George Edwards is a senior analyst with The Edge Group, an independent equity research firm specializing in micro cap companies that have recently had an initial public offering, or are likely to go public within the next three years. Over the current market cycle, small company stocks have been the leading performers in the equity market, and micro cap money managers have had huge cash inflows due to their funds’ strong performance. With an excess amount of cash and few good investment opportunities due to the high valuations in the marketplace, fund managers have turned to independent research firms like The Edge Group to help them discover new investment ideas.
With a large number of mutual fund managers asking them for research reports, business at The Edge Group is booming. To help handle the large amount of business, Edwards has hired two new junior analysts, Paul Kelley and Rachael Schmidt. Both Kelley and Schmidt have degrees in finance, and came highly recommended to Edwards.
In Kelley and Schmidt’s orientation meeting, Edwards told them that what has made The Edge Group successful in delivering quality research to its clients is its willingness to dig into company financial statements and not take the accounting numbers at face value. Every item in the financial statements should be scrutinized and adjusted if necessary. Edwards tells the new analysts that if there is one lesson they should learn, it is that “there is a difference between accounting reality and economic reality.”
For their first assignment, Edwards has asked the new analysts to put together a draft of a research report on Landesign, an architecture firm specializing in landscape design for municipalities, residential developments, and wealthy individuals. The firm also sells various kinds of stone and plastic products which are used in landscaping applications. Edwards tells the new analysts that he will help put together the report, but he would like them to do a majority of the legwork.
Since it was founded seven years ago, Landesign has grown at an annual rate exceeding 20%. Much of the growth comes from Landesign’s acquisitions of regional competitors. Edwards points out to the analysts that Landesign uses purchase method accounting. Kelley, looking to impress Edwards with his knowledge, tells him that when one company acquires another, assets of both companies are restated to fair market value, and that higher depreciation can lead to lower quality earnings. Not wanting to be outdone, Schmidt adds that liquidity measures such as the quick ratio and the cash ratio should improve as Landesign makes acquisitions.
Kelley decides to review Landesign’s 2004 financial statements and make notes about significant accounting practices being used. His notes are shown in the exhibit below:
Exhibit 1: Kelley’s Notes on Landesign’s Accounting Practices
- The firm uses First In, First Out (FIFO) accounting. As a side note, the current inflation rate has remained relatively constant at an annual rate of 3%.
- Equipment and office furniture are depreciated based on the 200% declining balance method.
- Fixed assets (equipment) are generally assigned short useful life estimates.
- The expected return on defined benefit pension plan assets is 2 to 3 percentage points below the long-term rate of return for similar assets.
- Landesign reports deferred taxes of $350,000 for 2004, compared with $300,000 and $280,000 in deferred taxes for 2003 and 2002, respectively.
Schmidt notices that the footnotes to Landesign’s financial statements include a reference to an agreement to receive a minimum amount of stone used to construct landscape walls from a supplier. Under the terms of the agreement, Landesign will pay for the stone whether it is used in the current accounting period or not. The agreement allows Landesign to pay a price that is significantly less than the current market price for similar quality stone.
A second footnote indicates that Landesign has an eight-year rental commitment for a greenhouse used to grow plants and store mulch that Landesign uses in the landscaping process. On the financial statements, $55,000 in rent expense for the greenhouse is listed on the income statement. The footnote also states that the $55,000 rental expense payment was agreed upon with Fred’s Nursery, the owner of the greenhouse, based upon an interest rate of 7%.
A third footnote indicates that Landesign has sold its accounts receivable to Dais Enterprises for 95% of their original value of $130,000. The footnote indicates that Landesign retains the risk of noncollection of the receivables.
The final footnote on the page indicates that Landesign has a revolving line of credit at which it can borrow funds in the future at an interest rate of 6%.
After going through the information, Kelley and Schmidt discuss their findings and start to work on their report for Edwards.
Which of the following items noted in Kelley’s Notes on Landesign’s Accounting Practices would least likely be considered indicators of high earnings quality. Landesign’s use of:
|
A) |
FIFO accounting in a mildly inflationary economy. | |
|
B) |
the 200% declining balance method of depreciation on its furniture and equipment. | |
|
C) |
short useful life estimates for fixed assets. | |
High earnings quality is established by a clear and conservative approach to stating earnings. Even though inflation is relatively mild, FIFO accounting will result in lower cost of goods sold (COGS), and higher net income. This is more aggressive than the use of Last In, First Out (LIFO) method. Short useful lives for fixed assets, use of accelerated depreciation, and using a conservative estimate for returns on pension assets will all tend to increase expenses and are examples of conservative accounting practices. (Study Session 7, LOS 26.d)
Which of the following adjustments should Kelley make to Landesign’s balance sheet to account for deferred taxes? Kelley should:
|
A) |
add $350,000 to equity and subtract $350,000 from liabilities. | |
|
B) |
add $56,000 to equity and subtract $56,000 from liabilities. | |
|
C) |
add $56,000 to assets and subtract $56,000 from liabilities. | |
Deferred tax liabilities are shown to be growing over the last three years, indicating a low probability of reversal in the near future. In this case, Kelley should assume zero deferred tax liabilities on the adjusted balance sheet, and an increase in equity of $350,000. Note that if the deferred taxes were expected to reverse, Kelley would have needed to calculate the present value of the expected tax liability. (Study Session 7, LOS 27.b)
Which of the following adjustments should Schmidt make to Landesign’s financial statements to account for the greenhouse that Landesign uses to grow plants and store mulch?
|
A) |
Increase liabilities and decrease equity by $440,000. | |
|
B) |
Increase both liabilities and assets by $341,500. | |
|
C) |
Increase both liabilities and assets by $328,400. | |
The rental agreement for the greenhouse is an operating lease and essentially represents off-balance sheet financing. To adjust Landesign’s balance sheet for the operating lease, Schmidt needs to capitalize the lease by increasing both liabilities and assets by the present value of the lease payments. The interest rate used in the present value computation is the lower of the firm’s financing rate or the rate implicit in the lease. We are told that the rental payments of $55,000 are based on an interest rate of 7%. However, we are told in another footnote that Landesign expects to be able to borrow funds in the future at a rate of 6%. We therefore use the lower firm financing rate of 6% in our computation. The present value of the lease payments is: N = 8; I/Y = 6%; PMT = -55,000; FV = 0; CPT PV = $341,539. (Study Session 7, LOS 27.c)
Regarding the comments made about Landesign’s growth through acquisition strategy:
|
A) |
Kelley’s comment was incorrect; Schmidt’s comment was correct. | |
|
B) |
Kelley’s comment was correct; Schmidt’s comment was incorrect. | |
|
C) |
Kelley’s comment was incorrect; Schmidt’s comment was incorrect. | |
Kelley and Schmidt both made incorrect comments concerning Landesign’s growth through acquisition strategy. Kelley was correct that purchase method accounting will lead to higher depreciation, and potentially lower quality earnings as a result of restating asset values to fair market value. However, Kelley was incorrect insofar as the comment on balance sheet restatement, since only the assets of the target are restated to fair value – the value of the acquirer, in this case Landesign, would not be revalued. Schmidt was incorrect in stating that liquidity ratios such as the quick ratio and cash ratio should improve. The current ratio is likely to improve in a purchase method acquisition due to the revaluation of the target’s inventory. However, the quick ratio and cash ratio do not include inventory in their calculation, so the effect of the acquisition on those ratios is inconclusive. (Study Session 5, LOS 21.c)
Which of the following statements regarding the adjustments that Schmidt should make to Landesign’s financial statements for its sale of receivables is most accurate?
|
A) |
$123,500 should be added to cash flow from financing, and $123,500 should be subtracted from cash flow from operations. | |
|
B) |
Accounts receivable should be increased by $123,500, cash should be decreased by $123,500, and a loss of $6500 should be recognized on the income statement. | |
|
C) |
Accounts receivable should be increased by $123,500, loans payable should be increased by $123,500, and a loss of $6,500 should be recognized on the income statement. | |
When receivables are sold with recourse, the risk of noncollection of sold receivable is retained by Landesign. Therefore, Schmidt should make two adjustments: (1) The sale of receivables should be reclassified as CFF instead of CFO, meaning that $123,500 should be added to cash flow from financing, and $123,500 should be subtracted from cash flow from operations. (2) The full amount of the receivables, $130,000, should be added to accounts receivable, and a liability called loan payable of $123,500 should be added to the liabilities side of the balance sheet. Note that no adjustments to income are made at this time. As the receivables are collected, the 5% discount ($6,500) is amortized as interest expense. (Study Session 7, LOS 27.b) | 
发表于 2010-4-15 11:13
|