Chapter 6
Accounting Quality
6-29
in whole or in part.
Case 6.2: Citi: A Very Bad Year
evidence of the difficulty in predicting the market movements that lead to large gains and
losses in financial instruments. The exposure of a financial institution to severe market
fluctuations in the underlying determinants of the value of these instruments (market
returns, interest rate movements, exchange rate movements, and commodity price move-
ments as described in Note 7) increases risk.
principal transactions gains and losses.
Provision for loan losses. The provision for loan losses is a major operating item in the
income statements of lending institutions such as Citi. This accrual is similar to bad debt
expense for manufacturers and wholesalers. Citi’s charge for 2008, a spectacular $33,674
Restructuring. Citi reports restructuring charges in operating income in 2008 ($1,766
million pretax) and in 2007 ($1,528 pretax) related to asset impairments and employee
severance costs under two restructuring plans. (See Note 10.) These charges are unlikely
to persist and should be eliminated in the assessment of current profitability and predic-
(a 27.5% increase in net income for the year).
Nonrecurring cash outflows relating to the restructuring are given by the “Utilization”
rows in the two years in the “Severance” and “Employee termination cost” columns.
These amounts are small in 2008 relative to the total restructuring cost. Analysis of cash
Chapter 6
Accounting Quality
6-30
in whole or in part.
impairment of another intangible asset.
These charges are not persistent and should be eliminated from operating income and
income tax expense. Both charges are material. In fact, the after-tax goodwill impairment
is more than eight times larger than the after-tax restructuring charge. For the goodwill
Discontinued operations. Citi sold several operating units over the past three years that
qualified for discontinued operations treatment. In each year presented, Citi reports an
income from operating the discontinued segment. In two of the years presented, Citi
reports a gain on sale. In all three years presented, Citi reports the associated income tax
expense.
current profitability and predicting future earnings.
Also, Citi’s Note 3 presents a schedule of cash flows from discontinued operations
for each year presented. These cash flows also should be removed from the statement of
cash flows when predicting future cash flows.
Chapter 6
Accounting Quality
6-31
in whole or in part.
Case 6.3: Arbortech: Apocalypse Now
I. Objectives
ments.
B. Assess the credit worthiness of a high-growth firm that has experienced lapses
in its financial controls.
C. Apply bankruptcy prediction models and assess the likelihood of bankruptcy.
II. Responses to Case Questions
a. Year 5
Constant ………………………………………………………………………………. –4.840
DSRI: 0.920[($3,932/$12,445)/($1,662/$8,213)] ………………………. 1.436
GMI: 0.528{[($8,213 – $4,523)/$8,213]/[($12,445 – $6,833)/
$12,445]} …………………………………………………………………………. 0.526
Year 6
Constant ……………………………………………………………………………………. – 4.840
DSRI: 0.920[($12,592/$37,848)/($3,932/$12,445)] ………………………… 0.969
GMI: 0.528{[($12,445 – $6,833)/$12,445]/[($37,848 – $23,636)/
$37,848]} …………………………………………………………………………….. 0.634
AQI: 0.404({1 – [($48,191 + $4,698)/$55,782]}/{1 – [($15,443 +
$1,323)/$18,199]}) ……………………………………………………………….. 0.266
Chapter 6
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in whole or in part.
b. Signals of Accounting Irregularities: Beneish’s manipulation index shows a
that the analysts should interpret the inventory turnovers carefully. Use of aver-
age inventories in the denominator of the inventory turnover ratio for a high-
growth firm tends to increase the rate of turnover. Even with this upward bias,
the inventory turnover ratios for Arbortech seem unusually small. With products
ceivable and inventories to maintain its growth. The use of a line of credit to
finance the receivables and inventories also is not unusual. Finally, the use of
equity instead of long-term debt financing is common among high-growth tech-
nology companies. Such firms have few long-term assets that can serve as colla-
c. Effect of Irregularities on the Financial Statements:
(1) Invalid Sales Transactions: The invalid sales transactions overstate sales,
cost of goods sold, income tax expense, and net income on the income
statement. In turn, the transaction overstates accounts receivable for
rect. The financing section of the restated statement of cash flows shows the
amount collected each year from Mr. Pinoza.
(2) Bill and Hold Transactions: The improper cutoff of sales at each year-end
Chapter 6
Accounting Quality
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in whole or in part.
30, Year 6. The balance sheet for each intervening period reports overstated
(3) Inventory Counts: The firm likely overstated its ending inventories each
year in an effort to reduce cost of goods sold and inflate net income. Thus,
cost of goods sold is understated, income tax expense is overstated, and net
income is overstated. The irregularity resulted in overstated inventories, in-
(4) Product Obsolescence: The failure to write down inventories for product
obsolescence resulted in the same errors as the preceding ones for the inven-
tory counts.
subsequent years, it overstated operating expenses, understated income tax
expense, and understated net income each year. At the end of the deprecia-
ble lives of these fixed assets, the initial errors were corrected on a cumula-
tive basis. The amount of cash flow from operations each year is understated
(6) Improper Classification of Prepaid License Fees: The classification of
the advance as a receivable instead of a prepaid cost to be amortized results
the correction).
(7) Inadequate Provision of Uncollectibles on Advances to Investees: Bad
debt expense is understated and income tax expense and net income are
overstated by the amount of the estimated uncollectible accounts. Most
provides adequately for these bad debts.
Chapter 6
Accounting Quality
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in whole or in part.
determinable market value. Firms that use the cost method must write down
their investments in securities when there has been a permanent decline in
for uncollectible accounts.
reestablishes its credibility. Thus, the firm will need a line of credit to sustain its
growth. The unpaid balance of $10,090,000 on notes payable on March 31,
Year 7, represents 78% of accounts receivable and inventories on that date, a
relatively high percentage. Substantially all of the firm’s assets are pledged as
covenants containing debt and interest coverage ratio constraints also would
seem appropriate.
e. The calculation of Altman’s Z-score is as follows:
$4,569 $53,630 $42,271 $50,069 $28,263
Z = 1.2 + 1.4 + 3.3 + 0.6 + 1.0
$51,198 $51,198 $51,198 $22,644 $51,198
Chapter 6
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in whole or in part.
case illustrates the circularity of the Altman model. Analysts would like to use
such a model to decide whether to invest in a firm at current market prices.
of bankruptcy.
As with the assessment of credit risk, the assessment of bankruptcy risk
comes down to a trade-off between the positive business attributes and the weak
face serious bankruptcy risk.
Chapter 6
Accounting Quality
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in whole or in part.
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