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1. Explain the benefits and costs associated with a company’s disclosure of information.
Answer:
Supplying information benefits a company by helping it to compete in capital, labor, input, and output markets. A company’s performance hinges on successful business activities and the markets’ awareness of that success. Economic incentives exist for those companies that disclose reliable accounting information, especially when the company discloses good news about products, processes, management, etc. Direct costs associated with the disclosure of information pertain to its preparation and dissemination. More significant are other costs including competitive disadvantage, litigation potential, and political costs. Managers must weigh these costs and benefits to determine how much information to voluntarily disclose.
Topic: Demand for Financial Accounting Information
LO: 1
2. List three users of financial accounting information and explain how each might use financial information.
Answer:
Managers and employees – Managers and employees demand financial information on the financial condition, profitability and prospects of their companies for their own well-being and future earnings potential. They also demand comparative financial information on competing companies and other business opportunities. This permits them to conduct comparative analyses to benchmark company performance and condition.
Creditors and suppliers – Creditors and other lenders demand financial accounting information to help decide loan terms, dollar amounts, interest rates and collateral. Suppliers similarly demand financial information to establish credit sales terms and to determine their long-term commitment to supply-chain relations. Both creditors and suppliers use financial information to continuously monitor and adjust their contracts and commitments with a debtor company.
Shareholders and directors – Shareholders and directors demand financial accounting information to assess the profitability and risks of companies. Shareholders look for information useful in their investment decisions. Both directors and shareholders use accounting information to evaluate manager performance. Managers similarly use such information to request further compensation and managerial power from directors. Outside directors are crucial to determining who runs the company, and these directors use accounting information to evaluate manager performance.
Customers and Sales Staffs – Customers and sales staffs demand accounting information to assess the ability of the company to provide products or services as agreed and to assess the company’s staying power and reliability. Customers and sales staffs also wish to estimate the company’s profitability to assess fairness of returns on mutual transactions.
Regulators and Tax Agencies – Regulators and tax agencies demand accounting information for tax policies, antitrust assessments, public protection, price setting, import-export analyses and various other uses. Timely and reliable information is crucial to effective regulatory policy. Moreover, accounting information is often central to social and economic policy.
Voters and their Representatives – Voters and their representatives to national, state and local governments demand accounting information for policy decisions. The decisions can involve economic, social, taxation and other initiatives. Voters and their representatives also use accounting information to monitor government spending. Contributors to nonprofit organizations also demand accounting information to assess the impact of their donations. Topic: Balance Sheet Components
LO: 2
3. What are the three broad groups that make up a balance sheet? List and define each.
Answer:
1. Assets – Investments which are expected to produce revenues, either directly when the asset is sold or indirectly, like a manufacturing plant that produces inventories for sale or a corporate office building that house employees supporting revenue-generating activities of the company.
2. Liabilities – Borrowed funds (accounts payable, accrued liabilities, and obligations to lenders or bond investors).
3. Equity – Capital that has been invested by the shareholders, either directly via the purchase of stock (net of any repurchases of stock from its shareholders by the company) or indirectly in the form of retained earnings that have been reinvested into the business and not paid out as dividends.
Topic: Owner vs. Nonowner Financing
LO: 2
4. Businesses rely on financing activities to fund their operating and investments. Explain the difference between owner and nonowner financing, and explain the benefits and risks involved in relying more heavily on each type of financing.
Answer:
Owner financing, also called equity, refers to money given to the business in exchange for partial control of the company. Stocks are the most common form of owner financing. Companies are not obligated to guarantee a return on owner investments. However, if returns are unacceptable to owners, they may use their power to take the business in different directions. In sum, owner financing provides cash inflow to the company without any guarantee of repayment. Control over the company is vested in the shareholders.
Nonowner financing refers to money given to the business in exchange for a guaranteed repayment, usually with interest. Loans and bonds are very common examples of nonowner investment. The risk to the company lies in potential default if operations decline. The benefit is that the company does not need to cede operational control to its creditors, unless it defaults on its repayment. In sum, nonowner financing allows the current owners to maintain full control of the company, but requires repayment with interest.
Companies that rely more heavily on owner financing are said to be financed conservatively. Companies that rely more heavily on nonowner financing are said to be financed less conservatively.
Topic: Usefulness of ROA for Managers
LO: 4
5. Investors and lenders place significant importance on management’s effectiveness in generating a high return on assets (ROA). Explain how ROA is also important for managers’ analysis of its own performance, particularly when ROA is disaggregated.
Answer:
Return on assets (ROA) is a helpful measure of a company’s profitability. In its most basic form, ROA is a ratio between net income and average assets, i.e. it indicates the return the company is earning from its assets. While ROA is a valuable indicator for investors, it is just as valuable for company managers. This is because ROA indicates how successful managers are in acquiring and using investments on behalf of shareholders. ROA is particularly useful for managers when it is disaggregated into more focused, meaningful components.
Return on assets can be disaggregated into profit margin (PM), which measures profitability and asset turnover (AT), which measures efficiency or productivity.
The ratio of net income to sales is called profit margin and the ratio of sales to average assets is called asset turnover. The profit component reflects the amount of profit from each dollar of sales, and the productivity component reflects the effectiveness in generating sales from assets.
This disaggregation yields additional insights into the factors that cause overall ROA to change during the year. It could be that the company is more or less profitable or that the company is more or less efficient or both. This disaggregation provides more information than just knowing that ROA has increased or decreased during the year.
1. The statement of cash flows for Snap-On Incorporated for the year ended December 28, 2013, includes the following items (excerpts only):
a. Why does Snap-On add back depreciation to compute net cash provided by operating activities? Is depreciation a source of cash?
b. Snap-On reports cash flows associated with accounts receivable. In 2012, this item is a cash outflow of $43.4 million and in 2013 this item is a cash outflow of $42.0 million. Explain why this item is on the statement.
c. Did Snap-On accounts payable increase or decrease during 2013? How do you know?
Answer:
a. Snap-On adds back depreciation to undo the effect it had on the income statement. In 2013, Snap-On deducted $51.2 million depreciation in computing net income. Depreciation is a non-cash expense so Snap-On did not actually use $51.2 million cash to pay depreciation expense. Thus, to determine how much cash was generated, net income is too low by the depreciation amount of $51.2 million. The depreciation add-back is NOT a source of cash as some mistakenly believe. Cash is, ultimately, generated by profitable operations, not by depreciation.
b. Snap-On reports changes in its accounts receivable during the year. When accounts receivable decrease during the year it means that cash was collected. This source of cash is reported as a cash inflow. When accounts receivable increase it means that cash was not collected on those accounts. This shows up on the statement of cash flows as a use of cash (as in 2012 and 2013).
c. Accounts payable increased during 2013 because the line item for accounts payable shows a cash inflow. This reflects expenses that have been deducted to arrive at net income, but have not yet been paid in cash, therefore an add back to net income.
Topic: Statement of Cash Flows
LO: 1
2. The statement of cash flows for Snap-On Incorporated for the year ended December 28, 2013, includes the following items (excerpts only). Explain why the company’s net earnings are not the same as its net cash provided by operating activities.
Answer:
The balance sheet and income statements are prepared using accrual accounting, in which revenues are recognized when earned and expenses when incurred. This means that companies can sometimes report income even though no cash is received and expenses even though no cash is paid. For example, the income statement included depreciation of $51.2 million, which was not a cash expense. Thus, to determine how much cash was generated, net income is too low by the depreciation amount of $51.2 million.
Topic: Book Value vs. Market Value
LO: 1
3. Book value of stockholders’ equity usually differs from company market value. Explain some reasons why a company’s book value of stockholders’ equity can differ from a company’s market value.
Answer:
1. GAAP generally reports assets and liabilities at historical costs; whereas the market attempts to estimate fair values for assets.
2. GAAP excludes resources that cannot be reliably measured such as talented management, employee morale, recent innovations and successful marketing; whereas the market attempts to value these with some recognition of uncertainty.
3. GAAP does not consider market differences in which companies operate such as competitive conditions and expected changes; where as the market attempts to factor in these differences in determining value.
4. GAAP does not usually report expected future performance; whereas the market does attempt to predict future performance.
Topic: Articulation of the Financial Statements
LO: 2
4. Explain the concept of articulation among the four financial statements.
Answer:
Articulation refers to the fact that the four financial statements are linked to each other and that changes in one statement affect the other three. For example, net income reported on the income statement is linked to the statement of retained earnings, which in turn is linked to the balance sheet. Also, the statement of cash flows explains how the cash reported on the balance sheet changes from one period to the next. Understanding how the financial statements articulate, helps us to analyze transactions and events and to understand how events affect each financial statement separately and all four together.
1. Discuss factors that limit the usefulness of financial accounting information for ratio analysis.
Answer:
The first limitation arises from GAAP concepts such as non-measurable values, non-capitalized costs, and the irrelevance of historical costs. The second limitation arises when companies experience significant year over year changes. For example, a company may acquire or divest a subsidiary, thus throwing the numbers off. The final limitation is the impact of conglomerates. Most companies actually comprise several smaller companies. Taken as a whole, their combined numbers impair the ability to compare ratios with other competitors.
Topic: Conglomerates and Ratio Analysis
LO: 1-4
2. Ratio analysis is more complicated when a company is a conglomerate. Why?
Answer:
Conglomerates are difficult to analyze because they are a blend of several businesses under one parent company. Since the different companies operating under the conglomerate may participate in a wide variety of industries, it is difficult to compare the conglomerate’s consolidated financial statements with its competitors.
Topic: Margin and Turnover
LO: 2
3.Explain the trade-off between net operating profit margin and net operating asset turnover.
Answer:
There are an infinite number of combinations of margin and turnover that yield a given RNOA. Typically companies with higher NOPM have lower NOAT. To attract investors, companies need to demonstrate an ability to earn an acceptable return on capital. Service companies can operate on a lower profit margin since they achieve a high turnover of net operating assets. Manufacturers, however, require higher profit margins in order to offset the lower asset turn.
Topic: Disaggregation of ROE
LO: 3
4.Explain how return on net operating assets (RNOA) and financial leverage (FLEV) affect Return on Equity (ROE). Is greater FLEV always better?
Answer:
ROE is the return on equity and is the ultimate performance measurement from the investor’s standpoint. ROE is computed by taking a company’s net income attributable to controlling interests (less preferred dividends) and dividing by the stockholders equity attributable to controlling interests. The ROE equation can also be disaggregated into RNOA + (FLEV × Spread) x NCI ratio. RNOA is the return on net operating assets and is a ratio of a company’s net operating profit after tax to net operating assets. RNOA measures the return on the company’s main operations, it shows how a company uses its operating capital and how much profit it is able to realize from these resources. FLEV is a measure of a company’s leverage (how much debt the company uses compared to shareholders’ investment), and Spread measures the difference between the company’s operating return and the cost of debt. If the RNOA is higher than the cost of debt, leverage will increase a company’s overall profits.
Too much financial leverage can be risky. Debt is a contractual obligation that must be fulfilled regardless of the financial situation of the company. Therefore, creditors can force a company into bankruptcy and liquidate its assets, and this can cause shareholders to lose their entire investments. The higher the amount of debt, the higher the risk of bankruptcy. Therefore, shareholders expect a higher rate of return which increases the minimum ROE for company survival. On the other hand, too little financial leverage results in shareholders’ equity not being optimally utilized, resulting in a lower stock price. When a firm first takes on debt the stock price increases, reflecting the positive benefits of low cost financing, as their interest rates will be low due to low amounts of debt. However, there is a point when the cost of the loan covenants, increased bankruptcy risk, and increased costs offset the positive effects of financial leverage. There is an optimal amount of financial debt to shareholder equity that will maximize the stock price and the ROE.
Topic: Traditional ROE (DuPont) analysis compared to RNOA analysis
LO: 4
5.What is the difference between the traditional ROA measure (part of the traditional DuPont analysis) and the return on net operating assets (RNOA)?
Answer:
The traditional ROA includes net income in the numerator and adjusts for interest expense. Thus, the ROA numerator includes all the profits (losses) from operating and nonoperating sources except for interest expense. The denominator (average total assets) includes all assets – this is different from the RNOA denominator in two ways. First, the ROA denominator it is not net of any liabilities, ROA includes only assets. In contrast, the denominator in RNOA is net of operating liabilities. Second, the ROA denominator includes all assets, both operating and nonoperating. The ROA measures total profit from all sources generated by all the resources (regardless of how the resources were financed) whereas RNOA measures operating profits generated from net operating assets. The two measures are useful but it is important to remember that they measure different things.
Topic: Demand and Supply for Credit
LO: 1
- Companies have many types of credit to access. For each of the following terms provide a concise definition:
- Line of credit
- Letter of credit
- Revolving credit line
Answer:
All three forms of credit are available from banks.
- Line of credit – a guarantee from a bank that funds will be available when needed
- Letter of credit – a situation where a bank stands between a seller and a buyer and through the letter of credit guarantees payment by the buyer
- Revolving credit line – bank loans that companies draw upon as needed, analogous to a credit card
Topic: Credit Risk Analysis Process
LO: 2, 3
- When assessing a company’s chance of default analysts normally try to predict the company’s future performance and cash flow in order to determine the likelihood the company will be able to repay the loan. What are the four steps that an analyst would take to determine a company’s chance of default?
Answer:
Step 1: Assess the nature and purpose of the loan
- Determine why the borrower is requesting the loan
Step 2: Assess the macroeconomic environment and industry conditions
- Use a framework like Porter’s Five Forces to consider the broader business context in which the company operates
Step 3: Perform financial analysis
- Adjust financial statements
- Profitability analysis
- Short-term liquidity analysis
- Long-term solvency analysis
- Coverage analysis
Step 4: Perform prospective analysis
- Forecast the borrower’s cash flows to estimate its ability to repay obligations
Topic: Motivations for Investment
LO: 1, 2, & 3
1.Why do corporations undertake intercorporate investments? How might our understanding of these reasons influence our analysis of such investments?
Answer:
There are several reasons for intercorporate investments and the various accounting methods reflect this.
Passive ownership, (either trading, available-for-sale, or held-to-maturity securities), is generally used as a way to put excess cash to good use. However, in our analysis we should watch for investor companies that place a disproportionate amount of their wealth in marketable securities, rather than into their core operations. If these securities are held for trading, then we should be even more attuned to the possibility that the investor company is attempting to “play the market” in an unwise fashion, mimicking the practices of a financial services corporation.
Significant-influence equity ownership often stems from a strategic alliance with the investee company, and such relations are often very sensible business arrangements. Unfortunately, these relations cloud our ability to analyze the investor company because some of the investee’s assets and all of its liabilities are not represented. Additionally, even though the investor company is not legally liable for the debts of the investee, business realities may dictate that the practical exposure of the investor company is more significant.
Investments with control investment allow the investor company access to new markets, new technologies, or new products. Acquisitions often bring skilled personnel, such as researchers or sales staff. Even though consolidation of the balance sheet makes many details of the investment more transparent, complications can arise, especially with regards to income. Many things about the structure and policy of the investee company may differ from the investor company, and these differences are allowed to persist after consolidation. Some of these differences can pertain to dividend policy or restrictions, varying international regulations, and the power of minority shareholders.
Topic: Accounting for Investments
LO: 1, 2, & 3
2. What are the various methods used to account for investments? When is each appropriate? Explain how each method affects a company’s balance sheet and income statement and the appropriate uses for each method.
Answer:
The accounting methods are as follows:
- Fair-value method: Used with available-for-sale and trading securities, which do not represent more than 20% ownership in the investee company’s business. Mark-to-market accounting reports investments on a company’s balance sheet at fair values as determined by security exchanges and the appropriate markets. Therefore, the reporting of such investments is both relevant and objective. Dividends and capital gains on sale of such investments affect current income. Interim changes in fair values may or may not affect current income, depending on whether the securities are classified as trading or available-for-sale.
- Cost method: Used for passive investments in debt securities, where the intention of the investor is to hold the debt instrument until it matures. Because of this long-term investment intention, the investment is not adjusted to fair value each period. The balance sheet reports the amortized cost of the investment. The income statement includes interest income earned each period.
- Equity Method: Used with investments where the investor company has significant influence over the investee company’s operations. Significant influence is often in evidence when the investor owns 20-50% of a company’s common stock. Under the equity method, the investment account equals the percent ownership in the investee’s stockholders’ equity, plus the percent of income declared by the investee that belongs to investor, minus any dividends paid. Therefore the investment is reported at “adjusted cost.” Assets and liabilities associated with the investment are not appropriately represented on the investor’s balance sheet. The investor records income equal to the percent owned of investee company income. Any capital gains resulting from sale the sale of investment are reported as income by the investor as well.
- Consolidation: Consolidation accounting is used with investments in which the investor company practically has control over the investee company’s operations. Control is determined by greater than 50% ownership in the investee’ outstanding common stock. Under consolidation, the balance sheets and income statements of the investor and investee companies are combined and reported under a single entity. In the process of consolidation, certain intercompany transactions are eliminated and adjustments in stockholders’ equity are made to avoid double counting income and assets. Therefore, consolidation accurately represents assets and liabilities of the investor associated with its investment in the other entity.
Topic: Equity Method vs. Consolidation
LO: 2 & 3
3.Explain the standards that determine if an investor company will report its investment in an investee company using the equity method or will consolidate the investee. Why might the investor company prefer the equity method?
Answer:
Consolidation must be used if the investor has “control,” usually indicated if the investor owns more than 50% of the investee company voting stock. Other contractual agreements can result in “control” even if the percentage held is less than 50%. The relevant test is whether or not the investor company can dictate key strategic policies. The equity method is used when a lesser standard of “significant influence” is met, typically assumed when the portion of the investee company shares owned lies between 20-50%.
Consolidation (purchase) requires that the balance sheet of the investee company be combined with that of the investor company. This increases both the assets and liabilities of the investor company. As long as the investor holds just enough of the investee company to maintain equity-method status, some of assets and (more importantly) all of the liabilities of the investee company are missing from the investor company’s balance sheet. Without consolidation, ratios that measure leverage and profitability are improved.
Topic: Ratio Effects of Equity Method Investments
LO: 2
4.How does the equity-method of accounting for investments affect financial ratios of the investor company?
Answer:
Effects on the financial ratios of the investor company can be significant. Specifically, the investment account reports only the percentage owned of the investee company’s stockholder equity and not the underlying assets and liabilities. Similarly, the income statement reports the proportionate share of investee income and not its sales and expenses. Equity method accounting for investments results in the following effects on the components of return on equity (ROE). The net operating profit margin (NOPM) is overstated due to nonrecognition of sales and total operating profit. The net operating asset turnover (NOAT) is understated due to nonrecognition of sales, but is overstated by nonrecognition of assets. Financial leverage (FLEV) is understated due to nonrecognition of assets and the correct reporting of income. ROE, however, is correct because net income is correct and equity is correct.
Topic: Definition of Significant Influence
LO: 2
5.What is meant by the term, “significant influence”? Describe situations in which you believe a company has significant influence over the operations of another company. What is the accounting method used when there is significant influence over an investee?
Answer:
Significant influence is determined by such factors as representation on the board of directors of the investee company, participation in decision making processes, sharing of managerial personnel, legal agreements (such as license to use technology, a formula or a trade secret) or substantial intercompany transactions (such as sole supplier, sole customer relationships). Unless there is evidence to the contrary, significant influence is presumed if a company owns more than 20% and no more than 50% of the outstanding voting stock of an investee. Significant influence can be determined, however, in cases when the investor owns less than 20% of the outstanding common stock of another entity, if one or more of the above described situations exist. In general, if a company can exercise some control over the operations of another entity, it should be scrutinized for significant influence over that entity.
Significant influence investments are accounted for using the equity method: the investor sets up an investment account and records the percent of its ownership in the investee’s equity. The percent of investee’s income/loss is added to the investment account and any dividends are subtracted. Equity method does not present the actual assets and liabilities associated with the investment.
Topic: Allocation of Purchase Price
LO: 3
6.What steps are taken to allocate the purchase price when it exceeds the book value of the investee’s stockholders’ equity? Include an explanation of intangible assets and goodwill.
Answer:
The purchase price of the investee company is first allocated to tangible assets and liabilities, at their fair value at the time of acquisition. Then value is ascribed to intangible assets, again at current fair values. Intangible assets include assets that provide quantifiable benefits to a company but do not have physical substance. Examples of intangible assets include trademarks, internet domain names, customer lists, customer contracts, books, video, licensing and royalty agreements, franchise agreements, and patents. After the appropriate amount is ascribed to identifiable intangible assets, the remainder of the purchase price is allocated to goodwill. Intangible assets that have a definite life expectancy should be amortized over time. Goodwill, however, is not amortized, but it can be impaired. Goodwill should be evaluated for impairment on an annual basis.
Topic: Goodwill Impairment
LO: 3
7.Why is goodwill not amortized? When is goodwill impaired and how is it treated?
Answer:
Goodwill has an indefinite life and, for that reason, it is not amortized. Previously, goodwill was amortized over a period of up to 40 years. Under current GAAP, goodwill is tested at least annually for impairment.
The impairment of Goodwill is a two-step process. First, the fair value of the company is compared with the book value of its associated investment account on the investor’s books. Fair value is determined using a number of alternative methods (such as comparable market prices of existing businesses or discounted free cash flow valuation method). If the result of that valuation is less than the investment balance, goodwill is deemed to be impaired, and an impairment loss is computed and recorded in the consolidated income statement. Disclosure of the facts and circumstances are also required, and this information is typically reported in a footnote.
Topic: Limitations of Consolidated Financial Statements
LO: 3
8.Describe the limitations of consolidated financial statements.
Answer:
While consolidated financial statements can be helpful in analyzing the state of a company, the financial statements have certain limitations. First, there can be difficulty in comparing the financial statements of individual subsidiaries. Differences in accounting procedures, etc, means that the financial statements were arrived at differently, and therefore are not directly comparable. Second, because the assets for all the subsidiaries are lumped together on the consolidated balance sheet, there is no indication of the cash flows of individual subsidiaries. Potential problems with liquidity may not be easily recognizable. Next, in some cases a financially strong company will combine with a financially weak company. Because the assets, liabilities, etc, are all rolled into one, the strength or weakness of individual companies is hidden. This is inaccurate partly because the resources of one company will not necessarily be used to settle the debts of another. Fourth, the consolidated financial statements generally do not indicate intercompany transactions. Last, the consolidation of finance and insurance subsidiaries can be particularly problematic for analysis. Because the companies are so dissimilar, the consolidated numbers could be very distorted.
Topic: Capital and Operating Leases
LO: 1
1.Generally accepted accounting principles (GAAP) classify leases into two types for accounting purposes. Explain the accounting treatment for the two types of types of leases. Is one preferable to the other? Explain.
Answer:
For capital leases, the asset is recorded on the lessee’s balance sheet when acquired and is treated as though it was purchased. The asset is depreciated like all other long-term assets held by the lessee. The related lease obligation is recorded as a liability on the lessee’s balance sheet and is amortized over the life of the lease. When a lease payment is made, the amount is separated as principal repayment and interest expense on the income statement.
Operating leases are not accounted for on the lessee’s balance sheet. The existence of operating leases appears only in the footnotes that accompany the lessee’s financial statements. All lease payments are recorded as rent expense on the lessee’s income statement. The asset remains on the lessor’s balance sheet where it is depreciated accordingly.
Most managers prefer operating leases because they are a form of off-balance-sheet financing. Keeping the assets and liabilities of operating leases off the balance sheet improves a company’s liquidity, debt level, and profitability. The enhancement of these 3 factors reduces the perception of risk that the company will go bankrupt. The market will perceive the company more favorably, which could lead to a better debt rating and lower interest rates on borrowed funds.
Topic: Lease Capitalization Criteria
LO: 1
2.There are four criteria established by GAAP to determine if a lease is capital or operating. List and briefly explain the four criteria a lease must satisfy in order for it to be considered an operating lease so it can be reported off-balance sheet.
Answer:
Transfer of Title – There is no transfer of title to the lessee when the terms of the lease expire. If ownership did pass to the lessee, than the lease is nothing more than a purchase contract that was financed by the lessor.
Bargain Purchase Option – The lease does not contain a bargain purchase option at the end of the lease. That means the lessor cannot sell the lessee the asset at a price that is below the asset’s fair market value. This criterion was established because lessors often structured leases so the lessee could purchase the asset for $1 at the end of the lease. This structure allowed both parties to satisfy the transfer of ownership requirement and categorize these leases as operating.
The term of the lease is less than 75% of the estimated economic life of the leased asset. If the lease is for 75% or more of the asset’s economic life, than essentially all risks and benefits have passed to the lessee.
The present value of the lease payments must be less than 90% of the fair market value of the asset. If the present value of the lease payments is 90% or more, then for all practical purposes, the lessee has purchased the asset and should capitalize it on his/her balance sheet.
Topic: Discussion of Pension Standard
LO: 2
3.Why would most corporations prefer to use long-term expected return rates instead of actual returns when computing pension expense?
Answer:
Companies did not want the difference between expected and actual returns to be reported on the income statement because most pension fund investment portfolios are heavy on government bonds and the prices of those bonds fluctuate in response to changes in the market and changes in interest rates. They argued that over time the unrealized gains and losses should cancel each other out and net around zero. Therefore, by allowing the differences in returns on pensions to be recorded in off-balance-sheet financing, the income is smoothed. In other words, the income statements are not distorted by everyday fluctuations.
Topic: Income Smoothing Features of Pension Accounting
LO: 2
4.Discuss the concept of “income smoothing” that is built into GAAP as it relates to pensions.
Answer:
GAAP permits companies to compute pension expenses using the expected return on fund assets rather than the actual return on those pension investments. Because investment returns fluctuate from year to year, the FASB agreed to allow a firm’s managers to report the long term expected returns rather than the short term returns that would reflect the true effects of a bull or bear market. This has the effect of “income smoothing” as it “smoothes” out the ups and downs from the bond and stock markets. The difference between actual and expected returns is then accumulated off of the balance sheet. The difference between the plans assets and the plans liabilities is what is reported on the balance sheet.
Topic: Pension Accounting Issues
LO: 2
5.Companies have raised at least two objections with respect to pension accounting. First, companies oppose putting pension assets and liabilities on the balance sheet at gross amounts (as opposed to netting the assets and liabilities). Second, companies oppose marking pension assets and liabilities to fair value each period. Explain both of these objections and describe how GAAP accounts for each.
Answer:
There are two major accounting issues with respect to pensions. First reporting the pension assets and liabilities would adversely impact the market’s perception of their companies’ financial reports. This is because both the asset and liabilities would go up on the balance sheet. This would increase leverage ratios and worsen profitability metrics such as return on assets. GAAP requires that the net asset or liability be reported, not the gross amounts.
The second objection is the potential effect on the income statement from fluctuations in the market values of pension investments and pension obligations. These changes would impact equity and hence the retained earnings. Thus market fluctuations would make the income statement more volatile. Managers believe that stock prices would be negatively impacted by such an increase in volatility.
Topic: Understanding Lease and Pension Estimates
LO: 1 & 2
6. Alleghany Corporation includes the following in its 2013 annual report (in thousands).
On an ongoing basis, we evaluate our estimates, including those related to the value of long-lived assets, deferred acquisition costs, incentive compensation, pension benefits, and contingencies and litigation. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances.
a. What estimates does the company make when accounting for capital leases?
b. What estimates does the company make when accounting for defined benefit pensions?
Answer:
a. To account for lease liability, the company must estimate the discount rate. The other inputs are given by the lease contract. Accounting for the leased assets involves estimating the assets’ expected life, salvage value and the depreciation method.
b. The pension obligation requires the company to estimate discount rate, growth rate in wages, expected rate of return on plan assets, life span of employees, retirement rates, attrition rates and inflation rates. Many of these estimates will be made by the actuaries but the company likely has some input.
Topic: Benefits of Using SPEs
LO: 3
7.What are SPE’s? What are the benefits of using them? How do they work? Provide an example of the use of a SPE.
Answer:
An SPE is a special purpose entity. The relationship involves a sponsoring company and a subsidiary that purchases assets from the sponsoring company and sells them to a securitization trust (the SPE) which purchases the assets using borrowed funds. SPEs allow companies to structure projects or transaction with a number of financial advantages.
SPEs can often secure a lower rate on financing because of the limited nature of a SPE’s activities (remember that they are sponsored for a specific purpose.) Investors thereby supply well-secured debt that is not exposed to the same business risks that the sponsor has (that is, the risk of more creditors lining up to collect on debt) of the sponsoring company. SPEs reduce business risk and bankruptcy risk for their lenders.
SPEs are often used to finance construction and real estate projects. SPEs can use contracts from the sponsoring company in order to collateralize debt, often at a lower rate than the sponsoring company may be able to secure. The sponsoring company utilizes the asset, such as a new plant at lower cost, through an operating lease.
Consumer finance companies, retailers, and financial subsidiaries of manufacturing companies commonly use SPEs to securitize (sell) their financial assets.
Topic: Off-Balance-Sheet Financing
LO: 1, 2, & 3
8.What is off-balance-sheet financing, and why would managers use it?
Answer:
Off-balance-sheet financing means that company managers do not report assets, liabilities, or both, on the balance sheet. For instance, with operating leases, listing assets and liabilities off of the balance sheet improves market perception of a company’s operating performance and financial condition. GAAP, however, does require that management disclose information related to leases in the footnotes.
Managers want to report adequate liquidity and little debt in order to appear more solvent. Managers also aim to report fewer assets in order to appear more profitable. Fewer assets will drive ROA and ROE higher, and thus the firm will appear more attractive. In addition, if ROE and/or cash flows appear inadequate, managers will see their companies’ stock prices and debt ratings decline significantly. As a result, the pressure to “window dress” a firm to make it appear more profitable and more solvent is considerably high.
1.Define strategic cost management and briefly discuss the three themes that make up strategic cost management.
Answer:
Strategic cost management is defined as making decisions concerning specific cost drivers within the context of an organization’s business strategy, internal value chain, and position in a larger value chain stretching from the development and use of resources to final customers. Strategic cost management has emerged from a blending of three themes:
- Cost driver analysis—the study of factors that cause or influence costs.
- Strategic position analysis—an organization’s basic way of competing to sell products or services.
- Value chain analysis—the study of value-producing activities, stretching from basic raw materials to the final consumer of the product or service.
Topic: Strategic Position
LO: 2
2.Identify and describe the three strategic positions that lead to business success.
Answer:
The three strategic positions are: (1) cost leadership, (2) product or service differentiation, and (3) focus on a market niche.
Cost leadership requires aggressive construction of efficient-scale facilities, vigorous pursuit of cost reductions from experience, tight cost and overhead control, avoidance of marginal customer accounts, and cost minimization in areas like R & D, service, sales force, advertising, and so on.
Product and service differentiation involves creating something that is perceived as being unique and worth a premium price.
The strategic position of focusing on a specific market niche (such as a buyer group, segment of the product line, or geographic market) rests on the premise that the firm will be able to serve its narrow target more effectively and efficiently than will competitors.
Topic: Functions of Management
LO: 2
3.Briefly discuss the planning, organizing, and controlling functions of management.
Answer:
The three functions of management are planning, organizing, and controlling.
Planning is the process of selecting goals and strategies to achieve these goals. The implementation of plans requires the development of subgoals and the assignment of responsibility to achieve subgoals to specific individuals or groups within the organization.
Organizing is the process of making the organization into a well-ordered whole as management attempts to structure and divide the tasks that need to be done. Specific people are assigned specific tasks. Within a formal structure established to show the relationships among organization members, authority is delegated to managers and other employees who are subsequently held accountable for the activities they control.
Controlling is the process of ensuring that results agree with plans. In the process of controlling operations, management compares actual performance with plans. If actual results deviate significantly from plans, management either attempts to bring operations into line with the original plan or adjusts the plan. The original plan is adjusted if management determines that it is no longer appropriate because of changed circumstances. Hence, the process of controlling feeds back into the process of planning to form a continuous cycle.
Topic: Dimensions of Competition
LO: 3
4.Identify and briefly discuss the three dimensions on which competition takes place.
Answer:
Competition takes place on the dimensions of (1) price/cost, (2) service, and (3) quality. Well-informed buyers routinely search the world for the product or service that best fits their needs on the three interrelated dimensions. To compete on the basis of price, the seller must carefully manage costs. Otherwise, reduced prices might squeeze product margins to such an extent that a sale becomes unprofitable. Quality refers to the degree to which products or services meet the customer’s needs. Service includes such things as timely delivery, helpfulness of sales personnel, and subsequent support.
Topic: Types of Cost Drivers
LO: 4
5.Differentiate among structural, organizational, and activity cost drivers.
Answer:
Structural cost drivers are fundamental choices about the size and scope of operations and about technologies employed in delivering products or services to customers. Organizational cost drivers are choices concerning the organization of activities and choices concerning the involvement of persons inside and outside the organization in decision making. Activity cost drivers are specific units of work (activities) performed to serve customer needs that consume costly resources.
Topic: Ethics in Managerial Accounting
LO: 5
6.Briefly explain the nature of the ethical dilemmas that managers and accountants confront, giving examples.
Answer:
Situations involving ethics are not guided by well-defined rules; they are often subjective. Ethical dilemmas often involve decisions that are viewed as grey areas – they are not clearly ethical or unethical. Examples include (a) accelerating shipments at the end of the quarter to improve current profits, (b) keeping inventory that is unlikely to be used so as to avoid recording a loss, (c) basing a budget on an overly optimistic sales forecast, and (d) assigning some costs of one contract to another contract to avoid an unfavorable performance report on the first contract. Many ethical dilemmas involve actions that are perceived to have desirable short-run consequences and highly probable undesirable long-run consequences. The ethical action is to face the undesirable situation now to avoid a worse situation later, yet the decision maker prefers to believe that small short-term compromises will work out in the long run.
1.Your company has just performed a least-squares regression analysis of the monthly costs of manufacturing a new product. What are some considerations that should be made before making a decision based on the results of this analysis?
Answer:
First of all, there are some factors relating to the manufacturing of a new product that should be considered. With a new product, data used in the analysis may not be representative of future costs because the process of producing a new product will likely undergo significant changes during the initial year. Also, new products are likely to be initially manufactured at low levels of production due to the preliminary development of the product’s market. At low levels of production, variable costs per unit are likely to be higher than they would at normal levels of production. The least-squares regression assumes a linear relationship throughout the entire range. Therefore, results could be questionable for this reason.
In any event, results should be measured against other available knowledge and data for reasonability. The real-world processes generating the data are constantly in a state of change. Consequently, common sense and prior expectations should consistently be applied to the interpretation of any results.
One tool that provides assistance in assessment of the degree to which the regression is well-specified is a scatter diagram. A scatter diagram can provide a visual assessment as to the degree to which the data are arranged in a straight line, and are thus suited for regression analysis. A scatter diagram can also direct attention to “outlier” observations, which represent months that are not necessarily representative of typical months of operations.
Topic: Alternative Cost Estimation Methods
LO: 2
2. Identify the three different cost estimation methods discussed in this course and provide a description of the strengths and weaknesses of each.
Answer:
Scatter Diagrams: Scatter diagrams help identify representative high and low volumes. They are also useful in determining if costs can be reasonably approximated by a straight line. Scatter diagrams are simple to use, but professional judgment is required to draw a representative straight line through the plot of historical data. This method is subjective in nature, and probability intervals cannot be developed.
High-Low Cost Estimation: This method uses data from two time periods to estimate fixed and variable costs. This is a good method to use when data are limited. It is a subjective method, and probability intervals cannot be developed. It is very important that the high and low volumes represent the normal operating conditions of all observations. Again, professional judgment is required to select the appropriate data.
Least-Squares Method: This method uses all available data. It uses a mathematical criterion, which provides for an objective approach to cost estimation. In addition, this method can provide information on how well the cost estimating equation fits the historical cost data and information needed to construct probability intervals for cost estimates. It can also be used to develop equations that are not linear in nature. This method requires more data points than do the high-low or scatter diagram methods.
3.Briefly explain why changes in technology and prices make cost estimation difficult.
Answer:
Care must be taken to make sure that data used in developing cost estimates are based on the existing technology. When this is not possible, professional judgment is required to make appropriate adjustments. In addition, only data reflecting a single price level should be used in cost estimation. The prices for various cost elements are likely to change at different rates and at different times. Old data should always be used cautiously. If data from different price levels are used, an attempt should be made to restate them to a single price level.
4.Identify some of the areas of concern that make cost estimation difficult.
Answer:
Several items to be wary of when developing cost estimating equations include:
- Data that are not based on normal operating conditions
- Nonlinear relationships between total costs and activity
- Obtaining a high R-squared purely by chance
- Changes in technology and prices
- Matching activity and cost within each observation
- Identifying activity cost drivers
5.Describe the changes in composition of total manufacturing costs during the last century, using the three major cost categories: direct materials, direct labor, and manufacturing overhead.
Answer:
1.Direct materials, the cost of primary raw materials converted into finished goods, have increased slightly as organizations purchase components they formerly fabricated.
2.Direct labor, the wages earned by production employees for the time they spend converting raw materials into finished products, has decreased significantly as employees spend less time physically working on products and more time supporting automated production activities.
3.Manufacturing overhead, which includes all manufacturing costs other than direct materials and direct labor, has increased significantly due to automation, product diversity, and product complexity.
6.Describe the unit level approach to cost behavior analysis. Discuss the appropriateness of this approach.
Answer:
The unit level approach to cost analysis assumes changes in an organization’s costs are best explained by changes in the number of units or sales dollars (or some other measure of business volume). Because of its relative simplicity, unit level analysis has been widely used and accepted. In many circumstances this approach may provide acceptable results. However, in many other circumstances, this approach may be insufficient to capture the critical drivers of cost. This is especially true in organizations offering multiple products of various complexities, which vary in their consumption of the organization’s resources. In these situations, an analysis that includes additional variables for considerations such as the influence of number of batch runs on costs and the influence of the number of products offered on costs would provide more accurate estimation.