Can someone explain this?
Cooper Creek Cable Case Scenario
Hannah Treadway is an analyst at Knight Investment Management (Knight). Knight holds Cooper Creek Cable Limited (CCCL) as part of its AFE (Australian and Far East) investment portfolio. CCCL is a diversified cable and communications company operating in Western Australia. The company consists of three divisions:
- Cable: Provides subscription television services and high speed internet to residential customers.
- Media: Owns and operates a group of radio stations and publishes several magazines.
- Wireless: Is engaged in wireless voice and data communications services.
Treadway is just starting her annual review of the company based on its most recent financial statements, excerpts of which are in Exhibits 1 and 2. The financial statements for CCCL are prepared in accordance with Australian Accounting Standards (AASB), which comply with IFRS. All figures are in Australian dollars ($).
Exhibit 1
Cooper Creek Cable Limited Statement of Earnings for Years Ending December 31 (all figures in $ thousands)
2016 | 2015 | ||
Revenue | 711,200 | 674,600 | |
Programming and communication expenses | 312,900 | 317,000 | |
Gross margin | 398,300 | 357,600 | |
Depreciation expense | 98,750 | 78,650 | |
Amortization of intangibles | 7,250 | 8,150 | |
Reversal of impairment loss | –12,500 | ||
Gain on sale of assets held for sale | –14,400 | ||
Operating costs | 185,900 | 173,000 | |
Interest expense | 64,100 | 65,900 | |
Income from investments in associates | 1,200 | 850 | |
Profit before tax | 70,400 | 32,750 | |
Tax benefit (expense) | 17,600 | –8,187 | |
Net profit for the year | 88,000 | 24,563 |
Exhibit 2
Cooper Creek Cable Limited Balance Sheet as of December 31 (all figures in $ thousands)
2016 | 2015 | ||
Cash | 95,600 | 74,400 | |
Accounts receivable, net | 35,700 | 33,500 | |
Assets held for sale | 23,500 | ||
Total current assets | 131,300 | 131,400 | |
Investments in associates | 42,700 | 42,300 | |
Capital assets, net | 221,800 | 241,200 | |
Intangible assets, net | 43,250 | 24,500 | |
Goodwill | 11,000 | 6,500 | |
Deferred tax assets | 185,500 | 169,900 | |
Total assets | 635,550 | 615,800 | |
Trade payables | 92,100 | 104,200 | |
Interest bearing loans | 49,700 | ||
Short-term unearned revenue | 12,500 | 21,250 | |
Other liabilities | 23,800 | 23,000 | |
Total current Liabilities | 178,100 | 148,450 | |
Interest bearing debt | 703,800 | 814,300 | |
Long-term unearned revenue | 6,500 | 13,500 | |
Total liabilities | 888,400 | 976,250 | |
Issued capital | 556,400 | 536,800 | |
Accumulated losses | –809,250 | –897,250 | |
Total equity | –252,850 | –360,450 | |
Total liabilities and equity | 635,550 | 615,800 |
CCCL sustained substantial losses in its start-up period (2001–2005) (from which it is still benefiting for tax purposes) but has been profitable since 2005, reporting a record profit after tax in 2016. However, Treadway is wondering if CCCL’s revenues in general are supported by cash flows and if the company might be trying to increase the appearance of profitability in order to increase the share price, which remains low.
The Wireless division was acquired by CCCL in a share purchase in late 2015. Treadway wants to review the accounting policies CCCL has adopted for both revenue and expenses incurred on long-term wireless contracts (Exhibit 3).
Exhibit 3
Excerpts of Accounting Policy Notes (all figures in thousands)
Note 1 d) Long-Term Wireless Contracts
Customers who enter into long-term service contracts for wireless services can obtain their mobile devices for a nominal amount. Commencing in 2016, the discount offered on the devices, relative to the regular price, is capitalized as a customer acquisition cost and amortized straight-line over the life of the contract, or a minimum of three years. Previously this amount was recognized in income immediately.
Note 1 g) Unearned Revenue
Unearned revenue for subscriptions, or for services paid in advance, was historically recognized on a straight-line basis over the term of the contract or subscription, which was typically three years. After reviewing the historical pattern of usage and cancellations for service contracts in 2016, the pattern of recognition was changed to recognize the majority of the revenues in the first 12 months after the service contract is signed with the remainder recognized in the following year.
Note 12) Broadcast Licenses
During 2016, the company successfully disposed of broadcast licenses that were held for sale for $37,900 (net book value of $23,500). Based on the successful completion of that sale the impairment losses taken in 2014 on other licenses have been reversed, restoring those intangible assets to their amortized historical cost. Broadcast licenses are amortized over a period of 15 to 25 years.
On reading the note about the rapid reversal of the impairment loss related to the Broadcast licenses (Exhibit 3, Note 12) Treadway strongly believes that it arose as an attempt by management to manage earnings. She realizes that both her 2014 and 2015 analyses were impacted by these actions and now need to be reconsidered.
As part of her annual review, Treadway determines the Altman’s Z-scores for CCCL. The results for the current and past years are reported in Exhibit 4.
Exhibit 4
Cooper Creek Cable Limited Altman Z-Scores
2016 | 2015 | |
Altman Z-score* | 2.14 | 1.82 |
* Critical values: 1.81 and 3.0
Finally, Treadway noted that during 2016 CCCL acquired 100% of MusicMusic (MM), a specialty cable music channel in an all-stock deal. At the time of the acquisition MM reported intangible assets for broadcast licenses at a value of $2,500. CCCL estimated the fair value of those licenses to be $5,500 at that date and estimated the value of the MusicMusic brand name to be $2,000, all figures in thousands. The acquisition did not give rise to any goodwill.
Question
If Treadway’s belief about management’s motivation behind the 2014 treatment of the broadcast licenses is correct, compared to the actual economic results in 2015, her original 2015 analysis would most likely have:
- understated fixed asset turnover.
- overstated net profit margin.
- understated ROA.
Is the answer A please confirm.
Yes