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Earnings Management Homework

Earnings Management Homework. Ashlee Hunt. The accounting for r&D and economic profit measures. A) Expensed R&D. B ) Capitalized R&D. C) Difference between accounting treatments.

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Earnings Management Homework

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  1. Earnings Management Homework Ashlee Hunt

  2. The accounting for r&D and economic profit measures

  3. A) Expensed R&D

  4. B) Capitalized R&D

  5. C) Difference between accounting treatments • Treatment looks better overall under the capitalization of R&D versus expensing the R&D. RNEA and REI are more volatile while expensing R&D. • REI is negative at the beginning of 2014 in expensing R&D but is extremely high in 2019. • When expensing R&D, EPAT is negative for the first four years because the company is expensing the whole cost of R&D instead of amortizing it over time. • Therefore, capitalizing R&D makes the income statement and balance sheet look better because EPAT, NEA, RNEA, and REI are steadily growing over time.

  6. D) Forecasted RNEA and REI for 2020 • In forecasting RNEA and REI, I took the historical average for years 2018-2019 because they seemed to stabilize • The RNEA differs and is higher in Expensing the R&D because NEA is smaller because R&D is on the income statement rather than the balance sheet • REI is higher in Expensing method for similar reasons that NEA is lower because R&D is expensed instead of capitalized

  7. E) Valuation of Expensed R&D

  8. E) Valuation of Capitalized r&D • The valuations are the same because the REI model is the same value regardless of the accounting method that is used for the firm

  9. F) Difficulties forecasted to 2016 • The difficulty by just forecasting until 2016 is that the models do not reach steady state and in order to compare the models the REI growth should be zero • The overall value of the companies for each accounting method would no longer be the same because the accounting methods have to reverse out in order to compare the two methods

  10. G) Decreasing R&d by $20 million in 2016 and so on • There is a lag effect of revenue • Even though revenue is decreasing, it is decreasing at a slower rate than the R&D Expense

  11. Depreciation methods, profitability, and valuation: Earnings Management

  12. A) 3 year useful life depreciation method forecast

  13. A) 5 year useful life depreciation method forecast

  14. B) Which forecast shows the firm most profitable in 2017 • The forecast using the 3 year useful life looks more profitable • This is because the depreciation is accelerated in three years instead of five years

  15. C) DCF Values

  16. D) Reply to the founders • The three year useful life model does have $100 more profit in 2017 than the five year model but overall, both models have the same intrinsic value • On the basis of valuation of the company, the founders should be indifferent to which depreciation method is used because they yield the same value

  17. E) Argument based on 2022 profits • The five year useful life model should be used because it is more conservative and EPAT grows over time instead of reaching a steady state in 2020 like in the three year useful life model • But both models have the same profit in 2022 so if the CFO was just focusing on profits, then he would be indifferent between the two models

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