Financial Statement Reformulation of the CRUF Group - Case Study Example

Financial ment Reformulation Introduction: Pronouncements made by the FASB and IASB are to be followed by all companies in the preparation of financial statements. However, many sectors of business and the community are not in favor of some of the statements issued by the Board. This topic focuses on the reformulation of the balance sheet, income statement and statement of cash flows as mandated by the FASB and the IASB. The following paragraphs have explained in detail the comments on the CRUF group’s petition to change some of the provisions of the two Boards’ rules and principles on how to prepare the financial statements (Riahi-Belkaoui 1999, p. 1). Question 1 The Corporate Reporting Users’ Forum is right with all their comments. In terms of accounting valuation models, a better picture would be presented if the United Kingdom companies listed in the stock exchanges would prepare financial performance reports classified under the areas of operating, financing and investing activities. The operating activities would pertain to the daily production of sales as well as services offered to their clients. Financing activities refers to those that are infused into the business by creditors and stockholders. Investing activities refers to the sale and purchase of property, plant and equipment accounts (Watkins 1998, p.51). One of the important tools in the hands of professional accountants for ascertaining changes in funds at the disposal of the company, during the course of every accounting year is the Cash Flow Statement. A cash flow statement is mainly categorized in to three heads like, cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Cash flow from operating activities is mainly dealing with the deduction of major operating expenditure from the revenues attained. Cash flow from financing activities dealing with major receipts and payments, and cash flow from investing activities alludes to the acquisition and disposal of assets or properties. Further, the CRUF group is right in affirming that financial statements should have coherent and cogent classifications that include the balance sheet, income statement and statement of cash flows. The new accounting standards recommended by the IASB and FASB group led by Sir David Tweedie and Bob Herz respectively would definitely resolve perennial problems using the traditional financial reporting standards. The current reporting standards focus on the net income as the benchmark for every business endeavor. The new standards are better because the new financial performance reports will be dispersed into the three activities as stated above (Michael 2004, p. 42). Moreover, the financial performance would focus on the amount of profits each of these three activities that contribute to the overall company objective of generating net profits. In addition, the CRUF group rightfully requested that only one financial reporting standard should be used. In terms of financial statement analysis, many companies find it easier to implement the current financial reporting standards of the lesser time and money used as compared to the new financial performance reporting outcomes. In terms of financial statements: practice and evidence, the current reporting standards are better because the new standard uses a much longer time and more money outflow. The companies must be given the freedom to choose either the single performance or the two statement performance presentation (West 2003, p. 112). However, the choice must be similar for several periods in order to be consistent. In terms of reformulation and analyzing financial statements, the companies should be given the freedom to choose which reporting method to use. However, once a method is used, this method must be continued for the next few years in order to analyze the company’s comparative financial performance over a period of time. In this regard, it is easier to compare and contrast company financial performance reports between companies, as well as between two accounting periods, if only one type of reporting format is used (Friedland 1994, p. 5). Furthermore, the CRUF group rightfully agreed that clear and easily accessible historical accounting and finance data will be helpful for decision making. The earnings subtotal should not be done away with, in order to validate or substantiate the other financial figures presented in the financial statements. Evidently, more income related figures will provide more relevant financial information, than a company that presents only one figure, which is the net income. Likewise, the CRUP group correctly agreed that assets acquired must use cost as the basis for recording assets, liabilities and capital. For, this will generate lesser work for the accounting personnel as compared to other functionaries. Recording assets using the fair market value model would entail using a lot of time trying to interpret as to what would constitute a fair market value (Van Riper 1994, p. 1). Further, assets that are historically recorded should not be restated at their fair market value every year because this may seen as an expensive and time consuming exercise. However, high value assets that include property, plant and equipment should be restated at their fair market value whenever appropriated. A good example, is land which increases in value every year. Land bought ten years ago would definitely be higher today. In terms of accounting quality and valuation, international accounting standards dictate that accounting performance standards should include the comments, suggestions as well as criticisms of different stakeholders of the business community (Chen & Dodd 2001, p. 65). The stakeholders include the customers, the management, the board of directors, the suppliers, the banks, the credit institutions, the government regulatory agencies, the stockholders, the employees and labor union. In terms of capital market research on usefulness of financial statement information, the group correctly stated their views. For, the major elements of the company’s performance reporting would pursue deep analysis of what activities would be included in the operating reports, how much should form part of the financing reports and when the activity costs will be recorded in the investment performance reports. The CRUF group rightfully stated that the companies must study any impairments or losses in the values of company’s resources and make the corresponding adjustments in order to present a more realistic picture of the financial performance of the company (Link & Boger 1999, p. 21). Q2. Reformulated financial statement. Reformulated Balance sheet -Smiths BALANCE SHEET 2007 2006 Reformulated Reformulated Assets Financial assets Investments (equity method) 12.00 14.00 Other investments 0.70 0.80 Financial derivatives 13.90 32.30 26.60 47.10 Operating Assets Intangible assets 1,021.30 1,530.60 Property Plant & Equipment 260.90 497.80 Retirement benefit assets 333.70 183.70 Deferred Tax Assets 94.00 92.30 Trade & other receivables 504.50 741.20 Inventories 319.70 558.40 Cash & cash equivalents 186.20 120.60 Assets of business held for sale 31.30 - 2,751.60 3,724.60 Total 2,778.20 3,771.70 Liabilities Financial Liabilities Financial borrowings (779.20) (1,047.30) Financial derivatives (5.30) (9.30) (784.50) (1,056.60) Operating Liabilities Provisions for liabilities & charges (233.50) (108.30) Retirement benefit obligations (150.10) (235.80) Deferred tax liabilities (118.00) (49.70) Trade & other payables (435.10) (814.30) Current tax liabilities (137.50) (144.10) Liabilities of businesses held for Sale (16.20) (1,090.40) (1,352.20) TOTAL (1,874.90) (2,408.80) Stockholders Equity Share capital 144.60 141.80 Share premium account 289.00 224.10 Capital redemption reserve 5.70 - Revaluation reserve 1.70 1.70 Merger reserve 234.80 234.80 Retained earnings 208.90 734.00 Hedge Reserve 18.60 26.50 TOTAL 903.30 1,362.90 Book value per share common Stockholders Equity 903.30 1,362.90 Share premium (289.00) (224.10) Share capital 1,192.30 1,587.00 Common shares 385.50 567.00 Book value per share common 806.80 1,020.00 Preferred Stockholders equity Share premium 289.00 224.10 Number of shares 5.00 578.00 Preferred per share 57.80 0.39 NET OPERATING ASSETS Operating Assets 2,751.60 3,724.60 Operating Liabilities (1,090.40) (1,352.20) Net operating assets 1,661.20 2,372.40 NET FINANCIAL OBLIGATIONS Financial liability 784.50 1,056.60 Financial asset (26.60) (47.10) Preferred stockholders equity 289.00 224.10 Net financial obligations 1,046.90 1,233.60 BOOK VALUE COMMON STOCKHOLDERS EQUITY Net operating assets 1,661.20 2,372.40 Net financial obligations (1,046.90) (1,233.60) Book value common Stockholders equity 614.30 1,138.80 NET OPERATING ASSETS Net financial obligations 1,046.90 1,233.60 Book Value Comm. Stock. Equity 614.30 1,138.80 Net operating assets 1,661.20 2,372.40 Estimated Income Statement for the First Two Years Particulars 1st Year 2nd Year Sales (Revenue) 490,000 1,190,000 Cost of Sales 245,000 595,000 Gross Profit 245,000 595,000 Sales 106,000 177,000 Expenses Administration and Overhead 72,000 $1,190,000 Other variable expenses. 35,000 595,000 Net Profit (Loss) 32,000 595,000 Projected Cash Flow Statement for 1 year (or 12 months) MONTHS 1 2 3 4 5 6 7 8 9 10 11 12 Sales 0 49 171,5 269,5 294 294 294 294 490 637 833 980 Cash Receipts 0 24,5 122,5 245 294 294 294 294 392 588 784 882 Disbursements 80 190 181,5 241 255 267 271 295 453,5 542,5 630 736,5 Opening Balance 0 80 245 304 300 261 234 211 212 273,5 228 74 Closing Balance 80 245 304 300 261 234 211 212 273,5 228 74 71,5 The reformulation of the financial statements seems to be an appropriate strategy since it is able to classify transactions under relevant significance of operating, financing and investment. As is often the case, a mismatch between the interpretations of these classes could result in gross misrepresentation of accounting data and its usage. Asset Based Equity Model The assumption used here is that the above reformulated financial statements used the Asset Based Equity Model. The assumptions used is clearly is shown in the computations of the reconstituted balance sheet, the reconstituted income statement and the reconstituted statement of cash flows. The balance sheet uses such formulas as the net operating assets, financial assets, non –financial assets, the financial liabilities, the non –financial liabilities and other reclassifications of the historically –named journal entry account titles. One advantage is that there will be a new perspective brought about by the reformulated balance sheet, income statement and statement of cash flows. One disadvantage of the new financial statement formats will be to bring about in some people a feeling of helplessness. For, these employee segments of the company work will forcibly prevent all changes in the work environment at all costs because it is a change in the way they do their job (Jenkins, and Kane 2006; p.1). Capital Asset Pricing Model (CAPM) is one of the important methods of asset based equity model. CAPM is giving stress for two concepts like time value of money and risk factor. CAPM specifies the relationship between expected return and risk for all securities and all portfolios. CAPM is based on Security Market Line (SML), which is a straight line joining between risk free asset, which has a beta coefficient of zero, and the market portfolio, which has a beta coefficient of one. “A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. .” (Capital Asset Pricing Model. 2008). There fore, assume, Beta of Equity 1.7, the risk-free rate of return is 4% and the market risk premium is estimated to be 5.94%. So, CAPM= 4%+1.7*(5.94%_4%) = I.e. 1.74*0.0194= 0.033756. Equity model means the determination of the valuation of either any asset or any security. The different methods are being utilizing for measuring the value of the firm. Some of such methods are Economic Value Added (EVA), Discounted Dividend Model (DDM), Residual Income Model (RIM) etc. “Economic Value Added (EVA), or economic rent, is a widely recognized tool that is used to measure the efficiency with which a company has used its resources” (Kotelnikov). Equity investments: Investment in equity shares is a complex procedure; this is because unlike debt and preference shares there is no fixed rate of interest or dividend against ordinary shares. So, while evaluating the concept of investment in equity shares requires the behavior of investors and their expectations. The investors in equity shares are the real owners, as far as the company is taken in to fact. Equity holders are ready to undertake the risks of business. They should have optimum control over the management of the company. Equity share holders shall be paid off only in the event of liquidation of the company. They are entitled to get dividend, only there are distributable profits. However, the cost of ordinary shares is the highest. This is due to the fact that such share holders expect a higher rate of return on their investment as compared to other suppliers of long term funds. Further, the dividend payable on shares is an appropriation of profits and not a charge against profits. This means that it has to be paid only out of profits after tax. It is necessary to undertake investment in equity more systematically. While undertaking the investment in equity markets, it is necessary to taken in to consideration about the concept of timing. The concept of investment and timing are interred related to each other. For evaluating capital expenditure projects or investment decisions, it is necessary to consider the fundamental concepts of equity investments and timing strategy. Asset Based Equity valuation model is one of the important theoretical valuation models that can be applied to equity valuation. This model assigns a value to the firm using the fair market value of the assets. The liabilities are recorded at fair market value. The difference between the revised total assets and total liabilities is the amount assigned to stockholders’ equity. This formula generates an earning with the corresponding zero costs. This model works best if the assets and the liabilities are correctly recorded at their fair market values. Residual income is arrived at by the formula: Comprehensive earnings segregated for the common stockholders less cost of the earnings from the book value at the beginning of the current period. This model is very useful for valuing bet financial obligations that are recorded at market value but not for valuing the net operating assets. For, some of the amounts are zero because they do not include knowledge assets and other intangibles. This model is a good equity valuation method to apply if the companies have large amounts of property, plant and equipment. Likewise, companies that apply basic technology are highly recommended to use this equity valuation model. However, the asset based equity model will give the company model formula as the sum of all fair market values of both the intangible and tangibles assets if all goodwill transactions are recorded or there are no omitted amounts. (Vardavaki & Mylonakis 2007, P. 105). Dividends are payable by the company out of profits to its shareholders. It is payable both to equity and preference share holders. As far as the company is concerned, payment of dividend is not expenditure, but an appropriation of earned profits such that, a portion of profits is distributed among the shareholders. Whenever the profits of the company increase, then the rate of dividend may, at the discretion of directors, also increases correspondingly. The dividend policy, and its growth and the determination of the valuation of shares are closely related with the earning capacity of the company. Dividend Discount Model (DDM) is an important technique which is used to analyze the valuation of equity shares. Making investment in equity shares is quiet risky, but at the same time it is the most beneficial return on investments, as compared to other forms of finance. So, equity financing is a fundamental concept with risk and return concept, and the timing of such investment is prominent in nature. Similarly, Capital Asset Pricing Model, (CAPM) is giving stress for two concepts like time value of money and risk factor. CAPM specifies the relationship between expected return and risk for all securities and all portfolios. CAPM is based on Security Market Line (SML), which is a straight line joining between risk free asset, which has a beta coefficient of zero, and the market portfolio, which has a beta coefficient of one. Dividend valuation model By using the Dividend valuation model, it is necessary to evaluate the actual returns of equity shareholders. The concept of cost of equity helps to evaluate the returns obtained by the equity share holders on their relevant investment. For computing the cost of ordinary shares, number of factors is related, such as dividend price approach, earnings/price approach, realized yield approach, etc. The basic factor behind determining the cost of ordinary share capital is to measure the expectation of investors from the equity shares of the company. The actual returns earned by the equity holders are equivalent to the number of shares held in each year is multiplied with the current market price per share. The important tool applicable for the share valuation of a company, is that of discounted Cash Flow (DCF), which helps to evaluate the time value of money. The valuation of shares is very essential as far as the companies are taken in to consideration. The impact of PE (Price Earning ratio) is also important in share concept, it means, the total value of stock available in the market avenues divided by the EPS (Earnings per Share) of the company. The major benefits of applying dividend valuation method are that it maximizes the overall profitability and dividend growth. The growth rates of dividend paying companies are mostly less fluctuating in nature. The investors lay high focus on their returns. Moreover, by using discounted valuation model, emphasis is also laid on cost of equity. In addition to this, this technique should evaluate and improves the ROE and EPS of a firm. Moreover, this concept is also lays emphasis on perpetuity model or OPT (Option Pricing Theory). But like any other methods, Dividend valuation model is also having its own limitations. It is very difficult to make an evaluation of the fixed income bearing securities using this model. Especially, the declaration of equity shareholders dividend is very crucial. Moreover, several concepts like ROI, percentage of dividends on both equity and preference shares, etc., are significant. Dividend also varies as fixed and variable wise. In case of fixed income bearing securities, it is necessary to taken in to consideration about the market value, and expected rate of dividend also. There is always a risk factor related with the concepts of return and dividend, because it is essential to consider the time value of money. Every investor is expecting a reasonable return, but this concept is not providing cent percent guarantee. In order to overcome these difficulties, it is necessary to make a well-planned managerial policies and forecasting of financial projects to ensure the technical feasibility and financial viability of the projects under evaluation. Free Cash Flow Model Likely, Free Cash Flow Model (FCFM), is the amount of cash that remains after deducting funds that a company must commit to continue operating at its planned level. Such commitments must cover almost all operations like interest, income tax etc. if free cash flow is positive, it means that the company has met all its planned commitments and the cash has available to reduce the debt or expand. But on the other hand, if it is negative free cash flow, the company will have to sell investments, borrow money or issue stock. With the help of FCFM, it is possible to calculate certain ratios. Price per share/free cash flow per share; and Operating cash flow/Operating profit For calculating the FCF, it is necessary to follow several equations, because it is a step by step process. EBIT= Revenue_ Expenditure (Including Depreciation) EBIAT (Earnings before Interest but After Tax) = EBIT_ Taxation cost FCF (Free Cash Flow) = EBIAT+ Depreciation Capital Expenditure Net Working capital (if there is increase) Calculation of Estimated Amount of Free Cash Flow: - (all figures are based on assumptions) EBIT= 2, 00, 000; There fore, EBIAT= 2, 00,000_ 50,000 = 1, 50,000 FCF= 1, 50,000+ 25,000_ 35,000_ 65,000= 75,000. Assume the amount of depreciation is 25,000; capital expenditure is 35,000; and NWC is 65,000. So, the amount of FCF is 75,000. Briefly discuss the advantages and limitations of the equity valuation approach you have adopted compared with alternative approaches. There are several advantages of using the Asset Based Equity valuation model as compare to other models. One advantage is that it is easier to compute. The company can literally change the values of the assets and the liabilities to arrive at the computed value for the total equity amount. For, example fair value of total assets of ₤ 1,000,000 will be deducted the total fair market value of liabilities of ₤ 400,000. The amount of ₤ 600,000 will be assigned as the equity account. This is what fundamentals of accounting teach us. For, using the free cash flow model, the dividend discount model and the residual income model will produce almost similar estimated computed values for the stockholders equity by computing. Thus, the company will save time and money by using only this equity valuation model. Further, the preparers of the financial statements will not need to study another equity valuation model (Campbell &Viceira 2002, p. 1). Asset based equity valuation method is one of the simple tool as far as the valuation approach is taken in to consideration. “The advantage of using the firm valuation approach is that cash flows relating to debt do not have to be considered explicitly since the FCFF is a pre debt cash flow, while they have to be taken in to account in estimating FCFE” (Damodaran 2002, P. 388). Also, another advantage for using the asset based equity valuation model is because it is more realistic. For, the reformulated assets and liabilities would be restated showing the current values of the company’s assets and liabilities at the time of the preparation of the financial statements. All the accounting models will produce almost similar financial data that will be used for their decision making purposes (Campbell & Viceira 2002, p. 5). There are several disadvantages of using the Asset Based Equity valuation model as compared to other models. (Vardavaki & Mylonakis 2007) As compared to other methods, the asset based equity valuation is providing only a summary of the overall performance of the entity. With the help of a small sample data, it is not possible for the company to evaluate the overall financial implications made during the accounting year. It would be better if the company would use additional financial performance data to validate and support the financial performance information generated by the asset based equity valuation model. Thus, a bigger and more colorful picture would include the use of the Free Cash Flow equity valuation model, the Dividend Valuation Model, the Residual Earnings Model, Residual Operating Income Model and the financial statement analysis ratios. These financial statement ratios include the current ratio, the debt to equity ratio, the earnings per share ratio, the receivables turnover ratio, the inventory turnover ration financial leverage ratio among other ratios. Further, “Excess financial capacity is free cash flow plus excess debt capacity. Jensen (1986) defines free cash flow as the cash flow in excess of that needed to fund all positive net present value (NPV) projects. Excess debt capacity is defined as the difference between an optimal debt level and the companys current level of debt. The optimal level of debt is that level that maximizes shareholder wealth, the minimum point on the average cost curve. We know that if a firm is financing at a less than optimal level of debt, it can increase the value of the firm by simply increasing the level of debt and using the funds to repurchase shares. This lowers the average cost of capital and increases the firm value. In addition, the tax deductibility of interest provides a debt tax shield that also increases the value of the firm. For these reasons, the difference between the optimal debt level and a less than optimal level is included in excess financial capacity along with free cash flow” (Carroll & Griffith 2001). Clearly, the above paragraph explains that the free cash flow equity model is also a good alternative to the asset based equity valuation model above. The focus of this model is the cash inflows and the cash outflows from the company’s operating, financing and investing activities. However, the cash flow statement is based on raw data taken from the company’s balance sheet and income statement. The cash flow statement is arrived at by adding back depreciation and amortization expenses to the net income. For, the depreciation and amortization expenses are deductions from net revenues. However, it does not involve a literally cash outlay. People use the financial statements above for decision –making. (Hirtle 2006). Conclusions: The CRUf group was right when they advised the two chairmen to implement their recommendations. For one, these two accounting boards are required to get the reactions, comments, suggestions and complaints from as many sectors of the United Kingdom society in order to come up with a more realistic. For, the accounting principles will be easily implemented by the people preparing the financial statements if they had been consulted. The above questions show that some people hate to change their work routines in the workplace. For, they would feel old dogs (employees) are hard to train. On the other hand, the young employees as well as the newly hired employees would excitingly embrace new work descriptions that would hasten their production as well as bench mark outputs. Conclusively, the Asset Based equity valuation method is the best model to use because of its simplicity and its very realistic computational results when compared to the other equity valuation models. However, it is quiet difficult to find out an optimum debt and equity mix where the capital structure would be optimum, because it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. In this context, the finance manager has to carefully look in to the existing capital structure and also consider the raising of funds properly. Under these circumstances, finance manager should maintain a proper balance between both long term and short term funds. Bibliography Bloom, Robert., 2004. Financial Statement Analysis: A Global Perspective. Issues in Accounting Education 19, no. 2: 264+. Capital Asset Pricing Model. (2008). [online]. Investopedia. Last accessed 06 January 2008 at: http://www.investopedia.com/terms/c/capm.asp Campbell, John Y., & Luis M. Viceira., 2002. Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. New York: Oxford University Press. 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