Q6. For the past three years Paul Schindler, CFA, has worked for Zirconia Capital Management (Zirconia) as a research analyst in

the firm’s small cap equity division. Last week, Schindler was promoted to portfolio manager of the Zirconia Small Cap Equity

Fund, where he co-manages the fund with Zirconia’s founder, Dick Killen. Over the last three quarters, performance for the

Zirconia Small Cap Fund has been excellent, ranking in the top 10% of its peer group. Since the fund now has a three year track

record, it is showing up in many of the screens run by investment managers and consultants, and assets have been flowing into

the fund at a rapid pace. Due to the large influx of assets, Schindler and Killen are considering expanding the number of

companies held in their fund and are looking for new investment ideas.

One company that looks interesting to them is Bingaman Corporation (Bingaman), a manufacturer of oil and gas exploration equipment. Killen and Schindler have talked to Bingaman’s management and like the story behind the firm. Before taking a position in the firm, the fund managers want to analyze their financial statements to assess the true financial situation at the firm. This will necessarily involve a review of the accounting methods used by Bingaman’s management.

Financial statements for Bingaman Corporation for the year ended December 31, 2004, are shown below with relevant footnotes:

• Inventory is valued under the Last In, First Out (LIFO) cost flow assumption. The LIFO reserve was $50 million on January 1, 2004 and $60 million on December 31, 2004.
• The firm has operating leases with a present value of $100 million. Rent payments of $20 million equate to $10 million interest expense plus $10 million depreciation expense.
• A class action lawsuit has been filed against Bingaman for environmental contamination of a wildlife reserve. According to Bingaman’s attorney’s, the likely outcome is a $12,000,000 judgment adverse to Bingaman in early 2006.
• Because of an increase in market interest rates during the year, the market value of Bingaman’s long-term debt has changed by $15 million.
• Goodwill is from previous acquisitions.

Schindler has determined that Bingaman’s marginal tax rate is 40%, and he assumes that that inflation will average 2.5% per year over the foreseeable future.

Factoring out the impact of LIFO accounting on Bingaman’s 2004 net income, normal net income for the year ended December 31, 2004, would be:

A)   $40 million.

B)   $56 million.

C)   $44 million.

Q7. On the 2004 modified balance sheet of Bingaman Corporation, total assets are:

A)   $720 million.

B)   $880 million.

C)   $910 million.

Q8. On the 2004 modified balance sheet of Bingaman Corporation, net adjustments to equity are:

A)   ?$16,000,000.

B)   $14,000,000.

C)   $43,000,000.

Q6. For the past three years Paul Schindler, CFA, has worked for Zirconia Capital Management (Zirconia) as a research analyst in fficeffice" />

the firm’s small cap equity division. Last week, Schindler was promoted to portfolio manager of the Zirconia Small Cap Equity

Fund, where he co-manages the fund with Zirconia’s founder, Dick Killen. Over the last three quarters, performance for the

Zirconia Small Cap Fund has been excellent, ranking in the top 10% of its peer group. Since the fund now has a three year track

record, it is showing up in many of the screens run by investment managers and consultants, and assets have been flowing into

the fund at a rapid pace. Due to the large influx of assets, Schindler and Killen are considering expanding the number of

companies held in their fund and are looking for new investment ideas.

One company that looks interesting to them is Bingaman Corporation (Bingaman), a manufacturer of oil and gas exploration equipment. Killen and Schindler have talked to Bingaman’s management and like the story behind the firm. Before taking a position in the firm, the fund managers want to analyze their financial statements to assess the true financial situation at the firm. This will necessarily involve a review of the accounting methods used by Bingaman’s management.

Financial statements for Bingaman Corporation for the year ended December 31, 2004, are shown below with relevant footnotes:

Balance Sheet (in $ millions)
Cash	35	Accounts Payable		60
Accounts Receivable	75	Long Term Debt		120
Inventory	190	Common Stock		360
Equipment	400	Retained Earnings		230
Real Estate	50
Goodwill	20
Income Statement
(in $ millions)
Sales	600
Cost of Goods Sold	(450)
Depreciation	(50)
Rent Payments	(20)
Interest Expense	(10)
Other Expenses	(20)
Net Income	50
Statement of Cash Flows for the period ffice:smarttags" />1/1/2004 – 12/31/2004 (in $ millions)
Cash Flow from Operations (CFO)			120
Cash Flow from Investing (CFI)			(95)
Cash Flow from Financing (CFF)			(10)
Change in cash			15
+ Beginning of Period Cash			20
Ending Cash Balance			35

• Inventory is valued under the Last In, First Out (LIFO) cost flow assumption. The LIFO reserve was $50 million on January 1, 2004 and $60 million on December 31, 2004.
• The firm has operating leases with a present value of $100 million. Rent payments of $20 million equate to $10 million interest expense plus $10 million depreciation expense.
• A class action lawsuit has been filed against Bingaman for environmental contamination of a wildlife reserve. According to Bingaman’s attorney’s, the likely outcome is a $12,000,000 judgment adverse to Bingaman in early 2006.
• Because of an increase in market interest rates during the year, the market value of Bingaman’s long-term debt has changed by $15 million.
• Goodwill is from previous acquisitions.

Schindler has determined that Bingaman’s marginal tax rate is 40%, and he assumes that that inflation will average 2.5% per year over the foreseeable future.

Factoring out the impact of LIFO accounting on Bingaman’s 2004 net income, normal net income for the year ended December 31, 2004, would be:

A)   $40 million.

B)   $56 million.

C)   $44 million.

Correct answer is B)

During 2004, the LIFO reserve increased from $50 to $60 during the year implying that the higher priced new inventory was passed along, understating net income. To calculate the adjustment, we need to multiply the change in the LIFO reserve by (1 ? tax rate).

Change in LIFO reserve = (50 ? 60) = ?10. Change in net income = (?)(?10)(1 ? 0.4) = +$6. To adjust net income we add the $6 to our original value of $50 for an adjusted value of $56.

Q7. On the 2004 modified balance sheet of Bingaman Corporation, total assets are:

A)   $720 million.

B)   $880 million.

C)   $910 million.

Correct answer is C)

Modified total assets are calculated by adding in the fair market value of the operating leases, the LIFO reserve as of December 31, 2004, and subtracting the goodwill from previous acquisitions. ($770 + $60 + $100 ? $20) = $910 million.

Q8. On the 2004 modified balance sheet of Bingaman Corporation, net adjustments to equity are:

A)   ?$16,000,000.

B)   $14,000,000.

C)   $43,000,000.

Correct answer is C)

Bingaman’s modified balance sheet will show the following net adjustments to equity: adding the entire LIFO reserve (due to the assumption of rising prices), less the value of the goodwill from previous acquisitions, less the expected litigation exposure, plus the offset to equity for the decrease in the value of the long term debt due to rising interest rates: ($60,000,000 ? $20,000,000 ? $12,000,000 + $15,000,000) = $43,000,000.

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