For each of the following two scenarios, identify
1. Factors that might motivate the company’s managers to manipulate reported financial amounts,
2. Possible/expected manipulations
3. Applicable mechanism that could discipline financial reporting quality.
Senario-1: ABC Co. is a private company. Bank NTBig has made a loan to ABC Co. ABC is required to maintain a minimum 2.0 interest coverage ratio. In its most recent financial reports, ABC reported earnings before interest and taxes of $1,200 and interest expense of $600. In the report’s notes, the company discloses that it changed the estimated useful life of its property, plant, and equipment during the year. Depreciation was approximately $150 lower as result of this change in estimates.
Senario-2: DEF Co. is a publically traded company. For the most recent quarter, the average of analysts’ forecasts for earnings per share was $2.50. In its quarterly earnings announcement, DEF reported net income of $3,458,780. The number of common shares outstanding was 1,378,000. DEF’s main product is a hardware device that includes a free two- year service contract in the selling price. Based on management estimates, the company allocates a portion of revenues to the hardware device, which it recognizes immediately, and a portion to the service contract, which it defers and recognizes over the two years of the contract. Based on the disclosure, a higher percentage of revenue was allocated to hardware than in the past, with an estimated after-tax impact on net income of $27,000.
Coverage Ratio = EBIT / Interest Expense
Earnings Per Share = Net Income / Number of shares outstanding
Senario1: The factor that might motivate the company’s manager to manipulate reported financial amount is maintainning a minimum 2.0 interest coverage ratio. Following the reported of ABC’s company, the interest coverage ratio equal exactly 2.0 ( $1200/ $600 = 2). Moreover, the reported of EBIT of ABC’s company equals $1200. After the effects of depreciation expense of changed assumptions about useful life, EBIT of ABC’s company adjustment equals
$1200 - $150 = $1050.
Therefore, the interest coverage ratio adjustment equals
$1050/ $600 = 1.75.
Base on this number, we can see that this ratio have decreased from 2.0 to 1.75 if ABC’s manager had not changed the estimated useful life of its property, plant, and equipment during the year.
The potential disciplining mechanisms include the auditors, who will evaluate the reasonableness of the depreciables life time. In addition, because the company can’t achieve the minimum coverage ratio without the estimated accounting so the lender has to analyze carefully the change in estimate.
Senario 2: The factor that might motivate DEF Co.’s manger to manipulate reported financial is the desire too equal or exceed the average of analysts’ forecasts for earnings per share 2.50. Following the reported of DEF Co. company, the Net Income equals $3,458,780. After the impact of Impact on gross profit of changed revenue recognition, net of tax, the Net Income adjusment is
$3,458,780 + $27,000 = $3,431,780.
So, the earning per share, as reported:
$3,458,780/ 1,378,000 = $2.51
The earning per share, as adjusted:
$3,431,780/ 1,378,000 = $2.49
We can see that, after the impact on gross profit of changed revenue, the earning per shares on reported is higher then the forecasts by $0.01.
The potential disciplining mechanisms include the auditors, market regulators, financial analysts, and financial journalists
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