Treatment of Goodwill: Aragon Limited - Case Study Example

 Treatment of Goodwill: Aragon Limited Executive Summary Financial Statements represent data, which related to the company’s financial status, its business results, and other indicators that are used by the company's stakeholders to assess the health of a company. Annual financial statements would usually consist of the Balance Sheet, the Cash Flow Statements and Income & Expenditure Statement which is commonly refered to as the Profit & Loss Account. Financial Statements are to be drawn up in compliance with the Generally Accepted Accounting Principles (GAAP)which represent the common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP rules cover such things as revenue recognition, balance sheet item classification, outstanding share measurements, and many others and are imposed to maintain a minimum level of consistency in the financial statements. Broad requirement is that financial statements should be true and fair to provide proper feedback on company to its stakeholders. Financial statements and financial indicators sometimes contain the limitation of not being able to express and quantify certain elements and key factors of the organization. At the same time, they also lacks in being user friendly for those persons who are not from a financial background. As all stake holders of an organization are not going to be from a financial background, need for simple explanations in layman’s terms will be required for certain accounting principles and financial indicators. 1. Introduction The perspective from which a person of non-financial background evaluates a company’s financial statements will differ vastly from that of an accountant or a financial director. A person lacking knowledge of accounting and financial practices would tend to take a common sense approach in interpreting the content in financial statements. However, as accounting statements are drawn up in compliance with accounting principles and standards, manner in which certain expenses and asset values are treated in accounting context may differ from common sense approach. This report is intended to provide simplified explanations of some of the accounting principles, risk evaluation methods and treatment of expenses in the final accounts of Aragon Limited for persons of non financial background in its director board. 2. Accounting Treatment of Good Will and Human Resource As a well-established business with loyal staff & customers Aragon Limited enjoys an enormous amount of goodwill - from customers, staff & local community. This is one of the key influential factors, which has contributed to the past year’s sales and business development. Common sense would suggest that this is undoubtedly a major asset of the company. Such assets enhance the value of a business and should rightfully be included in company asset accounts to reflect its worth. However this is not included in current financial statements of Aragon Limited. Reasons for this lies in the guidelines pertaining to treatment of goodwill in Generally Accepted Accounting Principles (GAAP). 2.1 Treatment of Goodwill in Final Accounts In the context of accounting, Goodwill refers to the "premium" paid above the actual book value of a business when purchasing a business. This additional amount may be paid for the value the company has in terms of brand value, process excellence or high caliber employees, which are not included in the accounting book value. When one company buys another company, two accounting methods can be used. One is the pooling of interest and the other is purchase.  When the pooling of interest method is used, the balance sheets of the two businesses are combined and no goodwill is created.  When the purchase method is used, the acquiring company will account for the amount they pay in addition to the actual book value of the business, in the balance sheet under the "Goodwill" category.  Accounting rules require the goodwill be amortized over the course of 40 years. Other than the purchased good will as explained above, there is also the non-purchased goodwill. Non-purchased goodwill is any goodwill created and accumulated by a company over its operational period, other than purchased goodwill. This non-purchased goodwill is not accounted for in financial accounts and some of the reasons why this non-purchased goodwill is left out from accounts is as below: The fact that goodwill cannot be realized separately from the business. The value of goodwill has no reliable or predictable relationship to any costs that the company may have incurred. It is impossible to value intangible factors that may contribute to goodwill. The value of goodwill may fluctuate widely, depending on external circumstances over short period of time. Any assessment of the value of goodwill is highly subjective. Therefore, while recognizing that Aragon Limited has created a wealth of goodwill through its consumer loyalty, brand image and loyal and dedicated staff and supplier chain, the accounting practices does not provide for inclusion of this element in financial account due to the highly subjective nature of assessment of value. 2.2 Human resource accounting In today’s knowledge based economy, the human capital of an organization becomes a key asset. Organizations in the past did not value the human resource in financial terms nor did they represent this worth as an asset in the financial statements. However with the increasing recognition of the critical worth of employees to organizations, provisions are being made to disclose human resource assets in company’s financial statement. Methods of valuing and accounting of human resources are classified into cost based and value based methods. Cost based valuations take in to account the costs incurred by the company to recruit, hire, train and develop human resources while the methods based on economic value take in to account the present and future earning contributions by the employees. Aragon Limited can adopt one of these methods and disclose the value of its employees so that stakeholders are well aware of the economic value of the company’s human capital. 3. Depreciation & Fixed Assets Companies acquire fixed assets such as land & buildings, plant and equipment, vehicles and office equipment for facilitating its operations. In accounting sense, fixed asset is a resource, which is used to generate future economic benefits. For depreciation purposes, useful economic life span of fixed asset will be considered. Depreciation will therefore record the so-called consumed value of the fixed asset during the period. For example, a plant having a book value of $ 500,000 with 5-year life span will then have $ 100,000 consumed per year and recorded as its depreciation. There are different methods of charging Depreciation. Straight Line method is the most common method used in practice. Reducing Balance Method results a higher charge in the earlier years and is used, when there are higher charges for repairs and maintenance in later years. Other methods available include Sum Of Digits methods and Annuity method. 3.1 The Fixed asset account Fixed Asset Account balances can be affected by new purchases as well as selling off of old assets. In the case of Aragon Limited, the following transactions took place in the Fixed Asset account to provide the final Fixed Asset Value of $ 640 Fixed Assets As at end of year 2003 the company had purchased equip to the value 460 Less/ During the year the company sold equip purchased at 170 Add/ Value of equip purchased during the year 2004 350 Therefore the value of equip at the end of year 2004 640 3.2 Accumulated Depreciation Account The depreciation account is where the annual provisions for depreciations or consumed cost of fixed assets are accumulated. When Equipment is sold off, the depreciation which has been charged on those items sold will be taken off from the accumulated depreciation account and transferred to “Disposal of Fixed Asset Account”. Thus, the Accumulated Depreciation account’s closing balances can be less than its opening balance if sales of assets have taken place within the year. Aragon Limited’s Accumulated Depreciation Account Balance is affected in following manner. Accumulated Depreciation Depreciation charged in previous years for equip 320 Add/ Depreciation charged for equip used in 2004 48 Less/ depreciation charged on equip sold 68 Depreciation charged up to end of year 2004 on equip in hand 300 3.3 Disposal of Fixed Assets When fixed assets are sold off after a period of time, a company can incur losses or gain a profit from such sales. For the purpose of accounting, when a fixed asset is sold, a “Disposal of Fixed Assets” Account is created. The book value of fixed asset is transferred to this Disposal of Fixed Asset from the Fixed Assets account. Te total depreciation which has been charged for that particular asset being sold will also have to be transferred from the Accumulated Depreciation Account. Below is how the Aragon Limited’s sale of fixed Assets will yield a loss of $ 72 Disposal of Fixed Assets Original Cost of equipment being sold 170 Less/ Depreciation already charged on these equipment 68 Therefore the net cost of the assets sold 102 Disposal price of Equipment 30 Therefore the loss on equipment Disposed or sold 72 4. Issue of Debentures Companies issue debentures as a means of raising long-term capital. The difference between issuing shares and debentures is that debentures carry the advantage of a guaranteed Interest payment to the holder. These interests are made before payments of dividend to share holders. In the case of shareholders, the payment of dividend will be made, only if there is any profit leftover after the payment of the interest. However since the payment of interest is a fixed sum, if higher profits are made by the company the debenture holders do not enjoy an additional interest payment However the shareholders stand to enjoy an additional dividend. If Aragon Limited had issued shares instead of Debentures, any profit the company generated would have to be shared among the existing and new shareholder. If company enjoyed a substantially high profit, then the increased profits will be passed on equally to new shareholders as well. When debentures are issued, only the fixed sum of interest is given out. Therefore, it can be seen that risk and return go hand in hand. Following Example will show how dividends per share can be affected if shares are issued in place of debentures. Option 1 - Issue of Debentures Existing Number of Share 400 Issue of Debentures 200 @ 10% Profits Before Interest Payments 240 Interest Paid for debentures 20 Existing Net Profits 220 Dividends per share (If not retained) 0.55 Option 2 – Issue of Shares in place of debentures Existing Number of Shares 400 New Shares 200 Total Shares 600 Profits Before Interest Payments 240 Interest Payments Nil Existing Net Profits 240 Dividends per share (If not retained) 0.40 If the risk of debentures vs., share issues needs to be measured, then the company’s interest cover and the gearing ratio would provide the answers. Gearing ratio is the ratio between long-term debt verses equity. If debt is low and the equity is high the risk is low. Interest cover is the ratio between profit before interest and tax divided by interest. If the interest cover is high the risk is less whereas if the interest cover is low the risk is higher. 5. Money owed by Customers Money owed by a company’s customers appears as debtors in the financial account statements. This is treated as a current asset in the balance sheet. As the amount which outsiders owes to the company has a risk element of turning in to bad debts, the management of this is of crucial importance. At the same time, debtor balance also impact on the company’s working capital status and thus should be kept within acceptable range. Companies usually provide credit periods up to 90 days for its customers depending on their purchase quantities, reliability of payment and duration of relationship with the company. Credit terms are used as sales ammunitions by the sales force, especially during period of heavy competition due to market slow downs. In the case of Aragon Limited, when debtor balances are considered, at a first glance it can be said that the money owed by the customers has gone up. But it should not be looked at in isolation. It should be considered in relation to the Turnover. 2003 2004 Turnover 1980 2400 Debtors 320 410 Debtors turnover 6.19 5.85 Days credit taken 59 days 62 days Debtor’s turnover is an indication of how many time each debtor has paid up during the year. This is calculated by dividing the total turnover by debtors. When debtor’s turnover is multiplied by 365, the number of days the debtors have taken to pay can be arrived at. Compared to 59 days in 2003, company has taken 62 days to collect the money in 2004. But by giving 3 days extra credit may have contributed to the increase in turnover of $ 420. Therefore, it is important to consider all interrelated aspects which related to data presented in financial statements. 6. Increase in Inventory Inventory control and management is a key priority for any company as costs of capital tied down with excess inventory erodes profits. Lack of proper inventory management can result in other losses in the form of obsolete goods, extra handling and storage charges and increased damages and pilferages. However when financial statements indicate an increased inventory, it should be looked at in relation to the level of purchases as well as level of sales and forecasted and anticipated demand levels. While overstocking can lead to losses, being out of stock can also result in losses in the form of loss of goodwill, lost orders and lost customers. In the case of Aragon Limited, the efficiency of inventory control can be assessed with the calculation of stock holding period as below. 2003 2004 Stock 290 370 Cost of sales 1600 1900 Stock turnover 5.52 5.14 Stock holding 66 days 71 days Stock turnover = Cost of sales  Balance Stock. Stock turnover represents how many times goods have been bought and sold during the year. When Stock turnover is multiply by 365, the stock holding can be calculated. Stock holding represents how many days each item has been in stock before being sold. Stock holding has increased from 66 days to 71 days and this is as additional stock has been required to meet the increased demand levels reflected in increased sales. As suppliers has minimum delivery quantities, meeting these additional demands will sometimes lead to increased inventory. 7. Profit & Cash Balance In accounting context, Profit and Cash balance represent two entirely different aspects. The profit and loss statement shows the profit or loss of an establishment. Profit refers to the amount that remains from generated income after expenses for the period is deducted. When calculating the profits, there will be charges like depreciation, and provisions for bad debts. which does not actually involve cash movement. Although such expenses are deducted as expenses from the income, no one is paid and no reduction in company’s cash balance takes place. On the other hand, the cash flow statement will show the movement of cash. A company making a good profit can go bankrupt because of bad cash management. Cash flow statement will also indicate payments, which may relate to expenses in past years that are due for payment now. Practices such as amortization and depreciation of an expense on acquiring assets, spread its impact on profits over a period of years. However in the Cash Flow Statement, this will be reflected fully during the year of incurring, as the money will be spent in that year as a lump sum. In the case Aragon Limited, it is therefore possible that although the company has generated a profit, the cash balance has reduced. 8. The Price/Earnings ratio When making decisions to purchase or sell shares on the stock market, PE ratio is used as an indication of the attractiveness of the stock. It is a measure of the relationship between the market value of a company’s share and the earnings from those shares It is an important ratio because it relates two key considerations for investors, the market price of a share and its earning capacity. The P/E ratio = Market price  Earnings per share. Earnings per share = Net profit Number of Shares. As Aragon Limited is likely to have a PE ratio of 15: 1, the market price of shares can be estimated as shown in the below calculations. If P/E Ratio is applied in assessing the stocks of Aragon Limited, the share value can be seen to have increase over the past year. P/E Ratio and Share Value – Year 2004 Earnings per share = Net profit  No of ordinary shares = 220/400 = 0.55 Price /Earnings ratio =Market price  Earnings per share. Market price = P/E ratio x Earnings per share =15 x 0.55 =8.25 Therefore a person selling Aragon Limited shares in year 2004 can expect a price in the region of 8.25 per share. P/E Ratio and Share Value – Year 2003 Earnings per share = Net profit  No of ordinary shares = 140/400 = 0.35 Price /Earnings ratio =Market price  Earnings per share. Market price = P/E ratio x Earnings per share =15 x 0.35 =5.25 If the Aragon Limited’s shares were sold in year 2003, the price that could have been expected is in the region of 5.25 per share. The share value has increased over the year by $3 per share, which is a 57% appreciation. 9. Conclusion It can be noted that while Financial Statements tend to provide confusing and seemingly faulty information to those who are not from a financial background, their overall validity and accuracy of content is generally high. Data in financial statements cannot be compared with previous years or with other organizations in isolation. To gain accurate picture of the situation, evaluations should be made with the aid of financial indicators such as the debtor turnover, debtor period, inventory cover, PE ratio and percentage change analysis. Even then, financial statements would provide only a financial perspective of the company’s performance. Risks of market conditions, new competition or product and service obsolence, which can wipe out even a highly profitable company, cannot be gauged by analyzing financial statements. However as profit and financial performance is a primary consideration, it is important that company executives and stakeholders familiarize themselves with basis financial performance indicators that can be applied in interpreting Financial Statements of a company. BALANCED SCORECARD AS A PERFORMANCE EVALUATION TOOL Prepared by Ms………………………………………………. - Finance Director, Aragon Limited For The Board of Directors, Aragon Limited Dated 6th Oct 2005 Table of Content Content Page Executive Summary i 1. Introduction 01 2. Effectiveness Of Balanced Scorecard 02 3. Process Of BSC Implementation For Effective Results 03 4. Conclusion 05 5. References 06 Executive Summary Increased competition fuelled by the process of globalizations, vast developments in the information and telecommunication technology as well as rapid changes in the world social and political structures have created intensely competitive markets in which today’s organizations are struggling to find a competitive foothold. Nature of today’s business is that an organization no longer can hope to achieve a competitive advantage through singular aspects of product quality, speed of supply or production costs. These factors have become prerequisites to stay in business and no longer offer a platform for competitive advantage. In today’s globalized scenario, the competitive advantage lies in how successful an organization is in linking its strategic intent and direction to its overall operations. Today the opportunities for creating value and achieving competitiveness is shifting from managing tangible assets to managing intangibles such as brands, the goodwill and the knowledge worker resources. Traditionally the norm of evaluating the success of the organizational performance was solely restricted to the financial perspective, measured by financial performance indicators. Focus on financial performances, at most times encouraged management decisions to be skewed towards trade-off decisions favoring financial gains based on short-term perspectives. Even the most innovative management systems introduced in recent history focus on, postmortems carried out through tools of financial measurements. Such systems fail in providing long-term perspective to the strategic management process and a firm’s goal of establishing a sustainable competitive advantage. Thus, need arises for a strategic management tool which would aid organizations in management of tangible as well as intangible assets of an organization by taking an overall and balanced view of the operations. 1. Introduction In order to steer an organization in its intended direction and be successful in achieving its overall objectives, evaluation becomes a key process in the management function. Evaluating the organizational performance also provides information for corrective action if the performance is deviating from desired levels. However the effectiveness of performance evaluation depends on whether the right things have been evaluated. If a company has focused on evaluating the wrong aspects or neglected evaluating key aspects, which has significant implications on its performance, then results from the evaluation process will not be complete. Traditionally, the organizational performance was solely evaluated through performance measures linked to financial indicators such as the profitability ratios, gearing ratios, liquidity ratios etc. These financial measures had its advantages of being quantified measures having globally accepted standards of applications under management accountancy principles. Most organizations used these financial performance indicators as benchmarks of the overall organization performance and set them as the key objectives being pursued. In doing so, organizations inevitably failed in focusing in other aspects of critical importance such as customers, internal processes and the human resources of the organization, which jointly drive organizational success and the ultimate profit generation. Focus on financial performance results in short term perspectives with trade-off decisions foregoing long tern organizational development in favor of short-term financial gains. In response to the need for a strategic management tool which takes a long-term perspective of organizational goals and address the development of organization’s overall resource base, Balanced Scorecard (BSC) was introduced in year 1992 by Robert Kaplan and David Norton. BSC is a strategic management system with a dual functionality of planning as well as a built in measurement system linking performance to organizational objectives (Kaplan & Norton, 1992). Balanced Scorecard provides today’s executives with a comprehensive framework that translate a company’s strategic objectives in to a set of measurable performance objectives. In place of the traditional focus on so-called “lag indicator” – the financial perspective, BSC aims at enhancing the organizational performance by introducing three additional business drivers in to the planning and measurement process. Under the BSC, the financial perspective is complimented by internal process perspective, customer perspective and learning and innovation perspective. 2. Effectiveness Of Balanced Scorecard Balanced Scorecard concept hinges upon a number of core principles, which the implementers need to fully understand and appreciate for deriving success from the system. Effectiveness of the BSC lies in that it derives its strategic objectives, not from the financial perspective, but though a clearly defined organizational mission and strategy. Importance of identifying and selecting the critical indicators within each of the four perspectives allows equal attention to these areas than bias for financial performance. These objectives are then expressed in terms of quantitative measures so that they can be influenced or controlled by the user. This allows the managers to focus on improving those processes that are the most critical to the company’s strategic success. Another key factor related to the concept of BSC is that it uses its measurements to inform employees about the key objectives of the organization. It also provides employees an understanding of how their work contributes to the achievement of overall company goals. Targets set through the BSC cascades down through the structure to individual level from the organizational level. Effectiveness of BSC as a strategic planning and management too as well as a performance measure lies in its emphasis on regular monitoring and reporting of actual performance. The multiple measures consist of a linked series of objectives and measures that are both consistent and mutually reinforcing (Kaplan & Norton 1993). Concept of BSC model illustrating the importance of interlinking the four perspectives is provided in figure 1. Figure 1- Conceptualization of Balanced Scorecard Model 3. Process Of BSC Implementation For Effective Results BSC implementation has to be initiated with the identification of the strategic intent of the organizational, which is clarified in an organization’s vision. The vision has to be established with consensus. For the success of BSC implementation, the vision has to be translated in to strategic objectives under the four perspectives. Table 1 indicates an example of a balanced scorecard with milestone targets. Only one objective per perspective is provided in the example. Table 1 - Balanced Scorecard with Corresponding Measures, Mile stones and Targets Perspectives Strategic Goals Measures Mile Stones 1st Year Targets 2nd Year Targets 3rd Year Financial ROI of 10% ROI 8% 9% 10% Customer Flexibility and Product Variety Number of customized options available per product. 3 5 10 Process Cost effectiveness through integration. Percentage of cost reduced in each process element of the integration chain. 3% 5% 8% Innovation & Learning Promoting R&D and product innovation 30% of sales revenue to be generated by new products aged less than 5 years 10% 20% 30% Key drivers having greatest impact on strategic objectives needs to be identified. The second step involves the communication and linking of these objectives through cause and effect relationships and setting up of goals. The success of the BSC implementation will depend upon how clearly the concept of BSC is communicated to the employees. Clear targets should be communicated to the employees through individual scorecards and how reward systems are linked to performance should be explained to the employees. Next stage of business planning involves setting up of targets, aligning strategic initiatives, allocating resources and establishing milestones. Budgets are drawn up to supports the strategic plan of the organization and milestone setting ensures that long-term targets are broken down to short-term evaluation targets. Staff is provided with individual scorecards, which are developed from departmental scorecards, which are cascaded down from the organization’s main scorecard. BSC also emphasis the need for feedback and learning, facilitating the evaluation of strategies on real-time basis and identify the deviations if any. Figure 2 illustrates the four-pronged process of implementing a BSC system. 4. Conclusion With the changing environment of business organizations, greater importance is placed upon managing intangible aspects of the business such as the knowledge workers, the customer relationships and the business processes. Need has risen for performance measurement tools that recognize the importance of not only the organizational financials but also the intangibles outlined above. Balanced Scorecard system is one such change programs, which not only focus on performance measurements but also carries the dual functionality of being a strategic planning tool. Justification of BSC process lies in the recognition that traditional means of performance evaluation through financial indicators will provide only a partial perspective and that too of a historic view. Therefore introducing and managing the other three perspectives, namely the customer perspective, internal process perspective and the learning and innovation perspective is expected to provide a balanced focus in driving the overall resource base of an organization towards achievement its strategic intent. References Kaplan, R. S. & Norton, D. P. 1992, “The Balanced Scorecard: Measures that Drive Performance,” Harvard Business Review, Jan-Feb, pp. 71-79. Kaplan, R.S. & Norton, D. P. 1996, The Balanced Scorecard: Translating Strategy into Action, Harvard Business School Press, Boston. Jonson T.H & Kaplan, R.S. 1986, Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press, Boston, pp. 61-124. Kaplan, R.S. & Norton, D. P. 2001, The Strategy Focused Organization, Harvard Business School Press, Boston, pp. 1-27. Read More