Project: Assessing Earning Quality: Nuware, INC

Assume Nuware has used the same accounting methods and assumptions as R.P. Stuart, we need to do the following adjustments.

For the AR, the percentage of allowance of AR for R.P. Stuart company is 4.48% in 2013 while that for Nuware company is 3.09%. Nuware set a relatively low level for the allowance of AR which may be considered as an aggressive accounting method. We apply the percentage of allowance of RP Stuart to Nuware in order to make Nuware’s risk of credit sales more comparable with R.P. Stuart.

Nuware recorded beneficial interest in securitized receivables as a current asset on the balance sheet but in the footnotes the fair value of it is different from the record value, as the only financial instrument with a fair value, it should be classified as long terms assets at fair value, and thus we remove this beneficial interest in securitized receivables. In addition, sales of available for sale securities resulted in net realized gains of $6.7 million should be removed from the retained earnings.

Nuware deferred the advertising expenses, but GAAP requires costs should be realized as expenses as soon as it happened. So we need to add it back.

For the inventory, we need to adjust Nuware’s inventory from LIFO to FIFO. As indicated in the footnote, Nuware’s inventory would be increased by 29.5 million in 2013 and 35.1 million in 2012 if using FIFO. Because of (LIFO reserve at end of year – LIFO reserve at beginning of year = LIFO COGS – FIFO COGS), Nuware’s COGS would go up by 5.6 million under FIFO.

In addition, we also need to adjust the change in the tax expense, NI and RE based on the adjustment we did above.

From the table in the appendix, we can clearly see that Nuware’s profitability ratio is higher than that of R.P.Stuart. ROE of Nuware is 6% higher than that of R.P.Stuart. Comparing two firms’ Asset turnover ratio and Receivable turnover, we can conclude that Nuware uses assets more efficiently. However, the risk embedded in Nuware is also higher than R.P.Stuart. Nuware has a much higher leverage ratio than R.P. Stuart, which means that Nuware’s equity holders bear more risk than R.P.Stuart’s shareholders. In terms of short-term default risk, Nuware is also higher than R.P.Stuart because its current ratio and quick ratio are both higher than that of R.P. Stuart, respectively.

We would like to characterize the accounting discretion applied by Nuware’s management is aggressive in terms of net income. After adjusting the Nuware’s financial statements with R.P Stuart accounting method and applying assumptions of R.P Stuart to Nuware’s case, we can safely arrive at the conclusion that previous accounting method is aggressive with the observation that the interest and investment income, net income and net account receivables of Nuware have decreased. From another perspective, if we compare its total accruals (= Net income – Cash flow operations) to net income over time, we can easily draw the same conclusion since increase in net income is built up by using accruals.