Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 11
On December 14, 1987 (4.15 pm), the Bank of Boston (not a money–center bank)
announced a $200 million increase in its LDC loan loss reserve, classified $470 million
of LDC loans as non–accrual of interest status, and wrote off $200 million of LDC
loans. In the 3–day window centred on 15 December, 1987, its share price rose by
9.9%. Banks were required to maintain a capital adequacy ratio (see note) of at least
5% for regulatory purposes. The Bank of Boston’s capital adequacy ratio remained
strong (8%) after the writeoff.
Note: The capital adequacy ratio is calculated as the ratio of shareholders’ equity plus
loan loss reserves to total assets. Thus, a provision for loan losses does not affect the
ratio (i.e., debit shareholders’ equity, credit loan loss provision), while a writeoff of
loans does.
For a 3–day window centred around 15 December, 1987, EHS report the following
abnormal returns:
12 money–center banks –7.26%
33 other banks – 1.14%
Required
a. Why did Citicorp’s share price fall by 3.1% on May 19, 1987 and rebound by
10% over the next two days?
b. Why did the abnormal 3–day return for 11 money–center banks exceed the
return for the 34 other banks for the same period?
c. Why did the Bank of Boston’s share price rise by 9.9% over a 3–day window
surrounding December 15, 1987?
d. Why was the average abnormal return of 12 money–center banks significantly
lower (–7.26%) than the abnormal return of 33 other banks (–1.14%) over the 3–day
window surrounding December 15, 1987?
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11A-2. Shown below are the income statement and comparative balance sheets of ACR Ltd.,
from its 2008 annual report. The 2008 cash flow statement of ACR Ltd. (not shown)
reports operating cash flow as $2,386.
ACR Ltd.
Income Statement
Year Ended December 31, 2008
Contract income $11,684
Cost of contracts 9,073
Gross profit 2,611
General and administrative expenses 1,346
Amortization 276
Interest 16
1,638
Operating profit 973
Equity income from affiliates 165
Other income 52
217
Income before income taxes
and extraordinary items 1,190
Income taxes:
Current 584
Future 59
643
Income before extraordinary items 547
Extraordinary items —
Net income for year $547
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ACR Ltd.
Balance Sheets
As at December 31
2008 2007
Assets
Current assets:
Cash $693 $ —
Trade accounts receivable 2,107 3,464
Income taxes recoverable — 506
Inventories 810 410
Prepaid expenses 61 99
3,671 4,479
Investments in affiliated companies 405 203
Machinery and equipment 1,532 1,632
$5,608 $6,314
Liabilities
Current liabilities:
Bank indebtedness $ — $1,291
Accounts payable and accrued liabilities 398 497
Income taxes payable 282 34
Liability for future income taxes 83 64
763 1,886
Future income tax liability 62 22
825 1,908
Shareholders’ Equity
Share capital 2,268 2,268
Capital contributed on issue of warrants 80 80
Retained earnings 3,895 3,275
Excess of appraised value of fixed
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assets over amortized cost 1,175 1,307
7,418 6,930
Less: Cost of shares purchased 2,635 2,524
4,783 4,406
$5,608 $6,314
Required
a. What is the amount of net accruals included in ACR Ltd.’s year 2008 net
income?
b. Use the information in the income statement and balance sheets of ACR Ltd. to
calculate the various individual accruals and reconcile to the net total in part a.
c. Upon comparing operating cash flow and net income, we see that the accruals
have substantially lowered the reported income for the year. Give reasons why
management may want to manage income downwards in this manner.
11A-3. A way to manage earnings is to manipulate the point in the operating cycle at which
revenue is regarded as earned. An article entitled “Bausch & Lomb Posts 4th–Quarter
Loss, Says SEC Has Begun Accounting Probe” appeared in The Wall Street Journal
on January 26, 1995.
The article reported on questions raised by the SEC about Bausch & Lomb Inc.’s
premature recording of revenue from products shipped to distributors in 1993.
“Bausch & Lomb oversupplied distributors with contact lenses and sunglasses at the
end of 1993 through an aggressive marketing plan, and was forced to buy back a
large portion of the inventory [in 1994] when consumer demand didn’t meet
expectations.” The oversupply amounted to around $10 million, which Bausch & Lomb
claimed was not “material.”
In addition, the article points out that in the fourth quarter of 1994 Bausch & Lomb had
incurred $20 million in “one–time expenses,” which included expenses from “previously
announced staff cuts of about 2,000.” Also, in the fourth quarter Bausch & Lomb took
a $75 million charge in its oral–care division in order “to reduce unamortized goodwill
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that it recorded when Bausch & Lomb bought the business in 1988.” Many analysts
are saying that Bausch & Lomb are looking to sell the oral–care division, and this
reduction of unamortized goodwill will make the division look better.
Required
a. What earnings management policy did Bausch & Lomb appear to be following
in 1993?
b. Evaluate revenue recognition policy as an earnings management device.
c. The article refers to a $20 million writeoff in 1994 relating to staff cuts, and
another $75 million writeoff in Bausch & Lomb’s oral–care division. What
earnings management strategy does the firm appear to have followed in 1994?
Why?
d. Do Bausch & Lomb’s 1993 and 1994 earnings management strategies suggest
that its management does not accept efficient securities market theory? Explain
why or why not.
11A-4. Note: The 5th and subsequent editions of this text have removed discussion of push–
down accounting.
Earnings management extends into the realm of new share offerings (IPOs), since the
prospectus for a new offering includes current and recent financial statements. An
article entitled “RJR Nabisco’s Use of Accounting Technique Dealing with Goodwill Is
Getting a Hard Look,” which appeared in The Wall Street Journal on April 8, 1993,
describes some earnings management considerations surrounding a $1.5 billion new
share offering of Nabisco, a food subsidiary of RJR Nabisco Holdings.
According to the article, the parent, RJR Nabisco Holdings, has substantial goodwill
on its books arising from its acquisition of Nabisco, which is being amortized at a rate
of $607 million annually (at the time, in the United States, APB 17 required that
goodwill from acquisitions be amortized over a period of up to 40 years). However, this
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goodwill amortization appears only on the books of the parent—not on those of
Nabisco.
According to the article, “What RJR is doing is presenting Nabisco’s annual earnings
without the burden of $206 million of 1992 ‘goodwill,’ leaving this earnings–depressing
item with the parent company instead.” This resulted in Nabisco increasing its 1992
after–tax profit from $179 million to $345 million or from 48 cents a share to 93 cents a
share.
The article goes on to state “Nabisco executives indicated the food company could
generate 1993 earnings of as much as $1.30 a share. That earnings level might justify
the proposed selling price of $17 to $19 a share for the new Nabisco shares, analysts
say.”
The article questions whether RJR is managing the reported net income of its Nabisco
subsidiary by not “pushing down” goodwill to Nabisco.
Required
a. What pattern of earnings management is RJR following? Why?
b. Without considering any strategic issues surrounding the pricing of the new
shares, do you think that goodwill should be pushed down to the subsidiary
company?
c. Do you think the strategy of not pushing down the goodwill will be successful in
raising the issue price of the new shares? Explain why or why not.
11A-5 The potentially serious consequences of bad earnings management are illustrated by
the case of Atlas Cold Storage Income Trust, which operates a system of refrigerated
warehouses across Canada and the United States. During June 2004, the Ontario
Securities Commission filed quasi–criminal charges under the Ontario Securities Act
against four senior officials of the company, including its CEO. The company itself was
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not charged because it cooperated with the investigation and took steps to remedy the
problems.
The OSC charged that during 2001–2003, Atlas had engaged in several types of
financial statement manipulations. One tactic was to capitalize certain costs that,
according to GAAP, should have been charged to expense. Another involved deferring
recognition of a large customer claim for damaged goods from 2001, where it
belonged, to 2002. A third tactic was to disguise breaches of debt covenants by a
subsidiary company by advancing money to the subsidiary at financial statement
dates. These advances were repaid shortly thereafter. According to revised financial
statements filed by the company, net income was originally reported too high by $5.2
million for 2001 and $32.4 million for 2002.
The company also faced a class–action lawsuit by investors. In 2008, this lawsuit was
settled, without admission of liability, by a deposit from Atlas of $39.5 million into a
fund to reimburse investor losses.
Required
a. Evaluate the short–run (i.e., one year) and long–run effectiveness of capitalizing
expenses as an earnings management device.
b. The motivation for some of the claimed manipulations was apparently to meet
earnings targets. Why is it important to managers to meet earnings targets?
Use concepts of market efficiency and investor rationality in your answer.
11A-6 Spanish banks largely avoided the consequences of the 2007–2008 meltdown in the
markets for ABSs, CDOs, ABCPs, etc. A possible reason was “dynamic provisioning,”
under which, in addition to provisions for loan losses on loans currently outstanding,
Spanish banks recorded additional provisions when loans were growing strongly,
drawing on them to reduce loan loss provisions during periods of lending contraction.
The idea is that over the course of a business cycle, the loan loss overprovisions early
in the cycle will be balanced out by underprovisions later on, with no net effect on total
earnings over the cycle. Thus, when financial instruments markets melted down and
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lending contracted in 2007–2008, Spanish banks did not need to make as large
provisions for losses as many other banks, since some of these losses were absorbed
by overprovisions in earlier boom years. As a result, Spanish banks did not run into
capital adequacy shortfalls to the same extent as banks in other countries.
Dynamic provisioning is a form of earnings management, in which loan losses are
smoothed over the course of a business cycle. This is contrary to IAS 39 (now
replaced by IFRS 9), under which financial asset writedowns are based only on
balances outstanding as at the financial statement date.
Required
a. Evaluate the relevance and reliability of dynamic provisioning.
b. Does dynamic provisioning constitute good or bad earnings management?
Explain.
c. Assuming that manager compensation is based on both net income after
dynamic provisioning and share price performance, how do you think bank
management would react to an accounting standard requiring dynamic provisioning?
11A-7 On October 3, 2007, Deutsche Bank AG announced that it would record a writedown
of EUR 2.2 billion. Most of the writedown applied to its investments in asset–backed
securities and related financial instruments, following from the August meltdown of the
market for these investments. This writedown materially reduced third quarter, 2007,
earnings. At the same time, the Deutsche Bank CEO reaffirmed the company’s
previous earnings guidance for 2008, which was for a profit of EUR 8.4 billion.
However, he qualified this forecast with the comment that this assumed “normally
functioning markets.”
Comments appeared in the financial press, following these announcements, about the
difficulties faced by Deutsche Bank in determining the new fair value of these written–
down investments, since market values were not readily available. Some comments
suggested the possibility that the company was taking a bath, thereby creating a
“cookie jar” that could be used to augment future earnings. Other commentators were
473
concerned that the writedowns may have been understated, rather than overstated, so
as to disguise losses, and that further writedowns would likely follow. The company
assured investors, however, that it had used “a rigorous process applying appropriate
accounting principles.”
In the face of these events, the share price of Deutsche Bank rose 2.1% on October 3,
compared with a rise of about 0.6% on that day for the Dow Jones Stoxx European
banking index. On October 4, Deutsche Bank shares closed unchanged, compared
with a 0.96 increase in the banking index.
Required
a. Give reasons why Deutsche Bank’s share price rose on October 3.
b. Give reasons why Deutsche Bank may want to take a bath.
c. Give reasons why Deutsche Bank may want to understate its writedown.
d. You are an auditor of Deutsche Bank. Prior to the writedown, suppose the bank
suggested that the investments in question be reclassified from held–for–trading (their
present classification under IAS 39) to held–to–maturity. What is your reaction to this
suggestion? Explain.
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Suggested Solutions to Additional Problems
11A–1 a. The 3.1% fall could have been due to a fall in the stock market index (i.e.,
economy–wide risk) on that day. (EHS investigated this possibility, and concluded that
the fall was not “the outcome of general macroeconomic events.”)
Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 11
c. The same reasons as for part a apply here. In addition, the Bank of
Boston’s capital adequacy ratio was still well above the regulatory minimum, even
after its $200 million writeoff. This seems to have been interpreted by the market
as an indication of the bank’s financial strength.
d. The answer seems to lie in the fact that the Bank of Boston, in addition to
increasing its loan loss provision, actually wrote off $200 million of LDC debt, thereby
11A–2 . a. Net accruals are the difference between operating cash flows and
reported net income. Here, net accruals for 2005 are $2,386 – 547 = $1,839.
b. The individual 2008 accruals of ACR Ltd. can be calculated and reconciled as
follows:
Cash flow from operations $2,386
Less: Amortization expense $276
Future income taxes expense 59