Mgmt 497

1. Mgmt 497 Accounting, Finance & Other Interesting Stuff

2. Overview • This lecture will cover the most complicated accounting and finance questions from the Player’s Manual

3. Basic Strategies • High price, low share, best quality & features • Rolex • Low price, high market share, low unit cost • Timex • Mid-price point • Seiko

4. Basic Strategies • Choose your approach • Rolex, Timex, Seiko • Establish goals in writing • Market share • Unit cost • Net income • ROA • ROE • Stock price

5. Performance Measurement • Performance measures (Weighting Factors) should support strategies • Timex—UPC, market share • Rolex—probably not UPC, or market share • Financial leverage—ROE, not ROA

6. Basic Financial Statements • Income statement • Cash flow statement • Balance sheet

7. Basic Financial Statements • Consolidated financial statements require • Elimination of intracompany sales and purchases (only sales and purchases between combined entities and the outside world matter) • Elimination of intracompany payables and receivables

8. Basic Financial Statements • Consolidated financial statements require • Elimination of reciprocal investment accounts • Translation of foreign currency into $US (you can’t add apples and oranges)

9. Calculation of Consolidated Sales • See page 164 of Players Manual • Home Area sales total (Intracompany and outside): $2,199 • Intracompany sales: $1,190 • M2 sales to outsiders: $755 • M3 sales to outsiders: $755 • N/P/S sales to outsiders: $806 (4841/6)

10. Calculation of Consolidated Sales • Consolidated sales total: $3,325 • ($2,199-$1,190) + $755 + $755 + $806

11. Calculation of Consolidated Cost of Goods Sold • Beginning inventory total: $549 $271 +$118 + $118 + $42 (250/6) • Cost of goods manufactured: $1,494 • Intracompany purchases: $1,190 • $397 + $397 + $396 (2,380/6) • Ending inventory total: $523 $287 + $86 + $86 + $64 (382/6)

12. Calculation of Consolidated Cost of Goods Sold • Total goods available for sale = Beginning inventory + Cost of goods manufactured + intracompany purchases • Consolidated goods available for sale = Beginning inventory + Cost of goods manufactured (does not include intracompany purchases)

13. Calculation of Consolidated Cost of Goods Sold • Consolidated cost of goods sold = Consolidated goods available for sale – consolidated ending inventory • Consolidated cost of goods sold: $1,520 ($549 + $1,494 - $523)

14. Cost Structure • TC = VC + FC • Increased volume reduces unit fixed cost • Increased volume may increase unit variable costs (e.g., overtime) • Adding FC: • Increases operating leverage • Increases operating risk • May reduce variable costs • Example: Fixed training reduces VC

15. Production Cost Analysis • Increased production volume reduces unit fixed costs (depreciation) • Decreased production volume increases unit fixed costs (depreciation) • See page 128 of Players Manual

16. Production Cost Analysis • Equipment depreciation for one quarter: $107,000 • Plant depreciation for one quarter: $26,000 • Six lines at 40 hours per week will produce 312,000 units per quarter (100 units/hour for 13 weeks per quarter) • Six lines at 42 hours per week will produce 328,000 units (rounded)

17. Production Cost Analysis • Produce 312,000 units • Equipment depreciation per unit: $ .343 • Plant depreciation per unit: $ .083 • Labor cost per unit: $2.880 • Produce 328,000 units • Equipment depreciation per unit: $ .326 • Plant depreciation per unit: $ .079 • Labor cost per unit: $2.950

18. Operating Leverage • Production worker training: $68,000 per quarter, indexed for inflation (fixed cost) • Reduction in per unit labor (variable) costs (e.g. $.20 per unit) • See page 123-124 of Players Manual

19. Production Layoffs and Deactivation • Production layoffs and deactivation lowers morale and output for several quarters • A layoff or deactivation of second shift that is replaced by a new first shift has no impact on output

20. Tax Loss Carryforwards • If you lose money in a quarter, the business unit in question does not pay taxes • Losses may be carried forward to offset future income and reduce future taxes • No loss carrybacks are allowed • See page 174

21. Tax Loss Carryforwards • If a subsidiary loses money in a quarter, it pays no taxes that quarter, and the loss reduces consolidated taxable income and taxes in the quarter of the loss (assumes parent’s total taxable income is positive) • The subsidiary’s loss is carried forward to a future quarter when it makes income, reducing the subsidiary’s taxable income and taxes in that future quarter

22. Tax Loss Carryforwards • The consolidated net income is not reduced in the future quarter, since the loss was deducted from consolidated net income in the prior quarter • In summary, the loss reduces consolidated net income and taxes in the quarter of the loss, leaves consolidated net income and taxes unchanged in the carryforward year, and reduces subsidiary income and taxes in the carryforward year

23. Foreign Currency Gain or Loss • N/P/S revenues and expenses in a quarter are translated into $US at the current exchange rate for that quarter • The Home Area uses the Equity Method of Accounting for its investment in subsidiaries, including N/P/S • Equity in Subsidiaries on the Balance Sheet will equal the sum of the Capital Stock and Retained Earnings for each subsidiary (see page 187)

24. Foreign Currency Gain or Loss • If the exchange rate rises (falls), Equity in Subsidiaries will decrease (increase), creating a loss (gain) in comprehensive income • See page 175 and 187 of Players Manual

25. Foreign Currency Gain or Loss • N/P/S beginning Capital Stock: 5,762 • N/P/S beginning Retained Earnings:2,540 (assumed) • Beginning Equity in N/P/S: 8,302 • Beginning exchange rate: 6.0 • Ending exchange rate: 6.3 (Rate rises) • Foreign currency loss: $66 (see page 175)

26. Cash Flow Statement • Net Operating Cash Flows • Net Investment Cash Flows (Home Area) • Net Financing Cash Flows (Home Area) • See page 179

27. Cash Flow Statement • A good company has Operating Net Cash Flow ≥ Operating Net Income • If Operating Net Cash Flow ≤ Operating Net Income, there is usually a build up in Accounts Receivable and Inventories • A good company has Operating Cash Flow ≥ Investing Cash Outflows, requiring no additional financing

28. Cash Flow Statement • Initially, your net operating cash flow may not be sufficient to cover your investments, and some financing may be required • Hopefully, you will have excess operating cash flow at a later date

29. Investing Excess Cash • “Investments” • CDs • Repayment of debt • Repurchase of stock • Need for liquidity

30. Operating Cash Inflows • All sales are on credit • For Merica: 50% collected current quarter; 50% next quarter • For N/P/S: 40% collected current quarter; 60% next quarter • Net sales to affiliates and purchases from affiliates result in zero cash flow from a consolidated point of view

31. Operating Cash Outflows • All operating expenses except depreciation, are paid in cash • Taxes are paid the following quarter, creating a taxes payable liability • Two thirds of operating and cash production costs are paid in current quarter; one third are paid in the following quarter

32. Investing and Financing Cash Flows • Subsidiary Dividends Received and Dividends Paid to Parent result in zero net cash flow from a consolidated point of view • Subsidiary Stock Purchased and Stock Sold to Parent result in zero net cash flow from a consolidated point of view

33. Balance Sheet • The income statement and cash flow statements should be prepared first, and the balance sheet will follow • The year end balance sheet, is the Q4 balance sheet, not the sum of quarterly balance sheets

34. Balance Sheet • The N/P/S asset and liability accounts on the balance sheet are translated using the “current quarter exchange rate” as of the balance sheet date • The N/P/S Capital Stock account is translated using the historical rate in effect at the time the stock was sold

35. Balance Sheet • The N/P/S Accumulated Earnings account is translated using historical exchange rates in effect when the earnings were earned • The inconsistent use of current and historical exchange rates necessitates the use of an Accumulated Foreign Currency Adjustment (see pages 192 and 197)

36. Accumulated Foreign Currency Adjustment • Consolidated Total Assets minus Consolidated Total Liabilities equals Consolidated Total Equity $12,370 ($14,370-2000) • Consolidated Capital Stock and Accumulated Earnings equal $12,373 ($9,500 + 2873), requiring an adjustment of -$3 (plug figure)

37. Equity in Subsidiaries • The Home Area uses the “Equity Method” to account for its investment in subsidiaries • The formula for Equity in Subsidiaries is: Beginning Equity in Subsidiaries + Net Income of Subsidiaries – Dividends paid by Subsidiaries = Ending Equity in Subsidiaries

38. Equity in Subsidiaries • In the consolidation process, the assets and liabilities of M2, M3, and N/P/S are added to the Home Area’s assets and liabilities • In the consolidation process, the subsidiaries are treated as wholly owned “departments” of the Home Area, with no common stock outstanding

39. Equity in Subsidiaries • The Home Area’s Capital Stock account includes the value of its original investment in the capital stock of the subsidiaries • Since the Home Area is using the Equity Method of Accounting, the net income (Accumulated Earnings) of the subsidiaries has been added to Home Area’s net income (Accumulated Earnings)

40. Equity in Subsidiaries • Moreover, the Equity in Subsidiaries account includes the original value of the subsidiaries capital stock and the subsidiaries’accumulated earnings • To avoid “double counting” from a consolidated point of view, the Equity in Subsidiaries is eliminated against the capital stock and accumulated earnings accounts of the subsidiaries in the process of consolidation

41. Consolidated Retained Earnings • The formula for Consolidated Retained Earnings is: Beginning Consolidated Retained Earnings + Home Area’s Net Income from its own operations + Subsidiaries’ Net Income from their own operations – Dividends paid to outside shareholders (excluding intercompany dividends)

42. Consolidated Retained Earnings • Example: See page 191 • Home Area NI: $147 M2 NI: $ 20 M3 NI: $ 20 N/P/S NI: $ 53 (316/6) Total NI: $240 Total Sub NI: $ 93

43. Consolidated Retained Earnings • Intercompany dividends: M2: $ 20 (100% payout) M3: $ 20 (100% payout) N/P/S: $ 42 ((316/6)x.8) (80% payout) Total: $ 82 • Subsidiary Earnings Retained: $ 11 • “Outside” dividends: $ 209

44. Consolidated Retained Earnings • Beginning RE: $ 2,842 + Home Area NI: +147 +M2 NI: + 20 +M3 NI: + 20 +N/P/S NI: + 53 (316/6) - Outside Dividends: -209 • Ending RE: $ 2,873

45. Repurchase of Stock • Stock repurchases are accounted for using the “par value,” not the cost method • Even though the stock has no “par value,” treat the “book value” as if it were the par value

46. Repurchase of Stock • Upon repurchase, the repurchase price is subtracted from cash • The book value of the repurchased shares is subtracted from Capital Stock • The excess of the repurchase price over book value is subtracted from retained earnings • See page 190

47. Capital Structure • Debt vs. Equity Financing • ROA • Profit Margin (NI/Sales) x Asset Turnover (Sales/Assets) = ROA (NI/Assets) • ROE • ROA x Financial Leverage (Assets/Owners Equity) = ROE (NI/OE) • Financial leverage • Financing assets with debt

48. External Financing Sources • Emergency loans • Bank loans • Bonds • Stock

49. Bank Loans • Emergency loans • Very expensive • 1st time r + 5% • 2nd time r + 15% • 3rd time r + 30% • After 3 r + 45% • Generally due to poor planning • Hurts credit rating

50. Bank Loans • For 1 Quarter • Automatic repayment of P + I • Maximum: 50% of (AR + Inventory), or $2.5 million • Clean out 1 in 4 Qtrs