Composea 200- to 300-word response to the Question on the FindWhat.com, Inc Case on p. 188 (Ch. 5).
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CheckPoint FindWhat,com, Com CaseResources: Ch. 5 of Understanding Financial Statements and Exhibit 5.1: A Checklist for Earnings Quality on p. 153 (Ch. 5) Compose a 200- to 300-word response to the Question on the FindWhat.com, Inc Case on p. 188 (Ch. 5). Refer to the checklist, Exhibit 1, on p. 153 (Ch. 5) for assistance with identifying quality issues using the first five items included in Part I of the Checklist
CheckPoint FindWhat,com, Com Case Resources: Ch. 5 of Understanding Financial Statements and Exhibit 5.1: A Checklist for Earnings Quality on p. 153 (Ch. 5) Compose a 200- to 300-word response to the Question on the FindWhat.com, Inc Case on p. 188 (Ch. 5). Refer to the checklist, Exhibit 1, on p. 153 (Ch. 5) for assistance with identifying quality issues using the first five items included in Part I of the Checklist ORMIMC05_0131878565.qxd 152 A Guide to Earnings and Financial Reporting Quality 5 A Guide to Earnings and Financial Reporting Quality Qual-i-ty (n). Synonyms: excellence, superiority, class, eminence, value. C H A P T E R Before delving into the analysis of financial statements in Chapter 6, this chapter considers the quality of reported financial information, which is a critical element in evaluating financial statement data. The earnings statement encompasses a number of areas that provide management with opportunities for influencing the outcome of reported earnings in ways that may not best represent economic reality or the future operating potential of a firm. These include: • Accounting choices, estimates, and judgments. • Changes in accounting methods and assumptions. • Discretionary expenditures. • Nonrecurring transactions. • Nonoperating gains and losses. • Revenue and expense recognitions that do not match cash flow. In evaluating a business firm, it is essential that the financial statement analyst consider the qualitative as well as the quantitative components of earnings for an accounting period.The higher the quality of financial reporting, the more useful is the information for business decision making. The analyst should develop an earnings figure that reflects the future ongoing potential of the firm. This process requires a consideration of qualitative factors and necessitates, in some cases, an actual adjustment of the reported earnings figure. In addition to earnings quality, the quality of the information on the balance sheet and statement of cash flows is equally important. Because these financial statements IS B N : 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 5 A Guide to Earnings and Financial Reporting Quality 153 EXHIBIT 5.1 A Checklist for Earnings Quality I. Sales 1. Premature revenue recognition 2. Gross vs. net basis 3. Vendor financing 4. Allowance for doubtful accounts 5. Price vs. volume changes 6. Real vs. nominal growth II. Cost of Goods Sold 7. Cost-flow assumption for inventory 8. Base LIFO layer liquidations 9. Fulfillment costs 10. Loss recognitions on write-downs of inventories (also see item 13) III. Operating Expenses 11. Discretionary expenses 12. Depreciation 13. Asset impairment 14. “Big bath” or restructuring charges 15. Reserves 16. In-process research and development 17. Pension accounting—interest rate assumptions IV. Nonoperating Revenue and Expense 18. Gains (losses) from sales of assets 19. Interest income 20. Equity income 21. Income taxes 22. Unusual items 23. Discontinued operations 24. Accounting changes 25. Extraordinary items V. Other Issues 26. Material changes in number of shares outstanding 27. Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA are interrelated, quality of financial reporting issues often affects more than one finan- cial statement. The primary focus of this chapter is to provide the financial statement user with a step-by-step guide that links the items on an earnings statement with the key areas in the financial statement data that affect earnings quality. Exhibit 5.1 is a checklist for earnings quality. Items that affect the quality of information on the balance sheet and statement of cash flows will be covered later in this chapter. The list does not, by any means, include all of the items that affect earnings quality. Rather, the examples illustrate some of the qualitative issues that are most IS B N : 0- 53 6- 48 04 4- 3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 154 CHAPTER 5 A Guide to Earnings and Financial Reporting Quality commonly encountered in financial statement data. Another purpose of the chapter is to provide the financial statement user with an approach to use in analyzing and interpreting the qualitative factors. The checklist represents an attempt to pro- vide a framework for the analysis of earnings quality rather than a complete list of its components. Although the examples in this book deal primarily with the financial reporting of wholesale, retail, and manufacturing firms, the concepts and techniques presented can also apply to other types of industries. For instance, there is a discussion in this chapter of the provision for doubtful accounts as it impacts earnings quality. The same princi- ples, on a larger scale, would apply to the provision for loan loss reserves for financial institutions. Almost all of the items on the checklist—other than those directly related to cost of goods sold—would apply to most types of business firms, including service- oriented companies. Using the Checklist 1Harris Collingwood, “The Earnings Game: Everyone Plays, Nobody Wins,” Harvard Business Review, June 2001. Each item on the checklist in Exhibit 5.1 will be discussed and illustrated with examples from publicly held corporations. I. Sales or Revenues 1. Premature Revenue Recognition According to generally accepted accounting principles (GAAP), revenue should not be recognized until there is evidence that a true sale has taken place; that is, delivery of products has occurred or title to those products has passed to the buyer, or services have been rendered, the price has been determined, and collection is expected. Unfortunately, many firms have violated this accounting principle by recording revenue before these conditions have been met. While users of financial statements usually cannot determine if revenue has been recorded prematurely, clues that some- thing is amiss can be found by analyzing key areas of the financial statements, such as the relationship among sales, accounts receivable, the allowance for doubtful accounts, and inventories. Sunbeam, in an effort to boost revenues in the years 1995–1997, chose to book sales of backyard grills and related products during the winter months, even though the goods weren’t shipped to customers until the spring. Sunbeam permitted customers to defer payment and also to return for full credit any unsold items.1 What readers of Sunbeam’s 1997 annual report could have found as clues to the problems involve the relationship between accounts receivable and sales (discussed in Chapter 2) and the growth in inventories relative to sales. Between 1996 and 1997, sales grew 19%, while receivables grew 38.5%, indicating the company might not be successful in collecting on sales. Inventory increased by 58%, which means the company may not actually be selling the goods produced. Sunbeam ultimately had to restate earnings for 1995–1997 because of its revenue recognition practices and other problems, leading eventually to bankruptcy. IS B N : 0-536-48044-3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. CHAPTER 5 A Guide to Earnings and Financial Reporting Quality 155 2Sarah Ellison and Scott Kilman,“SEC Expands Food-Industry Probe,” Wall Street Journal, November 6, 2003. 3Almar LaTour, “How a Quest for Rebates Sent Ahold on Unusual Buying Spree,” Wall Street Journal, March 6, 2003. 4Charles Forelle, “Improper Booking Wasn’t Unusual at CA, Court Told,” Wall Street Journal, January 23, 2004. Royal Ahold, a Dutch company, corporate parent of U.S. Foodservice, and the world’s largest supermarket operator, announced in 2003 that its executives had inflated revenues, requiring a restatement of its earnings by $880 million.2 With the outlook for bonuses bleak, executives at U.S. Foodservice embarked on a strategy to order huge quantities of food from manufacturers who agreed to pay the distributor hefty rebates. By booking the rebates immediately and prematurely, earnings could be increased. The consequences of this action have resulted in the company’s having to cut prices, sometimes below cost, to unload the excess inventory acquired. In addition, the stock price of the firm dropped over 65%, reducing the $33 billion market value as of June, 2001, to about $2.7 billion in March, 2003.3 Another scheme used to inflate revenues is to keep the accounting books open longer than the end of the quarter. Computer Associates may have used such a strategy, referred to as the “35-day month practice,” to prematurely record more than $1 billion of revenue in fiscal year 2000.The company ended use of this practice in 2001, causing the firm to miss the earnings expectations on Wall Street. A dramatic drop in stock price was the result.4 2. Gross Versus Net Basis Another tactic to boost revenues is to record sales at the gross rather than the net price. Reading the notes to the financial statements to determine how revenue is recorded can enlighten users of financial statements that a firm is recording at gross prices. In the Yahoo! 2004 Annual Report, the company states: The Company generates revenue from the display of text based links to the web- sites of its advertisers which are placed on the websites of third party entities (which the Company refers to as affiliates) who have integrated the Company’s sponsored search offerings into their websites.The Company recognizes revenue from these arrangements as “click-throughs” occur.“Click-throughs” are defined as the number of times a user clicks on an advertiser’s listing. The Company pays affiliates based on click-throughs on the advertiser’s listings that are displayed on the websites of these affiliates. These payments are called traffic acquisition costs. In accordance with EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal Versus Net as an Agent,” the revenue derived from these arrangements that involve traffic supplied by affiliates is reported gross of the payments to affiliates. This revenue is reported gross due to the fact that the Company is the primary obligor to the advertisers who are the customers of the advertising service. Securities and Exchange Commission (SEC) guidelines allow companies such as Yahoo! to record revenues at gross amounts when the company acts as a principal in the transaction.5 The problem from a financial statement user’s perspective is that, in 5“Revenue Recognition in Financial Statements,” Staff Accounting Bulletin No. 101, Washington, DC, Securities and Exchange Commission, December 3, 1999. IS B N : 0- 53 6- 48 04 4- 3 Understanding Financial Statements,Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright © 2007 by Pearson Education, Inc. 156 CHAPTER 5 A Guide to Earnings and Financial Reporting Quality reality, the company will receive only the net amount when the transaction is complete. Google