Earnings Quality Analysis Assignment

Analyze the results (trends) for the for 20X1 through 20X5, for the FirstRate company, and write your comments in 150 words or less.By completing this assignment, you will learn how to assess the quality of earnings of a business by examining the relationship between its reported accounting income and cash flows from operating activities over several accounting periods, including the nature and trend of its accounting accrualsThe topic 3 document attached is just for reference if needed. The attached topic 4 document is the assignment
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Topic 4
Earnings Quality Analysis
College of Business and Economics
Master of Business Administration
MBA C604 Accounting and Finance Concepts for Managers
17F8W2
FirstRate Company and subsidiaries
Quality of Earnings Analysis
Ma
Fiscal year ended December 31,
20X1
Net income
Adjustments to reconcile Net Inc to OCF
20X2
20X3
20X4
20X5
$23,900
$24,900
$22,000
$18,100
10,500
11,200
11,700
12,000
â??
â??
â??
â??
900
â??
â??
â??
Decrease (increase):Accounts Receivable, net
-2,000
-8,000
-11,000
-13,000
Decrease (increase) in inventory
Increase (decrease) in accounts payable
-4,400
2,200
-14,000
11,100
-14,900
10,100
-17,700
15,400
Increase (decrease): Accrued Income Tax Pay
-300
100
-400
-400
Increase (decrease): Accrued Interest Payable
100
200
400
600
Net Cash provided by (used in) Oper Activities
$30,900
$25,500
$17,900
$15,000
Depreciation: Property, Plant, and Equipment
Gain on disposal of equipment
Loss on sale of equipment
Changes in working capital accounts
Ratio of OCF-to-Net income
Cumulative ratio of OCF-to-Net income
1
For this assignment, the 20X5 currency amounts come from the SCF in the Topic 3 (Financial
Accounting) Assignment you previously completed. Before completing THIS assignment, be sure you
have made any changes or corrections indicated by your instructor/facilitator on the SCF workbook tab
of your returned Topic 3 assignment to the extent that they relate to the operating cash flow (OCF)
section of your SCF. (Recall that, OCF is the first section of a SCF, preceding the “investing” CF section of
the SCF. In case you remain uncertain about this, net cash provided by operating activities in 20X5
should be $1,300 in your finalized SCF for 20X5.)
Studentâ??s narrative analysis is limited to 150 words. Please provide your word count here:
Your response here:
1
Your response here:
FirstRate Company and subsidiaries
Quality of Earnings Analysis
(U.S. dollars in thousands)
Fiscal year ended December 31,
20X1
Net income
Adjustments to reconcile Net Inc to OCF
20X2
20X3
$23,900
$24,900
$22,000
10,500
11,200
11,700
â??
â??
â??
900
â??
â??
Decrease (increase):Accounts Receivable, net
-2,000
-8,000
-11,000
Decrease (increase) in inventory
Increase (decrease) in accounts payable
-4,400
2,200
-14,000
11,100
-14,900
10,100
Increase (decrease): Accrued Income Tax Pay
-300
100
-400
Increase (decrease): Accrued Interest Payable
100
200
400
Net Cash provided by (used in) Oper Activities
$30,900
$25,500
$17,900
Ratio of OCF-to-Net income
Error
Error
Error
Cumulative ratio of OCF-to-Net income
Error
Error
Error
Depreciation: Property, Plant, and Equipment
Gain on disposal of equipment
Loss on sale of equipment
Changes in working capital accounts
s
ended December 31,
20X4
20X5
1
$18,100
Error
12,000
Error
â??
Error
â??
-13,000
Error
-17,700
15,400
-400
Error
Error
Error
600
Error
$15,000
Error
Error
Error
Error
Error
B10
Background Paper:
Financial Statement
Concepts and Financial
Reporting
College of Business and Economics
Master of Business Administration
MBA C604 Accounting and Finance Concepts for Managers
Contents
Topic 3
ï?·
Introduction and Purpose
ï?·
General-Purpose Financial Statements
ï?·
Regulatory Structure of Financial Reporting by U.S. Public Companies
ï?·
Objective of Financial Reporting
ï?·
The Accounting Information System and the Accounting Cycle
ï?·
Events and Transactions Recognized in the Accounting Information System
ï?·
Accrual Basis Accounting
ï?·
Content and Meaning of General-Purpose Financial Statements
â?? Balance Sheet (or Statement of Financial Condition)
â?? Income (or Operating) Statement and Statement of Comprehensive Income
â?? Cash Flow Statement
â?? Statement of Changes in Stockholdersâ?? Equity
â?? Footnote Disclosures
ï?·
Financial Statement Articulation
ï?·
Definitions of Financial Statement Elements
ï?·
Desired Qualitative Characteristics of Accounting Information
ï?·
Basic Assumptions and Principles of, and Constraint on, Financial Reporting
Topic 4
ï?·
Limitations on the Usefulness of Financial Statements
â??
â??
â??
â??
Trade-offs between Relevance and Representational Faithfulness due to Articulation and Conservatism
Definitions of Financial Statement Elements and Measurement Uncertainty
Political Influence and Accountings Principles that Fail to Reflect Economic Reality
Management Judgment: Accounting Policy Choices, Accounting Estimates, and Earnings Management
ï?·
Earnings Management: Cosmetic and Real
â?? Earnings Management Incentives
â?? Earnings Management Indicators
â?? Earnings Quality and Effects of Earnings Management
ï?·
Ethical Dimensions of Financial Reporting
1
Introduction and Purpose
As a student in this course, you previously completed a financial accounting principles course (as well as a
managerial accounting principles course). Your financial accounting principles course introduced you to:
â?? General-purpose financial statements,
â?? Accrual accounting as the basis for such financial statements, and
â?? The essential accounting systems and processes that businesses maintain to support their financial
reporting
The users of these reports include managers and external parties, such as investors and creditors.
Of course, this foundational accounting skill and knowledge is necessary for students pursuing careers as
accounting, auditing, and finance professionals. However, as an effective manager of a businessâ?? marketing,
operations, or other functions, you need the skill of financial reporting literacy. The purpose of this background
paper is to help you build on your foundational skills by acquiring this literacy.
Financial reporting literacy means that a manager is able to interpret general-purpose financial statements in
connection with making business decisions, including those related to a businessâ?? strategy, operations,
investments, and finances. In making such business decisions, managers who have financial reporting literacy
appreciate the limitations of general-purpose financial statements. To acquire financial reporting literacy,
managers must examine:
ï?·
ï?·
ï?·
ï?·
ï?·
ï?·
ï?·
The objective and basic regulatory framework of financial reporting
The content and meaning of general-purpose financial statements, including the elements comprising
them, and how they articulate with each other
The desired qualitative characteristics of accounting information
The basic assumptions, principles, and constraint underlying financial reporting
The limitations on the usefulness of financial statements resulting from trade-offs made necessary by
the present accounting model, political influences, and the need for managersâ?? judgment
The importance of earnings quality to the usefulness of financial statements and how earnings
management affects this quality, and
The ethical dimensions of financial reporting policies and practices, including managersâ?? incentives to
engage in earnings management
2
Topic 3
General-Purpose Financial Statements
Generally Accepted Accounting Principles in the U.S. (U.S. GAAP) has long required that businesses
preparing general-purpose financial statements for external (non-manager) users include each of the following
basic statements and disclosures:
Balance Sheet (or Statement of Financial Condition)
Assets
Liabilities
Stockholdersâ?? equity
Income (or Operating) Statement
Sales
Cost of sales
Gross profit
Cash Flow Statement
Cash flows provided by operating activities
Net income
Adjustments to reconcile net income to cash flows provided by operating activities:
Statement of Changes in Stockholdersâ?? Equity1
Preferred
stock
Common
stock
Treasury
stock
APIC
AOCI
Retained
earnings
Balance, Jan. 1
Common stock issued
Comprehensive income
Footnotes
Summary of Significant Accounting Policies . . .
Composition of Inventory . . .
Commitments and Contingencies . . .
______
1
Throughout this course, unless stated otherwise, assume that the organizational form of businesses is a corporation organized under
the state laws in which the business is domiciled. Recall from your foundation courses in financial accounting principles and business
finance that financial statements label ownersâ?? equity interests in a corporation stockholdersâ?? equity or shareholdersâ?? equity, and
stockholdersâ?? interest in the corporation take the form of shares of capital stock, more commonly referred to as common stock.
3
Regulatory Structure of Financial Reporting by U.S. Public
Companies
Since 1973, the Financial Accounting Standards Board (the FASB) has had primary responsibility for
establishing U.S. GAAP. In the case of public companies â?? those having debt and equity securities traded on
U.S. securities exchanges (such as the NYSE and NASDAQ) â?? the FASB obtained this authority from the U.S.
Securities Exchange Commission (the SEC). This is because the Securities Exchange Act of 1934 (the 1934
Act) created the SEC and empowered it to establish U.S. GAAP. The SEC largely delegated this authority to
the FASB (and its predecessor standard-setters) since its inception in 1934. However, the SEC continues to
oversee the FASB and has occasionally overridden the FASBâ??s accounting policy decisions, as set forth in the
FASBâ??s Statements of Financial Accounting Standards.
The SEC also regulates companiesâ?? issuance of debt and equity securities that investors trade on U.S.
exchanges (or by inter-state mail), the exchanges themselves, and certain activities of various market
participants. These market participants include (among others) investment advisors, mutual funds, securities
brokers and dealers, investment bankers, and independent auditors of public companiesâ?? financial statements.
The SEC refers to public companies as registrants. Regulations of the SEC require registrants to issue
periodic reports that include general-purpose financial statements:
ï?·
Annual Report on Form 10-K. Public companies must file these reports within 60 days of their fiscal year
end and include financial statements audited by an independent auditor. These audited financial
statements must include:
â?? Balance sheets as of the two most recent fiscal year-end dates, presented in comparative form
â?? Income statements, cash flow statements, and statements of changes in stockholdersâ?? equity for the
three most recent fiscal years, each presented in comparative form for all years included, and
â?? Footnote disclosures of information necessary to amplify, explain, or supplement the content of the
basic financial statements.
ï?·
Quarterly Reports on Form 10-Q. Public companies must file these reports within 40 days of their fiscal
quarter end, for each of the first three fiscal quarters of the companiesâ?? fiscal year. The purpose of these
reports is to update the information included in the most recently filed report on Form 10-K. The Form 10Q includes unaudited, interim general-purpose financial statements. These financial statements must
include:
â?? Balance sheets of the most recent quarter end and the most recent fiscal year end dates, presented in
comparative form
â?? Income statements for the most recent fiscal quarter and fiscal year-to-date, and for the comparable
periods of the previous fiscal year, presented in comparative form for all such periods, and
â?? Cash flow statements for the most recent fiscal year-to-date and for the comparable period of the
previous fiscal year, presented in comparative form.
SEC regulations require public companies to obtain a review (but not an audit) of their interim, quarterly
financial statements, included in Forms 10-Q filed with the SEC. A review is much more limited in scope
than an independent audit. (The A605 course examines this point in detail.)
ï?·
Current Reports on Form 8-K. Public companies must file these reports within four business days of the
occurrence of certain events that the SEC has deemed sufficiently important to affect financial statement
usersâ?? judgments and decisions about the company. The SECâ??s instructions for completing reports on
Form 8-K includes an extensive list of reportable events, a sample of which includes:
â?? The registrant has changed its independent auditor
â?? Information comes to light that indicates users should no longer rely on previously issued financial
statements, or a related audit report, or completed interim review
4
â?? The registrant has issued an â??earnings releaseâ? reporting summarized results of operations and
financial condition
â?? The registrant has determined that it has experienced material impairment in the realizable
(recoverable) value of significant operating assets
â?? A director or principal officer has departed the registrant, or there has been an election of directors or
appointment of principal officers
â?? The registrant has amended it code of ethics, or waived a provision of its code of ethics
â?? An exchange has notified the registrant that it is delisting its securities or the registrant has failed to
satisfy a rule or standard for continued listing
â?? The registrant has materially modified the rights of security holders
â?? There has been a change in control of the registrant
â?? The registrant has entered into bankruptcy or receivership
â?? The registrant has entered into a definitive agreement relating to a material acquisition or disposition of
assets
The principal regulations of the SEC affecting financial reporting by public companies are Regulation S-X
(affecting the form and content of general-purpose financial statements) and Regulation S-K (affecting the form
and content of other financial information and disclosures included in reports filed with the SEC, but not within
the financial statements that comprise a part of these reports).
Outside the U.S., in recent years, many countries have adopted International Financial Reporting Standards
(IFRS), established by the International Accounting Standards Board (the IASB), as the basis for financial
reporting by companies domiciled within their borders and therefore subject to securities and business
regulations in those countries. The FASB and the IASB are engaged in a long-running effort to â??harmonizeâ?
their respective accounting standards with the ultimate goal of complete â??convergenceâ? of their respective
standards. In that regard, in 2008, the SEC adopted a rule that will eventually, and gradually, require
registrants to prepare their financial statements (included in reports filed with the SEC) using IFRS. While
there are both significant and minor differences between present U.S. GAAP and IFRS, the basic financial
reporting concepts and principles examined in this course are largely unaffected by the transition from existing
U.S. GAAP to the eventual, â??convergedâ? IFRS. (The A608 course examines IFRS in detail.)
5
Learning
Objective 3
Objective of Financial Reporting
The U.S. Congress passed the Securities Act of 1933 (the 1933 Act) and the 1934 Act in response to the
market abuses that contributed to the stock market â??crashâ? of 1929. Recall that the 1929 â??crashâ? was a
material contributing factor in the Great Depression of the early 1930s. One of Congressâ?? objectives in
adopting these statutes was to improve the quality and transparency of financial reporting as a means to
protect the integrity and enhance the efficiency of the securities markets. The securities markets include
principally the national securities exchanges.
Consistent with this legislative objective, the FASB determined that the objective of general-purpose financial
statements is to provide financial information about a business that is useful for making capital allocation
decisions by
ï?·
ï?·
Equity investors and
Creditors, such as
â?? Banks
â?? Insurance and finance companies, and
â?? Investors in bonds and other debt securities
In addition to current and potential investors and creditors (collectively, the capital markets), financial statement
user groups include (among others)
â??
â??
â??
â??
â??
Managers of public companies (financial statement issuers)
Employees and unions
Customers and suppliers
Government agencies with oversight responsibility (such as the SEC, FCC, FRB, and FTC), and
Environmental and social interest groups
6
The Accounting Information System and the Accounting Cycle
The Topic 1-2 background paper defines the accounting information system within a business as the collection
of people, policies, procedures, information technology, and processes that identifies, classifies, processes,
summarizes, and distributes economic and financial information to the various financial statement user groups.
Check your understanding of the accounting information system (examined in detail in your financial
accounting principles course) by reviewing the essential steps of the accounting cycle and the related basic
terminology (identified in bold type) below:
Steps in the Accounting Cycle
1. Enter transactions and events of the period in the appropriate accounting journal (such as the cash
receipts journal, purchases journal, cash disbursements journal, sales journal, and general journal).
These entries, also called journal entries, use the double-entry rules that employ the customary
debits (left) and credits (right), which businesses maintain in equality.
2. Post from the various journals to the accounts, including
â?? Real (or permanent) accounts such as cash, accounts receivable, accounts payable, and
equipment, and
â?? Nominal (or temporary) accounts such as sales, purchases, and salaries
Collectively, the accounts comprise the general ledger.
3. Prepare an unadjusted trial balance from the general ledger
4. Prepare adjusting journal entries and post these to the general ledger
5. Prepare an adjusted trial balance from the general ledger after posting adjusting journal entries
6. Prepare the financial statements from the adjusted trial balance. These include the balance sheet,
income statement, statement of comprehensive income, and statement of changes in
stockholdersâ?? equity.
7. Prepare closing journal entries and post these to the general ledger
8. Prepare a post-closing trial balance from the general ledger after posting the closing journal entries
A business will normally perform all these steps at the end of each of its fiscal years.
7
Learning
Objective 1
Events and Transactions Recognized in
the Accounting Information System
Under U.S. GAAP, businesses do not recognize (that is, record) in their accounting information systems every
transaction and event. For example, even though they may have important effects on the business,
companies do not recognize in their financial statements:
â??
â??
â??
â??
Increases in customer credit limits
Extension of customer payment terms
Modifications to personnel policies, or
Adoption of business strategies or dividend policies
Transactions and events that businesses do recognize in their accounting information systems may be either
external or internal in nature:
ï?·
Internal transactions and events occur within a business. These include, for example:
â?? Consumption of plant and equipment in the process of producing goods for sale
â?? Transfers of raw materials into production, and
â?? Application of labor and other conversion costs to the production of goods for sale
ï?·
External transactions and events occur between a business and other parties or its environment. These
include, for example:
â?? Purchases or sales of goods and services
â?? A customerâ??s refusal or inability to pay amounts owed to the business
â?? A change in an interest rate affecting the value of fixed-rate securities in which the business holds an
investment, and
â?? The introduction by a competitor of technology superior to that used by a business in its products,
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