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 annulled sales of $51. 6 billion and an implied annulled inventory turnover rate Of 16. 1 at the end Of 2010 and $696 billion and 13. , 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 notational 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 to readers. To Clarita/ 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 liana ; 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; ; 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 Mitten 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 Wall-Mart Critical success factors for a high firm, such as Microsoft: ; Investment in search 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 Wall-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 bye of information to investors?
For a high-tech firm, non-financial accounting types of useful information could include: ; 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. ERM 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 to 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 retailers assets are tangible and its costs and performance re 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. L 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 laundry disclosure. 3. Management frequently objects to disclosing additional information on the grounds that it is proprietary. For instance, when the FAST proposed to expand disclosures on (a) accounting for stock-based 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 to these areas? It 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 alienable 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 he most severe when its compensation is difficult to justify given the performance of the firm. . In contrast to U. S. GAP, FIRS permits management to reverse impairment on fixed assets which have increased in value since the time toothier impairment.
Revaluations are typically based on estimates of realizable value made why management or independent values. 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 values, the press, the board of directors, and financial analysts, permitting management discretion in financial reporting Will increase the usefulness Of financial accounting reports. However, fetishes institutional constraints are ineffective, discretion will actually reduce the value of accounting data. S. 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? Hove would you respond to a proposed management buyout it 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 o 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 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 too 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 e 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.
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 it auditors approved to the firm’s accounting decisions, the rim’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 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 efforts ; Initiating or increasing its dividend ; Stock repurchases ; Sale to a block of stock to a pharmaceutical company or other knowledgeable firm While each of these options could he 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 purchases 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 off 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 rim’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 placeholder sees the private information and decides that the firm is undervalued, it may decide to try to acquire the firm outright. Furthermore, the firer may not want to disclose the information to a potential competitor.
However, there may be legal arrangements between the fir-n and a potential placeholder that could limit the likelihood of any of these events. 8. Why might the CEO of the biotechnology firm discussed in Question 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 valued 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. Fifth 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 Coos compensation may be tied to firm value. It is 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 asses it 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 Coo’s bonus may depend on the firm’s value.
It the stock price falls as 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 Avail 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 stockholders may represent a large portion to her personal wealth. Illness 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 fir-n for another job, ; Current owners want to “cash out” or reduce their holdings in the firm. This category could include managers of an LOBO 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 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. Old. 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 to communications challenges than American firms, due to variations in the ownership structure. Relative to American firms, German firms tend to have tar 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 LLC. 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.