Question 17.2: A Quality-of-Earnings Comparison of Two Companies Siemens AG...

Solution to 1. Net operating assets is defined as (Total assets – Cash and marketable securities) – (Total liabilities – Total debt). For example, in 2006 Siemens reported total assets of 90,973 and cash and marketable securities of 10,214 + 596 = 10,810. Total liabilities were 61,667 and total debt was 2,175 + 13,399 = 15,574. (90,973 – 10,810) – (61,667 – 15,574) =  80,163 – 46,093 = 34,070. The values for each firm are summarized below.

Solution to 2. Balance sheet aggregate accruals are defined as the change in net operating assets. As such, only two years worth of accruals can be calculated from the data given. For example, for Siemens, using the answers to Problem 1, balance sheet aggregate accruals for 2006 equals €34,070 – €29,547 = €4,523.

Cash flow statement aggregate accruals are defined as Net income – (Cash flows from operating activity + Cash flows from investing activity). For example, for Siemens in 2006, cash flow statement aggregate accruals is found as NI of €3,033 – [CFO of €4,981 + (CFI of –  €4,614)] = €3,033 – €367 = €2,666.

Solution to 3. The accrual ratio is defined as aggregate accruals divided by average net operating assets. Because the denominator requires an average of two years’ data, only two years of accrual ratios can be calculated. For example, for Siemens, average net operating assets for 2006 were (€34,070 + €29,547) ÷ 2 = €31,808.5. With aggregate accruals for 2006 of €4,523 and €2,666 by the balance sheet and cash flow statement methods respectively, the corresponding accrual ratios were €4,523 ÷ €31,808.5 = 14.2 percent and €2,666 ÷ €31,808.5 = 8.4 percent.

Solutions to 4.
A. Using the balance-sheet-based accrual ratio, General Electric has higher earnings quality (i.e., lower accruals ratio) in both years. Using the cash-flow statement-based measure, GE actually shows lower earnings quality than Siemens only in 2006.
B. Using either earnings quality measure, Siemens shows improving earnings quality from 2005 to 2006, while GE shows deteriorating earnings quality.

Solution to 5. Subtracting the results of discontinued operations from net income and using the cash flow data from continuing operations, the results of the calculations are:

Using continuing operations does not significantly alter either the level or trends in accruals for these companies.

Solution to 6. The $41,593 million change in financing receivables accounts for a large portion of GE’s $53,879 million change in net operating assets. Compared to treating the leases as operating leases (see the chapter on long-term liabilities), accounting for leases as direct financing leases increases net income in the early years of a lease but the same total net income is recognized over the lease life. Under operating lease accounting, operating cash fl ow is lower, but investing cash flows are higher. When considering the cash versus accrual portions of earnings, this disclosure allows us to conclude that GE’s 2006 earnings are likely less persistent (of lower quality) than its 2005 earnings.