Lecture 3: Measurement Financial Reporting quality and red flags

Measurement methods: pros and cos

Measurement is obviously a very findamental issue in FA. masurement allows us to attribute numbers to
the items that appear in financial reports
measurement is the process of quantifying, in monetary terms, inforamtion about an entity's assets,
liabilities, equity, cincome and expense

Choice of measurement methods

- historic cost
- current value : fairvalue (exit pricing ) or value-in-use
choice should depend on
objectives of financial reports
relevance/reliability (Faithful presentation) trade-off of the measurement information required.

aasb 116 provides reporting entities with the choice to either adopt the ‘cost model’ (measuring PPE at
historical cost) or the FV model

objectives of financial reports

- valuation of debt and equity (equity investors and creditors need info to forecast future net CFs
and to assess credit risk
- stewardship/contracting (for assessment of performance of mgt, for writing efficient contracts with
debt holders and mgt)

HISTORICAL COST

Arguemnts for HC
- past transaction (past performance) is an imprttant input into the prediction of future CFs
profit concept provides a measure of past economic value added measured as the excess of selling price
over historical cost(ast nomial financil capital is the definition of wealth)
Penman shows HC may be relevant to measuring operating performance of a business and if margins
are stable then HC may be suitable for predicting future operating return
- Past transaction and events are important for stewardship to make mgt accountable
- reliable and verifiable
- confirmatory value: historical numbers provide integrity to the forecasts by providing a means to
confirm their accuracy after the fact
- forecasts will only have credibility if they accuracy is subsequently confirmed

Critisms of HC; P&L

HC may not match current revenue with current operating costs
- HC matches current revenue against historic operating cost. if current operating costs differ from
HC operating costs reported profit may be uninformative of future profits
- can observe profits in times of rising prices, wth distribution of profits leading to an erosion of
operating capacity
Revenue recognition lag (since revenue is not recognised until receipt of cash is probable)
- no recognition in P&L of losses or gains from simply holding assets (or liabilities) due to their
changing value
Problem with PL intimes of rising prices
- inc holding gains from selling an asset which accrued in previous periods in current years’s
income distorts the current year’s operating results
Criticism of HC: BS
No recognition BS of the current value of A or L
- BS reflects unallocated/unamortized costs
Aggregation of different measurement units
- problem of additivity (adding together As bought at different times)
- HC will report similar As/Ls acquired at dif points in time at very dif amounts
- this can reduce comparability both within and between reporting entities

Any evidence support of HC

- predominant method used for many years so tended to maintain support of profession
- if not found useful, business entities would have abandonded it
- nevertheless, recent acct std being released have embraced. ‘FVs’ as the basis of measurement,
However, various assets are still measure on an historical cost basis

FAIR VALUE

Fv is exit price, market pricce

FV are market based measures not entity-specific measurements
=> reflects the price market participants would pay for assets rather than the alue generated through the
unique use of an A in s specific business

Benefits
- reports current information. current FVs may provide more relevant info for forecasting the future
- Opportunity osts. FV in the BS provides info to measure a firm’s OCs from selling the firms assets
and using in an alternae invesment
- comparability, consistency and additivity. the measuremnt sales of allAs and Ls are the same
- free of cost allocation decisions

Capacity to aspat and PCs(benefits of OCs)

- exit value provides information in relation to new oportunities (the ability of the enity to aspt to
changing circumstances, provides information to measure OCs)
- the ability of the firm to ‘go into the market with cash for the purposes of adapting oneself to
contemporary conditions’
- assumes the objective of acct is to guide future actions

Arguments against FV
- Measures profit based on value-in-exchange but for firm valuation primary interest is value-in-use

firm valued based on prospects for future CFs based on As being used
firm can consider an asset to have value bacuse of its use in a business and synergistic vlue
aded y combining with ther As

- may not reliablt as market price may not be avilabe for all of the fir;s As nad LS, maynot be
efficient and thusprces may depart from fundamentals
- excessive income volatility
- stewardship is an objective of general purpose financial reporting
- HC may provide a clearer prespective about what mgt has done with the funds that were
entrusted to it. Demonstrating how funds have been used is a key commponent of stewardship (
stewardship is likely to lay greater emphasis on past, rather tahn prospective, transactions)

VALUE-IN-USE
VIU is the present value of the CFs that an entity expects to derive from the continuing use of an As and
from its ultimate disposal
Determined form the perspective of the reporting entiy not the market. Based on entity specific
assumptions instead of assumptions by market participants
Used for impairment testing

Can be used in assessing the prospects for futre CFs, particularly if the A will contribute to future CFs of
the entity

Cons
- Cannot be deternmined meaningfully for individual As as they are used in combination with other
As(the value may or maynot reflect synergies with other As and Ls and so may not measyre only
the item that they purport to measure
- Complex and unreliable

Measurement Approches in Current Acct Std

There is no conceptual framework for. measurement

Different measuremnt value basis for dif purpose

- FV is more levant ot the valuation of As held for trading and sale
- A cost valu is more relevant for items that will be used in ncombination with other As to produce
GoS

Item Measurement basis

Inventories lower of cost or net realizable value

PPE Cost or FV and subject to Impaiment Tests which may results in VIU

In asseessing impairment, the RA of the A is estimated inorder to determine the

extent of the impairment loss
The RA of an A is the greater of its VIU and its FV - cost to dispose

Goodwill Internally generated goodwill not recognised. Goodwill only recognised when a
subsidiary is acquired and is measure. as the excess of the cost of an acquisition
over FV of the share of the net identifiable Asacquired

Following initial recognition, goodwill is measures at cost less anyy accumulated

impairent losses

Other IAs Internaly generated are ot recognised. Externally acquired IIAs are measured at
cost less accumulated amortixation if finite life. if indefinite life then no
amortization. subject to impairment testing

wehere acquired in a BC, cost represents the FV at the date of acquisition

R&D research is expensed as incurred. D may be capitalised at cost

Bio A at FV
 Item Measured basis

ASSETS

Cash face value

AR face value less DD

Equity investment (no significant influence) Mandated FV

Associated company ( EI with wignificant Equiy Acct

influence)

debenture/ Bon investment Face value or amortised cost if held to maturity

trading financial Instrusment mandataed at FV

derivatives //

LIABILITIES

AP face value

Employees benefits and provisiona VIU (estimated current settlement cost to the
entity

Loans Amortized cost (or option for FV under certain

condition)

Measurement Errors, Quality of Fiancial report, and RED FLAGS

Motivation and Main long-term working capital Analysis and

context resouce,statistical resources capital and structure Valuation
types and acct revenue and Cost
properties of errors of Debtt

Motivation for analysis:

- Financial reporting info is noisy and biased
- if the potential distortions are large, acounting analysis of measuremnt error can add
considerable value
Context for erros infinancial reports
Financiel statements due to recognition and ,easurement error do not always provude a complete and
FF picture of a company’s activities and condiiotn

Graph slide 45, 46

The sources can be catogorised into 3 statistical types of measurement erros

3 statistical types of measurement error:

- Biased measurement errorcaused. by rules in acct stds and conventions
- Randomestimation error that occur due to lack of perfect foresight in the use of acct estimates
- biased measurement error cauased by mgts intentional misrepresentaion of acct estimates
Fundamental acct properties of measurement eror
There are two fundamental acct properties of measurement error that impact how y ou shoule use
financial reports
- double entry
- accruals reverse

DOUBLE-ENTRY AND MEASUREMENT ERROR

Double entry: where every en try to an acct rruqires a corresponding and opposite entry to a dif acct

therefore, errors in one occur will give rise to errors in another acct
typically, errors will affect both the reported value of both net income and shareholder equity 9due to the
doule-entry systems)

Impact:
- Bias up or downward in net As
- // in net Income (depend on bias in net As, rate of growth of investment, timing of future benefits
- Bias up or downwar din ROE ( depend on both direction and relative magnitude of the biases in
both NI and NA)

ACCRUALS REVERSE

Accrual measurement errors will reverse in following years

thus implies an accrual measurement error in any year t will give rise o the opposite erroe in a year
following t
Net incom = CFs +/- accruals

Accruals reverse:
- in long run, net income =CF
- total accruals = 0
- Implication: a bias up(down)ward in reported income ue to a biased estimate will be followed by a
bias down(up)ward income in the following years

Measurement errors in firms resources of economc activity.

- long-term resources: PPE, IA, goodwill
- Revenue, working capital and accruals: revenue, AR, Inventory
- Capital structure and the costs of finance
Measurement error in the original value of PPE when acquired
For individual new PPE assets that are externally acquired there will be minimal measuremnt error

For PPE assets acquired as part of a business combnation there could be both random error and an
intentional bias downward in the FVs assigned to PPE:
- In business acquisitions, firms have substantial discreion measuring FVs of PPE
- ingeneral, firms have anincentive to understate the valueof finite-life fixed As as this will increase
near-future reported earnings due to lower depreciatio
- errors in the valuation of individual assets are absorbed in goodwill which is not subject to
periodic amortization

MEASUREMENT ERROR IN ESTIMATING DEPRECIATION

There will be ranom unintentional error as the true life of an asset is not known with certainty

there could be a bias due to intentional overstatement of useful lives or salvage valus of fixed or IAs
subject to depreciation or amortization
- this results in understated depreciaation expenses in early years.

RED FLAGS = Examine Depreciation RAtes

Measurement error in return on capital due to depraciation and declining net bookvalue

- straight-line dep. yeilds an increasing bias in the asset’s rate of return pattern over time
- this occurs because the exected benefits remain constant across time but the net book value
becomes lower across time due to increasing accumulated depreciatioin
- this is known as the ‘old plant trap’ and i have an example on the next slide

REDFLAGS for ME in Dep and value of PPE

Depreciation rate = depraciation of PPE / Gross PPE

- if the ratio is low compared to industry oeers, r if it decrease over time, it may indicate that the
firm understates depreciation by overstating the asset’s useful lives or their residual values

Average age= accumulated depreciation / current year dep exp

- a high level of this ratio indicates that old (and typically relatively small) HC are used to measure
As and dep, which inturn implies (that earnings are overstated, the computed rates of return
could be overstated

Measurement error for goodwill and intangibles

Goodwill is economically significant for most firms. as example the percentage of goodwill to TAs in the
customer discretionary industry is 20%

The measured value of Gw when acq as part of a business acquisition could be overstated for 2 reasos
- when acq as part of business acquisition firms have strong incentives to understet FVs of As that
are subject to depreciate or amortization as this enables firm to report lower expense but his will
result in ilfalted Gw
- ther is some evidence, due to overconfidence, that firms may pay to uch on acquisition in turn
implying Gw when acquired is overvalued
Measurement Error in Revenue and Working Capital Accruals
Measurement error in cost of finance
TUTORIAL 3
tial errors and biases is fundamental to being able to use financial reports.
Question 1
Extract from Qantas Investor Centre Webpage 22nd February 2018
“The turnaround of Qantas over the past few years has been remarkable. It’s a testament to the strategy
executed by Alan Joyce and his Management team, and to the 30,000 people working across the Group to
make it better every day.” http://investor.qantas.com/investors/?page=annual-reports
Leigh Clifford AO
Chairman and Independent Non-Executive Director

Obtain the 2017 financial report for Qantas and compute the ROE. Using the following questions provide
an explanation for the high ROE due to accounting measurement error in the 2017 financial report
a) Consider the major PPE assets of Qantas. Which assets are likely to have measurement
error? What is the likely nature of this error (eg. random, rule-based bias, or management
driven)?
b) Examine the PPE item Aircraft and Engines. Determine whether it is likely that straight
line depreciation, in this case, has contributed to measurement error. To do so, you should
examine where in the useful life (on average) the assets are currently located, and whether
the age of the assets, on average, results bias for ROE.
c) How does the impairment on Aircraft and Engines in 2014 affect future ROE?
d) Aside from the effect on ROE, why is the age of assets important from a valuation
perspective ?

Compute ROE
ROE 2017 = 853 / ((3,540+3,260)/2) = 25%
This is a very high ROE which could be due to fundamentals (if you viewed Qantas as extremely high
risk or Qantas has captured abnormal profits). However, it is also likely to be partially explained by
accounting measurement error. This measurement error can have its origins in either numerator or
denominator. Beginning with denominator consider Qantas’s balance sheet and it can be observed that
Qantas is a capital-intensive company with total assets of $M17,221 of which $M12,253 are PPE. Of this,
according to Note 11, $M10,032 is aircraft and engines. Therefore, let’s consider the measurement of
aircraft and engines as a possible source of measurement error bias.

a) Consider the major PPE assets of Qantas. Which assets are likely to have
measurement error? What is the likely nature of this error (e.g. random, rule-based bias, or
management driven)?

Qantas has three types of PPE assets: Aircraft and Engines, Leasehold improvements and Plant and
Equipment.
To examine the accounts most likely to contain measurement error, start with the largest – Aircraft and
Engines, which is 83% of PPE (at closing BV).
The nature of the measurement error is likely to be both a rule-based bias in the sense that these assets are
recorded at historical cost (expanded on in question part b. further below), and also random as
depreciation may be randomly (as opposed to intentionally) over or under-specified. In the past, Qantas
also performed an impairment write-down of the international fleet introducing the possibility of
management driven bias if the write-down was not justified by fundamentals (expanded on further below)
Similar issues apply to the other assets.
b) Examine the PPE item Aircraft and Engines. Determine whether it is likely that straight
line depreciation has contributed to measurement error. To do so, examine where in the
useful life (on average) the assets are currently located, and whether the age of the assets
results in bias in ROE.

First, we must determine a way to measure the age of the fleet as it does not appear to be directly reported
by Qantas. Therefore, we will use the reported accounting numbers to determine “how much” of the
asset is depreciated, as this will provide an estimate of the average distance into the life of the asset.
To approach this using the reported information in Note 10 on PPE we divide the accumulated
depreciation of $M10,960 by the original gross amount of $M20,992 cost, giving 52%. Therefore, we are
just about halfway into the life.
As discussed in the lecture and the readings, later in an assets life, ROE is likely to be positively biased
due to the relatively low asset book value. This is because a significant bias arises in the computation of
rates of return on equity when straight-line depreciation is used and the depreciated value (net book
value) is used in the denominator. Straight-line depreciation yields an increasing bias in the asset's rate of
return pattern over time. This occurs because the expected benefits remain constant across time but the
book value of the assets is becoming lower
Given that the Qantas fleet is approximately midway through its useful life the recorded book value of
$M10,032 is substantially lower the original capital value of $M20,992 implying the ROE could be
substantially biased upward.

c) How does the impairment on Aircraft and Engines in 2014 affect future ROE?

The impairment in 2014 will have the affect of biasing future ROE upwards.
The impairment will reduce both profit and the carrying value of assets in the 2014 year of the
impairment. Therefore, in the initial 2014 year, ROE will decrease due to an equal dollar effect on profit
and assets. In subsequent years, ROE will by biased upward, as the carrying value of assets are
understated and the firm will also book lower depreciation or costs.

d) Aside from the effect on ROE, why is the age of assets important from a valuation
perspective?

The age of the equipment has two implications for valuation:

• First, valuation is a function of expected future cashflows (the numerator) and thus the
margins = sales less costs
– Pasts costs from old equipment may not be reflective of the future cost of equipment
• Second, valuation is a function of the cost of capital (the denominator)
– To the extent a large amount of new equipment is required to be purchased then extra funding may
be required which may have implications for cost of capital

Question 2
Assessment of Financial Reporting Quality of the Financial Report of A2 Milk
Read the articles below about A2 Milk which alleges that A2 Milk undertook actions to boost sales.
Review the working capital current assets and liabilities and the corresponding revenue and expense
accounts of A2 as reported in the 2021 Annual Report. Address the following question:
Which of the working capital current accounts and corresponding revenue and expenses is likely to
have the greatest measurement error either due to biases or random error?
As part of this overall analysis:
· First consider if management had an incentive and an opportunity to bias the measurement of
revenue and COGS and the corresponding balance sheet accounts of accounts receivable and
inventory.
· Then secondly consider if there is any evidence of a bias in the measurement of these
accounts. To provide some evidence compute and analysis the ratios for Days-in-Receivable
and Days-in-Inventory using the account variables provided below. A benchmark of
Days-in-Receivable and Days-in-Inventory for large stocks in the Consumer Staples industry
has been provided.

For self-learning to re-produce the benchmark I have attached an excel spreadsheet of the time-series of
the Days-in-Receivable of the Consumer Staples industry that A2 is in. The R-Code to compute
descriptive statistics using only large stocks (> rank 2) is attached.

Background to A2 Milk
GICS Sector Consumer Staples GICS Industry Group Food, Beverage & Tobacco GICS Industry
Food Products
Other Major Players
Fonterra Co-operative Group Limited, Industry Park Pty Ltd, Teys Australia Pty Ltd, Inghams Group
Limited, Nestle Australia Ltd, Food Investments Pty Limited, Goodman Fielder Pty Limited, Bega
Cheese Limited, Lactalis Australia Pty Ltd

Overview of the Working Capital Accounts

The primary working capital accounts for most firms are cash, trade receivables, inventory, trade payables
and provisions for warranties and employee leave.
The magnitude of error is a function of the size of accounts and the degree of imprecision in estimating
and measuring the value of the accounts.
Cash and Trade Payables are very reliable as they are underpinned by financial contracts. Revenue and by
association Trade Receivables, COGS and by association Inventories are the accounts that are likely to
have the greatest measurement error due to both their size and the degree of imprecision in measuring
their value. We will review each in turn and then determine which has the greatest error. We will first
review if there is an both an incentive and an opportunity to bias the measurement. We will then consider
if there is any evidence of a bias.

REVENUE and ACCOUNTS RECEIVABLE

Background
The a2 Milk Company Limited is involved in the sale of a2 Milk branded milk and related products in
targeted markets in New Zealand, Australia, Asia and the US. The product is made with milk from cows
that produce milk naturally containing only the A2 protein type.

To assess if there is an intentional bias determine if there is an incentive to bias the reported numbers and
if there is an opportunity.

Incentive

As A2 milk’s revenue was declining during 2021 the company may have had an incentive to artificially
boost sales. Therefore, there is potential for an intentional biased measurement error in the reporting of
revenue.

Opportunity

Is there subjectivity in the recognition and measurement of revenue and thus an opportunity for discretion
to bias measurement?

There are many types of revenue transactions where it would be expected that the recognition and
measurement of revenue would be reasonably objective and thus limited opportunity for biased
discretion. This is because for many transactions the point in time at which a product is delivered to a
customer can be determined and there is an invoice with an objective financial contractual amount.
However, there are also many revenue transactions that can involves considerable discretion in particular
when there is ‘variable consideration’ (e.g. estimating sales returns) which involves substantial
discretion. Research indicates that about half of the cases of misstatements of financial reports are related
to revenue recognition.

For A2 there are two distinct opportunities to present a biased measure of revenue. First, in the timing of
revenue recognition by physically bringing forward the timing of the sale of good and then secondly in
measuring the value of goods sold.

Physically bring forward the timing of sales

A2 could physically being forward sales by forcing A2 products through the distribution channel to
expedite revenue recognition. This can be achieved by extending excessive discounts or credit terms to
[1]
distributers to “pull in” sales from the next quarter. This is known as channel stuffing.

Measuring the Revenue Value of Milk that has been Sold.

For A2 the majority of sales are to major retailers and other significant customers with established
creditworthiness and minimum levels of default. Other sales are made for cash on delivery.

According to A2’s 2021 Annual Report Notes to the Financial Statements Note B2 Page 69.
“A sale is recognised when control of the product has transferred, being when the product is delivered to the customer and
there is no unfulfilled obligation that could affect the customer’s acceptance of the product. Delivery occurs when the product
has been shipped to the location specified by the customer and the customer accepts the product…………..Revenue is
recognised after offsetting items of variable consideration such as rebates agreed with customers.

Revenue is recognized net of trade discounts, volume rebates and promotional allowances owed to
customers. The recognition and measurement of rebates involves considerable judgment in particular in
[2]
relation to expected level of rebate claims by customers. Therefore, in summary there is an opportunity
for A2 to exercise discretion in the estimation of rebates and therefore the potential to bias their estimates
of the value of revenue that is recognized at year end. Consistent with this the auditors in the audit report
disclosed “Discounts and Rebates Provided to Customers” as a key audit matter. See extract from Audit
Report in the appendix.

Detection

The primary red flag for detecting a bias in the measurement of revenue at year-end is
[3]
Days-in-Receivable (DIR). If A2 have biased their measurement of revenue upwards at year-end then
[4]
DIR will be greater than normal.

Days in Receivable (DIR) = Accounts Receivable/(Sales/365)

Thus, DIR for A2 as at 30 June 2021 = 47,838/ (1,205,034/365) = 14.48
Is 14.48 days greater than normal? There are two possible benchmarks of normal. First, the past
time-series of DIR for A2 and secondly DIR in 2021 for other firms in the same industry as A2.

The past time-series of DIR for A2 is tabulated below. The DIR in 2021 of 14.48 is greater than the most
recent benchmark in 2020 of 13.41 possibly suggesting Accounts Receivable is greater than normal and
revenue has been biased upward. However, the evidence is very weak as there has been substantial
variation across time in the DIR, due to either random economic shocks or systematic changes in the
business model of A2 making it difficult to determine what the unbiased “norm” is with precision.
Therefore, as an alternate benchmark, we can use the norm of DIR of other firms in the same industry in
2021. A2 is in the Consumer Staples industry and the median DIR for that industry across time is
reported in the Table. Clearly there is a substantial difference in the DIR in 2021 between A2 (14 Days)
and the benchmark (44 Days) implying a fundamental difference in the business model between A2 and
the median firm in the Consumer Staples industry implying it is not a highly relevant benchmark (e.g it is
biased).

However, an approach to partially alleviating this concern is to examine if there has been any change in
the trends of the difference between A2 and the benchmark in 2021 consistent with intentional bias by
A2. In this case the DIR increases for both A2 (from 13 to 14 days) and the benchmark (from 37 to 44
days) implying there is no evidence of a change in A2 that does not also occur for the benchmark.

Summary of the Properties of an Ideal Benchmarks

Given the above discussion it is now useful to briefly discuss the properties of an ideal benchmark. To
identify abnormal performance (for any business decision) we need a benchmark of the norm. All
benchmarks are imperfect. The ideal benchmark is both relevant (and thus unbiased) and reliable (and
thus precise and thus free from random error). A relevant benchmark measures identical business
fundamentals so in the case of A2 that would be a firm that produces and sales milk.
In general most benchmarks have some degree of both bias and random error and there is a trade-off
between these two statistical properties.
So for example using the firm’s own most recent past time-series may be unbiased (assuming the
business model has not changed) however it is likely to be imprecise due to the impact of random
economic shocks from only having a small number of yearly firm observations (we may only have 2 to 3
of relevant years). For example last year the performance of the firms may have been effected by a
random weather event. An industry benchmark may be more precise as it has less random noise due to
the larger number of observations in the industry sample. However it may be biased (alternatively
expressed like less relevant) as the business model of the industry may be systematically different from
the firm we are examining.

INVENTORY
There are three possible sources of bias in the measurement of A2’s inventories and in turn cost of goods
sold.
• The Determination of Costs
• Assigning Costs to Inventory Sold
• Determination of Net Realizable Value

In the case of A2 the greatest subjectivity will most likely be the determination of net realizable value.
However we will consider all three potential sources of measurement error.

C2. Inventories (Extract from A2’s note disclosure on inventory)

Determination of Costs
Regarding the determination of cost’s this involves determination of which costs to allocate as fixed
overheads and what value to measure this at. It appears there was some small amount of plant and
equipment (P&E) involved in the production of A2 Milk. Note C4 shows that total depreciation expense
is $1,050,000 (thus $M1). Given that the total costs of sales is $M695, the depreciation expense of $M1
is very immaterial and thus not a source of significant measurement error in the valuation of inventory.
However, for completeness we will briefly discuss.
A possible source of error is the allocation of this $1,050,000 between product costs associated with cost
of production of A2 milk and period expenses such as equipment used in head office which is unrelated
to cost of producing inventory. There is no disclosure of how this is attributed. For example, in Note C4 it
is not clear what portion of Plant and Equipment relates to production of A2 milk and what portion relates
to head-office equipment such as computers.
The second, source of measurement error (which will affect the prediction of future margins) is the value
that is assigned to this cost of production. Per note C4 this plant and equipment is measured at cost.
Therefore, to the extent this historic cost does not reflect future cost then it may not be relevant regarding
forecasting future cash flows. To obtain some understanding of this we need to know the age of P&E. The
disclosure in Note C4 is very poor in this regard simply reporting that the estimated useful live of P&E
ranges from 10 to 15 years. We can estimate the average age of the P&E from Note C4 which is 8 years
(see calculation below). Therefore, to the extent the cost of P&E brought 8 years ago is not representative
of future cost, this measurement basis could give rise to a biased measure of future costs. However, as
A2 is not a capital-intensive companies this is not a significant measurement issue. Capital intensive
companies with aged facilities will often have profit margins not reflecting the higher costs of replacing
aging assets.

Computing Age of P&E using Note C4 Plant and Equipment. The gross MPE cost = $20,244;
Accumulated Depreciation = $(8,842) and Net book value = $11,402. Estimated depreciation expense =
$1,050
Therefore:
Average Total Life Span = $20,244/$1,050 = 19
Average Age = $8,842/$1,050 = 8 years
Remaining life = 19 – 8 = 11

Assigning Costs to Inventory Sold

According to Note C2 (reproduced below) costs are assigned to inventory sold (COGS) based on the
weighted average method and the first-in, first-out (FIFO) is not used. The use of weighted average as
opposed to FIFO implies there is no bias that can arise when FIFO used. The use of FIFO for the
valuation of inventories, assuming the costs of the goods produced earlier in the year is lower than the
cost of the goods produced latter in the year, will generally result in a higher inventory on the balance
sheet and a lower cost of goods sold (and higher income) in comparison to the weighted average method.

Determination of Net Realizable Value

According to AASB 102 Inventory must be valued at the lower of cost of and net realizable value.

Throughout the year ended 2021 it was alleged (see AFR articles) that inventory levels increased during
the year as a consequence of managing the uncertainties and complexities of the impacts of COVID-19
on supply chains.

Due to the ongoing challenges in the infant nutrition category, the rundown of this inventory was slower
than expected. A2 have stated in their annual report that “Older infant nutrition inventory has been written off
and has or will be destroyed”. During the year $M108 was recognised as an expense in cost of sales for the
write-down of inventories (see copy of note from financial statement reproduced below).
A substantial amount of judgment by management is involved in measuring the net realisable value of
inventories. Provisions are established for obsolete or slow moving inventories, taking into consideration
the ageing and seasonal profile of inventories, discontinued lines, sell through history and forecast sales.

Has A2 management under or over-estimated the write-down of the value of inventory by $M108?

Detection

A red-flag that may indicate that inventory is over-valued due to slow-moving inventory lines is
days-in-inventory (D-INV) which is calculated as follows = Inventory/(COGS/365).

A significant increase in D-INV may indicate that the value of inventory is overstated and thus expenses
are understated due failure to recognize inventory write-downs.
The Table below reports the D-INV for A2 computed using Inventory values before and after inventory
write-down ( the inventory value before write-down = Final Reported Inventory + write-down). The
benchmark D-INV of large companies in the Consumer Staples industry is also reported.

The table and the figure for Days-in-Inventory before write-down shows there has been a significant
increase in D-INV from 72 days to 116 days in 2021. Furthermore, the DIH of 116 days in 2021 is greater
than the industry benchmark of 82 days. At face-value this may imply that inventory turnover
(pre-write-down) of A2 has decreased due to declining demand and/or deteriorating inventory
management.
Therefore, the declining inventory turnover would appear to justify a substantial inventory write-down in
2021. Consistent with this A2 had a write-down of Inventory in 2021 of $M108 compared to $M3 in
2020 (see Table and extract from financial report notes above).
Is the magnitude of the write-down of $M108 fair and does the magnitude of the write-down have any
implications for the analysis of the performance of A2?
To assess the fairness of the magnitude of the write-down, consider the Days-in-Inv computed using
inventory after the write-down. These ratios show there has a been a significant decrease in DIH from 71
days to 59 days. Furthermore, the DIH of 59 days is lower than the industry benchmark of 82 days and
the industry benchmark has increased from 75 to 82 while the DIH of A2 has decreased.
This could imply the inventory write-down was greater than it should have been and thus inventory in the
balance sheet is under-valued. What are some implications of this for the analysis of the performance of
A2 in the current and future periods:
· If the value of inventory has been written down below its true value then the future COGS in
2022, which is based on the written-down inventory values in 2021, will be lower than the
true cost value. This will thus make the future gross profits (Sale -COGS) in 2022 greater than
normal. Management may have had a “big bath” incentive to overstate the write-down in 2021
as they have to report bad news anyway so by overstating they create a benefit for future
periods.
· The point above illustrates that while the lower‑of‑cost‑or‑market method values inventory in
the balance sheet conservatively in the current period it can have the opposite effect on profits
in future periods which could be inflated
· The estimated losses of $M108 (the excess of actual cost over NRV) is an unrealized expense
as the losses will only be realized when the goods are sold.
· The charge for the inventory write‑down of $M108 is included in the cost figure for goods
sold. Thus the COGS is inflated by the amount of the estimated shrinkage in price of the
unsold goods and the implicit title "Cost of Goods Sold" therefore becomes a misnomer. This
makes it difficult to analyse the determinants of the decrease in the gross profit margin from
56% in 2020 ($M968/$M1,731) to 42% in 2021 ($M509/$1,205). Is this decrease due to
decline in price of A2 products, an increase in their cost due to increase in raw milk prices, a
change in product mix from high margin to low margin, foreign currency movements or due
[5]
to the write-down?

Therefore, overall there is likely to be significant measurement error in the value of both inventory and
COGS.

Conclusion
In summary based on the above the working capital current accounts in order of likely measurement error
from lowest to greatest is: Cash, Trade Payables, Trade Receivables and Inventory.

Appendix
From the 10/6/2021 Financial Review

A2 Milk slapped with class action over

earnings guidance
Carrie LaFrenz

A2 Milk CEO David Bortolussi has one more headache after the company was served a class action
claim.

Slater and Gordon has filed a class action against dual-listed The a2 Milk Company on
behalf of investors who bought shares during a nine-month period in which the infant
formula maker posted four earnings downgrades and shares plunged 62 per cent.
The class action alleges that the $4.7 billion company engaged in misleading or deceptive
conduct in breach of the Corporations Act, and breached continuous disclosure rules in
posting downgrades on September 28 and December 18 last year, and February 25 and
May 10, 2021.
The claim – first revealed by The Australian Financial Review in May – was filed yesterday
in the Supreme Court of Victoria.
It is brought on behalf of shareholders who suffered losses after acquiring shares in the
baby formula and fresh milk maker on the ASX and New Zealand stock exchanges between
August 19, 2020 and May 9, 2021.
Investors are waiting for the investor day on October 27 for new CEO David Bortolussi to
reveal his China business strategy. A2 Milk flagged a review of this key market in tandem
with a blowout of more than $NZ100 million ($92.9 million) in provisions for old stock on May
10.
The last cut to its outlook left a2 Milk expecting full-year sales of $NZ1.2 billion to $NZ1.25
billion and a group earnings before interest, tax, depreciation and amortisation (EBITDA)
margin of 11 per cent to 12 per cent of sales. This compared with August 2020 guidance for
strong sales growth and an EBITDA margin of 30 per cent to 31 per cent.
Slater and Gordon class actions practice group leader Kaitlin Ferris said a2 Milk was or
ought to have been aware the full-year 2021 guidance did not adequately consider factors
likely to worsen its financial performance.
‘‘This includes a2 Milk’s attempts to boost sales by pushing English label infant formula tins
through the cross-border e-commerce channel with discounting consequences that would in
turn negatively impact sales in the daigou channel,’’ she said.
The claim also alleged that a2 Milk’s sales in the cross boarder e-commerce channel would
then be impeded by the disruption to the daigou/reseller channel and the loss of associated
marketing activity to stimulate consumer demand.
Ms Ferris said there was a strong basis to allege that the company provided misleading
guidance and was obliged to correct the market’s understanding of its financial position at a
much earlier date.
‘‘Investors are entitled to assume that when they purchase shares in a listed company, all of
the material information relevant to its financial position has been disclosed,’’ she said.
‘‘The repeated downgrades by a2 during the August 2020 to May 2021 claim period caught
the market by surprise, and revealed that a2 had been facing systemic and structural issues
with its distribution networks at an early stage of the financial year.’’
Ms Ferris said Slater and Gordon would run the case on the basis that it would seek a group
cost order in the Supreme Court of Victoria. This means the firm will self-fund, rather than
rely on a litigation funder.

Appendix

Recognition and measurement Sales of products