Reading 25: Evaluating Financial Reporting Quality-LOS d 习题 2010, companies, contrast, measures, compare

土豆妮

Session 7: Financial Reporting and Analysis: Earnings Quality Issues
and Financial Ratio Analysis
Reading 25: Evaluating Financial Reporting Quality

LOS d: Discuss earnings quality and the measures of earnings quality, and compare and contrast the earnings quality of peer companies.

 

 

 

Hatfield Industries is a large manufacturing conglomerate based in the United States with annual sales in excess of $300 million. Its shares are traded on the New York Stock Exchange, and have a market capitalization of nearly $750 million. Hatfield is currently under investigation by the Securities and Exchange Commission (SEC) for accounting irregularities and possible legal violations in the presentation of the company’s financial statements. A due diligence team from the SEC has been sent to Hatfield’s corporate headquarters in Philadelphia for a complete audit in order to further assess the situation.

Several unique circumstances at Hatfield are discovered by the SEC due diligence team during the course of the investigation:

• Management has been involved in ongoing negotiations with the local labor union, of which approximately 40% of its full-time labor force are members. Labor officials are seeking increased wages and pension benefits, both of which Hatfield’s management states is not possible at this time due to decreased profitability and a tight cash flow situation. Labor officials have accused Hatfield’s management of manipulating the company’s financial statements in order to have a reason to not grant any concessions during the course of negotiations.
• All new equipment obtained over the past several years has been established on Hatfield’s books as operating leases, although past acquisitions of similar equipment was nearly always classified as capital leases. Financial statements of industry peers indicate that capital leases for this type of equipment are the norm. The SEC wants Hatfield’s management to provide justification for this apparent deviation from “normal” accounting practices.
• Inventory on Hatfield’s books has been steadily increasing for the past few years in comparison to sales growth. Management credits improved operating efficiencies in its production methods that have contributed to boosts in overall production. The SEC is seeking evidence that Hatfield somehow may have manipulated its inventory accounts.

The SEC due diligence team is not necessarily searching for evidence of fraud, but possible manipulation of accounting standards for the purpose of misleading shareholders and other interested parties. Initial review of Hatfield’s financial statements indicates that at a minimum, certain practices have resulted in low quality earnings.

Labor officials believe that the management of Hatfield is attempting to understate its net income in order to avoid making any concessions in the labor negotiations. Which of the following actions by management will most likely result in low quality earnings?

A) Lengthening the life of a depreciable asset in order to lower the depreciation expense.

B) Lowering the discount rate used in the valuation of the company’s pension obligations.

C) The recognition of revenue at the time of delivery rather than when payment is received.

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Certain GAAP rules can be exploited by companies in order to achieve specific goals, while still remaining within the letter of the law. Aggressive assumptions, such as lengthening the depreciable life of an asset, that are utilized to boost earnings results in a lower quality of earnings. (Study Session 7, LOS 26.d)

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Hatfield has begun recording all new equipment leases on its books as operating leases, a change from its consistent past use of capital leases. What is the most likely motivation behind Hatfield’s change in accounting methodology? Hatfield is attempting to:

A) reduce its cost of goods sold and increase it profitability.

B) increase its operating margins relative to industry peers.

C) improve its leverage ratios and reduce its perceived leverage.

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Off balance-sheet financing through the use of operating leases is acceptable when used appropriately. However, companies can use them too aggressively in order to reduce their perceived leverage. A comparison among industry peers and their practices may indicate improper use of accounting methods. (Study Session 7, LOS 26.f)

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The SEC due diligence team is searching for the reason behind Hatfield’s inventory build-up relative to its sales growth. One way to identify a deliberate manipulation of financial results by Hatfield is to search for:

A) receivables that are growing faster than sales.

B) a delay in the recognition of expenses.

C) a decline in inventory turnover.

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A warning sign of accounting manipulation is abnormal inventory growth as compared to sales growth. By overstating inventory, the cost of goods sold is lower, leading to higher profitability. (Study Session 7, LOS 26.g)

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土豆妮

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?

A) The difference in a firm’s reported earnings and the consensus buy-side earnings forecast.

B) The difference in a firm’s reported earnings and the firm’s internal earnings forecast communicated to the market.

C) The difference in a firm’s reported earnings and the consensus sell-side earnings forecast.

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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 26.c)

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土豆妮

Using Nolan’s consolidated balance sheet, which of the following amounts is closest to the accruals ratio for 2008.

A) 15.5%.

B) 14.4%.

C) 16.6%.

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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 ROA_END + $24,740 NOA_BEG) / 2].

Finally, calculate the accruals ratio for 2008: ($28,580 NOA_END ? $24,740 NOA_BEG) / $26,660 NOA_AVG = 14.4%. (Study Session 7, LOS 26.d)

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Using Nolan’s consolidated income statement and cash flow statement, which of the following amounts is closest to the accruals ratio for 2008. (Note: for the purposes of this question, assume that the average NOA is $24,000.)

A) 16.0%.

B) -1.8%.

C) 9.5%.

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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 26.d)

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Using the information regarding the accrual ratios of the Soccer and Hockey subsidiaries, which of the following statements is most appropriate?

A) Hockey’s earnings quality is lower than Soccer’s and its earnings quality is deteriorating compared to Soccer’s.

B) Hockey’s earnings quality is higher than Soccer’s but its earnings quality is deteriorating compared to Soccer’s.

C) Hockey’s earnings quality is higher than Soccer’s and its earnings quality is improving compared to Soccer’s.

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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 26.d)

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In examining Nolan’s consolidated income statement for 2008, which of the following definitions of earnings result in the same amount?

A) Net income and income from continuing operations.

B) EBIT and income from continuing operations.

C) EBITDA and income from continuing operations.

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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 25.a)

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With respect to a hedge undertaken in the Lacrosse subsidiary that utilizes a put option to protect one of its equity investments, which of the following best describes the accounting treatment for the hedge under U.S. GAAP?

A) Unrealized gains and losses from the derivative bypass the income statement and are reported in shareholders’ equity as part of other comprehensive income.

B) Only realized gains and losses from the derivative are recognized in the income statement.

C) Unrealized gains and losses from the derivative are recognized in the income statement.

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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 25.c)

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土豆妮

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

A) suggests lower earning quality nonoperating revenues

B) suggests higher earning quality nonoperating revenues

C) suggests lower earning quality deferred revenues

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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:

Accruals^BS = NOA_END ? NOA_BEG

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.

土豆妮

In measuring earnings quality, which of the following statements is most appropriate?

A) Accruals can be measured as the change in net operating assets (NOA) over a period of time.

B) The higher the accruals ratio, the higher the earnings quality.

C) Accruals can be measured as net income less cash flows from operations (CFO) less cash flows from financing (CFF).

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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:

Accruals^BS = NOA_END ? NOA_BEG

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:

Accruals^CF = NI ? CFO ? CFI

The lower the accruals ratio, the higher the earnings quality.

土豆妮

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?

A) Higher degree of conservatism of earnings.

B) Higher degree of persistence of earnings.

C) Higher level of 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.

Measuring earnings quality based on conservative earnings is an inferior measure when attempting to forecast future earnings because most accruals will self-correct over time. For example, the lower earnings that result from accelerated depreciation will increase in the later years of the asset’s life. Focusing on accruals and deferrals is a more effective way of measuring earnings 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.