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Chapter 6
Accounting Quality
6-21
in whole or in part.
c. Cooper nets investing and financing cash flows of discontinued operations
against cash flows from operations for the discontinued businesses and shows
the net cash flow of $324 million in the operating section. The following
analysis summarizes the cash flow pattern.
Continuing Discontinued
Total Businesses Businesses
d. The analyst should compare the restated amounts for Year 8 with the reported
amounts for Year 9. One issue the analyst must face is the treatment of the net
amount should convert into cash at the time of sale. Thus, the analyst might
cash.
e. The analyst should compare the restated amounts related to continuing opera-
tions for Year 8 with the continuing operations amounts for Year 9. The same
operating activities underlie each set of amounts and provide comparability
going forward.
related to continuing operations.
Chapter 6
Accounting Quality
6-22
in whole or in part.
Integrative Case 6.1: Starbucks
The solution to this case is organized around topics related to the key risk and success
factors for Starbucks (each part of the solution addresses the three questions in Parts a–c).
The Starbucks Experience
Product differentiation is a key success factor. Starbucks has successfully differentiated
its product in several ways, but three of these ways appear to resonate with customers.
First, Starbucks engages in market research to support site selection, product offerings,
various product differentiation costs are expensed, a balance sheet quality issue arises.
The value of the Starbucks’ brand is not reflected as an asset. An earnings quality issue
also arises because the changes in brand value, either increases or decreases, are not
reflected in earnings.
Fiscal year end 2011: $3,663 million (96th largest world brand)
Fiscal year end 2012: $4,062 million (88th largest world brand)
From this data, an analyst could effectively capitalize the asset to be placed on the
balance sheet and recognize asset changes as a component of pretax income. For fiscal
year 2012, the balance sheet adjustments would be:
Chapter 6
Accounting Quality
6-23
in whole or in part.
For fiscal year 2012, the income statement adjustments would be to add $399
analysis, (2) equity valuation, and (3) management evaluation?
Credit analysis: If the analyst believes that capitalizing brand assets better captures the
economics of Starbucks activities, then Starbucks current non-capitalization approach
causes Starbucks solvency risk ratios to be too high. These ratios, which have some
considering the decision at hand, the credit analyst may not make the adjustment for two
reasons. First, the asset is not tangible and therefore is highly unlikely to be liquid should
financial distress occur. Some analysts prefer a ratio of long term debt to tangible equity,
and thus would find little value in this adjustment. Second, the balance sheet is not the
18.1%, respectively. If an analyst were to capitalize the brand asset and reflect its
changes in income, the marginal effects of the adjustments on ROE and ROA are:
Add $3,663m “Brand asset” to intangible assets
Adding these marginal effects to ROE and ROA as reported would reduce both. The
lesson is that omission of the brand asset makes Starbucks look more risky from a
policy. If an analyst considers all financial statements when assessing credit risk, then the
adjustment for brand assets may not be necessary.
Chapter 6
Accounting Quality
6-24
in whole or in part.
Equity valuation: As shown in Chapters 11–13, valuation models based on accrual
accounting concepts and cash flows or dividends yield the same valuations if based on
the same underlying assumptions. Thus, because valuation, per se, is not directly affected
by accounting policy, the more important issue is whether Starbucks’ accounting for
activities that enhance brand value affects the ability to forecast financial statements that
forecasting is somewhat circular reasoning.)
Management evaluation: Financial statements also have a role in evaluating management
stewardship. ROAs are overstated by failure to capitalize brand assets. If the amount of
Customer Loyalty
An important strategy for Starbucks is the creation and maintenance of customer loyalty.
Accordingly, the accounting for stored value cards and customer awards programs is
important. The notes indicate that cash received up front for stored value cards are
$510.2 million, which represents 23% of current liabilities and 16.4% of total liabilities.
These accounting methods appear appropriate. In both cases, revenue is not recognized
until promised product is delivered. Thus, balance sheet quality and earnings quality in
this area is high.
2.2% of pretax income in 2012, 2011, and 2010, respectively. If the analyst believes
these increases in revenue are transitory, then earnings quality is impaired to some extent.
However, the amounts are material and a growing part of pretax income. Accordingly,
the analyst may want to treat the amounts as permanent and devote some time to
forecasting future amounts.
Chapter 6
Accounting Quality
6-25
in whole or in part.
Store Openings and Closings
A key value driver for Starbucks is store expansion, and regular consideration of whether
stores underperform leads to store closures. Preopening costs (market research, site
selection, etc.) are expensed. Capital expenditures for store openings and leasehold
With respect to store openings/closings, the remaining accounting quality issues
are:
• Whether operating leases are present and material
Operating Leases. Starbucks accounts for some of its leases as operating. Balance sheet
quality is impaired because, although these leases are noncancellable promises to pay
cash to a lessor and Starbucks uses the stores in its operations, neither a liability nor an
asset appear on Starbucks’ balance sheet. This off-balance-sheet financing causes
Chapter 7 for further details).
Credit analysis: Because of the significance of noncapitalization of operating leases for
assessments of solvency risk, it is likely that the analyst would want to effectively
capitalize the leases before performing credit analysis. Lease capitalization methods are
Chapter 6
Accounting Quality
6-26
in whole or in part.
Year Minimum Lease
Payment
Discount Factor
Based on 6.25%
Present Value of
Minimum Lease
Payment
2013 787.9 0.9412 741.6
2014 728.5 0.8858 645.3
2015 640.4 0.8337 533.9
The journal entry to effectively capitalize the operating leases is:
As an example of the effect on a solvency risk ratio, consider the total liabilities to total
assets ratio:
Total Liabilities Total Assets Ratio
Equity valuation: Although financial statement predictability is not likely to be affected
by operating lease treatment, failure to reflect financial liabilities misstates the weights
operating leases are present.
as increases in stock prices.
Chapter 6
Accounting Quality
6-27
in whole or in part.
Manipulation of useful lives. Note 1 provides a list of useful lives used in depreciation
that is not precise. This is a typical disclosure given that firms have many types of assets
with varying useful lives and it would be neither useful nor cost effective to list them all.
However, given the significance of property, plant, and equipment to Starbucks, it is
through growth but through earnings management.
We discuss a technique to ascertain changes in useful lives in Chapter 8, and for
this reason, we do not provide Starbucks’ Note 7 with this case so that the data could be
Subtract non-depreciable construction in progress (264.1) (127.4) (173.6) (119.2)
The average number of years used to depreciate PP&E is increasing. Is the increase
material? Assume FY2012’s depreciation had been computed using FY2011’s average
useful life:
Adjusted FY2012 depreciation expense $6,291.8/10.59 years = $594.1
As reported (580.6)
Chapter 6
Accounting Quality
6-28
in whole or in part.
Licensing Revenue and Product Sales to Foodservice Accounts and Stores
Starbucks attempts to lever its brand through licensing and product sales to foodservice
accounts and stores. Based on the information in Note 1, Starbucks’ revenue recognition
policies appear to be reasonable and in line with other companies. Revenue from product
relates to channel development activities which are generally business-to-business.
Currently, accounts receivables arising from such sales are relatively small. Should they
become larger, the analyst should check for reasonableness of allowances for doubtful
accounts (see Chapter 9 for greater detail). Both balance sheet and earnings quality can
Supply Chain Management
Starbucks notes in its 10K that acquisition of raw materials, especially high-quality
coffee beans, at favorable prices is a key success factor. Starbucks uses average cost (a
method yielding inventory balance sheet number somewhere between FIFO and LIFO
$22.6, $19.5, and $18.1 million at 2012, 2011, and 2010, respectively. To gauge material-
ity, note that the 2012 and 2011 reserves are a relatively small 1.79% and 1.98% of gross
inventory values, respectively. Also, the changes in reserves are very small relative to
pretax income.
Summary
