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Exam 16: Quality of Earnings Cases: A Comprehensive Review

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Exam 1: Financial Accounting and Its Economic Context104 Questionsadd course
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Exam 16: Quality of Earnings Cases: A Comprehensive Review15 Questionsadd course
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The following information is presented from the financial statement of four companies that operate in the same industry, use similar processes, and are competitors in the same market. The following information is presented from the financial statement of four companies that operate in the same industry, use similar processes, and are competitors in the same market. Based on this limited information, which company likely has the weakest quality of earnings? Based on this limited information, which company likely has the weakest quality of earnings?

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Question 1
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B

Xenon, a major defense contractor, was faced with huge liabilities and feared violation of debt covenants. Therefore, Xenon declared Chapter 11 bankruptcy protection. Under Chapter 11, a company continues to operate but is protected from creditors while it tries to work out a reorganization plan. At that time the company's management chose to take several significant charges under bankruptcy proceedings, including a $1 million liability not required by GAAP, but that better reflected its commitments to employees. Required: Why would Xenon's management have chosen to take these charges at this time?

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As part of the Chapter 11 reorganization, Xenon can negotiate new credit agreements. These credit agreements contain debt covenants, most likely related to the amount of debt Xenon can have. If Xenon waited until after emerging from Chapter 11, the $1 million liability along with other charges might have caused the company to violate the amount of allowable debt as specified in its debt agreements. Such a violation could have forced the company back into Chapter 11 or to renegotiate its debt agreements at less favorable terms. By recording the charges prior to negotiating its new debt agreements, the new charges would be considered by creditors in creating the debt covenants. Thus, this liability would not place Xenon into an automatic violation of its debt covenants. Reasons for taking several significant charges while under bankruptcy proceedings include:
(1) The significant charges would adversely affect Xenon's reported results of operations and financial position, and Xenon may have been trying to extract more favorable settlement terms from its creditors by demonstrating weakened performance and financial position.
(2) Xenon may have been positioning itself to show improved performance once it emerged from Chapter 11. By taking the charges now, not only does Xenon avoid having to reduce its earnings in the future, but it also reduces the company's earnings so much that its earnings can only increase next year. This latter strategy is known as "taking a bath."

The following information is presented from the financial statement of four companies that operate in the same industry, use similar processes, and are comparable in size. The following information is presented from the financial statement of four companies that operate in the same industry, use similar processes, and are comparable in size. Based on this limited information, which company likely has the weakest quality of earnings? Based on this limited information, which company likely has the weakest quality of earnings?

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Question 3
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D

The net income amounts for Box and Wood, Inc. over a four-year period is as follows: The net income amounts for Box and Wood, Inc. over a four-year period is as follows: After further examination of the financial report, you note that Box and Wood, Inc. made accounting method changes in 2008 and 2010, which affected net income in those periods. In 2008, the company changed depreciation methods. This change increased the book value of its fixed assets in each subsequent year by $10,000. In 2010, the company adopted a new inventory method that increased the book value of the inventory by $18,000. Requirements: a. Calculate the effect of each of these changes on net income in the year of the change. b. Prepare a chart that compares net income across the four-year period, assuming that Box and Wood, Inc. made no accounting changes. How would your assessment of the company's performance change after you learned of the accounting method changes? c. What principle of financial accounting makes it difficult to make such changes? Describe the conditions under which Box and Wood, Inc. would be allowed to make changes in their accounting methods. After further examination of the financial report, you note that Box and Wood, Inc. made accounting method changes in 2008 and 2010, which affected net income in those periods. In 2008, the company changed depreciation methods. This change increased the book value of its fixed assets in each subsequent year by $10,000. In 2010, the company adopted a new inventory method that increased the book value of the inventory by $18,000. Requirements: a. Calculate the effect of each of these changes on net income in the year of the change. b. Prepare a chart that compares net income across the four-year period, assuming that Box and Wood, Inc. made no accounting changes. How would your assessment of the company's performance change after you learned of the accounting method changes? c. What principle of financial accounting makes it difficult to make such changes? Describe the conditions under which Box and Wood, Inc. would be allowed to make changes in their accounting methods.

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Question 4

-You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications. Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover. -You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications. Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover. -You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications. Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover. -You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications. Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover. -You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications. -You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications. Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover. Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover.

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Question 5

The following information is presented from the financial statement of four companies that operate in the same industry, use similar processes, are similar in size, and are competitors in the same market. The data cover Years 2009 to 2012. The following information is presented from the financial statement of four companies that operate in the same industry, use similar processes, are similar in size, and are competitors in the same market. The data cover Years 2009 to 2012. Based on this limited information, which company likely has the weakest quality of earnings at Year 4 or 2012? The following information is presented from the financial statement of four companies that operate in the same industry, use similar processes, are similar in size, and are competitors in the same market. The data cover Years 2009 to 2012. Based on this limited information, which company likely has the weakest quality of earnings at Year 4 or 2012? Based on this limited information, which company likely has the weakest quality of earnings at Year 4 or 2012?

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Question 6

Carlton Electronics posted net income of $500,000 in 2009, compared with a loss of $100,000 in 2008. Over $200,000 of the 2009 profit was due to a problem with faulty approximation in its Toledo operations. The problem occurred when a tax liability had been accrued in prior years assuming a higher tax rate that was actually in effect when the taxes were paid. Required: How do you interpret this in terms of quality of earnings? How can a change in expected tax rates lead to a positive effect on reported earnings? Does the $200,000 represent an increase in overall wealth of the company?

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Question 7

-The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries: Required: a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not? b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income? -The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries: Required: a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not? b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income? -The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries: Required: a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not? b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income? -The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries: Required: a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not? b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income? -The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries: -The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries: Required: a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not? b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income? Required: a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not? b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income?

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Question 8

When looking at the statement of comprehensive income in the 2009 annual reports of four similar companies in the same industry, you find the following: When looking at the statement of comprehensive income in the 2009 annual reports of four similar companies in the same industry, you find the following: Which company has an expense item that is likely to be persistent in terms of earnings? Which company has an expense item that is likely to be persistent in terms of earnings?

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Question 9

-Parton Company began operation on January 1, 2008. The initial investment by the owners was $100,000. The following information was extracted from the company's records. Required: a. Compute the return on equity for each year. (Assume a $0 inventory for January 1, 2008). Has the company been effective at managing the capital provided by the equity owners? b. Does the information about inventory and the cost of goods sold indicate any reason for the trend in return on equity? Support your answer with any relevant ratios. -Parton Company began operation on January 1, 2008. The initial investment by the owners was $100,000. The following information was extracted from the company's records. Required: a. Compute the return on equity for each year. (Assume a $0 inventory for January 1, 2008). Has the company been effective at managing the capital provided by the equity owners? b. Does the information about inventory and the cost of goods sold indicate any reason for the trend in return on equity? Support your answer with any relevant ratios. -Parton Company began operation on January 1, 2008. The initial investment by the owners was $100,000. The following information was extracted from the company's records. Required: a. Compute the return on equity for each year. (Assume a $0 inventory for January 1, 2008). Has the company been effective at managing the capital provided by the equity owners? b. Does the information about inventory and the cost of goods sold indicate any reason for the trend in return on equity? Support your answer with any relevant ratios. -Parton Company began operation on January 1, 2008. The initial investment by the owners was $100,000. The following information was extracted from the company's records. Required: a. Compute the return on equity for each year. (Assume a $0 inventory for January 1, 2008). Has the company been effective at managing the capital provided by the equity owners? b. Does the information about inventory and the cost of goods sold indicate any reason for the trend in return on equity? Support your answer with any relevant ratios. -Parton Company began operation on January 1, 2008. The initial investment by the owners was $100,000. The following information was extracted from the company's records. -Parton Company began operation on January 1, 2008. The initial investment by the owners was $100,000. The following information was extracted from the company's records. Required: a. Compute the return on equity for each year. (Assume a $0 inventory for January 1, 2008). Has the company been effective at managing the capital provided by the equity owners? b. Does the information about inventory and the cost of goods sold indicate any reason for the trend in return on equity? Support your answer with any relevant ratios. Required: a. Compute the return on equity for each year. (Assume a $0 inventory for January 1, 2008). Has the company been effective at managing the capital provided by the equity owners? b. Does the information about inventory and the cost of goods sold indicate any reason for the trend in return on equity? Support your answer with any relevant ratios.

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Question 10

The following chart presents the cash flow profiles of four companies. All four companies are in the same industry and are comparable in size. Based on this limited information, which company likely has the weakest quality of earnings? The following chart presents the cash flow profiles of four companies. All four companies are in the same industry and are comparable in size. Based on this limited information, which company likely has the weakest quality of earnings?

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Question 11

The following information was taken from the 2009 annual reports of four different companies in the same industry. The following information was taken from the 2009 annual reports of four different companies in the same industry. Based on this limited data, which company appears to be more conservative and have stronger earning power? a. Company 1 b. Company 2 c. Company 3 d. Company 4 Based on this limited data, which company appears to be more conservative and have stronger earning power? a. Company 1 b. Company 2 c. Company 3 d. Company 4

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Question 12

You are reviewing the annual report for Mega City Electronics. You noticed that Mega City cut its dividend last year and the stock price when up. Required: Explain how a dividend cut could lead to an increased stock price.

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Question 13

The following information is available on four different companies. Assume that there is no salvage value on the equipment. All companies operate in the same industry and use similar processes and equipment. The following information is available on four different companies. Assume that there is no salvage value on the equipment. All companies operate in the same industry and use similar processes and equipment. Based on this limited information, which company likely has the weakest quality of earnings? Based on this limited information, which company likely has the weakest quality of earnings?

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Question 14

The following information is available on four different companies. All companies operate in the same industry, are of similar size, and use similar processes and equipment. The following information is available on four different companies. All companies operate in the same industry, are of similar size, and use similar processes and equipment. Based on this limited information, which company likely has the highest quality of earnings at the end of the three year period? Based on this limited information, which company likely has the highest quality of earnings at the end of the three year period?

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Question 15
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