THE HONG KONG POLYTECHNIC UNIVERSITY

SCHOOL OF ACCOUNTING AND FINANCE

Final Examination

Subject : Accounting for Business Analysis (AF5115)

Date : 20 December 2020 (00:01 am) ~ 21 December 2020 (11:59 pm)

Time Allowed : 2 days

Session : 2020/2021 (Semester One)

This question paper has 16 pages (including this cover page).

Instructions to Candidates:

 There are 15 questions.

 Answer all questions of this paper.
 Write down all your answers directly on this file.
 You have 2 days to complete this exam.
 The answers should be submitted via Blackboard by December 21 at 11:59
pm.
 Do not ask about the final exam questions during the time of examination

Student ID: Name:

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[Question 1 – 6] (Total – 31 points)

At the beginning of 2004, Overstock.com, Inc., was one of the hottest growth stocks on Wall
Street. Operating in the highly competitive “e-tail” industry, the company had grown revenue
from less than $2 million in 1999 to over $200 million in 2003. By March of 2004,
Overstock.com’s stock price had risen to around $30, representing a price-sales multiple of 2
and a market-book multiple of 10. The company’s spectacular rise was attributed in large part
to its high-achieving chief executive, Dr. Patrick Byrne. Byrne, who holds a master’s from
Cambridge University and a doctorate from Stanford University, had previously run a
subsidiary of Warren Buffett’s Berkshire Hathaway. Enthusiasm for the company in early
2004 was summarized in The Washington Post as follows:

Fifty-five venture capitalists turned down Patrick Byrne’s discount-shopping

Web site for funding at the peak of dot-com investing mania. So the graduate
of Walt Whitman High, Stanford University and Warren Buffett’s real world
school of business funded it himself. Five years later, Overstock Inc. is a
publicly traded company, pulling in nearly 7 million shoppers a month to its
Internet bargain bazaar and ranking right up there with Target.com and
BestBuy.com as one of the Web’s top 20 e-commerce sites. But Byrne, its
maverick chief executive, won’t be satisfied until Overstock.com becomes a
household name on par with eBay and Amazon.com, the Internet’s top
shopping hangouts, each of which draws more than 30 million people a
month.

The news, however, was not all good. Overstock.com had yet to report a positive annual
profit and had only logged one quarterly profit, with that being back in the fourth quarter of
2002. The last 12 months had seen the departure of the company’s chief financial officer,
chief operating officer, and president. Moreover, competition was heating up from the likes
of industry giants Amazon.com and eBay as well as smaller start-ups, such as privately held
SmartBargains.com. Against this backdrop, Overstock.com entered 2004 with plans to raise
an additional $50 million, primarily to fund the inventory acquisitions necessary to maintain
the company’s aggressive growth plans. Its capital-raising plans called for the issuance of 1.5
million additional shares through an offering underwritten by W. R. Hambrecht and Co. and
JMP Securities. Enthusiasm for Overstock.com remained high on Wall Street, with analysts
at both W. R. Hambrecht and JMP Securities issuing “buy” recommendations on the stock.
Analysts at W. R. Hambrecht summarized their investment opinion as follows:

Reiterating Buy rating and increasing price target to $40. Our price target
implies an enterprise value to CY04 revenue of 1.4x, vs. a 1.1x multiple for
OSTK’s discount retailing peers and vs. 8.7x for internet bellwethers AMZN
and eBay (EBAY: Buy Rated). We think OSTK shares deserve a premium to
its discount retailing peers because of the company’s superior top-line growth
prospects.

To answer this question, please refer to 10-K filings (Overstock_10K.pdf) attached with this
question.

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(Question)
1. Overstock.com’s critical accounting policies include (1) Revenue Recognition, (2)
Reserve for Return, Allowance for Doubtful Accounts, (3) Allowance for
Obsolete and Damaged Inventory, (4) Accounting for Income Taxes, (5) Long-
Lived Assets, (6) Intangible Assets, and (7) Goodwill. Briefly comment on
whether you think that these accounting policies fairly present Overstock’s
financial performance. (4 points)

2. The growth rate in Overstock’s total revenue from 2002 to 2003 exceeded 150
percent. Explain whether this growth rate is sustainable with your calculation. (4
points)

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3. The growth rate in Overstock’s gross profit from 2002 to 2003 was less than 50
percent, despite the fact that total revenue grew by over 150 percent. Explain why
the growth rate in gross profit was so much lower. (4 points)

4. Overstock.com has reported substantial losses in each of the last three years. How
might you go about restating Overstock.com’s accounting results in order to better
reflect Overstock.com’s underlying economic performance? (5 points)

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5. Maximizing return on equity involves a trade-off between operating profitability
(margin on sales) and turnover (efficiency of asset utilization). Consider the
different business models of
• A closeout e-tailer, such as Overstock.com (OSTK).
• A regular e-tailer, such as Amazon.com (AMZN).
• A traditional closeout retailer, such as Ross Stores (ROST).
• A department store retailer, such as May Department Stores (MAY).

Discuss how the different business models involved in each of these categories
will influence the trade-off between profitability and turnover. (Compare
Overstock.com vs. AMZN, ROST, MAY) (5 points)

6. Tables below contain information about OSTK, AMZN, ROST, and MAY.
Complete the table for Overstock.com for 2003 on page 6. (4 points)
And discuss the key strengths and weaknesses of OSTK’s financial performance
compared to its competitors (the data related to competitors is presented on page
7, 8 and 9). (4 points)

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Overstock.com

Advanced Dupont Model 2001 2002 2003

Net Operating Margin (0.327) (0.045)

x Net Operating Asset Turnover 7.507 3.663

= Return on Net Operating Assets (2.454) (0.163)

Net Borrowing Cost (NBC) 0.312 3.078

Spread (RNOA - NBC) (2.766) (3.241)

Financial Leverage (LEV) 0.782 0.107

ROE = RNOA + LEV*Spread (4.617) (0.512)

Margin Analysis 2001 2002 2003

Gross Margin 0.187 0.227

EBITDA Margin (0.194) 0.015

EBIT Margin (0.339) (0.044)

Net Operating Margin (b4 non-rec.) (0.339) (0.044)

Net Operating Margin (0.327) (0.045)

Turnover Analysis 2001 2002 2003

Net Operating Asset Turnover 7.507 3.663

Net Working Capital Turnover 10.551 4.231

Avge Days to Collect Receivables 7.140 17.018

Avge Inventory Holding Period 42.551 55.404

Avge Days to Pay Payables 26.918 49.199

PP&E Turnover 15.944 18.425

Numbers in parenthesis represent negative values.

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Amazon.com

Advanced Dupont Model 1999 2000 2001 2002 2003

Net Operating Margin (0.387) (0.464) (0.137) (0.002) 0.031

x Net Operating Asset Turnover 1.889 3.273 4.713 5.686

= Return on Net Operating Assets (0.876) (0.449) (0.007) 0.179

Net Borrowing Cost (NBC) 0.072 0.065 0.064 0.061

Spread (RNOA - NBC) (0.948) (0.513) (0.072) 0.117

Financial Leverage (LEV) (5.171) (1.793) (1.598) (1.775)

ROE = RNOA + LEV*Spread 4.027 0.471 0.107 (0.030)

Amazon.com
Margin Analysis
Gross Margin 0.218 0.238 0.239 0.273 0.253
EBITDA Margin (0.192) (0.123) (0.032) 0.049 0.066
EBIT Margin (0.364) (0.240) (0.074) 0.027 0.051
Net Operating Margin (b4 non-rec.) (0.364) (0.240) (0.074) 0.027 0.051
Net Operating Margin (0.387) (0.464) (0.137) (0.002) 0.031
Turnover Analysis
Net Operating Asset Turnover 1.889 3.273 4.713 5.686
Net Working Capital Turnover 8.002 8.867 9.098 9.272
Avge Days to Collect Receivables 0.000 0.000 5.210 8.472
Avge Inventory Holding Period 34.261 24.458 22.103 23.043
Avge Days to Pay Payables 80.458 70.558 69.293 68.349
PP&E Turnover 8.076 9.786 15.389 22.704

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Ross Stores

Advanced Dupont Model 1999 2000 2001 2002 2003

Net Operating Margin 0.061 0.057 0.053 0.057 0.058

x Net Operating Asset Turnover 5.391 5.551 5.824 5.321

= Return on Net Operating

Assets 0.306 0.292 0.332 0.310

Net Borrowing Cost (NBC) 0.066 0.060 0.014 0.000

Spread (RNOA - NBC) 0.240 0.231 0.318 0.310

Financial Leverage (LEV) 0.068 0.063 0.021 0.054

ROE = RNOA + LEV*Spread 0.323 0.306 0.339 0.326

Ross Stores
Margin Analysis
Gross Margin 0.314 0.312 0.311 0.274 0.275
EBITDA Margin 0.123 0.114 0.107 0.112 0.115
EBIT Margin 0.103 0.093 0.086 0.094 0.095
Net Operating Margin (b4 non-rec.) 0.063 0.057 0.053 0.057 0.058
Net Operating Margin 0.061 0.057 0.053 0.057 0.058
Turnover Analysis
Net Operating Asset Turnover 5.391 5.551 5.824 5.321
Net Working Capital Turnover 12.847 13.087 13.552 11.131
Avge Days to Collect Receivables 2.028 2.136 2.010 2.031
Avge Inventory Holding Period 103.866 104.916 95.437 100.076
Avge Days to Pay Payables 52.056 52.599 52.606 56.791
PP&E Turnover 9.426 9.433 9.619 8.841

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May Department Stores

Advanced Dupont Model 1999 2000 2001 2002 2003

Net Operating Margin 0.080 0.074 0.065 0.058 0.049

x Net Operating Asset Turnover 1.764 1.650 1.585 1.609

= Return on Net Operating

Assets 0.131 0.107 0.091 0.078

Net Borrowing Cost (NBC) 0.055 0.050 0.055 0.056

Spread (RNOA - NBC) 0.075 0.057 0.036 0.022

Financial Leverage (LEV) 1.074 1.233 1.161 1.016

ROE = RNOA + LEV*Spread 0.212 0.178 0.133 0.101

May Department Stores

Margin Analysis
Gross Margin 0.358 0.351 0.350 0.340 0.339
EBITDA Margin 0.164 0.156 0.145 0.134 0.138
EBIT Margin 0.131 0.120 0.105 0.093 0.096
Net Operating Margin (b4 non-rec.) 0.079 0.074 0.065 0.062 0.065
Net Operating Margin 0.080 0.074 0.065 0.058 0.049
Turnover Analysis
Net Operating Asset Turnover 1.764 1.650 1.585 1.609
Net Working Capital Turnover 4.758 4.837 5.327 5.293
Avge Days to Collect Receivables 53.501 51.744 49.768 47.817
Avge Inventory Holding Period 111.519 115.175 117.459 115.828
Avge Days to Pay Payables 39.162 39.121 43.396 46.779
PP&E Turnover 3.002 2.790 2.515 2.514

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[Question 7 – 15] – Earnings Quality (Total 59 points)

Groupon is a local e-commerce marketplace and the leading daily deal site worldwide, connecting
millions of subscribers around the world with merchants by offering goods and services at a discount.
The name Groupon is a blend of “group” and “coupon”. Groupon's first deal was a half-price offer for
pizzas for the restaurant on the first floor of its building in Chicago. Groupon, Inc. operates online
local commerce marketplaces that connect merchants to consumers by offering goods and services at
a discount in North America, Europe, the Middle East, Africa, and internationally. It also provides
deals on products for which it acts as the merchant of record. The company offers deals in various
categories, including food and drink, events and activities, beauty and spa, health and fitness, home
and garden, and automotive; and deals on various product lines, such as electronics, sporting goods,
jewelry, toys, household items, and apparel, as well as provides discounted and market rates for hotel,
airfare, and package deals. It offers its deal offerings to customers through Websites; search engines;
and mobile applications and mobile browsers, which enable consumers to browse, purchase, manage,
and redeem deals on their mobile devices, as well as sends emails to its subscribers with deal
offerings that are targeted by location and personal preferences. The company was formerly known as
ThePoint.com, Inc. and changed its name to Groupon, Inc. in October 2008. Groupon, Inc. was
founded in 2008 and is headquartered in Chicago, Illinois.

Refer to Groupon’s 2018 10-K filings attached with this exam from Blackboard.

7. Complete blanks in the following table (Use average balance to calculate NFO and NOA
and show your calculation). (9 points)

Inputs FY 2018

Net Income 1,988,000

EBT  1,031,000

Effective Tax Rate  (92.8)%

 21,900,000*(1-92.8%)+1,363,000-
Net Financing Expenses (NFE) 872,000=2,067,800

 (54,039,000+6,400,000+2,400,000)* (1-92.8%)
Net Operating Income (NOI) +53,008,000=57,532,408

Net Financial Obligations (NFO)  201,669,000

 1,642,142,000-325,491,000-108,515,000-
Net Operating Assets (NOA) 1,259,531,000+201,669,000=150,274,000

RNOA  1,988,000/150,274,000=0.013

NBC  21,909,000/150,274,000=0.146

NFO  

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Leverage  

Spread  0.013-0.146=-0.133

ROE (using Advanced Dupont)  

8. Calculate each number and discuss the quality of Groupon’s earnings (FY 2018) by
focusing on accrual quality (Use beginning and ending balance of NOA, COA, and
NCOA and show your calculation. To evaluate the earnings quality, refer to the Figure 1
– Percentile Cut-offs for the Historical Distributions of Accruals Components) – (4
points)

Inputs 2018

Net Operating Assets (NOA)  150,274,000

Current Net Operating Asset

(COA)  998,629,000-957,174,000=41,455,000

Noncurrent Net Operating Assets

(NCOA)  108,819,000

Operating Accruals (150,274,000-155,264,000)/155,264,000=-0.034

Current Operating Accruals (41,455,000-(-61,051,000))/-61,051,000=1.679

Noncurrent Operating Accruals  (108,819,000-216,315,000)/216,315,000=-0.497

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Figure 1- Percentile Cut-offs for the Historical Distributions of Accruals Components

[Discussion of Earnings Quality] – (10 points)

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 9. What future events will cause ‘s future earnings to be lower (higher) because current
earnings are potentially overstated (understated)? (6 points)

There are several future events as follows will cause ‘s future earnings to be lower
(higher) because current earnings are potentially overstated (understated)

 The Purchase Obligations: Company has entered into non-cancellable arrangements with third-
parties. The purchase has been recorded in current period but if cloud computing and other
information technology services would to be discontinued. The contractual obligations still need
to be fulfilled.

 The company has entered into various non-cancellable operating lease agreements, and the lease
of 600 West Chicago has taking into account rent escalations and lease incentives. If the lease
would not be as optimistic as expected, the income might be overstated.

10. Identify line items creating the accounting distortion in Groupon’s financial statements
(Balance Sheets or Income Statements) and adjust accounting distortions. Estimate the
income (loss) from operations that Groupon would have reported for 2018 after the
adjustment of accounting distortions. (The number of line items creating the accounting
distortion can be more than one.) – (6 points)

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11. Groupon’s cash and cash equivalents in 2013 is $1,240,472. Provide possible reasons for
holding large amount of cash and modify operating assets, operating accruals, current
operating accruals and non-current operating accruals as appropriate. (6 points)

 Holding such a large amount of cash is required by a such big listed company, which
will have shares to be practiced. There are also employee Stock Purchase Plan.

 As we can see from the “Legal Matters and Other Contingencies’’ section, there are
significant legal proceedings that the company faced. The issues with IBM,
consumer claims or lawsuits, regulatory inquiries, audit and investigations that might
happened are time consuming and costly. There might be fines and penalties,
injunctive relief or increased costs of doing business.

 The operating assets should be assessed and modification will be necessary if the
assets have not been used maximizing and rationally to generate profit.

12. Evaluate Groupon’s Economies of Scale and Operating Risks. You may refer to relevant
ratios and financial statement line items using time-series and comparative analysis. (6
points)

 The company has pressure to retain and acquire new customers in order to increase
the profitability. The purchase of the company’s offering is depending on the
consumers’ preference. The organic traffic to company websites and mobile
applications, including traffic from consumers responding to the company emails,
has declined in recent years. Changes to search engine algorithms or similar actions
are not within the company’s control.

 International operations brought the commercial and regulatory challenges to the

company. And the company’s ability to adapt to the diverse and changing landscapes
of international markets may has significant influence on the company’s business.

 The company is operating in a highly competitive industry, and there are many new
coming competitors as the entry barriers are low for this industry. The company has
to be succeeded in the competitions in order to maintain and growth the business.

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 The company is subject to inventory management and order fulfilment risks as a
result of our Goods category.

封闭式的电子零售商，例如 Overstock, 其运营模式为通过互联网渠道，提供便宜的

品牌折扣商品，主要关注于线上客户，受限于品牌方折扣，将一定程度上影响盈利
能力
常规的电子零售商，例如亚马逊，其运营模式为纯网络型运营企业，客户通过网络
购买产品，这种模式不仅使得许多固定资产不再重要，还可于 7*24 小时接受订单，
有助于增加营业额，盈利能力增强
传统的封闭式零售商，例如 Ross Stores，其运营模式将传统零售业务与网络相结合，
客户既可通过线上也可通过线下购买产品。这种模式可获得更多的顾客（包括线上
及线下），从而增加营业额
百货商店零售商，例如 May 百货商店，其运营模式为线下面向广泛消费群体进行
“大而全”的百货销售业态，该模式受制于固定成本，销售利润上具有一定压力，
需要通过投入一定运营成本提高营业额。

Earnings quality analysis focus on identifying the impact of accounting distortions on

earnings. There are two simple red flags that we can use to isolate suspect accruals.
Firstly, if a firm’s accruals are unusually large, accounting distortions are more likely to
be at work. Secondly, if the unusually large accruals relate to balance sheet accounts that
typically consist of less reliable accrual estimates, accounting distortions are even more
likely at work.
As a rule of thumb, whenever any individual line item on the balance sheet changes by
more than 5 percent of net operating assets, it represents a large accrual and warrants
further investigation.
Firstly, we confirm the operating assets, then we classify the operating items based on
whether they are asset versus liabilities. Operating assets are generally measured with less
reliability than operating liabilities, because operating liabilities primarily relate to
financial obligations that are the result of a contractual commitment (e.g., accounts
payable). Thus, we classify operating assets as low reliability and operating liabilities as
medium reliability. Finally, it is useful to distinguish between current and noncurrent
items. Noncurrent items involve estimates in the more distant future, and hence tend to be
less reliable.
Just as we calculated, COA and NCOA are unusually large. According to the balance
sheet of Groupon, these phenomena might stem from accounting distortions. Especially
the Current Operating Accruals, which is larger than the 90th percentiles. When see an
unusually large accrual, a red flag goes up. Other than bad accounting distortions,
legitimate growth in investment will lead to increased net operating assets and hence high
accruals. However, when we checked whether the sales growth rate is commensurate with
the operating asset growth rate and that the sales themselves are not the product of
revenue manipulation, we found that there were no abnormalities, so that we make sure
that the firm is not artificially inflating receivables in order to boost revenues.

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 13. Evaluate credit risks of Groupon using relevant statistics. (6 points)

The credit risks of Groupon mainly concentrated in these fields:

Firstly, for transactions in which we earn commissions when customers make purchases
with retailers using digital coupons accessed through our websites and mobile
applications, we generally collect payment from affiliate networks on terms ranging from
30 to 150 days.
In addition, the company intend to refinance our Credit Agreement with JPMorgan Chase
Bank, N.A. during the first half of 2019.
Thus, the company may not have the ability to use cash to settle the principal amount of
our 3.25% convertible notes due 2022.

14. Evaluate Groupon’s financial performance from the perspective of cash flow and net
income. – (6 points)

 Investors can have a better understanding of a company's cash needs by looking at things like
future cash flows, business cycles, capital expenditure plans, and upcoming liability payments.

 As we can see from the cash flow from operating activities. There is a large amount of non-cash
flow that would be added back to the net income. Especially the expenses in depreciation and
amortisation of the property, equipment and software, as well as the Impairments of investments.

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15. Groupon excludes stock-based compensation, amortization of acquired intangible assets,
acquisition-related expenses, special charges including restructuring charges, non-cash
interest expenses, non-operating foreign currency gain and losses, non-operating gains
and losses, income from discontinued operations, and etc. Discuss the advantages and
disadvantages of excluding recurring, non-recurring items and non-cash items to calculate
non-GAAP earnings and how non-GAAP earnings disclosures by Groupon can mislead
investors. (Refer to Groupon_Earnings_Announcement_2018.pdf file to read Groupon’s
earnings announcement.) (10 points)

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