ACC 311 Intermediate Accounting I

CASE STUDY: LONE STAR POWER 3 points bonus

Ward Johnson stared out the window. In the three months since he had assumed the role of chief investment officer at Lone Star Power, Johnson thought the companys communications with the investing public had been superb, particularly with respect to its SEC filings. A single letter from an apparently upset analyst had changed that view.

Lone Star Power was a midsize power generation and power distribution company based in the Southwest. It provided electrical power to more than 750,000 homes, businesses, and government agencies. In addition to power generation and distribution, Lone Star sold and installed a wide-ranging array of products, from appliances to power-generation backup systems. It also offered service and repairs to customers throughout its territory. Total revenues for the quarter ended December 31, 2016, had topped $1 billion for the first time. With only one exception, the company had managed to grow both revenues and profits in each quarter since 2000. Put in place in early 2014, the companys formal investor-relations function was relatively new. Prior to that, Lone Star had a small support staff that would send annual reports and similar literature in response to phone requests and handle other routine investor inquiries. In addition to his other duties, Johnson was expected to develop the investor-relations department in a way that would enhance Lone Stars standing with the investing community.

Marianne Relzo was a senior, all-star equity analyst with Pitt Financial, a well-regarded U.S. investment bank. In a letter to Johnson, Relzo detailed her discontent with the companys external financial communications. She complained about items as specific as Lone Stars financial-statement footnote disclosures and as general as the companys composite accounting policies. Johnson knew he would have to meet with Lone Stars senior financial staff and receive input as to whether these issues had merit and how he should respond. With a red pen in hand, he read the letter once again.

Relzos letter raised a number of issues for Johnson to consider. In the margins of the letter, he jotted notes regarding each one. From his experience, Johnson knew it was an analysts objective to gather as much information about a company as possible. Regulation FD, however, defined the landscape regarding how he and other Lone Star officer should release information, but he was unsure what was implied regarding how he should deal with financial-reporting questions.

Johnson was not an accountant, and was not at all confident that he could articulate Lone Stars position on what revenues and expenses were recorded. On the expense side, in particular, he was perplexed as to why it was even an issue if the company were to negotiate a discount that required promotional fees to be paid in advance, charging net income when paid. By recording in this fashion, he thought Lone Star was only being conservative by accelerating a loss.

The company was also being questioned on its overall financial-reporting transparency. Lone Star followed Generally Accepted Accounting Principles (GAAP) to the letter and filed timely reports with the SEC. Its financial statements were audited, and each major topic required in the Management Discussion and Analysis (MD&A) was dutifully disclosed. It seemed unreasonable to Johnson that the company be expected to provide real-time details on such items as negotiations with specific customers and write-offs of assets.

Required:

Define Earnings management. Provide methods of Earnings Management. In your answers to the below questions, indicate if Earnings Management applies and in what way.

What potential issues is the analyst trying to determine by raising the points in 1a, 1b, and 3? Consider each item separately. When answering these questions explain why analysts should be concerned about these particular issues.

Relzo raises issues with the consistent application of accounting methods (item 4) and the consistent classification of certain line items (item 5). Do you think it is within the rights of a company to vary accounting methods and reclassify certain line items?

Relzo is critical of Lone Stars transparency. What is financial transparency and how would we know whether a firm has achieved it? You may need to look at the conceptual framework characteristics to answer this question.