Question

As Surfboard Co. fiscal year-end was nearing, the CFO presented the CEO expected financial statement results for the year. The after-tax operating income (OI) was to be $43.7 million resulting in a return on beginning-of-period net operating assets (NOA) of 19.0 percent. “This won’t do!,” declared the CEO. “The Street is expecting a 20.0 percent RNOA,” the CEO continued and sent the CFO back to her office to find any “accounting tricks” to meet the target.

A. How much after-tax operating income does the CFO need to add to meet the Street’s expectations?

B. What is the likely effect of the earnings management on NOA in the current year and its implication for RNOA the following year?

C. Explain how, in general, a manipulation of current operating income has an “accounting effect,” but does not have a “valuation effect.”

Answer 1

A. How much after-tax operating income does the CFO need to add to meet the Street’s expectations?

After tax OI resulting into 19% RNOA = $ 43.70 mn

After tax OI that will result into 20% RNOA = $ 43.70 x 20% / 19% = $ 46.00 mn

Hence, after-tax operating income the CFO needs to add to meet the Street’s expectations = 46 - 43.70 = $ 2.30 mn

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B. What is the likely effect of the earnings management on NOA in the current year and its implication for RNOA the following year?

NOA in the current year = NOA at the beginning of the year + addtion during the year.

Due to earnings management, addition to NOA will increase and hence NOA in the current year and the subsequent year will be inflated (higher than actual). Since the denominator will be higher, RNOA calculated using NOA as denominator will be relatively lower.

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C. Explain how, in general, a manipulation of current operating income has an “accounting effect,” but does not have a “valuation effect.”

Valuations are derived using projected free cash flows to the firm which in turn is dependent upon projected post tax operating income. Expected or forecast earnings contribute to valuation and not the historical or the current one. Hence, in general, a manipulation of current operating income has an “accounting effect,” but does not have a “valuation effect.”