II. Solutions to Study Questions, Problems, and Cases ...

[Pages:86]II. Solutions to Study Questions, Problems, and Cases

Chapter 1

1.1 The annual report is published primarily for shareholders, while the 10-K report is filed with the Securities and Exchange Commission and is used by regulators, analysts, and researchers. The financial statements and much of the financial data are identical in the two documents; but the 10-K report contains more detail (such as schedules showing management remuneration and transactions, a description of material litigation and governmental actions, and elaborations of many financial statement accounts) than the annual report; and the annual report presents additional public relations type material such as colored pictures, charts, graphs, and promotional information about the company.

1.2 The analyst should use the financial statements: the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows; the notes to the financial statements; supplementary information such as financial reporting by segments; the auditor's report; management's discussion and analysis of operating performance and financial condition; and the five-year summary of financial data.

Use the public relations "fluff," such as colored pictures and descriptive material with caution.

1.3 A qualified report is issued when the overall financial statements are fairly presented "except for" items which the auditor discloses; an adverse opinion is issued when the financial statements have departures from GAAP so numerous that the statements are not presented fairly. A disclaimer of opinion is caused by a scope limitation resulting in the auditor being unable to evaluate and express an opinion on the fairness of the statements. An unqualified opinion with explanatory language is caused by a consistency departure due to a change in accounting principle, uncertainty caused by future events such as contract disputes and lawsuits, events which the auditor believes may present business risk and going concern problems.

1.4 The proxy statement is a document required by the SEC to solicit shareholder votes, since many shareholders do not attend shareholder meetings. The analyst can find important information in the proxy statement such as background information on the company's nominated directors, director and executive compensation, any proposed changes to those compensation plans and the audit and non-audit fees paid to the auditing firm.

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1.5 Employee relations with management, employee morale and efficiency, the reputation of the firm with its customers and in its operating environment, the quality and effectiveness of management, provisions for management succession, potential exposure to regulatory changes, "bad publicity" in the media.

1.6 Depreciation is a process of cost allocation, which requires estimation of useful life, salvage value, and a choice among depreciation methods affecting the timing of expense recognition.

1.7 Expense and revenue recognition can be different for purposes of calculating taxable income and earnings reported in the financial statements. Thus, companies calculate taxable income taking advantage of every item that will reduce income; and the firm reports the highest possible income to shareholders. Two sets of books (at least!) are kept: one for the I.R.S. and one for the annual report. The financial analyst should be aware of the "deferred taxes" account, which reconciles differences between taxable and reported income.

1.8 (a) Annual Depreciation Expense =

Asset cost Dep. period

Annual Depreciation Expense =

$450,000 15

= $30,000

(b) Accum. Dep. at end of Yr. 1 = $30,000 Accum. Dep. at end of Yr. 2 = Dep. Yr. 1 + Dep. Yr. 2 = $60,000

(c) Historical Cost Accum. Dep. Fixed Assets (Net)

Year 1 $450,000

30,000 $420,000

Year 2 $450,000

60,000 $390,000

(d) Dep. exp. for tax purposes Dep. expense reported in financial statements Amount by which dep. exp. for tax purposes exceeds dep. exp. for reporting purposes

= $45,000 = $30,000

= $15,000

(e) Amount by which taxable exp. exceeds reported exp. Tax rate Amount by which reported tax exp. exceeds actual taxes paid

= $15,000 = 0.3

= $ 4,500

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1.9 (a) 1. Switch to straight line depreciation if not using.

2. Lengthen depreciation period for depreciable assets. (Items 1 and 2 would lower quality unless made to reflect economic reality.) 3. Sell assets for a gain. 4. Postpone loss recognition on inventory or investments. 5. Reduce advertising and marketing expenditures. 6. Reduce research and development expenditures. 7. Reduce repair and maintenance expenditures. (b) To have a positive "real" impact on the firm's financial position, the company would have to increase revenue from a beneficial policy rather than a cosmetic change or to reduce costs in a manner that would not impair the long-term profitability of the firm. Examples: 1. Have a special end-of-year sale, offer discounts, offer rebates. 2. Invest in plant and equipment at end of year to get tax savings

from depreciation. 3. Get employees involved in cost-cutting measures. 4. Sell assets, if for a profit, that the firm had already planned to

sell at some point because of inefficiencies.

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1.10 Memorandum

Date: To: From: Subject:

Current Date B.R. Neal, Director of Marketing Student's Name Contents of an Annual Report

The company's annual report presents financial information about the firm. This information package is published primarily for shareholders and the general public. The major components of an annual report are briefly described in this memo.

1) An annual report contains four financial statements: The balance sheet shows the financial condition (assets, liabilities, stockholders' equity) at end of year; the income or earnings statement presents the results of operations including revenues, expenses, net profit or loss, and net profit or loss per share for the year; the statement of stockholders' equity reconciles beginning and ending balances of accounts in the equity section of the balance sheet; and the statement of cash flows shows inflows and outflows of cash from operating, financing, and investing activities for the year.

2) Notes to the financial statements provide additional detail about particular items in the financial statements. 3) The auditor's report is prepared by an independent accounting firm and attests to the fairness of the information presented. 4) The five year summary shows key financial data including net sales, income/loss from continuing operations on a dollar and per share basis, assets, long term debt, and dividends per common share. 5) Quarterly stock prices record how the company's stock shares have performed over the past two years. 6) Management's Discussion and Analysis provides management's perspective on how the company is doing including favorable or unfavorable trends, and significant events or uncertainties.

The remaining material in the annual report is included primarily to provide background information about the company and its management, and to make the document attractive and interesting to read.

If staff members would like to learn more about any of the material in the company's annual report, the following book is highly recommended: Understanding Financial Statements by Fraser and Ormiston (Prentice Hall, 2004).

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1.11 (a) Earnings management refers to the practice of using accounting choices and techniques in such a way that earnings reports reflect what management wants the user to see, instead of the true financial performance of the company.

(b) Managers are motivated to meet the earnings expectations of analysts on Wall Street. Companies not meeting these expectations have been punished with immediate stock price declines. This in turn negatively impacts the firm's total market capitalization and the value of stock options granted employees.

(c) The following five techniques used by companies create illusions according to Levitt:

1. "Big Bath" restructuring charges ? these charges are taken when a company reorganizes its businesses. Often companies overestimate the amount of the charges which then results in income being recorded at a later date to correct the error. These supposed one-time charges are usually received on Wall Street favorably since analysts tend to focus on future earnings.

Author's example: An example of restructuring charges which led to confusion occurred over the ten-year period from 1986 to 1996, when AT&T took four major restructuring charges totaling over $14 billion-- more than their reported earnings for that entire period.

2. Creative acquisition accounting ? classifying part of the acquisition price when a merger occurs as "in-process" research and development. This item is then written off in the year of acquisition because there is a chance that the research will not result in increased earnings. If, in fact, earnings are increased later, the already written off expense will not negatively impact the earnings number.

Author's example: In 1998, Compaq acquired Digital and immediately wrote off over $3 billion of "in-process" research and development.

3. Cookie jar reserves ? overestimating liabilities for such items as sales returns, loan losses or warranty costs. This results in expenses being recorded in the year of the estimation, but allows a company to reverse these charges in a year when earnings are lower than desired.

Author's example: The W.R. Grace and Co. used cookie jar reserves to stash away profits to be used in later years to mask declining earnings. The

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former in-house audit chief blew the whistle on the firm in 1999, but the company had been abusing these reserves since the early 1990s.

4. Materiality ? the concept that insignificant items need not be reported. Some companies abuse this concept by arguing that items are insignificant when in fact they are meaningful to users.

Author's example: Years ago many firms offered to pay for retirees' medical costs not covered by Medicare. This was a relatively inexpensive benefit at the time. Severe healthcare inflation quickly made this benefit extremely costly to firms; however, companies used the materiality concept to claim that this liability need not be reported. When FASB forced companies to disclose what they had promised in medical benefits, many companies reported large losses. In 1991, IBM reported an accumulated cost of over $2 billion for postretirement benefits.

5. Revenue recognition ? recording revenue before the transaction has actually occurred.

Two examples of recognizing revenue erroneously were discussed in Chapter 1: Waste Management, Inc. and Xerox.

(d) Levitt proposes the following steps of action:

1. The SEC must implement rules regarding more detailed disclosures of changes in accounting assumptions. 2. The AICPA must clarify the rules to auditors of what is acceptable and what is unacceptable with regard to the illusory techniques described above. 3. The SEC must publish better guidance on the concept of materiality. 4. The SEC should consider guidance on the do's and don'ts of revenue recognition. 5. Private sector standard setters need to address areas where current rules are inadequate. FASB needs to promptly resolve current issues which will bring clarity to the definition of a liability. 6. The SEC will formally target companies for review that appear to manage earnings and will aggressively act on abuses of the financial reporting process. 7. The way audits are performed must be assessed.

8. Audit committees must be empowered and function as the ultimate guardian of investors.

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9. Corporate management and Wall Street must embrace a cultural change. Companies should be rewarded for honesty, not for being clever enough to deceive users through financial reporting.

(e) Levitt believes that audit staff are insufficiently trained and supervised. He also believes that audit committees in some firms are severely lacking in financial expertise. Remedies include the investigation and review of the auditing process and the development of recommendations intended to empower audit committees to perform their job correctly.

1.12 (a) Intel supplies the computing and communications industries with chips, boards, systems and software building blocks for computers, servers and networking and communication products.

(b) The analyst could learn the following by reading the letter to stockholders: ? the significant negative financial impact (21% revenue decrease and 88% decline in net income) of the worldwide recession on Intel. ? nearly two-thirds of Intel's sales were outside the Americas. ? Intel is responding to the recession by looking to the future and is increasing capital investments and research and development, while also finding ways to increase productivity and cut costs.

(c) Intel received an unqualified audit opinion. The audit report states that the audit was conducted according to generally accepted auditing standards and the financial statements are in conformity with generally accepted accounting principles.

(d) The MD&A for Intel discusses the following items:

1. The company expects the key source of liquidity to be internal cash, cash from operating activities and short-term investments and trade assets. A relatively small amount of cash is generated externally from the sale of stock through employee plans. To date, Intel has not used other external sources of cash, but the company has the potential to borrow on sale securities already registered with the SEC in the total amount of $4.4 billion ($3.0 billion in commercial credit plus $1.4 billion in debt, equity, and other financing sources). 2. No material deficiencies of liquidity currently exist. 3. Intel plans to spend $5.5 billion in 2002 for capital expenditures. Specifics are not given with regard to what the funds will be spent on

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or how the funds will be acquired. It is implied that funds will be internally generated and used to increase capacity for future products. 4. No anticipated changes in the mix and cost of financing resources are discussed. 5. The new FASB accounting rule for goodwill will cause amortization expense to decrease, thereby causing operating income to increase in 2002. 6. See 5 above. 7. Sales decreased 21% overall, caused by a combination of lower volume and lower prices. (e) Intel appears to be doing a good job positioning themselves for an economic recovery, when, and if, that occurs. The company is largely dependent on the worldwide computing industry. As a result, the main concerns are whether the economy will recover in the near future and whether Intel's customers will have also positioned themselves for a recovery.

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