Learning Module 5: Evaluating Quality of Financial Reports

Learning Module 5 Evaluating Quality of Financial Reports EXAMPLE 2 Balance Sheet Reclassifications Merck & Co., Inc. and Subsidiaries In the 2002 Annual Report, inventory was reported at $3.411.8 million. In the 2003 Annual Report, the 2002 inventory value was reported at $2.964.3 million and $447.5 million of inventory was included in other assets. This information was contained in Note 6 to the financial statements, reproduced in Exhibit 3. Exhibit 3: Note 6 to Consolidated Financial Statements 6. Inventories Inventories at December 31 consisted of: 15 in millions) 2003 2002 Finished goods $5525 $1,2623 Raw materials and work in peseesa 2,1098 20738 Supplies 90.5 77 Total (approximate current cost) 19528 83.4118 Veduction to LIFO cost $2,9528 83.4118 Recognized as Inventories 52.5547 52.904.3 Other amets 398.1 4475 Inventories valued under the LIFO method comprised approximately 51% and 39% of inventories at December 31, 2003 and 2002, respectively. Amounts recognized as Other assets consist of inventories held in preparation for product launches and not expected to be sold within one year. The reduction in finished goods is primarily attributable to the spin-off of Medco Health in 2003 1. The reclassification of a portion of inventory to other assets will most likely result in the days of inventory on hand: A. decreasing B. staying the same. Increasing Solution: A is correct. The number of days of inventory on hand calculated using the reported inventory number will most likely decrease because the amount of Inventory relative to cost of goods sold will decrease. 2. As a result of the reclassification of a portion of inventory to other assets, the current ratio will most likely. A. decrease B. stay the same. C increase Solution: A is correct. The current ratio will decrease because current assets will decrease and current liabilities will stay the same EXAMPLE 2 Balance Sheet Reclassifications Merck & Co., Inc. and Subsidiaries In the 2002 Annual Report, inventory was reported at $3.411.5 million. In the 2003 Annual Report, the 2002 inventory value was reported at $2.964.3 million and $447.5 million of inventory was included in other assets. This information was contained in Note 6 to the financial statements, reproduced in Exhibit 3. Exhibit 3: Note 6 to Consolidated Financial Statements 6. Inventories Inventories at December 31 consisted of: (5 in millions) 2003 2002 Finished goods $5525 $3.3623 Raw materials and work in process 2,309,8 20718 Supplies 90.5 75.7 Total (approximate carrent cost) Reduction to LIFO cost 52.952.8 53,4118 Rocognized an Inventaries 523047 83,4118 Other anets 399.1 529643 Inventories valued under the LIFO method comprised approximately 51% and 39% of inventories at December 31, 2003 and 2002, respectively. Amounts recognized as Other assets consist of inventories held in preparation for product launches and not expected to be sold within one year. The reduction in finished goods is primarily attributable to the spin-off of Medco Health in 2003. 147.5 1. The reclassification of a portion of inventory to other assets will most likely result in the days of inventory on hand: A decreasing B. staying the same. C increasing Solution: A is correct. The number of days of inventory on hand calculated using the reported inventory number will most likely decrease because the amount of inventory relative to cost of goods sold will decrease. 2. As a result of the reclassification of a portion of inventory to other assets, the current ratio will most likely. A. decrease. B. stay the same C. Increase Solution: A is correct. The current ratio will decrease because current assets will decrease and current liabilities will stay the same. EXAMPLE 3 Treatment of Variable Interest (Special Purpose) Entities SEC enforcement action regarding the financial status of Digilog, Inc. In order to develop and introduce a new product, Digilog created a separate business entity, DBS, that was capitalized with $10 million of convertible debt issued to Digilog. Upon conversion, Digilog would end up owning nearly 100% of DBS. Initially, owners' equity of DBS consisted of a few thousand dollars of common stock issued to DBS's manager During the first two years of DBS's operations, Digilog did not consolidate DBS; it argued that DBS was controlled by its manager, who owned 100% of the out- standing common shares. Even though DBS generated substantial losses over its first two years of existence, Digilog reported interest income on its investment in the convertible debt. After two years, when DBS started to generate profits, Digilog exercised its conversion option and consolidated from that point forward. Although DBS had been set up as an "independent" corporation, the SEC took the position that the contractual and operating relationships between the two companies were such that they should have been viewed as constituting a single enterprise for financial reporting purposes. The defendants in the enforcement action, Digilog's auditors, consented to a settlement. The settlement included the opinion by the SEC that consolidation would have provided a user of the financial statements with the most meaningful presentation in accordance with GAAP, even though no specific GAAP at that time directly addressed Digilog's "creative" accounting solution. Eventually, after many more years of debate, and in the wake of the Enron scandal, which also involved abuse of subsequent consolidation rules, the concept of a "variable interest entity" (VIE) was created. A key aspect is control for consolidation purposes, even in the absence of voting control, consolidation is necessary if the investor has the ability to exert influence on the financial and operating policy of the entity and is exposed, or has rights, to variable returns from its investment in the entity. Although the term VIE is not employed by IFRS, its provisions are similar. 1. Given the facts above and the consolidation rules for a variable interest entity, Digilog is most likely to try to argue that it does not need to consolidate DBS because: A. Digilog does not have voting control B. Digilog's interest income from DBS is not variable. CDBS's manager has operational and financial control. Solution: C is correct. Digilog is most likely to assert that operational and financial control rest with DBS's manager. However, the assertion is not likely to be accepted because the manager's investment is a few thousand dollars compared with $10 million by Digilog. Simply not having voting control is not sufficient to avoid consolidation. Digilog is exposed to variable returns because of possible losses and the convertibility option. EXAMPLE 4 Asset Impairments and Restructuring Charges 1. Two related topics that almost always require special consideration on the part of analysts are asset impairments and restructuring charges. Asset im- payments are write-downs of assets required when circumstances indicate that the carrying amount of an asset is excessive compared with the expected future benefits. The term "restructuring charge" is used under IFRS to indicate a sale or termination of a line of business, closure of business locations, changes in management structure, and/or a fundamental reorganization. All of these events could also give rise to the recognition of a liability (e.g., a commitment to make employee severance payments or to make a payment to settle a lease). On 25 April 2013, Fuji Electric Co., Ltd, a Japanese company reporting un- der the GAAP of its home country, announced an impairment loss on land, buildings, structures, and leased assets employed in its "solar cell and module business in the amount of ¥6.5 billion (Fuji Electric 2013). The entire loss was recorded in its 2012 fiscal year (ending 31 March). Assets and net income were reduced by ¥6.5 billion. Elan Corporation, plc, a biotechnology company headquartered in Ireland, reported US$42.4 million in restructuring and other costs incurred during fiscal year 2012 related to its decision to close a research facility in San Francisco, with the loss of around 200 jobs, and to shift much of its operations back to Ireland because of changing business conditions. Some of these costs were associated with the obligation to make current and deferred employee severance payments (Leuty 2012). Recognizing an impairment loss and restructuring charges in a single period, although consistent with most GAAP, is most likely to overstate. A. prior periods' net incomes. B. current period's net income. C. future periods" net incomes. Solution: A is correct. The impairment and the restructuring were likely the result of past activities and should be taken into account when evaluating past net incomes. The current period's net income, unless the impairment or restructuring is expected to be repeated, is understated. Future period net income may be overstated if reversals occur, but such behavior is not likely. Charging the entire impairment loss and restructuring charge in the current period are examples of conservative accounting principles. EXAMPLE S Application of the Beneish Model Exhibit 5 presents the variables and Bearish's M-Scure for XYZ Corporation (a hypothetical company). Exhibit 5: XYZ Corporation M-Score Value of Variable Coefficient from Boneish Model Calculations DSH 1300 0.920 1196 CIMI 0.528 0.581 AQI 0.500 0.323 SGI 1.100 0892 0981 DEPI 1100 0.115 0.127 SGAI 0600 -0172 -0101 Accruala 0.150 4.679 0.702 LEVI 0600 -0327 Intercept -4340 M-scote -1231 Probability of manipulation 10.93% 1. Would the results of the Bencish model lead an analyst, using a-178 M-score as the cutoff, to flog XYZ as a likely manipulator! Solution: Yes, the model could be expected to lead an analyst to flag XYZ as a likely manipulator. The M-score is higher than the cutoff of 1.78, indicating a higher-than-acceptable probability of manipulation. For XYZ Corporation, the model estimates the probability of manipulation as 10.93%. Although the classification of companies as manipulators depends on the relative cost of Type I errors and Type II errors, the value of 10.93% greatly exceeds the cutoff of 3.8% that Beneish identified as the relevant cutoff. 2. The values of DSR, GML SGL and DEPI are all greater than one. In the Be neish model what does this indicate for each variable? Solution: Indications are as follows: A. The value greater than one for DSR indicates that receivables as a percentage of sales have increased, this change may be an indicator of inappropriate revenue recognition. XYZ may have shipped. goods prematurely and recognized revenues belonging in later periods. Alternatively, it may be caused by customers with deteriorating credit-paying ability, which is still a problem for the analyst of XYZ. B. The value greater than one for GMI indicates that gross margins were higher last year; deteriorating margins could predispose companies to manipulate earnings. The value greater than one for SGI indicates positive sales growth relative to the previous year. Companies could be predisposed to manipulate earnings to manage perceptions of continuing growth and also to obtain capital needed to support growth D. The value greater than one for DEPI indicates that the depreciation rate was higher in the prior year; a declining depreciation rate can indicate manipulated earnings 1. Sealed Air Corporation's financial statements indicate that the number of common shares issued and outstanding in 2011 was 192,062,185. The price per share of Sealed Air Corporation's common stock was around $18 per share in December 2011 and around $14 in August 2012; the Wall Street Journal article (Thurm 2012) was written in 2012. What was the company's market value? 2. How did the amount of goodwill as of 31 December 2011 compare with the company's market value? 3. Why did the Wall Street Journal article state that goodwill in excess of the company's market value is "a potential clue to future write-offs"? 4. Based on the information in Exhibit 28, does the Wall Street Journal article statement appear to be correct? Solution to 1: Sealed Air Corporation's market cap was about $3,457 million (= 192,062,185 shares x $18 per share) in December 2011 and around $2,689 million (= 192,062,185 shares x $14 per share) when the Wall Street Journal article was written in August 2012. Solution to 2: The amount of goodwill on Sealed Air Corporation's balance sheet as of 31 December 2011 was $4,209.6 million. The amount of goodwill exceeded the company's market value. (Also note that goodwill and other intangible assets represented about 55% of Sealed Air Corporation's total assets as of 31 December 2011.) Solution to 3: If the market capitalization exactly equaled the reported amount of goodwill, the value implicitly assigned to all the company's other assets would equal zero. In this case, because the market capitalization is less than the re- ported amount of goodwill, the value implicitly attributed to all the company other assets is less than zero. This suggests that the amount of goodwill on the balance sheet is overvalued, so a future write-off is likely. Solution to 4: Yes, based on the information in Exhibit 28, the Wall Street Journal article statement appears correct. In the fiscal year ending 31 December 2012 after the article, Sealed Air Corporation recorded an impairment of goodwill and other intangible assets of $1,892.3 million. EXAMPLE 11 Use of Disclosures Use the excerpts from Royal Dutch Shell's note disclosing information about financial instruments in Exhibit 32 to answer the following questions: Exhibit 32: Disclosures about Financial Instruments, Excerpt from Royal Dutch Shell's Note 21 21 Financial Instruments and Other Derivative Contracts A- Risks In the normal course of business, financial instruments of various kinds are used for the purposes of managing exposure to interest rate, currency and commodity price movements. Interest rate risk Most debt is raised from central borrowing programs. Interest rate swaps and currency swaps have been entered into to effectively convert most centrally issued debt to a floating rate linked to dollar Libor (London Inter-Bank Offer Rate), reflecting Shell's policy to have debt principally denominated in dollars and to maintain a largely floating interest rate exposure profile. Consequently, Shell is exposed predominantly to dollar Libor interest rate movements. The financing of most subsidiaries is also structured on a floating-rate basis and, except in special cases, further interest rate risk management is discouraged. On the basis of the floating rate net debt position at December 31. 2012, and assuming other factors (principally foreign exchange rates and commodity prices) remained constant and that no further interest rate management action were taken, an increase in interest rates of 1% would decrease pre-tax income by $27 million (2011: $146 million). Foreign exchange risk Many of the markets in which Shell operates are priced, directly or indirectly, in dollars. As a result, the functional currency of most Upstream companies and those with significant cross-border business is the dollar. For Downstream companies, the local currency is typically the functional currency. Consequently, Shell is exposed to varying levels of foreign exchange risk when it enters into transactions that are not denominated in the companies' functional currencies when foreign currency monetary assets and liabilities are translated at the reporting date and as a result of holding net investments in oper- ations that are not dollar-functional. The main currencies to which Shell is exposed are sterling, the Canadian dollar, euro and Australian dollar. Each company has treasury policies in place that are designed to measure and manage its foreign exchange exposures by reference to its functional currency. Exchange rate gains and losses arise in the normal course of business from the recognition of receivables and payables and other monetary items in currencies other than individual companies' functional cur- rency. Currency exchange risk may also arise in connection with capi- tal expenditure. For major projects, an assessment is made at the final investment decision stage whether to hedge any resulting exposure. Hedging of net investments in foreign operations or of income that arises in foreign operations that are non-dollar functional is not undertaken. Assuming other factors (principally interest rates and commodity prices) remained constant and that no further foreign exchange risk management action were taken, a 10% appreciation against the dollar at December 31 of the main currencies to which Shell is exposed would have the following pre-tax effects: Increase (decrease) in income $ millions 10% appreciation against the dollar of: 2012 2011 Increase in net assets 2012 2011 1.214 Sterling Canadian dollar Euro Australian dollar. (185) 131 30 (58) (360) 458 153 1.042 1,364 1,384 1,883 1,768 246 142 120 The above sensitivity information is calculated by reference to carrying amounts of assets and liabilities at December 31 only. The pre-tax effect on income arises in connection with monetary balances denominated in currencies other than the relevant entity's functional currency; the pre-tax effect on net assets arises principally from the translation of assets and liabilities of entities that are not dollar-functional. 1. Does Shell appear to take a centralized or decentralized approach to managing interest rate risk? Solution: Shell appears to take a centralized approach to managing interest rate risk based on its statements that most debt is raised centrally and that interest rate swaps and currency swaps have been used to convert most interest rate exposure to dollar market reference rate (MRR). In addition, Shell states that apart from structuring subsidiary financing on a floating-rate basis, it discourages subsidiary's further interest rate risk management. 2. For the year ended 31 December 2012, Shell reported a pre-tax income of $50,289 million. How significant is Shell's exposure to a 1% increase in inter-rates? Solution: For the year ended 31 December 2012, Shell's exposure to a 1% increase in interest rates is relatively insignificant. An increase in interest rates of 1% would decrease pre-tax income by $27 million, which is less than 0.1% of Shell's 2012 reported pre-tax income of $50,289 million. 3. For the year ended 31 December 2012, what would be the impact on Shell's pre-tax income of a 10% appreciation of the Australian dollar against the US dollar? Solution: The impact on Shell's pre-tax income of a 10% appreciation of the Australian dollar against the US dollar would be an increase of $246 million, which is about 0.5% of Shell's 2012 reported pre-tax income of $50,289 million. These disclosures, along with expectations about future market conditions, can help an analyst assess whether the company's exposures to interest rate risk and foreign exchange risks pose a significant threat to the company's future performance.