theoretical. People often say, “If you like the answer, you’ll love the theory.” It is also

alleged that those who are regulated by the standard-setting process have excessive influence

over the regulatory process. One FASB member declared: “The business community has much

greater influence than it’s ever had over standard setting. I think it’s unhealthy. It is the preparer

community that is really being regulated in this process, and if we have those being regulated

having a dominant role in the regulatory process, that’s asking for major trouble.”

Required: Discuss the relevance of the accounting standard-setting process to analysis of financial

statements.

EXERCISE 2–14 Banks and

Hidden Reserves

In the past decade, several large “money center” banks recorded huge additions

to their loan loss reserve. For example, Citicorp recorded a one-time addition to

its loan loss reserve totaling about $3 billion. These additions to loan loss reserves led to large net

losses for these banks. While most analysts agree that additional reserves were warranted, many

speculated the banks recorded more reserve than necessary.

Required: a. Why might a bank choose to record more loan loss reserve than necessary? b. Explain how overstated loan loss reserves can be used to manage earnings in future years. EXERCISE 2–13 Accounting for

Hidden Reserves

A former Chairman of the SEC refers to hidden reserves on the balance sheet as “cookie-jar”

reserves. These reserves are built up in periods when earnings are strong and drawn down to

bolster earnings in periods when earnings are weak.

Required: Reserves for (1) bad debts and (2) inventory, along with the (3) large accruals associated with

restructuring charges, are transactions that sometimes yield hidden reserves.

a. For each of these transactions, explain when and how a hidden reserve is created. b. For each of these transactions, explain when and how a hidden reserve is drawn down to boost earnings. EXERCISE 2–12 Accrual Accounting Measurement Error

Accrual accounting requires estimates of future outcomes. For example, the reserve for bad debts

is a forecast of the amount of current receivables that will ultimately prove uncollectible.

Required: Identify and explain three reasons why accounting information might deviate from the underlying

economic reality. Cite examples of transactions that might give rise to each of the reasons.

Citicorp 128 Financial Statement Analysis

Financial reporting has been likened to cartography:

Information cannot be neutral—it cannot therefore be reliable—if it is selected or presented

for the purpose of producing some chosen effect on human behavior. It is this

quality of neutrality which makes a map reliable; and the essential nature of accounting,

I believe, is cartographic. Accounting is financial mapmaking. The better the map, the

more completely it represents the complex phenomena that are being mapped. We do

not judge a map by the behavioral effects it produces. The distribution of natural wealth

or rainfall shown on a map may lead to population shifts or changes in industrial

location, which the government may like or dislike. That should be no concern of the

cartographer. We judge his map by how well it represents the facts. People can then

react to it as they will.


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Required: a. Explain why neutrality is such an important quality of financial statements. b. Identify examples of the lack of neutrality in accounting reports. PROBLEM 2–2 Neutrality of

Measurements in


PROBLEM 2–3 Analysts’ Information Needs and Accounting

Measurements

An editor of the Financial Analysts Journal reviewed an earlier edition of this book and asserted:

Broadly speaking, accounting numbers are of two types: those that can be measured

and those that have to be estimated. Investors who feel that accounting values are more

real than market values should remember that, although the estimated numbers in the

accounting statements often have a greater impact, singly or together, than the measured

numbers, accountants’ estimates are rarely based on any serious attempt by

accountants at business or economic judgment.

The main reason accountants shy away from precise statements of principle for the

determination of asset values is that neither they nor anyone else has yet come up with

principles that will consistently give values plausible enough that, if accounting statements

were based on these principles, users would take them seriously.

Required: a. Describe what is meant by measurement in accounting. b. According to this editor, what are the kinds of measurements investors want? c. Discuss whether the objectives of accountants and investors regarding accounting measurement are reconcilable. PROBLEM 2–4 Standard Setting and Politics

A FASB member expressed the following view:

Are we going to set accounting standards in the private sector or not? . . . Part of the

answer depends on how the business community views accounting standards. Are they

rules of conduct, designed to restrain unsocial behavior and arbitrate conflicts of economic

interest? Or are they rules of measurement, designed to generalize and communicate

as accurately as possible the complex results of economic events? . . . Rules of

conduct call for a political process . . . Rules of measurement, on the other hand, call

for a research process of observation and experimentation . . . Intellectually, the case is

compelling for viewing accounting as a measurement process . . . But the history of

accounting standard setting has been dominated by the other view—that accounting

standards are rules of conduct. The FASB was created out of the ashes of predecessors

burned up in the fires of the resulting political process.

Chapter Two | Financial Reporting and Analysis 129 Required: a. Discuss your views on the difference between “rules of conduct” and “rules of measurement.” b. Explain how accounting standard setting is a political process. Identify arguments for and against viewing

accounting standard setting as political. PROBLEM 2–7 Financial Reporting or

Financial Subterfuge

Consider the following claim from a business observer:

An accountant’s job is to conceal, not to reveal. An accountant is not asked to give outsiders

an accurate picture of what’s going on in a company. He is asked to transform the

figures on a company’s operations in such a way that it will be impossible to recreate

the original figures.

An income statement for a toy company doesn’t tell how many toys of various kinds

the company sold, or who the company’s best customers are. The balance sheet doesn’t

tell how many of each kind of toy the company has in inventory, or how much is owed

by each customer who is late in paying his bills.

PROBLEM 2–6 Conservatism

A standard setter recently made a private remark that conservatism was a “barbaric relic” that

violated the “neutrality” requirement of accounting information and that financial statements

would be far more informative without conservatism.

Required: a. What is conservatism? What are the reasons why conservatism continues to be dominant in financial statements?


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b. Do you agree with the observation by the standard setter? c. As an analyst would you prefer conservative accounting? Does your answer depend on your analysis objective? For example, would you prefer conservative accounting if you were an equity analyst? d. Many regard conservative accounting as “high-quality” accounting. Do you agree with this statement? Provide arguments for why you think conservative accounting increases or impedes accounting quality. e. Academics refer to two forms of conservatism. What are they? Which form of conservatism do you think is more useful for an analyst? PROBLEM 2–5 Accounting in Society

Consider the following excerpt from the Financial Analysts Journal:

Strictly speaking, the objectives of financial reporting are the objectives of society and

not of accountants and auditors, as such. Similarly, society has objective law and

medicine—namely, justice and health for the people—which are not necessarily the objectives

of lawyers and doctors, as such, in the conduct of their respective “business.”

In a variety of ways, society exerts pressure on a profession to act more nearly as if it

actively shared the objectives of society. Society’s pressure is to be measured by the degree

of accommodation on the part of the profession under pressure, and by the degree

of counterpressure applied by the profession. For example, doctors accommodate society

by getting better educations than otherwise and reducing incompetence in their

ranks. They apply counterpressure and gain protection by forming medical associations.

Required: a. Describe ways in which society has brought pressure on accountants to better serve its needs. b. Describe how the accounting profession has responded to these pressures. Could the profession have better responded?


In general, anything that a manager uses to do his job will be of interest to some

stockholders, customers, creditors, or government agencies. Managerial accounting

differs from financial accounting only because the accountant has to hide some of the

facts and figures managers find useful. The accountant simply has to throw out most of

the facts and some of the figures that the managers use when he creates the financial

statements for outsiders.

The rules of accounting reflect this tension. Even if the accountant thought of

himself as working only for the good of society, he would conceal certain facts in the

reports he helps write. Since the accountant is actually working for the company, or

even for the management of the company, he conceals many facts that outsiders would

like to have revealed.

Required: a. Discuss this observer’s misgivings on the role of the accountant in financial reporting. b. Discuss what type of omitted information the business observer is referring to. PROBLEM 2–8 Contemporary Valuation

Equity valuations in today’s market are arguably too high. Many analysts assert that price-toearnings

ratios are so high as to constitute an irrational valuation “bubble” that is bound to burst

and drag valuations down. Skeptics are especially wary of the valuations for high-tech and Internet

companies. Proponents of the “new paradigm” argue that the unusually high price-to-earnings

ratios associated with many high-tech and Internet companies are justified because modern business

is fundamentally different. In fact, many believe these companies are still, on average, undervalued.

They argue that these companies have invested great sums in intangible assets that will

produce large future profits. Also, research and development costs are expensed. This means they

reduce income each period and are not reported as assets on the balance sheet. Consequently,

earnings appear lower than normal and this yields price-to-earnings ratios that appear unreasonably

high.

Required: Assess and critique the positions of both the skeptics and proponents of this new paradigm.

PROBLEM 2–9 Income Measurement

and Interpretation

In a discussion of corporate income, a user of financial statements alleges that “One of the real

problems with income is that you never really know what it is. The only way you can find out is

to liquidate a company and reduce everything to cash. Then you can subtract what went into the

company from what came out and the result is income. Until then, income is only a product of

accounting rituals.”

Required: a. Do you agree with the above statement? Explain. What problems do you foresee in measuring income in the

manner described?


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b. What assumptions underlie periodic measurement of income under accrual accounting? Which income

approach do you think is more reasonable? Explain. PROBLEM 2–10 Specialized

Accounting Information

According to an article in TheWall Street Journal, a European filmmaking studio,

Polygram, is considering funding movie production by selling securities.

These securities will yield returns to investors based on the actual cash

flows of the movies that are financed from the sale of these securities.

Polygram Chapter Two | Financial Reporting and Analysis 131 Required: a. What information would you suggest the filmmakers provide to investors to encourage them to invest in the production of a particular movie or movies (i.e., what information is relevant to your decision to invest in a movie)? b. What kind of evidence can be included to support claims in the prospectus (i.e., what can maximize the reliability of the information released)?

Lands’ End PROBLEM 2–12 Relations between Income, Cash Flow,

and Stock Price

The following information is extracted from the annual report of

Lands’ End (in millions, except per share data):

Fiscal year Year 9 Year 8 Year 7 Year 6 Year 5 Year 4

Net income $31.2 $64.2 $ 51.0 $30.6 $36.1 $43.7 Cash from (used by) operations 74.3 (26.9) 121.8 41.4 34.5 22.4 Net cash flow 0.03 (86.5) 75.7 11.8 (16.1) (1.2) Free cash flow* 27.5 (74.6) 103.3 27.5 2.4 5.1 Market price per share (end of fiscal year) 32.375 39.312 28.375 14.625 16.125 24.375 Common shares outstanding 30.1 31.0 32.4 33.7 34.8 35.9 *Defined as: Cash flow from operations _ Capital expenditures _ Dividends.

Required: a. Calculate and graph the following separate relations:

(1) Net income per share (EPS) and market (3) Net cash flow per share and market price per share price per share (2) Cash from operations per share and market (4) Free cash flow per share and market price per share price per share PROBLEM 2–11 Politics and

Promulgation of Standards

The FASB in SFAS No. 123, “Accounting for Stock-Based Options,” encourages (but does not

require) companies to recognize compensation expense based on the fair value of stock options

awarded to their employees and managers. Early drafts of this proposal required the recognition

of the fair value of the options. But the FASB met opposition from companies and chose to only

encourage the recognition of fair value. Recently, however, FASB has revised this standard (SFAS

123R) so as to require recognition of option compensation expense.

Required: a. Discuss the role you believe the following parties should play in the accounting standard promulgation process: (1) FASB (5) Companies (CEO) (2) SEC (6) Accounting firms (3) AICPA (7) Investors (4) Congress b. Discuss which parties likely lobbied for the change from requiring expense recognition to only encouraging the

expensing of stock options. CHECK

b. Which of the measures extracted from the annual report appear to best explain changes in stock price? Discuss EPS performs

best

the implications of this for stock valuation. c. Choose another company and prepare similar graphs. Do your observations from Lands’ End generalize?


PROBLEM 2–14 PROBLEM 2–13 Earnings

Management Strategies


2-57

Marsh Supermarkets CHECK Big bath strategy Earnings Management

Strategies

Emerson Electric CHECK Income smoothing strategy

The following information is taken from Marsh

Supermarkets fiscal 20X7 annual report:

During the first quarter, we made several decisions resulting in a $13 million charge to

earnings. A new accounting pronouncement, FAS 121, required the Company to take a

$7.5 million charge. FAS 121 dictates how companies are to account for the carrying

values of their assets. This rule affects all public and private companies.

The magnitude of this charge created a window of opportunity to address several

other issues that, in the Company’s best long term interest, needed to be resolved. We

amended our defined benefit retirement plan, and took significant reorganization and

other special charges. These charges, including FAS 121, totaled almost $13 million.

The result was a $7.1 million loss for the quarter and a small net loss for the year.

Although these were difficult decisions because of their short term impact, they will

have positive implications for years to come.

Marsh Supermarkets’ net income for fiscal 20X5 and 20X6 is $8.6 million and $9.0 million,

respectively.

Required: What earnings management strategy appears to have been used by Marsh in fiscal 20X7 in conjunction

with the FAS 121 charge (note, the $7.5 million charge from adoption of FAS 121 is not

avoidable)? Why do you think Marsh pursued this strategy?

Emerson Electric is engaged in design, manufacture, and

sale of a broad range of electrical, electromechanical,

and electronic products and systems. The following shows

Emerson’s net income and net income before extraordinary items for the past 20 years

(in millions):

Net Income Net Income Net Income before before before Net Extraordinary Net Extraordinary Net Extraordinary Year Income Items Year Income Items Year Income Items

Y1 $201.0 $201.0 Y8 $408.9 $408.9 Y15 $ 708.1 $ 708.1 Y2 237.7 237.7 Y9 467.2 467.2 Y16 788.5 904.4 Y3 273.3 273.3 Y10 528.8 528.8 Y17 907.7 929.0 Y4 300.1 300.1 Y11 588.0 588.0 Y18 1,018.5 1,018.5 Y5 302.9 302.9 Y12 613.2 613.2 Y19 1,121.9 1,121.9 Y6 349.2 349.2 Y13 631.9 631.9 Y20 1,228.6 1,228.6 Y7 401.1 401.1 Y14 662.9 662.9 Emerson has achieved consistent earnings growth for more than 160 straight quarters (more than

40 years).

Required: a. What earnings strategy do you think Emerson has applied over the years to maintain its record of earnings

growth? b. Describe the extent you believe Emerson’s earnings record reflects business activities, excellent management, and/or earnings management. c. Describe how Emerson’s earnings strategy is applied in good years and bad. d. Identify years where Emerson likely built hidden reserves and the years it probably drew upon hidden reserves.

Chapter Two | Financial Reporting and Analysis 133 PROBLEM 2–17B

Earnings Quality

American Express PROBLEM 2–16 Relevance of Accruals

Consider the following: While accrual accounting information is imperfect, ignoring it and making cash

flows the basis of all analysis and business decisions is like throwing the baby out with the bath water.

Required: a. Do you agree or disagree with this statement? Explain. b. How does accrual accounting provide superior information to cash flows? c. What are the imperfections of accrual accounting? Is it possible for accrual accounting to depict economic


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reality? Explain. d. What is the prudent approach to analysis using accrual accounting information? PROBLEM 2–15 Usefulness of

Accrual Accounting

A finance textbook likens accrual accounting information to “nail soup.” The recipe for nail soup

includes the usual soup ingredients such as broth and noodles, but it also includes nails. This

means with each spoonful of nail soup, one gets nails with broth and noodles. Accordingly, to eat

the soup, one must remove the nails from each spoonful. The textbook went on to say that

accountants include much valuable information in financial reports but one must remove the

accounting accruals (nails) to make the information useful.

Required: Critique the analogy of accrual accounting to “nail soup.”

The following is an excerpt from a quarterly earnings

announcement by American Express:

American Express Reports Record Quarterly Net Income of $648 Million QUARTER ENDED SEPTEMBER 30 Percentage ($ millions except per share amounts) 20X9 20X8 Inc./(Dec.)

Net income $ 648 $ 574 13.0% Net revenues $ 4,879 $ 4,342 12.4% Per share net income (Basic) $ 1.45 $ 1.27 14.2% Average common shares outstanding 446.0 451.6 (1.2%) Return on average equity 25.3% 23.9% NINE MONTHS ENDED SEPTEMBER 30 Percentage ($ millions except per share amounts) 20X9 20X8 Inc./(Dec.)

Net income $ 1,869 $ 1,611 16.0% Net revenues $14,211 $12,662 12.2% Per share net income (Basic) $ 4.18 $ 3.53 18.4% Average common shares outstanding 447.0 456.2 (2.0%) Return on average equity 25.3% 23.9% Due to a change in accounting rules, the company is required to capitalize software costs rather than expense them as they occur. For the third quarter of 20X9, this amounted to a pre-tax benefit of $68 million (net of amortization). Also, the securitization of credit card receivables produced a gain of $55 million ($36 million after tax) in the current quarter.


Required: Evaluate and comment on both (a) the earnings quality and (b) the relative performance of

American Express in the most recent quarter relative to the same quarter of the prior fiscal year. CHECK Adjust for unusual items

CASES CASE 2–1 Analysis of

Colgate’s Statements

CASE 2–2 Industry Accounting and Analysis:

Historical Case

Answer the following questions using the annual report of Colgate in

Appendix A.

a. Who is responsible for the preparation and integrity of Colgate’s financial statements and notes? Where is this responsibility stated in the annual report? b. In which note does Colgate report its significant accounting policies used to prepare financial statements? c. What type of audit opinion is reported in its annual report and whose opinion is it? d. Is any of the information in its annual report based on estimates? If so, where does Colgate discuss this? Two potential methods of accounting for the cost of oil drilling are full cost and successful efforts.

Under the full-cost method, a drilling company capitalizes costs both for successful wells and dry

holes. This means it classifies all costs as assets on its balance sheet. A company charges these

costs against revenues as it extracts and sells the oil. Under the successful-efforts method, a company


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expenses the costs of dry holes as they are incurred, resulting in immediate charges against earnings.

Costs of only successful wells are capitalized. Many small and midsized drilling companies

use the full-cost method and, as a result, millions of dollars of drilling costs appear as assets on

their balance sheets.

The SEC imposes a limit to full-cost accounting. Costs capitalized under this method cannot

exceed a ceiling defined as the present value of company reserves. Capitalized costs above the

ceiling are expensed. Oil companies, primarily smaller ones, have been successful in prevailing on

the SEC to keep the full-cost accounting method as an alternative even though the accounting

profession took a position in favor of the successful-efforts method. Because the imposition of the

ceiling rule occurred during a time of relatively high oil prices, the companies accepted it, confident

that it would have no practical effect on them.

With a subsequent decline in oil prices, many companies found that drilling costs carried as assets

on their balance sheets exceeded the sharply lower ceilings. This meant they were faced with writeoffs.

Oil companies, concerned about the effect that big write-offs would have on their ability to conduct

business, began a fierce lobbying effort to change SEC accounting rules so as to avoid sizable

write-offs that threatened to lower their earnings as well as their equity capital. The SEC staff supported

a suspension of the rules because, they maintained, oil prices could rise and because companies

would still be required to disclose the difference between the market value and book value of their

oil reserves. The proposal would have temporarily relaxed the rules pending the results of a study by

the SEC on whether to change or rescind the ceiling test. The proposal would have suspended the

requirement to use current prices when computing the ceiling amount in determining whether a

write-off of reserves is required. The SEC eventually rejected the proposal that would have enabled

250 of the nation’s oil and gas producing companies to postpone write-downs on the declining values

of their oil and gas reserves while acknowledging that the impact of the decision could trigger defaults

on bank loans. The SEC chairman said “the rules are not stretchable at a time of stress.”

Tenneco Co. found a way to cope with the SEC’s refusal to sanction postponement of the

write-offs. It announced a switch to successful-efforts accounting along with nearly $1 billion in

charges against prior years’ earnings. In effect, Tenneco would take the unamortized dry-hole

drilling costs currently on its balance sheet and apply them against prior years’ revenues. These

costs would affect prior year results only and would not show up as write-offs against currently

reported income.

Required: a. Discuss what conclusions an analyst might derive from the evolution of accounting in the oil and gas industry. b. Explain the potential effect Tenneco’s proposed change in accounting method would have on the reporting of its

operating results over the years.

Colgate Chapter Two | Financial Reporting and Analysis 135 CASE 2–3B

Earnings Quality and

Accounting Changes

Canada Steel Co. produces steel casting and metal fabrications for sale to manufacturers of heavy

construction machinery and agricultural equipment. Early in Year 3, the company’s president sent

the following memorandum to the financial vice president: TO: Robert Kinkaid, Financial Vice President FROM: Richard Johnson, President

SUBJECT: Accounting and Financial Policies Fiscal Year 2 was a difficult year for us, and the recession is likely to continue into Year 3. While the entire

industry is suffering, we might be hurting our performance unnecessarily with accounting and business

policies that are not appropriate. Specifically: (1) We depreciate most fixed assets (foundry equipment) over their estimated useful lives on the “tonnageof-

production” method. Accelerated methods and shorter lives are used for income tax purposes. A switch to straight-line for financial reporting purposes could (a) eliminate the deferred tax liability

on our balance sheet, and (b) leverage our profits if business picks up in Year 4.

(2) Several years ago you convinced me to change from the FIFO to LIFO inventory method. Since inflation is now down to a 4 percent annual rate, and balance sheet strength is important in our current

environment, I estimate we can increase shareholders’ equity by about $2.0 million, working capital by

$4.0 million, and Year 3 earnings by $0.5 million if we return to FIFO in Year 3. This adjustment is real—

these profits were earned by us over the past several years and should be recognized.

(3) If we make the inventory change, our stock repurchase program can be continued. The same shareholder who sold us 50,000 shares last year at $100 per share would like to sell another 20,000

shares at the same price. However, to obtain additional bank financing, we must maintain the current ratio at 3:1 or better. It seems prudent to decrease our capitalization if return on assets is unsatisfactory

and our industry is declining. Also, interest rates are lower (11 percent prime) and we can save $60,000

after taxes annually once our $3.00 per share dividend is resumed. These actions would favorably affect our profitability and liquidity ratios as shown in the pro forma income

statement and balance sheet data for Year 3 ($ millions).

Year 3


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Year 1 Year 2 Estimate

Net sales $50.6 $42.3 $29.0 Net income (loss) $ 2.0 $ (5.7) $ 0.1 Net profit margin 4.0% — 0.3% Dividends $ 0.7 $ 0.6 $ 0.0 Return on assets 7.2% — 0.4% Return on equity 11.3% — 0.9% Current assets $17.6 $14.8 $14.5 Current liabilities $ 6.6 $ 4.9 $ 4.5 Long-term debt $ 2.0 $ 6.1 $ 8.1 Shareholders’ equity $17.7 $11.4 $11.5 Shares outstanding (000s) 226.8 170.5 150.5 Per common share: Book value $78.05 $66.70 $76.41 Market price range $42–$34 $65–$45 $62–$55* *Year to date. Please give me your reaction to my proposals as soon as possible.

Required Assume you are Robert Kinkaid, the financial vice president. Appraise the president’s rationale for

each of the proposals. You should place special emphasis on how each accounting or business

decision affects earnings quality. Support your response with ratio analysis.


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Vastly edited by:

Sazzad Hossain MBA, CSCA™

University of Dhaka, Bangladesh

[email protected]

mailto:[email protected]

chapter 02 - financial reporting and analysis

Economy & Finance

accounting rules

accounting analysis

financial statement

user of financial information

purpose of financial

business analysis

implications of accruals

cash flows accruals