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P1-14. Debt Covenants and Aggressive Accounting Practices (LO 1-4)
Requirement 1:
When a company violates its debt covenants, lenders can respond in
any of several ways. They can simply waive the violation which is
akin to a “slap on the wrist”. Or, they can amend the loan agreement
Requirement 2:
Although the details of the company’s EBITDA covenant are not
spelled out in the company’s press release, Friedman’s is required to
maintain a minimum level of profitability (measured using EBITDA)
over several periods. Aggressive accounting practices—premature
Requirement 3:
Friedman’s is required to maintain a minimum ratio of accounts
P1-15. Toshiba Corporation (LO 1-6)
Requirement 1:
The company’s 2015 annual report opens with a Management
Discussion and Analysis typical of U.S. companies. This MD&A
contains a five-year summary of selected income statement and
balance sheet accounts, a review of operations and key performance
Requirement 2:
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
The following financial statements are included in the 2015 annual
report: Consolidate Balance Sheets, Statements of Income,
Requirement 3:
According to Note 2 Summary of Significant Accounting Policies, the
company’s financial statements are prepared in accordance with
Japanese GAAP. However, “certain adjustments and reclassifications
have been incorporated in the accompanying consolidated financial
Requirement 4:
In this case, the answer lies in the response to Requirement 3: No
P1-16. Carrefour Group (LO 1-5)
Requirement 1:
The company’s 2015 “annual report” contains summary consolidated
financial statements of income, financial position, and cash flow. No
Requirement 2:
Most of the annual report is devoted to describing the company, its
strategic goals and core values including the customer value
proposition: brand strategy, store configuration and development
goals, convenience and pricing. A section of the annual report
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
Requirement 3:
The company’s 2015 “financial report” contains detailed consolidate
financial statements (financial position, income, shareholders’ equity,
Requirement 4:
Carrefour’s consolidated financial statements are prepared in
Requirement 5:
The order in which individual accounts are listed by Carrefour Group
on the asset side and liabilities/equity side of the statement of financial
position is the reverse of what is common among U.S. companies.
For example, the first asset listed is Goodwill, followed by other
Financial Reporting and Analysis (7th Ed.)
Chapter 1 Solutions
The Economic and Institutional Setting for Financial Reporting
Cases
Cases
C1-1. Novartis AG: Form 20-F Reconciliation (LO 1-6)
Requirement 1:
For 2006, the difference between IFRS net income from continuing
Requirement 2:
Most people would argue that Novartis management would prefer to
report the high dollar amount (IFRS net income) rather than the lower
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
Requirement 3:
Which is warmer, a room with a temperature of 22.2 Celsius or one
where the temperature is 72 Fahrenheit? Even though “72” is bigger
Sophisticated investors understand that a similar concept applies to
income measured using two different accounting scales: US GAAP
Requirement 4:
Investors who contemplate buying (selling) a foreign company’s stock
traded on a U.S. stock exchange may evaluate its relative profit
Requirement 5:
Form 20-F reconciliations of IFRS earnings to U.S. GAAP earnings
are less important to investors in this setting. There may be rare
cases where investors who contemplate buying (selling) a foreign
company’s stock traded on a foreign stock exchange want to evaluate
C1-2. Henley Manufacturing Inc.: Announcing sales and earnings
goals (LO 1-3)
Requirement A:
1) Potential costs of announcing earnings and sales goals include:
(a) possible shareholder lawsuits if goals are not met; (b) loss of
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
Potential benefits include: (a) investors can better understand the
risks and rewards of stock ownership because they know more about
the management’s plans; (b) disclosure may improve relationships
2) Should management disclose its earnings and sales goals? It
Easily achievable goals are likely to be disclosed without much
reservation. Difficult goals are less likely to be disclosed because
management may not want to risk disappointing investors if results fall
3) In all likelihood, the recommendation would change. Consideration
would now be given to the fact that, as the planning horizon increases,
Requirement B:
In this case, the nature of the goals is quite varied. In all likelihood,
investors and financial analysts are going to be more interested in
C1-3. Fortress International: Disclosing major customers (LO 1-2)
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
1) The SEC requires firms to alert financial statement readers about
major customers that contribute 10% or more to annual sales. Such
information helps investors and analysts assess sales volatility and
2) Financial analysts might use these disclosures in the following
ways:
To assess customer risk. The more revenue a company derives
from a single customer or small group of customers, the greater the
By studying a firm’s major customers (i.e., the products they sell,
expected future demand for such products, untapped markets in
other countries or geographical areas), an analyst can determine
3) Fortress International (now TSS Inc.) offers planning, design,
engineering, construction management, commissioning and
maintenance services for specialized facilities such as data centers,
The primary reason major customers might monitor the financial
health of Fortress International is to ensure that Fortress can be relied
upon as a supplier of facilities services for new or existing locations.
Customers are likely to be interested in monitoring Fortress’s overall
4) Fortress monitors the financial health of key customers to ensure
that they will be a continuing source of demand for its services in the
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
C1-4. The gap in GAAP (LO 1-4)
1) Advantages of allowing managers some flexibility in the choice of
financial reporting methods include:
Accounting must serve as a slave to many masters. Stated
differently, financial accounting information is used for many
purposes including valuation, credit analysis, and contracting, and
If managers have some latitude in their choice of financial
reporting methods, they can adapt the firm’s financial reporting
practices to changes in the firm’s economic characteristics and/or
environment over time. For example, a change in the rate of
2) The current financial reporting system in the United States is really a
combination of the two approaches.
On the one hand, firms have latitude in the selection of accounting
methods to summarize various transactions and events. Examples
include inventory valuation where firms may select from LIFO, FIFO,
On the other hand, there are numerous cases where the FASB (or
SEC) has mandated a single accounting method or treatment for
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sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
3) The advantages of a single set of accounting methods include:
Facilitates comparability of financial information across firms at a
Ease of verification by the auditing profession. This may lead to
fewer shareholder lawsuits against the company or its auditors for
The disadvantages of a single set of accounting methods include:
Assumes that the financial performance and condition of all firms
can adequately be captured by a single set of accounting methods.
Assumes that a single set of accounting methods serves all the
Firms can tailor their choice of financial reporting methods to the
specifics of their economic environment and circumstances. For
example, depending on whether the prices of its input products are
increasing or decreasing, FIFO may be a more realistic choice of
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
The disadvantages of allowing some flexibility in the choice of
financial reporting methods include:
Managers may use their discretion over reporting methods to
distort the firm’s performance. They might adopt financial reporting
practices that create the appearance of profitability in an attempt to
C1-5. Landfil’s accounting change (LO 4)
Here are the major positions outlined at the meeting:
“It’s consistent with GAAP and fully disclosed.” While true, this approach may
not be comforting to analysts and investors concerned about whether
capitalization makes the company look more profitable than it really is. Given
“We capitalize, and we’re proud of it!” The heart of this strategy is the notion
that the company has already made the “correct” accounting decision—one
“We can afford to change.” Even if capitalization is the “best” (most
appropriate) accounting method for Landfil, it still might be advantageous to
change. First, a change to immediate expensing will dispel any remaining
skepticism on the part of investors and analysts. Second, it demonstrates
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© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for
sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or
posted on a website, in whole or part.
