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Asset Valuation: Atlantic Airlines Case

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Atlantic Airlines Case

Atlantic Airlines issued $100 million in bonds in 2008. Because of the firm's low credit rating (B3), the bonds were considered junk bonds. At the time of the issue, the 20 year bonds were paying a yield of 12 percent.
Investor Tom Phillips thought the yield on the bonds was particularly attractive and called his broker, roger Brown, to ask for more information on the debt issue. Tom currently held Treasury bonds paying four (4) percent interest and corporate bonds yielding six (6) percent. He wondered why the debt issue of Atlantic Airlines was paying twice that of his other corporate bonds and eight (8) percent more than Treasury securities.
His broker, Roger Brown has been a financial consultant with Merrill Lynch for 10 years and was frequently asked such questions about yield. He explained to Tom that the bonds were not considered investment grade because of the industry they were in. Bonds of airlines are considered inherently risky because of exposure to volatile energy prices and the high debt level that many airlines carry. He further explained that they frequently were labeled "junk bonds" because their rating did not fall into the four highest categories of ratings by the bond rating agencies of Moody's and Standard and Poor's.

Questions from Tom Phillips

This explanation did not deter Tom from showing continued interest. In fact, he could hardly wait to get his hands on the 12 percent yielding securities. First, he asked Roger, What is the true risk and is it worth taking?
Roger explained there was a higher risk of default on junk bonds. It sometimes ran as high as 2-3 percent during severe economic downturns (compared to .5 percent for more conventional issues). Roger also indicated that although the yield at the time of issue appeared high, it could go considerably higher should conditions worsen in the airline industry. This would take place if the price of oil moved sharply upward or people began flying less due to a downturn in the economy. Roger explained that if the yield (required return) on bonds of this nature went up, the price of the bonds would go down and could potentially wipe out the high interest payment advantage.

Required
1. If the yield in the market for bonds of this nature were to go up to 15 percent due to poor economic conditions, what would the new price of the bonds be? They have an initial par value of $1,000. Assume two years have passed and there are 18 years remaining on the life of the bonds. Use annual analysis.
2. Compare the decline in value to the eight (8) percent initial interest advantage over Treasury bonds (12 percent versus four (4) percent) for this two (2) year holding period. Base your analysis on a $1,000 bond. Disregarding tax considerations, would Tom come out ahead or behind in buying the high yield bonds?
3. Recompute the price of the bonds if interest rates went up by only one (1) percent to 13 percent with 18 years remaining. Does the 8 percent interest rate advantage over the two year holding period cover the loss in value?
4. Now assume that economic conditions improve and the yield on similar securities goes down by 2 or 3 percent over the two years. How does Tom come out? Merely discuss the answer. No calculation is necessary.
5. If Tom holds the bonds to maturity (and there is no default), does the change in the required yield in the market over the life of the bond have any direct effect on the investment?

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This solution discusses asset valuation in a Atlantic Airlines case study.

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Johnson & Johnson Audit Risk Case

Company is Johnson & Johnson
Audit Risk Case

The audit risk case involves your participation in activities that auditors undertake before an engagement. Each team will be composed of three or four members. A team leader will be selected at random. A leader can resign, if another student can be found to take over leadership for that team (without interference of the professor). The team leader will choose the other two (or three) members of the team. The team members will then be given one corporation from a selected industry for analysis. Teams may exchange their corporations before leaving class.

The audit risk case involves the investigating a potential audit client and preparation of an audit risk memorandum. The audit risk case extends the second standard of field work in the study of the client and its environment in the preliminary stage of the audit to assess areas of potential audit risk. For additional discussion of the reasons for an audit risk assessment see Chapters 5 and 6, with appendices, of your textbook. You should also consult AU Sections 312, 314, 316, 326 and 329.

Your memorandum will be composed of four parts and 3 appendices, beginning with a discussion of your understanding of your corporation's business and industry, including the answers to "who, what, where, when, why, and how" in the business analysis. You will continue with your assessment of accounting practices and the significant accounts with their inherent risks of material misstatement of management's assertions, in your accounting analysis. You will then perform preliminary analytical procedures on your corporation's financial statements and do a comparison to industry standards in your financial analysis. You will conclude with your assessment of potential material misstatement of management's assertions, whether due to the possibility of error or fraud, in view of the understanding you have developed. A single memo is required, which gives your rationale for your conclusions from your insights in the four interrelated areas:

 business analysis
 accounting analysis
 financial analysis, (2010 Financial statement) and
 assertion misstatement risk assessment.

The memo should include separate sections for each of the four interrelated parts, and the three appendices. Analyses from the first three parts-business, accounting, and financial-are required to provide a proper basis for misstatement risk assessment in the fourth section. Thus, the final part on misstatement risk will discuss clearly and succinctly the linkages between your three analyses and your assessment of the potential for material misstatement of management's assertions.

The most important element of your memo will be your supporting rationale for why you think that some management assertions will require more attention in the audit. Your rationale should be derived from your discussions in the business, accounting and financial analyses. Identification of the linkages between your assertion risk assessment and your integrated business understanding should help you develop your rationale.

Business Analysis:

The business analysis section of your memo should present the results of your evaluation of your corporation's industry and how it operates in the competitive environment. You will be answering questions pertaining to the factors on how the company operates within its industry and environment to create value for shareholders. Another way to think of this is: How does the corporation make money in its industry? Examples of factors you may want to consider during this part of your analysis given below [additional factors can be are found in AU Section 314.125 - Appendix A]:

 category of the industry
 nature of competition in the industry
 regulatory environment in the industry
 business model
 business strategy1
 nature of revenue sources - products or services
 method of conducting operations
 geographic areas of customers, production, product distribution
 competence and expertise of top management
 composition of the Board of Directors, and independence of the audit committee
 critical success factors for your corporation in its industry such as: changes in competitive, economic, social and demographic factors that could affect the success of both the industry in which the company operates and the company itself.

To complete this section you need to obtain at least 6 articles from business publications, or recognized business sources of the internet (Wall Street Journal, Barron's, Investors Business Digest, Forbes, Fortune, S&P NetAdvantage, etc.) discussing the industry and the corporation's financial situation. You will also read the management discussion and analysis (MD&A) portion of the annual report, the corporation's latest press releases, and consult the corporation's web site. You will cite all your sources in a bibliography, using APA form, in Appendix A to your memo.

Accounting Analysis

The accounting analysis section of your memo should present the results of your evaluation of your corporation's account areas, accounting principles adopted for use and footnote disclosure. Consider the extent to which the corporation's financial statements, with related footnotes, and management's disclosures in the MD&A, reflect the inherent risk of material misstatement of management's assertions. You should also consider how effectively they communicate that reality to the users of the financial statements. This section also concerns an initial evaluation of management's assertions [AU Sections 326.14 - 326.19], and audit risk and the concept of materiality [AU Sections 312.01 - 312.33].

Examples of factors you may want to consider during this part of your analysis are:
 management's key accounting policies found in the footnote disclosures pertaining to the accounting areas, and the impact of those policies on reported financial results.
 how well reported earnings reflect the company's economic performance, or the quality of earnings in the income statement.
 how well reported values of assets and liabilities reflect its economic resources and obligations on the balance sheet.
 relationship between earnings and cash flow from operations.
 complexity of critical transactions for recording assets and revenues.
 extent to which revenues, expenses, assets and liabilities involve estimates, judgments, and forecasts made by management.
 changes in accounting policies and management's estimates, judgments, and forecasts during the past year.
 whether notes to the financial statements enhance information in the financial statements.
 related party transactions, loans to management.
 extent to which information in the financial statements is consistent with other related disclosures such as MD&A, press releases, and management's letter to shareholders.

To complete this section you need to obtain the latest corporate annual report, including either the financial statements or the 10K from the corporation's web site or SEC (www.sec.gov). You will attach a copy of the financial statements, with footnotes from the annual report or Form 10-K, to your memo as Appendix B.

Financial Analysis: (not needed for this post)

OMIT THIS ONE

Audit Risk Assessments:

To prepare the audit risk section of your planning memorandum you will use the business, the accounting, and the financial analyses and the appendices prepared for each of the three parts given above. In addition you will use the round robin discussion handouts as a tool to identify any potential assertion misstatement risk.

Assertion misstatement risk can be due the importance of a particular account to the fairness of the financial statements (a large percent of current assets, cost of goods sold in the income statement for manufacturing business). Misstatement risk can also be due to error or fraud [AU Sections 316.01 - 316.42]. Misstatement risk can be associated with the one or more of management's assertions as explained in Chapter 2 of your textbook and AU Sections 326.14 - 326.19.

a) existence and occurrence,
b) completeness,
c) rights and obligations,
d) valuation and accuracy,
e) presentation and disclosure

Management assertions are linked to transactions and events for the period; they are linked to account balances at the end of the period; and to the presentation of and disclosures in the financial statements as follows:

1) Transactions: Revenue, Cost of Sales, Operating Expenses, Administrative Expenses, Non-operating Items; Investments and Financing.
2) Balances: Cash, Other Current Assets, Non-Current Assets, Current Liabilities, Non-Current Liabilities, Shareholders' Equity
3) Presentation and Disclosure Issues

In this section, please provide a table to help me organize the risks by each transaction or balance in 1-3 above.

REQUIRED:

Business analysis
Accounting analysis
Table of audit risks by transactions and balances

This give the background and ideas I need to complete the project.

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