Reading 27: Analysis of Financial Statements: A Synthesis

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LOS d: Analyze and interpret 1) the effect on reported financial results and ratios of a company's choices of accounting methods and assumptions, 2) the effect on reported financial results and ratios of changes in accounting methods and assumptions, and 3) the effects of balance sheet modifications and earnings normalization on a company's financial statements, financial ratios, and overall financial condition.

Q1. Express Delivery Inc. (EDI) reported the following year-end data:

Depreciation expense	$30 million
Net income	$30 million
Total assets	$535 million
Shareholder’s equity	$150 million
Effective tax rate	35 percent

Last year EDI purchased a fleet of delivery vehicles for $140 million. For the first year, straight-line depreciation was used assuming a depreciable life of 7 years with no salvage value. However, at year-end EDI’s management determined that assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were more appropriate. How would the return on assets (ROA) and return on equity (ROE) for last year change due to the change in depreciation assumptions? ROA decreases to:

A) 5.7% from 5.6% and ROE decreases to 19.7% from 20.0%.

B) 5.3% from 21.43% and ROE increases to 20.7% from 20.0%.

C) 5.0% from 5.6% and ROE decreases to 18.4% from 20.0%.

Q2. Consider the balance sheet shown below for the Starburst Corporation:

Starburst Corporation Balance Sheet ($ millions)
Assets		Liabilities & Owners’ Equity
Cash	$ 20	Accounts payable	$ 30
Marketable securities	10	Notes payable	10
Accounts receivable	40	Total current liabilities	$ 40
Inventories	80
Total current assets	$150	Long-term debt	$120
		Common stock	40
Net property, plant, & equipment (P,P&E)	$230	Retained earnings	200
Intangible assets	20	Total stockholders’ equity	$240
Total assets	$400	Total liabilities & equity	$400

Footnotes to Starburst’s financial statements include the following information:

Inventories are valued at cost as determined by the last in, first out (LIFO) method. The LIFO reserve is $10 million.
Additional operating facilities and equipment are financed with operating leases that have a present value of $20 million.
Intangible assets represent $4 million of goodwill from previous acquisitions.
Due to a decrease in interest rates, Starburst’s long-term debt has a current market value of $150 million.

Which of the following is closest to Starburst's total debt ratio after making the necessary balance sheet adjustments?

A) 0.49.

B) 0.35.

C) 0.60.

[2009] Session 7 - Reading 27: Analysis of Financial Statements: A Synthesis

Q1. Express Delivery Inc. (EDI) reported the following year-end data:

A) 5.7% from 5.6% and ROE decreases to 19.7% from 20.0%.

B) 5.3% from 21.43% and ROE increases to 20.7% from 20.0%.

C) 5.0% from 5.6% and ROE decreases to 18.4% from 20.0%.

Correct answer is C)

The reported ROA and ROE are 5.6% (30/535) and 20.0% (30/150) respectively. Under the new depreciation assumptions, depreciation expense would be (140-14)/5 = 25.2 million. Under the original assumptions depreciation of the fleet was 20 million. Therefore depreciation increases by 5.2 million. With the change in depreciation methods EDI would have reported:

Depreciation expense	$35.20 million	(30 + 5.2)
Net income	$26.62 million	(30 ? (5.2 × (1-0.35)))
Total assets	$529.80 million	(535 ? 5.2 )
Shareholder’s equity	$144.80 million	(150 ? 3.38 ? 1.82)

Note that assets would have been lower by $5.2 million due to the new depreciation assumptions and shareholder’s equity by $3.38 million (5.2 × (1 ? 0.35)) due to lower retained earnings and an additional $1.82 million from equity to balance the $5.2 million reduction in assets. Therefore, ROA would have been 5.0% (26.62 / 529.80) and ROE would have been 18.4% (26.62 / 144.8).