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Financial Reporting and Analysis【 Reading 27】Sample

Wanda Brunner, CFA, is analyzing Straight Elements, Inc., (SE). SE is a discount manufacturer of parts and supplies for the railroad industry. She has followed her firm’s suggested financial analysis framework, and has assembled output from processing data. When applying the financial analysis framework, which of the following is the best example of output from processing data?
A)
Audited financial statements.
B)
A written list of questions to be answered by the analysis.
C)
Common-size financial statements.



Common-size financial statements are created in the data processing step of the framework for financial analysis. Audited financial statements would be obtained during the “collect input” phase of the financial analysis framework. Creating a written list of questions to be answered by the analysis is part of the “define the purpose” phase of the financial analysis framework.

An analyst is analyzing TRK Construction (TRK) for possible recommendation to his firm’s clients. He wants to use TRK’s financial statements to answer such questions as “Is TRK suitable for firm clients?”, “Is TRK priced properly relative to peers?”, “What is TRK’s earnings quality?” The analyst is most likely to begin with:
A)
a DuPont analysis.
B)
analysts adjustments to the financial statements.
C)
a review of his firm’s framework for analysis of financial statements.



Analysis of financial statements should be performed in the context of an overall framework for the analysis of financial statements. Specific adjustments or analysis of specific ratios is a secondary concern.

TOP

An analyst is developing a framework for financial statement analysis for his firm. The primary goal of financial statement analysis is to:
A)
facilitate an economic decision.
B)
justify trading decisions for purposes of the Statement of Code and Standards.
C)
document portfolio changes for purposes of the Prudent Investor Rule.



The primary goal of financial statement analysis is to facilitate an economic decision. For example, the firm may use financial analysis to decide whether to recommend a stock to its clients. Documentation and justification of trading decisions may be aided by financial statement analysis, but these are not the primary purposes.

TOP

An analyst is developing a framework for financial statement analysis for his firm. This framework is most likely to include:
A)
Determine the allocation of firm fees, interpret processed data, and communicate conclusions.
B)
Maintain integrity of capital markets, perform duties to clients and employers, and avoid conflicts of interest.
C)
Define the purpose of the analysis, process input data, and follow up.


Proper analysis framework should include:
  • Define the purpose of the analysis.
  • Collect input data.
  • Process input data.
  • Interpret processed data.
  • Develop and communicate conclusions.
  • Follow up.

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An analyst is analyzing a discount manufacturer of parts and supplies. She has followed her firm’s suggested financial analysis framework and has communicated with company suppliers, customers, and competitors. This is an input that occurs while:
A)
processing data.
B)
collecting data.
C)
establishing the objective of the analysis.



Communication with management, suppliers, customers, and competitors is an input during the data collection step. Processing data is the third phase of the financial analysis framework. Establishing the objective of the analysis is part of the “define the purpose” phase of the financial analysis framework.

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



The highly probably LIFO liquidation suggests net income, income tax expense, and equity will rise. The analyst can make this adjustment now for forecasting purposes. The adjustment to retained earnings will be: $125,000 × (1 − 0.36).

TOP

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



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 both liabilities and assets by $341,500.
B)
Increase liabilities and decrease equity by $440,000.
C)
Increase both liabilities and assets by $328,400.



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

Express Delivery Inc. (EDI) reported the following year-end data:

Depreciation expense

$30 million

Net income

$30 million

Total assets

$535 million

Shareholder’s equity

$150 million

Effective tax rate

35 percent

Last year EDI purchased a fleet of delivery vehicles for $140 million. For the first year, straight-line depreciation was used assuming a depreciable life of 7 years with no salvage value. However, at year-end EDI’s management determined that assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were more appropriate. How would the return on assets (ROA) and return on equity (ROE) for last year change due to the change in depreciation assumptions? ROA and ROE would be closest to:
A)
ROA 5.0% and ROE 18.2%.
B)
ROA 5.7% and ROE 19.5%.
C)
ROA 5.3% and ROE 20.5%.



The reported ROA and ROE are 5.6% (30/535) and 20.0% (30/150) respectively. Under the new depreciation assumptions, depreciation expense would be (140-14)/5 = 25.2 million. Under the original assumptions depreciation of the fleet was 20 million. Therefore depreciation increases by 5.2 million. With the change in depreciation methods EDI would have reported:

Depreciation expense

$35.20 million

(30 + 5.2)

Net income

$26.62 million

(30 − (5.2 × (1-0.35)))

Total assets

$529.80 million

(535 − 5.2 )

Shareholder’s equity

$146.62 million

(150 − 3.38)

Note that assets would have been lower by $5.2 million due to the new depreciation assumptions and shareholder’s equity by $3.38 million (5.2 × (1 − 0.35)) due to lower retained earnings. Tax liabilities would have fallen by $1.82 million to balance the $5.2 million reduction in assets. Therefore, ROA would have been 5.0% (26.62 / 529.80) and ROE would have been 18.16% (26.62 / 146.62).

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)
LIFO.
C)
Average cost.



During a inflationary period, using LIFO would increase COGS, since the most recent (highest cost) inventory would be sold. Therefore, earnings and taxes would be lowest under LIFO.

TOP

Millennium Airlines Corp. (MAC) reported the following year-end data:

Rent expense

$23 million

Depreciation expense

$17 million

EBIT

$88 million

Interest expense

$22 million

Total assets

$500 million

Long-term debt

$150 million

Capital lease obligations

$100 million

Total equity

$250 million

MAC also reported that the present value of its operating leases at the beginning of the year was $240 million. The term on the leases was 8 years. What are the effects on the leverage (liabilities / total capital) and times interest earned if an analyst chooses to capitalize the leases at a rate of 10% using a straight-line depreciation assumption? Leverage measures:
A)
increase to 65% from 50% and times interest earned decreases to 1.33 times from 4 times.
B)
increase to 65% from 50% and times interest earned decreases to 1.76 times from 4 times.
C)
remain unchanged and times interest earned decreases to 1.23 times from 4 times.



Using the reported data the leverage measure is 0.50 ((150 + 100) / (150 + 100 + 250)) and times interest earned is 4 times (88 / 22). Following the capitalization of the operating leases the balance sheet values are:

Total assets

$710 million

(500 assets + 240 leases - 30 depreciation on leases)

Value of operating leases

$210 million

(increase in financing liabilities)

Long-term debt

$150 million

unchanged

Capital lease obligations

$100 million

unchanged

Total equity

$250 million

unchanged

Therefore, the leverage measure is 0.65 ((210 + 150 + 100) / (210 + 150 + 100 +250)).
The income statement is affected in the following way:

reported EBIT

88


+ rent expense

23


= EBIT excluding cost of operating leases

111


- depreciation of operating leases

30

($240 million/8 years)

= adjusted EBIT

81


Interest expense will increase by $24 million ($240 million × 0.10) to $46 million. Therefore times interest earned decreases to 1.76 times (81 / 46). Recall that when capitalizing operating leases interest expense is calculated as the present value of the lease obligations multiplied by implied interest rate.

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