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Chapter 6
Accounting Quality
6-11
in whole or in part.
critical in developing forecasted financial statements used for
valuation. The false growth implied by the revenue inflation will
lower when it is not.
6.18 Adjusting for Unusual Income Statement and Classification Items.
a. (1) Gain on sale of a portion of the branded product line—The case for
eliminating the gain on the sale involves the materiality of its amount and
the peripheral nature of such sale as compared to the manufacturing and
brand food products companies.
(2) Extraordinary loss—The case for eliminating the loss is its nonrecurring
nature. The case against eliminating the loss is the immateriality of the
amount.
b. Year 10 Year 11 Year 12
c. Revenues should appear as the amount of cash the firm expects to receive from
customers. The incentives represent reductions in the selling price of products
sold and therefore should appear as a reduction in revenues, not as a selling ex-
Chapter 6
Accounting Quality
6-12
in whole or in part.
d. Year 10 Year 11 Year 12
Sales .................................................... 100.0% 100.0% 100.0%
Gain on Sale of Businesses ................. 5.2 — —
Income before Income Taxes and
Cumulative Effect of Accounting
Change ............................................ 16.4% 7.6% 13.6%
e. Sales .................................................... 100.0% 100.0% 100.0%
Gain on Sale ................................... — — —
Income before Income Taxes and
Extraordinary Loss ......................... 11.2% 7.6% 13.6%
Year 11, the cost of goods sold to sales percentage, the selling and administra-
tive expenses to sales percentage, and the interest expense to sales percentage
all increased when compared to Year 10. Sales decreased between Year 10 and
Year 11. Henry spread any fixed costs over a smaller sales base, causing these
expense percentages to increase. Henry also sweetened its sales and promotion
Chapter 6
Accounting Quality
6-13
operating expenses as a percentage of revenues is a reduction in Henry’s effec-
tive tax rate. The effective tax rate after eliminating the gain on the sale of the
branded product line classroom business was 41.1% [($573 – $163)/($1,463 –
incentives as a percentage of gross revenues to 6.8% [$693/($9,431 + $693)] in
Year 12 from 6.5% in Year 11, which should have increased the expense percen-
6.19 Unusual Income Statement Items.
a. (1) Goodwill impairment. Goodwill impairment charges are generally consi-
dered transitory and should be eliminated when assessing current profita-
bility and future earnings. However, the analyst should consider whether
the unique tax accounting rules for mergers and acquisitions that determine
the deductibility of goodwill amortization depending on whether the initial
business combination was taxable or non-taxable.
(2) Discontinued operations. Although discontinued operations appear in
amounts) should be excluded from the prediction of future earnings.
(3) Loss (Gain) on sale of property, plant, and equipment and businesses
(net). Although losses and gains come from peripheral transactions, the
taxes) when predicting future income.
Chapter 6
Accounting Quality
6-14
in whole or in part.
b. Common-Size Income Statement (amounts in thousands)
2008 2007 2006
Total Revenues ................................... 100.0% 100.0% 100.0%
Other Operating (Income) Expense,
Net .................................................. (0.0) 0.2 (0.7)
Total Operating Expenses, Net ........... 93.2% 78.5% 79.2%
Discounted Operations (Note 2):
Loss from Results of Discontinued
Operations ...................................... (0.1)% (0.6)% (0.5)%
79.5%. Even after elimination of the non-recurring goodwill amortization, total
Note that losses on discontinued operations are relatively small when scaled
by revenues and are not significant contributors to the decline in profit margin.
Chapter 6
Accounting Quality
6-15
6.20 Implications of a Goodwill Impairment Charge for Future Cash Flow and
Profitability.
a. Companies examine annually whether goodwill is impaired by simulating what
the acquisition price would be if the segment were repurchased in the open
market at the balance sheet date. That is, what is the current fair value of the
segment? If the fair value of the segment is less than its book value, impairment
has occurred. The amount of impairment is computed by comparing the book
observe the multiple of their book value reflected in market prices of the traded
firms. Multiplying the market to book ratio of these traded companies by the
book value of Northrop’s Shipbuilding and Space Technology segment would
imply a fair value for the segment.
b. If one assumes that the simulation process in the goodwill impairment test
yields accurate measures of the implied goodwill at a given balance sheet date,
denominator of ROA) will be lower and ROA will be higher, all else held equal.
However, earnings also are likely to be lower for the reasons stated above.
6.21 Restructuring Charges at Intel.
a. Given the information in Intel’s Note 15, it appears that management has
earnings seems warranted.
Chapter 6
Accounting Quality
6-16
b. Asset impairments are recorded by an asset write-down rather than by accrual of
a liability. Asset impairments decrease net income through the increase in
restructuring charges and asset impairments reported on the income statement.
c. The accrued restructuring liability increases by “additional accruals,” which
represent new employee severance and benefit accruals that decrease net in-
come. “Adjustments” occur when additional information becomes available
are realizations of the expected payments to employees and thus reduce the re-
structuring liability and cash (no income statement effect).
d. Under U.S. GAAP, firms record a restructuring liability on the balance sheet
and the associated restructuring charge (an expense) on the income statement
when two conditions are present: management has committed to the restructur-
ing plan and restructuring costs meet the definition of a liability. Recall that a
liability is a present obligation (not a planned obligation) that the firm has little
under U.S. GAAP.
6.22 Interpreting the Statement of Cash Flows.
a. The sales decline is a primary indicator of an operating problem. During a pe-
riod of decreased sales, accounts receivable and inventories usually decrease.
improve the quality of its products and stimulate sales. Sunbeam sold some
businesses and acquired others, suggesting that it recognized the need to change
Chapter 6
Accounting Quality
6-17
the mix of businesses in which it was involved. Cash flow from operations was
insufficient to finance its investing needs. The firm engaged in short-term bor-
that it issued to employees.
b. Net income turned negative during Year 6, primarily as a result of the provision
for restructuring and asset impairment. Assuming an income tax rate of 35%,
the restructuring and asset impairment charge reduced net income for Year 6 by
problems and of concerns about its financial health.
c. Net income increased significantly in Year 7, as one would expect from an
18.7% increase in sales. The surprising signal was that the increased sales did
not result in positive cash flow from operations. The negative cash flow from
of goods sold for Year 7. Furthermore, one would expect that an increase in in-
ventories would result in a similar increase in accounts payable to suppliers.
Accounts payable actually declined during Year 7, perhaps indicating an unwil-
It continued to engage in short-term borrowing.
Chapter 6
Accounting Quality
6-18
6.23 Applying and Interpreting the Earnings Manipulation Model.
a. 1998
Constant ................................................................................................. –4.840
1999
Constant ................................................................................................. –4.840
Chapter 6
Accounting Quality
6-19
2000
b. The probability of manipulation increased over the three years. Note, however,
The most important contributing factors were as follows:
1. DSRI: The days receivables outstanding variable steadily increased, indicat-
tions.
2. GMI: The gross margin index steadily increased, which indicates that the
to create earnings in other ways.
3. SGI: The sales growth index exceeded 1.0 each year, indicating growing
4. DEPI: The depreciation index increased between 1999 and 2000. Although
property, plant, and equipment increased between 1999 and 2000, deprecia-
hancing earnings.
Chapter 6
Accounting Quality
6-20
in whole or in part.
5. SAI: The selling and administrative expense index decreased steadily during
change is that the firm may have capitalized expenditures it should have
treated as expenses.
6.24 Using Originally Reported versus Restated Data.
a. Cooper reclassified both the assets and liabilities of discontinued business into
the single line Net Assets of Discontinued Businesses. The smaller reported
assets result from the netting of liabilities against assets. Total assets and total
$1,535 million.
b. Cooper reclassified individual revenues and expenses of discontinued businesses
into the single line Earnings from Discontinued Operations. A comparison of the
originally reported and restated amounts portrays the following picture of
operating performance during Year 8:
Continuing Discontinued
Businesses Businesses Total
Sales ....................................................... $ 8,751 $ 3,322 $ 5,429a
9 to discontinue
bReflects amounts for operations for which Cooper made a decision prior to
Year 9 to discontinue
