Chapter 1, Introductory Cases Dublin Small Animal Clinic, Inc. 1 page; introductory

10 pages; intermediate

Corporate governance

Unauthorized financial transactions

Forensic accounting

Audits

In late December 2009, a federal complaint charged Koss’s CFO with embezzling as much as $4.5 million from Koss, which had 2009 revenues of only $38.2 million. Two days later Koss issued a press release stating that the embezzlement might be as high as $20 million. On January 4, 2010, Koss issued a press release stating that the embezzlement may have exceeded $31 million for the fiscal years ending June 30, 2005 through 2009. Later reports disclosed that the embezzlement ranged from $2,195,477 in fiscal year 2005 to $8,485,967 in fiscal year 2009, and were approximately $5 million per quarter for the two quarters ended September 30, 2009, and December 31, 2010.

The embezzlement was detected when American Express notified Koss’ CEO that the firm was making very large wire transfers of cash to pay off a personal American Express card.

The case takes the perspective of a hedge fund manager who is analyzing Koss’ financial statements in an attempt to value Koss with no more information than previous financial statements and the knowledge that the CFO may have embezzled $35-$40 million during the previous ten years. A quick review of Koss’s annual financial statements from 2005-2009 reveals Koss had virtually no liabilities and that its assets could not have been overstated by the amount of the embezzlement; total assets as of December 31, 2009, were only $28.5 million.

Although accounts receivable and inventories might be overstated by as much as $5 million each, it seems highly unlikely that auditors would miss that much of an overstatement of receivables. Even if receivables and inventory were overstated by a total of $10 million, the remaining $25-30 million embezzled must have been recorded by debiting an expense account and crediting cash. Koss must have been highly profitable before the embezzlement and only moderately profitable after the embezzlement.

Assuming the embezzlement was primarily recorded as an expense, then Koss’ balance sheet is reasonably accurate, so Koss may need only a minor write-off of inventory and receivables. In the future, the major change to Koss’ operations will be that it is far more profitable because no one is embezzling. Koss’ market value should increase as a result of the discovered embezzlement, not decrease, which would have been the initial reaction to a major embezzlement.

Prior to the embezzlement, Koss was trading at about $5.50 per share. After the embezzlement disclosure, Koss’s share price declined to $3.90 per share, but has subsequently risen to $5.65 per share. During that same period the DJIA and SA&P 500 each declined by about 5%. Koss expects to release the results of its investigation in June 2010, so the teaching note will include information that is not now available.

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Valuation

43.Asher Associates: Acquisition Targets

10 pages; advanced

Acquisitions

Valuation

EBITDA

Receivables

Many privately held firms have high costs for executive salaries, travel, entertainment, automobiles, and similar items that would be substantially reduced by a new owner. The first firm adds back numerous costs but many of them seem necessary to operate the business.

The first firm also expects the acquirer to pay the current owner for 70% of the cash and 80% of the accounts receivable retained in the business (or have the owner withdraw those amounts prior to the acquisition). Sellers and buyers typically specify the net current assets that will remain in the business at the time of the sale; this adjustment effectively specifies that the acquired firm will probably not have enough cash or receivables to operate without additional funding.

The second firm is an “S” corporation so it will be an asset sale. The acquirer will be able to record as intangible assets the difference between the selling price and the net book value of tangible assets, and then amortize that amount over 15 years. That clearly adds value to the acquired company.

The second company also reports on the cash basis, although from the case it is unclear whether the firm can legally use that method for tax purposes. From the potential buyer’s perspective, that is irrelevant because the buyer will switch to accrual accounting. However, there is a very significant issue related to the cash basis accounting. The firm’s financial statements do not include credit sales and at the time the business is being offered for sale, receivables are very high. That leads to two questions. First, are the receivables collectible? From the case, that does not seem to be a problem. The second question is more of a problem.

The firm did not record accounts receivable for prior years. The firm’s owner recently estimated year-end receivables for prior years so the firm could prepare accrual-based income statements. Those accrual statements show a firm with steadily increasing revenues and profits; in contrast, cash-based income statements show a firm with slowing increasing revenues and declining profits. Because the firm has no records of year-end receivables, the potential buyer has no way to know which set of financial statements is more reliable. Hiring a firm to perform due diligence might help, but the results would still be questionable.

The case presents information that is similar to what a buyer would encounter when evaluating businesses that sell for between $10 million and $50 million (and possibly much larger businesses). Sellers know that buyers often price a business based on EBITDA, information is often of questionable quality, and sellers often adjust EBITDA so as to improperly inflate a firm’s offering price.

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial statement analysis

Valuation

Use with:

Brief Excel Case: Valuation (Chapter 8)

10 pages; advanced

Business valuations

Fair value

Litigation

The case covers a wide range of valuation methods by three valuation experts. The court completely rejected all but one method. That method is based on the Morning Star/Ibbotson discount rates by firm size. The case provides enough information that students can discuss the validity of each valuation method and the validity of the judge’s decisions.

Best uses:

First-year MBA/Executive MBA Financial accounting

Valuation

Use with:

Brief Excel Case: Valuation (Chapter 8)

Chapter 7, Topic Notes

Discounted cash flow analysis using Excel

8 pages; introductory

Best uses:

First-year MBA/Executive MBA Financial accounting

Executive education

Use with:

4 pages; introductory

Ratio analysis

Best uses:

First-year MBA/Executive MBA Financial accounting

Executive education

47.Note on Bonds

4 pages; introductory

Bond valuation

Reported bond yield conventions

Bond pricing conventions

Accrued interest conventions

Best uses:

First-year MBA/Executive MBA Financial accounting

Use with:

13 pages; intermediate to advanced

Defined benefit plans

Retiree health care benefit plans

Employee Retirement Income Security Act of 1974 (ERISA)

Pension Benefit Guarantee Corporation (PBGC)

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Use with:

The Boeing Company: Retiree Benefits, 2008 (Chapter 3)

General Motors Corp: Bankruptcy (Chapter 5)

49.Fair value reporting

7 pages; advanced

Fair value reporting

The fair value option

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Executive education

Valuation

Use with:

11 pages; advanced

Accounting for business combinations

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Executive education

Valuation

Use with:

Barclays’ Acquisition of Lehman Brothers (Chapter 4)

InBev: the Anheuser-Busch Acquisition (Chapter 6)

51.Business valuation

Fair value

Business valuation

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Executive education

Valuation

Use with:

Sunbelt Beverage Corp: Fair Value Litigation (Chapter 6)

Chapter 8, Excel-based Problem Sets

7 pages; introductory

Discounted cash flow analysis using Excel

Best uses:

First-year MBA/Executive MBA Financial accounting

3 pages; intermediate

Revenue recognition

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Use with:

2 pages; intermediate

Revenue recognition

It also requires students to prepare financial statements for a retail firm that sells extended warranties. The first set of financial statements must report extended warranty payments as revenue on the date of sale. The second set of financial statements must report amounts received for extended warranties as revenue during the periods when the firm expects to incur extended warranty costs. Students must then compare the two methods.

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Use with:

3 pages; intermediate

Accounting for asset impairments under IFRS and U.S. GAAP

Goodwill impairments

Accounting for restructurings

Best uses:

First-year MBA/Executive MBA Financial accounting

3 pages; intermediate

Accounting for the sale of fixed income securities

Fixed income valuation

Early retirement of fixed income securities

The second problem requires students to calculate the cost of acquiring those bonds at a later date and to the show the journal entries needed to record the acquisition and retirement of those bonds.

The third problem requires students to compute the amount received for a zero-coupon bond issue, and to then show the journal entries for that bond issue.

Best uses:

First-year MBA/Executive MBA Financial accounting

Use with:

4 pages; intermediate

Accounting for sales-type leases

Accounting for operating leases

The effect of discount rates on reported revenues

Best uses:

First-year MBA/Executive MBA Financial accounting

Use with:

Leasing Restatements in the Restaurant Industry (Chapter 3)

3 pages; intermediate

Pricing conventions for derivative securities

They also learn that a quote of 109’112 for a Treasury note futures contract does not mean the contract price is $109.112. Instead, the 112 is a quote in thirty-seconds; specifically 11.25 thirty seconds, so in decimals, the quote is $109.351563. For Treasury futures contracts, the quote is multiplied by $2,000, so the value is slightly more than $200,000.

The purpose of this problem set is to illustrate that it is necessary to learn numerous details to price complex securities.

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

59.Brief Excel Case: Defined Benefit Retirement Plans

5 pages; intermediate

Accounting for defined benefit retirement plans

Service costs

Interest costs

Cost of changes in actuarial assumptions

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Use with:

6 pages; advanced

Accounting for securitizations

Retained interests

Discount rates

Assumed default rates

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Best use:

New Century Financial Corp (Chapter 3)

Mitchells & Butlers plc (Chapter 4)

Harley-Davidson, Inc. (B): February 2010 (Chapter 5)

4 pages; intermediate

Discounted cash flow valuations

Market comparable/market multiple valuations

Best uses:

First-year MBA/Executive MBA Financial accounting

Financial reporting

Financial statement analysis

Valuation

Best uses:

Sunbelt Beverage Corp: Fair Value Litigation (Chapter 6)