Chapter 12 solutions 5th edition - Solution manual of Business Analysis & Valuation Using financial statement.

Chapter 13

Chapter 12
Communication and Governance
Discussion Questions
1.

Amazon’s inventory increased from $3.2 billion on December 31, 2010, to $5.0 billion
one year later. In addition, sales for the fourth quarter of those years increased from $12.9
billion in 2010 to $17.4 billion in 2011. What is the implied annualized inventory turnover for
Amazon for these years? What different interpretations about future performance could a
financial analyst infer from this change? What information could Amazon’s management
provide to investors to clarify the change in inventory turnover? What are the costs and benefits
to Amazon from disclosing this information? What issues does this change raise for the auditor?
What additional tests would you want to conduct as Amazon’s auditor?
Amazon had annualized sales of $51.6 billion and an implied annualized inventory turnover rate of 16.1 at
the end of 2010 and $69.6 billion and 13.9, respectively, at the end of 2011.

Analysts could view this change in a positive manner if they anticipate that the increase in inventory
is a signal that Amazon expects higher sales in the future. Once these higher sales are realized, the
turnover rate will return to its prior level (unless the company anticipates continual sales increases,
which certainly is a possibility with a company such as Amazon).
Analysts could also view this change in a negative way. While sales have increased, inventories
have increased faster, suggesting that Amazon is not managing its inventories well. Because
Amazon has more resources tied up in inventory, it will have to cut back on spending related to
improving its operations and developing new products such as the Kindle series of e-readers.
To clarify the reasons for changes in inventory turnover, Amazon could provide information about:
•

The types of products in inventory. Is the inventory mainly old products that have not sold and
will have to be deeply discounted or written-off or is it new, popular products that have not yet

been released to the public?

•

Forecasts of sales by product line.

•

Technical specifications, marketing strategies and release dates for new product introductions.

•

Changes in overall firm strategy that might be related to the increase in inventory.

The costs of providing this type of additional information include:
•

Disclosure of proprietary information about the firm. Amazon’s competitors could use this
information to adjust their business plans;

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•

Loss of credibility if Amazon’s forecasts turn out to be incorrect. Investors and analysts will be
more skeptical in the future; and

•

Potential legal liability if Amazon’s forecasts turn out to be incorrect and disgruntled
shareholders sue.

The benefits of providing this type of additional information include:
•

Provide analysts and investors with a better understanding of the firm’s plans; and

•

Added credibility for the firm in the future if the current forecasts and information turn out to be
correct.

The firm’s auditors would be interested in answering the same types of questions as outside
analysts. They would be especially concerned about whether the slower turns are attributable to old
obsolete inventory that may have to be written off. This will require tests that help clarify what type
of inventory has increased, whether that inventory is for older lines or for new lines that are
expected to be strong sellers next quarter/year.
2. a. What are likely to be the long-term critical success factors for the following types of firms?
• a high-technology company, such as Microsoft
• a large, low-cost retailer such as Wal-Mart

Critical success factors for a high-tech firm, such as Microsoft:
•

Investment in research and development of new technologies and applications;

•

Continual improvement of existing products to keep ahead of competitors; and

•

Large installed base of customers. Provides a ready market for compatible products and
upgrades and makes it harder for competitors to build market share.

Critical success factors for a large, low-cost retailer, such as Wal-Mart:
•

Maintenance of its low cost structure;

•

Growth in sales per store; and

•

Ability to open new stores in untapped markets.

2. b.  How useful is financial accounting data for evaluating how well these two companies are managing
their critical success factors? What other types of information would be useful in your evaluation? What
are the costs and benefits to these companies from disclosing this type of information to investors?

For a high-tech firm, non-financial accounting types of useful information could include:
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Chapter 12  Communication and Governance  3

•

Long-term strategy for the firm;

•

Market share by product;

•

Introduction schedules for new products and updates of existing ones;

•

Profitability of individual products;

•

Forecasts of future performance;

•

Third-party evaluations of firm’s products; and

•

Estimates of switching between firm’s products and those of its competitors.

For a large, low-cost retailer, types of useful non-financial accounting information could include:
•

Long-term strategy of the firm;

•

Sales and profitability per store, per existing store, per new store, and by region of the country;

•

Number and locations of new stores;

•

Number and locations of closed stores;

•

Management initiatives to reduce costs;

•

Disclosure of volume discounts negotiated with major suppliers;

•

Understanding of how firm manages its value chain through use of technology; and

•

Sales and cost projections.

In general, both types of firms will benefit from greater disclosure by increasing analysts’ and
investors’ understandings of the firm. They will both bear costs related to the release of proprietary
information to competitors, decreased credibility if subsequent actions and results do not match the
disclosure, and legal liability from dissatisfied investors.
Overall, the benefits and costs of disclosing this type of information are likely to be greater for the
high-technology firm than for the low-cost retailer. Financial statement information will typically
provide a better understanding of the low-cost retailer than the high-tech firm. Most of the retailer’s
assets are tangible and its costs and performance are reasonably well captured by financial
statements. A high-tech firm’s most significant assets are often intangible (e.g., R&D, patents, trade
secrets, etc.), and financial statements have a more difficult time capturing these values. Thus,
voluntary disclosure is likely more important to the understanding of the high-tech firm rather than
the low-cost retailer. Of course, voluntary disclosure is also likely to be more costly for high-tech
firms, since their key information is more likely to be proprietary. In addition, higher business
uncertainty for high-tech firms potentially increases the risk of legal liability arising from voluntary
disclosure.
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3.  Management frequently objects to disclosing additional information on the grounds that it is
proprietary. For instance, when the FASB proposed to expand disclosures on (a) accounting for stockbased employee compensation (issued in December 2002) and (b) business segment performance (issued
in June 1997), many corporate managers expressed strong opposition to both proposals. What are the
potential proprietary costs from expanded disclosures in each of these areas? If you conclude that
proprietary costs are relatively low for either, what alternative explanations do you have for
management’s opposition?

Expanded disclosure standards require firms to report using the same segments used for internal
reporting and organization. This information potentially provides additional information to a
company’s competitors. More detailed business segment data offers a better picture of performance
and profitability across a company’s various business segments. It also provides insight into
differences in cost structures across components. Using this information, competitors could choose
to compete head to head with the firm’s most profitable segments or where the firm was most
vulnerable due to high costs. Thus, additional business segment disclosures are potentially quite
costly to a company. It is more difficult to identify any significant proprietary costs related to
expanded disclosure of executive stock compensation.
Management’s opposition to the ongoing debates about whether to record an expense for stock
options can probably be better explained by management’s concerns about providing stockholders
with information about its stock compensation. Management’s concerns are likely to be most severe
when its compensation is difficult to justify given the performance of the firm.
4.   nI aconstr to SU. GAP, IFRS permits manget ot revs mpainrte on dfixe aset whic have indcreas ni uvael ncesi het time of heirt impaenrt. Revaluations are typically based on estimates of realizable value made by management or
independent valuers. Do you expect that these accounting standards will make earnings and book values
more or less useful to investors? Explain why or why not. How can management make these types of
disclosures more credible?

The usefulness of earnings and book values will depend on any information asymmetry between
management and investors as well as management’s incentives to manage reported performance
using fixed asset revaluations. Consider the case where management has more precise information
on the value of certain key assets than investors. Asset revaluations are one way for them to provide
information to investors on these values.
Of course, information asymmetry also provides management with the opportunity to use discretion
in making revaluations to conceal poor performance, perhaps to increase compensation or job
security, or to reduce the risk of violating debt contracts.
Hence, if there are effective institutional constraints on the abuse of management reporting
discretion, such as monitoring by independent auditors and valuers, the press, the board of directors,
and financial analysts, permitting management discretion in financial reporting will increase the

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Chapter 12  Communication and Governance  5

usefulness of financial accounting reports. However, if these institutional constraints are ineffective,
discretion will actually reduce the value of accounting data.
5.  Under a management buyout, the top management of a firm offers to buy the company from its
stockholders, usually at a premium over its current stock price. The management team puts up its own
capital to finance the acquisition, with additional financing typically coming from a private buyout firm
and private debt. If management is interested in making such an offer for its firm in the near future, what
are its financial reporting incentives? How do these differ from the incentives of management that are not
interested in a buyout? How would you respond to a proposed management buyout if you were the firm’s
auditor? What about if you were a member of the audit committee?

If management is interested in making a buyout offer for the firm, its primary concern may be
paying as low a price as possible. This goal may give management an incentive to use accounting
discretion to make the firm appear to be under-performing. This “bad news” might lower the stock
price and eventual purchase price. As a result, management may be able to arrange to purchase the
firm at a price that is lower than its economic value. Of course, management interested in a buyout
also has to be concerned about audiences other than current stockholders, such as bankers and bond
investors. These parties will be asked to lend management funds to buy the firm, and will demand
higher interest rates if they believe the firm is a poor performer.
In contrast, if management is not interested in a buyout, it probably has incentives to make financial
reporting assumptions that increase earnings, thereby increasing its own compensation job security.
Alternatively, if management is concerned about establishing credibility in the capital market, it
may report in an unbiased fashion, or perhaps even smooth performance, to ensure earnings reports
do not surprise investors.
Management incentives for reporting prior to a management buyout should be of interest to the

external auditor and audit committee because they could affect the firm’s reporting. If management
has incentives to understate performance, to be able to acquire the firm at a low price, the auditors
and audit committee would want to pay close attention to those areas where managers have room to
manage earnings.
6.  You are approached by the management of a small start-up company that is planning to go public. The
founders are unsure about how aggressive they should be in their accounting decisions as they come to
the market. John Smith, the CEO, asserts: “We might as well take full advantage of any discretion offered
by accounting rules, since the market will be expecting us to do so.” What are the pros and cons of this
strategy? As the partner of a major audit firm, what type of analysis would you perform before deciding to
take on a new start-up that is planning to go public?

Pros
Generate better-looking financial statements. More aggressive accounting decisions could make the
firm’s performance appear better than it would otherwise.
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Facilitate a future initial public offering. If aggressive accounting decisions lead to higher earnings,
etc., it may be easier for the company to go public with higher earnings than lower, all other things
equal.
Promote interest in the firm. With higher earnings due to aggressive accounting decisions, the
company may capture a higher profile in the media. Press coverage about the firm could lead to
greater investor interest in the company and facilitate a subsequent initial public offering.
Cons
Difficulties with auditors. The firm’s auditors would have to approve the aggressive accounting
decisions by the firm. If the auditors did not sign off on some of the firm’s choices, then the firm
would have to make less aggressive accounting choices or change accounting firms. Either of these

changes could serve as a warning about the firm to potential investors.
Difficulties with underwriters. Even if auditors approved of the firm’s accounting decisions, the
firm’s underwriters will also evaluate their accounting choices during the due diligence process
before the firm goes public. An underwriter that is not confident about a firm’s accounting may
delay or cancel an underwriting rather than be embarrassed by poor firm performance subsequent to
an underwriting.
Less accounting discretion going forward. By making the most aggressive accounting choices
today, the firm will have less flexibility in the future to change its accounting without generating
considerable investor scrutiny.
Increasingly skeptical investors. Firms that make more aggressive accounting choices may appear
riskier to investors. As a result, underwriters and investors will require greater compensation for that
risk, increasing the firm’s cost of going public.
7.  Two years after a successful public offering, the CEO of a biotechnology company is concerned about
stock market uncertainty surrounding the potential of new drugs in the development pipeline. In his
discussion with you, the CEO notes that even though they have recently made significant progress in their
internal R&D efforts, the stock has performed poorly. What options does he have to help convince
investors of the value of the new products? Which of these options are likely to be feasible?

The CEO could potentially take advantage of the following options to provide information about the
value of the firm’s new projects:
•

Analysts meetings

•

Voluntary disclosure of internal R&D efforts

•

Initiating or increasing its dividend

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Chapter 12  Communication and Governance  7

•

Stock repurchases

•

Sale of a block of stock to a pharmaceutical company or other knowledgeable firm

While each of these options could be used to communicate directly or signal management’s private
information about the value of the firm’s new projects, the firm may be either unable or unwilling to
undertake some of these options.
Stock repurchases and initiating/increasing the dividend are likely to be infeasible. Both of these
strategies require cash that the firm probably does not have. The typical biotech firm does not turn a
profit for several years after going public. In fact, it often returns to the capital markets for
additional resources to support it while products are developed and the firm waits for regulatory
approval. Hence, these high-cost strategies are probably not realistic options for the firm.
Analysts meetings and increased voluntary disclosure are more likely actions for the firm. These
represent efficient ways for the firm to provide detailed information about its new projects. If
management information is not considered to be credible, investors and analysts may not pay
attention to information provided in this manner. Furthermore, management may be reluctant to
provide detailed information to the diverse group of shareholders and analysts because of critical
information it could provide to competitors.

Sale of a block of stock to a pharmaceutical company or other knowledgeable firm would also be
feasible for the firm to do. It would signal to outsider investors and analysts that a very
knowledgeable player with access to sensitive company information about the firm’s new projects
has decided to make a substantial investment in the firm. The firm may prefer not to sell a block of
stock in this manner for reasons of corporate control. If the potential blockholder sees the private
information and decides that the firm is undervalued, it may decide to try to acquire the firm
outright. Furthermore, the firm may not want to disclose the information to a potential competitor.
However, there may be legal arrangements between the firm and a potential blockholder that could
limit the likelihood of any of these events.
8.  Why might the CEO of the biotechnology firm discussed in Question 7 be concerned about the firm
being undervalued? Would the CEO be equally concerned if the stock were overvalued? Do you believe
that the CEO would attempt to correct the market’s perception in this overvaluation case? How would you
react to company concern about market under- or overvaluation if you were the firm’s auditor? Or if you
were a member of the audit committee?

The CEO could be concerned about the firm being undervalued for several reasons. First, an
undervalued firm makes a good takeover target. Once another firm discovers that the firm is
undervalued, it may try to acquire the firm. If successful, the acquiring firm may fire the CEO.
Second, undervaluation makes raising equity capital more expensive. If the firm’s shares are trading
below their true value, the firm will have to sell a larger portion of the company to raise the same
amount of new equity capital. Finally, the CEO’s compensation may be tied to firm value. It is
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unlikely if the firm is undervalued that the CEO will earn a substantial bonus. Moreover, the CEO
may be rewarded if the stock price moves from being undervalued to being fairly valued.
The CEO has different incentives to take action if he believes that the firm is overvalued. Equity

capital is less expensive to raise if the firm is overvalued. Academic research suggests that there are
more equity issues during periods when firms are likely to be overvalued. In addition, the CEO’s
bonus may depend on the firm’s value. If the stock price falls as a result of his actions, the CEO
could lose his bonus as well as put his job at risk. The CEO also has an incentive to correct the
overvaluation to reduce the firm’s legal liability. Assume the CEO has private information that
suggests that his company is overvalued. Even if the CEO never discloses the information, at some
point the market will learn the information and adjust the firm’s stock price. Dissatisfied
shareholders may sue the company with the belief that the CEO manipulated the market by not
revealing his private information sooner. Top management may also lose credibility with the market
if they delay reporting bad news. Thus, it is unclear whether the CEO would attempt to correct the
market’s overvalued perception of the firm.
9.  When companies decide to shift from private to public financing by making an initial public offering
for their stock, they are likely to face increased costs of investor communications. Given this additional
cost, why would firms opt to go public?

Despite the increased costs of investor communications, firms go public for many reasons,
including:
•

Improved access to capital markets. Some quickly growing firms find their growth outstrips the
ability of their private funding sources. Some firms find it easier and less expensive to raise
capital in public markets. Some investors (some types of mutual funds, retirement funds, trusts,
etc.) cannot invest in privately held companies. Thus, for a variety of reasons, firms go public to
take advantage of greater access to public capital markets.

•

A significant portion of employees’ wealth is the firm’s stock. Just like publicly held firms, many
private firms compensate employees with stock or stock options. Over time, an employee’s
stockholdings may represent a large portion of her personal wealth. Unless the stock is publicly

traded, it is difficult for employees to sell their stock to diversify their holdings, to raise cash to
purchase a house, etc., or even just to leave the firm for another job.

•

Current owners want to “cash out” or reduce their holdings in the firm. This category could
include managers of an LBO who want to take the firm public again and receive compensation
for their work. It could also include family-owned businesses where the family is no longer
interested in running the company.

•

Provide outside value for the firm. It is difficult to value the equity of a privately held firm. A
company will often sell a share of its equity to get better information about the value of the
remaining equity. Until Microsoft went public, it was almost impossible, even for people

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Chapter 12  Communication and Governance  9

working within the firm, to begin to value the intangible assets that the firm had developed. It
allows people who owned stock when the firm was privately held to place a better value on their
holdings.
•

Easier evaluation of firm performance. A firm’s publicly traded stock price provides one
measure of its performance. Stock price and performance measures based on it can be used to
compare the firm with itself, others in its industry, and the market as a whole. This information

may be valuable to a firm’s managers as they make operating decisions and form plans for the
future.

10.  German firms are traditionally financed by banks, which have representatives on the companies’
boards. How would communication challenges differ for these firms relative to U.S. firms, which rely
more on public financing?

German firms face a different set of communications challenges than American firms, due to
variations in the ownership structure. Relative to American firms, German firms tend to have far
fewer individual investors and a greater level of holdings by financial institutions. In addition to
their equity holdings, financial institutions are often represented on these companies’ boards of
directors. These differences in ownership imply that German firms can communicate with their
major owners through board meetings and informal channels, so that the major owners do not have
to rely on published financial information. This reduces the information available to German firms’
competitors, a potential advantage over broad dissemination of information. As a result, major
shareholders of German companies have the opportunity to have access to more detailed and
proprietary information than U.S. public shareholders. An interesting question is whether German
firms actually take advantage of this opportunity. Some have argued that the German model of
capital market creates a cozy relationship between financial institutions and their clients, and that
the board of directors provides limited oversight of a firm’s management.

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