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QUESTIONS
Under the current circumstances wherein asset value increases are not
recognized, the balance sheets of many U.S. companies do not reflect the
current value of their long-lived assets. Thus, the presence of this asymmetric
treatment reduces the utility of the balance sheet for many investors and
investment professionals.
Q1.7 Human Assets. Companies that are most adversely affected by the absence of
a human assets account on the balance sheet would include:
Literally, all companies are affected; but, those companies that are highly
automated (Amazon.com) or that require little contact with their customers are
likely to be less adversely affected.
1. Forecasted revenues
2. Future demand for Internet purchases
3. Pro forma net income (or EPS)
4. Pro forma cash flow from operations
5. Future tax policy of the U.S. government regarding Internet purchases
Q1.9 Audit Reports. Amazon.coms audit report was prepared by the firm of Ernst
and Young, one of the Big Four audit firms. Audit reports may take one of
several forms:
Unqualified, or clean
Qualified (e.g., the scope of the investigation was limited; there was a
change in accounting principle with which the auditor disagreed; the
statements were prepared using a non-generally-accepted practice; or,
the existence of material uncertainties or potential material future
developments)
Adverse (e.g., the financial statements do not fairly present the firms
financial condition or results of operations)
Disclaimer (i.e., no opinion is issued)
The fourth paragraph of Amazons audit report indicates that the firm adopted a
new accounting standard regarding the accounting for fair value
measurements. This change is problematic for investors since it limits the utility
of prior financial data prepared under the old accounting standard.
Statement of
Shareholders
Equity
If American Airlines does not agree to these constraints (i.e., debt covenants), it
is unlikely that the financial institutions would be willing to extend or refinance
the loan contract.
A useful discussion here is What happens when a firm like TIMET violates one
of its debt covenants? Although the U.S. lender would have the legal right to
demand an immediate repayment of the loan, it is far more likely that the loan
agreement would be renegotiated, with TIMET paying higher interest charges
and fees in return for the lender not immediately calling the loan.
1. Corporate executives retain too much control over the hiring and firing of
outside auditors, consequently discouraging auditors from filing critical
reports about a firm or its management.
2. Sarbanes-Oxley puts only minimal constraints on auditors subsequently
gaining employment with their clients thereby potentially encouraging
auditors to try to curry favor with their clients (i.e., as potential future
employers).
3. Sarbanes-Oxley does not restrict sufficiently the non-audit work that
auditors may do for their clients, thereby increasing the likelihood that an
auditor will yield to client demands due to financial issues.
Q1.18 Should the Sarbanes-Oxley Act Be Revised? The criticisms leveled at the
Sarbanes-Oxley Act have been substantial, and in many cases, justifiedit is
unnecessarily costly in its implementation; it is unfair to foreign and small firms;
it fails to provide sufficient guidance in its application. Nonetheless, given the
large number (i.e. over 8 percent of all U.S. publicly-listed firms) of companies
that restated their earnings in the aftermath of the passage of the Act suggests
that whatever the costs, the implementation of the Act was necessary to
achieve the high standard of corporate reporting that is expected by the capital
markets in the U.S. Can the Act be improved upon? Without doubt, and most
observers believe that the Act will be modified, but not repealed (although a
case is pending before the U.S. Supreme Court regarding the constitutionality
of SOX).
Q1.21. (Appendix 1B) The preparation of the basic financial statements requires that
corporate managers make a variety of accounting policy decisions, to include
(for example) which depreciation method to utilize to depreciate a companys
property, plant and equipment, the expected useful lives of those assets, and
their expected salvage value. These policy decisions are subject to review, and
revision, by a companys independent auditor; and thus, most financial
statement users feel confident that the decisions and estimates adopted have
been properly vetted, and consequently, may be relied upon for purposes of
credit and investing decisions. Because of this inherent system of checks-and-
balances, companies are able to assure their creditors and investors that the
financial statements contain objective, verifiable data that is useful for their
particular decisions needs.
1. B/S A 9. I/S E
2. B/S SE 10. B/S L
3. I/S R 11. N/A
4. B/S A 12. B/S A
5. B/S SE 13. I/S E
6. B/S L 14. B/S A
7. N/A 15. I/S E
8. B/S A 16. I/S R
Since no dividends were declared and no additional capital was invested, the
increase in shareholders equity from Year 1 to Year 2 must have resulted from
operations; hence, net income must have been $10,000. The decrease in
liabilities of $20,000 suggests that assets in the amount of $20,000 were used
to repay debt. In the absence of the debt reduction, total assets would have
increased by $10,000 (i.e., the amount of net income).
E1.24 The Balance Sheet Equation. Since no dividends were declared in Year 2,
and since there was no additional capital investment, the decrease in
shareholders equity of $5,000 must have resulted from operations; hence,
there must have been a net loss of $5,000. The increase in liabilities of $20,000
resulted in an equal increase of $20,000 in assets; however, the net increase in
assets of $15,000 reflects the increase of $20,000 from debt, offset by the
decrease of $5,000 in assets from the operating loss.
Common-size data:
Revenues 100% 100% 100%
Less: Expenses (84)% (95)% (93)%
Net income 16% 5% 7%
Although the level of revenues did increase from 2010 to 2011/2012, costs
increased at a faster rate, suggesting either an absence of economies of scale
or that the benefits of the revenue growth have not yet been realized. But in any
case, the high dividend payout (i.e., 43 percent, 100 percent, and 75 percent in
2010, 2011, and 2012, respectively) appears excessive.
Common-size data:
Revenue 100% 100% 100%
Less: Expenses (102)% (106)% (90)%
Net income (2)% (6)% 10%
The companys revenues increased each year, but it was not until 2012 that
revenues increased faster than costs. Although the modest dividend payment in
2012 appears reasonable, the large dividend in 2011 after two years of losses
appears irrational, especially since the company had paid no dividends in 2010.
r eta*
Clearly, GE provided the greatest return over the one year period. To evaluate
the return/risk trade off provided by each security, it would be beneficial to know
the historical standard deviation of the return on each of the three companies.
Missing Values
2011 2012
Balance sheet:
Cash 10,000
Property, plant and equipment (cost) 286,000
Land 4,000
Intangible assets 11,000
Missing Values
2011 2012
Balance sheet:
Cash 15,000
Property, plant and equipment 162,000
Intangible assets 10,000
Return on sales
(net earnings net sales) 13.0% 14.7% 16.6%
Net sales are trending upward over the three-year period, while net earnings
are trending downward. This is causing a decrease in the return on sales
ratio.
The trend of the cash flow from operations is fairly consistent with the trend
in net earnings, showing a decline over the three year period. The operating
funds ratio, reflects a downward trend from 2010 to 2011, but reflects a very
slight upward trend in 2012 due to only a slight change in cash flow from
operations, despite decreased net earnings from the prior year. If the cash
flow from operating activities is consistently greater than net earnings (a
ratio >1.0, which we see here) the companys earnings are said to be of
high quality.
Cambridge Business Publishers, 2014
1-18 Financial Accounting for Executives & MBAs, 3 rd Edition
Cambridge Business Publishers, 2014
Solutions Manual, Chapter 1 1-19
d. Financial Leverage
2012 2011
e. Audit Report
P & Gs auditors are Deloitte & Touche LP, one of the Big Four firms. The
audit report indicates that Deloitte & Touche opine that P & Gs
b. Under IFRS, the noncurrent assets are listed prior to the current assets, and
noncurrent liabilities are listed before current liabilities. This listing appears
to emphasize the longer-term aspects of a business by drawing attention
first to the long-term revenue-producing assets of a business. Regardless of
the listing sequence, the informational content of the balance sheet remains
unaltered.
c. LVMHs current assets are listed in reverse order of liquidity, with the least
liquid current assets listed first, followed by the most liquid current assets.
(Cash and cash equivalents are listed last.) Again, this listing appears to
de-emphasize the short-run aspects of a business.