Business 30116 (sections01, 02, & 85) Course Pack
Accounting and Financial Analysis I
Philip G. Berger
Wallace W. BoothProfessor of Accounting
BoothSchool of Business
University of Chicago
Chicago, IL
Autumn 2012
Class Notes
Professor Berger B30116 – Table of Contents Autumn 2012
Chapter Name of Itempage number
A.First Class Assignment...... 3
B.Syllabus...... 7
C.FASB and IFRS Standards Listing...... 15
1.The Audit Report
1a. Audit Report Notes...... 19
1b. Blyth, Inc. (CASE #1)...... 25
1c.“New SEC Rules Will Likely DrawMore 8-K Filings”...... 41
1d.“Not Everyone Hates SarbOx”...... 43
2.Income Taxes and Deferred Income Tax Accounting
2a. Introduction to Deferred Taxes...... 47
2b. Details on Deferred Taxes...... 49
2c. Example of Temporary and Permanent Differences...... 53
2d. MDC Manufacturing Problem...... 55
2e. Taxes – Lecture 1 Slides...... 57
2f. Taxes – Lecture 2 Slides...... 69
2g. Tax Disclosures – Cheat Sheet...... 73
2h. Monterey Pasta Company (CASE #2)...... 77
2i. Self-Study Problem 1 – Anheuser-Busch...... 89
2j. Solution to Self-Study Problem 1...... 95
2k. Self-Study Problem 2 – Illustrative Example...... 97
2l. Solution to Self-Study Problem 2...... 99
3.Revenue Recognition & Securitization
3a. Revenue Recognition Notes...... 107
3b. Self-Study Problem 3 – U.S. Air...... 111
3c. Solution to Self-Study Problem 3...... 121
3d. Installment Method Notes...... 123
3e. Factoring of Accounts Receivable - Notes...... 127
3f. Patten Corporation (CASE #3)...... 131
3g-(i)Securitization Notes ...... 161
3g-(ii)More Details on SPEs and Securitization...... 171
3h.Overview of FASB Statement No. 140...... 181
3i. Navistar Financial (CASE #4) ...... 185
4.Statement of Cash Flows Analysis
4a. SCF Classification Issues...... 203
5.Ratio and Profitability Analysis
5a. Profitability Analysis...... 213
5b. Ratio Analysis...... 215
6.Capitalization and Write-Offs
6a. Interest Capitalization – An Illustration...... 221
6b. Long-Lived Assets Slides...... 223
6c. McCormick and Co. (CASE #5)...... 231
6d. Sunbeam Corporation (A) (CASE #6)...... 237
Professor Berger B30116 - Table of Contents (continued) Autumn2012
Chapter Name of Itempage number
7. Intercorporate Investments
7a. Investments, Significant Influence & Control, Notes.... 265
7b. Purchase Accounting: A Simple Example ...... 271
7c. Purchase Accounting: A Simple Example (Solution Notes) 273
7d. The Equity Method: A Simple Example...... 275
7e. The Equity Method: A Simple Example (Solution Notes)... 277
7f. “Mishmash Accounting” ...... 281
7g. “The Real Thing: Bottling Plan Taps Coke's Profits” ...283
7h. “Firms Facing Rule to Include Results From Minor Stakes” 285
7i. New FASB Rule on Accounting for Minority Stakes...... 287
7j. The Coca-Cola Company (CASE #7) ...... 291
8.Long-Term Debt Overview
8a. Long-Term Debt Obligations, Slides...... 305
8b. Bonds – Example Problem...... 307
8c. Convertible Debentures – Example Problem...... 309
8d. Super-LYONs...... 311
9.Long-Term Debt Application
9a.“Kirk Kerkorian’s Personal Money Machine”...... 315
9b.Metro-Goldwyn-Mayer (CASE #8)...... 319
10.Lease Accounting Overview
10a. Leases, Slides...... 325
10b. Transforming Capital to Operating Leases (& vice-versa). 329
10c. Leases – Example Problem...... 331
10d. Giant Food Inc. – Lessee Accounting (CASE #9)...... 335
10e.Lessor Accounting...... 339
11.Capital Leases for the Lessor: Application
11a.Crime Control – Notes on how to solve question 2...... 343
11b.“You Better Believe”...... 345
11c. Crime Control (CASE #10)...... 347
12.Analysis of Earnings Quality
12a.Prototype Company – Income Statement Format...... 377
12b.The Seven Financial Statement Shenanigans...... 379
12c. Red Flags of Questionable Earnings Quality...... 381
12d. The Role of Accounting Analysis...... 383
12e. Wired Wanda’s (CASE #11)...... 385
13.Accounting and Organizational Form
13a.“The Squawk Over BostonChicken”...... 397
13b.Boston Chicken, Inc. (CASE #12)...... 401
14.Employee Stock Options and Earnings Per ShareCalculations
14a.Notes on Employee Stock Options ...... 419
14b.Notes on EPS Calculations...... 425
14c.Microsoft Corporation (CASE #13)...... 427
14d.Who Rules Accounting?...... 437
Professor Berger B30116 - Table of Contents (continued) Autumn 2012
Chapter Name of Itempage number
15.Course Summary Notes...... 445
16.Homework #1 Questions (Due Oct. 19th/20th)...... 453
17.Homework #1 Financial Statements...... 463
18.Homework #2 Questions (Due Nov.9th/10th)...... 477
19.Homework #2 Financial Statements...... 489
20.Homework #3 Questions (Due Dec.7th/8th)...... 509
21.Homework #3 Financial Statements...... 519
22.Sample Exam Problems...... 531
23.Solutions to Sample Exam Problems...... 605
24.Spring 2003 Midterm Exam Questions, Financial Statements, and Solutions...... 621
25.Spring 2003 Final Exam Questions, Financial Statements, and Solutions...... 663
26.Fall 2010 Midterm Exam Questions, Financial Statements, and Solutions...... 715
27.Fall 2010 Final Exam Questions, Financial Statements, and Solutions...... 743
University of Chicago
GraduateSchool of Business
Accounting and Financial Analysis I – B30116
Sections 01, 02, and 85 – Fall 2012
First Day Assignment:
As indicated on the syllabus in this course packet, please read the chapter 1 packet notes on The Audit Report and then prepare a write-up for hand-in of CASE #1: BLYTH, INC . The write-up should be about three (3) to five (5) pages long (using double spacing) and should answer the four questions on the first page of the case. Please include your name and student ID number on your case write-up. The write-up will count for 5% of your course grade, but will be graded as much on effort as on correctness.
As described in the syllabus, the first day assignment write-up is to be done individually and I will be cold-calling people on their case write-ups in class. Cold-calls count for 20% of your course grade. You will be submitting your case via the Chalk, but you may also want to bring a printed copy of your case with you to help in answering if you are called on.
B30116 – BergerChapter 1 - The Audit Report
1.The Audit Report
I.Role of the Auditor
A.Auditors attest to the financial statements which are prepared by management.
1. Auditors do not attest to the quality of the firm as an investment.
2. Audits are not designed solely to detect fraud.
B.Who Audits the Auditors?
1. Auditors can be held liable for negligence.
2. After the Sarbanes-Oxley Act of 2002 (SOX), audits of publicly traded companies in the United States are overseen by the Public Company Accounting Oversight Board (PCAOB).
3. The value of an auditor to a client is based upon the auditor's reputation. Thus, auditors' desire to maintain the value of their reputation by avoiding signing off on statements that are subsequently revealed to be faulty.
II.The Audit Report
A.The Standard Report -- 4 items (the items are sometimes displayed as separate paragraphs, but are sometimes grouped together in less than 4 paragraphs).
1. Item 1 -- What statements have been audited? Who is ultimately responsible for the statements? What responsibility is the auditor assuming?
2. Item 2 -- What is the basis for the auditor’s opinion? What work was done?
3. Item 3 -- The auditor’s opinion regarding the financial statements.
a.unqualified -- statements in conformity with GAAP
b.qualified -- statements in conformity with GAAP except for some particular items
1.scope of the audit was limited -- statement of what balances were not audited
2.inadequate disclosure regarding some balances or events -- audit report usually supplements the disclosure
3.GAAP violation regarding some balances -- audit report usually quantifies magnitude of the violation
c.disclaimer of opinion -- scope of audit too limited to warrant an opinion
d.adverse -- deviations from GAAP are so extensive that a qualified opinion is not even possible (extremely rare)
4. Item 4 – This paragraph was introduced after enactment of SOX[it became effective for the first time for fiscal years ending after November 15, 2004]. In it, the auditor offered [as of the time of the Blyth case] an opinion on both internal control effectiveness and management’s assessment of internal control effectiveness[the external auditor no longer expresses an opinion about management’s assessment of the internal controls].
An example of the standard version of Item 4 as of the time of the Blyth case follows (taken from Microsoft’s annual report for the year ended June 30, 2005):
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2005, based on the criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated August 23, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
An example of the standard version of Item 4 as of today follows (taken from Microsoft’s annual report for the year ended June 30, 2008):
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June30, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July31, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting.
B.Additional Items (beyond the 4 standard items)
1. uncertainties highlighted
2. changes in accounting policy highlighted
3. emphasis of matter -- auditor wants to highlight a particular issue for the reader
4. going concern -- auditor wants to express doubt regarding the firm's ability to continue for the next fiscal year. In other words, a going-concern opinion indicates that the auditor thinks the company may not avoid bankruptcy during the next 12 months.
The Audit Report
Auditor Changes -- Some Observations
Current SEC requirements [effective since August 23, 2004] require that upon a change in auditor, a registrant must notify the public by filing certain information on Form 8-K within four business days of the change [prior to August 23, 2004 the registrant had up to 15 calendar days to file the 8-K]. The 8-K filed for the auditor change must provide the following [per SEC Regulation S-K, item 304(a)]:
- Whether the auditors resigned, declined to stand for reelection, or were dismissed, as well as the date of the auditor change.
- The type of audit report issued for the last two years, and whether it contained anything other than an unqualified opinion (e.g., going concern, disclaimer, adverse opinion, or scope limitation).
- Whether the decision to change accountants was recommended or approved by the board of directors or the audit committee.
- Whether there were any disagreements with the auditors, and the nature of such disagreements.
- Whether any of the following reportable events occurred, and their nature:
- Internal controls necessary to develop reliable financial statements don’t exist;
- Management’s representation can’t be relied on, or the auditors are unwilling to be associated with the financial statements prepared by management;
- Audit scope needs to be expanded; or
- Other information has arisen that materially impacts previous audit reports or their underlying financial statements.
- The name of the newly engaged auditors, and the effective date of engagement.
- Any consultation with the new auditors regarding accounting principles, potential opinions, or any matter that was subject to disagreements or reportable events with the predecessor auditors. If any of these have occurred, the nature of each must be described and possibly filed as an exhibit.
- The 8-K must be provided to the previous auditors. They must state their agreement or disagreement with the filing and this response should be included with the 8-K as an exhibit (previous auditors’ response letter is usually very brief to avoid controversy and reduce lawsuits).
Auditor changes result from either auditor resignations or client-initiated dismissals. Auditor resignations are more likely to occur when litigation risk (with regard to the audit report) increases or when the audited company’s financial health deteriorates. Client-initiated dismissals occur more frequently over disagreements about such issues as internal control weaknesses and the reliability of the audited company’s financial reporting.
A study by Turner, Williams and Weirich (2005) of all auditor changes filed on form 8-K during 2003 and 2004 reveals the following:
- Auditor changes are not infrequent, and have continued to increase in recent years. There were 905 companies registered with the SEC that changed auditors in 2003 and 1,609 in 2004.
- Although the filings reveal whether the auditor resigned or was fired, the underlying reason for the auditor change is not disclosed in about 2/3 of the filings. Thus, investors should always be cautious when a company announces an auditor change because it may be related to underlying but undisclosed problems in the company’s financial reporting and accounting practices. Companies often attempt to hide the real reason behind auditor changes, so investors often have to read the disclosure carefully to “dig out” the reason(s).
- About 1/3 of registrants reporting changes in auditors also had a going concern opinion included in the audit report of the departing auditor.
- About 2% of registrants reporting auditor changes in 2003 or 2004 also restated their financial statements around the time of the auditor change. About half of these companies also reported internal control weaknesses. All of these auditor changes occurred after the restatements and appeared to be related to the restatements (which may strain the auditor-client relationship).
- About 2% of registrants reporting auditor changes in 2003 or 2004 also reported accounting disagreements with the departing auditor. Companies and their auditors are required to report disagreements about accounting matters even if the disagreement is subsequently resolved to the auditor’s satisfaction [think about why the rule works in this manner]. Accounting disagreements are important because they may indicate that the company is attempting to apply improper, aggressive, or non-GAAP accounting that the auditor is unwilling to accept. A company will sometimes fire an auditor that disagrees with it and subsequently hire a more conciliatory one (this is often referred to as “opinion shopping”).
On average, auditor changes, have not been consistently associated with significant negative abnormal returns. (See, for example, Johnson and Lys (1990)).
If switches are partitioned into those that occurred after a disagreement disclosed in an 8K filing and those that reported no such disagreement, then the following average results are attained. (See, for example, Dhaliwal, Schatzberg, and Trombley (1993))
- Negative abnormal returns are observed for the disagreement subsample around the 8K filing and positive abnormal returns are observed for the remaining subsample. The magnitude of the negative abnormal return is larger.
- The disagreement subsample exhibits poorer financial performance and increasing leverage before the disagreement, and deteriorating financial performance and increasing leverage after, relative to the remaining subsample.
- The disagreement subsample has positive abnormal returns in the 12 month's after the disclosure (greater than 15%) while the remaining subsample exhibits slightly positive abnormal returns over the same period.
The impact of having a going concern opinion included as an additional item in a firm’s audit report has also been examined by a number of academic studies. These studies fall into five categories – four types of stock market effect studies, and a fifth type of study that has directly investigated how useful a going concern opinion is in predicting bankruptcy.
- (1) With regard to stock price reactions, there is a short-run negative stock price reaction to the announcement of going concern opinions [Fleak and Wilson (1994); Carlson, Glezen and Benefield (1998)].
- (2) The short-run reaction around the announcement underestimates the total economic effect, however, as the studies above also find a negative price reaction in the period leading up to the going concern announcement. This suggests that information regarding the going concern status of the firm is leaking to the market in the period prior to the issuance of the audit report.
- (3) In addition, the combined reaction during the pre-announcement plus announcement periods may represent an under-reaction to the news content of the going concern opinion, as the stock returns of firms receiving going concerns are abnormally low for anywhere from one quarter to one year following the going concern announcement [Elliott (1982); Taffler, Lu and Kausar (2004); Kausar, Taffler and Tan (2009)].
- (4) A going concern audit opinion if not a prediction by the auditor about bankruptcy and U.S. auditing standards are explicit in saying that users of financial statements should not interpret a going concern opinion as a prediction of bankruptcy [why do you think the auditor issues a going concern opinion if it is not an attempt to make a prediction about bankruptcy?]. Nevertheless, going concern opinions do indicate an increased likelihood of bankruptcy. This link has been studied indirectly by examining how the stock price reaction to a bankruptcy announcement is affected by having a preceding going concern audit opinion. Chen and Church (1996), Holder-Webb and Wilkins (2000) and Tan (2000) all find that the negative price reaction to a bankruptcy announcement is reduced when it is preceded by a going concern audit opinion. This suggests that the going concern opinion causes investors to increase the probability they assign to a bankruptcy for the firm.
- (5) Other papers directly examine how useful a going concern opinion is in predicting bankruptcy. Hopwood, McKeown and Mutchler (1989) find that going concern audit opinions provide useful information for predicting bankruptcy beyond what is obtainable from financial statement data alone. While going concern opinions are a useful addition to other variables in predicting bankruptcy, they do not have great predictive power by themselves. Thus, Raghunandan and Subramanyam (2003) find that traditional bankruptcy prediction models do a better job of forecasting bankruptcy than the existence of a going concern audit opinion does.
The Audit Report – Summary
1.Auditor reports are useful because they contain information regarding the following.
.What information was audited?
.Highlights of accounting issues the auditor deems important.
.Highlights of other information the auditor deems important.
.Identification of the auditor allows the reader to infer auditor changes.
- Analyze auditor changes and attempt to assess the reasons for auditor changes.
Item 1aAudit Report NotesPage 1 of 6
B30116 – BergerChapter 1 - The Audit Report
CASE #1 Blyth, Inc.
1.The auditor's report for the fiscal 2003 (i.e., year ended January 31, 2004) financial statements of Blyth, Inc. is on page 2 of the case. Items from the fiscal 2003 10-K filing that are related to the auditor's report follow on pages 3 and 4.
a.What standard information relevant to users of Blyth's financial statements is contained in the 2003 auditor's report?
b.How does the 2003 audit report depart from the standard audit report? What is the purpose served by the departure(s)?
c.What purposes are served by the additional items from the 10-K that follow the auditor’s report?