Sample Question 1 (2 + 2 + 4 = 8 Marks)

Title: Intuitive Announces Third Quarter Earnings

Source: Intuitive Surgical Inc.
Found: Global Newswire

[article begins]

Gross profit, income from operations, net income, net income per diluted share, and diluted shares
are reported on a GAAP and non-GAAP* basis. The non-GAAP* measures are described below and
are reconciled to the corresponding GAAP measures at the end of this release.

Third quarter 2019 revenue was $1,128 million, an increase of 23% compared with $921 million in
the third quarter of 2018. Higher third quarter revenue was driven by increased procedures and
systems placements.

Third quarter 2019 instrument and accessory revenue increased by 25% to $606 million, compared
with $486 million for the third quarter of 2018, primarily driven by nearly 20% growth in da Vinci
procedure volume.

Third quarter 2019 systems revenue increased by 23% to $339 million, compared with $275 million
for the third quarter of 2018. The Company shipped 275 da Vinci Surgical Systems in the third
quarter of 2019, compared with 231 in the third quarter of 2018. The third quarter 2019 system
shipments included 92 systems shipped under operating lease and usage-based arrangements,
compared with 58 during the third quarter of 2018.

[article continues]

Required:

A) Does it make sense for a firm such as Intuitive Surgical to report non-GAAP measures for
each of gross Profit, income from operations, net income, net income per diluted share
and diluted shares? Explain your answer.

Non-GAAP measures aim to provide additional information to markets, specifically, the

nature of persistent earnings. As investors may be concerned about the specific items that
make up earnings, not just the final earnings number, reporting non-GAAP numbers for
these items may provide addition information to investors with which they can forecast the
individual items going forward.

B) At earnings announcement, what are some of the typical earnings management incentives
that may exist?

Managers often face incentives from the market at earnings announcements. Specifically,
management may have incentives to ensure that earnings are greater than analyst forecasts,
greater than a/the previous period, or are positive rather than negative. Aside from these
 clear benchmarks, management may have general incentives to ensure that earnings
surpass expectations by as much as possible, leading to earnings maximisation outcomes.

C) Based on the extract from the earnings announcement above, what earnings management
technique(s) could be in evidence? Would this constitute accrual or real earnings
management? Fully explain your answer.

The article provides information with respect to systems shipments. From the article,
Systems shipments have increased to 275 from 231, including considerable increases in the
number of systems shipped under lease arrangements. These lease arrangements are the
provision of financing by the firm to increase the sales of equipment. To the extent that this
financing is engaged in by Intuitive Surgical to boost earnings (potentially, financing costs
were dropped to encourage short-term growth in the market) this would constitute Real
Earnings Management, as it has an effect on the cash flows of the firm.
Sample Question 2 (3 + 3 + 4 = 10 Marks)

Title: Kill quarterly reporting? Some investors ring alarm bells

Source: Reuters
By: Lewis Krauskopf
Link: https://www.reuters.com/article/us-usa-sec-trump-investors-analysis/kill-quarterly-reporting-
some-investors-ring-alarm-bells-idUSKBN1L2227

NEW YORK (Reuters) - Less reporting by U.S. corporations could put shareholders in the dark, allow
companies to drift off course and even make U.S. stocks less attractive and create less public
company investment, some investors and analysts argue.

U.S. President Donald Trump’s move to ask the Securities and Exchange Commission to study
allowing companies to file reports every six months instead of every three alarmed financial
professionals who are used to getting detailed reports from companies every 90 days.

“Cut reporting frequency in half and you invite mischief and remove an established discipline,” said
David Kotok, Chairman & Chief Investment Officer at Cumberland Advisors in Sarasota, Florida.

[article continues]

Required:

A) What are the benefits of quarterly reporting vis-à-vis half yearly reporting? Explain these
benefits.

The benefits of reporting quarterly related to the provision of additional information to

investors. Specifically, investors are able to gain more clarity on the pattern of earnings
between quarters, which is otherwise hidden by half-yearly reporting. This should reduce
information risks and cost of capital.

B) How could quarterly reporting “invite mischief” from firms? Explain your answer.

The provision of quarterly reporting then also introduces quarterly earnings pressures.
Analysts and the market now have expectations of quarterly earnings performance, and
these expectations may filter through into the decision making of managers, creating a
short-term perspective.

Furthermore, these incentives may then flow on to more frequent use of earnings
management to meet the expectations of market.

C) Provide arguments in support of removing quarterly reporting in favour of half-yearly

reporting. Fully explain them.

There are several arguments built around the premise that the costs of quarterly reporting
will outweigh the benefits. Aside from the above, an additional cost of more frequent
reporting is the “actual cost” or out of pocket expense of performing more frequent
reporting, and taking management attention away from the operating parts of the business
to the reporting. While these costs may be minimal in larger firms, they can be significant in
smaller firms.

Further, the additional disclosure may provide little useful information to investors. As
indicated above, the difference is predominantly just the ability to breakdown earnings into
quarters. Whether this materially informs investors (who may be more focused on long-term
issues) is unclear.