Week 6: Accounting Analysis 2
Dell, Inc 8-K dated 13 August 2007
The investigation raised questions relating to numerous accounting issues, most of which involved adjustments to various reserve and accrued liability accounts, and identified evidence that certain adjustments appear to have been motivated by the objective of attaining financial targets. According to the investigation, these activities typically occurred in the days immediately following the end of a quarter, when the accounting books were being closed and the results of the quarter were being compiled. The investigation found evidence that, in that timeframe, account balances were reviewed, sometimes at the request or with the knowledge of senior executives, with the goal of seeking adjustments so that quarterly performance objectives could be met. The investigation concluded that a number of these adjustments were improper, including the creation and release of accruals and reserves that appear to have been made for the purpose of enhancing internal performance measures or reported results, as well as the transfer of excess accruals from one liability account to another and the use of the excess balances to offset unrelated expenses in later periods. The investigation found that sometimes business unit personnel did not provide complete information to corporate headquarters and, in a number of instances, purposefully incorrect or incomplete information about these activities was provided to internal or external auditors.
The investigation identified evidence that accounting adjustments were viewed at times as an acceptable device to compensate for earnings shortfalls that could not be closed through operational means. Often, these adjustments were several hundred thousand or several million dollars, in the context of a company with annual revenue of between $35 billion and $56 billion and annual net income of between $2.1 billion and $3.6 billion for the periods in question. Nevertheless, the errors and irregularities identified in the course of the investigation revealed deficiencies in our accounting and financial control environment that require corrective and remedial actions. For a description of the control deficiencies identified by management as a result of the investigation and our internal reviews described below, as well as management’s plan to remediate those deficiencies, see “Control Deficiencies” and “Remediation Plan” below.
Question 1
How do the above accounting adjustments affect Dell’s reported income?
What is the effect on cash flow from operations?
Question 2: Home Depot
Comment on the change in Cash Flow from Operations between 2000 and 2001? Is earnings management likely?
What kind of earnings management might the management of Home Depot have engaged in?
Question 3: Is there a red flag?
ABC Ltd, JFK Ltd, and IJK Ltd are the three major retail businesses in Imaginaryland. Their market shares have been constant for the past decade. Below is some information about their sales and inventory balances expressed in I$ million, the reporting currency, for the past 5 years.
There is steady economic growth in Imaginaryland and the retail business is stable. A group of investors is concerned about the health of ABC Ltd because it took an inventory writedown of I$1.815 million in 2021. There was no further writedown of inventory in 2022 and 2023. There is no incremental growth opportunity in the retail business. Do you think there is reason for concern?
Question 4: Understated expenses
ABC Ltd is listed on the Imaginary Stock Exchange. Its reporting currency is Imaginary Dollars (I$). ABC Ltd has been experiencing some financial troubles lately. However, management believes that this is a temporary phase, and that it will soon return to normal times. Cash flow has been declining for the past two years, and ABC Ltd has been consistently falling behind on contractual payments to suppliers for raw materials. Consequently, the suppliers have sued ABC Ltd over unpaid bills. The court is expected to rule in favour of the suppliers, and ABC Ltd would be liable to pay I$40 million in fines. The management of ABC Ltd argue that there is a low probability of such a ruling, and have not recognised this liability in the books. Assume that the tax rate is 30%.
Do you agree with ABC Ltd’s financial reporting choice? If not, what adjustments will you make to the financial statements?
Question 5: Overstated Asset
Imagine you're a financial analyst following StellarTech Inc., a cutting-edge technology company known for its innovative products in the field of artificial intelligence and robotics. Recently, you've discovered a significant error in the company's financial statements. During your analysis, you discover that the company had overvalued its inventory by $5 million in its most recent annual report.
Assume a tax rate of 30%. What adjustments would you make to StellarTech’s reported financials?
Question 6
Read the article titled “Adjusted EBITDA Is in the Eye of the Beholder”
What are some advantages of using non-GAAP earnings measures like adjusted EBITDA?
What are some disadvantages of such measures?