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Reading 28: Integration of Financial Statement Analysis Techn

Session 7: Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis
Reading 28: Integration of Financial Statement Analysis Techniques

LOS b: Identify financial reporting choices and biases that affect the quality and comparability of companies' financial statements and illustrate how such biases affect financial decisions.

 

 

Inventories are listed on the balance sheet at $600,000, retained earnings are $1.9 Million. In the notes to financial statements, you find a LIFO reserve of $125,000. Also, the probability of a LIFO liquidation is high. Assuming a tax rate of 36%, what will be the adjusted value of retained earnings?

A)
$1,980,000.
B)
$1,820,000.
C)
$1,855,000.


 

The adjustment to retained earnings will be: $125,000 × (1 ? 0.36).

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 used 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)
the 200% declining balance method of depreciation on its furniture and equipment.
B)
short useful life estimates for fixed assets.
C)
FIFO accounting in a mildly inflationary economy.


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.


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 $328,400.
C)
Increase both liabilities and assets by $341,500.


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.

TOP

A firm seeking to lower current tax liability may elect to use which method of inventory valuation during an inflationary period?

A)
FIFO.
B)
Average cost.
C)
LIFO.


During a inflationary period, using LIFO would increase COGS, thereby decreasing earnings and taxes.

TOP

Holdall Corporation recently reclassified many of their assets such that the average useful life of their depreciable assets was reduced. Which of the following is the most likely result from this change on net income and inventory turnover? (Assume everything else remains constant.) Net income will:

A)
increase and inventory turnover will not change.
B)
decrease and inventory turnover will rise.
C)
decrease and inventory turnover may or may not change.


Depreciation expense increases as the depreciable life of an asset decreases. Thus, net income will decline. Depreciation will only affect inventory turnover if depreciation has been allocated to individual inventory items; when and why this happens is outside the scope of the Level 2 curriculum.

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