Inventories are listed on the balance sheet at $600,000, retained earnings are $1.9 Million. In the notes to financial statements, you find a LIFO reserve of $125,000. Also, the probability of a LIFO liquidation is high. Assuming a tax rate of 36%, what will be the adjusted value of retained earnings?
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The adjustment to retained earnings will be: $125,000 × (1 ? 0.36).
George Edwards is a senior analyst with The Edge Group, an independent equity research firm specializing in micro cap companies that have recently had an initial public offering, or are likely to go public within the next three years. Over the current market cycle, small company stocks have been the leading performers in the equity market, and micro cap money managers have had huge cash inflows due to their funds’ strong performance. With an excess amount of cash and few good investment opportunities due to the high valuations in the marketplace, fund managers have turned to independent research firms like The Edge Group to help them discover new investment ideas.
With a large number of mutual fund managers asking them for research reports, business at The Edge Group is booming. To help handle the large amount of business, Edwards has hired two new junior analysts, Paul Kelley and Rachael Schmidt. Both Kelley and Schmidt have degrees in finance, and came highly recommended to Edwards.
In Kelley and Schmidt’s orientation meeting, Edwards told them that what has made The Edge Group successful in delivering quality research to its clients is its willingness to dig into company financial statements and not take the accounting numbers at face value. Every item in the financial statements should be scrutinized and adjusted if necessary. Edwards tells the new analysts that if there is one lesson they should learn, it is that “there is a difference between accounting reality and economic reality.”
For their first assignment, Edwards has asked the new analysts to put together a draft of a research report on Landesign, an architecture firm specializing in landscape design for municipalities, residential developments, and wealthy individuals. The firm also sells various kinds of stone and plastic products which are used in landscaping applications. Edwards tells the new analysts that he will help put together the report, but he would like them to do a majority of the legwork.
Since it was founded seven years ago, Landesign has grown at an annual rate exceeding 20%. Much of the growth comes from Landesign’s acquisitions of regional competitors. Edwards points out to the analysts that Landesign uses purchase method accounting. Kelley, looking to impress Edwards with his knowledge, tells him that when one company acquires another, assets of both companies are restated to fair market value, and that higher depreciation can lead to lower quality earnings. Not wanting to be outdone, Schmidt adds that liquidity measures such as the quick ratio and the cash ratio should improve as Landesign makes acquisitions.
Kelley decides to review Landesign’s 2004 financial statements and make notes about significant accounting practices being used. His notes are shown in the exhibit below:
Exhibit 1: Kelley’s Notes on Landesign’s Accounting Practices
- The firm uses First In, First Out (FIFO) accounting. As a side note, the current inflation rate has remained relatively constant at an annual rate of 3%.
- Equipment and office furniture are depreciated based on the 200% declining balance method.
- Fixed assets (equipment) are generally assigned short useful life estimates.
- The expected return on defined benefit pension plan assets is 2 to 3 percentage points below the long-term rate of return for similar assets.
- Landesign reports deferred taxes of $350,000 for 2004, compared with $300,000 and $280,000 in deferred taxes for 2003 and 2002, respectively.
Schmidt notices that the footnotes to Landesign’s financial statements include a reference to an agreement to receive a minimum amount of stone used to construct landscape walls from a supplier. Under the terms of the agreement, Landesign will pay for the stone whether it is used in the current accounting period or not. The agreement allows Landesign to pay a price that is significantly less than the current market price for similar quality stone.
A second footnote indicates that Landesign has an eight-year rental commitment for a greenhouse used to grow plants and store mulch that Landesign uses in the landscaping process. On the financial statements, $55,000 in rent expense for the greenhouse is listed on the income statement. The footnote also states that the $55,000 rental expense payment was agreed upon with Fred’s Nursery, the owner of the greenhouse, based upon an interest rate of 7%.
A third footnote indicates that Landesign has sold its accounts receivable to Dais Enterprises for 95% of their original value of $130,000. The footnote indicates that Landesign retains the risk of noncollection of the receivables.
The final footnote on the page indicates that Landesign has a revolving line of credit at which it can borrow funds in the future at an interest rate of 6%.
After going through the information, Kelley and Schmidt discuss their findings and start to work on their report for Edwards.
Which of the following items noted in Kelley’s Notes on Landesign’s Accounting Practices would least likely be considered indicators of high earnings quality. Landesign’s use of:
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High earnings quality is established by a clear and conservative approach to stating earnings. Even though inflation is relatively mild, FIFO accounting will result in lower cost of goods sold (COGS), and higher net income. This is more aggressive than the use of Last In, First Out (LIFO) method. Short useful lives for fixed assets, use of accelerated depreciation, and using a conservative estimate for returns on pension assets will all tend to increase expenses and are examples of conservative accounting practices. (Study Session 7, LOS 26.d)
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Deferred tax liabilities are shown to be growing over the last three years, indicating a low probability of reversal in the near future. In this case, Kelley should assume zero deferred tax liabilities on the adjusted balance sheet, and an increase in equity of $350,000. Note that if the deferred taxes were expected to reverse, Kelley would have needed to calculate the present value of the expected tax liability. (Study Session 7, LOS 27.b)
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The rental agreement for the greenhouse is an operating lease and essentially represents off-balance sheet financing. To adjust Landesign’s balance sheet for the operating lease, Schmidt needs to capitalize the lease by increasing both liabilities and assets by the present value of the lease payments. The interest rate used in the present value computation is the lower of the firm’s financing rate or the rate implicit in the lease. We are told that the rental payments of $55,000 are based on an interest rate of 7%. However, we are told in another footnote that Landesign expects to be able to borrow funds in the future at a rate of 6%. We therefore use the lower firm financing rate of 6% in our computation. The present value of the lease payments is: N = 8; I/Y = 6%; PMT = -55,000; FV = 0; CPT PV = $341,539. (Study Session 7, LOS 27.c)
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Kelley and Schmidt both made incorrect comments concerning Landesign’s growth through acquisition strategy. Kelley was correct that purchase method accounting will lead to higher depreciation, and potentially lower quality earnings as a result of restating asset values to fair market value. However, Kelley was incorrect insofar as the comment on balance sheet restatement, since only the assets of the target are restated to fair value – the value of the acquirer, in this case Landesign, would not be revalued. Schmidt was incorrect in stating that liquidity ratios such as the quick ratio and cash ratio should improve. The current ratio is likely to improve in a purchase method acquisition due to the revaluation of the target’s inventory. However, the quick ratio and cash ratio do not include inventory in their calculation, so the effect of the acquisition on those ratios is inconclusive. (Study Session 5, LOS 21.c)
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When receivables are sold with recourse, the risk of noncollection of sold receivable is retained by Landesign. Therefore, Schmidt should make two adjustments: (1) The sale of receivables should be reclassified as CFF instead of CFO, meaning that $123,500 should be added to cash flow from financing, and $123,500 should be subtracted from cash flow from operations. (2) The full amount of the receivables, $130,000, should be added to accounts receivable, and a liability called loan payable of $123,500 should be added to the liabilities side of the balance sheet. Note that no adjustments to income are made at this time. As the receivables are collected, the 5% discount ($6,500) is amortized as interest expense. (Study Session 7, LOS 27.b)
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For 2004, Brenda’s Bakery Supply reports prepaid pension plan costs (a pension asset) of $190 and pension and other benefit liabilities of $512 for a net pension liability of $322. The main balance sheet adjustment should result in the actual economic status of the plan (funded status) being represented rather than the assets and liabilities reported for accounting purposes. Because the plan is over-funded, the pension liability should be eliminated and a net pension asset of $40 should be reported. Therefore, we will decrease pension assets by 40 ? 190 = ?$150. The net adjustments to the liability and equity side of the balance sheet will total (512 ? 150) = $362 and equity should be increased by this amount. Remember that for balance sheet adjustments related to pension expense, tax effects should be ignored. (Study Session 7, LOS 27.b)
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Brenda’s reports that the current market value of its outstanding long-term debt is $2.5 million. Long-term debt and the current portion of long-term debt are reported on the balance sheet at $2.380 million and $0.310 million respectively, for a total of $2,690,000. (Don’t forget to include the current portion of long-term debt in the total!) Therefore, we need to adjust long-term debt downward and equity upward by $2,690 ? $2,500 = $190. (Study Session 7, LOS 27.b)
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The existence of operating leases is essentially off-balance sheet financing. To adjust the balance sheet for operating leases, the present value of the lease payments is added to both assets and liabilities. The interest rate used in the present value computation is the lower of the firm’s financing rate or the interest rate that is implicit in the lease. In this case, Brenda’s financing rate is 7%, while the rate implicit in the lease is 9%, so we use 7% in our computation. Using our financial calculator, the present value of the lease payments is: N = 8; PMT = 50; I/Y = 7; FV = 0; CPT PV = $298.56. Therefore, we will increase net fixed assets by $299 and also increase long term debt by $299. (Study Session 7, LOS 27.b)
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To account for the obligation of the environmental clean-up, Brenda’s would increase liabilities by $100 and decrease equity by $100. The financial leverage multiplier, which is calculated as (assets / equity) would increase as equity would be lower while assets would remain unchanged. Note that the other answers are incorrect. Capitalizing the operating lease will serve to increase future cash from operations and decrease cash flow from financing as part of the lease expense will be considered repayment of debt. Because prices are rising, the use of LIFO inventory accounting is considered conservative and indicates high earnings quality. (Study Session 7, LOS 27.b)
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Comprehensive income (CI) is an income figure that allows for all changes in equity. CI aggregates all valuation changes to assets and liabilities in a component of the equity account called comprehensive income (loss). One of the criticisms of comprehensive income is that it is inherently volatile because of its dependence on valuation changes and is not a reliable measure of a firm’s earning power. Douglas’ statement is therefore incorrect – it appears Douglas is confused with another term, normalized earnings, which adjusts income for nonrecurring items in an effort to get a better idea of the firm’s earning power. Berenz’s statement is also incorrect. While comprehensive income under U.S. GAAP does not include an adjustment for a pension fund’s funding status, GAAP does dictate that a direct to equity adjustment be made for minimum pension liabilities determined under SFAS 87. (Study Session 7, LOS 27.b)
Which of the following statements is correct when inventory prices are falling?
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Remember, prices are falling.
Below is the balance sheet for Tim's Termites, Inc.:
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2008 |
2009 |
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Cash |
300 |
330 |
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Accounts receivables |
630 |
650 |
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Inventories |
600 |
660 |
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Other current assets |
300 |
320 |
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Gross PP&E |
5,860 |
6,890 |
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Less accumulated depreciation |
1,740 |
2,100 |
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Net PP&E |
4,120 |
4,790 |
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Deferred tax assets |
60 |
55 |
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Goodwill |
920 |
900 |
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Other fixed assets |
120 |
120 |
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Total assets |
7,050 |
7,825 |
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Accounts payable |
420 |
480 |
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Current portion of LTD |
600 |
600 |
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Notes payable |
130 |
95 |
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Other current liabilities |
180 |
180 |
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Deferred tax liabilities |
60 |
70 |
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Long-term debt |
1,800 |
1,200 |
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Common stock |
1,940 |
1,960 |
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Paid in capital |
420 |
870 |
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Retained earnings |
1,500 |
2,370 |
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Total Liabilities and Equity |
7,050 |
7,825 |
The footnotes indicate that the company sold 600 of receivables with recourse to a subsidiary.
After adjusting the balance sheet for current value, the current ratio is:
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The 600 of receivables should be added to both current assets and current liabilities to calculate the new current ratio, which would be (330 + 650 + 600 + 660 + 320) / (480 + 600 + 95 + 180 + 600) = 1.31.
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The goodwill should be deducted from and receivables should be added to the balance sheet, so the long-term debt to asset ratio is 1,200 / (7,825 ? 900 + 600) = 0.1595.
Holdall Corporation recently reclassified many of their assets such that the average useful life of their depreciable assets was reduced. Which of the following is the most likely result from this change on net income and inventory turnover? (Assume everything else remains constant.) Net income will:
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Depreciation expense increases as the depreciable life of an asset decreases. Thus, net income will decline. Ordinarily, depreciation has no effect on inventory turnover.
A firm seeking to lower current tax liability may elect to use which method of inventory valuation during an inflationary period?
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During a inflationary period, using LIFO would increase COGS, thereby decreasing earnings and taxes.
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