Financial Statements

The disadvantages of line item budgeting, according to Martin (2001) line-item budgets say nothing about how much service a human service agency provides, the cost of that service, the number of outcomes the agency accomplished, or their attendant costs. Another disadvantage is it limits the ability to aka change decisions as the environment and conditions change. For the most part, a line item budget is simple to read. The purpose of Performance budgeting system is to plan, budget and evaluate emphasis in relationships between money budgeted and services and or results expected.

The advantages and disadvantages of performance budgeting system are they give information on the amount of services provided by an agency and the program costs, including estimation of the cost per output per unit AT service. I en Lastingness AT performance Educating system are It is not always reliable. In some organization, the performance budget system is depended up other departments input in order to know the output for the agency. If one-department documents are available or inaccurate, it can throw off the entire performance system.

The purpose of program budgeting system is it gives insight to the effectiveness of an agency. It also relates outcome to inputs. The major advantages of program budgeting systems are that (a) they provide information on the amount of (client) outcomes achieved by a human service program and the attendant costs, including determination of cost per outcome, and (b) they raise the bevel of debate from service and efficiency concerns to clients and effectiveness concerns. The disadvantages are it is difficult to measure the outcome of performance.

With program budgeting systems, the debate is on effectiveness concerns (what happens to clients in terms of outcomes), not on line items or efficiency considerations. Program budgeting systems represent one way of personalizing that most elusive of all human service and social work goals: maintaining a client focus, Martin, (2001). Two types of traditional approaches to fund development that are appropriate for the EX. Corporation are Grant writing and undersides. In writing a grant proposal, one has to be precise in the what and why he/she is requesting a grant.

In many cases a fundraiser can and will meet the needs of an organizations. Two types of nontraditional approaches to fund development that are appropriate for the EX. Corporation are A Walk-A-Thong fundraiser is one way of raising funds for PH. ; Location – Most colleges will allow walk-a-thong on their campuses as long as the date does not conflict with any other events they may have scheduled. ; Date – Check dates in the community to make sure there are no conflicting dates to hinder the outcome of the walk-a-thong outcome. ; Food & Drinks – although it is a walk-a-thong, people will need food and drinks to keep up their strength.

Solicit area grocery stores for fruits and things for sandwiches as well as drinks, such as water and Juices. ; Print up and pass out boosters. Boosters are sheets of paper that people sign stating their pledge amounts as well as their names. Soliciting funds from local area businesses may be another way to raise funds for PH. ; Organize a team of individuals who are willing to either make phone calls to different businesses in the area, asking for donations or send a am out into the community personally soliciting funds from area businesses.

Since most people enjoy dinner, dancing and conversations, one method I would use would be a Pasta Dinner Fundraiser. Steps into making this a success are: ; Choose a Date – Check school calendars, holidays, major town events, and other organizations so there is no conflict with other events that could potentially affect the outcome of dinner. ; Location – Seek out a place that will donate space for the event, such as a church or school. ; Advertise – Sell Tickets in advance. Make posters and post them in noticeable areas. ;

The Food – Solicit food or paper good donations from area groceries, Italian restaurants (sauce), bread stores, and grocery stores. In soliciting for food, products include drinks, such as coffee, soft drinks, creamers, sugar substitutes as well as sugars. ; The Ambiance – Solicit music: search for a DC or a band to play for the event. Solicit area businesses for prizes and sell raffle ticket, Brewer (2011). If calculations are correct, EX. Corporation financial status is in good standing. If they continue on ten path teen are on, Ana malignant tenet annual average organization should continue to provide services for those in need.

Findings – Authors have found out that the adoption of fair value of financial assets has increased the disclosure requirements and It gives more value to financial statements. Results obtained from research revealed that earnings have decreased due to convergence to ALAS 39 and Management has overall positive perception regarding adoption of fair value for financial assets. Key Words Fair value, Diversified holdings, Earnings per Share, Return on Investment Paper Type Research paper 1. Introduction For many years, the users of financial statements have sought relevant and timely Information about balancing instruments.

Traditionally, the elements of financial statements – assets, liabilities, Income and expenses ? have been recognized under the historical cost and as such, the financial instruments, not different from the rest, were measured at historical cost. During the sass, some categories of financial Instruments changed from being based entirely on historical cost to a mixed historical cost,’market value approach, reflecting developments in the accounting standards. For example, under this model the trading book in the banks is measured at market value while the banking book is measured at historical cost.

However, after sometime it became apparent that such a separation does not always reflect the way banks manage their books. Trading book Instruments are, for example, used to hedge the interest rate risk in the banking book. Over time greater use will probably be made of credit derivatives to hedge credit risk in the banking book. Where there is hedging of this kind, the trading book item has to be shown at book value. (Jackson, 2000; Lodge, 2000). Due to such discrepancies, the need for a revision of the measurement of financial instruments came into existence.

However, with the nonviolence to ALAS 39, the measurement of financial instruments was diverted to fair value. The superiority of fair value measurement over historical cost accounting has been gaining broad-based acceptance among accounting professionals and standard setters (Berth, 1994: Berth et al. , 1995). It Is believed that fair value measurements and recognition of these values in the financial statements, along with adequate disclosures, will provide accurate, comprehensive and timely information to evaluate an enterprise’s exposures to financial risks, as well as rewards In a proper Asia (Adamant, 2002; Ball, 2006).

Though there are detailed discussions as to why financial instruments should be recorded in the balance sheet at fair value, they do not explore the earnings process and the interrelationship between fair value ‘OFF evident that there is a lack of research in this area, and this study aims to fill this void. The purpose of this paper is to examine the academic literature on the effect of the adoption of Fair value for Financial Instruments on the earnings of an entity. In the study, we have focused on the effect of adoption of fair value for the financial stets on the earnings of Diversified Holdings, from the perspective of the company.

On the outlook, we test whether the level of earnings is significantly lower before the convergence to ALAS, and reported earnings is more value relevant during the FIRS period. This study covers the two time periods, one year before the convergence and one years after the adoption (FIRS period). Since there was no other change in the financial reporting environment of Sir Lankan during the period studied, we assume that the potential country-level factor that could affect firm’s earnings during the erred was the convergence FIRS.

Secondly, this work paper provides the impact of the change in accounting treatment on the Return of Equity and Return on Investments of the holding company. Finally, this study reviews the insights and perceptions of the managers of the holding companies on the adoption of fair value for the measurement of Financial Assets in their entities. 2. Literature Review 2. 1 Background Over the years there has been a burgeoning need among standard setting bodies, academia, shareholders and professional bodies in improving the comparability and reliability of financial statements.

To achieve this objective, SAAB introduced many relevant accounting standards including one of the most complex and debatable important standards namely, FIRS 13 and AS 39. FIRS 13- Fair Value Measurement defines the fair value, sets out framework for measuring fair value and discusses the disclosures required on fair value measurement. One of the major modules discussed in FIRS 13 is that fair value measurement of financial instruments. FIRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the assortment date (I. . An exit price). That definition of fair value emphasizes that fair value is a market-based measurement, and not an entity-specific measurement. (Ball, 2006). When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or liability under current market conditions, including assumptions about risk (Penn and Belly, 2010). According to AS 39 financial asset can be defined as any asset that is A. Cash, B. An equity instrument of another entity, a) a contractual right: I. O receive cash or another financial asset from another entity; or it. O exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity: or b) a contract that will or may be settled in the entity’s own equity instruments and is: I. A non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or I’. A derivative that will or may be settled other than by the exchange off fixed equity instruments.

For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery f the entities own equity instruments. 2. 2 Prior studies on Fair Value measurement of financial assets Previous research articles and case studies on fair value measurement adoption provide valuable insights on how other countries have dealt with its consequences and difficulties they have faced. A case study on how China has adopted fair value accounting (Penn and Belly, 2010) discusses on high degree of adoption of FIRS fair value measurement for financial instruments within China AGAPE.

Since China is an emerging country they place much attention on adopting international standards to attach with the investors’ information requirements. As per the proposals of Joint Working Group of standard setters, the reliability of financial statement figures plays an important role when providing information to the users of financial statements. With the fair value adoption for financial assets, it clearly gives an idea of true economic conditions of the financial assets. On the other hand it has an inherent risk of volatility incorporated in to financial statements.

In Fair Value Accounting and Future Financial Instruments Jackson and Lodge) discusses on the difficulties in adopting fair value accounting in banking sector as they have high amount of financial assets in their asset portfolio. Hence banking books are exposed to higher amount of volatility if fair value accounting is adopted. Also when bringing financial assets to fair value the discounts rate to be used is debatable; whether to use market rate or internal discount rate. Additionally banks might be taxed on unrealized gains if gains from fair value changes are used for tax purposes. When fair value measurements are calculated only for external financial reporting purposes, they often will not have been produced from a defined process with consistent valuation methods and systems and strong internal control. We are concerned that fair value prepared only purpose, not used by the enterprise to manage its business and prepared without the benefit of major investment in systems and human resources, may be unreliable and frequently would present significant audit difficulties.

Although this situation present today with fair value disclosures for financial instruments and for hedging requirements of AS 39 and FAST Statement No. 33, the broader use of fair value measurements for all financial instruments in the primary financial statements would exacerbate the reliability and audit issues” explains Leister Wilson and Ernst & Young in his article Fair Value and Measurement; Where the conflict lie. 3. Methodology The main research question, as outlined above, is “Does the measurement of fair value for financial assets of diversified holdings improve the earnings? To provide a consistent platform for assessing the impact from the measurement of fair value for financial assets, this study examines the diversified holdings which had been listed at Colombo Stock exchange. Diversified Holdings are of particular interest for several reasons. Firstly, the core business of the diversified holding companies is engaging in considerably large amount of investments compared to that of the companies listed under other sectors in Colombo Stock Exchange.

Secondly, the focus on this study is on the Financial Information relating to the “company’ rather than the “group” because when taken as a group, the fair value impact of investments of companies might set off each other thus giving misleading results and conclusions. This study analyses the related information of four holding companies namely, John Keels Holdings PL, Carson Cumberland PL, Aitkin Spence PL and C T Holdings PL which represents 74% of the total market capitalization of diversified holdings listed in Colombo Stock Exchange as at 22nd November 2013. Refer appendix 01). Data for the study includes financial accounting information retrieved from the annual reports of the companies in the selected sample pertaining to the years 2012/13 and 2011/12 and non-financial data on the perception of the managers on the convergence, obtained in the form of open ended interviews with a set of limited questions. The variables used in this research paper to determine the effect of the earnings of the company as a result of convergence are earnings per share (PEPS) and return on investments (ROI).

Data analysis for the study includes both quantitative and qualitative methods. A Comparative Analysis has been used to study quantitative data and a perception analysis and they were conducted to identify the perceptions of financial mangers regarding the measurement of fair value for financial assets. To pursue its overall research goal, the study is organized to address the following three interrelated research objectives.

The first objective of the study is the examination of the change in accounting treatment and disclosure requirements due to the measurement of fair value for financial assets. For this purpose a disclosure analysis was conducted using the annual reports of the selected sample. Under this methodology, a comparison was carried out between the disclosures made in the annual reports of 2011/2012 and the disclosures made in 2012/2013 annual reports in order to ascertain the new disclosure and measurement requirements from the adoption of SLURS/ALAS.

The second objective of the study is the examination of the impact of the change on key performance indicators (PEPS, ROI). The hypothesis selected for the study supports this objective is “The measurement of fair value for financial assets has increased ROI and PEPS of diversified holdings”. The methodologies used for the analysis are mean, variation and regression analysis. The approaches were carried out in this study to pursue the above designated objectives.

As per the first time adoption of ALAS/SLURS, the companies were required to prepare conciliations to restate 2012 and 2011 financial statement figures in accordance with Sulfurs. The increase or decrease in fair value of financial assets due to adoption of Fires was obtained using these reconciliations. Then the delta of ROI and PEPS was calculated based on the change in fair value. Further, the mean and variation of such calculated ROI and PEPS was calculated using relevant formulas to identify the average impact on earnings due to the fair value measurement.

Then a relationship between particular variables was obtained using regression analysis to identify the eat value of variable to test the hypothesis of the study which states that there is a positive impact on ROI and PEPS due to the measurement of fair value. Variables used in regression analysis are the value of financial assets before the convergence of with regard to financial assets were obtained from 2011/2012 annual reports, which had been measured under cost and they were analyses against the comparatives in 2012/2013 annual reports which have been restated as per the ALAS 39.

As such, the outright change occurred as a result of the convergence to FIRS could be able to identify. The percentage difference between above two variables is used as X values of the regression graph and the resulted ROI and PEPS were taken to the Y axis. After conducting regression test we could identify beta values between the variables and the nature of relationship among them. The third objective of the study is to analyses manager’s perception regarding the measurement of fair value.

To achieve this, a set of open ended interviews were conducted with manages to identify their views on the convergence. Here we have not tested any hypothesis nonetheless generalized their own views. 4. Analysis and Discussion 4. 1 Disclosure Analysis Adoptions of Sulfurs significantly broaden the presentation and disclosure requirement. From the convergence, it is expected to reduce the risk of wrong decision making and give more relevant information (Ryan, 2008).

Based on the research carried out, it was identified that the quality of disclosure on financial assets has been improved. The financial statements prepared according to CLASS have not included any separate disclosures on financial assets, further the investments on financial assets have been recognized at cost and only the market value of the investments have been separately disclosed. In the examination of financial reports prepared according to the Sulfurs; after convergence to ALAS 39, it was evident that financial assets are disclosed separately and measured at fair value.

The convergence requires disclosing definition of fair value, hierarchy in determining fair value, fair value used in initial and subsequent measurement, and also the fair value used in impairment testing of financial assets. At the circumstances where the fair value of financial assets recorded in the statement of financial position cannot be rived from active markets, the fair values have been determined using valuation techniques and these valuation techniques have been disclosed in the notes to the financial statements.

If this is not feasible and a degree of Judgment is required in establishing fair values, the liquidity risk, credit risk and volatility have been disclosed as the basis for Judgments. 4. 2 Analysis of the impact of the change on the key performance indicators This analysis examines the impact of the change on key performance indicators, the Earnings per Share (PEPS) and Return on Investment (ROI). The ROI has been calculated using following formula and the calculations and are included in Appendix 01. ROI Earnings change due to convergence Total asset value as per ALAS transition to SLURS/ALAS.

Mean of ROI has decreased by 1. 25% which revealed that the fair value measurement for financial asset has a negative impact on the earnings. The PEPS has been calculated using following formula: = Earnings change due to convergence PEPS Weighted average number of shares The mean value of PEPS has increased to 15. 18%. The increment of ROI is largely due to the increased PEPS of CT Holdings. CT holdings PEPS has increased by a significant amount due to the lower number of shares. PEPS of John Keels Holdings and Aitkin Spence have decreased and PEPS of Carson has increased by a negligible amount.

Graphs for above discussed results are presented in Appendix 02. Graph 01 shows the relationship between the value of financial asset according to both ALAS and CLASS and the respective ROI. A trend line was obtained and the formula of the regression line was extracted. The beta value of the line is -10. The downward slope shows that there is a negative relationship between the earnings and the changes on air value measurement. Graph 02 shows the relationship between PEPS and the value of financial asset according to both CLASS and ALAS.

The slope of the regression line was -6. Under this also, a negative impact was identified. 4. 3 Perception Analysis This was carried out in order to address the perception of key financial managerial persons of the companies in the selected sample regarding the adoption of fair value for financial assets. The conversion process of Sir Lankan Accounting Standards with International Financial Reporting Standards (FIRS) has given an opportunity to the UAPITA market to raise confidence of stakeholders and promote good accounting practices.

But it’s human nature to dislike change, and most of the responses to the changes arising from the use of the new Standards have been negative. In some cases, despite a similar requirement being existent in the Sir Lankan Standards (Class) companies want to continue their past practices, not recognizing that accounting has also changed to keep pace with business and the environment. Therefore perception analysis has been carried out to get overall idea on organizations’ perception regarding fair value adoption and the results of the analysis has briefed below.

Approximately one fourth of the interviewees were in the perception that accounting for financial instruments considered a challenge as companies will be required to identify such instruments. FIRS provides detailed guidance on recognition, measurement and disclosure requirements for financial instruments. It requires all financial instruments to be initially recognized at fair value, while some instruments are re-measured at fair value at each reporting date. This will result in increased volatility in the income statement and/or equity.

Measuring at financial instruments at fair value is considered as cumbersome and external stakeholders and create awareness of the impact of adoption of fair value for financial assets. The rest of the interviewees claimed that the adoption of fair value in financial instruments has upgraded the quality of financial instruments to world class level. Suppliers, lenders, counter parties, customers, investor community and many other stake holders will give a premium for the best as they receive more reliable and up to date information through financial reports. . Conclusion The first objective of this study is to assess of the change in accounting treatment and disclosure requirements due to the measurement of Fair Value for Financial Assets. From the study performed, it could be identified that, quality of disclosure on financial assets under SLURS has improved after the convergence which in turn has increased the value of the financial statements. As per the second objective of this study, the impact of convergence on the change of key performance indicators (PEPS, ROI) of selected companies was analyses.

The hypothesis built up at the enhancement of the research is “The effect of adopting Fair value for Financial Assets has a positive impact on Key Performance Indicators”. Based on the results obtained from our research revealed that, the earnings have decreased due to the convergence to ALAS 39. This concludes that our hypothesis has rejected and null hypothesis has accepted as the conclusion. The final objective of the research was to obtain the perceptions of the convergence from the financial managers on the convergence to obtain an overall idea on the convergence of ALAS.

A Framework for Business Analysis Using Financial Statements

Question 1

Matti, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to Matti when financial analysis can add value, even if capital markets are efficient. The efficient market hypothesis states that security prices reflect all available information, as if such information could be costlessly digested and translated immediately into demands for buys or sells.

The efficient market hypothesis implies that there is no further need for analysis involving a search for mispriced securities. However, if all investors adopted this attitude, no equity analysis would be conducted, mispricing would go uncorrected, and markets would no longer be efficient. This is why there must be just enough mispricing to provide incentives for the investment of resources in security analysis. Even in an extremely efficient market, where information is fully impounded in prices within minutes of its revelation (i. e. where mispricing exists only for minutes), Matti can get rewards with strong financial analysis skills:

1. Matti can interpret the newly-announced financial data faster than others and trade on it within minutes;
2. financial analysis helps Matti to understand the firm better, placing him in a better position to interpret other news more accurately as it arrives.

Markets may be not efficient under certain circumstances. Mispricing of securities may exist even days or months after the public revelation of a financial statement when the following three conditions are satisfied:

1. elative to investors, managers have superior information on their firms’ business strategies and operation;
2. managers’ incentives are not perfectly aligned with all shareholders’ interests;
3. accounting rules and auditing are imperfect.

When these conditions are met in reality, Matti could get profit by using trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process. Capital in market efficiency is not relevant in some areas. Matti can get benefits by using financial analysis skills in those areas.

For example, he can assess how much value can be created through acquisition of target company, estimate the stock price of a company considering initial public offering, and predict the likelihood of a firm’s future financial distress.

Question 2

Accounting statements rarely report financial performance without error. List three types of errors that can arise in financial reporting. Three types of potential errors in financial reporting include:

• error introduced by rigidity in accounting rules;
• random forecast errors;

systematic reporting choices made by corporate managers to achieve specific objectives.

Accounting Rules

Uniform accounting standards may introduce errors because they restrict management discretion of accounting choice, limiting the opportunity for managers’ superior knowledge to be represented through accounting choice. For example, SFAS No. 2 requires firms to expense all research and development expenditures when they are occurred. Note that some research expenditures have future economic value (thus, to be capitalized) while others do not (thus, to be expensed). SFAS No. does not allow managers, who know the firm better than outsiders, to distinguish between the two types of expenditures. Uniform accounting rules may restrict managers’ discretion, forgo the opportunity to portray the economic reality of firm better and, thus, result in errors.

Forecast Errors

Random forecast errors may arise because managers cannot predict future consequences of current transactions perfectly. For example, when a firm sells products on credit, managers make an estimate of the proportion of receivables that will not be collected (allowance for doubtful accounts).

Because managers do not have perfect foresight, actual defaults are likely to be different from estimated customer defaults, leading to a forecast error. Managers’ Accounting Choices. Managers may introduce errors into financial reporting through their own accounting decisions. Managers have many incentives to exercise their accounting discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting. For example, many top managers receive bonus compensation if they exceed certain prespecified profit targets.

This provides motivation for managers to choose accounting policies and estimates to maximize their expected compensation.

Question 3

Juan Perez argues that “learning how to do business analysis and valuation using financial statements is not very useful, unless you are interested in becoming a financial analyst. ” Comment. Business analysis and valuation skills are useful not only for financial analysts but also for corporate managers and loan officers. Business analysis and valuation skills help corporate managers in several ways.

First, by using business analysis for equity security valuation, corporate managers can assess whether the firm is properly valued by investors. With superior information on a firm’s strategies, corporate managers can perform their own equity security analysis and compare their estimated “fundamental value” of the firm with the current market price of share. If the firm is not properly valued by outside investors, corporate managers can help investors to understand the firm’s business strategy, accounting policies, and expected future performance, thereby ensuring that the stock price is not seriously undervalued.

Second, using business analysis for mergers and acquisitions, corporate managers (acquiring management) can identify a potential takeover target and assess how much value can be created through acquisition. Using business analysis, target management can also examine whether the acquirer’s offer is a reasonable one.

Loan officers can also benefit from business analysis, using it to assess the borrowing firm’s liquidity, solvency, and business risks. Business analysis techniques help loan officers to predict the likelihood of a borrowing firm’s financial distress.

Commercial bankers with business analysis skills can examine whether or not to extend a loan to the borrowing firm, how the loan should be structured, and how it should be priced.

Question 4

Four steps for business analysis are discussed in the chapter (strategy analysis, accounting analysis, financial analysis, and prospective analysis). As a financial analyst, explain why each of these steps is a critical part of your job and how they relate to one another. Managers have better information on a firm’s strategies relative to the information that outside financial analysts have.

Superior financial analysts attempt to discover “inside information” from analyzing financial statements. The four steps for business analysis help outside analysts to gain valuable insights about the firm’s current performance and future prospects.

Business strategy analysis is an essential first step because it enables the analysts to frame the subsequent accounting, financial, and prospective analysis better. For example, identifying the key success factors and key business risks allows the identification of key accounting policies.

Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business strategy analysis enables the analysts to make sound assumptions in forecasting a firm’s future performance. Accounting analysis enables the analysts to “undo” any accounting distortion by recasting a firm’s accounting numbers. Sound accounting analysis improves the reliability of conclusions from financial analysis. The goal of financial analysis is to use financial data to evaluate the performance of a firm.

The outcome from financial analysis is incorporated into prospective analysis, the next step in financial statement analysis. Prospective analysis synthesizes the insights from business strategy analysis, accounting analysis, and financial analysis in order to make predictions about a firm’s future.

Strategy Analysis

Question 1

Judith, an accounting major, states: “Strategy analysis seems to be an unnecessary detour in doing financial statement analysis. Why can’t we just get straight to the accounting issues? ” Explain to Judith why she might be wrong.

1. Strategy analysis enables the analyst to understand the underlying economics of the firm and the industry in which the firm competes. There are a number of benefits to developing this knowledge before performing any financial statement analysis.
2. Strategy understanding provides a context for evaluating a firm’s choice of accounting policies and hence the information reflected in its financial statements. For example, accounting policies (such as revenue recognition and cost capitalization) can differ across firms either because of differences in business economics or because of differences in management’s financial reporting incentives. Only by understanding differences in firms’ business strategies is it possible to assess how much to rely on a firm’s accounting information.
3. Strategy analysis highlights the firm’s profit drivers and major areas of risk. An analyst can then use this information to evaluate current firm performance and to assess the firm’s likelihood of maintaining or changing this performance based on its business strategy.
4. Strategy analysis also makes it possible to understand a firm’s financial policies and whether they make sense.

As discussed later in the book, the firm’s business economics is an important driver of its capital structure and dividend policy decisions. In summary, understanding a firm’s business, the factors that are critical to the success of that business, and its key risks is critical to effective financial statement analysis.

Question 2

What are the critical drivers of industry profitability?

Rivalry Among Existing Firms

The greater the degree of competition among firms in an industry, the lower average profitability is likely to be.

The factors that influence existing firm rivalry are industry growth rate, concentration and balance of competitors, degree of differentiation and switching costs, scale/learning economies and the ratio of fixed to variable costs, and excess capacity and exit barriers.

Threat of New Entrants

The threat of new entry can force firms to set prices to keep industry profits low. The threat of new entry can be mitigated by economies of scale, first mover advantages to incumbents, greater access to channels of distribution and existing customer relationships, and legal barriers to entry.

Threat of Substitute Products

The threat of substitute products can force firms to set lower prices, reducing industry profitability. The importance of substitutes will depend on the price sensitivity of buyers and the degree of substitutability among the products.

Bargaining Power of Buyers

The greater the bargaining power of buyers, the lower the industry’s profitability. Bargaining power of buyers will be determined by the buyers’ price sensitivity and their importance to the individual firm.

As the volume of purchases of a single buyer increases, its bargaining power with the supplier increases.

Bargaining Power of Suppliers

The greater the bargaining power of suppliers, the lower the industry’s profitability. Suppliers’ bargaining ability increases as the number of suppliers declines when there are few substitutes available.

Question 3

One of the fastest growing industries in the last twenty years is the memory chip industry, which supplies memory chips for personal computers and other electronic devices. Yet the average profitability has been very low.

Using the industry analysis framework, list all the potential factors that might explain this apparent contradiction.

Concentration and Balance of Competitors

The concentration of the memory chip market is relatively low. There are many players that compete on a global basis, none of which has a dominant share of the market. Due to this high degree of fragmentation, price wars are frequent as individual firms lower prices to gain market share. Degree of Differentiation and Switching Costs. In general, memory chips are a commodity product characterized by little product differentiation.

While some product differentiation occurs as chip makers squeeze more memory on a single chip or design specific memory chips to meet manufacturers’ specific power and/or size requirements, these differences are typically short-lived and have not significantly reduced the level of competition within the industry. Furthermore, because memory chips are typically interchangeable, switching costs for users of memory chips (computer assemblers and computer owners) encouraging buyers to look for the lowest price for memory chips.

Scale/Learning Economies and the Ratio of Fixed to Variable Costs

Scale and learning economies are both important to the memory chip market. Memory chip production requires significant investment in “clean” production environments. Consequently, it is less expensive to build larger manufacturing facilities than to build additional ones to satisfy additional demand. Moreover, the yield of acceptable chips goes up as employees learn the intricacies of the extremely complicated and sensitive manufacturing process.

Finally, while investments in memory chip manufacturing plants are typically very high, the variable costs of materials and labor are relatively low, providing an incentive for manufacturers to reduce prices to fully utilize their plant’s capacity.

Excess Capacity

Historically, memory chip plants tend to be built in waves, so that several plants will open at about the same time. Consequently, the industry is characterized by periods of significant excess capacity where manufacturers will cut prices to use their productive capacity (see above).

Threat of Substitute Products. There are several alternatives to memory chips including other information storage media (e. g. , hard drives and disk drives) and memory management software that “creates” additional memory through more efficient use of computer system resources. 8 Price Sensitivity. There are two main groups of buyers: computer manufacturers and computer owners. Faced with an undifferentiated product and low switching costs, buyers are very price sensitive. All the above factors cause returns for memory chip manufacturers to be relatively low.

Question 4

Examples of European firms that operate in the pharmaceutical industry are GlaxoSmithKline and Bayer. Examples of European firms that operate in the tour-operating industry are Thomas Cook and TUI. Rate the pharmaceutical and tour operating industries as high, medium, or low on the following dimensions of industry structure:

1. Rivalry;
2. Threat of new entrants;
3. Threat of substitute products;
4. Bargaining power of suppliers,
5. Bargaining power of buyers.

Given your ratings, which industry would you expect to earn the highest returns?

Pharmaceutical firms historically have had some of the highest rates of return in the economy, whereas tour operators have had moderate returns. The following analysis reveals why. Pharmaceutical Industry Medium Firms compete fiercely to develop and patent drugs. However, once a drug is patented, a firm has a monopoly for that drug, dramatically reducing competition. Competitors can only enter the same market by developing a drug that does not infringe on the patent. Low Economies of scale and first mover advantages are very high for the industry. Patents deter new entrants.

In addition, drug firms’ sales forces have established relationships with doctors which act as a further deterrent for a new entrant. This distribution advantage is changing as managed-care firms have begun negotiating directly with drug companies on behalf of the doctors in their network. Low New drugs are protected by patents giving manufacturers a monopoly position.

In the 1990s the European tourism industry exhibited strong growth. After a slowdown in growth due to the 2001 terrorism attacks, growth has been steady in the 2000s.

However, the trend towards short-term bookings and web-based bookings (in combination with high price transparency) has structurally changed the industry and increased competition. Medium to high “Tourism e-mediaries” such as expedia. com can relatively easily enter the market. In addition, suppliers of accommodation and travel services (such as Ryanair) start bypassing tour operators by offering their products online.

Once the patent expires, a company will reduce prices as other manufacturers enter the market. The threat of substitute products, however, is likely to increase as biotech products enter the market. Low Historically, doctors have had little buying power. However, in some countries managed-care providers have become more powerful recently, and have begun negotiating substantial discounts for drug purchases. Low The chemical ingredients for drugs can be obtained from a variety of chemical suppliers.

High The online offering of accommodation, flight services, car rentals etc. has increased price transparency and, consequently, increased buyers’ bargaining power. Medium Tour operators are large and concentrated relative to the suppliers of accommodation and other services. However, suppliers have the ability to “bypass” tour operators by selling their accommodation directly through the internet. Tour operators respond to this threat by means of vertically integrating their activities (e. g. , owning their own hotels and airlines).

Question 5

Joe argues: “Your analysis of the five forces that affect industry rofitability is incomplete. For example, in the banking industry, I can think of at least three other factors that are also important; namely, government regulation, demographic trends, and cultural factors. ” His classmate Jane disagrees and says, “These three factors are important only to the extent that they influence one of the five forces. ” Explain how, if at all, the three factors discussed by Joe affect the five forces for the banking industry. Government regulation, demographic trends, and cultural factors will each impact the analysis of the banking industry.

While these may be important, they can each be recast using the five forces framework to provide a deeper understanding of the industry. The power of the five forces framework is its ability to incorporate industry-specific characteristics into analysis for any industry. To see how government regulation, demographic trends, and cultural factors are important in the banking industry, we can apply the five forces framework as follows: Rivalry Among Existing Firms. Government regulation has played a central role in promoting, maintaining, and limiting competition among banks.

Banks are regulated at the national and European levels. In the past, national regulations restricted banks from 10 operating across (some European) borders. The government also regulates the riskiness of a bank’s portfolio in an effort to prevent banks from competing for new customers by taking on too many high-risk investments, loans, or other financial instruments. These regulations have limited the degree of competition among banks. However, European deregulation of the industry has made it easier for banks to expand into new geographic areas, increasing the level of competition.

• Threat of New Entrants. Government regulations have limited the entry of new players into the banking industry. New banks must meet the requirements set by regulators before they can begin operation. However, as noted above, deregulation of some aspects of banking has made it easier for out-of-country banks to enter new markets. Further, it appears to be relatively easy for non-banking companies to successfully set up financial services units (e. g. , car manufacturers). Finally, as consumers have become more comfortable with technology, “Internet banks” have formed.

These “banks” provide the same services as traditional banks, but with a very different cost structure. Threat of Substitute Products. The primary functions of banks are lending money and providing a place to invest money. Potential substitutes for these functions are provided by thrifts, credit unions, brokerage houses, mortgage companies, and the financing arms of companies such as car manufacturers. Government regulation of these entities varies dramatically, affecting how similar their products are to those of banks.

In addition, consumers have been become increasingly familiar with non-bank options for investing money. As another example, some brokerage houses provide money market accounts that function as checking accounts. As a result, the threat of substitutes for bank services has grown over time. Bargaining Power of Buyers. Business and consumer buyers of credit have little direct bargaining power over banks and financial institutions. The buying power of customers is probably also stronger in relationship banking than under a transactions approach, where consumers seek the lowest-cost lender for each new loan.

Because the use of these approaches varies across countries (due to legal differences; see chapter 10), the bargaining power of buyers may also vary. Bargaining Power of Suppliers. Depositors have historically had little bargaining power. In summary, bank regulations have historically had a very important role in determining bank profitability by restricting competition. However, deregulation in the industry as well as the emergence of non-bank substitutes has increased competition in the industry.

Question 6

In 2005, Puma was a very profitable sportswear company. Puma did not produce most of the shoes, apparel and accessories that it sold. Instead, the company entered into contracts with independent manufacturers, primarily in Asia. Puma also licensed independent companies throughout the world to design, develop, produce and distribute a selected range of products under its brand name. Use the five forces framework and your knowledge of the sportswear industry to explain Puma’s high profitability in 2005. While consumers perceive an intensely competitive relationship between companies such as Puma, Nike and Adidas, these major players in the portswear industry have structured their 11 businesses to retain most of the profits in the industry by concentrating operations in its least competitive segments. Puma competes primarily on brand image rather than on price. The company sources the manufacturing of its sports products to smaller independent manufacturers, located in Asia and Eastern Europe, over which the company has significant bargaining power. The threat of new entrants is restricted by limited access to adequate distribution channels, (even more) by the valuable brand name that has been created by Puma, and Puma’s expertise in development and design.

While sportswear is relatively inexpensive and easy to make (also given the large number of independent manufacturers), a sportswear manufacturer would have difficulty finding a distributor that could get its products to retail stores and placed in desirable shelf space. The high levels of advertising by Puma (including sponsoring contracts with celebrity athletes) have created a highly valued, universally recognized brand, which would be difficult for a potential competitor to replicate. Puma’s valuable brand name and the great demand for the company’s products improve the company’s bargaining power over its distributors (retail stores).

To reduce the power of distributors/retail stores even more, the company has started to open own stores in an increasingly number of large cities around the world (such as in Amsterdam, Stockholm, Frankfurt, London, Rome, Milan, Melbourne, Tokyo, Boston, Seattle, Sydney, Osaka, Philadelphia, and Las Vegas). Puma also makes money by licensing other companies to produce and distributes products under the Puma brand name. The sports licensing business tends to be highly competitive, which makes that Puma has substantial bargaining power over licensees.

Potential threats to Puma’s competitive position are the following: – Puma needs to continue investing substantial amounts in advertising, sponsoring, design and innovation in order to sustain its brand image. – Some of the companies to which Puma sources its production are by no means small, powerless production companies. For example, in 2005, one of Puma’s suppliers was Hong-Kong-based Yue Yuen. This supplier employed 252,000 people, had production plants in China, Vietnam and Indonesia with in total 3. 4 million square meters of floor space, and produced 167. million pairs of shoes per year for most of the larger athletic shoe sellers.

Question 7

In response to the deregulation of the European airline industry during the 1980s and 1990s, European airlines followed their U. S. peers in starting frequent flier programs as a way to differentiate themselves from others. Industry analysts, however, believe that frequent flyer programs had only mixed success. Use the competitive advantage concepts to explain why. Initially, frequent flier programs had only limited success in creating differentiation among airlines.

Airlines tried to bundle frequent flier mileage programs with regular airline transportation to increase customer loyalty and to create a differentiated product. Furthermore, the airlines anticipated that the programs would fill seats that would otherwise have been empty and would, so they believed, have had a low marginal cost. However, because the costs of implementing a program were low, there were very few barriers to other airlines starting their own frequent flier programs. Before long, every airline had a frequent 12 flier program with roughly the same requirements for earning free air travel.

Simply having a frequent flier program no longer differentiated airlines. Airlines have had some success in differentiating frequent flier programs by creating additional ways to earn frequent flier mileage and increasing the number of destinations covered. Airlines have developed “tie-ins” with credit card companies, car rental companies, hotels, etc. to allow members of a particular frequent flier program more ways to earn frequent flier mileage. They have also reached agreements with foreign airlines (within alliances) so that frequent flier mileage can be redeemed for travel to locations not served by the carrier.

Finally, the programs have provided additional services for their best customers, including special lines for check-in and better flight upgrade opportunities. As a result of these efforts, airline programs have been somewhat successful in increasing customer loyalty. Question 8. What are the ways that a firm can create barriers to entry to deter competition in its business? What factors determine whether these barriers are likely to be enduring? Barriers to entry allow a firm to earn profits while at the same time preventing other firms from entering the market.

The primary sources of barriers to entry include economies of scale, absolute costs advantages, product differentiation advantages, and government restrictions on entry of competitors. Firms can create these barriers through a variety of means.

1. A firm can engineer and design its products, processes, and services to create economies of scale. Because of economies of scale, larger plants can produce goods at a lower cost that smaller plants. Hence, a firm considering entering the existing firm’s market must be able to take advantage of the same scale economies or be forced to charge a higher price for its products and services.
2. Cost leaders have absolute cost advantages over rivals. Through the development of superior production techniques, investment in research and development, accumulation of greater operating experience or special access to raw materials, or exclusive contracts with distributors or suppliers, cost leaders operate at a lower cost than any potential new entrants to the market.
3. Differentiation of the firm’s products and services may also help create barriers to entry for other firms. Firms often spend considerable resources to differentiate their products or services. Soft drink makers, for example, invest in advertising designed to differentiate their products from other products in the market. Other competitors that would like to enter the market will be forced to make similar investments in any new products.
4. Firms often try to persuade governments to impose entry restrictions through patents, regulations, and licenses. In the U. S. , AT fought with the government for many years to prevent other providers of long distance telephone service from entering the market. Similarly, the local Bell operating companies have lobbied the ederal government to write laws to make it difficult for other firms to provide local phone service. Several factors influence how long specific barriers to entry are effective at preventing the entry of competitors into an industry.

Economies of scale depend on the size and growth of the market. If a market is growing quickly, a competitor could build a larger plant capable of producing at a cost lower than the incumbent. If a market is flat, there may not be enough demand to support additional production at the efficient scale, which forces new entrants to have higher costs. Absolute cost advantages depend on competitors’ difficulty in designing better processes. Some processes receive legal protection from patents. Entrants must either wait for the patent to expire or bear the expense of trying to invest around the patent. Similarly, differentiation advantages last only so long as a firm continues to invest in differentiation and it is difficult for other firms to replicate the same differentiated product or service.  Incumbent firms and potential entrants can both lobby the government.

If potential entrants launch intensive lobbying and public interest campaigns, laws, regulations, and rules can change to ease entry into a once-protected industry. Several recent examples in Europe are deregulation of the airline and banking industries.

Question 9

Explain why you agree or disagree with each of the following statements.

It’s better to be a differentiator than a cost leader, since you can then charge premium prices. Disagree. While it is true that differentiators can charge higher prices compared to cost leaders, both strategies can be equally profitable.

• Differentiation is expensive to develop and maintain. It often requires significant company investment in research and development, engineering, training, and marketing. Consequently, it is more expensive for companies to provide goods and services under a differentiated strategy. Thus, profitability of a firm using the differentiated strategy depends on being able to produce differentiated products or services at a cost lower than the premium price. On the other hand, the cost leadership strategy can be very profitable for companies.

A cost leader will often be able to maintain larger margins and higher turnover than its nearest competitors. If a company’s competitors have higher costs but match the cost leader’s prices, the competitors will be forced to have lower margins. Competitors that choose to keep prices higher and maintain margins will lose market share. Hence, being a cost leader can be just as profitable as being a differentiator.

• It’s more profitable to be in a high-technology than a low-technology industry. Disagree. There are highly profitable firms in both high technology and low technology industries.

The argument presumes that high technology always creates barriers to entry. However, high technology is not always an effective entry barrier and can be associated with high levels of competition among existing firms, high threat of new entrants, substitute products, and high bargaining power of buyers and/or sellers. For example, the personal computer industry is a high-technology business, yet is highly competitive. There are very low costs of entering the industry, little product differentiation in terms of quality, and two very powerful suppliers (Microsoft and Intel).

Consequently, firms in the PC business typically struggle to earn a normal return on their capital. In contrast, Aldi is a cost leader in a very low-tech industry, and is one of the most profitable retailers in Europe.

• The reason why industries with large investments have high barriers to entry is because it is costly to raise capital. Disagree. The cost of raising capital is generally related to risk of the project rather than the size of the project. As long as the risks of the project are understood, the costs of raising the necessary capital will be fairly priced.

However, large investments can act as high entry barriers in several other ways. First, where large investments are necessary to achieve scale economies, if additional capacity will not be fully used, it may make it unprofitable for entrants to invest in new plant. Second, a new firm may be at an initial cost disadvantage as it begins to learn how to use the new assets in the most efficient manner. Third, existing firms may have excess capacity in reserve that they could use to flood the market if potential competitors attempt to enter the market.

Question 10. There are very few companies that are able to be both cost leaders and differentiators. Why? Can you think of a company that has been successful at both? Cost leadership and differentiation strategies typically require a different set of core competencies and a different value chain structure. Cost leadership depends on the firm’s ability to capture economies of scale, scope, and learning in its operations. These economies are complemented by efficient production, simpler design, lower input costs, and more efficient organizational structures.

Together, these core competencies allow the firm to be the low cost producer in the market. On the other hand, differentiation tends to be expensive. Firms differentiate their products and services through superior quality, variety, service, delivery, timing, image, appearance, or reputation. Firms achieve this differentiation through investment in research and development, engineering, training, or marketing. Thus, it is the rare firm that can provide differentiated products at the lowest cost.

Companies that attempt to implement both strategies often do neither well and as a result suffer in the marketplace. Differentiation exerts upward pressure on firm costs while one of the easiest sources of cost reduction is reducing product or service complexity which leads to less differentiation. Question 11. Many consultants are advising diversified companies in emerging markets, such as India, Korea, Mexico, and Turkey, to adopt corporate strategies proven to be of value in advanced economies, like the U. S. and the U. K. What are the pros and cons of this advice?

Economic theory suggests that the optimal level of diversification depends on the relative transaction costs of performing activities inside or outside the firm. A focus on core businesses, as is popular in advanced economies, is economically efficient if markets, such as capital, product, and labor markets, work well. However, market failures in emerging economies are a good reason to choose for diversification. For example, in some emerging economies, information problems prevent companies from raising capital at economically efficient rates in public capital markets.

Instead, these companies rely strongly on internal sources of financing. Because subsidiaries of diversified companies can cross-subsidize each other, diversification is necessary in emerging markets to create and benefit from internal capital markets. Similarly, large diversified companies in emerging economies can benefit from having internal labor markets.

Overview of Accounting Analysis

Question 1

A finance student states: “I don’t understand why anyone pays any attention to accounting earnings numbers, given that a ‘clean’ number like cash from operations is readily available. ” Do you agree?

Why or why not? There are several reasons for why we should pay attention to accounting earnings numbers. First, net profit predicts a company’s future cash flow better than current cash flow does. Net profit aids in predicting future cash flows by reporting transactions with cash consequences at the time when the transactions occur, rather than when the cash is received or paid. Net profit is computed on the basis of expected, not necessarily actual, cash receipts and payments. Second, net profit is potentially informative when there is information asymmetry between corporate managers and outside investors.

Note that corporate managers with superior information choose accounting methods and accrual estimates which determine the net profit number. Because accrual accounting requires managers to record past events and to make forecasts of future effects of theses events, net profit can be used to convey managers’ superior information. For example, a company’s decision to capitalize some portion of current expenditure, which increases today’s net profit, conveys potentially informative signals to outside investors about the company’s ability to generate future cash flows to cover the capitalized costs.

Question 2

Fred argues: “The standards that I like most are the ones that eliminate all management discretion in reporting—that way I get uniform numbers across all companies and don’t have to worry about doing accounting analysis. ” Do you agree? Why or why not? We don’t agree with Fred because the delegation of financial reporting decisions to corporate managers may provide an opportunity for managers to convey their superior information to investors. Corporate managers are typically better than outside investors at interpreting their firms’ current condition and forecasting future performance.

Since managers have better knowledge of the company, they have the potential to choose appropriate accounting methods and accruals which portray business transactions more accurately. Note that accrual accounting not only requires managers to record past events, but also to make forecasts of future effects of these events. If all discretion in accounting is eliminated, managers will be unable to reflect their superior information in their accounting choices.

When managers’ incentives and investors’ incentives are different and contracting mechanisms are incomplete, giving no accounting flexibility to managers may result in a costlier solution to investors. Further, if uniform accounting standards are required across all companies, corporate managers may expend economic resources to restructure business transactions to achieve a desired accounting result. Manipulation of real economic transactions is potentially more costly than manipulation of earnings.

Question 3

Bill Simon says, “We should get rid of the IASB, IFRS, and E. U. Company Law Directives, since free market forces will make sure that companies report reliable information. ” Do you agree? Why or why not? We partly agree with Bill on the point that corporate managers will disclose only reliable information when rational managers realize that disclosing unreliable information is costly in the long run. The long-term costs associated with losing reputation, such as incurring a higher capital cost when visiting a capital market to raise capital over time, can be greater than the short-term benefits from disclosing false information.

However, free market forces may work for some companies but not all companies to disclose reliable information. Note that Bill’s argument is based on the assumption that there is no information asymmetry between corporate managers and outside investors. In reality, the outside investors’ limitation in accessing the private information of the company makes it possible for corporate managers to report unreliable information without being detected immediately. The E. U. and IASB standards attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways either over time or across firms.

Compliance with these standards is enforced by external auditors, who attempt to ensure that managers’ estimates are reasonable. Without the E. U., IASB standards, and auditors, the likelihood of disclosing unreliable information would be high.

Question 4

Many firms recognize revenues at the point of shipment. This provides an incentive to accelerate revenues by shipping goods at the end of the quarter. Consider two companies, one of which ships its product evenly throughout the quarter, and the second of which ships all its products in the last two weeks of the quarter.

Each company’s customers pay thirty days after receiving shipment. How can you distinguish these companies, using accounting ratios? There is no difference between the two companies in their income statements. Both companies have the same amount of revenues and expenses. However, the two companies are different in their balance sheets. Assuming that all other things are equal, the company that sells product evenly has a higher cash and a lower trade receivables balance at the quarter-end than the company which ships all products in the last two weeks.

The following accounting ratios can be used to differentiate the two companies: Trade Receivables Turnover = Sales Trade Receivables The company with even sales will have a higher receivable turnover ratio. Trade Receivables Days’ Receivables = Average Sales per Day The company with even sales will show lower days’ receivable. Cash Ratio = Cash + Marketable Securities Current Liabilities. The company with even sales will have a higher cash ratio.

Question 5

If management reports truthfully, what economic events are likely to prompt the following accounting changes?

Increase in the estimated life of depreciable assets. Managers may increase the estimated life of depreciable assets when they realize that the assets are likely to last longer than was initially expected. For example, Delta Airlines extended the estimated life of the Boeing 747, a relatively new product, by 5 years when Delta found out that some of the first Boeing 747s manufactured were still flying in commercial service. Excellent maintenance and less usage than initially expected may also prompt corporate managers to extend the estimated life of depreciable assets.

Decrease in the allowance for doubtful accounts as a percentage of gross trade receivables. The firm’s change of customer focus may prompt managers to decrease the allowance for uncollectible receivables. For example, when a firm gets large sales orders from reliable customers such as Tesco and Volvo, it does not have to reserve the same percentage of allowance used for small (or high default risk) customers. Recognition of revenues at the point of delivery, rather than at the point cash is received. Revenues can be recognized when the customer is expected to pay cash with a reasonable degree of certainty.

Suppose that a company re-evaluated its customer’s credit and found out that its customer’s financials improved significantly. In dealing with that customer, the company can recognize revenues at the point of delivery rather than at the point when cash is received, because the risk of cash collection is no longer significant. Capitalization of a higher proportion of development expenditures. According to IAS No. 38, costs incurred on product development (after the establishment of technical feasibility and commercial feasibility) are to be capitalized.

Technical feasibility is considered to be established when the firm has completed a product design. Commercial feasibility is established when the uncertainty surrounding the development of new products or processes is sufficiently reduced. If the company completes the product design earlier than it initially expected, it can capitalize a higher proportion of development costs during that period.

• What features of accounting, if any, would make it costly for dishonest managers to make the same changes without any corresponding economic changes?

Third-Party Certification

Public companies are required to get third-party certification (auditor’s opinion) on their financial statements. Unless the accounting policy changes are reasonably consistent with underlying economic changes, auditors would not provide clean auditor’s opinion. A qualified auditors’ opinion will penalize the company by increasing its cost of capital. Reversal Effect. Aggressive accounting choices may inflate net profit in the current period but they hurt future net profit due to the nature of accrual reversal.

For example, aggressive capitalization of software R expenditures may boost current period earnings but it will 18 lower future periods’ net profit when the capitalized costs have to be subsequently writtenoff. Investors’ Lawsuit. If a company disclosed false or misleading financial information and investors incurred a loss by relying on that information, the company may have to pay legal penalties. Labor Market Discipline. The labor market for managers is likely to penalize individuals who are perceived to be unreliable in their dealings with external parties.

Question 6

The conservatism (or prudence) principle arises because of concerns about management’s incentives to overstate the firm’s performance. Joe Banks argues, “We could get rid of conservatism and make accounting numbers more useful if we delegated financial reporting to independent auditors rather than to corporate managers. ” Do you agree? Why or why not? We don’t agree with Joe Banks because the delegation of accounting decisions to auditors may reduce the quality of financial reporting.

Auditors possess less information and firmspecific business knowledge than corporate managers when portraying the economic reality of a firm. The divergence between managers’ and auditors’ business assessments is likely to be most severe for firms with distinctive business strategies or ones which operate in emerging industries. With such an information disadvantage, even if auditors report truthfully without having any incentive problem, they cannot necessarily choose “better” accounting methods and accruals than corporate managers do.

Auditors also have their own incentive to record business transactions in a mechanical way, rather than using their professional judgment, which leads to poor quality of financing reporting. For example, auditors are likely to choose accounting standards that require them to exercise minimum business judgment in assessing a transaction’s economic consequences, especially given their legal liability risk. The current debate on market value accounting for financial institutions illustrates this point.

While there is considerable agreement that market value accounting produces relevant information, auditors typically oppose it, citing concerns over audit liability.

Question 7

A fund manager states: “I refuse to buy any company that makes a voluntary accounting change, since it’s certainly the case that its management is trying to hide bad news. ” Can you think of any alternative interpretation? One of the pitfalls in accounting analysis arises when analysts attribute all changes in a firm’s accounting policies and accruals to earnings management motives.

Voluntary accounting change may be due merely to a change in the firm’s real economic situations. For example, unusual increases in receivables might be due to changes in a firm’s sales strategy. Unusual decreases in the allowance for uncollectable receivables might be reflecting a firm’s changed customer focus. A company’s accounting change should be evaluated in the context of its business strategy and economic circumstances and not mechanically interpreted as earnings manipulation. 19 Promises that require future expenditures are liabilities even if they cannot be measured precisely.

According to the definition, liabilities are economic obligations of a firm arising from benefits received in the past that are (a) required to be met with a reasonable degree of certainly and (b) at a reasonably well-defined time in the future. Airline companies have economic obligations to serve frequent flyer program passengers due to ticket sales (benefits) in the past to the frequent flyer program passengers. These obligations are (a) likely to be met (for example, United Airline frequent flyer program totaled 1. million free trips in 1990) and (b) fulfilled within a well-defined time in the future (for example, within 3 to 5 years after the revenue ticket sales are made). A frequent flyer program has an impact not only on the balance sheet but also on the income statement. In principle, the costs associated with benefits that are consumed in this time period are estimated and recognized as expenses (matching concept). Note that airline companies increased revenue ticket sales (i. e. , benefits) in this period by promising free-trip tickets (i. e. , costs) in the future.

However, it is not easy to measure the costs associated with frequent flyer program accurately. At least the following three cost categories should be considered in the estimation:

1. The administrative costs, such as maintaining the accounting system for the program, mailings to program members, and providing service to those who request free flights
2. The costs related to the flight itself, including meal expenses, luggage handling costs, addition fuel expenditure, etc.
3. The opportunity costs that airline companies may incur because the seats used by flight award passengers could have been sold to revenue paying passengers

Implementing Accounting Analysis

Question 1

On the companion website to this book you can find a spreadsheet containing the financial statements of the Unilever Group. Use the templates shown in Tables 4-1, 4-2, 4-3, and 4-4 to recast Unilever’s financial statements. [See spreadsheet CH4Q1Unilever_solution.

Question 2

On March 31, 2006, Germany’s largest retailer Metro AG reported in its quarterly financial statements that it held inventories for 54 days sales. The inventories had a book value of €6,345 million.

How much excess inventory do you estimate Metro is holding in March 2006 if the firm’s optimal Days’ Inventories is 45 days? Calculate the inventory impairment charge for Metro if 50 percent of this excess inventory is deemed worthless? Record the changes to Metro’s financial statements from adjusting for this impairment. Metro’s inventories on March 31, 2006 were €6. 345 billion, equivalent to 54 days. If the optimal days’ inventories was 45 days, the value of the optimal inventories would be 45/54*€6. 345 billion, or $5. 88 billion. If 50% of the gap (50%*(6. 345-5. 288)=$0. 529 billion was impaired, the changes to Metro’s financial statements would be as follows: Adjustment Liabilities Assets & Equity -529 -185 -344 +529 -185 -344 (€millions) Balance Sheet Inventories Deferred Tax Liability Ordinary Shareholders’ Equity Income Statement Cost of Sales Tax Expense Net Profit

Question 3

Dutch Food retailer Royal Ahold provides the following information on its finance leases: Finance lease liabilities are principally for buildings.

Terms range from 10 to 25 years and include renewal options if it is reasonably certain, at the inception of the lease, that they will be exercised. At the time of entering into finance lease agreements, the commitments are recorded at their present value using the interest rate implicit in the lease, if this is practicable to determine; if not the interest rate applicable for long-term borrowings is used.

Question 4

What approaches would you use to estimate the value of brands? What assumptions underlie these approaches?

As a financial analyst, what would you use to assess whether the brand value of 3. 2 billion reported by Cadbury Schweppes in 2005 was a reasonable reflection of the future benefits from these brands? What questions would you raise with the firm’s CFO about the firm’s brand assets? In the United Kingdom firms like Cadbury Schweppes have been allowed to report brand value on their balance sheets. Generally, these firms must hire independent valuation experts to value the brand assets. The valuation experts may use any of the following approaches to estimate brand value. First, the experts might estimate brand value based on the premium price hat branded products command over their non-branded counterparts. Given the firm’s sales volume of branded products, the expected life of the brand, and a discount rate, it is possible to estimate the present value of any price premium over the foreseeable future. Second, a brand could be valued based on the present value of advertising costs required to convert a non-branded product into a branded product. Third, brand valuation experts could estimate value based on industry practice, amounts that were paid for similar branded products in recent mergers and acquisition transactions.

Several assumptions underlie the above brand valuation approaches. First, under the price premium approach, brands will only have value if:

• the consumers will continue to value branded products more highly than non-branded in the foreseeable future,
• companies continue to maintain the value of their brands, despite potential competition,
• premium prices are accompanied by higher advertising outlays, so that brands create economic value for shareholders.

The second and third valuation approaches requires that the valuer assume that the product being valued requires the same level of advertising or has the same relative value as comparable brands used to benchmark the valuation. A financial analyst should question the 3. 2 billion pounds reported on Cadbury Schweppes’ financials. Is this outlay reasonable or excessive compared to similar companies that report brands on their balance sheet? How was the figure calculated? Was an independent valuation expert hired? Did the independent auditors question the amount?

Has the amount grown or declined in the past couple years? Why? What activities and expenditures did Cadbury incur to maintain the brand name?

Question 5

As the CFO of a company, what indicators would you look at to assess whether your firm’s non-current assets were impaired? What approaches could be used, either by management or an independent valuation firm, to assess the value of any asset impairment? As a financial analyst, what indicators would you look at to assess whether a firm’s non-current assets were impaired? What questions would you raise with the firm’s CFO about any charges taken for asset impairment?

Impairment is the loss of a significant portion of the utility of an asset through casualty, obsolescence, or lack of demand for the asset’s service. A loss should be recognized when an asset suffers permanent impairment. A CFO should look for evidence of such potential impairment of the firm’s assets. Assessing the monetary value of an asset impairment: If the current book value exceeds the sum of the expected undiscounted future cash flows, an asset impairment has occurred. The conservatism principle requires that a firm write down 24 its asset to its then current fair value, which is the market value of the asset.

The accounting transaction would show the asset and any contra-asset being written off, the new market value of the asset being recorded, and the residual amount recorded as a loss due to impairment of the asset. Hence, the loss amount that appears in the income statement is the difference between the old net book value and the current market value. On the other hand, if the firm cannot assess the current market value of the asset, the impairment loss amount is calculated as the difference between the old net book value and the expected net present value of the future cash flows.

Example: Darden Restaurants Inc. Darden recorded asset impairment charges of $158,987 in 1997, representing the difference between fair value and carrying value of impaired assets. The asset impairment charges relate to low-performing restaurant properties and other long-lived assets. Fair value is generally determined based on appraisals or sales prices of comparable properties. ” A financial analyst should look for the same types of indicators that the CFO looks for, of course understanding that the CFO, as an insider of the company, has a great deal more information about such issues as casualty, obsolescence, or lack of demand of certain assets.

Indicators of impairment include sustained declines in a firm’s and/or industry’s return on assets relative to its cost of capital, recognition of asset impairments by competitors, and the introduction of new technologies that make existing assets obsolete. The financial analyst should question the CFO concerning the cause of the asset impairment. Was the loss due to casualty, obsolescence, or lack of demand? If not, what did cause the loss? The analyst should inquire about the method the impairment of asset loss was calculated? If it was calculated using a fair market value, how was the fair value determined?

Question 6

Refer to the British American Tobacco example on provisions in this chapter. The cigarette industry is subject to litigation for health hazards posed by its products. In the U. S. , the industry has been negotiating a settlement of these claims with state and federal governments. As the CFO for U. K.-based British American Tobacco (BAT), which is affected through its U. S. subsidiaries, what information would you report to investors in the annual report on the firm’s litigation risks?

How would you assess whether the firm should record a provision for this risk, and if so, how would you assess the value of this provision? As a financial analyst following BAT, what questions would you raise with the CFO over the firm’s litigation provision? The litigation risks that BAT faces are reported as contingent liabilities defined in IAS 37. Contingent liabilities arise from events or circumstances occurring before the balance sheet date, here the filling of lawsuits against BAT, the resolution of which is contingent upon a future event, the court ruling or a potential settlement.

The accounting treatment for BAT’s pending litigation depends on the likelihood that it will lose or settle the lawsuit and whether the amount of damages the firm will be liable for is reasonably estimable. Accounting rules on required disclosure for these types of liabilities depend on whether the loss is probable, possible, or remote. Probable – If it is probable that BAT will lose the lawsuit and the loss can be reasonably estimated, the estimated loss should be reported as a charge to profit and as a liability. If the 25 loss is probable but no specific reasonable estimate can be agreed upon, rather only a range of possible losses can be estimated without any amount being more reasonable than the other, the amount that should be

To compare the advantages and limitations of different financial statements begins with first understanding what financial statements are and what different purposes they can be used for, as well as the differentiation between cash and accrual accounting. The cash and accrual methods of accounting are the two principle ways of keeping track of businesses takings and expenses and in the majority of cases it is possible to decide which method is best for a business on an individual basis, although in all cases cash based accounting can only apply to small businesses earning less than £1.35 million, so large businesses will always have to rely on the accrual based method to prepare their financial statements.

Financial statements are written reports that describe the financial status of a company; it is one of the main functions of financial accounting. It consists of a profit and loss account and a balance sheet. Within the financial statement there are a few limitations that apply to both accrual and cash based accounting, the first thing is that the financial statement is ‘largely historical’, meaning that it can tell you what an entity has done positive or negative in the previous overview but it cannot necessarily ‘reflect future events or transactions’. The financial statement also mainly focuses on the financial effects of the company and not, essentially, the non-financial effects or information in general. But as an advantage the financial statement can be used as the main source of a company’s activities for those who do not have full ability to access a company’s economic activity.

Cash-based prepared financial statements are those that are recognised when a fee has been received or paid. A cash basis would mean that a payment is shown even if a service has not yet been provided or good has not yet been shipped. An advantage of this is that it can provide an accurate image of how much profitability at the current time within a business because it shows revenue being counted when funds are exchanged and when cheques, for example, are handed over.

Accrual-based accounting is a concept where non-cash effects of a company’s transactions are reflected in the ‘period in time at which the costs have been incurred’, rather than when cash is paid. According to FRS18, an entity should prepare its financial statements ‘on the accrual basis of accounting’. It corresponds with the accrual idea that all revenue and costs are accrued, so that revenue is recognised when products are dispatched or the service has been provided. One advantage because of this is that you can use the ‘matching method’ where income, whether it has been received or not can be matched to a cost whether that cost has yet to be paid, or not. This can show the true match of revenue, with the cost used to make the revenue, showing a more reasonable picture of a company’s transactions.

The limitations for financial statements prepared on a cash basis are that even though it may show what cash is in the bank at the present, in the long run it can distort the true picture of how much money a company actually has. For example, a company may be appearing to be profitable in one month even if sales in the books have been slow because several creditors may have paid them. This means that could keep having several months with slow sales but the extent of the damage may not be apparent to the business until too late when it could be too late to save a business from bankruptcy.

Accrual based financial statement has the disadvantage that although it shows the ins and outs of business income and debts more accurately, it can distort what cash is actually available, which could result in cash flow problems. For example, a takings ledger may show multiple sales, when in fact because it is owed by creditors it may be seen that there is not much money within the business.

Cash based accounting can work for small businesses for tax reasons, if you use cash accounting for VAT then you don’t need to pay it until the customer has paid you. If the customer never pays then you will never have to pay the VAT. This can only apply to small businesses because once a business’ income exceeds £1.6 million pounds then it must use the normal VAT system. A benefit of using cash based accounting for VAT is that it could help your cash flow, especially if an entity’s customers are slow payers. But the entity can also be disadvantaged because; if you buy most of your stock or services on credit you can’t reclaim the VAT until you have paid your suppliers.

In conclusion, financial accounting in general has many advantages and limitations, it can present shareholders and members of the business how it has been doing and is sometimes the most available picture for people with limited access to a company’s information. But on the other hand it also mainly based on the past and cannot necessarily reflect what is too happen in the future. Cash based financial statements as we have seen can be beneficial for small businesses to use because of tax reasons; it means that VAT only has to be paid when a customer has paid the business.

But cash accounting also has its limitations; in the long run it can distort the real impact that transactions are having on a business. To prepare financial statements with the accrual method seems to be the most desirable method for a business, as you can use the matching method where income can be matched to a cost. Accrual also means that revenue can be recognised when a service or good has been provided making the transactions of a company clearer and more precise.

Retained earnings is the profit generated by a company that are not distributed to stockholders (shareholders) as dividends but are either reinvested in the business or kept as a reserve for specific objectives (such as to pay off a debt or purchase a capital asset). A balance sheet figure shown under the heading retained earnings is the sum of all profits retained since the companys inception. Retained earnings are reduced by losses, and are also called accumulated earnings, accumulated profit, accumulated Income, accumulated surplus, earned surplus, ndistributed earnings, or undivided profits.

Profit and loss account is one of the financial statements of a company and shows the companys revenues and expenses during a particular period. It Indicates how the revenues (money received from the sale of products and services before expenses are taken out, also known as the “top line”) are transformed into the net income (the result after all revenues and expenses have been accounted for, also known as “net profit” or the “bottom line”). It displays the revenues recognized tor a specific period, nd the cost and expenses charged against these revenues, including write- offs (e. . , depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported. When any amount is kept separate by a company out of its profit for future purpose then that is called as General reserves. In other words, the general reserves are the ‘retained earnings’ of a company which are kept aside out of company’s profits to meet future known or unknown obligations.

General reserves are the part of ‘Profit and Loss Appropriation Account’. The general reserve is a free reserve which can be utilized for any purpose after fulfilling certain conditions. The primary differences between the retained earnings , profit and loss account and general reserve is as follows: Point of difference Retained earning Account General reserve Definition This is the profit which is not distributed to the stockholders but probably reinvested In the business. This Is the financial statement of a company which shows the tOf2 for future purposes. Uses

This is used or retained as earnings for specific objectives like to pay off debts etc. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported. General reserve is certain amount of money kept aside for future need or unexpected expenses. Found under A balance sheet figure shown under the heading retained earnings is the sum of all profits retained since the company’s inception. Found in the final accounts statement book General reserves are the part of Profit and Loss Appropriation Account.

The is however possibility of deferring costs still under IFRS. However, there appears to be more difficulty of capitalizing under IFRS because of the additional requirements that must complied. Hence, this means that capitalization has better chance of being done under the US GAAP if the SOP requirement is complied with. As a rule better profitability at the earlier part will result from easier chance of capitalizing costs and investors would more likely also be affected because they normally give more value to more profitable companies as shown in their financial statements.

The possible problem that stockholders after the shift to IFRS would be a lesser chance of getting a more profitable result based on financial statements as what had been experienced under the US GAAP. This would however make way for more objective presentation of financial statements and stocks would have a better chance of not being overvalued because of the difficulty of capitalizing such development costs.

Works Cited

Ernst and Young, U. S. GAAP vs. IFRS: The Basics, n. d. {www document} URL, http://www2. eycom. ch/publications/items/2007_ey_us_gaap_v_ifrs_basics/2007_ey_us_gaap_v_ifrs_basics. pdf, Accessed November 13, 2008 MSN Company Report – Company Background, 2008 {www document} URL, http://moneycentral. msn. com/companyreport? Symbol=PG, Accessed November 13, 2008 Proctor and Gamble , 2008 Annual Report, 2008{www document} URL , http://www. pg. com/content/pdf/home/PG_2008_AnnualReport. pdf, Accessed November 13,2008

A corporation represents a complex entity. It is an independent legal entity which operates under the leadership of an executive director or a group of executive directors. The Directors have full control of the company, but they generally do not have full ownership of the corporation. The directors are functioned like agents, their duty is to ensure that shareholders funds invested in their disposal are managed and used in the most effective and efficient manner, to produce optimum profitability and growth.

As compensation for their work this executive directors are given salaries and usually bonuses, relating to the quality of their job leading the company. Sometimes they are given a part of the company’s share, in order to nurture the sense of ownership and to create caring attention towards the company’s welfare. The familiar issue arises regarding to the relationship between the directors and the shareholders is known as the Agency issue. The shareholders are, due to their part in providing funds and furthermore, company’s assets, the true owners of the corporation.

Therefore, it is their will that supposed to be guiding the corporation conducting their operations. Nevertheless, the shareholders have no control towards the company and they have no information regarding the company’s operations unless what the directors gave them. This creates a reasonable doubt of whether the will of the shareholders is generated through the company’s operations or is it not. If we continue to walk on this path of logic, we will be guided to understand why viable financial reports are significantly required. Financial reports are communication tools between corporate executives and company’s shareholders.

This function will be portrayed clearly as we analyze the financial statements of British Vita PLC, producer of polymer for products required by a wide range of customers in foam, plastics and non-woven markets. II. Historical Background The original company was named Vitafoem Limited, formed by the late Norman Grimshaw on 1949, in Oldham, England. By 1954 the company has diversified into automotive products, mattress and divans. This was the first year Norman Grimshaw made the trip to Malaysia to examine a rubber plantation. On 1957, the first latex plant production was already producing.

The company purchase it first associate overseas in 1960. The first polyether company was installed at Middleton in 1963, 3 years later; The British Vita Company was formed. One year after its formation, Vita became a public company. After establishing joint ventures in Australia and Canada, management structure changed to autonomous profit centers in 1975. The company introduced share options schemes for all employees. 2 years after the original founder died, the company, following the Companies Act changed the company name into British Vita PLC.

Acquisition was continuously made trough out the world. Affiliates established in Germany, Switzerland, Australia and the United States. On the year1998 alone, the total acquisition value was 170 million pound sterling. British Vita made six acquisitions during 2003. The group has 3 division, Cellular Foams division, Industrial polymer and Non-woven polymer. The cellular division’s product includes block polyether, molded foams, and polyester in rolls; rebound foams, and a wide range of reticulated and impregnated foams.

These products are used in everyday objects as well as for special purpose like medical and industry needs. The Industrial use varies from automotive to undersea pipeline applications. Companies made partners with Vita because of its ability for compounding and forming various innovative products. The non-woven products including flame retardant, weldable, and hydrophobic and mould able waddings, non-wovens and a wide range of textures yarns. These products are distributes worldwide and achieved the highest reputation in a number of countries. III.

Financial Statement Analysis – 2000-2003 performance trends To a certain extent, a company’s profile and profitability ratio describes the management’s performance producing profit from its available resources. But a fair evaluation of management’s work cannot be done by means of profitability ratios only; attention need to be paid towards the balance sheet and cash flow statements also. An increase of a company’s performance in profitability ratios can be the result of their increased efficiencies, but could also be caused by changes in the amount of their capital employed.

Below is British Vita’s profile and profitability ratio followed by assessments of company’s performance trend over the last 4 years (in ? million). For a clearer perspective of the British Vita Group, we will divide the ratios above into certain categories. 3. 1 Activity Performance Ratio Some of these ratios are stock turnover, debtor’s turnover, debtor’s collection days, and assets turnovers. Activity performance ratio is a measure of management’s efficiency to manage and regulate the company’s daily operation.

British Vita’s performance trend on this aspect seems to experience a mild fluctuation, but overall having a relatively high rate of efficiency. The stock turnover for instance, shows an average rate of 12. 2. This means that the company repurchases their stock averagely 12 times over the year, which indicates management’s success of keeping the amount of inventory sitting in their warehouse small and thus, displays an efficient management inventory. The debtor’s collection days show an average number 63. 1, these means that their debtors usually pay their debt within 64 days after the purchase.

Net and fixed assets turnover showed a relatively low number, but this is most likely due to the nature of the industry itself. Overall activity performance ratio displayed an only mild fluctuation trend of performance. There is a little decrease in receivables and inventories management during 2002 and also an increase in asset turnovers in the same year. By observing the balance sheet and cash flow statements (which is not displayed due to the limited extent of this paper) carefully we can see that the increase turnover was caused by the decrease in net and fixed assets.

The decrease in net and fixed assets is caused by management’s decision to sell a few of their current and fixed assets to meet their long term debt and liabilities which is due to payment within the year 2002. While the decrease in receivable and inventory management efficiency measure might be a short term under achievement (during an adjustment period) influenced by the sale of fixed assets. This is proven by their next year (2003) performance which relatively “bounced back” rapidly. 3.

2 Liquidity and Solvability Performance Ratios These ratios consist of liquidity ratio, creditor’s payment days, and interest cover ratio. The liquidity ratio shows an average number of 0. 89, which means every pound sterling of debt is guaranteed by 0. 89 pound of current assets. The condition displays the company’s low ability to pay for it current debts. However, the creditor’s payment day’s average number of 47. 86 indicates that the company is able to pay their short term debt in the very fast manner.

The interest cover ratio also indicate a high solvency rate as the numbers indicate that its earnings before interest tax (EBIT) outnumbered the long term debt interest 16 to 1. Overall review of liquidity and solvability also displays little fluctuation of the company’s ability to meet their short and long term obligations over the 4 period of analysis. However, there is a rather significant increase (298 % compared to last year) in the interest cover ratio during 2002 indicating the payment of a significant amount of long term debt during the period.

This is then justified by looking at the balance sheet and cash flow statements which displayed over ? 200,000,000 of the company’s long term debts and loans are due and paid during the year. 3. 3 Profitability Performance Ratio This category consists of profit margins and earnings, return on equities, and return on assets. These ratios indicate the raising ability of the company to produce profit from its sale. The profit margin, gross margin, EBIT margin and EBITDA margin shows a more significant fluctuation compared to the other ratios.

The most significant change happened during 2002, where the profit margin ratios all together indicate a significant increase. The significant increased during 2002 seemed to indicate that management has found a way to enhance production’s efficiency or a way to reduce costs, but by taking a glance trough the balance sheet we understand that the rise of the numbers was due to the company’s significant assets and investments disposal. This is then dignified by their next year profitability ratios number which dropped at least as hard as it has climbed up during 2002.

The return on equities and return on assets employed ratios indicates a mild performance fluctuation. These ratios represent company’s ability to produce profit using equities and funds invested in them. Due to its function to explain how effective the management using the funding invested in them, many consider these ratios as the core of financial analysis. The management’s best performance according to these ratios happened during the year 2002. Relating to the previous analysis on activity and profitability ratios, the considerable incline in ROA (13.

62 % increase, 117 % incline from the previous year) and ROE (12. 4 % increase, 74% increased from the previous year) during 2002 are generally not caused by the increasing of management efficiency, but only a short term effect of the company selling its assets to pay their debts. This assessment is again, proven by the next year ratio which dropped similarly to their rise. Our final assessment towards the management’s 4 years performance is stated below: The British Vita PLC displayed a relatively stable performance during the 4 years.

There are no significant rises or falls regarding management’s efficiency or its ability to produce profit, except the 5 % increase of company sale during 2003. The significant raise and fall in certain ratios during the year 2002 was an effect of the company’s financing activities, which is the payment of a significant amount of long term debts and loans, and have little to do with management’s changing ability to produce profit. IV. Financial Statement Analysis – Evaluation for 2003 British Vita PLC’s profit and loss account during the year 2003 indicate a stable efficiency rate.

There is a 5 % increase of sale from the previous year as mentioned before, but the cost of sale also shows an increase of 13. 5 % indicating that the cost of production has mildly increased and efficiency has mildly decreased. The account also shows that higher retained profit for 2002 was caused by the profit from disposal of businesses occurred during the year. Further analysis on the company’s 2003 Annual Report elaborates the company’s present condition. According to year’s chairman, D. Cotterill, Vita has succeeded in delivering a good performance over the year.

The two business segment of Vita’s, which is Cellular Polymer and Industrial Polymer has continue to grow and producing significant profit over the year. Cotterill has also mention that the third segment however, has experienced an unfortunate sale results. He also mentioned a sale of the US Spartech investment which explains the significant decrease on Vita’s investment account during 2002. Some of the fund raised is then used for a share buyback program with to date has repurchased 14 % of their issued share capital.

A study of the financial review also indicates that the non-woven segment’s loss has overcome the profit growth of the other two segments. The decline of ? 1. 0 million is partly caused by the profit adjustment for the previously overstated profit in the US business. Another cause of the decline is caused by the reduced demand of the entire Continental Europe, Scandinavia and in the UK. The market overcapacity severely impacted Vita’s margins. The governance report displayed an orderly fashioned management activity. The board of directors meets 8 times each year and holding additional meetings if necessary.

The directors are encouraged to make an independent judgment regarding company’s issues. The solutions are then to be discussed on their scheduled meetings. The decisions are then given to the chairman for approval and chief executive to be implemented in business operations. The chief Executive has 4 ECG’s (Executive Control Groups) responsible for running the daily business, one for each of the cellular polymer and non-woven polymer divisions, and two for the Industrial Polymer The company uses the internet as company’s link of communication and also as a promotional tool of the company.

Company information site is available 24 hours a day and its integrity is constantly maintained by the board of directors. The company also has independent audit committees meeting three times in 2003. The committee reviews internal and external audit activities and monitors compliance with statutory requirements of financial reporting. The directors’ report indicates that the company also concerns about their social and environment responsibility. Environmental report is integrated with the rest of the annual report describing corporate performance.

The group donates over than ? 50. 000 to charity during the year. V. Assessment of Future Prospects 1 As we have stated before, financial statements carries a major significance to a company’s existence. Trough the financial reports of British Vita PLC, we can asses the company management’s competence in performing their duty as an agent. We have elaborated the company’s entire growth trend in the third chapter of this paper. Concluded from the analyses, British Vita’s management performance ratios showed a stable rate of high efficiency.

The major shifts in some of the ratios are a temporary fluctuation which has been managed in a good manner by the company, causing the next year’s performance to quickly bounce back to their general rate of growth. There is no reason yet to question management’s ability to ensure the company’s growth and profitability. Without certain major disruption in the group’s working conditions, future performance will most likely show increasing result also. The lack of sale in the non-woven market was due to a shift in market that hasn’t been anticipated.

The other two segments displayed an encouraging rate of profitability growth. Even so, predictions say that the decreasing demand in the non-woven market might have not be over yet by the beginning of the next period of productions. These mean that the segments managers must find a way to regenerate the sale growth to avoid similar reduction on the group’s overall sale. Bibliography British Vita PLC [online]. 2004. Available at www. britishvita. com British Vita PLC [online]. 2004. Available at http://www. britishvita. com/index. html