Solutions – Chapter 3

Chapter 3 Overview of Accounting Analysis

Question 1.
Many firms recognize revenues at the point of shipment. This provides an incentive to accelerate
revenues by shipping goods at the end of the quarter. 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. Each company’s customers pay thirty days after receiving shipment. 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 Turnover = Trade Receivables

The company with even sales will have a higher receivable turnover ratio.

Trade Receivables
Days’ Receivables = Average Sales per Day

The company with even sales will show lower days’ receivable.

Cash + Marketable Securities

Cash Ratio = Current Liabilities

The company with even sales will have a higher cash ratio.

Question 2(a).
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 realize 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 allowance for doubtful accounts as a percentage of gross trade receivables. The
firm’s 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 Tesco

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and Volvo, 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 recognized when the customer is expected to pay cash with a reasonable degree of certainty.
Suppose that a company re-evaluated its customer’s credit and found out that its customer’s
financials improved significantly. In dealing with that customer, the company can recognize
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.

Capitalization of a higher proportion of development expenditures. According to IAS No. 38, costs
incurred on product development (after the establishment of technical feasibility and commercial
feasibility) are to be capitalized. Technical feasibility is considered to be established when the firm
has completed a product design. Commercial feasibility is established when the uncertainty
surrounding the development of new products or processes is sufficiently reduced. If the company
completes the product design earlier than it initially expected, it can capitalize a higher proportion
of development costs during that period.

Question 2(b).
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 (auditor’s
opinion) on their financial statements. Unless the accounting policy changes are reasonably
consistent with underlying economic changes, auditors would not provide clean auditor’s opinion. A
qualified auditors’ opinion will penalize the company by increasing its cost of capital.

Reversal Effect. Aggressive accounting choices may inflate net profit in the current period but they
hurt future net profit due to the nature of accrual reversal. For example, aggressive capitalization of
software R&D expenditures may boost current period earnings but it will lower future periods’ net
profit when the capitalized costs have to be subsequently 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 penalize individuals who are
perceived to be unreliable in their dealings with external parties.

Question 3.
The conservatism (or prudence) principle arises because of concerns about management’s incentives
to overstate the firm’s performance. Joe Banks argues, “We could get rid of conservatism and make
accounting numbers more useful if we delegated financial reporting to independent auditors rather
than to corporate managers.” Do you agree? Why or why not?

We don’t agree with Joe Banks because the delegation of accounting decisions to auditors may
reduce the quality of financial reporting. Auditors possess less information and firm-specific
business knowledge than corporate managers when portraying the economic reality of a firm. The
divergence between managers’ and auditors’ business assessments is likely to be most severe for
firms with distinctive business strategies or ones which operate in emerging industries. With such an

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information disadvantage, even if auditors report truthfully without having any incentive problem,
they cannot necessarily choose “better” accounting methods and accruals than corporate managers
do.

Auditors also have their own incentive to record business transactions in a mechanical way, rather
than using their professional judgment, which leads to poor quality of financing reporting. For
example, auditors are likely to choose accounting standards that require them to exercise minimum
business judgment in assessing a transaction’s economic consequences, especially given their legal
liability risk. The current debate on market value accounting for financial institutions illustrates this
point. While there is considerable agreement that market value accounting produces relevant
information, auditors typically oppose it, citing concerns over audit liability.

Question 4.
A fund manager states: “I refuse to buy any company that makes a voluntary accounting change,
since it’s certainly the case that its management is trying to hide bad news.” Can you think of any
alternative interpretation?

One of the pitfalls in accounting analysis arises when analysts attribute all changes in a firm’s
accounting policies and accruals to earnings management motives. Voluntary accounting change
may be due merely to a change in the firm’s real economic situations. For example, unusual
increases in receivables might be due to changes in a firm’s sales strategy. Unusual decreases in the
allowance for uncollectable receivables might be reflecting a firm’s changed customer focus. A
company’s accounting change should be evaluated in the context of its business strategy and
economic circumstances and not mechanically interpreted as earnings manipulation.

Promises that require future expenditures are liabilities even if they cannot be measured precisely.
According to the definition, liabilities are economic obligations of a firm arising from benefits
received in the past that are (a) required to be met with a reasonable degree of certainly and (b) at
a reasonably well-defined time in the future. Airline companies have economic obligations to serve
frequent flyer program passengers due to ticket sales (benefits) in the past to the frequent flyer
program passengers. These obligations are (a) likely to be met (for example, United Airline frequent
flyer program totaled 1.2 million free trips in 1990) and (b) fulfilled within a well-defined time in the
future (for example, within 3 to 5 years after the revenue ticket sales are made).

A frequent flyer program has an impact not only on the balance sheet but also on the income
statement. In principle, the costs associated with benefits that are consumed in this time period are
estimated and recognized as expenses (matching concept). Note that airline companies increased
revenue ticket sales (i.e., benefits) in this period by promising free-trip tickets (i.e., costs) in the
future.

However, it is not easy to measure the costs associated with frequent flyer program accurately. At
least the following three cost categories should be considered in the estimation:

1. The administrative costs, such as maintaining the accounting system for the program, mailings
to program members, and providing service to those who request free flights
2. The costs related to the flight itself, including meal expenses, luggage handling costs, addition
fuel expenditure, etc.
3. The opportunity costs that airline companies may incur because the seats used by flight award
passengers could have been sold to revenue paying passengers

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Question 5.

On the companion website to this book there is a spreadsheet containing the financial statements
of:

1. Vodafone plc for the fiscal year ended March 31, 2018
2. The Unilever Group for the fiscal year ended December 31, 2017.
3. Audi AG for the fiscal year ended December 31, 2017.

Use the templates shown in Tables 3.1-3.5 to recast these companies’ financial statements.

[See spreadsheets ‘CH3 Q5 Vodafone solution – 5e.xlsx’, ‘CH3 Q5 Unilever solution – 5e.xlsx’, and
‘CH3 Q5 Audi solution – 5e.xlsx’]

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Problem 1. Key Accounting Policies

1. Identify the key accounting policies for each of these companies.

2. What are these companies’ primary areas of accounting flexibility? (Focus on the key
accounting policies.)

1. Key accounting policies 2. Areas of accounting flexibility

Juventus F.C.:
Revenue recognition: One of the key - Timing and amount of revenue
accounting issues for Juventus is how to recognition
account for its revenues. The primary sources
of revenues are ticket sales, media rights,
sponsorship contracts, and the agreement
selling the exclusive naming rights. In exchange
of these revenues, Juventus often has a long-
term commitment to provide services (i.e.,
play games). Key accounting choice: when to
consider these revenues as realized.
Timing of expense recognition / Accounting for - Determining the fair value of
players’ long-term contracts: Juventus often considerations given to players’
pays substantial amounts to a player’s previous clubs
previous club when it hires a new player. - Amortization method choice
These outlays are initially capitalized and must - Determining the timing and amount of
be recognized as an expense sometime during write-downs
the contract period of the player. Another
issue is the recognition of write-downs once a
player gets injured or otherwise impaired.
Operating lease agreement: How to account
for the operating lease payments for the
stadium?
Naming rights agreement: Juventus has sold - Timing and amount of the recognition
the naming rights for the new stadium to a of the advance payment as revenue
large sports marketing agency. A key
accounting issue is how to recognize the
advance payment.

Spyker Cars:
Accounting for inventories: Spyker has large - Determining the timing and amount of
inventories and experiences significant write-downs
problems in selling its products. One of the key
accounting decisions that Spyker’s
management has to make is whether or not to
recognize write-offs for the impairment of
inventories.
Accounting for R&D: Whether and to what - Determining the proportion of
extent the company’s development development expenditures that should
expenditures will result in future revenues is be capitalized
very uncertain. Based on its assessment of the - Amortization method and period
expenditures’ future benefits, management choice

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should decide whether these expenditures - Determining the timing and amount of
must be capitalized. write-offs
Carry forward losses: Only if it is probable that - Determining the necessity and size of
management will realize the tax-deductible an allowance for non-realizable carry
carry forward losses in future years, such carry forward losses
forward losses constitute a true asset to the
firm. If a proportion of the carry forward losses
is unlikely to be realized, the recognition of an
allowance warranted.

Sainsbury:
Accounting for property: One of the retailer’s
key assets is its property. A key accounting
choices that Sainsbury must make is deciding
on the value of its property and determining
whether write-downs are necessary. Further,
retailers often have large amounts of
operating lease agreements. Assets leased
under operating lease agreements can be kept
off-balance or recognized as economically
owned by the retailer.
Accounting for personnel: A retailer typically
has a large staff for which it provides pensions.
Pension obligations arising from defined
benefit plans increase during the year because
employees provide service to the retailer, thus
giving rise to a need to recognize a pension
expense (i.e., an increase in the obligation).
The pension expense is reduced if the retailer
earns a return on its pension plan investments.
- Choice between fair value and
historical cost accounting for property
- Determining the fair values of property
- Determining the timing and amount of
write-offs
- Determining whether leased assets are
economically owned
- Determining the (change in the)
present value of future pension
obligations (e.g., discount rate
assumption)
- Determining the (change in the) fair
value of the pension plan assets

Problem 2. Fashion Retailers’ Key Accounting Policies

1. Based on your knowledge of the fashion retail industry, discuss for each of the above
accounting policies why the accounting policy is considered as ‘‘key’’ by one or more of the
eight fashion retailers.
2. Discuss which economic, industry, or firm-specific factors may explain the observed variation
in key accounting policies across the eight retailers.

Key accounting policies:

- have a material effect on the company’s accounting for its critical success factors and risks
and
- require significant judgment.
Using these two general characteristics of key accounting policies, students can systematically
evaluate the key accounting policy choices of the eight fashion retailers. The table of the next page
helps to evaluate and discuss the various accounting policies.

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Solutions – Chapter 3
Key policy Succes factor
Depreciation and/or Efficient management of
impairment of investments in stores, storage
property, plant and capacity (logistics management),
equipment and store equipment
Employee/post- Management of personnel cost
retirement benefits (operating efficiency) +
management of investments
pension assets
Fair value of financial Efficiency of management of
instruments financial investments
Impairment of goodwill Making value-creating acquistions
and trademarks
Impairment of trade Monitoring and managing the
receivables collection of receivables from
internet and catalog sales and/or
affiliated companies
Recoverability of Effective tax management,
deferred tax assets including managing the value of tax
loss carryforwards
Provisions for obsolete Operating efficiency, logistics
inventory management, design and
production
Other provisions (store Operating efficiency (i.e., managing
closures, litigation) costs)
Areas of judgment Especially relevant if…
Estimates about economic useful lives and
residual values, impairment testing
assumptions
Pension assumptions (expected return on … the retailer has material defined
plan assets, discount rate, inflation rate). benefit pension plans.
Further, until recently firms could keep
pension liabilities off balance.
Estimation of fair value sometimes … the retailer has a material amount
requires significant judgment. of excess cash and equivalents
and/or other non-operating
investments.
Goodwill impairment testing strongly … the retailer has made material
relies on assumptions about future acquisitions in the past.
(growth rates in) cash flows and discount
rates.
Receivable impairment testing strongly … the retailer has a internet or
relies on assumptions about default rates. catalog sales or significant
transactions with affiliate
companies.
Estimation of the realizable value of tax … the retailer has had a loss-making
loss carryforwards (deferred tax assets) business unit in one of the previous
requires making assumptions about (a (or the current) fiscal year(s).
business unit’s) future profitability.
Estimation of provisions requires making
assumptions about the marketability of
products.
Estimation of provisions requires making … probable claims exist.
assumptions about the size and
probability of future (litigation) claims.
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Problem 3. Euro Disney and the First Five Steps of Accounting Analysis

1. Identify the key accounting policies (step 1) and primary areas of accounting flexibility (step
2) for Euro Disney.
2. What incentives may influence management’s reporting strategy (step 3)?
3. What disclosures would you consider an essential part of the company’s annual report,
given its key success factors and key accounting policies (step 4)?
4. What potential red flags can you identify (step 5)?

1. Key accounting policies and areas of accounting flexibility for Euro Disney are:
a. Revenue recognition. Areas of discretion are:
i. Timing of revenue recognition (especially regarding pre-sold entrance tickets,
multi-day tickets and pre-paid hotel/convention/show fees). Revenues
should be recognized when services have been provided. In the past, Euro
Disney has had a significant liability for deferred revenues (approximately 10
percent of total sales).
ii. Amount of revenues (especially regarding discounts and promotional
activities).
b. Accounting for property. One of Euro Disney’s key assets is its property. A key
accounting choices that Euro Disney must make is deciding on the value of its
property and determining whether write-downs are necessary. The company’s
management has discretion in the choice between fair value and historical cost
accounting, the assessment of fair values, the timing and amount of write-offs and
the assessment of whether leased property is economically owned.
c. Accounting for employee expenses. Euro Disney has a large number of employees
with permanent contracts. Because of the high uncertainty surrounding the future
values of pension commitments and assets, the determination of pension expenses is
discretionary.
d. Recognition of royalties and management fees. An important accounting choice
related to royalties and management fees is when these should be recognized as an
expense (when the liability arises or when they are paid).
e. Prior to 2012: Accounting for the special-purpose financing companies. Euro Disney
leased land and hotels from special-purpose financing companies. This could have
helped the company to keep some of its assets off the balance sheet; however, the
company had chosen to consolidate all special-purpose companies because of the
influence that it (and its primary shareholder) had on the SPEs. From an investor’s
perspective, this is certainly the most desirable and informative solution (note that
most operating lease commitments automatically arise on the balance sheet).
2. Some incentives that may influence management’s reporting strategy are:
a. Large controlling shareholder. The Walt Disney Company (TWDC) controls Euro
Disney’s operating and financing decisions (via the Gerant, via the finance
agreements between Euro Disney and TWDC, and via TWDC’s loans to Euro Disney).
Consequently, TWDC has the incentive and means to “expropriate wealth” from Euro
Disney’s minority shareholders. Also note that the incentives of the CEO of the
Gerant are closely aligned with the incentives of TWDC as the result of the CEO’s
TWDC stock and option holdings.
b. Frequent management changes and poor performance. Euro Disney has performed
poorly in the past, also after restructurings in 2005 and 2012. The company has been
making losses and the company’s average stock return has been negative during the

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many years. At the same time, the company is highly leveraged and has negative free
cash flows, indicating a high need for financing. If Euro Disney plans to issue equity,
the company’s management has the incentive to overstate performance in an
attempt to boost the company’s share price.
c. Powerful unions. Unions play an important role in France. An improvement in
performance might affect the union’s demands. This could create an incentive to
understate company performance around union negotiations.
d. Euro Disney’s fixed obligations to TWDC may create an incentive to understate
performance, create hidden reserves, and reduce dividends to minority
shareholders.
e. Debt covenants. Prior to 2012, being close to the violation of debt covenants may
have created an incentive to overstate performance. After 2012, Euro Disney has
only negative debt covenants.
3. Examples of relevant disclosures are:
a. Disclosures about related-party transactions, in particular transaction with the
company’s primary shareholder and creditor TWDC.
b. Disclosures about the company’s governance and compensation structure.
c. Disclosures about revenue recognition policies.
d. Disclosures about pension assumptions.
e. Disclosures about property values and impairment methods/decisions.
4. The following potential red flags can be discussed:
a. The presence of a controlling shareholder.
b. Unusual financing mechanisms and related party transactions.
c. Impairment charges for tangible and intangible assets.
d. Fluctuations in the allowance for uncollectible receivables.
e. A significant (though slightly increasing) liability for deferred revenues.
f. The company has significant tax loss carry forwards. Currently, the company does not
recognize a deferred tax assets for these tax loss carry forwards; however, it may do
so in future years (helping it to boost income).

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