Quiz 5: Worldcom Wizardry: From Worldcom to Worldcon
Case Study Requirement a Signal number 1 Signal number 1 referring to the misuse of acquisition or merger reserves. Acquiring (parent)companies willfully understates the value of net assets of the selling company, to overstate the amount of goodwill. Main purpose of overstatement of reserves is to reverse the reserves into revenue in the later period. Determine goodwill to total assets ratios for Company T Working notes: Calculate goodwill to total assets ratio. For the year 1998: For the year 1999: For the year 2000: For the year 2001: For the year 2002: Explanation about Company T's fictitious allocation to goodwill with reference to signal number 1. • Goodwill to total assets ratios surprisingly raised from 30.31% in 1998 to 40.42% in 2000, but it gets decrease to 32.76% in 2001. Even though, goodwill to total assets ratio was decreased in 2001, it fell by a large percentage. • $10.598million of total assets was recorded as net assets of discontinued operations in the consolidated balance sheet of Company T for the year 2001. Hence, it is necessary to deduct the amount of net assets of discontinued operations ($10,598 million)from the total assets ($71,022 million)of Company T, to arrive at goodwill as a percentage of total assets of continuing operations in 2001 amounted to 38.50%). • Goodwill to total assets ratio of Company T increased to 39.29% during the year 2002. • If the purchase price of the acquiring company exceeds its net asset value, then the surplus amount can be allocated to goodwill. Accordingly, Company T created false reserves. It is very clear that the Company T allocates a larger amount to goodwill at the time of acquisition of companies. Company T creates reserve to reverse them into profit in the future period. Hence, signal number 1 indicates that the Company T allocates a larger portion of amounts to goodwill at the time of acquisition of other companies. Working note: Calculate the ratio of goodwill to total assets of continuing operations for the year 2001: Signal number 4 Signal number 1 referring to the misuse of large one-time charges in income statement. The investors of the company need to be very alert with the large one-time charges that are reported in the income statement during the acquisition period. This is signal that the company creates false reserves which help to increase the earnings of the future period. Therefore, it is necessary to inspect the one-time charges of company T in its income statement. Identify the one-time charges of Company T. Explanation about Company T's fictitious allocation of large one-time charges with reference to signal number 4. • The above one-time charges have been used by Company T to produce cookie-jar reserves, which can be released in later years to overstate earnings. SEC (Securities and Exchange Commission)took action Company T for its overstatement of earnings of $500million in the year subsequent to acquisition. • Company T overstate its earnings by understate the value of net asset of acquired companies, and by increase the equivalent amount of goodwill, or by increase the one-time charges in its income statement. Requirement b Calculate sales to total assets ratio. For the year 1998: For the year 1999: For the year 2000: For the year 2001: For the year 2002: Determine the trend of sales to total assets ratios for Company T. Explanation for Company T's trend in sales to total assets ratio: • According to DuPont formula, the return on assets can be split into the following: • It is important to find that the investment made in assets produce revenues and that can be measured by the turnover ratio. Also it is very important to note, whether the generated revenue exceed the total costs and create a profit. Profit can be measured by the margin ratio. • The sales to total assets ratio of Company T gradually goes down from 0.1832 in 1998 to 0.4792 in 2001. • Massive investment in goodwill in the past years did not facilitate the Company T to generate sales at a stable rate, when compared to the amount of investment made in all assets. • Obviously, investors should have been worried that the amounts invested on acquisition did not generate reasonable revenue. • From the year 2000 to 2002, Company T split the revenue as sales revenue and service revenue in its disclosure. • Thus, sales to total asset ratios from 2000 to 2002 consist of service revenue since the warning sign is actually testing whether the assets are earning income at a feasible rate as opposed to just earning sales specifically. Requirement c Explanation about understating assets or overstating liabilities and reserves on acquisition of a new company: • If a current asset (stock)is devalued at the time of acquisition and it is sold at a future period, then the resulting amount of gross profit will be larger. • If a liability of an expense is recognized on acquisition, but the actual expense will be occurred only in future, then this will bring about increased revenue in the subsequent period. • If a reserve for doubtful debts is overstated in a financial statement of a company on acquisition, then the company requires recording the smaller bad-debt expenses in future, otherwise it should reverse the reserve in the subsequent period.• On acquisition if a company understates its assets or overstates the amount of reserves, then it will allocates an equivalent amount of purchase price to goodwill.
Goodwill According to an economist, "goodwill" has the capability to make a supernormal profit on assets. Sometimes, acquiring companies willfully understates the value of net assets of the selling company. This has been done to overstate the amount of goodwill. When there is an appearance of goodwill on the acquisition of a company, which relates to a company that does not have "supernormal return on assets" or when it is minimal, it is an indication that the company's goodwill may be fabricated.The above explanation is matching with the given statement. Hence, the statement is true. Therefore, the correct answer is .
Improper Use of Merger Reserves Company W used two schemes to overstate the earnings of the company: 1. Company W created unwanted cookie-jar reserves to increase the later earnings and present false picture of company that, it is financially healthy. 2. Company W reclassified the line-cost expenses as the capital assets. Therefore, those costs were classified as capital asset instead of expenses. They were reported in the balance sheet instead of the income statement. This overstated the earnings. Answer: F Justification: As per above explanation, the company has used unwanted cookie-jar reserves and line-cost expense to overstate the sales. It has not hold the books open at the close of reporting period. Therefore, the answer is F. Thus, the correct answer is .