FINANCIAL INFORMATION ANALYSIS

Accounting Analysis
Application Exercises
Question 2
Most airlines have frequent flyer programs that promise customers free flights once they
have accumulated 25,000 miles of travel with the same airline. Using the simple
definition of assets, liabilities, revenues, and expenses presented in the lecture, how
should these programs be reflected in the airlines financial statements?
Promises that require future expenditures are liabilities even if they cannot be measured
precisely. According to the definition, liabilities are economic obligations of a firm arising
from benefits received in the past that are:
(a)
required to be met with a reasonable degree of certainty;
(b)
at a reasonably well-defined time in the future;
Airline companies have economic obligations to serve frequent flyer program passengers due
to ticket sales (benefits) in the past to the frequent flyer program passengers. These
obligations are:
(a)
likely to be met1;
(b)
fulfilled within a well-defined time in the future2;
A frequent flyer program has an impact not only on the balance sheet but also on the income
statement. In principle, the costs associated with benefits that are consumed in this time
period are estimated and recognized as expenses (matching concept) 3;
However, it is not easy to measure the costs associated with frequent flyer program accurately.
At least the following three cost categories should be considered in the estimation:
1.
The administrative costs, such as maintaining the accounting system for the program,
mailings to program members, and providing service to those who request free flights;
2.
The costs related to the flight itself, including meal expenses, luggage handling costs,
and additional fuel expenditure;

1For example, United Airline frequent flyer program totaled 1.2 million free trips in
1990;
2 Typically within 3 to 5 years after the revenue ticket sales are made;
3 Note that airline companies increased revenue ticket sales (benefits) in this period by
promising free-trip tickets (costs) in the future;

3.
The opportunity costs that airline companies may incur because the seats used by flight
award passengers could have been sold to revenue paying passengers.
Question 3
If there are no accounting standards on reporting for frequent flyer programs, what
incentives are likely to drive managements choices of accounting for these transactions?
Managers have potential incentives not to accrue liability and to recognize expenses related to
frequent flyer programs - and hence increase net income - for the following reasons:
1.

Managers do not want competitors to know how much or how successfully the
frequent flyer program is used. The disclosure of liability may help competitors in their
business decisions;

2.

Managers do not want to show low net income because it may cause investors to
overreact and result in negative stock price changes. When there are information
asymmetries between managers and outsiders, and when accounting is imperfect, the
managerial decision not to recognize expenses may affect investors perceptions
favorably (at least temporarily);

3.

Corporate managers bonuses may be tied to the target net income of the airline
company. Managers are not likely to choose accounting methods which will lower net
income;

4.

An airline company may have debt covenants which require the company to maintain
certain accounting ratios. Suppose that the company is close to violating their
profitability ratios, managers will choose not to recognize expenses related to the
companys frequent flyer program.

Question 4
Fred argues: The standards that I like most are the ones that eliminate all management
discretion in reporting - that way I get uniform numbers across all companies and dont
have to worry about doing accounting analysis. Do you agree? Why or why not?
Agreeing with Fred is not a good idea because the delegation of financial reporting decisions
to corporate managers may provide an opportunity for managers to convey their superior
information to investors. Corporate managers are typically better than outsiders at
interpreting their firms current condition and forecasting future performance. Since managers
have better knowledge of the company, they have the potential to choose appropriate
accounting methods and accruals which portray business transactions more accurately. Note
that accrual accounting not only requires managers to record past events but also to make
forecasts of future effects of those events. If all discretion in accounting is eliminated,
managers will be unable to reflect their superior information in their accounting choices.

Question 6
Many firms recognize revenues at the point of shipment. This provides an incentive to
accelerate revenues by shipping goods at the end of the quarter. Consider two
companies, one of which ships its products evenly throughout the quarter, and the
second of which ships all its products in the last two weeks of the quarter. Each
company pays thirty days after receiving shipment. How can you distinguish these
companies using accounting ratios?
There is no difference between the two companies in their income statements. Both
companies have the same amount of revenues and expenses. However, the two companies are
different in their balance sheets. Assuming that all other things are equal, the company which
sells product evenly has a higher cash and a lower account receivable balance at the quarterend than the company which ships all products in the last two weeks. The following
accounting ratios can be used to differentiate the two companies:

Accounts Receivable Turnover (Sales/Accounts Receivable):

The company with even sales will have a higher accounts receivable turnover ratio;
Days Receivable (Accounts Receivable/Average Sales per Day):
The company with even sales will show lower days receivable;
Cash Ratio (Cash + Short-Term Investments/Current Liabilities):
The company with even sales will have a higher cash ratio;

4. Many firms recognize revenues at the point of shipment. This provides an incentive to
accelerate revenues by shipping goods at the end of the quarter. Consider two
companies, one of which ships its products evenly throughout the quarter, and the
second of which ships all its products in the last two weeks of the quarter. Each
companys customers pay 30 days after receiving shipment. Using accounting ratios,
how can you distinguish these companies?
Both companies will have the same amount of revenues and expenses in their income
statements. However, their balance sheets will show different amounts. At the end of each
quarter, the company that ships its products evenly throughout the quarter should have higher
cash and a lower accounts receivable balance than the company that ships all its products in
the last two weeks of the quarter.
We can distinguish between these companies using the following accounting ratios:
a.
Accounts
Accounts Receivable

Receivable

Turnover

Ratio

Sales

The company that ships its products evenly throughout the quarter and has steady sales will
have a higher accounts receivable turnover ratio.
b. Accounts Receivable Days Ratio = Accounts Receivable
Average Sales per Day

The company that ships its products evenly throughout the quarter and has steady sales will
have a lower accounts receivable days ratio.
c. Cash Ratio = Cash + Short-Term Investments
Current Liabilities
The company that ships its products evenly throughout the quarter and has steady sales will
have a higher cash ratio.
5. A. If management reports truthfully, what economic events are likely to prompt the
following accounting changes?
a. Increase in the estimated life of depreciable assets.
If managers find out that the actual life of the depreciable assets lasted longer than was
expected, managers will increase the estimated life of depreciable assets.
b. Decrease in the uncollectible allowance as a percentage of gross receivables. The firm will
decrease the percentage of uncollectable allowance when it receives orders from reliable
customers. In contrast, the firm will increase the percentage of uncollectable allowance when
it receives orders from unreliable customers.
c. Recognition of revenues at the point of delivery, rather than at the point cash is received. A
firm could recognize revenues at the point of delivery rather than at the point of cash receipt
when its customers credit improves or its customers cash payment is not a risk.
d. Capitalization of a higher proportion of software R&D costs. A firm will capitalize a higher
proportion of software R&D costs when the firm has established the technical and commercial
feasibility of the asset for sale or use. For example, technical and commercial feasibility may be
established when the firm completes the software and either uses it or sells it and is able to
demonstrate how the intangible asset will generate future economic benefits.
5.B. What features of accounting, if any, would make it costly for dishonest managers to make
the same changes without any corresponding economic changes?
Opinion of third parties. Auditors provide a clean opinion of a firms financial statements. If
the changes in the accounting policy are reasonably consistent with economic changes,
auditors will not provide a clean opinion of the financial statements.
Accrual reversal effect. Aggressive capitalization of software R&D expenditures will increase
net income in the current period, but the later writing-off of capitalized R&D costs will
decrease net income in the following period.
Lawsuit. If a firm discloses false financial information and its investor loses because of that
information, the firm will pay legal penalties.
Labor Market Discipline. The labor market for managers will discipline those who are
perceived as unreliable managers in dealing with external parties.
6. The conservatism principle arises because of concerns about managements incentives
to overstate the firms performance. Joe Banks argues: We could get rid of
conservatism and make accounting numbers more useful if we delegated financial
reporting to independent auditors, rather than to corporate managers. Do you agree?
Why or why not?

I dont agree with Joe Banks, because if we delegate financial reporting to independent
auditors rather than to corporate managers, we will decrease the quality of financial reporting.
Auditors dont have all the inside information that corporate managers have when the
economic reality of the firm is displayed. Furthermore, the way managers and auditors assess a
firm is different. Auditors could apply accounting standards to assess business transactions in a
mechanical way rather than using their professional judgment, leading to poor quality financial
reporting. For example, everybody agrees that market-value accounting provides relevant
information; however, auditors are concerned more about the audit liability.
7. A fund manager states: I refuse to buy any company that makes a voluntary
accounting change, since its certainly a case of management trying to hide bad news.
Can you think of any alternative interpretation?
Voluntary accounting change could happen because business circumstances have changed in
the firm. For example, unusual increases in receivables might be due to changes in a firms
sales strategy, or unusual decreases in the allowance for uncollectible receivables might be
reflecting a change in a firms customer focus. Therefore, an analyst should use qualitative
information such as the evaluation of the context of the business strategy and economic
circumstances, and not deliberately interpret the firms accounting change as earnings
manipulation.
8. Fair value accounting attempts to make financial information more relevant to
financial statement users, at the risk of greater subjectivity. What factors would you
examine to evaluate the reliability of fair value assets?
We should examine the fair value hierarchy to evaluate the reliability of fair value assets. Level
1 is the most reliable in terms of valuating fair value assets because it is based on quoted
prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable
and would rely on evaluating similar assets or liabilities in active markets
Level 3 is the least reliable level because it requires a good deal of judgment and is based on
the best information available (such as a companys own data or assumptions) to arrive at a
relevant and reliable fair value measurement. Financial statement users can trust prices in liquid
markets as long as observable inputs such as level 1 and 2 reflect quoted prices for identical
assets or liabilities. In level 3, we encounter unobservable inputs.