Financial Reporting and Analysis【 Reading 25】Sample reported, disposal, following, 2012, net

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Duster Corporation’s year-end income statement reported the following:

Operating income		$187,000
Results from discontinued operations:
Loss from segment operations
(net of $1,440 tax effect)	($2,160)
Gain on segment disposal
(net of $8,640 tax effect)	12,960	10,800
Gain on sale of equipment		3,400
Interest expense		12,400
Extraordinary loss
(net of $2,200 tax benefit)		3,300
Income tax expense		71,200

Calculate Duster’s income from continuing operations for the year.

A) $103,500.

B) $106,800.

C) $114,300.

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Income from continuing operations includes all revenues and expenses except discontinued operations and extraordinary items: $187,000 operating income + $3,400 gain on sale of equipment – $12,400 interest expense – $71,200 income tax expense = $106,800.

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Fero Inc. (Fero) is a successful computer consulting services firm that has an established policy of investing its excess cash in short-term, virtually riskless, and highly liquid money market securities. However, it has recently deviated from this policy by investing in commercial paper and medium-cap domestic equities. As well, Fero entered into a $1.0 million lease with Pasquale Inc. (Pasquale) for some specialized computer equipment on December 28, 2008 that will be shipped at the very start of its next fiscal period on January 1, 2009. In exchange for the lease, Fero agrees to provide consulting services to Pasquale. Which of the following activities is one in which Fero is least likely involved?

A) Managing cash flow.

B) Misclassifying cash flow.

C) Ignoring cash flow.

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Fero is ignoring cash flow, most likely misclassifying cash flow, but there is no evidence that Fero is managing cash flow. Firms can misrepresent their cash generating ability by misclassifying investing activities as operating activities and vice versa. For example, under U.S. GAAP, the cash flow statement reconciles the changes in cash and cash equivalents. Cash equivalents include short-term, highly liquid investments. Some firms park cash in longer-term investments such as marketable debt and equity securities. Typically, the acquisition and disposal cash flows from these longer-term investments are reported as investing activities in the cash flow statement.
Noncash investing and financing activities are not reported in the cash flow statement since they do not result in an inflow or outflow of cash. For example, a capital lease is both an investing and financing decision in that the transaction is the equivalent of borrowing the purchase price. However, since no cash is involved, the transaction is not reported (it is ignored) on the cash flow statement throughout the life of the lease.

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The failure to recognize inventory obsolescence is an example of ___________.

A) Understating expenses.

B) Delaying expenses.

C) Misclassifying expenses.

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Inventory must be tested for obsolescence using the lower-of-cost-or-market method. Obsolete inventory must be written down (expensed) in the income statement which results in lower earnings. Thus, failure to recognize obsolescence understates expenses and overstates earnings.
Delaying expenses involves deferring recognition to a future period. Delaying expense is the result of capitalizing a cost instead of immediately recognizing the cost in the income statement. This is not the same as failing to recognize inventory obsolescence.
Investors typically focus more on operating income than nonrecurring and non-operating income. Thus, firms may have an incentive to increase operating income by misclassifying an operating expense as a nonrecurring or non-operating item. Therefore, failure to recognize obsolescence is not an example of misclassification.

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Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment. This would:

A) overstate earnings.

B) overstate liabilities.

C) understate earnings.

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Overstating the salvage value reduces depreciation expense, which in turn increases earnings.

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Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment. This would:

A) overstate earnings.

B) overstate liabilities.

C) understate earnings.

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Overstating the salvage value reduces depreciation expense, which in turn increases earnings.

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Samson Therapeutics records all leases as operating leases. The company most likely wanted to reduce:

A) expenses.

B) inventory.

C) leverage.

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Finance (capital) leases are recorded on the balance sheet, and by recording all leases as operating leases, the company can reduce its leverage. Lease accounting has no effect on inventory. "Expenses" is not the best answer as operating leases will result in higher expenses in the later years relative to the finance (capital) lease.

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Charger Corporation offers extended payment terms to its customers. In order to finance its accounts receivable, Charger is considering two alternatives. The first alternative is to borrow against the receivables. The second alternative is to securitize the receivables through a special purpose entity. Which alternative would result in lower operating cash flow and lower financing cash flow?

Lower operating cash flow

Lower financing cash flow

A) Securitize Securitize

B) Securitize Borrow

C) Borrow Securitize

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The cash received from borrowing would be reported as a financing inflow. The cash received from securitizing the receivables would be reported as an operating inflow. So, borrowing would result in lower operating cash flow and higher financing cash flow. Securitizing would result in lower financing cash flow and higher operating cash flow.

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Which of the following statements about cash flow is (are) CORRECT?

Statement #1:	The cash effects of decreasing accounts payable turnover are unlimited.
Statement #2:	The tax benefits from employee stock options can result in a significant source of investing cash flow.

Statement #1

Statement #2

A) Correct Incorrect

B) Incorrect Correct

C) Incorrect Incorrect

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Statement #1 is an incorrect statement. The cash effects of decreasing accounts payable turnover are limited. Suppliers will eventually stop extending credit because of delayed payments. Statement #2 is an incorrect statement. The tax benefits from employee stock options can result in a significant source of operating and financing cash flows. Tax benefits do not affect investing cash flows

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Junior analyst Xander Marshall sends an e-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is manipulating its results to artificially inflate profits. He cites four reasons for his conclusion:

• The LIFO reserve is declining.
• Earnings are much higher in the September quarter than in other quarters.
• Many nonoperating and nonrecurring gains are being recorded as revenue.
• Much of Peterson’s earnings come from equity investments not reflected on the cash-flow statement.

Jacobs is less concerned about Peterson’s earnings than Marshall is, though she does resolve to check out one of his concerns. Which of Marshall’s observations best supports his conclusion?

A) Nonoperating and nonrecurring gains recorded as revenue.

B) Equity investment earnings not reflected on the cash-flow statement.

C) The declining LIFO reserve.

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On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and disclosed the LIFO liquidation in its footnotes. When unusual gains are recorded as revenue they will artificially boost sales growth. Each of the above issues are potential danger signs, but can also be easily explained in a manner beyond reproach. However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further examination.

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De Freitas Inc. (De Freitas) is a conglomerate. Its computer division was very profitable in the current year because it launched a successful new lightweight laptop computer. Prices in the automobile division have been rising over the years but it is engaged in a LIFO liquidation in the current year. Which of the following best describes the effect on the long-run earnings of the computer division and the automobile division compared to the most recent year?

Computer division earnings

Automobile division earnings

A) Decrease Increase

B) Increase Decrease

C) Decrease Decrease

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When examining earnings, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is known as mean reversion. For example, capital is attracted to successful projects (i.e. the new laptop) thereby increasing competition and decreasing earnings in the long-run.
A LIFO liquidation involves selling more goods than are replaced. Thus, the automobile division penetrates the older, lower cost layers of inventory thereby increasing profit. The profitability is not sustainable, however, because the firm will eventually run out of inventory. In the long-run, the earnings will decrease.