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Appendix B
Quality of Earnings Cases: A Comprehensive Review
Multiple Choice Questions
1. 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?

a. Company 1
b. Company 2
c. Company 3
d. Company 4
Answer: B
Because Company 2 is apparently selling off long-term assets to finance operating cash flow
losses and payments to capital providers as well as to de-emphasize its negative cash flows
from operations.
2. 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?
a. Morton

b. Starburst
c. Ames
d. Summers
Answer: C
Because Ames’ depreciation is out of line with the other companies indicating a 50 year life,
which is highly unlikely.
3. 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?
a. Company 1
b. Company 2
c. Company 3
d. Company 4
Answer: D
accounts receivable changes are not in line with changes in sales, which are declining from
2009 to 2010.
4. 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?
a. Company 1
b. Company 2
c. Company 3
d. Company 4
Answer: B
inventory changes are not in line with changes in sales.
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.

Based on this limited information, which company likely has the weakest quality of earnings
at Year 4 or 2012?
a. Company 1
b. Company 2
c. Company 3
d. Company 4
Answer: D

because there is a reduction of discretionary expenditures for R & D and advertising.
6. 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?
a. Company 1
b. Company 2
c. Company 3
d. Company 4
Answer: C
because items that are expected to be persistent in terms of earning are those transactions like
research and development costs, that are expected to be repeated in future years during the
normal operation of the business. The other items, like a charge for disposal of a business
segment, a provision for restructuring, and litigation charges, are all items that are not
expected to occur again in future years.
7. 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?
a. Company 1
b. Company 2

c. Company 3
d. Company 4
Answer: B
Company 2 is consistent with the industry averages and also shows no P/E ratios below the
industry average or declining ratio trends.
8. 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
Answer: A
Based on the information provided in this problem, the conservatism ratio of each company
can be computed, indicating that the lower the ratio, the more conservative the company. The
higher conservatism ratio indicates that management is more aggressive with its tax policies
and results in higher future tax liabilities. Company 1’s conservatism ratio is the lowest and it
therefore has stronger earning power.

Short Problems
1. 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.
Answer: a. (1) During 2008 the company changed depreciation methods. This change
resulted in an increase of the book value of the assets versus if no change in accounting
method had occurred. In other words, the depreciation expense went down by the same
amount, i.e., $10,000. A decrease in the depreciation expenses would increase the net income
by the same amount, i.e., $10,000.
(2) During 2010 the company changed its method of inventory valuation, which also
increased the book value of the inventory. Since the cost of inventory is allocated either to the
cost of goods sold account or to the ending inventory account, this change implies that the
Cost of Goods Sold decreased by $18,000. This would also increase the net income by
$18,000.
Overall it seems the company is having a bad year and is attempting to use liberal accounting
policies to paint a “rosy” picture of the operations.

The adjusted net income figures indicate that if the company had not changed accounting
methods, it would have reported declining profits. In fact, the company would have reported
net income of only $30,000 in 2010. The reported net income figures have been enhanced
with accounting techniques rather than by sound economic health. Consequently, the
company's performance would be viewed less positively.
2. 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.
Answer: As a loan officer, there should be concern about the potential borrower’s ability to
meet its debts as they come due. Since both companies are requesting only nine-month loans,
you should be interested in the potential borrowers' short-term solvency. Therefore, you
would examine their current ratios and quick ratios. Further, you would consider the effect of
the potential loan on these ratios. The current ratio is calculated as current assets divided by
current liabilities.
Seaton: $715,000 ÷ ($285,000 + $125,000) = 1.74
Martin: $835,000 ÷ ($325,000 + $125,000) = 1.86
It appears that both companies have more than sufficient current assets to meet their current
obligations, including the new loan. However, some current assets, such as prepaid expenses
and inventory, are not near-cash assets. Thus, a better measure of a potential borrower's
ability to meet its current obligations is the quick ratio. This ratio is calculated as the sum of
cash, marketable securities, and accounts receivable divided by current liabilities. Again, the
effect of the new loan should be considered.

Seaton: ($15,000 + $215,000) ÷ ($285,000 + $125,000) = .561
Martin: ($160,000 + $470,000) ÷ ($325,000 + $125,000) = 1.400
Based on the quick ratio, Martin appears to be a much better risk than Seaton. Martin has
approximately 2.5 times more near-cash assets available than Seaton to meet its current
obligations. Therefore, Martin does not have to rely as heavily on converting other assets to
cash as Seaton does to meet its obligations. The company that can most readily convert its
inventory and receivables to cash might be the better risk. Two possible measures of a
company's ability to generate cash from its receivables and inventory are the turnover and
number-of-days ratios. Receivables turnover is calculated as net credit sales divided by
average accounts receivable, and the number of days for receivables is calculated as 365
divided by the receivables turnover.

These ratios indicate that Seaton, on average, collects its receivables 27 days quicker than
Martin. Therefore, Seaton can more easily convert its receivables to cash than Martin can.
Inventory turnover is calculated as cost of goods sold divided by average inventory, and the
number of days is calculated as 365 divided by inventory turnover.

These ratios bode well for Martin. Martin sells its inventory, on average, 73 days sooner than
Seaton sells its inventory. This difference implies that Martin generates more sales which, in
turn, implies that it generates more accounts receivable. Although Martin does not turn over
its receivables as often as Seaton, it has a larger amount of receivables to turn over. Thus,
Martin potentially has more assets that can easily be converted into cash than Seaton.

Based upon Martin's superior quick ratio and potential ability to generate cash from its larger
receivables base, the recommendation should be that the bank grants the loan to Martin.
3. 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.
Answer: a. Return on Equity = Net Income ÷ Average Stockholders' Equity
2008: $51,000 ÷ [($100,000 + $100,000) ÷ 2] = 0.51 or 51%
2009: $49,000 ÷ [($100,000 + $290,000) ÷ 2] = 0.25 or 25%
2010: $51,500 ÷ [($290,000 + $315,000) ÷ 2] = 0.17 or 17%
2011: $50,500 ÷ [($315,000 + $510,000) ÷ 2] = 0.12 or 12%
It appears that the additional capital provided by the owners has not been used to generate net
income. The company's net income has been relatively constant from 2008 to 2011. If the
company had been effective at using the additional capital, the company's net income should
have increased, and return on equity should have been relatively constant or increasing over
time. However, if the company has used the additional capital for long-term projects, such as
a new product, these projects may not generate any net income for several years. Once these
projects begin generating income, the company's return on equity may increase to more
appropriate levels. Therefore, the effectiveness of the company at using the owners' capital
cannot be adequately evaluated without additional information.

b. It appears that the company has overinvested in inventory. The inventory turnover and the
days' supply of inventory for each year are:

These ratios indicate that the company went from having one month's supply of inventory on
hand to having almost three months of inventory on hand. It appears that the company has
more inventory on hand than is warranted, given demand for the inventory. The company
could reduce inventory on hand and invest the proceeds in income-producing assets such as
marketable securities. Such a move would make the company more profitable and provide
owners a greater return on their investments. This change in investment policy would
increase the company's return on equity.
4. 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?
Answer: a. Return on Equity = Net Income ÷ Average Stockholders' Equity

Based on return on equity, Turner is almost twice as efficient as Roper at managing the
shareholders’ capital. If unusual items were not considered, return on equity for each
company would be:

Turner now appears to be considerably worse than Roper at managing the stockholders'
capital. Including unusual items in calculating return on equity does provide a more complete
measure of how efficiently a company managed its stockholders' equity in the current year.
However, since unusual items are, by definition, items that occur infrequently, these items do
not indicate a company's continued ability to efficiently manage the stockholders' capital.
Thus, unusual items probably should not be used to calculate return on equity.
b. Financial leverage indicates how effectively a company uses debt for the benefit of
stockholders. Financial leverage equals return on equity less return on assets. Thus, return on
assets must be calculated before calculating financial leverage.
Return on Assets = (Net Income + Interest Expense (net of tax)) ÷ Average Total Assets

Financial Leverage = Return on Equity – Return on Assets

From this analysis, Roper is approximately twice as effective as Turner at using debt to
generate returns for its stockholders. If unusual items are not considered, the return on assets
for each company would be:
Roper: ($610,000 + $100,000) ÷ [($3,360,000 + $3,360,000) ÷ 2] = 0.211
Turner: [($1,675,000 – $1,300,000) + $175,000] ÷ [($1,870,000 + $1,870,000) ÷ 2] = 0.294
Therefore, the financial leverage of the two companies would be:
Roper: 0.607 – 0.211 = 0.396
Turner: 0.260 – 0.294 = –0.034
If extraordinary items are not considered, Turner has negative financial leverage. That means
that Turner is not generating a large enough return on its debt to even cover the interest
expense. Thus, Turner is using debt to the detriment of its stockholders. It appears, therefore,
that extraordinary items can affect the conclusions one draws when analyzing a company and
its quality of earnings.
5. 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?
Answer: Working through an accounting adjustment due to a change in the tax rates of the
Toledo operations, Carlton earned $200,000, rather than through its operations. A change in
the expected tax rate can lead to a positive effect on reported earnings due to the fact that tax
liability was accrued at a higher tax rate and eventually paid at a lower tax rate. However, the

quality of earnings and overall wealth of the company is not increased by this transaction. It
seems that Carlton estimated its tax liability to be higher, and it had to pay much less lower
taxes at the end of the year. This is similar to a change of an accounting estimate.
6. 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?
Answer: 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."
7. 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.
Answer: The most likely scenario is that the company has been paying a dividend and is still
generating enough cash to pay the dividend but decides not to. This is usually because the
company feels that it has very good investment opportunities and wants to use the money to
pursue them. This is usually a positive sign and the stock price may rise.

Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt, Michael F. Peters
9780470635292, 9781119537571, 9781119444367

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