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BS3520

ANALYSIS OF FINANCIAL REPORTING  INFORMATION

SECTION A

ANSWER BOTH QUESTIONS IN THIS SECTION

The logistic regression model is as follows:

y = -2.4 - 0.07(lnSales) + 13.7(Total Liabilities / Total Assets)

- 1. 7(Earnings per share) – 0.8(OCF)

Where Sales is in £’s and OCF takes a value of 1 if operating cash flow for the year was positive, 0 otherwise. (7 marks)

c)  For predicting the failure of a firm, detail an alternative method to that of part (b) above and discuss any associated limitation with the model you describe.

(7 marks) [Total 25 marks]

2.      Your client, who holds a number of shares in Cans plc, has requested your advice as to whether to hold or sell their current investment. To aid you in your analysis, your client has obtained financial information from two elements of the annual report as follows:

Information from the Statement of profit or loss and other comprehensive income and the Statement of Financial Position:

i)       Earnings available for ordinary shareholders for the year 2014 were £120m.

ii)     Management of Cans plc forecast earnings to grow by 8% for the year 2015.

iii)    Opening book value for the year 2015 is £900m.

iv)     Residual earnings post 2015 are expected to grow at a constant rate of 7%.

Informationfrom the Segmental Analysis note to thefinancial statements

i)       Forecast revenue for 2015, 2016 and 2017 is £450m, £660m and £600m respectively.

ii)     Asset  turnover  for  2016  and  2017  is  forecast  to  be  0.73  and  0.57 respectively.

iii)    Opening net operating assets for the year 2015 is £800m.

iv)     Operating margin for the years 2015 – 2017 is forecast to be 23%.

v)      The weighted average cost of capital for the operating divisions is 9%.

vi)     Future growth of residual operating income post 2017 is forecast to be 5%.

(note the above information relates to the operating divisions of the firm which exclude any financing activities)

Other information

i)       Cans plc has 100m shares in issue as at the start of 2015. The firm has no expectations to issue any further shares in the future.

ii)     The share price of Cans plc at the start of 2015 is £20.00 per share.

iii)    Cost of equity of the firm is 12%.

REQUIRED:

a)  Using both the residual (abnormal) earnings valuation model (REVM) and the residual operating income model (ReOIM), advise your client as to whether sell or hold their investment in Cans plc. (15 marks)

b)  Explain why the two models applied in part (a) give differing valuations. (3 marks)

c)   Identify the rationale for focussing on a reformulated income statement and balance sheet when using the residual operating income model (ReOIM). (2 marks)

d)  Briefly discuss the limitations of the residual (abnormal) earnings valuation model (REVM).

(5 marks) [Total 25 marks]

SECTION B

ANSWER ONE QUESTION IN THIS SECTION

3.      “If financial reports are to convey managers' information on their firms' performance, standards must permit managers to exercise judgment in financial reporting. Managers can then use their knowledge about the business and its opportunities to select reporting methods,  estimates,  and  disclosures  that  match  the  firms'  business  economics, potentially increasing the value of accounting as a form of communication. However, because auditing is imperfect, management's use ofjudgment also creates opportunities for  "earnings  management,"  in  which  managers  choose  reporting  methods  and estimates that do not accurately reflect their firms' underlying economics. ” (Healy and Wahlen, 1999)

In response to the above authors, critically evaluate the attempts made by academics in detecting and measuring “earnings management” . (25 marks)

4.      Critically discuss the theoretical frameworks that may motivate managers to undertake

impression management and discuss the role narratives can play in such manipulation. (25 marks)