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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 c: Evaluate the quality of a company's financial data and recommend appropriate adjustments to improve quality and comparability with similar companies, including adjustments for differences in accounting rules, methods, and assumptions.

Northern Bottling (NB) currently shows minimum expected operating leases over the next 5 years of \$3 million, \$2.5 million, \$2 million, \$2 million, and \$1.5 million. The firm’s current financing rate is 6.75% and the rate implicit in the lease contract is 7%. What adjustments would an analyst make to modify the balance sheet of NB to include this off-balance sheet financing? Increase long-term:

 A) assets and long-term liabilities by \$9.22 million.
 B) assets and long-term liabilities by \$9.27 million.
 C) liabilities by \$9.27 million and decrease equity by \$9.27 million.

Recall that the interest rate in this present value computation is the lower of the firm’s financing rate or the interest rate that is implicit in the lease.  Therefore, the PV (operating leases) is:

= 3 / (1 + 0.0675) + 2.5 / (1 + 0.0675)2 + 2 / (1+ 0.0675)3 + 2 / (1 + 0.0675)4 + 1.5 / (1 + 0.0675)5

= 9.27 million

The proper adjustment is to increase both long-term assets and liabilities by the same amount.

Lucky Strike Mining Corp. (LSMC) reports in a footnote to the financial statements that it is party to a variable interest entity (VIE) through which it leases heavy equipment. LSMC has chosen not to report a residual value guarantee of \$120 million for the equipment because it is not required to do so under accounting standards. However, the standards will change next year. What is the appropriate analytical treatment of this residual value guarantee?

 A) Ignore the liability because current accounting standards do not require it to be included on the balance sheet. Include it in next year’s balance sheet adjustments.
 B) Increase long-term liabilities and long-term assets by \$120 million.
 C) Increase long-term liabilities by \$120 million and decrease equity by \$120 million.

Increase long-term liabilities and long-term assets by \$120 million.

Which of the following statements regarding problems that are commonly encountered in the analysis of a firm’s financial reports is least accurate?

 A) Cash flows may be affected by the exclusion of off-balance sheet obligations.
 B) Income statement items that may require adjustment include accounting changes, one-time charges and restructuring charges.
 C) Adjustments to the income statement that may not be recorded include operating leases, take-or-pay contracts and environmental obligations.

Adjustments to the balance sheet, (not income statement) that may not be recorded include operating leases, take-or-pay contracts and environmental obligations.

Adjustments for off-balance-sheet items include all but which of the following?

 A) Capitalizing operating leases, including this amount as an asset and a liability.
 B) Using the equity method in place of the proportionate consolidation to reflect the investment in affiliates.
 C) Estimating the probable obligation for contingent liabilities.

The correct statement is that proportionate consolidation should be used in place of the equity method.

A firm has booked as a sale, the transfer of \$100 million in short-term accounts receivable to Public Finance Co., subject to recourse. The notes to the financial statements disclose that as of the end of the fiscal year, \$80 million remained uncollected. In order to reflect this on the balance sheet, which of the following adjustments must be made?

 A) Increase accounts receivable and increase current liabilities.
 B) Decrease cash and increase accounts receivable.
 C) Decrease retained earnings and increase accounts receivable.

Since the accounts receivable were sold with recourse, the risk on uncollected accounts remains with the company.

What does the LIFO reserve measure?

 A) The results of older inventory flowing to cost of goods sold (COGS).
 B) The overstatement relative to the current cost of inventory.
 C) The accumulated difference between the reported inventory balance and the cost of that inventory if first in, first out (FIFO) had been used.

The LIFO reserve measures the accumulated difference between the reported inventory balance and the cost of that inventory if FIFO had been used.

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