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Chapter 24: Question 28Q (page 1446)

Presently, the profession requires that earnings per share be disclosed on the face of the income statement. What are some disadvantages of reporting ratios on the financial statements?

Short Answer

Expert verified

The data used in the research is based on actual prior results made public by the firm. As a result, the results of ratio analysis are not fundamentally predictive of future firm success.

Step by step solution

01

Meaning of Reporting Ratios

Reporting ratios are a helpful tool for indicating epochs from unrestricted detail information because they are easy to calculate and translate, and many improvements are possible.

02

Explaining disadvantage of Reporting Ratio of Financial Statement

Some believe that the FASB should not be engaged in developing guidelines regarding the use of ratios. This meeting addressed a fundamental concern: how far should the FASB go?

Specifically, where does financial reporting end and where does financial analysis begin? Furthermore, we know very little about the ratios that are employed and which combinations require the disclosure of specific ratios in this area, which would be counterproductive.

One reason for the profession's reluctance to prioritize ratio disclosures over financial explanations is that research on the use and value of rundown signals is currently limited.

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Most popular questions from this chapter

What is the full disclosure principle in accounting? Why has disclosure increased substantially in the last 10 years?

(Effect of Transactions on Financial Statements and Ratios) The transactions listed below relate to Wainwright Inc. You are to assume that on the date on which each of the transactions occurred, the corporation’s accounts showed only common stock (\(100 par) outstanding, a current ratio of 2.7:1, and a substantial net income for the year to date (before giving effect to the transaction concerned). On that date, the book value per share of stock was \)151.53.

Each numbered transaction on the next page is to be considered completely independent of the others, and its related answer should be based on the effect(s) of that transaction alone. Assume that all numbered transactions occurred during 2018 and that the amount involved in each case is sufficiently material to distort reported net income if improperly included in the determination of net income. Assume further that each transaction was recorded in accordance with generally accepted accounting principles and, where applicable, in conformity with the all-inclusive concept of the income statement.

For each of the numbered transactions you are to decide whether it:

  1. Increased the corporation’s 2018 net income.
  2. Decreased the corporation’s 2018 net income.
  3. Increased the corporation’s total retained earnings directly (i.e., not via net income).
  4. Decreased the corporation’s total retained earnings directly.
  5. Increased the corporation’s current ratio.
  6. Decreased the corporation’s current ratio.
  7. Increased each stockholder’s proportionate share of total stockholders’ equity.
  8. Decreased each stockholder’s proportionate share of total stockholders’ equity.
  9. Increased each stockholder’s equity per share of stock (book value).
  10. Decreased each stockholder’s equity per share of stock (book value).
  11. Had none of the foregoing effects.

Instructions

List the numbers 1 through 9. Select as many letters as you deem appropriate to reflect the effect(s) of each transaction as of the date of the transaction by printing beside the transaction number the letter(s) that identifies that transaction’s effect(s).

Transactions

  1. In January, the board directed the write-off of certain patent rights that had suddenly and unexpectedly become worthless.

(Ratio Computations and Additional Analysis) Bradburn Corporation was formed 5 years ago through a public subscription of common stock. Daniel Brown, who owns 15% of the common stock, was one of the organizers of Bradburn and is its current president. The company has been successful, but it currently is experiencing a shortage of funds. On June 10, 2018, Daniel Brown approached the Topeka National Bank, asking for a 24-month extension on two \(35,000 notes, which are due on June 30, 2018, and September 30, 2018. Another note of \)6,000 is due on March 31, 2019, but he expects no difficulty in paying this note on its due date. Brown explained that Bradburn’s cash flow problems are due primarily to the company’s desire to finance a \(300,000 plant expansion over the next 2 fiscal years through internally generated funds. The commercial loan officer of Topeka National Bank requested the following financial reports for the last 2 fiscal years

BRADBURN CORPORATION

BALANCE SHEET

MARCH 31

Assets

2018

2017

Cash

\) 18,200

\( 12,500

Notes receivable

148,000

132,000

Accounts receivable (net)

131,800

125,500

Inventories (at cost)

105,000

50,000

Plant & Equipment (net of depreciation)

1,449,000

1,420,500

Total assets

\)1,852,000

\(1,740,500

Liabilities and Stockholders’ Equity

Accounts payable

\) 79,000

\( 91,000

Notes payable

76,000

61,500

Accrued liabilities

9,000

6,000

Common stock (130,000 shares, \)10 par)

1,300,000

1,300,000

Retained earnings*

388,000

282,000

Total liabilities and stockholders’ equity

\(1,852,000

\)1,740,500

*Cash dividends were paid at the rate of \(1 per share in the fiscal year 2017 and \)2 per share in the fiscal year 2018.

BRADBURN CORPORATION

INCOME STATEMENT

FOR THE FISCAL YEARS ENDED MARCH 31

2018

2017

Sales revenue

\(3,000,000

\)2,700,000

Cost of goods sold*

1,530,000

1,425,000

Gross margin

1,470,000

1,275,000

Operating expenses

860,000

780,000

Income before income taxes

610,000

495,000

Income taxes (40%)

244,000

198,000

Net income

\( 366,000

\) 297,000

Depreciation charges on the plant and equipment of \(100,000 and \)102,500 for fiscal years ended March 31, 2017, and 2018, respectively, are included in the cost of goods sold.

Instructions

d. Should Topeka National Bank grant the extension on Bradburn’s notes considering Daniel Brown’s statement about financing the plant expansion through internally generated funds? Discuss.

Okay. Last fall, someone with a long memory and an even longer arm reached into that bureau drawer and came out with a moldy cheese sandwich and the equally moldy notion of corporate forecasts. We tried to find out what happened to the cheese sandwich—but, rats!, even recourse to the Freedom of Information Act didn’t help. However, the forecast proposal was dusted off, polished up and found quite serviceable. The SEC, indeed, lost no time in running it up the old flagpole—but no one was very eager to salute. Even after some of the more objectionable features—compulsory corrections and detailed explanations of why the estimates went awry—were peeled off the original proposal.

Seemingly, despite the Commission’s smiles and sweet talk, those craven corporations were still afraid that an honest mistake would lead them down the primrose path to consent decrees and class action suits. To lay to rest such qualms, the Commission last week approved a “Safe Harbor” rule that, providing the forecasts were made on a reasonable basis and in good faith, protected corporations from litigation should the projections prove wide of the mark (as only about 99% are apt to do).

Instructions

  1. What are the arguments for preparing profit forecasts?

Edna Millay Inc. is a manufacturer of electronic components and accessories with total assets of $20,000,000. Selected financial ratios for Millay and the industry averages for firms of similar size are presented below.

Edna Millay

2017 Industry

2015

2016

2017

Averages

Current ratio

2.09

2.27

2.51

2.24

Quick ratio

1.15

1.12

1.19

1.22

Inventory turnover

2.40

2.18

2.02

3.50

Net sales to stockholders’ equity

2.71

2.80

2.99

2.85

Return on common stockholders’ equity

0.14

0.15

0.17

0.11

Total liabilities to stockholders’ equity

1.41

1.37

1.44

0.95

Millay is being reviewed by several entities whose interests vary, and the company’s financial ratios are a part of the data being considered. Each of the parties listed below must recommend an action based on its evaluation of Millay’s financial position.

Archibald MacLeish Bank. The bank is processing Millay’s application for a new 5-year term note. Archibald MacLeish has been Millay’s banker for several years but must reevaluate the company’s financial position for each major transaction.

Robert Penn Warren. A brokerage firm specializing in the stock of electronics firms that are sold over-the-counter, Robert Penn Warren must decide if it will include Millay in a new fund being established for sale to Robert Penn Warren’s clients.

Working Capital Management Committee. This is a committee of Millay’s management personnel chaired by the chief operating officer. The committee is charged with the responsibility of periodically reviewing the company’s working capital position, comparing actual data against budgets, and recommending changes in strategy as needed.

Instructions

a) Describe the analytical use of each of the six ratios presented above.

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