1. QUESTION
   1. Assume the role of Hereford and re-state Nuwares 2013 earnings as if the company had used a similar accounting method and assumptions. After such a restatement, do Nuwares earnings and earnings growth remain superior to those of R. P. Stuart?

Your analysis should consider the following accounting methods and choices.

1. The difference in how the two companies estimate bad debt expense.
2. The difference in the average useful life that each company uses to estimate depreciation expense for its gross fixed assets.
3. The difference in cost of goods sold.
4. The impact of investment gains.

Assessing Earnings Quality: Nuware, Inc. Jack Hereford finished his second cup of coffee and flipped through the Nuware research file. He had been asked by IIarry Malone to provide a "restatement of Nuware's fiscal 2013 earnings, but unfortunately he had only a slight notion of how to proceed. Nuware was a midsize retailer based in the Midwest, and one of Wyburn Malone's largest institutional clients was interested in taking a substantial equity position in the company. One basis for the potential purchase was Nuware's continued earnings growth, particularly during a relatively difficult three-year period for the retail industry. As of its most current fiscal year, Nuware continued to show solid gains in both carnings and share price. Typical of any new rescarch project conducted at Wyburn Malonc, a first objective was an attempt at quantifying whether management leaned toward aggressive or conservative accounting policies. Hereford felt somewhat uncomfortable delving into any firm's accounting policies; he was not an accountant by trade, and moreover, this was only his second week at the firm. He clearly recognized the importance of this task, however, as many of the firm's clients depended on Wyburn Malone's investment analysis. Moreover, if in the end, its final report indicated significant over- or undervaluation, Nuware might be profiled in Wyburn Malone's next newsletter. Wyburn Malone Wyburn Malone was an independent cquity rescarch firm servicing more than 40 institutional clients, cach of whom had an annual subscription to the company's newsletterthe WM Report. The WM Report was published six times per year and concentrated on generating approximately 10 new target investment ideas, both long and short. Quality, rather than quantity, was the primary objective of the firm's research function. Recommendations generated by the research staff virtually always began with a thorough analysis of a firm's reported accounting data. Wyburn Malone's unique analysis and superb track record had led to rapid growth and one of the industry's highest client-retention rates. In addition to the WM Report, staff members were dedicated to providing research tailored to a client's specific needs, including recommendations about individual companies outside the scope of the newsletter and industry or sector analyses. In 1991, Wyburn Malone had been formed as a research firm when six inexperienced analysts were recruited by an ambitious Harry Malonc, then the director of a struggling stock-brokerage firm. The brokerage firm had recently lost its chairman, and in the ensuing power struggle many top brokers had joined competitors; most of the firm's client base followed them, and revenues fell sharply. Undaunted, Malone kept the company afloat. A fortuitous investor request to summarize the firm's current investment recommendations led to the first publication of what became the WM Report. That first report was made available via the then untested internet medium and was an immediate success. Within two years, the company had folded its trading operations in order to focus solely on buy-side research. As its reputation grew, the firm moved toward servicing only the institutional side of the business, marketing its services to pension and mutual funds. Within 10 years, through hard work and with some luck, Wyburn Malone became one of the most respected and reputable buy-side research firms in the country. As the director of research, Malone had been individually cited by the national press for his research in the retail and property sectors. Hereford was Malone's newest associate. The Task at Hand The thumping in Hereford's head intensificd as he tackled thc Nuwarc restatement. As he revicwed the file (sce Exhibits 2, 3, and 4), he recalled some important facets of financial reporting. Management of a company can exercise significant judgment when making estimates in its financial statements. Companies have a myriad of assumptions they can use, sometimes advantageously choosing one accounting method over another or selectively applying accounting estimates in an effort to show improved financial performance. When two companies appear to be the same, I lereford remembered, their individual business models must be considered first before any conclusions can be reached. Even then, an assessment of accounting policies should be made to determine if their respective performances were mcasured on the same bases. Fortunately for Hereford, Malone had recognized the difficulty of this task and had provided some direction on how to proceed. First, he gave Hereford a one-page primer he had prepared that illustrated the earnings sensitivity of Sears, Roebuck and Co. to its receivables and inventory accounting policies (Exhibit 1). The data for these calculations had been gathered by Malone directly from Sears's financial statements and footnotes. In the late 1990s, Scars had been accused of using its credit-reccivable accounts and available accounting discretion to smooth carnings.' Malone's analysis was designed to illustrate that that potential did indeed exist, and he suggested that Hereford review the Sears analysis before he began restating Nuware's earnings. Malone also provided Hereford with the research file for R. P. Stuart Company Exhibits 5, 6, and 7), a competitor of Nuware whose stock the WM Report had profiled the previous month as a solid "market outperform. Malone knew management personally and had a high degree of respect for the company's financial reporting transparency. While R. P. Stuart had struggled just to match the previous year's profitability, Nuware had increased carnings by almost 20% (Exhibit 8). Malone bluntly told Hereford to "make Nuware look as if it applied R. P. Stuart accounting and remove the effects of one-time transactions. As an example, Malone scratched out the income effects of excluding Nuware's gains on investment sales for each of the previous three years. Looking at both of the company's footnotes, he observed that Nuware appeared to hold significant investments while R. P. Stuart did not, and to the extent the company was selectively selling certain securities in order to time the recording of gains, net income would be artificially raised. Hereford wasn't so sure he agreed with Malonc's logic, because realized gains on sales must be recognized under GAAP. Nevertheless, he watched as Malone backed out $4.2 million from Nuware's 2013 net income. "Don't worry about being precise," Malone added. Just try to help us get a feel for how much of Nuware's profitability might be attributable to aggressive policies. Be sure not to ignore the accounting effects related to receivables, inventory, and PPE.2 These items are always important for retailers." Malone assured Hereford that the business models of Nuware and R. P. Stuart were virtually identical, and industry characteristics that may help explain earnings trends across the two companies were not factors. Both companies carried similar product lines. Both companies typically earned a disproportionate share of operating income in the fourth quarter, and each used January as a fiscal year-end. The principal factors that differentiated most other retail competitors (i.e., convenience of shopping facilities, quality of merchandise, competitive prices, brand names, and availability of ancillary services, such as credit, product delivery, repair, and installation) were also similar across the two companies. Both, in fact, offered their own credit card to customers and therefore had very high levels of receivables relative to other industry members. Hereford was pressed to get his preliminary report done quickly. An afternoon conference call was less than four hours away. Exhibit 1 Assessing Earnings Quality: Nuware, Inc. Earnings Sensitivity Analysis example for Sears: Accounts Receivable and Inventory (in millions, except per-share amounts) 2001 2000 1999 1998 $ 41,078 1,202 467 735 38.9 1,064 1,386 $ 40,937 2,174 831 1,343 38.2 251 1,498 $ 39,484 2,357 204 1,453 38.4 41 1,478 $41,575 1,838 766 1,072 41.7 Reported Earnings and Nonrecurring Items Net sales (T/S) Net income before tax (1/S) Tax expense (1/8) Net income after tax (1/S) Average effective tax rate computed,%) Nonrecurring charges before tax (I/S) Adjusted net income after tax (computed) Accounts Receivable Analysis Reported values: Gross receivables (B/S) Reserve for uncollectibles (B/S) Net receivables (B/S) Bad debt expense (I/S) Write-offs (footnotes) Inferred values and computed ratios: Reserve/accounts receivable %) Change in reserve/accounts receivable ratio (%) Accounts receivable turnover Days receivables turnover $ 29,321 1,166 28,155 1,866 1,386 $ 21,108 686 20,422 884 958 $ 21,937 760 21,177 871 1,085 $ 23,240 974 22,266 1,287 4.19 3.46 -0.73 3.98 0.73 1.69 216 3.25 -0.21 1.97 185 1.82 201 $99 Effect of 0.73% shift in reserve/accounts receivable As a % of net income (with nonrecurring items) As a % of net income (without nonrccurring items) $ 131 17.8% 9.4% $95 7.1% 6.4% 6.8% 6.7% $ 4,912 591 26,322 $ 5,618 566 26,899 $ 5,069 595 25,627 $ 5,322 679 27,444 Inventory Analysis Reported values: Inventory (LIFO, B/S) LIFO reserve (footnote disclosure) Cost of goods sold (LIFO, I/S) Inferred values and computed ralios Inventory (first in, first out) Cost of goods sold (FIFO) Inventory turnover (LIFO) Inventory turnover (FIFO) Days inventory turnover (LIFO) Days inventory turnover (FIFO) $ 6,001 $ 5,503 26,297 5.00 4.50 $ 6,184 26,928 5.03 4.55 72.51 80.30 $ 5,664 25,711 4.93 4.41 74.00 82.80 73.01 81.11 Effect of LIFO on reported earnings As a % of net income (with nonrecurring items) As a % of net income (without nonrecurring items) ($ 15.3) -2.1% -1.1% $ 17,9 1.3% 1.2% $ 51.8 3.6% 3.5% Note: B/S: reported on balance sheet: I/S: reported on income statement: LIFO: Last in, first out; FIFO: first in, first out. Data source: Sear's mal reports, Exhibit 2 Assessing Earnings Quality: Nuware, Inc. Nuware's Consolidated Statements of Operations For the fiscal year ended January 31, (in thousands, except per-share amounts) 2013 2012 2011 Net sales 1,754,861 1,709,254 1,611,498 1,001,892 586,124 36,356 1,009,893 555,508 32,196 919,871 565,475 30,229 Operating costs and expenses: Cost of sales (including occupancy costs) Selling, general and administrative expenses ..... Depreciation and amortization Operating income Nonoperating income, and expenses: Interest and investment income Interest expense Income before income taxes 130,489 111,657 95,923 (5,784) (9,382) 2,508 2,290 (5,014) 3,048 137,363 115,151 97,889 36,220 Provision for income taxes 50,784 42,576 Net income 86,580 72,575 61,670 Earnings per share: Basic Diluted 0.86 0.82 0.72 0.70 0.62 0.60 0.16 0.16 0.15 Dividends declared per share Average shares outstanding during period: Basic Diluted 100,883 105,823 100,883 103,972 99,631 102,003 Source: Created by case writer. Exhibit 3 Assessing Earnings Quality: Nuware, Inc. Nuwarc's Consolidated Balance Sheets (in thousands, excepi per-share amounts) As of January 31, Assets Current assets: Cash, including available for sale investments of $59,716 and $35,076 Beneficial interest in securitized receivables Accounts receivable, net of reserves of $9,438 and $16,140 Inventories Prepaid expenses and other current assets Total current assets 2013 192,114 40,538 295,888 247,502 56,179 832,221 2012 55,609 34,620 363,424 230,911 43,286 727,850 Properties, net Other noncurrent assets 374,493 49,411 370,262 47,895 Total assets 1,256,125 1,146,007 Liabilities and Shareholders' Equity Current liabilities: Current portion of long-term debt Accounts payable Gift cards, gift certificates, and merchandise credits outstanding Accrued income taxes payable Other accrued liabilities Total current liabilitics 393 176,702 117,495 35,798 192,348 522,736 356 129,076 139,852 29,738 170,053 469,075 Long-term debt Other noncurrent liabilitics 25,007 54,962 25,356 43,264 Shareholders' equity: Common stock, $0.10 par, 500,000,000 authorized, 100,883,000 issued Paid-in-capital Retained earnings 10,088 479,074 314,124 10,088 440,190 243,257 Cumulative other comprehensive income (loss) Less: 10,045,000 and 7,362,000 common shares in treasury, at cost (11,210) (138,656) (4,702) (80,521) Commitments and contingencies Total Liabilities and Shareholders' Equity 1,256,125 1,146,007 Source: Created by case writer. Exhibit 4 Assessing Earnings Quality: Nuware, Inc. Nuware's Selected Excerpts from Notes to Financial Statements Use of Estimates Financial statements are prepared in conformity with accounting principles generally accepted in the United States. They require management to make estimates and assumptions that affect the amounts reported. Actual results could differ from those estimates. Cash and Receivables The Company considers all investments with a maturity date of three months or less to be cash equivalents. The effect of foreign currency exchange rate fluctuations on cash has not been material. The company uses the percentage of sales method to estimate bad debts. Merchandise Inventories Inventories for are valued primarily at the lower of cost (using the last-in, first-out or "LIFO" method) or market, determined by the retail method. Lower of cost or market is determined on a combined basis for similar product lines. To estimate the effects of inflation/deflation on ending inventory, an internal index is calculated using cost data. Retail pricing is influenced by such factors as changes in pricing strategies, competitive pricing, and changes in styles and fashion, particularly in the apparel lines of merchandise. These factors affect the mcasurement of price changes, making it difficult to estimate inflation/deflation rates. Beginning in 2012, the company changed the basis of the internal index to measure inflation/deflation rates on supplier cost. This change results in a more accurate measurement of inflation/deflation rates used to adjust ending inventory cost under the LIFO method of inventory valuation. For 2012, the internal cost inflation/deflation rates were used to calculate the LIFO adjustment to ending inventory. The change resulted in a LIFO provision for 2012 of $35.1 million versus a provision of $33.0 million under the old method. For 2012, net income, basic EPS, and diluted EPS were lower by $2.1 million, $0.02, and $0.02, respectively, as a result of this change. The cumulative effect of the accounting change and pro forma amounts for periods prior to 2012 are not determinable because cost data is not available to calculate internal indices for years prior to 2012. The total charges to cost of sales include occupancy costs of $45 million, $44 million and $44 million in 2013, 2012, and 2011, respectively. If the first-in, first-out or FIFO method of inventory valuation had been used instead of the LIFO method, inventories would have been $29.5 million and $35.1 million higher at January 31, 2013, and January 31, 2012, respectively. Property and Equipment Property and equipment is stated at cost less accumulated depreciation. Depreciation is provided principally by the straight-line method over the estimated useful lives of the related assets, generally three to ten years for furniture and equipment and thirty years for buildings. Leasehold improvements are amortized over the shorter of the estimated useful lives of the improvements or the term of the lease. Accumulated depreciation as of January 31, 2013 and 2012, totaled $304.5 and $268.5 million, respectively. Routine repairs are expensed as incurred. Major improvements are capitalized. The cost of assets sold or retired and the related accumulated depreciation or amortization are removed from the accounts, with any resulting gain or loss included in net income. Dispositions were ncgligible in fiscal ycars 2013 and 2012. Depreciation costs were $35,698,000, $31,572,000, and $29,620,000 in fiscal 2013, 2012, and 2011, respectively. Financial Instruments The fair value of financial instruments is determined by reference to various market data and other valuation techniques as appropriate. With the exception of available-for-sale investment securities, there were no assets or liabilities with a fair value significantly different from the recorded value as of fiscal 2013, 2012, and 2011. The company records its investments in short-term stock securities using the available for sale classification, with all unrealized holding gains and losses recorded in cumulative other comprehensive income (loss). All other comprehensive income items are immaterial. During fiscal 2013, 2012, and 2011, sales of available-for- sale securities resulted in net realized gains of $6.7, 4.8, and 3.7 million, respectively. Revenue Recognition Revenue is recognized upon customer receipt or delivery, including sales under deferred payment promotions on the Company's proprietary credit card. Allowances have been established to provide for estimated merchandise returns. All revenue from gift cards and certificates is deferred until customer use. Advertising and Marketing Costs All promotional costs arc cxpensed when the bencfit is presumed to have been received. For advertising this is the first time the advertising takes place. Advertising costs were $62,211,000, $67,450,000, and $58,727,000 in fiscal 2013, 2012, and 2011, respectively. Other marketing and promotional costs amounted to $20,527,000, $17,561,000, and $19,044,000, of which $10.2 and $8.7 million have been dcferred as of the end of fiscal years 2013 and 2012, respectively. Short-Term and Long-Term Debt Carrying valuc approximates fair value for short-term dcbt. The fair value of long-term debt, excluding capital Icascs, is estimated by obtaining quotes from brokers or is based on current rates offered for similar debt. At January 31, 2013, long-term debt, including current maturities, had a carrying value of $25.0 million and a fair value of $27.3 million. At January 31, 2012, long-term debt, including current maturities, had a carrying value of $25.4 million and a fair value of $27.8 million. 2013 2012 in thousands) Issue: 7%-10% debentures Medium-term notes Sinking fund debentures $ 24,438 785 177 $ 24,467 1,050 195 Current maturities 25,400 (393) $ 25,007 25,712 (356) $ 25,356 Source: Created by case writer, Exhibit 5 Assessing Earnings Quality: Nuware, Inc. R. P. Stuart's Consolidated Statements of Income For the year ended January 31, (in thousands of dollars) 2013 2012 2011 Net sales 525,697 502,292 567,411 352,682 305,401 316,500 209,197 214,729 Cost of sales and occupancy Gross profit Selling, general, and administrative expenses Store preopening expenses Income from operations 196,891 149,884 164,550 156,942 4,603 5,371 4,584 45,576 46,884 42,424 Interest income 883 1,294 (4,999) (4,884) Interest expense Income before income taxes 1,180 (5,238) 38,366 41,575 43,179 Income taxes 16,214 16,836 14,956 Net income 25,361 26,343 23,409 Net income per share Basic Diluted 0.80 0.77 0.85 0.83 0.78 0.75 Weighted average shares outstanding Basic Diluted 31,649 32,960 31,105 31,876 30,064 31,199 Source: Created by case writer. Exhibit 6 Assessing Earnings Quality: Nuware, Inc. R. P. Stuart's Consolidated Balance Sheets (in thousands) 2013 2012 Assets Current assets: Cash and cash equivalents Credit receivables, net of allowances of $12,650 and $10,327 Merchandisc inventorics Other current assets Total current assets Property and equipment Accumulated depreciation Goodwill Other assets Total assets 45,420 269,115 131,344 16,789 462,668 430,256 (135,692) 4,178 9,287 770,697 111,815 217,123 109,829 11,107 449,874 356,096 (116,092) 4,340 10,080 704,298 Liabilities and Shareholders' Equity Current liabilitics: Current portion of long-term debt Accounts payable Income taxes payable Accrued compensation Other current liabilities Total current liabilities Capital lease obligations Other long-term obligations 4,809 73,990 15,082 8,305 28,986 131,172 13,216 55,091 3,468 81,592 29,993 18,506 18,251 151,810 15,498 44,035 Shareholders' equity: Preferred stock, $0.01 par value: 6,500,000 shares authorized; none issued and outstanding Common stock, $0.01 par value: 80,00,000 shares authorized; issued and outstanding 31,649,743 and 31,105,437 shares Additional paid-in-capital Retained carn Total shareholders' equity 316 275,089 295,813 311 220,056 272,588 571,218 492,955 Total Liabilities and Shareholders' Equity 770,697 704,298 Source: Created by casc writer, Exhibit 7 Assessing Earnings Quality: Nuware, Inc. R. P. Stuart's Selected Excerpts from Notes to Financial Statements RECEIVABLES: Receivables are shown net of an allowance for uncollectible accounts. The allowance is an estimate of losses in our credit card portfolio (including finance charges and credit card fee balances) as of the end of a fiscal year. The Company calculates the allowance using a model that analyzes factors such as bankruptcy filings, delinquency rates, and historical charge-off patterns. The Company's calculation is then reviewed by senior management to assess whether additional factors are required to appropriately estimate losses inherent in the credit card portfolio. The entire balance of an account is contractually delinquent if the minimum payment is not received by the payment due date, typically a revolving one month cycle. The Company's current credit processing system charges off an account automatically when a customer's number of missed monthly payments outstanding reaches six; however, accounts may be charged off sooner under specific circumstances (e.g., customer bankruptcy). Bankrupt customer accounts are charged off 15 days after the first meeting of the creditors for a filing under Chapter 7 of the U.S. Bankruptcy Code and 45 days after the first meeting of the creditors for a filing under Chapter 13 of the U.S. Bankruptcy Code. All amounts collected on previously charged off accounts are included in recoveries for the determination of net charge-offs. MERCHANDISE INVENTORIES: Merchandise inventories are valued at the lower of cost or market, with cost determined using the first-in, first-out cost flow assumption. To estimate the effects of inflation on inventories, the Company utilizes internally developed price indices. VENDOR ALLOWANCES: The Company receives allowances from its vendors through a variety of programs and arrangements, including co-operative advertising and markdown reimbursement programs. Given the promotional nature of the Company's business, the allowances are generally intended to offset the Company's costs of promoting, advertising and selling the vendors' products in its stores. Vendor allowances are recognized as a reduction of cost of goods sold or related selling expense when the purpose for which the vendor funds were intended to be used has been fulfilled. Co-operative marketing allowances are reported as a reduction of marketing expense in the period in which the marketing expenditures are incurred. Markdown reimbursements are credited to cost of goods sold during the period in which the related promotional markdown was taken. DEPRECIATION AND AMORTIZATION: Depreciation and amortization is provided principally by the straight-line method over the estimated useful lives of the related assets, generally 2 to 10 years for furniture, fixtures and equipment, 15 to 50 years for buildings and building improvements and 3 years for identifiable intangible assets with a definitive estimated useful life. Depreciation expense recorded during the years 2013, 2012, and 2011 is $26.9, $24.0, and $23.8 million, respectively, Source: Created by case writer. Exhibit 7 (continued) Notes Payables and Short-Term Lines of Credit 2013 3,072 Short-term borrowings consist of: (in thousands Unsecured commercial paper Asset-backed commercial paper Bank loans Promissory note Total short-term borrowings 2012 2,945 1,400 85 85 50 3,207 4,430 Weighted average interest rate 5.5 2.8 Long-term debt is as follows: Total long-term debt Current maturities Long-term debt 2013 45,752 4,809 40,943 2012 38,608 3,468 35,140 Weighted average annual interest rate 7.45 8.73 The fair value of long-term debt was $48.7 million and $41.6 million at January 31, 2013, and January 31, 2012, respectively. The company paid interest of $3.6 million, $3.7 million, and $3.9 million in 2013, 2012, and 2011, respectively. Interest capitalized was $0.3 million, $0.4 million, and $0.4 million in 2013, 2012, and 2011, respectively. Exhibit 8 Assessing Earnings Quality: Nuware, Inc. Miscellaneous Profitability Statistics Nuware R. P. Stuart 2013 2012 2011 2013 2012 2011 Net income S 86,580 $ 72,575 $ 61,670 $ 25,361 $ 26,313 $ 23,109 Net income per diluted share $ 0.82 $ 0.70 $ 0.60 $ 0.77 $ 0.83 0.75 Return on assets 7.3% 6.5% 3.8% 4.2% 13.7% 11.9% 4.8% 5.3% 37.0% 37.0% 37.0% 39.0% 39.0% 39.0% Return on equity Average effective tax rate Earnings per share growth Sales growth Gross profit margin 17.2% 15.5% -6.9% 10.1% 2.7% 6.1% 7.9% 4.7% 42.9% 40.9% 42.9% 37.8% 39.8% 39.2% Source: Created by case writer