Problem 2-16 (15 minutes) a. Most agree with the statement. Accruals do, in fact, have disadvantageous properties such as providing an opportunity for some manipulation. However, to ignore them because of a slight imperfection is not prudent. b. Accrual accounting information provides a better measure of performance because accruals eliminate the timing and matching problems of revenues and expenses. As a result, accrual-based net income is very useful in assessing the performance of the company and predicting future cash flows. c. Many accruals such as interest expense are largely non-discretionary. As a result, the amount of the accrual is reliable and verifiable. The imperfections of accrual accounting arise from the discretionary nature of certain accruals. These accruals involve predictions about the future that are slightly less reliable because of uncertainty about the future. Thus, accrual-based information may not exactly depict “economic reality.” However, the information is closer to economic reality than if no accruals were recorded.
Chapter 02 - Financial Reporting and Analysis 2-53 d. The prudent approach to analysis using accrual accounting information is to review the nature of the accruals for a company. If the company’s management appears to have had many discretionary accruals than this should be considered in the analysis. Discretionary accruals lead to the possibility of lower quality financial reporting. The quality of the information can be enhanced via accounting analysis and recasting certain disclosures to more closely reflect accounting reality. Problem 2-17 (30 minutes) The quarter ended September 30, 20X9 contains two unusual items. First, the company recorded the effect of a change in the accounting rules related to software development. This change resulted in additional income totaling $68 million (approximately $44 million after tax). Second, the company recorded a gain on sale of receivables totaling $36 million after incremental tax expense. If reported net income is reduced by these amounts, net income is actually less than the third quarter of the previous year. After these adjustments are made, earnings per share is approximately equal to the prior year. Return on equity as reported is 25.3%. This suggests equity totaling approximately $2,561 ($648/.253). If net income is reduced by the $80 million of unusual items, return on equity falls to 22.2%. Again, this would suggest that performance in the current quarter was worse than that of the same quarter in the prior year. Thus, while 22% return on equity is quite good, it is not as good as the reported 25%. Also, the trend would be much less positively sloped.
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