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Reading 27: Evaluating Financial Reporting Quality-LOS d 习题

Session 7: Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis
Reading 27: 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.

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).

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:

AccrualsBS = NOAEND ? NOABEG

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:

AccrualsCF = NI ? CFO ? CFI

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

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 level of earnings.
 C) Higher degree of persistence of earnings.

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.

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 deferred revenues
B)
 suggests lower earning quality nonoperating revenues
C)
 suggests higher earning quality nonoperating revenues

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?

 A) The difference in a firm’s reported earnings and the consensus sell-side earnings forecast.
 B) The difference in a firm’s reported earnings and the consensus buy-side earnings forecast.
 C) The difference in a firm’s reported earnings and the firm’s internal earnings forecast communicated to the market.

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)

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

 A) 14.4%.
 B) 15.5%.
 C) 16.6%.

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)

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) -1.8%.
 B) 16.0%.
 C) 9.5%.

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)

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

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)

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

 A) EBIT and income from continuing operations.
 B) Net income and income from continuing operations.
 C) EBITDA and income from continuing operations.

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)

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.

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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