978-1337614689 Chapter 6 Part 2

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3. Managers want to reduce risk in order to create a more optimal lending environment and to

manage debt restrictions and covenants.

4. Managers want to influence short-term stock price movements for their advantage.

5. Managers want to manage earnings in order to thwart industry-specific and anti-trust actions

against the firm.

6. Healy and Wahlen state that one type of earnings management occurs when managers use judgement

in financial reporting to alter financial reports in order to mislead some stakeholder about the

economic performance of the company. Earnings management is a consequence of a judgement by

management which results in lower economic information content of the financial reports.

Discuss four reasons that discourage managers from practicing earnings management.

ANS:

Reasons to NOT manage earnings:

7. Achieving comparability in financial reporting is important to the analysis of multinational firms.

However, the data from the reconciliation of foreign firm’s financial statement to U.S. GAAP must be

carefully interpreted. What types of things complicate the analysis of multinational firms?

ANS:

8. A company may try to paint a favorable picture of itself by accelerating the timing of revenues or

estimating the collectible amounts too aggressively. In these cases the quality of accounting

information declines because it does not represent the company’s true economic condition and may

not be sustainable. List four conditions which might suggest that a company is recognizing revenues

too early?

ANS:

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9. Many users of financial statements believe that the quality of accounting information for intangible

assets is low because firms seldom report intangible asset resources on the balance sheet. However,

from the perspective of accounting quality what are arguments in favor of expensing most intangibles

and not recording them on the balance sheet?

10. Penny Corp. manufactures telecommunication equipment and has been profitable each year for the

past ten years. During 2014 the company saw its core market decline sharply when a competitor

introduced a significant new product technology. In response to the decline in business Penny Corp.

announced a major restructuring of its operations. The restructuring plan which would be implemented

in 2010 would involve the following changes (all of the charges are material):

a. Severance payments to reduce work force $ 9 million

b. Write-down of inventory $13 million

c. Penalty payment for termination of lease on manufacturing facility $ 6 million

d. Write-down of equipment associated with manufacturing facility $12 million

Total 2010 restructuring charge $40 million

Penny Corp. has never previously restructured its operations and believes that it can return to

profitability within two years based on its current research and development activity.

Required:

1. Discuss whether or not you would eliminate the restructuring charge from the 2010 income

statement of Penny Corp. when using earnings to forecast future profitability.

2. Penny Corp.’s restructuring charges cover a wide range of different cost categories; identify those

that entail a cash payment and those that do not require a cash payment. For those charges not

requiring a cash payment how would they be treated in the Statement of Cash Flows?

ANS:

1. From the information provided it appears that this would be a case in which the restructuring

2. The following two charges would require a cash payment:

Severance payments to reduce work force $ 9 million

11. In the empirical research on earnings manipulation discussed in the chapter, a number of firm

characteristics are found to be associated with the likelihood of engaging in earnings manipulation. For

each of the characteristics listed below, discuss the rationale for their inclusion in the model:

a. Gross Margin Index

b. Asset Quality Index

c. Sales Growth Index

d. Depreciation Index

e. Leverage Index

ANS:

a. Gross Margin Index – Firms with weaker profitability in a given year are more likely to engage in

earnings manipulation in the future.

12. For each of the following factors, determine if the given change or level of that factor would lead an

analyst to believe that managers of a firm are more or less likely to engage in earnings manipulation:

Earnings Manipulation

More likely/less likely

1. Days Sales in Receivable Index increases

2. Gross Margin Index decreases below 1

3. Asset Quality Index increases

4. Depreciation Index decreases to below 1

5. Leverage Index increases

ANS:

Earnings Manipulation

More likely/less likely

13. A. Listed below are 12 accounting liabilities:

1. Insurance paid in advance

2. Interest payable

3. Unsettled lawsuits where a reasonable estimate of loss can be determined and the loss is

probable

4. Accounts payable

5. Warranties payable

6. Bonds payable

7. Accrued liabilities

8. Taxes payable

9. Employment commitments

10. Notes payable

11. Purchase commitments

12. Salaries payable

Place each of these accounting liabilities into one of the following six categories:

a. Obligations with fixed payment dates and amounts

b. Obligations with fixed payment amounts but estimated payment dates

c. Obligations for which the firm must estimate both timing and amount of payment

d. Obligations arising from advances from customers on unexecuted contracts and agreements

e. Obligations under mutually executed contracts

f. Contingent obligations

B. In addition, determine which of the liabilities would be recognized on the balance sheet as liabilities

and which would not be recognized.

Suggestion: format your answer as follows (this is not a correct sample answer):

a. Obligations with fixed payment dates and amounts (not generally recognized):

1. Rent Payable

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ANS:

a. Obligations with fixed payment dates and amounts

b. Obligations with fixed payment amounts but estimated payment dates

c. Obligations for which the firm must estimate both timing and amount of payment

d. Obligations arising from advances from customers on unexecuted contracts and agreements

e. Obligations under mutually unexecuted contracts – NOT GENERALLY RECOGNIZED

f. Contingent obligations

PROBLEM

1. On September 1, 2012, Ramos Inc. approved a plan to dispose of a segment of its business. Ramos

expected that the sale would occur on March 31, 2013, at an estimated gain of $375,500. The segment

had actual and estimated operating profits (losses as follows):

Realized loss from 1/1/12 to 8/31/12 $200,000

Realized loss from 9/1/12 to 12/31/12 (135,000

Expected profit from 1/1/13 to 3/31/13 475,000

Assume a marginal tax rate of 35%

Required:

A) In its 2012 income statement, what should Ramos report as profit or loss from discontinued

operations (net of tax effects)?

B) Calculate the amount of income that should be shown on the 2013 income statement as a result of

the operating profit and the gain on disposal (net of tax)

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Under U.S. GAAP, results of operations on an operating segment or component of an entity

classified as held for sale are to be reported in discontinued operations in the periods in

None of the expected profit from operating the segment or component for Ramos in 2013 or

2. Motor Corporation’s income statements for the years ended December 31, 2012 and 2011 included the

following information before adjustments:

2012 2011

Operating income $900,000 $600,000

Gain on sale of division 450,000 —0——

$1,350,000 $600,000

Provision for income taxes (405,000) (180,000)

Net income $945,000 $420,000

On January 1, 2012, Motor Corporation agreed to sell the assets and product line of one of its

operating divisions for $1,600,000. The sale was consummated on December 31, 2012, and it resulted

in a gain on disposition of $450,000. This division’s pre-tax net losses were $320,000 in 2012 and

$250,000 in 2011. The income tax rate for both years was 30%.

Required:

Starting with operating income (before tax), prepare revised comparative income statements for 2012

and 2011 showing appropriate details for gain (loss) from discontinued operations.

ANS:

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2012 2011

3. On November 15, 2012, Jacobs Co. sold a segment of its business for $2,750,000. The net book value

of the segment at the time of its disposal was $3,000,000. Jacobs had pretax operating income of

$1,750,000 for 2012 which included $380,000 earned by the discontinued segment prior to its

disposal. Assume Jacobs’ tax rate is 30%.

Required:

Prepare a partial income statement for Jacobs Co. beginning with pretax income from continuing

operations.

ANS:

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Income from continuing operations after tax 959,000

Discontinued operations:

Operating income (net of taxes of $114,000) from 1/1/12 through 11/15/12 266,000

Loss on disposal of discontinued operation (net of tax benefit of $75,000) (175,000)

Net income $1,050,000

Sale price of segment – book value of segment = gain (loss) on disposal = $2,750,000 – $3,000,000 =

$(250,000) pretax loss.

PTS: 1

4. On July 15, 2009 Time Services decided to sell its agricultural business and focus on its landscape

equipment business. The sale of the agricultural business qualifies for discontinued operations

accounting treatment. On November 11, 2009 Time Services signs a firm contract to sell the

agricultural business to Acme Inc. on March 10, 2010. For each of the situations listed discuss how

Time Services would report the discontinued operations in its December 31, 2009 income statement.

(You may disregard tax issues with respect to the sale.)

Situation 1: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural

business lost $3.2M. From July 16, 2009 to November 11, 2009 Time Services reports that the

agricultural business loses an addition $1.4 million dollars. At the end of the 2009 Time estimates that

it will lose an additional $800,000 on the sale of the agricultural business when it is finally completed

in 2010.

Situation 2: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural

business had a profit of $1.5M. From July 16, 2009 to November 11th, 2009 Time Services reports

that the net income from the agricultural business was $600,000 dollars. At the end of the 2009 Time

estimates that the sale of the agricultural business will result in a gain of $1.7 million dollars when it is

finally completed in 2010.

Situation 3: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural

business lost $3.2M. From July 16, 2009 to November 11th, 2009 Time Services reports that the

agricultural business loses an addition $1 million dollars. However, at the end of the 2009 Time

estimates that the sale of the agricultural business will result in a gain of $1.3 million dollars when it is

finally completed in 2010.

ANS:

Situation 1:

Situation 2:

Time Services

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Selected Information Related to Discontinued Operations

Year Ended 2009

Income from Discontinued Operations

Net Earnings of Discontinued Business $1,500,000

Gain on Disposal of Discontinued Business $ 600,000

Income from Discontinued Business $2,100,000

Situation 3:

Time Services

Selected Information Related to Discontinued Operations

Year Ended 2009

5. Mattel, Inc. designs, manufactures and markets various toy products worldwide through sales to

retailers and directly to consumers. Among the company’s many products are Barbie, GI Joe, and

American Girls. Below is an income statement for Mattel for years 2002, 2001 and 2000. Notes to the

financial statements reveal the following information.

1. Discontinued Operations – In 1999 Mattel merged with Learning Company, with Mattel being the

surviving company. The Learning Company, which produced consumer software, represented a

separate line of business for Mattel. In 2000 Mattel’s Board of Directors committed to dispose of the

Learning Company and its consumer software operations. In 2000 the Learning Company was

reported as a discontinued operation and the company was sold to Gores Technology on October 18,

2000.

In 2002 Mattel received a contractual payment from Gores Technology based on the sale of assets of

Learning Company and other liquidation events.

2. Accounting Change – In 2001 Mattel changed the manner in which it accounted for derivative

instruments consistent with the issuance of SFAS No. 133 Accounting for Derivative Instruments and

hedging Activities. The change resulted in Mattel recording a one-time adjustment of $12 million.

3. Accounting Change – In 2002 the FASB issued SFAS No. 142 Goodwill and Other Intangible

Assets. The standard requires that management estimate the value of its goodwill and, if necessary,

record an impairment charge. Consistent with SFAS No. 142 Mattel recorded a one-time adjustment of

$252.2 million, net of tax, as the cumulative effect of the change in accounting principle.

Mattel, Inc.

Selected Income Statement data

Fiscal year end 12/31/2002 12/31/2001 12/31/2000

(amounts in thousands of dollars)

Net sales $4,885,340 $4,687,924 $4,565,489

Cost of Goods Sold (2,524,353) (2,538,990) (2,572,247)

Gross profit 2,360,987 2,148,934 1,993,242

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Selling and Administrative Expenses (1,602,846) (1,507,793) (1,560,157)

Amortization of Goodwill 0 (46,121) (46,561)

Non-operating income/expense (22,747) (9,878) (8,121)

Interest expense (113,897) (155,132) (152,979)

Income from Continuing Operations

before Income Taxes 621,497 430,010 225,424

Provision for income taxes (166,455) (119,090) (55,247)

Income from Continuing Operations 455,042 310,920 170,177

Gain (Loss) from Discontinued Oper., net of tax 27,253 (601,146)

Income (Loss) before Cumulative Effect of

Change in Accounting Principles 482,295 310,920 (430,969)

Cumulative Effect of Change in Accounting

Principles, net of tax (252,194) (12,001) 0

Net Income (Loss) $230,101 $298,919 ($430,969)

Required:

a. Discuss whether or not you would adjust for each of the following items when using earnings to

forecast the future profitability of Mattel:

(1) Discontinuance of the Consumer Software operations.

(2) The change in accounting for derivative instruments.

(3) The change in accounting for goodwill and other intangible assets.

b. Indicate the adjustment you would make to Mattel’s net income for each of the items in part a.

c. Prepare a common size income statement for 2002, 2001, and 2000 for Mattel.

d. Repeat part c after making the income statement adjustments in part b.

e. Assess the changes in profitability of Mattel during the three-year period.

ANS: