Case Study Questions
1) The SEC requires company like Whirlpool to alert financial statement readers about the existence of major customers to contribute 10% or more to annual sales. This information is helpful for analysts and investors in assessing the volatility in sales and potential impact on profitability of loss of major customer. The information is mainly important for those companies who are operating in industries where competition of customer is intense.
2) This information might be used to financial analysts in following ways:-
a) To assess the risk of customer – More the revenue a company receives from a small group of customers, greater the negative impact on profits if one or more customers lost to a competitor or goes out of business.
b) By studying firm’s major customers – An analyst determines the likelihood of increase in future sales of that customer who sell products, expected future demand for products and hence profits of the company.
3) The main reason for Sear wants to monitor the Whirlpool’s financial health is to make sure that Whirlpool can rely on supplier of durable goods like washers, dryers and air conditioners to be sold at Sears. The buyer wants to make goods which will be available in Sears stores for consumers. Sears wants to monitor the following aspects of Whirlpools in terms of operations: expenditures for research development, overall profits, inventory levels, and financial health, mix of equity and debt and cash flow statement. Whirlpool provides the financial information to Sears which is beyond the company’s financial statements. The additional information might include new products required in development, inventory levels for individual products, lead production time of products and improvement in products is taken into consideration.
4) Whirlpool wants to monitor the financial health of Sears to make sure that Sears will continue the source of demand for the products in future. The company is likely to monitor the following aspects of the operation of its buyers such as inventory levels, advertising expenditures, overall profits, financial health, debt and equity level and cash flow ability. Sears may provide information to Whirlpool which is beyond that is reported in the financial statements of the shareholder. For Example, additional information could include day sales inventory of products of Whirlpool, market survey results about the features consumers wants in special promotions and new products.
1) The managers should be allowed some flexibility in their financial reporting because of the following reasons. Financial accounting information is used for purposes including credit analysis, valuation and contracting and no reason to believe that single set of financial reporting methods would serve all the purposes equally. By allowing some managers in the choice of methods of financial reporting, they can weigh the tradeoffs in making the firm’s financial report data very information for all the potential uses. If managers have choice in financial reporting methods, they can adapt firm’s financial reporting practices to change in the economic characteristics of the firm and environment with time. For Example, a change in technological advance in firm’s industry mean that new long-term assets should be written at faster rate than previous case. Assuming the firm had been using straight line, change in accelerate depreciation method might be optimal, assuming managers want it to be reported in income statement and balance sheet to present the accurate picture of firm’s economic environment.
2) The present financial reporting system in US is a combination of two approaches. On one hand, firms have to select the accounting methods to summarize various events and transactions. Examples include valuation of inventory where firms select LIFO, Weighted average or FIFO: depreciation policy where they select straight line or accelerated methods such declining balance or sum of year’s digits and accounting for costs of oil and gas exploration where firms may apply successful method. On the other hand, there are various cases where FASB has a single accounting method for various transactions. Examples include research expenditures which must be an expense in the year its incurred, leases must be capitalized and reported as liabilities on the balance sheet if certain conditions are met: accounting for pension benefits and foreign currency translation and other postemployment benefits other than pensions.
3) The advantages of single accounting methods include the following:-
a) Facilitating comparability of financial information across various firms at one point and over a period of time. This may be of interest to financial analysts because it makes their work easier.
b) Ease of verification by an auditor. It might lead to shareholder lawsuits and suit against auditors for aggressive financial decisions to be taken by managers. External auditors may find beneficial for them.
The disadvantages of single accounting methods include the following:-
a) Assume that financial performance of all the firms can be captured by a single set of accounting methods adequately. All the firms have identical characteristics and features and identical economic environments.
b) A single set of accounting methods servers all the uses of financial statement information like credit analysis, valuation and contracting.
The advantages of flexibility in choice of financial reporting methods include:
Firms can modify their financial reporting choices to specific aspects of economic environment and circumstances. For Example, it depends on whether the price of inputs products increases or decreases. FIFO may be realistic method of inventory valuation for income determination purposes when compared with LIFO.
The disadvantages of flexibility in choice of financial reporting methods include:
a) This may detract making comparisons across firms at one point and over a period of time.
b) Managers may use discretion over methods of reporting to distort the firm’s performance. They might adopt financial reporting practices that create profitability is an attempt to hide poor operating performance. They also adopt such financial reporting practices that accelerate the revenues recognition and delay in recognition expenses an attempt to maximize the present value of payout from plans tied to profitability.
1) The Company’s revenues include sales by the restaurants operated and fees from franchised restaurants and developmental fees. As sales by restaurants are least conservative but it does not mean that this division is booking the revenue in advance. This only suggests that it recognizes the revenues at the earliest time than other divisions. The enough information is not available to satisfy both critical event and measurability criteria. The additional information needed is:-
a) Completing of earning process – The Company recognizes revenues from sales in restaurants at the time of delivery because it one of the point of completing of earning process in the sense that seller has transferred the products to the customer.
b) Receipt of assets from customers – This measures the amount of cash seller receives from customer for the services provided. Hence it measures the cash ultimately receive or revenue earned.
2) The expected impact of refranchising on financial statement are:-
a) Improvement in combines operating margin.
b) Increase in ROA due to decrease in average asset balances.
c) Margin percentages are affected depending on the cost structures and sales of the restaurants franchised.
d) Fluctuations in other operating income or expense as we recognize gains and losses resulting from the sales of restaurants.
e) Consolidated revenues are reduced because rent and royalty is collected from sales from refranchised restaurant instead of 100% of sales.
f) Franchised marginal dollar increase which company operated margin of dollars decline.
We compute year to year change in income statement items.
|Income on the sale of installment||9.31%|
|Interest Income on installment||43.87%|
|Other operating Income, net||-7.16%|
|Selling, general and administrative||4.26%|
|Provision for doubtful accounts||-17.09%|
|Income before income taxes||2.59%|
|Income before cumulative effects of changes in accounting principles||3.86%|
|Cumulative effect of changes in postretirement and postemployment||NA|
Baldwin’s net sales increases by 9.6% and net income is decreased by 23%. One of the reasons for this is cumulative effect of changes in postretirement and postemployment. Even EBIT and change in principles of accounting increased by only 2.6%. Several factors that contribute to less than proportionate increase in profits
1) To show that gross margin rate has reduced from 27.7% to 25.4%. Given the net sales of $120,657,455, the drop translates into more than $2.6million of lower operating profits. The decrease in gross margin rate is likely to severely affect the performance of Baldwin.
2) Other operating income decreased by 7.2%. However, the case identifies the non-recurring items to be included in other net operating income. Eliminating the two nonrecurring items are as follows:-
Other operating income, net $ 3,530,761
– Eliminate gain on insurance settlement (1,412,000)
+ Eliminate expenses relating to period 1,105,000
Revised operating income, net 3,223,761
Additional decrease in other income ($307,000)
The elimination of nonrecurring items magnifies fall in operating income. From Baldwin Piano, it seems that fees paid by dealers on consigned inventory comprise of majority of operating income. The fall in this component of income is because of decrease in the level of consigned inventory. The level of finished goods inventory has decrease by greater than 8%. This decrease may be due to indication of reduced demand and results in lower fees during the year. This affects the future profitability. The following positive factors have effect on income statement.
a) Selling, general and administrative expenses increased by 4.3% because of economies of scale. In year 2, Selling, general and administrative expenses were 22.82% of sales revenue. Baldwin has improved the pre-tax profits by $1.3million by controlling its level.
Selling, general, and administrative ($26,187,629)
Selling, general, and administrative at 22.82% of sales (27,532,842)
Additional profit due to lower SG&A $1,345,213
b) Provision of doubtful accounts reduced from year 2 to 3 that is it has decreased from 1.87% of net sales to 1.41%. The decrease is consistent with change in estimates of management. There is little information in this case to understand the reason for revision. The composition of Baldwin’s sales revenue has changed from year 2 to year 3 which is decreased from 81.5% to 72.6%.
c) Interest expense is decreased by 14.5%. The statement of cash flows indicates that Baldwin has repaid $8.6 million of long-term debt in year 3 which indicates decrease in interest expense.
d) There are significant difference in the inter segment growth in revenues. The operating profitability decreased from 7.6% to 5%. Baldwin’s ability to maintain operating margin and growth may be an important factor for its future prospects.
|Cost of goods sold||($21,000)||($21,000)||($14,000)|
|Value added to unsold production ($3.60 – $0.20) – $0.50||$29,000||–||–|
|Less: Deferred profit on sale||–||–||($29,000)|
|Less: Carrying inventory value||($34,000)||($5,000)|
|Less: Delivery costs||($2,000)||($2,000)|
|Net Income (loss)||($8,000)||($21,000)|
The loss of $8,000 represents the speculative loss of $0.80 which occurred during the year on the inventory. The profit of $21,000 on basis of sales is difficult to explain. It can consider as speculative profit since there is a loss of $8000 in speculation. The profit of $21,000 is a mixture of $29,000 of unrecognized profit and loss of $8000. Thus, sales do not provide a clear picture of profit by source.
1) Pledged-collateral in order to secure bank loan, are shown in footnotes simultaneously by several entities, i.e., the pledged collateral is not owned by these firms but due to hypothecation rights.
2) This item would be reported as in the notes of the financial statements of David Company’s 2011 as all the settlements of lawsuits from claims arising before the date of balance sheet is a type of subsequent event.
3) It is considered to be non-accounting events that are not disclosed in the financial statement since this involves legislation.
4) Report the action of issue of bonds in notes to the balance sheet.
5) The loss of inventories from fire is a second type of subsequent event. Such events require disclosure but no adjustment in the financial statement before the statements are issued.
6) Loss on the uncollectible amount where the customer’s financial condition is deteriorating led to bankruptcy after the balance sheet date would be reported as first type of subsequent events. A supplier two whom David owes $15,000 was after the December 31, 2011.
2) Public companies disclose all the transactions of related parties such as family member, associated and executive in the annual 10-k report. While the majority of related party transactions are considered to be perfectly normal, the special relationship inherent between the parties involved creates conflicts of interest which results in actions for the benefit of the people involved as opposed to shareholders. A business transaction between the corporation and shareholder such as contract for the company of the shareholders to perform renovations the offices would be deemed as related party transaction. This note does not adequately explains the nature of related party receivables because it does not confirm to GAAP and hence created deleveraging.
3) The significance of Adelphia’s treatment of related party receivables and payables are:-
a) Report the related party receivables and payables as gross numbers on the balance sheet included in 2000 Form 10-k
b) The netting of receivables does not confirm to GAAP and assist Adelphia in creating the presence of deleveraging.
c) In accordance with GAAS, the procedures are designed to provide assurance of detecting improper netting of receivables and payables.
d) In accordance with GAAS, the procedures are designed to identify related party transactions were material to financial statements of Adelphia.
4) It is important for the companies to disclose related party transactions because they reflect corporate governance choice, except for dollar amount. The decision of whether or not to engage in the extent of related party transactions as an indicator of firm’s corporate governance environment. It is also consider that the dollar amount of related party transaction indicates amount of resources potentially expropriated.
1) Kroger appears to be more profitable in the year 2006 since its ROE and ROA both are greater than Safeway. The increase in two ratios reflects that Kroger has higher profits as they both depend on profit margins. When ROE of Kroger Company is compared to its prior year, there is decrease of 0.3% but still higher than Safeway Company. The ROA has increased from year 2005 to 2006 by 0.4% and also higher than the Safeway company by 0.4%.
3) Safeway company was more profitable in 2004 as it has higher EBI/Sales of 2.7% whereas Kroger Company has 2%. The profit is 0.7% higher for Safeway. Also Safeway has higher ROE and ROA than Kroger. This indicates that in 2004 Safeway was a profitable company and had a better control over its costs as compared to its competitor (Kroger).
4) The reasons for such low margins are:-
a) High risk reduces sales will erase margins for the companies
b) Low margin of safety.
c) They operate at lower level.
d) Moderate leverage.
e) Asset turnovers.
5) The receivables, inventories and payables are the primary element of working capital. From the day’s receivables, we see that on an average Kroger have better days receivable outstanding ratios which is the indication that the company its extension of credit and accounts receivables are efficient.
The day’s inventory held is higher for Safeway Company As Compared To Kroger. This means that Safeway has lower inventory turnover. Hence, a lower day in inventory is a good indicator for the performance of the company
Day’s payable outstanding for Kroger company is higher than Safeway on an average. The higher ratio indicates that the accounts payable turnover ratio is low and the company is being paid more quickly.
Hence Kroger company better manages its receivables, inventories and payables.
1) Analysis of cash flows provides the following:-
Operating cash flow for 2010 ($356) million
Long term debt repayment ($336) million
Other various cash uses ($176) million
Expansion of notes payable $868 million
The long term debt repayment is the decrease in account balance from $423 million to $87 million. Property, plant and equipment and investments reduced during 2010 which indicates that these items provide cash rather than consuming. There does not appear net expansion in the size of the company during the year. Other assets increased by $271 million but the reason for this increase in deferred tax related. Other liabilities reduced by $73 million and net purchase of $17 million and $9 million in dividends. Hence, the two factors appear to be responsible for increase in short term borrowing that is repayment of the existing long-term debt of the company and negative cash flow from operations. The operating cash flows of the company are troublesome because an established business should generate solid earnings and strong operating cash flows. The several aspects of financial statement in the decline is falling sales, recent losses and fall in earnings and negative operating cash flows coupled with the absence of plant expansion.
2) Since 2008 credit risk of Argenti’s has increased and sales have declined, operating cash flows are negative and losses are being recorded and company has violated the existing loan. In additions to this, the company recorded loss of $141 million for first quarter of 2011 and suggests higher erosion of profits and operating cash flows are likely to increase this coming year. This would not be the time for lender to expand the credit position with company from $165 million to $1.5 billion. This high concentration credit risk with a borrower would be considered as prudent. But circumstances are abnormal since GE capital is Argent’s largest stockholder. Here it may be advisable to provide refinance package to keep the company afloat thereby protecting equity investment of GE capitals.
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