Exam Financial Statement Analysis, Questions and Answers rn - ANSWERS QUESTION 1: Theory (7 marks) 1 - Studeersnel (2024)

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ANSWERS

QUESTION 1: Theory (7 marks)

1 Give four potential red flags an analyst can identify in a general accounting analysis.(4 marks) - Unexplained changes in accounting when performance is poor. - Unexplained transactions that boost profits. - Abnormal increases in receivables relative to sales. - Abnormal increases in inventory relative to sales. - Increasing gap between accounting profit and cash flows. - Increasing gap between accounting and tax profit. - Use of financing mechanisms. - Unexpected large asset write-offs. - Large fourth quarter adjustments. - Audit qualification or change in auditors. - Poor internal governance systems. - Related-party or entity transactions.

1 Briefly describe three sources of potential noise in accounting information.(3 marks) - Noise from accounting rules/standards. For example, by mandating the expensing of R&D outlays the financial statements do not reflect the potential value of these activities. - Management forecast errors. In making accrual adjustments, managers have to make predictions about the future. Ex-post errors are likely. For example, managers making estimates for pension accounting are required to make estimates on the future rate of return on pension plan assets. This is difficult, if not impossible. - Management-induced bias. Earnings management (or manipulation) to achieve some reporting objective.

QUESTION 2: Accounting analysis (18 marks)

2 Provide adjusting journal entries (with amounts) to correct for American Tissue’s impropercapitalization of operating expenses in its fiscal year ending September 30, 2000. Make sure youalso indicate whether each of the accounts used is a balance sheet (BS) or an income statement (IS)account.(6 marks) What they did (improper capitalization):Dr. Asset X (BS) 15.Cr. Operating expenses (Cost of sales) (IS) 15.Dr. Depreciation expense (IS) 0.Cr. (Accumulated depreciation) Asset X 0.where 0 = [2months / 12months]*[15 / 5years] To reverse this, book:Dr. Operating expenses (Cost of sales) (IS) 15.Cr. Asset X (BS) 15.Dr. (Accumulated depreciation) Asset X 0.Cr. Depreciation expense (IS) 0.

2 Compute the changes in Computer Associates’ assets, liabilities, and equity that result fromundoing the company’s improper recognition of revenue.(6 marks) - Accounts receivables (BS) and revenues (IS) overstated by $1,000 mln. Cost of sales (IS) overstated and inventory (or prepaid expense, BS) account understated by 350 mln (=35%). Pre-tax profits overstated by 650 mln; after-tax profits overstated by 650*(70%)=455 mln; taxes overstated by 650*(30%)=195 mln. - After correction: 1. Assets change by -650 (=-1000+350); 2. Liabilities change by -195 (taxes payable or deferred tax liability); 3. Equity changes by -455 (change in retained earnings).

2 Provide adjusting journal entries (no amounts required) to correct for Nortel’s overstatement ofreserves in 2002. Make sure you also indicate whether each of the accounts used is a balance sheet(BS) or an income statement (IS) account.(6 marks) What they did (booking of the reserve):Dr. Expenses (IS)Cr. Reserve (Liability, BS) To reverse the overstatement of this reserve, book:* Dr. Reserve (Liability, BS) Cr. Expenses (IS) * This is what Nortel actually did in 2003 to inflate its reported profits

QUESTION 3: Financial and fundamental analysis (36 marks)

3 Does Nike’s 2010 accounting satisfy clean surplus? If not, explain your answer and identify thetotal amount by which clean surplus is violated in 2010 and identify how many items arecontributing to this violation.(3 marks) - No - The balance sheet reveals a change in Accumulated other comprehensive income from 367 to 214. - Violation amount: 214.8-367.5=-152. - 5 items (see EXH 4): Foreign currency translation; Net gain on cash flow hedges; Net gain on net investment hedges; Reclassification to net income of previously deferred net gains; Reclassification of ineffective hedge gains.

3 Calculate the ratio of total accruals to earnings for Nike for each of the years 2008-2010. Whatdoes the over-time pattern in this ratio tell us about the quality of Nike’s financial reporting?Explain your answer.(4 marks) - EARN = CFO + ACCR 2010 2009 2008 EARN 1906 1486 1883. CFO 3164 1736 1936. ACCR -1257 -249 -52. Ratio -0 -0 -0. - Accruals become a smaller (more negative) component of earnings, while the cash component of earnings becomes bigger. This signals increasing quality of earnings.

QUESTION 4: Article questions (24 marks)

4 As can be gleaned from the financial statements, Nike has chosen to report comprehensiveincome in the statement of shareholders’ equity rather than in an “income-statement-likeperformance statement”. Explain why, according to Bamber et al. (2010), the choice of reportingcomprehensive income in a “performance statement” should be irrelevant. Why is it that managersdo care about where comprehensive income is reported?(6 marks) - Should be irrelevant (under a traditional rational markets view) because: same information available to financial statement user, only different location in the report. - Managers do care, because they believe their equity-based compensation and job security are affected by the perceived volatility of firm performance: 1. Lower stock price (higher cost of capital) through higher risk assessment by the market when reporting comprehensive income in a more salient place, therefore reduced value of equity-based compensation. 2. Lower job security as performance evaluation is affected by stock price (at least, that is what managers believe).

4 As Note 1 describes, all advertising costs are immediately expensed in the period when theadvertisem*nts are displayed to the public. According to Aboody and Lev (2000) in their article“The Value Relevance of Intangibles: The Case of Software Capitalization”, which two pieces ofevidence could argue in favor of capitalization – rather than the immediate expensing – ofadvertising costs?(6 marks) - An association between advertising expenses and contemporaneous stock price/returns. - An association between advertising expenses and future earnings (changes).

4 In each of the previous three years, it appears that Nike has overstated its allowance for doubtfulaccounts (information not given here). Explain the effect of this yearly overstatement on Nike’sability to meet future earnings targets. Use the article of Jackson and Liu (2010) “The Allowancefor Uncollectible Accounts, Conservatism, and Earnings Management” in your answer.(6 marks) - By overstating the allowance in the current year and thereby understating net assets (receivables), less charges to the allowance (and therefore lower expense charges in the income statement) are needed in future years to make sure the allowance adequately reflects the risk of expected losses on doubtful receivables. - In future years, the above makes it easier for Nike to meet earnings expectations as it can easily lower expenses needed to adjust the allowance (“cookie-jar accounting”). - Jackson and Liu (2010) show that – on average – the allowance for doubtful accounts is conservative (i., too large), that firms report lower bad debts expense when pre-bad debts expense EPS is slightly above the analyst forecast, and that a conservative allowance accentuates this behavior. Some firms even record income-increasing (negative) bad debts expense.

4 Explain what Akerlof (1974) refers to with a “lemon” in his article “The Market for Lemons:Quality Uncertainty and the Market Mechanism”. What is the effect of lemons on the functioning ofmarkets and what can we do about it?(6 marks) - Lemon: a bad product (company) that, because of information asymmetry, is indistinguishable from a good product (company).

• Effect: buyers are not able to separate good from bad, pay a price based on average quality, seller of good products are unable to sell their products against reasonable price and leave the market “the bad drive out the good”. Market breaks down.
• Insurance/brands/licensing.