978-0078025679 Chapter 7 Solution Manual Part 2

7-14

• Change one or more accounting methods to increase reported earnings.

For instance: expand straight-line depreciation to all long-lived assets,

eliminate LIFO accounting.

• Change one or more accounting estimates. For instance, increase the

confronting the banker involves a trade-off between (a) using covenants to

restrict management’s action and thereby reduce credit risk and (b) inhibiting

P7-9. Accounting in regulated industries

Requirement 1:

7-15

Requirement 2:

In this particular instance, Duke Energy is reminding readers that some debt

interest costs are assigned to the balance sheet, and thus are not included in

Interest expense. Readers who overlook this reminder may mistakenly

P7-10. Understanding rate regulation and accounting choices

7-16

Proposed accounting changes

($ in millions)

Base

Case

Extend

Plant Life

Increase

Bad Debts

Amortize

Takeover Costs

Write-Up

Inventories

Allowed operating costs

$1,120.0

Accounting change adjustment

–

(5.0)

7.0

1.5

–

$1,120.0

$1,115.0

$1,127.0

$1,121.5

$1,120.0

Assets in service

$3,200.0

Accounting change adjustment

–

175.0

(7.0)

3.0

60.0

$3,200.0

$3,375.0

$3,193.0

$3,203.0

$3,260.0

Allowed return at 8.75%

$280.0

$295.3

$279.4

$208.3

$285.3

Revenue requirement

$ 1,400.0

$ 1,410.3

$ 1,406.4

$ 1,401.8

$ 1,405.3

 Estimated demand (millions of KWH)

14,000

Rate per KWH allowed

$0.10000

$0.10074

$0.10046

$0.10013

$0.10038

Alternate solution format:

Rate per

Estimated KWH

($ in millions) Demand Allowed

Current allowed operating costs $1,120.0 14,000 $0.08000

Effects of proposed accounting changes:

Extend plant depreciation life ($5.0) 14,000 ($0.00036)

Increase bad debts $7.0 14,000 $0.00050

Amortize hostile takeover costs $1.5 14,000 $0.00011

Requirement 2:

The bad debt increase seems quite plausible as long as the revised

7-17

regulators have so far rejected this line of argument and required utilities to

maintain their balance sheet at historical cost.

The plant life extension would be allowed, but not the $175 million increase

P7–11. Determining whether citizens should have a say in CEO pay

Requirement 1:

U.S. companies are not required to obtain shareholder approval of the

compensation packages paid to top executives. Proposed pay packages are

assembled by the company’s compensation committee which is comprised of

generous executive pay levels. Management can, under certain

circumstances, refuse to place the proposal on the annual meeting agenda,

and management is not obligated to implement proposed changes in pay

practices even if the garner a majority vote of shareholders.

During the 2008 proxy season, shareholders filed resolutions seeking

Requirement 2:

One argument favoring continued use of golden parachutes is that they help

shareholders by reducing incumbent management’s tendency to fight hostile

takeover attempts. Takeovers can benefit shareholders in several ways.

First, takeover premiums are often 20% or more above the prevailing stock

7-18

takeover offers. Of course, golden parachutes also may just be one more

way of delivering overly generous compensation to top executives, and that

seems to be the view held by Mr. Minder.

Requirement 3:

(5) allow shareholders to determine whether executive pay practices are

effective.

Among the reasons for not supporting the right of shareholders to approve

CEO pay packages are: (1) labor market forces dictate top executive pay

might consider whether national votes should be held on other corporate

matters such as election of directors, approval of corporate acquisitions and

investment decisions, or approval of dividends. Given citizens the right to

7-19

Financial Reporting and Analysis (6th Ed.)

Chapter 7 Solutions

The Role of Financial Information in Contracting

Cases

C7-1. Microsoft’s “unearned revenue” account

Requirement 1:

Microsoft cannot recognize all of the revenue from software sales until it is

fully “earned.” Microsoft sets aside some software sales revenue as

“unearned” because, at the time of sale, the company still has an obligation to

Determining how much software sales revenue to set aside as unearned

each quarter is a challenge because it requires an estimate of the future cost

of providing the promised services to customers. Developing reliable cost

estimates is no easy matter, particularly in an industry where technologies

change rapidly and software released early is often error prone.

then recognize $95 of software sales revenue immediately and include this in

current earnings. The remaining $5 would be recorded as unearned revenue,

to be “earned” when the future services are performed.

A second approach would set aside enough revenue to not only cover the

estimated future costs of the promised services, but to also earn a “normal”

7-20

Requirement 3:

When the “unearned revenue” account is reduced by $100 million the dollars

go to the “revenue” account and are included in net income. That’s because

they are then considered earned revenue.

Requirement 4:

incentive to increase the amount of software sales revenue set aside as

unearned. Doing so will not jeopardize the bonus payment this year and it

creates a cushion than can be used next year if the company appears to be

falling short of its profit goal. Debt covenants can also provide incentives to

“manage” the unearned revenue account, although they are unimportant for

antitrust litigation or other forms or regulatory intervention.

Requirement 5:

Analysts and investors focus on changes in Microsoft’s unearned revenue

account for several reasons. First, the unearned revenue account is a lead

indicator of future profitability since today’s “unearned” revenues become

C7–2. Maxcor Manufacturing: Compensation and earnings quality

Requirement:

There are several reasons why Ms. Magee should feel uneasy about

7-21

above the level required to earn a 200% bonus. But in 2014, only about

34% of total R&D was charged to cost of goods sold. Operating profits that

year were barely above the bonus threshold of $4.0 million.

• Plant closing costs lowered net income for the year. The issue here is

tendency to shift earnings from one year to another. The bank would

accumulate bonuses over a three-year period, paying out one-third of the

bank balance each year.

• Charge for the capital used in the company so that bonus payments reflect

C7–3. Whole Foods Market: EVA-based Compensation

Requirement 1:1

Compared to GAAP earnings, there are two advantages to using EVA® for

7-22

Notice that performance is based on a measure of operating profits, which

means that non-operating gains and losses that might otherwise flow through

GAAP net income are excluded from EVA performance. This eliminates

non–operating “noise” in the performance measure and thus ensures that

managers stay focused on building profits from operating activities.

incentive pay—in any of several ways: increase sales at existing stores,

reduce operating costs at existing stores, or simply open more stores. This

last approach—opening more stores—requires an infusion of financial

resources (i.e., capital) and GAAP operating earnings overlooks the cost of

this added capital. Incentive pay tied to GAAP earnings (or GAAP operating

the company’s investment in that store.

Requirement 2:

The company says that “stock price performance has not been a factor in

determining annual compensation because the price of the Company’s

common stock is subject to a variety of factors outside our control.” In other

managers to create shareholder value. The use of stock options as incentive

compensation mechanisms has become quite controversial in recent years

(see Chapter 15).

Requirement 3:

At Whole Foods Market, EVA is based on GAAP operating earnings so

7-23

Requirement 4:

The annual EVA bonus for a particular Team Member is first deposited in a

“pool”, and then a portion of the pool balance is paid out annually. The

payout amount is 100% of the pool “up to certain job-specific dollar amounts

plus a portion of the excess.” If the payout amount will cause the Team

management to focus on the short term, consider the bonus pool of one

particular manager. Suppose the manger can increase EVA by $100,000 this

period by cutting back on consumer advertising. Doing so will add $20,000 to

the manager’s EVA bonus but only $5,000 of that bonus will be paid out this

year. The remaining $15,000 of the bonus stays in the pool for possible

short-run decisions that hurt future performance.

Requirement 5:

When an average of several metrics is used, it is more difficult for managers

to “game the system” by maximizing a single metric when doing so is not

optimal. For example, if a single metric of sales growth is used, managers

pursue sales growth if that is a component of the average. But if operating

margin is also a component of the average, the incentive to pursue

C7-4 Duke Energy Corp: Rate Regulation and Earnings Management

Requirement 1:

7-24

customers. One way to make it look like the company has fallen short of its

profit goal is to overstate expenses and thus understate earnings.

Requirement 2:

If the $10 million consulting fee is considered by regulators to be “above the

C7-5. Computer Associates International: Compensation and Accounting

Irregularities

Requirement 1:

Two features of the plan may have contributed to illegal backdating of sales

7-25

revenue growth. Backdated sales contracts allow management to hide

revenue declines, at least for awhile.

Requirement 3:

Auditors routinely look for an unusual clustering transactions at the end of a