Reading 30: Analysis of Financial Statements: A Synthesis L class

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1.The balance sheet shows real estate owned at $192,000. An analyst estimates the value of the property to be $4 Million and adjusts the balance sheet accordingly. What liability account(s) will you adjust and by how much, if you assume the effective tax rate is 36%?

A)   Increase retained earnings by $2,437,120.

B)   Increase retained earnings by $2,437,120 and increase deferred taxes by $1,370,880.

C)   Increase retained earnings by $3,808,000.

D)   Increase retained earnings by $1,370,880 and increase deferred taxes by $2,437,120.

2.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)   Increase accounts payable and increase accounts receivable.

D)   Decrease retained earnings and increase accounts receivable.

3.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 percent. Much of the growth comes from Landesign’s acquisitions of regional competitors. Edwards points out to the analysts that Landesign uses 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 percent.

§ Equipment and office furniture are depreciated based on the 200 percent 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 percent.

A third footnote indicates that Landesign has sold its accounts receivable to Dais Enterprises for 95 percent 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 percent.

After going through the information, Kelley and Schmidt discuss their findings and start to work on their report for Edwards.

All of the following items noted in Kelley’s Notes on Landesign’s Accounting Practices would be considered indicators of high earnings quality EXCEPT Landesign’s use of:

A)   short useful life estimates for fixed assets.

B)   the 200 percent declining balance method of depreciation on its furniture and equipment.

C)   First in, first out (FIFO) accounting in a mildly inflationary economy.

D)   an expected return on its defined benefit pension plan assets at 2-3 percentage points below the long-term rate of return for similar assets.

 

4.Which of the following adjustments should Kelley make to Landesign’s balance sheet to account for deferred taxes? Kelley should:

A)   add $56,000 to assets and subtract $56,000 from liabilities.

B)   add $350,000 to equity and subtract $350,000 from liabilities.

C)   add $56,000 to equity and subtract $56,000 from liabilities.

D)   add $350,000 to assets and subtract $350,000 from liabilities.

5.Which of the following adjustments should Schmidt make to Landesign’s financial statements for the agreement to purchase stone at a discount?

A)   An estimate of the future liability should be recognized on the balance sheet.

B)   No changes are necessary since Landesign expenses the costs as part of normal operating expense.

C)   Since Landesign is getting a break on the price of the goods, an adjustment should be made to cost of goods sold.

D)   A prepaid expense needs to be added to the asset side of the balance sheet.

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答案和详解如下：

1.The balance sheet shows real estate owned at $192,000. An analyst estimates the value of the property to be $4 Million and adjusts the balance sheet accordingly. What liability account(s) will you adjust and by how much, if you assume the effective tax rate is 36%?

A)   Increase retained earnings by $2,437,120.

B)   Increase retained earnings by $2,437,120 and increase deferred taxes by $1,370,880.

C)   Increase retained earnings by $3,808,000.

D)   Increase retained earnings by $1,370,880 and increase deferred taxes by $2,437,120.

The correct answer was C)    

Since the property has not been sold, there is not a tax effect. The entire market value adjustment is included in retained earnings.

2.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)   Increase accounts payable and increase accounts receivable.

D)   Decrease retained earnings and increase accounts receivable.

The correct answer was A)

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

3.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 percent. Much of the growth comes from Landesign’s acquisitions of regional competitors. Edwards points out to the analysts that Landesign uses 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 percent.

§ Equipment and office furniture are depreciated based on the 200 percent 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 percent.

A third footnote indicates that Landesign has sold its accounts receivable to Dais Enterprises for 95 percent 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 percent.

After going through the information, Kelley and Schmidt discuss their findings and start to work on their report for Edwards.

All of the following items noted in Kelley’s Notes on Landesign’s Accounting Practices would be considered indicators of high earnings quality EXCEPT Landesign’s use of:

A)   short useful life estimates for fixed assets.

B)   the 200 percent declining balance method of depreciation on its furniture and equipment.

C)   First in, first out (FIFO) accounting in a mildly inflationary economy.

D)   an expected return on its defined benefit pension plan assets at 2-3 percentage points below the long-term rate of return for similar assets.

The correct answer was C)

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 COGS, and higher net income. This is more aggressive than the use of LIFO. 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.

4.Which of the following adjustments should Kelley make to Landesign’s balance sheet to account for deferred taxes? Kelley should:

A)   add $56,000 to assets and subtract $56,000 from liabilities.

B)   add $350,000 to equity and subtract $350,000 from liabilities.

C)   add $56,000 to equity and subtract $56,000 from liabilities.

D)   add $350,000 to assets and subtract $350,000 from liabilities.

The correct answer was B)    

Deferred tax liabilities are shown to be growing over the last three years, indicating a low probability of reversal in the near future. In this case, Kelley should assume zero deferred tax liabilities on the adjusted balance sheet, and an increase in equity of $350,000. Note that if the deferred taxes were expected to reverse, Kelley would have needed to calculate the present value of the expected tax liability.

5.Which of the following adjustments should Schmidt make to Landesign’s financial statements for the agreement to purchase stone at a discount?

A)   An estimate of the future liability should be recognized on the balance sheet.

B)   No changes are necessary since Landesign expenses the costs as part of normal operating expense.

C)   Since Landesign is getting a break on the price of the goods, an adjustment should be made to cost of goods sold.

D)   A prepaid expense needs to be added to the asset side of the balance sheet.

The correct answer was A)

The adjustment for a take-or-pay contract is similar to adjusting for operating leases. The present value of future payments needs to be recognized as a liability on Landesign's balance sheet.