This is all one problem please and thank you :) Louise Stinson, the chief financ

Question

This is all one problem please and thank you :) Louise Stinson, the chief financial officer of Bostonian Corporation, was on her way ent's office. She was carrying the latest round of bad news. There would be no executive b this year. Corporate profits were down. Indeed, if the latest projections held true, the co to the presi. es e company would report a s mall loss on the year-end income statement. Executive bonuses were tied to cor porate prof its. The executive compensation plan provided for 10 percent of net earnings to be set aside for bo- nuses. No profits meant no bonuses. While things looked bleak, Stinson had a plan that might help soften the blow After informing the company president of the earnings forecast, Stinson made the following sug gestion: Because the company was going to report a loss anyway, why not report a big loss? She rea soned that the directors and stockholders would not be much more angry if the company reported a large loss than if it reported a small one. There were several questionable assets that could be written down in the current year. This would increase the current year's loss but would reduce expenses in subsequent accounting periods. For example, the company was carrying damaged inventory that was estimated to have a value of $2,500,000. If this estimate were revised to $500,000, the company would have to recognize a $2,000,000 loss in the current year. However, next year when the goods were sold the expense for cost of goods sold would be $2,000,000 less and profits would be higher by that amount. Although the directors would be angry this year, they would certainly be happy next year The strategy would also have the benefit of adding $200,000 to next year's executive bonus pool

Explanation / Answer

Ans. (a) The change in depreciation policy from straight line to accelarated method, will increase the current year depreciation vis-a-vis sbsequent years assuming the same stock of fixed assets. This will mean that there would be higher charge to P&L statement for depreciation and the following items in the Balance Sheet shall be impacted:    (i) Stock of Fixed Assets will be reduced more than in case of straight line due to higher charge    (ii) This incremental reduction in the Fixed Assets shall be balanced by proportionate reduction in the Shareholder's Equity since the incremental loss shall be reduced from the Reserves & Surplus

Increasing the percentage of receivables estimated to be uncollectible will effectively mean that a higher portion of credit sales (& any other receivables) are expected to go bad; hence the gross sales shall be accordingly incrementally reduced (by incremental allowance for uncollectbile receivables). In the balance sheet, this shall be:    (i) In the Account Receivables section, the allowance for uncollectible receivables (which is reduced from the gross receivables) shall be increased. This will result in lower Account Receivables hence the Current Assets shall be accordingly reduced.    (ii) This will be balanced by reduction in the Shareholder's Equity - which will happen by a higher loss (due to lower net sales number) being adjusted from the Reserves & Surplus in the Equity section.

Raising the percentage of estimated warranty claims, shall be similar to the above adjustment but on the cost side. This is an increase in the contingent liability and is usually debited as part of the cost of goods sold. Hence the incremental estimate shall result in higher cost and porportionately higher loss. This incremental loss shall be added to the Warranty Liability Account (contingent liability section or Provisions) and like above will not have any actual cash impact. In the balance sheet, it will be shown as below:    (i) The Contingent Liabilities shall increase by the increase in the estimate for the warranty claims    (ii) By the same amount, the Shareholder;s Equity will be reduced due to higher loss. Both the Equity & Contingent Liability are on the Source (Liabilities) side balance sheet and will adjust/balance each other.

Note in all the above case, there will be no actual cash impact.

Ans. (b) Theoretically, if the all other things remain same (& allowed) and the above changes are reversed in the subsequent accounting periods, the Shareholder's Equity should increase but not in the same proportion (since the tax will payable on the incremental profit).

Ans. (c) It is the responsibility of the Company officials especially the CEO & CFO to present the financial data in fair manner which represents the true health of company. In this instance, they are playing around with the accounting rules to advance expenses from subsequent accounting periods, which will allow them to inflate future profits. Further this is driven by the perverse incentive that since they (company officials) will not be any worse off by size of loss (since there will be no bonus irresective of size of loss), they have decided to increase the losses & reduce shareholder capital. Apart from the time value of the money, in pure accounting terms, even though there is no cash impact in current year, in subsequent years the shareholder's surplus gets impacted due to higher taxes. The reduction in Shareholder Equity was pre tax but any additions will always be post tax.

Ans. (d) If the value of bonus pool is linked to shareholder equity value, this problem can be solved. Hence the management can be incentivised by stock options instead of cash bonus wherein the stock value will be a motivation for them to maintain the long term value.

Ans. (e) The price is expected to go down, which will result in the reduction of P/E ratio. Even after the changes are reversed, the lower P/E ratio may result on lower equity value for shareholders.

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