Chapter 11 - Equity Analysis and Valuation

Problem Six: Adjusting Financial Statements

You are examining the financial statements of ABC Corporation for Year 2. ABC
Corporation manufactures widgets and has a unionized workforce. You are trying to assess
the earnings persistence of the company. To aid you in this endeavor you are adjusting
earnings for non-recurring, non-sustainable items.

Below is a list of items you believe might affect earnings persistence. Indicate why the item
may affect earnings persistence and how each item might affect net income.

Company has:
1. LIFO Liquidation of $3M

2. Decreased the discount rate used to determine post-retirement health benefits

3. Accumulated Depreciation as a percentage of gross depreciable assets is ninety percent

4. Labor unions went on strike for one month during the year

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Chapter 11 - Equity Analysis and Valuation

Problem Six: Adjusting Financial Statements

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Chapter 11 - Equity Analysis and Valuation

Problem Seven: Earnings Persistence/Future Earnings

Consider each of the scenarios below independently.

1. Luxury Limos is in the business of renting limousines in New York City. It has a fleet of
200 limos. It owns the limousines that they rent, and keeps them on average for five years. In
Year 3, Luxury Limos showed a loss on the sale of limos of $5,000. In Years 1 and 2 it
recorded a loss on sale of $2,000 and $1,000, respectively. Should the gains and losses on the
sale of limos be ignored when determining earnings persistence or not?

2. Turnaround Corporation has just hired new top management. In the new management's first
year they take a huge restructuring charge (looks as though they are taking a "big bath").
Included in the restructuring charge are:

● Recognition of a contingent liability for probable environmental clean-up

● Write-down of assets (which amounted to a 50% write-down of all assets)
● A charge for a future upgrade of its computer system

For each of the items included in the restructuring charge, and considering management's
possible motivation for taking a "big bath", identify how these items might affect future
recorded income.

Problem Seven: Earnings Persistence/Future Earnings

1. Luxury limos is buying and selling limos all the time. If it continually shows losses this
indicates that it is probably under-depreciating its limos. The losses should be included in
earnings persistence assessments as they are effectively operating expenses. The analyst may
want to smooth the losses out over time--but they should be included.
2. Contingent liability: If the company is taking a big bath, then the management may over-
estimate the size of the liability. This would allow them to have a reserve on the balance sheet
that they can use to enhance earnings in future periods (by reversing its estimate).

Write-down of assets: The amount that assets are written down is highly subjective. The effect
of write-downs is to decrease future depreciation charges. If management has written down
assets too much then future earnings will be overstated.

Upgrading computers: It is highly debatable whether this charge should even be allowed in
this accounting period, and debatable whether it should be called "restructuring". Upgrading
computers is a normal operating event for most companies. Recording it as part of the
restructuring charge is misleading in that it suggests that it is a one-time event. As
importantly, the cost is being recognized too early and will cause future periods income to be
overstated.

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