Intermediate Accounting Week 4
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6-4. “Income Smoothing and an IPO”
As an analyst for an investment fund that invests in initial public offerings (IPOs). You are looking at the financial statements of 2 companies, Clark Company and Durfee Company, that plan to go public soon. Net income for the past 3 years for the 2 companies has been as follows (in thousands):
Year Clark Durfee
Net Income Net Income
2005………………………….. $10,000 $17,000
2006………………………….. $14,000 $1,000
2007………………………….. $20,000 $26,000
If both companies issue the same number of shares and if the initial share prices are the same, which of the 2 companies appear to be a more attractive investment? Explain your reasoning. What alternate sources of data would you look at to find out whether the reported earnings amount accurately portray the business performance of these 2 companies over the past 3 years?
Cruella DeVil is the chief financial officer (CFO) of a local publicly traded company. She was recently invited to speak to accounting students at the local university. One of the students asked Cruella whether she thought earnings management was ethical. Cruella laughed and responded that her view was that anything that was not explicitly prohibited by the accounting standards or by government regulations was ethical. What do you think of Cruella’s opinion?
As a senior staff member in the office of the Chief Accountant of the Securities and Exchange Commission (SEC). You have been supervising a case brought against and audit firm. The audit client used a non-GAAP accounting practices that allowed it to report annual earnings of $47.3 million instead of a loss of $15.0 million. Earnings in the past 3 years averaged $10 million per year. The auditor explains that this non-GAAP accounting practice was not detected during the audit because of innocent mistakes made by staff auditors. Your thorough investigation has not turned up any evidence that the audit firm intentionally allowed the client to use this non-GAAP practice. Decide whether formally sanction the audit firm or whether to drop the case because of lack of evidence of wrongful intent. What should you do?
6-15. “Loading Up the Cookie Jar!”
Lily Company has historically reported a bad debt expense amount of between 1% and 4% of sales. The percentage for any given year is a function of both the business conditions for the year and whether recent experience suggests that the estimates in past years have been too high or too low. For example, if estimates in past years have been too high, a lower amount of bad debt expense is recognized in the current year. Lily Company’s board of directors has met to review the preliminary financial statements for the just-completed fiscal year. Assume that the board will decide on a bad debt estimate of wither 1% or 4% of sales. Consider the following two scenarios:
Scenario 1: The preliminary earnings number for the year is very high, far higher than expected. However, Lily’s board is concerned about future years; there is some indication of unsettled business conditions ahead.
Scenario 2: The preliminary earnings number for the year is quite low, lower than expected. The board has a reason to be optimistic that Lily’s operating performance will turn around next year.
What estimate (1% or 4%) do you think Lily’s board will choose in each of the 2 scenarios? Explain your choices. What risks are there to Lily Company if the bad debt estimate is chosen using only the type of information given here?
6-20. “GAAP Is a Point, Not an Oval!”
As chief financial officer (CFO) of Lorien Company, which is publicly traded. At the annual shareholder’s meeting you discussed the company’s recent reported results. As part of the presentation, you illustrated the minimum and maximum values for net income that Lorien could have reported using a range of accounting assumptions other companies in your industry use. Your statement prompted a cry of outrage from one of the shareholders present at the meeting, who accused you of being an unprincipled liar. This shareholder stated that any suggestion that there is a range of possible net income values for given company in a given year indicates an overly liberal approach to financial reporting. This shareholder has moved that your employment contract be immediately terminated because of an apparent lack of moral character. The shareholder’s arguments have been persuasive to a large number of people at the meeting. What can you say to defend yourself?
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