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The case at hand deals with contingent liabilities and events occurring after the balance sheet date.  We will discuss the appropriate accounting treatment by referring to accounting standards pertinent on the aforementioned factors.

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A contingent liability is a possible obligation that arises from past events and its existence will be verified through the incidence or non-incidence of future events.  The damage resulting form the explosion of the highly flammable tank is leading to a possible liability, which can be substantiated though future activities.  This case is highly in line with the definition outlined above, therefore leading this case to fall under contingent liabilities.

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The relevant accounting standard states that a provision for a contingent liability should be considered when the following factors are met:

  • The business entity has a present obligation resulting from a past event;
  • There is a high probability that an outflow of economic resource will result in order to settle such incidence; and
  • A reliable financial estimate can be computed of the obligation due.

As regards to this case, it is clear that the organization holds an obligation resulting from the damage occurring from the explosion of the storage tanks, which did not solely effect the firm but also the premises in the vicinity.  In addition, even though no law suits have yet occurred there is a high probability that legal action will be taken against the company to cover the damages occurred.  This stems from the doctrine of tort as stated in relevant laws.

At least the latter element noted in the factors above, a reliable estimate could even be derived through the use of experts.  An architect and a lawyer can be employed that can provide within reasonable assurance the maximum liability that the company may be sued for.  Since all the factors noted in the previous paragraph are met, the organization is required to account a provision for such contingent liability.  The standard also necessitates that during the passage of time the firm considers the effect that the time value of money holds on the provision noted, provided it is significant to the financial statements.

For this provision the company is also required to disclose the following elements in the notes of the financial statements:

  • The carrying amount of the provision at the beginning and end of financial year considered;
  • Notes on any additional provisions and/or increases in the present contingent liability taken into account during the period;
  • Amounts realized and charged against the present provision during the financial year;
  • Any unused amounts of the provision reversed in the books; and
  • The rise during the financial year in the discounted amount stemming from the time value of money.

An important factor that ought to be meticulously considered in this case is why the organization did not account for a contingent liability on grounds that no legal action has yet taken place.  Even though the organization is not yet legally committed, there are still events and conditions present at the balance sheet date that indicate to such a liability.  Indeed if one considers the accounting standards that tackles events after the balance sheet date, such case falls under an adjusting event.  Therefore if legal action commences even after the financial year-end, management is required to adjust the financial statements accordingly.

Therefore a full provision stemming from the storage tank incident should be considered in the financial statements of Pawnee Manufacturing Company.  This is required in order to abide with the standard requirements noted above.  If management refrains from adopting such accounting treatments, the financial statements are not being true and fair on such facet and the external auditor may duly take note in his audit report.

Question A

Earnings per share encompass the profit attributable to common stock holders, based on the profit generated during the period.  Earnings per share do not imply the dividend paid to ordinary shareholders.  It comprises the overall earnings available to such party.  The net income considered in the computation of the earning per share ratio is the net income after deducting financial costs, taxation and extraordinary items.  In case of corporation composed of a capital structure of one class common stock only the items mentioned above are deducted.  However in case of organizations that hold preference shares, the dividend attributable to such parties is also deducted from the net income applicable for such formula.

Question B

  1. If the organization issues preferred stock, this will affect the computation of earnings per share equation.  The relevant accounting standard concerning earnings per share states that the net income, which is the figure used as a numerator of the equation, should be net of preference dividend.  Therefore if the company issues preferred stock, at the end of the financial year, preference dividend would result and should be deducted accordingly.
  2. The difference in value of the stock option issue will not affect the earnings per share figure.  This arises since as clearly shown in the relevant standard the number of common stock are considered and not the value of such stock.  Therefore in such a stance the only factor that will affect the earnings per share figure is that new common stock is issued.  In this case the figure will decrease on the assumption that the relevant profits remain the same.
  3. If a fixed asset is replaced at a loss, a net loss on disposal would result in the financial statement.  Such loss would be included with the operating expenses for the year and deducted from the net income of the corporation.  Therefore the earnings per share would diminish due to such activity.  For example if in 2006 a company incurred a net income of $150,000 and in 2007 the same net income was reported.  However in 2007 a machine was replaced and a loss on disposal of $10,000 took place.  In this case the net income in 2007 would amount to $140,000.  Let us also presume that the weighted average number of common stock remained at 100,000 each year.  Therefore in 2006 the earnings per share were $1.50 per share, while in 2007 in amounts to $1.40 per share due to such loss.
  4. If dividends on preferred stock are declared, there would be the same effect as the one noted in number 3.  As already stated the relevant standard requests the deduction of preferred stock dividend from the net income attributable to common stockholders.  This stems from the preferential rights that such investors hold with respect to the payment of dividends.  Therefore the earnings per share will diminish on the presumption that the net income remains the same.
  5. If the company redeems part of its outstanding common stock, then the weighted average common stock of the company will diminish.  A decrease in the denominator of the earnings per share figure will give rise to an increase in the earnings per share, provided the net income does not decrease.
  6. In the case of a stock split, the number of common stock available will increase.  Therefore the weighted average number of common stock at the end of the year will rise.  This will decrease the earning per share because the number of shares upon which the net income will be distributed will be higher.  For example, if a company had reported a net income of $150,000 and the weighted average common stock amounted to 100,000.  Let us presume that in the next year the net income remained the same but a stock split took place increase the weighted average common stock to 150,000.  In this case the earnings per share from $1.50 per share would decrease to $1.00 per share due to a higher stock share.
  7. I a provision for a contingent liability stemming from a lawsuit is recognized in the financial statements, it will have no direct effect on the earning per share of the company.  This is due to the fact that it will not affect neither the net income of the company nor the weighted average number of common stock.  However, when the contingent loss is realized and considered in the accounts it will negatively affect the earnings per share figure.  Since the relevant accounting standard states that all expenditure has to be deducted from net income, once the provision is recorded in the income statement it will further reduce the profit figure.

The profitability of Packard Clipper Incorporation decreased sharply in the two years considered.  Indeed through a horizontal analysis conducted the net income decreased by 9% in 2007.  This argument of deteriorating profitability is also substantiated by the fall of $0.80 in the earnings per share.  The earnings per share ratio portray the earnings that investors are receiving from the stock investment they presently hold.  Therefore a fall in profitability may result into a decrease in such ratio.  However, the earnings per share ratio are not solely affect by profitability.

A movement in the capital structure, such as an additional increase in common stock may also diminish the earnings per share ratio.  For instance if the company in 2006 had a net income of $100,000 and a common stock issued of 50,000 shares, the earnings per share would amount to $2.00.  If in 2007, the net income remained at $100,000 but the common stock increase to 100,000 shares, due to an issue of stock, the earnings per share would fall to $1.00.  Therefore the horizontal analysis and the earnings per share ratio do not shed sufficient and appropriate evidence on the profitability of the company.

Therefore before rushing into any drastic conclusions the creditors would probably request additional profitability ratios that further amplify such aspect.  They would for instance demand the return on capital employed to examine the efficiency of management in the utilization of the firm’s resources to generate profits.  The net profit margin would also be opted for since it reflects the profits generated from every $100 of sales.  A horizontal examination of the material operating expenses would also take place in order to seek if the decrease in profitability stemmed from lower cost efficiency.

The information provided pertaining to the financial position of the company encompasses the current and acid test ratio.  The current ratio is decreasing over the years analyzed, which implies that the capability of the current assets to cover the current liabilities is deteriorating.  On the contrary, the acid test ratio improved over the years, which signifies that the ability of the most liquid asset to cover the current liabilities improved.

From the information provided at hand one cannot easily conclude if the financial position has improved or not during the years.  The only point that we can state is that the most liquid assets improved, while the current assets deteriorated in relation to the current liabilities.  This may be probably due to a decrease inventory level and an improvement in the other current assets in relation to short-term liabilities.

Creditors will therefore demand additional information on such facet in order to fully comprehend the financial position of the company.  The debtors collection period will probably be demanded in order to examine the effectiveness of the credit control function in the organization.  They will also seek the creditors payment period to envisage if the company is risking any liquidity problems.  For example, if the debtors collection period is 65 days, while the creditors payment period amounts to 30 days, there is a high possibility that the firm will have working capital problems in the nearby future.  This is due to the fact that the creditors are being paid before the money is collected from debtors.  Therefore there is a high probability of a cash shortage.

The stock turnover ratio and cash and cash equivalents to current liabilities would also be necessary to show the efficiency pertaining to inventory and the capability of cash resource to cover current liabilities.  The cash flow aspect would also be more illustrated with the aid of a cash flow statement.  Through such report creditors would comprehend the cash generated or used from operating activities, investing activities and financing activities.

This would enable the creditors to reach the correct conclusion.  For instance, if the cash and cash equivalents to current liabilities diminished, one should see the reason why.  A possible reason may be a material investment in property, plant and equipment in line with the expansion strategy of the company.  Such factor therefore does not reflect that the company is insolvent.  The future cash that will be generated from such investments will help the financial position of the company provided that the investment was undertaken on financially feasible projects.

Ratios pertaining to the financial stability of the company have also been prepared.  These encompass the property, plant and equipment to stockholders equity and the sales to stockholders equity.  The property, plant and equipment to stockholders equity indicate the stability of the organization by reviewing the acquired assets in relation to the equity of the company.  An increase in such ratio, as in the case above shows a better ability for the firm to pay debt commitments such as interest expense and unexpected expenditure.  This is therefore a viable argument for the financial stability of Packard Clipper Incorporation.

The effectiveness used in generating sales from stockholders’ equity diminished during the years under consideration.  A fall in this ratio reveals a shaky sales figure in relation to the equity of the firm.  This ratio can be highly linked with the profitability of the company because they usually follow the same trend.  Indeed the fall in such ratio is in line with the decrease in net income considered in previous paragraphs.

An important ratio that is not presently considered and is important to assess the risk of the company on a going concern basis is the gearing ratio.  This ratio examines the total debt in relation to the total equity of the firm.  The greater the gearing ratio the higher the debts of the company and therefore the greater the risks stemming from the firm.  An organization with a significant debt would hold higher interest commitments, which ought to be paid on time.

Companies like the one referred in this example, commonly known as a high geared company would be more susceptible to failure during periods of cash shortage or adverse economic conditions.  Creditors would thus be interested on such risk facet.  This is also particularly the case in light that the profitability of the company is deteriorating.

An investor’s ratio was also considered, which entails the book value per share ratio.  This measures the equity value of the company in light with the book value of the organization.  Such ratio increase indicates a positive enhancement in the net assets of the company.  The creditors of Packard Clipper Incorporation would not be interested on such aspect of the organization.

They are not concerned with how is the share value perceived in the market.  Trade creditors are normally keen in the profitability, liquidity and stability of the corporation, which we did already taken into account.  Therefore attention should more be placed to the additional ratios noted in the previous paragraphs than the aforesaid investor ratio.

It is dangerous that the creditors based their economic decision solely on the financial ratios that can be computed on the organization at hand.  There are certain limitations inherent in ratios that induce the need of including other factors in such decisions. Ratios, for instance, are static in their nature. A ratio by itself does not imply anything.  In order to be meaningful it should be compared with other ratios either over time or with companies in the same industry. Ratios are also based on past results and sometimes the past is not a guarantee that in the future the company will undertake the same trend.

Unexpected factors might happen, which may significantly deteriorate the financial health of the company.  For example, in the airline industry the financial health examined on a vast number of airline companies in 2000 was significantly different than the financial health portrayed in 2001.  This was due to the unexpected September 11th terrorist attack, which drastically affected the operations of a number of companies, leading to their demise.

Ratios, like the ones computed above fail to abide with the time value of money principle.  For instance the inflation element is ignored during the computation of ratios.  The fluctuation in inventory, cash and cash equivalents and other elements stemming from seasonal variations are also not considered in ratio analysis. In addition, the frequencies with which accounting ratios can be applied also hinder their effectiveness.  Ratios are normally adopted on the annual financial statements prepared by the company.

Company law also permits the organization to file the audited financial statements nine months after the financial year end.  Therefore if for example a firm holds a financial year end on 31st December and in 2007, it filed the published accounts eight months after in August.  External users that will adopt ratios on such financial statements will end up using historical data that is significantly old.

Another serious limitation of ratios is that they are solely based on quantitative figures.  Failure to consider qualitative characteristics may be detrimental to a decision.  For instance if you example the financial statements of a company and notice that the financial health was very good.  However, in the proceeding year the chief executive officer of the company resigns and his replacement is not as experienced and effective as the former one.  This might drastically affect the financial health of the organization.

 References:

Lewis R.; Pendrill D. (1996). Advanced Financial Accounting. Fifth Edition. Washington: Pitman Publishing.

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