Financial Reporting and Analysis - Galaxy

Galaxy Electronics Ltd. (Galaxy) is a manufacturer and distributor of personal computers and handheld electronic personal organizers. The company had grown rapidly from its inception in 2008 to 2012, but in early 2013, sales growth slowed significantly. The company prepares its financial statements in accordance with U.S. GAAP. With the company becoming quite well established in recent years, Nadeen Bhatty, the vice president of finance, introduced the following changes to its accounting methods and estimation procedures in 2013: 

         Galaxy produces its computers and organizers based on orders received. A 25% deposit is required on all orders, and then Galaxy manufactures and usually ships the units in two to six weeks. Some orders are placed even further in advance, although some shipments may not occur for up to three months following an order. Galaxy had been recording a sale when the product was shipped, but under Bhatty’s revised policy, the revenue recognition point occurs when the deposit is received. “If the products are made to order, then the critical event is the receipt of the order,” she explained. As of 31 August 2013, Galaxy had received deposits of $3 million for orders yet to be shipped.

         The company provides a one-year warranty on its products and records it as a selling and administrative expense at the time of sale. Now, after five years of experience with the products, the company has realized that the actual claims experience has been less than the amounts accrued. In 2013, the related warranty accounts were adjusted to reflect the new estimated claim rates.

 Since 2010, annual executive compensation has included stock options on the company’s stock. On 1 September 2013, the company introduced a restricted stock grant program for all non-executive employees who had worked for the company for three years or more. 

         The fair value of the company’s stock on the grant date was $4.2 million.         The employee has to remain with the company for another three years for the shares to vest. 

 The average volatility of the company’s stock had been in the range of 38–42% during 2008–2010, but since 2011, it has declined to the 19–24% range.

 Comparative income statements and balance sheets for Galaxy over the past few years are in Exhibit 1. Exhibit 1Galaxy Electronics Ltd.(US$ thousands)

Income statementfor the year ended 31 August

2013 2012 2011Sales $100,000 $ 95,000 $ 65,000Cost of goods sold         47,000       47,500       33,800 Gross profit     53,000    47,500   31,200Operating expenses     34,000    38,000   28,000Interest expense             2,400           2,700         3,000 Earnings before taxes     16,600      6,800        200Income taxes (33%)             5,478           2,244                   67 Net income $  11,122 $   4,556 $     134

   

Balance Sheetat 31 August

2013 2012AssetsCash and investments $ 21,122 $ 25,000Accounts receivable    25,000    13,500Inventories     9,000     6,500Prepaids and deferrals         4,000         2,000 Total current assets $ 59,122 $ 47,000Equipment, net    51,000    55,000Intangibles       21,000       25,000

Total assets $131,122 $127,000LiabilitiesAccounts payable $  15,000 $  11,000Unearned revenue       4,00

0Warranty provision      2,000       4,00

0Current portion of long-term debt           5,000             5,00

0Total current liabilities $ 22,000 $  24,000Long-term debt       35,000         40,00

0Total liabilities $ 57,000 $  64,000Shareholders’ equityCommon stock    58,000    58,000Retained earnings       16,122           5,000 Total shareholder equity $ 74,122 $ 63,000

Total liabilities and equity $131,122 $127,000

Question1  of 6

Which of the following is most likely a warning sign of deteriorating earnings quality? The new policy

relating to:

warranty expenses.

compensation using stock grants.

revenue recognition.

Question2  of 6

The most likely effect of the change in the warranty experience was to:

reduce off-balance-sheet liabilities.

increase the cash flow from operations.

increase the current ratio.

Question3  of 6

The amount which the new revenue recognition policy contributed to gross profit in fiscal 2013 ($millions)

is closest to:

6.4.

1.6.

4.8.

Question4  of 6

Based on Exhibit 1, the balance-sheet based aggregate accruals ($ thousands) for 2013 is closest to:

10,000.

14,122.

10,122.

Question5  of 6

The 2014 stock-based compensation expense from the stock grant program ($ millions) will be closest to:

$1.4.

$4.2.

$0.7.

Question6  of 6

If the recent changes in the volatility of the company's stock persist, it will most likely affect the company's

compensation expense for:

both non-executive employees and executives.

non-executive employees only.

executives only.

Financial Reporting and Analysis - Turner

Brad Turner is the chief financial officer at Foster Inc., a Canada-based manufacturing corporation that operates internationally and prepares its financial statements according to International Financial Reporting Standards (IFRS). Information about Foster’s equity portfolio and fixed-income portfolio is provided in Exhibits 1 and 2, respectively. All securities were purchased on the first day of the current fiscal year. Exhibit 1Foster Inc. Equity Portfolio(year end, C$ thousands)

CharacteristicSecurityAlton Inc. Barker Inc. Cosmic Inc. Darnell Inc.

(see notes)Classification Fair value

through profit or loss (held for trading)

Available-for-sale

Available for sale

Associated company

Cost,beginning of year

$100,000 $150,000 $250,000 $500,000

Market value,end of year

$97,000 $151,000 $257,000 $506,000

Dividends received during the year $1,000 $2,000 $3,000 $4,000

Foster’s share of investee’s net income for the year

$15,000

Notes:         Darnell Inc. has $2 billion in total assets.         Foster owns 40% of Darnell’s equity and has representation on Darnell’s Board of

Directors but does not have effective control.         At time of acquisition, the fair value of all assets and liabilities was equal to their book

value.         Darnell reported net income of $187.5 thousand on sale of goods to Foster during

the year. 

 Exhibit 2Foster Inc. Fixed-Income Portfolio(year end, C$ thousands)

CharacteristicSecurity

Eldon Inc. Fizz Inc. Gilt Inc. Harp Inc.

Classification

Fair value through profit

or loss (held  for trading)

Available for sale

Held to maturity

Held to maturity

Costa $20,000 $35,000 $50,000 $60,000Market value,end of year $23,000 $45,000 $45,000 $64,000Interest earned for the year $1,000 $2,000 $2,000b $5,000

aAll fixed-income securities were purchased at par value.bThe second coupon payment due during the year was not received.

  Turner is interested in understanding the effect of the investment portfolios on Foster’s year-end financial statements. The company is reevaluating its investment strategy, including what would have been the effect if it had designated more of the securities as investments at fair value. Turner does not think the decline in market value of any of the securities is permanent, but his investment officer, Charlene Chen, thinks Gilt’s is permanent, and she gives the following three reasons in support of her assessment: 

1.     Moody’s has recently downgraded Gilt’s credit rating.2.     The bond has been trading below the acquisition cost for most of the year.3.     Gilt has announced that the current and future interest payments will remain suspended

until it has the chance to restructure its debt. For Turner’s analysis, all tax effects are ignored.

Question1  of 6

The contribution of the equity portfolio to Foster's net income for the year is closest to:

$18,000.

$26,000.

$7,000.

Question2  of 6

If at acquisition, all of the equity securities that were eligible to be designated as investments at fair value

were so designated, the amount that the entire equity portfolio would contribute to Foster's net income for

the year would have been closest to:

$26,000.

$11,000.

$21,000.

Question3  of 6

Which of the following provides the least support to Foster's classification of Darnell as an associated

company? Foster's:

percentage of ownership

extent of intercompany transactions

position on the board of directors

Question4  of 6

At year-end, the carrying value of the fixed-income portfolio will be closest to:

$168,000.

$178,000.

$177,000.

Question5  of 6

The contribution of the fixed income portfolio to Foster's net income for the year is closest to:

$23,000.

$10,000.

$13,000.

Question6  of 6

Which of Chen's reasons concerning Gilt best supports her position on the security?

3

1

2

Financial Reporting and Analysis - Rhine

Claus Petersen, a pension fund equity analyst, is preparing an analysis of Rhine AG for the upcoming quarterly fund meeting. Rhine is a Germany-based manufacturer that operates three distinct divisions: children’s products (infant car seats, strollers, cribs, etc.), recreational products (bicycles, bicycle trailers, etc.), and home furnishings (contemporary furniture). All three divisions sell through retail outlets around the world. The company has been pursuing an aggressive growth strategy, achieved through both foreign acquisitions and organic growth. Petersen is interested in determining how well Rhine is allocating its resources between the three divisions and the effects of the foreign acquisitions on overall performance. Exhibit 1 summarizes selected divisional and corporate data for 2013 and 2012. Exhibit 1Rhine AGSelected Divisional and Corporate Data (€ millions)

Total for Three Divisions

Children’s Products

Recreational Products

Home Furnishings

2013 2012 2013 2012 2013 2012 2013 2012

Revenues 2,837.1 2,775.5 1,176.2 1,236.2 1,034.1 930.0 626.8 609.3Gross profit 621.4 640.8 296.6 337.6 246.0 220.3 78.8 82.9Operating profit

172.7 219.4 64.7 115.7 72.9 62.2 35.1 41.5Earnings before taxes (EBT)

136.6 170.0

Net earnings after tax

109.9 132.3

Total assets 2,498.0 2,479.5 1,270.9 1,249.6 961.5 948.5 265.6 281.4Capital expenditures 32.7 42.3 22.1 30.0 6.7 8.6 3.9 3.7Proportion of capital expenditures

100% 100% 67.6% 70.9% 20.5% 20.3% 11.9% 8.7%

Proportion of total assets 100% 100% 50.9% 50.4% 38.5% 38.3% 10.6% 11.3%

 Petersen’s preferred method to determine which division is becoming less significant over time is to review the relationship between capital expenditures and total assets by operating division. He plans to base his conclusion on the assumption that 2013’s investment behavior is representative of future investment patterns. Petersen knows that revenues in the children’s products division have suffered because of declining birth rates in Europe and North America, but he believes that if Rhine can maintain the operating margin for this division then overall company profitability should not be affected.Corinna Berg, another analyst with the fund, reminds Petersen that during 2013, the U.S. dollar weakened against the euro by 4% and that 50% of the sales in the recreational products division are sold in the United States. Petersen recalls that some of the recent global expansion was aimed at establishing operations in Ireland because its statutory corporate tax rate is lower than the German rate of 29.8%. If Petersen assumes that other tax credits were the same in 2013 as 2012, he can analyze changes in Rhine’s effective tax rate to determine whether the geographic mix of the company’s profits has changed in 2013. 

Petersen finally examines the company’s liquidity ratios, which are shown in Exhibit 2. Even though the company’s current and quick ratio have improved, his interpretation of the changes in the company’s cash conversion cycle is that the company’s liquidity position has deteriorated. Exhibit 2Rhine AGSelected RatiosRatio 2013 2012 2011Current ratio 2.31 2.17 1.16Quick ratio 1.06 0.89 0.53Accounts receivable turnover 5.82 6.08 6.11Inventory turnover 3.78 3.91 4.09Accounts payable turnover 5.71 5.78 5.60Cash conversion cycle 95 days 90 days 84 days

 Worried that the balance sheet–based and cash flow–based accruals ratios (not shown) raise some concerns about the possible use of accruals to manage earnings, Petersen asks Berg for advice on what further type of analysis he should do as a follow-up on this issue.

Question1  of 6

Using Petersen's preferred method and 2013 divisional data, the best conclusion Peterson can make

about which division will potentially become less significant in the future is that it will be:

children's products.

home furnishings.

recreational products.

Question2  of 6

If the children's products division had been able to maintain its 2012 operating margin in 2013, the

company's overall operating margin in 2013, compared to 2012, would have been:

higher.

the same.

lower.

Question3  of 6

Which of the following is the most appropriate use of Berg's reminder about the U.S. versus euro

exchange rate in 2013? Peterson should use the information:

to determine the exchange gains or losses included in net income.

to confirm that the division's organic growth was less than 11.2%.

when evaluating management's historical performance.

Question4  of 6

The best conclusion Petersen can make about the geographic mix of Rhine's profit in 2013 is that

compared with 2012 the mix is:

more international.

about the same.

more domestic.

Question5  of 6

Compared with 2011, the change in which working capital account most likely had the largest effect on

Petersen's observed deterioration in liquidity?

Inventory

Accounts payable

Accounts receivable

Question6  of 6

Berg's best answer to Petersen's question about further analysis is that he should conduct a:

Discounted cash flow analysis.

Cash flow ratio analysis.

DuPont analysis.

Financial Reporting and Analysis - Piezo

Jacob Smith is a hedge fund manager at Thames-Hill Advisers in New York City. He is currently reviewing the financial statements of Piezo Materials, Inc. of Atlanta, Georgia, USA. Piezo specializes in the production of materials that generate electricity when mechanical force is applied to them. The products are widely used in vibration sensors, automotive airbags, and numerous medical devices. Piezo prepares its financial statements using U.S. GAAP, and Smith wants to compare Piezo with several similar firms operating in Europe that report under International Financial Reporting Standards (IFRS) and account for their inventory on a first-in, first-out (FIFO) basis. As with Piezo, these firms face material costs that are continuing to rise. The company’s recent abbreviated financial statements are shown in Exhibit 1, and selected notes to the financial statements are provided in Exhibit 2. Exhibit 1Piezo Materials, Inc. Balance Sheet Excerpts and Income StatementBalance Sheet Excerpt (US$ thousands)As of 31 December 2013 2012Cash and accounts receivable $1,328 $1,025Inventories (Note 5) 1,406 2,220Total current assets 2,734 3,245Property, plant, and equipment, net (Note 11) 2,836 3,043Total assets $5,570 $6,288Total current liabilities $1,039 $1,697Long-term debt (Note 9) 974 1,237Income Statement (US$ thousands)Periods Ending 31 December 2013 2012Net sales $11,159 $8,895Cost of goods sold 9,898 7,901Selling & administrative expense (S&A) 872 717Interest 122 158Total costs and expenses $10,892 $8,776Earnings before tax 267 119

Taxes (Note 7) 89 38Net income $178 $81

 Exhibit 2Piezo Materials, Inc.Selected Notes to Financial Statements31 December 2013(All figures in US$ thousands)Note 5. InventoriesInventories are reported on a last-in, first-out (LIFO) basis. The LIFO Reserve was $867 and $547 at the end 2013 and 2012, respectively. During 2013, the company liquidated certain LIFO inventories that had been carried at lower costs in prior years, and the effect of the liquidation was to decrease cost of goods sold by $263. There was no LIFO liquidation in 2012.

Note 7. Tax RatesThe company’s tax rate in 2013 was 33.3% and 32% for all prior years.

Note 9. Debt and Debt CovenantThe debt covenant requires that an interest coverage ratio of 2.25 must be maintained; the ratio is to be calculated excluding the effects of capitalized interest.

Note 11. Property and EquipmentDepreciation expense for 2013 and 2012 was $388 and $362, respectively. These amounts include capitalized interest of $34 and $143, respectively.

Interest is allocated and capitalized to construction in progress by applying the firm’s cost of borrowing rate to qualifying assets. Interest capitalized in 2013 and 2012 was $66 and $170, respectively.

 Smith is interested in several aspects of the financial statements as presented. He wants to

         determine what impact the LIFO liquidation in 2013 had on the company’s gross profit margin when compared with 2012, and

         ensure that the company’s interest coverage ratio meets the requirements of the debt covenant. 

In early January 2014, Smith saw a news release that Piezo would be forced to reduce production at its highly specialized Peachtree City ceramics production plant because a new technology introduced by a competitor eliminated a major product line. Exhibit 3 summarizes information and estimates that Smith has been able to gather from various sources about the plant and its future prospects. Exhibit 3Piezo Materials Ltd. Selected Information Related toPeachtree City Ceramics Production Plant (US$ thousands)Acquisition cost (start of 2010) $2,800Estimated useful life at acquisition 10 yearsDepreciation method Declining balance, 13% /yearEstimated residual value $500At the end of 2013Expected future net cash flows $1,350Fair value of plant $1,225Revised estimate of useful life 4 yearsDepreciation method Straight lineRevised estimate of residual value $200

Question

1  of 6

When compared to how the European firms account for inventory, Piezo's method is most likely to result

in a lower:

total liabilities to equity ratio.

days of inventory on hand.

cash flow from operations.

Question2  of 6

On a comparable basis to the European firms in the industry, using Notes 5 and 7, Piezo's 2013 return on

assets ratio, based on end of year assets, isclosest to:

6.2%.

7.7%.

6.4%.

Question3  of 6

After adjusting for the LIFO liquidation in 2013, the change in gross profit margin compared to 2012

is most likely:

higher by 3.0%.

higher by 2.5%.

lower by 2.3%.

Question4  of 6

The most appropriate conclusion that Smith can make about the debt covenant restriction, using Notes 9

and 11, is that the firm has:

failed to meet it by at least 5%.

just satisfied it.

exceeded it by at least 5%.

Question5  of 6

Ignoring the effects of income taxes, the expensing of previously capitalized interest, Note 11, most

likely causes Piezo's cash flow from operations to be:

unchanged.

lower.

higher.

Question6  of 6

Assuming Smith's information and estimates concerning Peachtree City ceramics plant in Exhibit 3 prove

accurate, the depreciation expense (in $1,000s) that should be reported for 2014 related to the plant

is closest to:

256.

306.

279.