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 Bhattys 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 companys 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 companys 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 companys stock had been in the range of 3842% during 20082010, but
since 2011, it has declined to the 1924% range.

Comparative income statements and balance sheets for Galaxy over the past few years are in Exhibit 1.

Exhibit 1
Galaxy Electronics Ltd.
(US$ thousands)
Income statement
for the year ended 31 August
2013 2012 2011
Sales $100,000 $ 95,000 $ 65,000
Cost of goods sold 47,000 47,500 33,800
Gross profit 53,000 47,500 31,200
Operating expenses 34,000 38,000 28,000
Interest expense 2,400 2,700 3,000
Earnings before taxes 16,600 6,800 200
Income taxes (33%) 5,478 2,244 67
Net income $ 11,122 $ 4,556 $ 134



Balance Sheet
at 31 August
2013 2012
Assets
Cash and investments $ 21,122 $ 25,000
Accounts receivable 25,000 13,500
Inventories 9,000 6,500
Prepaids and deferrals 4,000 2,000
Total current assets $ 59,122 $ 47,000
Equipment, net 51,000 55,000
Intangibles 21,000 25,000
Total assets $131,122 $127,000

Liabilities
Accounts payable $ 15,000 $ 11,000
Unearned revenue 4,000
Warranty provision 2,000 4,000
Current portion of long-term debt 5,000 5,000
Total current liabilities $ 22,000 $ 24,000
Long-term debt 35,000 40,000
Total liabilities $ 57,000 $ 64,000
Shareholders equity
Common stock 58,000 58,000
Retained earnings 16,122 5,000
Total shareholder equity $ 74,122 $ 63,000
Total liabilities and equity $131,122 $127,000

Question
1 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.
Question
2 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.
Question
3 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.
Question
4 of 6
Based on Exhibit 1, the balance-sheet based aggregate accruals ($ thousands) for 2013 is closest to:

10,000.

14,122.

10,122.
Question
5 of 6
The 2014 stock-based compensation expense from the stock grant program ($ millions) will be closest to:

$1.4.

$4.2.

$0.7.
Question
6 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 Fosters 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 1
Foster Inc. Equity Portfolio
(year end, C$ thousands)

Characteristic
Security
Alton 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
Fosters share of
investees net income
for the year

$15,000
Notes:
Darnell Inc. has $2 billion in total assets.
Foster owns 40% of Darnells equity and has representation on Darnells 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 2
Foster Inc. Fixed-Income Portfolio
(year end, C$ thousands)
Characteristic
Security
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
Cost
a
$20,000 $35,000 $50,000 $60,000
Market value,
end of year
$23,000 $45,000 $45,000 $64,000
Interest earned for the
year $1,000 $2,000 $2,000
b
$5,000
a
All fixed-income securities were purchased at par value.
b
The second coupon payment due during the year was not received.


Turner is interested in understanding the effect of the investment portfolios on Fosters 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 Gilts is permanent, and she gives the following three reasons in support of
her assessment:

1. Moodys has recently downgraded Gilts 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 Turners analysis, all tax effects are ignored.

Question
1 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.
Question
2 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.
Question
3 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
Question
4 of 6
At year-end, the carrying value of the fixed-income portfolio will be closest to:

$168,000.

$178,000.

$177,000.
Question
5 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.
Question
6 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:
childrens 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 1
Rhine AG
Selected Divisional and Corporate Data ( millions)

Total for Three
Divisions
Childrens
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 1,034.1 930.0 626.8 609.3
Gross profit 621.4 640.8 296.6 337.6 246.0 220.3 78.8 82.9
Operating profit

172.7

219.4

64.7

115.7

72.9

62.2

35.1

41.5
Earnings 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 1,249.6 961.5 948.5 265.6 281.4
Capital
expenditures

32.7

42.3

22.1

30.0

6.7

8.6

3.9

3.7
Proportion 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%

Petersens 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 2013s investment behavior is representative of future
investment patterns.

Petersen knows that revenues in the childrens 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 Rhines effective tax rate to
determine whether the geographic mix of the companys profits has changed in 2013.

Petersen finally examines the companys liquidity ratios, which are shown in Exhibit 2. Even though the
companys current and quick ratio have improved, his interpretation of the changes in the companys cash
conversion cycle is that the companys liquidity position has deteriorated.

Exhibit 2
Rhine AG
Selected Ratios
Ratio 2013 2012 2011
Current ratio 2.31 2.17 1.16
Quick ratio 1.06 0.89 0.53
Accounts receivable turnover 5.82 6.08 6.11
Inventory turnover 3.78 3.91 4.09
Accounts payable turnover 5.71 5.78 5.60
Cash conversion cycle 95 days 90 days 84 days

Worried that the balance sheetbased and cash flowbased 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.

Question
1 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.
Question
2 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.
Question
3 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.
Question
4 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.
Question
5 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
Question
6 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 companys recent abbreviated financial statements are shown in
Exhibit 1, and selected notes to the financial statements are provided in Exhibit 2.

Exhibit 1
Piezo Materials, Inc. Balance Sheet Excerpts and Income Statement
Balance Sheet Excerpt (US$ thousands)
As of 31 December 2013 2012
Cash and accounts receivable $1,328 $1,025
Inventories (Note 5) 1,406 2,220
Total current assets 2,734 3,245
Property, plant, and equipment, net (Note 11) 2,836 3,043
Total assets $5,570 $6,288

Total current liabilities $1,039 $1,697
Long-term debt (Note 9) 974 1,237

Income Statement (US$ thousands)
Periods Ending 31 December 2013 2012
Net sales $11,159 $8,895
Cost of goods sold 9,898 7,901
Selling & administrative expense (S&A) 872 717
Interest 122 158
Total costs and expenses $10,892 $8,776
Earnings before tax 267 119
Taxes (Note 7) 89 38
Net income $178 $81

Exhibit 2
Piezo Materials, Inc.
Selected Notes to Financial Statements
31 December 2013
(All figures in US$ thousands)
Note 5. Inventories
Inventories 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 Rates
The companys tax rate in 2013 was 33.3% and 32% for all prior years.

Note 9. Debt and Debt Covenant
The 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 Equipment
Depreciation 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 firms 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 companys gross profit margin
when compared with 2012, and
ensure that the companys 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 3
Piezo Materials Ltd. Selected Information Related to
Peachtree City Ceramics Production Plant
(US$ thousands)
Acquisition cost (start of 2010) $2,800
Estimated useful life at acquisition 10 years
Depreciation method Declining balance, 13% /year
Estimated residual value $500

At the end of 2013
Expected future net cash flows $1,350
Fair value of plant $1,225
Revised estimate of useful life 4 years
Depreciation method Straight line
Revised 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.
Question
2 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%.
Question
3 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%.
Question
4 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%.
Question
5 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.
Question
6 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.