Short Answer 1. List and describe the four basic financial statements included in a corporate annual report.

Short Answer

1. List and describe the four basic financial statements included in a corporate annual report.

2. In a speech by Arthur Levitt, chairman of the SEC, he states: “Managing may be giving way to manipulation; Integrity may be losing out to illusion.”

Using examples, explain the meaning of this quotation.

3. Discuss the process FASB uses in writing Statements of Financial Accounting

Standards.

4. Explain how the timing of the recognition of revenues and expenses can lead to lower quality of reported earnings.

5. Read the auditors’ report for Royal Appliance Mfg. Co. What type of opinion was issued by the auditors? Explain why this type of opinion was given.

To the Shareholders and Board of Directors of

Royal Appliance Mfg. Co.

We have audited the Consolidated Financial Statements and the financial statement schedule of Royal Appliance Mfg. Co. and Subsidiaries listed in the index on page 31 of this Form 10-K. These financial statements and the schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and

disclosures in the financial statements. An audit also includes assessing the accounting principles used and

significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Royal Appliance Mfg. Co. and Subsidiaries as of December 31, 1994 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended

December 31, 1995, in conformity with generally accepted accounting principles. In addition, in our opinion, the

financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein.

As discussed in footnote 1 to the Consolidated Financial Statements, effective September 1995, the Company changed its method of accounting for domestic inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method.

Coopers & Lybrand LLP Cleveland, Ohio

March 27, 1996

Solutions

Multiple Choice

Short Answer

1. The balance sheet shows the financial position—assets, liabilities, and stockholders’ equity—of the firm on a particular date, such as the end of a quarter or a year.

The income statement presents the results of operations—revenues, expenses, net profit or loss and net profit or loss per share—for the accounting period.

The statement of shareholders’ equity reconciles the beginning and ending balances of all accounts that appear in the shareholders’ equity section of the balance sheet.

The statement of cash flows provides information about the cash inflows and outflows from operating, investing, and financing activities during an accounting period.

2. Levitt is referring to earnings management, the practice of using accounting choices and techniques in such a way that earnings reports reflect what management wants the user to see, instead of the true financial performance of the firm. Five techniques are commonly used to create illusions according to Levitt. They are “Big Bath” restructuring charges, creative acquisition accounting, cookie jar reserves, misuse of materiality concept and incorrect revenue recognition.

Note: Numerous examples exist which could be used to illustrate the above techniques. See examples in Chapter 1 or the solution to Problem 1.11.

3. The FASB uses a lengthy deliberation process that includes the following steps:

1. Introduction of topic on the FASB agenda.

2. Research and analysis of the problem.

3. Issuance of a discussion memorandum.

4. Public hearings.

5. Board analysis and evaluation.

6. Issuance of an exposure draft.

7. Period for public comment.

8. Review of public response, revision.

9. Issuance of Statement of Financial Accounting Standard.

10. Amendments and interpretations as needed.

4. Generally accepted accounting principles require that expenses be matched with the generation of revenue in order to determine net income for the accounting period. This matching process involves judgments by management regarding the timing of revenue and expense recognition. If management chooses to record revenues or expenses earlier or later than they should be recorded, lower quality of earnings will result. Many examples exist to illustrate this problem.

Xerox Corporation was accused of recognizing revenues prematurely. HBO & Co. went to great lengths to record sales prior to the time when recognition was appropriate in order to show higher profits prior to their acquisition by McKesson, Inc. After the acquisition, when the truth was learned, McKesson HBOC, Inc. had to revise its earnings figures downward by millions of dollars.

5. The opinion is unqualified with explanatory language. The Company is following generally accepted accounting principles and has presented their financial statements fairly, according to the auditors; however explanatory language is necessary to indicate that the Company has changed their method of inventory valuation in 1995. This will cause the statements to be inconsistent and not comparable to prior years.