Ways To Increase Return On Assets - Essay Example

Ways To Increase Return On Assets Set A does not now show a true and fair view since it does not comply with the International Financial Reporting Standards as declared by the IAS 1 paragraph 15. Since IAS 2 paragraph 9 requires that stocks should be valued at the lower of cost and net realisable value in the preparation of the financial statement, between Set A and Set B, it would seem Set B is ready to comply with the requirements because of the lower closing stock of £10,000 as against £14,000 closing stock for Set A. Since both sets of figures show similarity in the total expenses at £15,400 each, although Set B fails to present the break down of the expenses, then using the said expenses as criterion could not be deemed to indicate a material difference for purposes of inferring which of the two would or would not show a true and fair value. It is, therefore, the matter of the closing stock that will settle the issue of which set does or does not present a true and fair view since it is in the value of the closing where the two sets of figures materially differ. By taking the difference of £14,000 and £10,000, one will get a difference of £4,000 which represents about 40% and which could be now considered by auditors as material misstatement in the financial statement. As to why it affects materially the financial statements will be seen in the income statement and the balance sheet. The income statement is affected because closing stock or inventory takes the nature of revenues in the income statement as will be explained later. The balance sheet is also affected because the closing stock is part of the current assets and total assets which are parts the computation of liquidity using current ratio and the profitability using the return on assets. Since it affects the net income, the other ratios where net income is used will also be affected. As to how the material misstatement will affect the profitability ratios may be illustrated as follows: First, the closing stock is important in the computation of gross profit ratio (GPR) which is computed by dividing gross profit by the total sales. It must be noted that the closing stock affects the value of the cost of sales to be deducted from total sales to arrive at the gross profit. Applying, therefore, the formula for computing the GPR, set A would yield the result of 0.28 while set B would yield the result of 0.20. See Table I below. This will have the effect of misleading the decision maker to believe that a company has a higher gross margin than what it actually is. One of the qualitative characteristics of accounting information is reliability and to enhance the same, the principle of conservatism is adopted. Under the principle of conservatism, the users of the financial statements which include the managers, investors, and the accountant would normally take the side that possible errors might be there and such would be lead to understated (rather than overstated) net income or net assets or equity. This corresponds to the expression of anticipating no profits and providing for probable and estimable loss. What was derived as the conclusion in the computation of the GPR may more or less be closely related with the result of the net profit margin, which could be arrived at dividing net income (loss) to total sales? As to how net profit is computed, the gross profit is further reduced by the number of total expenses. Since operating expenses are higher than the gross profit, the result is no longer net profit but already the net loss, which means that the company did not earn enough to cover its operating expenses. But this fact does not change the analysis in terms of effects in the determining the profitability of the business since more losses would simply mean lower profitability or less desirability as an investment option. As computed, set A would yield net loss to sales ratio of (0.03) while set B will yield the ratio of (0.11). Compared with the effect on the GPR, it may be noted that the differences were both .08. Again as far as the financial accounting theory is concerned, that one that would comply with the qualitative characteristic of reliability should be followed by a financial statement to be closer to true and fair view. Set A presents a lower ratio than set B, which makes set B more conservative, hence more reliable and closer to show true and fair view. Therefore between the two sets of figures, Set A does not show a true and fair view. At this point, it may be asked: "How the difference in the values of the closing stock of the two set of figures have their effects in arriving at net profit or net losses?". The answer, of course, lies in the nature of closing stock which takes the nature of revenues, although unsold, for income statement purposes. It may be recalled that the value of the closing stock was deducted from total goods available for sale, which was equivalent to net purchases for the year since there was no beginning inventory, to get the cost of sales. It is, therefore, logical to value closing stock at the lower of cost or net realizable value since valuing the same at the market would be making a revenue a without actually making a sale or which should be the point of realization of revenue. Valuing, therefore, closing stock at market value would be putting the cart before the horse since at that time there is no realization of revenue yet. Financial accounting theory dictates that revenues should be recognized when they are realized under the revenue recognition principle (Kimmel, P. et. al, 2000). Such realization must come when products are sold or when services are rendered. Closing stocks are still goods not yet sold or to be sold hence there is no basis to include the same as revenues at higher than cost since they are not yet sold. It may be observed however that the case facts do not tell which value is the net realizable value and which one is the cost. Is it the £14,000? or the £10,000? It could be therefore assumed that one is either a cost and the other is the net realizable value, which could be an approximation of the market value. An issue of inventory write-down could arise when the cost is £14,000 while the net realizable market value is £10,000. It will be asked whether there is a justifiable to write down the cost of closing stock from £14,000 to £10,000. The answer to the question is in the affirmative since the combined international accounting standards (IAS) requires that the value should be lower of cost or market. The effect on the balance sheet and related ratios will now be explained using the following assumed data: Table I Set A Set B Difference Gross Profit Ratio 0.28 0.20 0.08 the cost to sales ratio 0.72 0.80 (0.08) the net profit margin (0.03) (0.11) 0.08 Assumed other current assets without closing stock 30,000 30,000 - Assumed total current assets with closing stock 44,000 40,000 4,000.00 Assumed Current Liabilities 44,000 44,000 - Current ratio 1.00 0.91 0.09 Assumed total assets w/o closing stock 100,000 100,000 - Assume total assets w/ closing stock 114,000 10,000 104,000.00 Return on Assets (ROA) (0.01) (0.54) 0.53 Assumed total equity w/o inventory 70,000 70,000 - Assume total equity w closing stock 74,000 70,000 (4,000.00) Return on Equity (ROE) (0.02) (0.08) 0.05 Using the data provided in the case facts and other assumptions the above information could be generated. It may be observed that the current ratio under set A would be higher by 9%. This difference could be explained by the fact that Set A would have higher current assets due to higher values of closing stock. A decision maker who may not well informed about the values used, would be led into believing the Set A figure allows the company to meet it currently maturing obligation due 1:1 current ratio but a more conservative presentation would have warned the same decision maker that the company was not actually as liquid as he or she was led to believe since if the IAS is used the current ratio is below 1:1. The same observation could be noted in terms of ROA and ROE, where set A shows better results than the actual using IAS. B.) Using your own numerical illustrations, show how alternative cost conventions can be used to meet the competing needs of different users of financial statements. B.1 Reported profit should represent the increase in capital year on year Using this alternative cost convention, an increased profit should be able to convince stockholders that the book values of their stock should be increased by the increase of profits during the year. For example, earning a profit of say £1 million should increase the retained earnings account of the corporation, which in turn increase the total stockholders account for the period. In the absence of additional investment by stockholders which is manifested by the issuance of new shares of stock of the corporation, without any dividends or any adjustment that would reduced the retained earnings account, which is part of the stockholders’ equity account of a corporation, and without any income or loss for the year, the value of the total stockholders' equity account would be left unchanged. Hence with the increase in profits, the same should necessarily increase the total stockholder's equity account. This could be understood by a numerical illustration. A total stockholders equity account of say £10 million would remain the same at the end of the year in the absence of any of changes as stated earlier but with a reported profit of say £1 million, the same would increase the retained earnings by the same amount and would make in turn the total stockholders’ equity account to £11 million. Reported profit had, therefore, represented an increase the capital for the year. B. 2 Reported profit should represent the increase in current purchasing power for any particular year To increase purchasing power is to increase the buying power of a business for a particular year by increasing the quantity of goods and services that it can acquire given the same amount of money. However, if there is the increase in prices due to inflation and there is also increase in the quantity of goods or services purchased it could not be completely said that purchasing power increased. In such case, there is the need for the use of consumer price index to convert the prices and to afford comparability of the same by referring to a base price. To say therefore that reported profit should represent the increase in current purchasing power for any particular year is to argue that the net profits should be net of inflation so that amounts reflected should be adjusted using consumer price index. To illustrate, the following assumed figures are needed: Reported Profits £ 100,000 £110,000 £121,000 Sold Units 100 100 100 Price Index 1.00 1.10 1.21 Net Profits as Restated, Net of Inflation £100,000 £100,000 £100,000 It may be observed that if there is no inflation there appears to be an increase of 10% per year in the reported profits. However if the increase in profits is due to increase in inflation by 10% per year, there is absolutely no increase in profits. If this is compared with purely historical cost accounting, it would turn out that a company may be increasing its capital because of the increase in the absolute values of figures but in reality there was really no increase in profits but just to recover the increase in prices (or inflation) which is external to the business. This is, therefore, one of the limitations of historical cost accounting where it assumes that monetary unit is stable while in reality, it is not. B.3. Reported profit should represent the increase in operating capability for any The following information is used to illustrate this section. Year 1 Year 2 Year 3 Net Income £10,000.00 £15,000.00 £20,000.00 Assets 100,000.00 105,000.00 110,000.00 Equity 40,000.00 42,000.00 44,000.00 Liabilities 60,000.00 63,000.00 66,000.00 Return on Assets 0.10 0.14 0.18 Return on Equity 0.25 0.36 0.45 It may be noted from figures above that net income increased in absolute values and in the ratios which indicate the reported profits have their impact felt by management and the stockholders. For management the increase in return on assets, which measure the capacity the company to produce more profits in relation to assets as it increased its assets from Year 1 through Year 3. The increase in the assets may appear to have been brought by the increasing net profits with no additional investment from stockholders. The increase therefore in return on assets from 0.10 in Year 1 to 0.14 in Year 2 to 0.18 in Year 3 is a clear proof of further increasing capability as the company report more profits. This, however, will not necessarily be the case for all companies as there are many factors that could influence the results, so that increase in assets may not be matched by an increase in the demand for company’s good and services. References: IAS 1 paragraph 15 IAS 2 paragraph 9 Kimmel, P. et.al (2000) Financial Accounting: Tools for Business Decision Making, Wiley Read More