Homework 5

When we discussed Present Value Techniques in connection with Concepts Statement No. 7 we encountered the proposed use of probabilities interacting with $ amounts to form an estimate of a future cash flow. In these cases the task was to estimate the future cash flow so we could take its Present Value and then use it as an accounting measure, for example, the liability in a lease. At the time I made the point that US GAAP had not yet developed a theory for the estimation of probabilities. Finance Theory is further along, but leaves much to be desired for an auditor who must audit the probability estimate incorporated in the estimate of a future cash flow.

Let's try our hand at an exercise in Probability and auditor intuition. We have been asked to audit a future cash flow. We are presented two separate files meant to document and support the future cash flow estimate. They happened to agree as to what the future cash flow should be - the estimated future cash flow is 30 in each case. But the probability lay out they use is quite different. The facts are spelled out below. Which probability fact pattern is the most "reliable" for use in accounting and why ?

FACT PATTERN 1 FACT PATTERN 2

Amount Probability Weighted Amount Probability Weighted

Estimated Estimate Estimated Estimate

50 20% 10 70 10% 7

40 20% 8 30 50% 15

30 20% 6 10 80% 8

20 20% 4

10 20% 2

Estimated Future Amount 30 Estimated Future Amount 30

Homework 6

Materiality continues to concern accountants, lawyers, the ESG community and most users of financial information. When is an item so important that to misstate it when including in reports or omitting it from reports would cause the report user to arrive at a different decision? If the decision would change then the misstatement of omission is material, in theory.

Consider two income statements. A banker trying to value a company is using this base year income statement to forecast an earnings-based estimate of FREE CASH FLOW for a valuation. The variable they will use is Earnings before Interest and Taxes adjusted for Depreciation and Amortization (EBITDA). For purposes of this exercise assume that the write off of Goodwill is considered an Amortization statistic. The EBITDA statistic should have one more characteristic. It should be composed of variables that are likely to continue into the future; one time elements such as special charges should not be part of the EBITDA base for this valuation.

Consider the two Income Statements below, the EBITDA Estimate provided. In the first a Goodwill amortization charge is reported separately. In the second the Goodwill charge is part of Amortization and since the reader is not provided information about it, the reader cannot adjust EBITDA for this one time element.

Here is the question: Is Goodwill material to users of this (partial) Income Statement and does that mean that Income Statement 1 is of higher quality than Income Statement 2?

INCOME STATEMENT 1 INCOME STATEMENT 2

Sales 100,000 100,000

Cost of Goods Sold (40,000) (40,000)

Gross Margin 60,000 60,000

General Expenses 20,000 50,000 (all elements combined)

Depreciation 10,000

Amortization of Leases 10,000

Goodwill Write Off 10,000

Earnings before Interest & Tax 10,000 10,000

Recurring EBITDA * 30,000 40,000 **

(Goodwill is not included because it is visible)

** Note: all Depreciation and Amortization including Goodwill which is not displayed separately - 30,000