In measuring earnings quality, which of the following statements is most appropriate?
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Using the balance sheet, we can measure accruals as the change in net operating assets (NOA) over a period of time. NOA is the difference in operating assets and operating liabilities. Operating assets are equal to total assets minus cash, equivalents to cash, and marketable securities. Operating liabilities are equal to total liabilities minus total debt (both short-term and long-term). In summary, the formula for balance sheet based aggregate accruals is: We can also derive the aggregate accruals by subtracting cash flow from operating activities (CFO) and cash flow from investing activities (CFI) from reported earnings as follows: The lower the accruals ratio, the higher the earnings quality.AccrualsBS = NOAEND ? NOABEG
AccrualsCF = NI ? CFO ? CFI
Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most indicative of a higher quality of earnings when attempting to forecast future earnings?
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The term earnings quality usually refers to the persistence and sustainability of a firm’s earnings; that is, more persistent and sustainable earnings are considered higher quality. A higher level of earnings has no impact on increasing the quality of earnings since the former may be derived largely from earnings manipulation on the part of management.
Costiuk Inc. (Costiuk) saw a large increase in its net operating assets (NOA) over the year. During the year, it also reported a number of nonoperating revenues and deferred revenues. Which of the following statements regarding Costiuk’s increase in NOA and the most likely item to self-correct is most accurate?
Increase in NOA | Most likely item to self-correct |
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Deferrals and accruals are most likely to self-correct. The large increase in net operating assets is indicative of a high accruals ratio as demonstrated by the following equation: AccrualsBS = NOAEND ? NOABEG In interpreting the ratio, the higher the ratio, the lower the earnings quality. Nonrecurring and nonoperating revenues do not typically self-correct like deferrals and accruals, thereby providing a greater manipulation benefit to the firm.
Nolan Corporation (Nolan) is a successful and publicly-traded U.S. company that has operated for many years. It manufactures various sporting goods and in recent years, established three subsidiary companies, Soccer Inc. (Soccer), Hockey Inc. (Hockey), and Lacrosse Inc. (Lacrosse). Soccer and Hockey are located in the U.S. and Lacrosse is located in Canada.
Given that its stock is widely followed by analysts, Nolan regularly communicates its earnings expectations to the market.
Nolan’s most recent financial statements are provided in Exhibit 1.
Exhibit 1: Consolidated financial statements for Nolan Corporation
Balance Sheet
As of December 31 (in thousands)
2008
2007
Assets
Cash
$1,230
$1,805
Accounts receivable
4,900
4,610
Inventory
7,240
4,830
Fixed assets, net
18,300
16,500
Total assets
$31,670
$27,745
Liabilities and Equity
Accounts payable
$1,860
$1,200
Current portion of long-term debt
3,306
3,095
Long-term debt
22,000
20,000
Total liabilities
$27,166
$24,295
Common stock
2,000
2,000
Retained earnings
2,504
1,450
Total Liabilities and Equity
$31,670
$27,745
Income Statement
Year Ended December 31, 2008 (in thousands)
Sales
$21,500
Cost of goods sold
(13,620)
Depreciation expense
(2,100)
SG&A expense
(1,750)
Interest expense
(1,420)
Taxes
(910)
Net income
$1,700
Cash flow Statement
Year Ended December 31, 2008 (in thousands)
Cash from operations
$1,760
Cash from investing
(3,900)
Cash from financing
1,565
Change in cash
$(575)
Nolan has calculated accrual ratios for its subsidiaries, Soccer and Hockey, in Exhibit 2.
Exhibit 2: Accrual ratios for Soccer and Hockey
Accrual Ratio
2008
2007
Soccer Inc.
13.5%
11.4%
Hockey Inc.
10.7%
11.2%
To protect itself from a multitude of business and financial risks, Nolan uses derivatives to manage its risks. It has engaged in several different hedges during the year, including a net investment hedge of a foreign subsidiary, a cash flow hedge, and a fair value hedge.
Which of the following statements best describes the term forecast error?
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The difference in a firm’s reported earnings and the consensus sell-side earnings forecast is known as forecast error. The consensus sell-side forecast is a benchmark the firm is trying to meet. Firms periodically communicate their earnings expectations to the market in order to move the benchmark. (Study Session 7, LOS 27.c)
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The first step is to compute the beginning and ending balances of NOA.
2008 2007 Total assets $31,670 $27,745 Cash (1,230) (1,805) Operating assets $30,440 $25,940 Total liabilities $27,166 $24,295 Current portion of long-term debt (3,306) (3,095) Long-term debt (22,000) (20,000) Operating liabilities $1,860 $1,200 Net operating assets $28,580 $24,740
Next, calculate the average NOA for 2008 of $26,660 [($28,580 ROAEND + $24,740 NOABEG) / 2].
Finally, calculate the accruals ratio for 2008: ($28,580 NOAEND ? $24,740 NOABEG) / $26,660 NOAAVG = 14.4%. (Study Session 7, LOS 27.d)
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The relevant equations to consider are as follows: AccrualsCF = NI ? CFO ? CFI First, calculate the aggregate accruals as follows:
Net income $1,700 Cash from operations (1,760) Cash from investing 3,900 Accruals $3,840
Next, using the average NOA of $24,000, calculate the accruals ratio for 2008: $3,840 Accruals / $24,000 NOAAVG = 16.0%. (Study Session 7, LOS 27.d)
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Hockey’s earnings quality is higher than Soccer’s because its accrual ratios are lower in both years (10.7% and 11.2% versus 13.5% and 11.4%). And Hockey’s earnings quality is improving (accrual ratios are decreasing from 11.2% to 10.7%) while Soccer’s earnings quality is deteriorating (accrual ratios are increasing from 11.4% to 13.5%). (Study Session 7, LOS 27.d)
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Income from continuing operations is a subtotal equal to Nolan’s earnings before any “below the line” items are considered. Only discontinued operations and extraordinary items are reported “below the line”, net of tax. In this case, there are no “below the line” items, so income from continuing operations and net income would be the same. (Study Session 7, LOS 26.a)
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Lacrosse is not using the derivative to speculate. Therefore the unrealized and realized gains would NOT NECESSARILY be recognized in the income statement. Since Lacrosse is using the derivative for hedging purposes, the gain or loss recognition depends on the type of hedge. By using the put option to hedge exposure to changes in the value of the equity investment, this is clearly an example of a fair value hedge. A fair value hedge requires unrealized gains and losses from the derivative to be recognized in the income statement. (Study Session 7, LOS 26.c)
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