Return on Common Equity - Research Proposal Example

Financial Accounting Return on Common Equity (ROE) ROE is a measure that shows the returns earned on common stockholders’ equity investments. The factors involved in the calculations ROE are: Earnings available to common stockholders, i.e., taxed earnings after the claim of dividend on preferred capital, and Common stockholders’ equity ROE in case of Test Company has remarkably increased to 21.29% in 2005 from a timid 5.94% in 2004. An analysis of financial statements of Test Company shows the following factors responsible for such huge increase. Increase in earnings belonging to common stockholders Net Income for 2005 is 9.58% of revenue as compared to 3.33 % of revenue in 2005, thus giving a rise of 6.24% of the revenue. As the revenue in absolute terms has gone up by $5652m in 2005 when compared with 2004 figures of sales, the boosted net margin of 9.58% of sales has pushed the retained earnings up by $1335m. The result is that retained earnings have soared to staggering $4005m in 2005 from $2670m in 2004. It may noted that net margin in 2005 has been doubly effected by the increase in absolute figures of sales as well increase in net margins. Further analysis shows that not only the Gross Margins have gone up by 1.73%, but there is huge decrease in operating expenses by 6.18% of revenue in 2005 comparing 2004.This efficiency in operating activities has been attained because of under noted contribution: Decreased as compared to 2004 Selling, general, and administrative exp: 3.82% of revenue Research and development exp. 2.08% -do- Restructuring Charges 0.28% -do- Total decrease in operating expenses 6.18% The other contributor to increase in net margins is the ‘other incomes’ by 0.49%; whereas provision for taxation has snatched 2.16% of net margins. A summary showing various effects on net margin is drawn as under: Gross Margin increase 1.73% Operating Expenses decrease 6.18% Other Income increase 0.49% 8.40% Less increase in tax provision 2.16% Increase in net margins 6.24% Total stockholders equity has increased by $2390m, mainly because of increase in 2005 retained earnings by 1.58% as compared to 2004. There is no preferred capital and the entire equity belongs to common stockholders. The increase in stockholders equity is not as high as in increase in the net income. In nutshell, contribution of the increase in net income played the major role resulting into tremendous hike in ROE for 2005. The increases in sales and efficiency shown in the reduction of operating costs have caused a double effect in boosting the net earnings. Though total stockholders’ equity also rose in 2005 but this high was mainly caused by increase in retained earnings affected by net earning increase, maintaining the major effect resulting into increased net earnings on ROE 2. a) US accounting standard setting At present The Financial Accounting Standard Board (FASB) is the body that formally issues accounting pronouncements in US. In fact FASB replaced Accounting Principal Board (APB) as the primary private body setting accounting standards for US; and in 1973 FASB formally succeeded American Institute of Certified Public Accountants (AICPA) as accounting standard body. The GASB is the other body setting accounting standards for states and municipal entities. Auditing Standard Board of AICPA issued SAS 91, which in fact formally recognized FASB pronouncements within auditing standards structures. FASB issues Statement of Financial Accounting Standards (SFAS), Statement of Financial Concepts (SAFC), FASB interpretations, and FASB Technical Bulletins, that constitute most of US GAAP. b) Importance of US GAAP US GAAP is not only important from the point of view of accounting and business community in US but elsewhere in the world as the success of a corporation is measured with the fact of it being listed in US stock exchanges.Accordingly, SEC has promulgated strict provisions that ensure strict adherence to US GAAP in order maintain continuous confidence of investors over both US and other outside corporations listed in US. The importance of US GAAP can further be gauged from its present confused scenario. Apparently FASB is the body churning out the accounting pronouncements for US businesses and accounting community for strict adherence. But, the scene in this regard has become quite confusing since unfortunate accounting scams, as to who is actually throwing the ball. The emergence of SOX Act, facing a lot of flak from business community causing increased expenses in keeping pace with compliances, is causing extra cautious attitude among standard makers and accounting professionals. Auditors are polishing their forensic caliber rather operating under normal circumstances. With emergence of IASB on the scene, the authority of FASB is getting murkier and murkier as issues pertaining to convergence are being delayed under the pretext of deliberations. All these happenings lead to one conclusion that FASB is not independent in standard settings; and other authorities like SEC in the grab of PCAOB of SOX Act, are actually controlling the task of standard settings. At this stage ensuring the independence of FASB is more crucial than ever. The global market is becoming more independent and larger than expectations. Accordingly it is very important that standard setters should work towards a common set of international accounting standards. c) Improvements required US GAAP for US and for the world economy is so important that its continuance improvements in following arena have become a necessity: i) Convergence with IAS Convergence of SFAS and IFRS is call of the day because of ever growing global business. Differences between two standards need be eliminated, and if that becomes controversial or impossible then agreeing to new commonly developed standards will only serve the purposes of international business community. ii) Professionals feel that the GAAP should be activity- based and not industries based as economies are bigger and more important than industries. This is a very important issue, that when implemented in respect of US GAAP will provide extra flexibilities to accounting standards to be moulded as per the prevalent circumstances. iii) Standards need to be simplified. Often companies need practicing professionals to assist in implementation of standards; and this often proves costlier than if standards would have been set up in an easy to understand language and procedures. Though simplification is not easily achievable, the following steps are needed at least to initiate matter in right direction: “ The conceptual framework will have to be improved. Standards will have to effectively balance implementation guidance and requirements to apply judgments. Identifying the standards that may apply to a particular transaction or event will have to be made easier. The simplification process will have to be managed so that the participants in the financial reporting process understand and adjust to the potential consequences of a standard setting approach that would likely to include more judgment in applying accounting principles.” (KPMG , February 2006) 3. The issue of valuation of Property, Plant & Equipment as of balance sheet date at cost, or at fair value, or at replacement value has become highly debatable, particular when issue of convergence with International accounting standards is on its way. Also it is true that the virtues of relevance and objectivity need to be served before the US standard setters arrive at a conclusion. Historical cost is the representation of initial cost less accumulated depreciation of pervious periods. This cost has advantage of maintaining consistency over the disclosures of assets. This consistency and uniformity in disclosure bring in the qualities of comparisons among figures of two different periods belonging to same asset or group of assets. Advocates of historical cost also put forth an argument that written down values of asset generally equals the remaining future benefits to be derived from such asset. From this point of view historical cost is certainly serving objectivity and also following the principle of conservatism. But historical cost suffers from under noted limitations: Under inflationary conditions assets depicted as per historical cost less accumulated depreciations are under stated, as there is no resemblance to current market value of assets Stating facts without use or relevance serve no purpose; and that is why business decision making is being shifted from financial accountants to management accountants. It is true that objectivity is the indispensable quality of income concept, but objectivity without relevance is not a virtue at all. IAS 16 allows two methods to measure PPE after the initial recognition. Companies can decide between historical cost (less accumulated deprecation) and fair value, provided fair value is measured reliably. Fair value is in fact net market or realizable value of assets. Fair value is reliable only when those are tested in the market. In other words there has to buyers to measures the fair value of assets. Putting hypothetical value as fair values would fail the test of objectivity. Assuming there are no buyers in secondary market (means assets for used assets). Will the fair value under such scenario be treated as of Nil Value? As per IAS 16 objectivity is served when there is reliability of fair value. Perhaps framers of IAS16 would have thought for such situation of no market and ‘nil’ fair value; and that is why the standard offers two alternatives to choose from. Let us now take the case of valuation based on of ‘replacement cost’ of the asset. As the name suggests ‘replacement cost’ is the value where by the existing running asset can be replaced with another similar asset, providing similar services or productivity. Though replacement cost may serve the purpose of objectivity, but is it relevant under present circumstances to find out a replica or replacement. Modernity is changing any asset’s utility and productivity overtime; and thus finding a replica to replace asset may seem a superficial exercise that may prove costlier. And what will happen when replacement cost increases the net realizable value (or fair value). It is very difficult to choose a method out of three alternatives for valuation of PPE that serves both the virtues of objectivity and relevance. But some rationality appears in case of valuing assets at end of accounting period at net realizable cost or fair value. The choice is based on the information that may be readily available. In view of historical costs being unacceptable to decision makers and difficulties in creating replica for replacement cost (and if possible the cost may be high and seem articial), the only other suitable alternative is fair value, the option suggested by IAS 16. Therefore the best suggestion for US standard setters is to follow the rule set by IAS 16, as this is the only workable alternative without creating unnecessary contradictions. 4. Inflationary effects on LIFO and FIFO Under LIFO, the prices at which goods most recently purchased are used to determine the amount charged to cost of goods sold. Ending inventory is valued using prices of units acquired the earliest. The result under LIFO cost of goods sold most closely approximates current cost. In period of rising prices or inflationary trend this method will have following effects: This method would result into lowest value for ending inventory. In addition this method would calculate highest amount for cost of sales and lowest amount of gross profit and net income When the entity is using lower of cost or market, the inventory is valued using one of the costing methods. The amount is then compared to market value of inventory and the lower amount will be used as the carrying value on the balance sheet. Under LIFO as costing will results into the lowest value for ending inventory, but the market value or current value would be higher than cost of inventory, carrying value of inventory would be cost, being less than market value. Under FIFO, the prices at which units are purchased most recently are assigned to ending inventory. Therefore ending inventory valued under FIFO most closely approximate current cost. Under inflationary trends the effect will be as under: FIFO will result in highest value of ending inventory. There will be lowest amount for cost of sales and highest gross profit and net income. When entity is using lower of cost or market value, costing of ending inventory under FIFO will be result into highest value, which in fact would resemble market prices. Market value is considered the ‘replacement cost’. This replacement cost is compared to a maximum amount called ‘ceiling’ and a minimum amount referred to as ‘floor’. In fact Ceiling= net realizable vale = Sales price- cost of disposal, and Floor = Ceiling- normal profit. The value of ‘replacement cost’, ‘Ceiling’, and ‘Floor’ is compared and the middle number is selected as market value. This market value is compared with costing of ending inventory and lowest figure is taken as carrying cost of ending inventory. 5. It is generally assumed that a company owning 20% or more of the stock of another company will have the ability to exercise significant influence over that company. This exertion of significant influence helps in deciding whether securities are held as ‘trading Securities’ or ‘available for sale’. When company cannot exert influence over the investee company, the securities are treated as ‘Trading’ and its accounting treatment is under: Trading securities are always classified as ‘current assets’ on the balance sheet and are acquired for obtaining short term gains. Trading securities are reported at fair value, regardless of the fact whether it is equal to, higher than, or lower than cost. When trading securities are reported at balance sheet at any amount other than cost, the difference is treated as unrealized gain or loss. This unrealized gain or loss is reported as income or loss from continuous operations in income statement in the period in which fair value changes. A valuation account is used to adjust the value of trading securities account reported on balance sheet date. When trading securities are sold, the difference between sales proceeds and original cost of securities is realized gain or loss. Realized gain and losses are likewise reported on the income statement as unrealized gains and losses. Most investor companies like to treat their investments as ‘trading securities’ because of the following reasons: Trading securities being short term investments bring the results at earliest. As current assets trading securities strengthen the working capital of the company. Securities classified as ‘trading securities’ do not convey risk involved as it is presumed that the investor company has no significant influence in investee company. Trading securities are results of market making, hedging, and proprietary activities. 6. Goodwill Goodwill is never classified as ‘current assets’. Accordingly an entry in Goodwill account reflects that investment has been made in company ‘B’on long term basis. The company A exert an influence over company B. That means holding of company A is more than 20% in company B. The securities of company are ‘held for sale’ and perhaps recorded in ‘Investments in Company B’ at fair value of investment and Goodwill contains difference between market value of securities paid by company ‘A’ and the total fair value of its holdings in company ‘B’. Short Term Investments An entry to this means securities are held as ‘Trading Securities’ and are classified as current assets. The investments in company B are less than 20% and the company cannot exert an influence into the affairs of company B. Securities may be valued at fair value with adjustment of unrealized profit/ losses to income statement under operating activities. Valuation allowance may be used to adjust the fair value on balance sheet date. Net, after tax, income from minority interest The company A is holding a minority interest in company B, that is less than the total holdings of company B and its voting powers. Long Term Investments in firm B An entry to this account means company A is holding securities in company B for longer period and are ‘held for sale’. The company A exerts influence in company B. Company A holding in company B is more than 20%. Reference KPMG, Defining Issues, February 2006, Trends and Challenges in U.S.Standard Setting, http://www.kpmg.com/aci/docs/DI_06_5%20TrendsChallenges.pdf Read More