*FINANCIAL STATEMENT ANALYSIS CASE RNA INC. (a) The calculation of selected financial ratios for RNA for the fiscal year 2015 is as follows: Current ratio = Current assets Current liabilities = $9,900 $6,300 = Acid-test ratio 1.57 Short-term Net = Cash + Investments + receivables Current liabilities = $3,900 $6,300 = .62 Times interest earned Profit margin on sales = Income before income taxes and interest expense Interest expense = $7,060 + $900 $900 = 8.84 = Net income Net sales = $4,260 $30,500 = 13.97% *FINANCIAL STATEMENT ANALYSIS CASE (Continued) Asset turnover Inventory turnover = Net sales Average total assets = $30,500 ($17,000 + $16,000) ÷ 2 = 1.85 times = Cost of goods sold Average inventory = $17,600 ($6,000 + $5,400) ÷ 2 = 3.09 times (b) The analytical use of each of the six ratios presented above and what investors can learn about RNA’s financial stability and operating efficiency are presented below. Current ratio  Measures the ability to meet short-term obligations using shortterm assets.  RNA’s current ratio has declined over the last three years from 1.62 to 1.57. This declining trend, coupled with the fact that it is below the industry average, is not yet a major concern; however, the company should be watched in the future as the ratio assumes that noncash current assets (particularly inventory) can be quickly converted to cash at or close to book value. Acid-test ratio  Measures the ability to meet short-term debt using the most liquid assets.  RNA’s acid-test ratio has remained stable over the last three years; however, it is still below the industry average. Furthermore, a quick ratio below 1 indicates that RNA may have difficulty meeting its shortterm obligations if inventory does not turn over fast enough. *FINANCIAL STATEMENT ANALYSIS CASE (Continued) Times interest earned  Measures the ability to meet interest commitments from current earnings. The higher the ratio, the more safety for long-term creditors.  RNA’s ratio has been improving over the last three years and is above the industry average. This provides an indication that RNA has been paying down or refinancing debt and/or increasing sales and profits, which indicates long-term stability. Profit margin on sales  Measures the net income generated by each dollar of sales. It provides some indication of the ability to absorb cost increases or sales declines.  RNA’s profit margin has been improving and is currently above the industry average, indicating a trend towards marginal operating efficiency. Furthermore, it improves the ability to absorb soft economic periods, pay down debt, or take on additional debt for expansion. Asset turnover  Measures the efficiency of resource use; i.e., the ability to generate sales through the use of assets.  RNA’s ratio has been steadily improving and is above the industry average, indicating good use of assets and ability to generate sales. Inventory turnover  Measures how quickly inventory is sold, as well as how effectively investment in inventory is used. It also provides a basis for determining if obsolete inventory is present or pricing problems exist.  RNA’s ratio has been steadily declining and is below the industry average. This slower-than-average situation may indicate a decline in operating efficiency, hidden obsolete inventory, or overpriced stock items. *FINANCIAL STATEMENT ANALYSIS CASE (Continued) (c) Limitations of ratio analysis include:  Difficulty making comparisons among firms in the same industry due to accounting differences. Different accounting methods may cause different results in straight-line depreciation versus accelerated methods, LIFO versus FIFO, etc.  The fact that no one ratio is conclusive. ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Integral Approach Sales Less: Variable manufacturing costs Fixed manufacturing costs Variable non manufacturing costs Fixed non manufacturing costs Net income 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $320,000 $600,000 $2,200,000 $480,000 32,000 64,000 60,000 120,000 220,000 440,000 48,000 96,000 28,000 52,500 192,500 42,000 96,000 $100,000 180,000 $187,500 660,000 $ 687,500 144,000 $150,000 Sales = (Number of units X $4.00) Variable manufacturing costs = (Number of units X $0.40) Variable non manufacturing costs = (Number of units X $0.35) Fixed manufacturing costs = Number of units X ($720,000 ÷ 900,000) Fixed non manufacturing costs = Number of units X ($1,080,000 ÷ 900,000) Discrete Approach Sales Less: Variable manufacturing costs Fixed manufacturing costs Variable non manufacturing costs *Fixed non manufacturing costs Net income (Loss) *$1,080,000 ÷ 4 1st Quarter $320,000 32,000 64,000 28,000 270,000 ($ 74,000) 2nd Quarter $600,000 3rd Quarter $2,200,000 4th Quarter $480,000 60,000 120,000 220,000 440,000 48,000 96,000 52,500 270,000 $ 97,500 192,500 270,000 $1,077,500 42,000 270,000 $ 24,000 ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis Profit margin on sales = Net income ÷ Net sales Integral approach: Net income (Loss) Net sales Profit margin on sales 1st Quarter $100,000 320,000 31.3% 2nd Quarter $187,500 600,000 31.3% 3rd Quarter $687,500 2,200,000 31.3% 4th Quarter $150,000 480,000 31.3% 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $(74,000) 320,000 (23.1%) $97,500 600,000 16.3% $1,077,500 2,200,000 49.0% $24,000 480,000 5.0% Discrete approach: Net income (Loss) Net sales Profit margin on sales The integral approach smoothes variation in profit margin on sales across quarters relative to the discrete approach. This smoothing happens because the integral approach allocates fixed costs across quarters according to the sales occurring in the quarter. The discrete approach, however, allocates fixed costs across quarters evenly (an equal amount each quarter). Because the sales vary from quarter-to-quarter, an even allocation of fixed costs to the quarter’s results in more variation in net income. Principles The concept underlying the integral approach is that an individual quarter is part of a larger time interval about which we have more information. In this problem, for example, we know that sales are seasonal. So, we know that a greater proportion of the revenue generating process occurs in the third quarter than in the other quarters. Arguably, then, a greater proportion of the fixed costs for the year should be allocated to the third quarter than to the other quarters. Part of the reason we incur fixed costs at the level we do is so that we can handle the volume of the third quarter. Allocating the same amount of fixed costs to each quarter paints a picture of the firm’s profitability across quarters that is arguably inaccurate. PROFESSIONAL RESEARCH (a) According to FASB ASC 235-10-50: 50-3 Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. A selection from existing acceptable alternatives b. Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry c. Unusual or innovative applications of GAAP. (b) According to FASB ASC 235-10-50. Examples of Disclosures 50-4 Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. Basis of consolidation b. Depreciation methods c. Amortization of intangibles d. Inventory pricing e. Accounting for recognition of profit on long-term constructiontype contracts f. Recognition of revenue from franchising and leasing operations. PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Analysis The current-ratio increase is a favorable indication as to solvency, but alone tells little about the going-concern prospects of the client. From this ratio change alone, it is impossible to know the amount and direction of the changes in individual accounts, total current assets, and total current liabilities. Also unknown are the reasons for the changes. The acid-test ratio is an unfavorable indication as to solvency, especially when the current ratio increase is also considered. This decline is also unfavorable to the going-concern prospects of the client because it reflects a declining cash position and raises questions as to reasons for the increases in other current assets, such as inventories. The increase in the ratio of property, plant, and equipment to stockholders’ equity cannot alone tell anything about either solvency or going-concern prospects. There is no way to know the amount and direction of the changes in the two items. If assets increased, one must know whether the new assets are immediately productive or need further development. A reduction in stockholders’ equity at this point would cause much concern for the creditors of this client. The decrease in the ratio of sales to stockholders’ equity is in itself an unfavorable indicator because the most likely reason is a sales decline. However, this decline, which is more relevant to going-concern prospects than to solvency, is largely offset by the fact that net income has significantly increased. The increase in net income is a favorable indicator for both solvency and going-concern prospects although much depends on the quality of receivables generated from sales and how quickly they can be converted into cash. A significant factor here may be that despite a decline in sales, the client’s management has been able to reduce costs to produce this increase. Indirectly, the improved income picture may have a favorable impact on solvency and going-concern potential by enabling the client to borrow currently to meet cash requirements. PROFESSIONAL SIMULATION (Continued) The 32-percent increase in earnings per common share, which is identical to the percentage increase in net income, is an indication that there has probably been no change in the number of shares of common stock outstanding. This in turn indicates that financing was not obtained through the issuance of common stock. It is not possible to reach conclusions about solvency and going-concern prospects without additional information about the nature and extent of financing. The percentage increases in book value per common share demonstrate nothing so far as solvency and going-concern potential are concerned. It is probable that the smaller percentage increase in the current year only reflects the larger base value created in the preceding year. It is not possible to tell from these figures what the dividend policy of the client is or whether there is an increase in net assets which is capable of generating future earnings, thus making it possible to raise capital for current needs by the issue of additional common stock. The collective implications of these data alone are that the client entity is about as solvent and as viable as a going concern at the end of the current year as it was at the beginning although there may be a need for short-term operating cash. Explanation The creditors will probably ask for the information listed below to overcome the limitations inherent in the ratios discussed above and to obtain more evidence to support the conclusions drawn from them. 1. Additional ratios and other comparative data may be requested. They are likely to include such items as the following: (a) Changes in current assets other than quick assets. (b) Accounts receivables turnover, inventory turnover, and the number of days it takes to complete the cycle from cash to inventories to receivables to cash. (c) Liabilities to stockholders’ equity. 2. The creditors will probably want explanations for the changes in ratios during the current year. The client should be prepared to respond to questions about the age and collectibility of the receivables, the condition and salability of the inventories, the cause of the quickasset position in the current year, the nature of increases in property, PROFESSIONAL SIMULATION (Continued) plant, and equipment and their potential for providing greater sales or cost reductions in the future, the presence of long-term debt and the dates when it must be repaid, and the manner of controlling costs so that a larger net income was shown in the current year. (The comparative financial statements themselves will answer many of these questions and will provide insight into the client’s capability of meeting current obligations as well as continuing profitable operations.) The client may also be expected to provide information about future plans and projections. 3. The creditors may also ask for ratios and related information for several recent years. These data may demonstrate trends and can be compared to data for other companies and for the industry. Although a quick evaluation of a reporting entity can be made using only a few ratios and comparing these with past ratios and industry statistics, the creditors should realize the limitations of such analysis even from the best prepared statements carrying a CPA’s unqualified opinion. A limitation on comparisons with industry statistics or other companies within the industry exists because material differences can be created through the use of alternative (but acceptable) accounting methods. Further, when evaluating changes in ratios or percentages, the evaluation should be directed to the nature of the item being evaluated because very small differences in ratios or percentages can represent significant changes in dollar amounts or trends. The creditors should evaluate conclusions drawn from ratio analysis in the light of the current status of, and expected changes in, such things as general economic conditions, the client’s competitive position, the public’s demand (for the product itself, increased quality of the product, control of noise and pollution, etc.), and the client’s specific plans. IFRS CONCEPTS AND APPLICATION IFRS24-1 The IFRS standards addressing related party disclosures are: IAS 1 (“First Time Adoption of IFRS”); IAS 24 (“Related Party Disclosures”); disclosure and recognition of post-balance sheet events in IAS 10 (“Events after the Balance Sheet Date”); segment reporting provisions in IFRS 8 (“Operating Segments”); and interim reporting requirements are presented in IAS 34 (“Interim Financial Reporting”). IFRS24-2 There are two types of subsequent events: (a) (b) (c) (d) (e) (f) (g) (h) (1) Those which affect the financial statements directly and should be recognized therein through appropriate adjustments. (2) Those which do not affect the financial statements directly and require no adjustment of the account balances but whose effects may be significant enough to be disclosed with appropriate figures or estimates shown. Probably adjust the financial statements directly. Disclosure. Disclosure. Disclosure. Neither adjustment nor disclosure necessary. Neither adjustment nor disclosure necessary. Probably adjust the financial statements directly. Neither adjustment nor disclosure necessary. IFRS24-3 (1) Net income will decrease by $10,000 ($160,000 –$170,000) as a result of the adjustment of the liability. The settlement of the liability is the type of subsequent event which provides additional evidence about conditions that existed at the statement of financial position date. (2) The flood loss ($80,000) is an event that provides evidence about conditions that did not exist at the statement of financial position date but are subsequent to that date and does not require adjustment of the financial statements. IFRS24-4 (a) The issuance of ordinary shares is an example of a subsequent event which provides evidence about conditions that did not exist at the statement of financial position date but arose subsequent to that date. Therefore, no adjustment to the financial statements is recorded. However, this event should be disclosed either in a note, a supplemental schedule, or even proforma financial data. (b) The changed estimate of income taxes payable is an example of a subsequent event which provides additional evidence about conditions that existed at the statement of financial position date. The income tax liability existed at December 31, 2014, but the amount was not certain. This event affects the estimate previously made and should result in an adjustment of the financial statements. The correct amount ($1,320,000) would have been recorded at December 31 if it had been available. Therefore, Keystone should increase income tax expense in the 2014 income statement by $220,000 ($1,320,000 – $1,100,000). In the statement of financial position, income taxes payable should be increased and retained earnings decreased by $220,000. IFRS24-5 1. 2. 3. (a) (c) (b) 4. 5. 6. (b) (c) (b) 7. 8. 9. (c) (c) (a) 10. 11. 12. (c) (a) (b) IFRS24-6 Interim reports are unaudited financial statements normally prepared four times a year. A complete set of interim financial statements is often not provided because this information is not deemed crucial over a short period of time; the income figure has much more relevance to interim reporting. The accounting problems related to the presentation of interim data are as follows: (a) The difficulty of allocating costs, such as income taxes, pensions, etc., to the proper quarter. (b) Problems of fixed cost allocation. IFRS24-7 A company records losses from inventory write-downs in an interim period similar to how it would record them in annual financial statements. However, if an estimate from a prior interim period changes in a subsequent interim period of that year, the write-down is adjusted in the subsequent interim period. IFRS24-8 While U.S. GAAP has a preference for the integral approach, IFRS leans toward the discrete approach to interim reports. Thus, if an IFRS company expenses interim amounts, like advertising expenditures that could benefit later interim periods, it may be difficult to compare to a U.S. company that would spread the cost across interim periods. IFRS24-9 (a) 1. The company should report its quarterly results as if each interim period is discrete. 2. Under the discrete approach the amounts should be reported as the company’s revenue and expenses would be reported as follows on its quarterly report prepared for the first quarter of the 2014–2015 fiscal year: IFRS24-9 (Continued) Sales revenue Cost of goods sold Variable selling expenses Fixed selling expenses Advertising Other $60,000,000 36,000,000 1,000,000 2,000,000 1,000,000 Sales revenue and cost of goods sold and other expenses receive the same treatment as if this were an annual report. Costs and expenses other than product costs should be charged to expense in interim periods as incurred. (b) The financial information to be disclosed to its shareholders in its quarterly reports as a minimum include: 1. 2. 3. 4. 5. 6. 7. 8. 9. Statement that the same accounting policies and methods of computation are followed in the interim financial statements as compared with the most recent annual financial statements or, if those policies or methods have been changed, a description of the nature and effect of the change. Explanatory comments about the seasonality or cyclicality of interim operations. The nature and amount of items affecting assets, liabilities, equity, net income, or cash flows that are unusual because of their nature, size, or incidence. The nature and amount of changes in accounting policies and estimates of amounts previously reported. Issuances, repurchases, and repayments of debt and equity securities. Dividends paid (aggregate or per share) separately for ordinary shares and other shares. Segment information, as required by IFRS 8, “Operating Segments.” Changes in contingent liabilities or contingent assets since the end of the last annual reporting period. Effect of changes in the composition of the company during the interim period, such as business combinations, obtaining or losing control of subsidiaries and long-term investments, restructurings, and discontinued operations. IFRS24-9 (Continued) 10. Other material events subsequent to the end of the interim period that have not been reflected in the financial statements for the interim period. IFRS24-10 (a) According to IAS 1, paragraph 117, “An entity shall disclose in the summary of significant accounting policies: (b) (1) the measurement basis (or bases) used in preparing the financial statements, and (2) the other accounting policies used that are relevant to an understanding of the financial statements.” A few examples taken from IAS 1:  Paragraph 118: It is important for an entity to inform users of the measurement basis or bases used in the financial statements.  Paragraph 120: Each entity considers the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity.  Paragraph 122: An entity shall disclose, in the summary of significant accounting policies or other notes, the judgements, apart from those involving estimations (see paragraph 125), that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements.  Paragraph 124: Some of the disclosures made in accordance with paragraph 122 are required by other IFRSs. For example, IAS 27 requires an entity to disclose the reasons why the entity’s ownership interest does not constitute control, in respect of an investee that is not a subsidiary even though more than half of its voting or potential voting power is owned directly or indirectly through subsidiaries. IAS 40 Investment Property requires disclosure of the criteria developed by the entity to distinguish investment property from owner-occupied property and from property held for sale in the ordinary course of business, when classification of the property is difficult. IFRS24-11 (a) The specific items M&S discusses in Note 1 are basis of preparation; accounting convention; basis of consolidation; subsidiaries; revenue; dividends; pensions; intangible assets; property, plant and equipment; leasing; leasehold prepayments; cash and cash equivalents inventories; provisions; share-based payments; foreign currencies; taxation; financial instruments; derivative financial instruments and hedging activities; embedded derivatives critical accounting estimates and judgments and non-GAAP performance measures. (b) M&S reported segments for its UK and International Operations. UK was further segmented into general merchandise and food. International was segmented into franchised and owned. The UK segment is the largest segment in terms of revenue and assets. M&S does not report its largest customer. (c) No interim information is reported.