Financial Reporting and Analysis【 Reading 26】Sample accounting, 2012, following, statements

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Consider the following statements:

Statement 1:	Compared to the cash basis of accounting, the accrual basis of accounting provides more timely information about future cash flows.
Statement 2:	Compared to the cash basis of accounting, the accrual basis requires more use of discretion than the cash basis.

Are these statements CORRECT?

A) Yes.

B) No, because it is actually the cash basis of accounting that provides more timely and relevant information to users about future cash flows.

C) No, because it is actually the cash basis of accounting that results in more difficulty in properly assigning revenues and expenses to the appropriate periods.

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Users of financial information seek timely information about future cash flows. The accrual basis of accounting provides this information at the earliest appearance of objective evidence. Thus, accrual accounting provides more timely and relevant information to users. The cash basis is more concerned with recording cash flows for transactions that have already occurred.Accrual accounting (not cash-based accounting) necessitates the use of discretion because of the many estimates and judgments involved with assigning revenue and expense to the appropriate periods.

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Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the year-end financial statements of Zartner Canneries. In those statements he sees a sharp increase in inventories well above the sales-growth rate, and an increase in the discount rate for its pension assets. To determine whether or not Zartner Canneries is cooking the books, what should Nicholls do?

A) Calculate Zartner’s turnover ratios and review the footnotes of its competitors.

B) Check Zartner’s cash-flow statement and review its footnotes.

C) Analyze trends in Zartner’s receivables and consider the changing characteristics of its work force.

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To assess the meaning of the inventory increase, look for declines in industry turnover. And if Zartner changes its pension assumptions, Nicholls should see how those new assumptions compare to those found in the footnotes of financial statements from other companies in the same industry.

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Marcel Schulte is analyzing various retailing firms. Which of the following items is least indicative of a potential problem with revenue recognition and earnings quality?

A) Use of barter transactions.

B) Disproportionate revenues in the last quarter of the calendar year.

C) Implementing a “bill and hold” arrangement.

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Disproportionate revenues in the last quarter may be an indication of aggressive revenue recognition to meet analyst forecasts but it is much more likely if the firm is a non-seasonal one. A retailing firm presumably has a disproportionate amount of sales during the busy Christmas season in the last quarter of the calendar year so this point alone would not be indicative of a potential problem.
In a barter transaction, two parties exchange goods or services. The main issue is whether: (a) a sale transaction has actually occurred in substance; (b) it is not a “sham” transaction; and (c) the transaction amount is overstated.
Bill and hold occurs when the retailer (seller) invoices the customer but does not ship the goods until a later date. Alternatively, the seller may ship the goods to a location other than the customer’s. In either case, the seller may be recognizing revenue prematurely.

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Frank Brill, CFA, is concerned that Moses Aviation is overstating its profits. The best indicator of such action would be Moses Aviation’s:

A) sales-growth rate of nearly twice the industry average.

B) rising inventory.

C) recognition of revenue from barter transactions.

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While an unusually high sales-growth rate may indicate fraud, it could also indicate good management. It’s a yellow flag, but not the best indicator of accounting shenanigans. Rising inventory is also a dual signal. It could be meant to overstate profits, or it could simply reflect an actual buildup of inventory in response to market forces or corporate operations. However, companies should not recognize revenue from barter transactions. The additional revenue is likely to improperly boost profits.

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Analyst Jane Kilgore is worried that some of Maxwell Research’s accrual accounting practices will lead to excessive operating earnings recognition in the near-term. Examples of Kilgore's concerns include the following:

• Accelerated revenue recognition of service agreements.
• Classification of recurring revenue as nonrecurring revenue.
• Understated inventory obsolescence.

Which of Kilgore’s concerns is least likely to overstate current operating earnings?

A) Classification of recurring revenue as nonrecurring revenue.

B) Accelerated revenue recognition of service agreements.

C) Understated inventory obsolescence.

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Classification of recurring revenue as nonrecurring revenue will understate current operating earnings. The other two items act to overstate revenue and understate expenses.

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With regard to specific measures to analyze in detecting manipulation in the financial reporting process, which of the following statements is the least accurate?

A) An increasing days’ inventory on hand (DOH) measure may be indicative of obsolete inventory.

B) A decreasing days’ sales outstanding (DSO) measure may be an indication of lower quality revenue.

C) Negative nonrecurring or non-operating items may be indicative of misclassifying an operating expense.

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Days’ sales outstanding (DSO) measures the number of days it takes to convert receivables into cash and is calculated by dividing the number of days in the period by the accounts receivable turnover ratio. An increasing DSO (decreasing receivables turnover) may be an indication of lower quality revenue; that is, the longer it takes to collect from customers, the more likely the receivables will turn into bad debt.
Days’ inventory on hand (DOH) is equal to the number of days in the period divided by inventory turnover ratio and it measures the number of days it takes to sell inventory. An increasing DOH may be indicative of obsolete inventory.
Analysts should compare changes in the core operating margin over time and look for negative nonrecurring (e.g., restructuring charges, asset impairments, and write-downs) or non-operating items that occurred when the ratio increased. This may be the result of misclassifying an operating expense.

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

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

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

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:

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.

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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) improve its leverage ratios and reduce its perceived leverage.

C) increase its operating margins relative to industry peers.

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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.d)

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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 decline in inventory turnover.

C) a delay in the recognition of expenses.

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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.e)

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In the U.S., which of the following mechanisms is least likely to reduce management’s opportunities to intervene in a firm’s external financial reporting process?

A) Threat of class action litigation.

B) Certification by senior management.

C) Risk of bankruptcy.

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Although the threat of bankruptcy could be a reason to prevent strategic manipulation, it is clearly the most indirect reason of the three choices. Often, the amount of manipulation is small (i.e. minor adjustments to allow for the reporting of small profits rather than small losses) and would not be perceived to cause a significant market valuation adjustment.In the U.S., the CEO and CFO must certify the financial statements, which increases their personal risk.
The threat of lawsuits serves as a deterrent to manipulating results.

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When a firm’s earnings are finally announced, a negative earnings surprise will most likely occur under which of the following situations?

A) Earlier in the fiscal year, analyst forecasts tend to be more pessimistic than what the firm ends up reporting. Later in the year, analyst forecasts tend to be more optimistic than what the firm ends up reporting.

B) Earlier in the fiscal year, analyst forecasts tend to be more optimistic than what the firm ends up reporting. Later in the year, analyst forecasts tend to be more pessimistic than what the firm ends up reporting.

C) Regardless of the timing, analyst forecasts are more pessimistic than what the firm ends up reporting.

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The negative earnings surprise occurs because the analyst earnings forecasts are higher (too optimistic) than what the firm ends up reporting. The opposite situation where the earnings forecasts are lower (too pessimistic) than what the firm ends up reporting would result in a positive earnings surprise