Q3. Bill Simon says, "We should get rid of the IASB, IFRS, and E.U.

Company Law
Directives, since free market forces will make sure that companies report reliable
information." Do you agree?
We partly agree with Bill on the point that corporate managers will disclose only reliable
information when rational managers realize that disclosing unreliable information is costly in the
long run. The long-term costs associated with losing reputation, such as incurring a higher capital
cost when visiting a capital market to raise capital over time, can be greater than the short-term
benefits from disclosing false information. However, free market forces may work for some
companies but not all companies to disclose reliable information.
Note that Bill's argument is based on the assumption that there is no information asymmetry
between corporate managers and outside investors. In reality, the outside investors' limitation in
accessing the private information of the company makes it possible for corporate managers to
report unreliable information without being detected immediately.
The E.U. and IASB standards attempt to reduce managers' ability to record similar economic
transactions in dissimilar ways either over time or across firms. Compliance with these standards
is enforced by external auditors, who attempt to ensure that managers' estimates are reasonable.
Without the E.U., IASB standards, and auditors, the likelihood of disclosing unreliable information
would be high.
Q4. Consider two companies, one of which ships its product evenly throughout the quarter,
and the second of which ships all its products in the last two weeks of the quarter. How can
you distinguish these companies, using accounting ratios?
There is no difference between the two companies in their income statements. Both companies
have the same amount of revenues and expenses. However, the two companies are different in
their balance sheets. Assuming that all other things are equal, the company that sells product
evenly has a higher cash and a lower trade receivables balance at the quarter-end than the company
which ships all products in the last two weeks. The following accounting ratios can be used to
differentiate the two companies: Sales/Trade Receivables = Trade Receivables Turnover The
company with even sales will have a higher receivable turnover ratio.
Trade Receivables/ Average Sales per Day =Days' Receivables The company with even sales will
show lower days' receivable. Cash + Marketable Securities/ Current Liabilities = Cash Ratio The
company with even sales will have a higher cash ratio.

5a) If management reports truthfully, what economic events are likely to prompt the
following accounting changes?

Increase in the estimated life of depreciable assets

Managers may increase the estimated life of depreciable assets when they realise that the assets are
likely to last longer than was initially expected. For example, Delta Airlines extended the
estimated life of the Boeing 747, a relatively new product, by 5 years when Delta found out that
some of the first Boeing 747s manufactured were still flying in commercial service. Excellent
maintenance and less usage than initially expected may also prompt corporate managers to extend
the estimated life of depreciable assets.

Decrease in the uncollectible allowance as a percentage of gross receivables

The firms change of customer focus may prompt managers to decrease the allowance for
uncollectible receivables. For example, when a firm gets large sales orders from reliable customers
such as Wal-Mart and General Motors, it does not have to reserve the same percentage of
allowance used for small (or high default risk) customers.

Recognition of revenues at the point of delivery, rather than at the point cash is received

Revenues can be recognised when the customer is expected to pay cash with a reasonable degree
of certainty. Suppose that a company re-evaluated its customers credit and found out that its
customers financials improved significantly. In dealing with that customer, the company can
recognise revenues at the point of delivery rather than at the point when cash is received, because
the risk of cash collection is no longer significant.

Capitalisation of a higher proportion of software R&D costs

According to IAS 38 Intangible Assets, when computer software is not an integral part of the
related hardware it is treated as an intangible asset. For computer software to be capitalised, IAS
38 requires an entity to demonstrate that the item meets: (a) the definition of an intangible asset;
and (b) the recognition criteria.
5b) What features of accounting, if any, would make it costly for dishonest managers to make
the same changes without any corresponding economic changes?

Third-Party Certification

Public companies are required to get third-party certification (auditors opinion) on their financial
statements. Unless the accounting policy changes are reasonably consistent with underlying

economic changes, auditors would not provide clean auditors opinion. A qualified auditors
opinion will penalise the company by increasing its cost of capital.

Reversal Effect

Aggressive accounting choices may inflate net income in the current period but they hurt future
net income due to the nature of accrual reversal. For example, aggressive capitalisation of software
R&D expenditures may boost current period earnings but it will lower future periods net income
when the capitalised costs have to be subsequently amortised or written-off.

Investors Lawsuit

If a company disclosed false or misleading financial information and investors incurred a loss by
relying on that information, the company may have to pay legal penalties.

Labor Market Discipline

The labor market for managers is likely to penalise individuals who are perceived to be unreliable
in their dealings with external parties
7. A fund manager states, I refuse to buy any company that makes a voluntary accounting
change, since its certainly a case of management trying to hide bad news. Can you think of
any alternative interpretation?
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors allows voluntary
accounting changes only when they result in the financial statements providing reliable and more
relevant information about the effects of transactions, other events or conditions on the entitys
financial position, financial performance or cash flows. Hence, a voluntary accounting change may
be due to a change in the firms real economic situation. Hence, a companys accounting change
should be evaluated in the context of its business strategy and economic circumstances and not
mechanically interpreted as earnings manipulation
2. Refer to the Creative Technology example on delaying write-downs of current assets.
How much excess inventory do you estimate Creative Technology is holding in March 2005 if
the firms optimal days inventory is 100 days? Calculate the inventory impairment charge
for Creative Technology if 50% of this excess inventory is deemed to be worthless. Record
the changes to Creative Technologys financial statements adjusting for this impairment.
If the optimal days inventory is 100 days, the value would be $285.61 million.
Step 1: 100 days divided by 158 days = 0.633.
Step 2: 0.633 multiplied by 451.2 = $285.61.

Step 3: Difference in values, $451.2 - $285.61 = $165.59.

If 50% of the excess is deemed to be worthless, the inventory impairment charge would be
$82.795 million ($165.59 * 0.50).
The changes in the financial statements would be:
Adjustment

Assets

Liabilities
Equity

&

Balance Sheet
Inventory
-82.8
Deferred Tax Liability
-16.6
Shareholders Equity
-66.2
Income Statement
Cost of Sales
+82.8
Tax Expense
-16.6
Net Income
-66.2
Note 1: In the second paragraph of the example on p. 4-10 where it states that Inventory at the
end of March 2006 was valued at $451.2 million the date should be March 2005
Note 2: The example assumes a local tax rate of 20%
5. What approaches would you use to estimate the value of brands? What assumptions
underlie these approaches?
In thinking about how to estimate brand value, an analyst might use any of the following
approaches. First, one might estimate brand value based on the premium price that companys
branded products or services command over their non-branded counterparts. Given the firms sales
volume of branded products and services, the expected life of the brand, and a discount rate, it is
possible to estimate the present value of any price premium over the foreseeable future. Second, a
brand could be valued based on the present value of advertising costs required to convert a nonbranded product or service into a branded product or service. Third, brand valuation experts could
estimate value based on industry practice, amounts that were paid for similar branded products in
recent mergers and acquisition transactions.
Several assumptions underlie the above brand valuation approaches. First, under the price
premium approach, brands will only have value if: (a) the consumers will continue to value
branded products more highly than non-branded in the foreseeable future, (b) companies continue
to maintain the value of their brands, despite potential competition, and (c) premium prices are
accompanied by higher advertising outlays, so that brands create economic value for shareholders.
The second and third valuation approaches requires that the valuator assume that the product or

service being valued requires the same level of advertising or has the same relative value as
comparable brands used to benchmark the valuation.
An analyst should question the company on the amount of any intangible asset reported on its
balance sheet that relates to its brand. Regardless of what Brand Finance is reporting, if the
company carries an intangible asset related to brand, is the company confident that this asset
valuation is reasonable? How was the figure calculated? Was an independent valuation expert
hired? Did the independent auditors question the amount? Has the amount grown or declined in
the past couple of years or is it expected to be adjusted in coming years? Why? What activities and
expenditures did Tata incur in order to build and maintain the brand name, and what future
expenditures and programs are planned?
Q4.
To estimate the interest rate that equates the value of capital lease payments to the reported value
of $604, students have to first make an assumption about how to split the 2016 and thereafter
payments over time. If the payments occur evenly over the next ten years ($34.9 per year), the
appropriate interest rate is 11%:

For operating leases, the average contract life appears to be longer. This is based on the large
balloon value for lease payments for 2016 and beyond. If we assume that the average life of the
operating leases is 20 years, the present value of operating leases using an 11% discount rate is as
follows:
Year
2011
2012
2013

Reported
Payment
$1,254
$1068
$973

Assumed
Payment
$1,254
$1068
$973

PV factor at
11%
0.9009
0.8116
0.7312

PV
1130
867
711

2014
2015
2016 thereafter

$831
$672
6006
$10,804

$831
$672
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
$400.4
400.4
$10,804

0.6587
0.5935
0.5346
0.4817
0.4339
0.3909
0.3522
0.3173
0.2858
0.2575
0.2320
0.2090
0.1883
0.1696
0.1528
0.1377
0.1240

547
399
214
193
174
157
141
127
114
103
93
84
75
68
61
55
50
$5,363

The adjusted balance sheet for December 31, 2010 is as follows:

Adjustment
Assets
Liabilities & Equity
Balance Sheet
Long Term Tangible Asset
+5,363
Long Term Debt
+5,363
Income Statement
Cost of Sales: Lease Expense
-1,254
Depreciation Expense (1/20 x 5363)
+268
Interest Expense (0.011 x 5363)
+590
Tax Expense (35% of sum)
+139
Net Income
+257

Q9.
In the Bristol-Myers Squibb example, the firm's Trade Receivables, Sales, and Net Profit are
overstated. To correct for this problem in the 2001 balance sheet, Trade Receivables needs to
decline by $3.35 billion, and Inventories need to increase by an amount that reflects the effect of
gross profit margins. The Inventories adjustment can be achieved by multiplying the Trade
Receivables adjustment by the ratio of Cost of Sales to Sales. The increase in Inventories is
approximately $1 billion (3.35 * (5,454/18,139)). The $3.35 billion decline in Trade Receivables is
mirrored by a decline in 2001 Sales of the same amount. Similarly, the $1 billion increase in

Inventories reflecting unsold product corresponds to a decline in the Cost of Sales by the same
amount. Multiplying the -$2.35 difference between the reduction in Sales and the reduction in Cost
of Sales by the firm's 35% marginal tax rate results in a $.82 billion reduction in Tax Expense,
with the remaining $1.53 billion ($2.35-.82) difference being charged to Net Profit. The decline in
both Tax Expense and in Net Profit are reflected in the Balance Sheet by a decline in Deferred
Taxes and in Ordinary Shareholders' Equity, respectively.