fingame 5.0 appendix financial statement construction
TRANSCRIPT
FinGame 5.0 AppendixFinancial Statement Construction
In this appendix, a set of pro forma statements is constructed to demonstrate the information contained on the statements and as a guide to help the FG manager construct his or her own pro forma statements.
The three most commonly used pro forma statements will be constructed for quarter 2. They include a projected performance report, a pro forma position statement, and a cash budget.
A projected income statement, also called the pro forma performance report contains estimates of the revenues, costs, and earnings expected in the quarter. Accrual accounting is used for the recognition of both costs and earnings, and therefore differences exist between income and cash recognition. The pro forma income statement is used to estimate the firm's quarterly operating costs and earnings performance.
The cash budget or pro forma cash flow statement provides an itemized breakdown of all expected cash receipts and disbursements for the quarter. The statement is needed to determine the items contributing to and detracting from maintaining the appropriate future liquidity position of the company. The cash budget permits a manager to have closer control of ending cash balances and thus decreases the likelihood of either cash shortages and a penalty loan or cash excesses and poor utilization of assets.
The pro forma position statement, also commonly called a projected balance sheet, provides an estimate of the future asset mix and capital structure of the firm. The statement incorporates estimated quarterly changes in equity from internal and external sources, the net changes in each type of debt outstanding, and shifts in the total dollar values of both fixed and current assets. The manager can judge whether the estimated future position of the company agrees with the objectives. Changes in decisions might be warranted if the projected results are not what was both originally desired and anticipated.
The Pro Forma Statements
A pro forma set of statements for quarter 2 is prepared from the FG company's actual quarter 1 statements. To aid comparison between historical and pro forma statements, the quarter 1 statements of Exhibits 4.1, 4.2, and 4.3 are presented again as Exhibits A.1, A.3, and A.5, respectively.
An explanation of the derivation of each item in the Pro Forma Performance Report (Exhibit A.2), Pro Forma Position Statement (Exhibit A.4), and Cash Budget (Exhibit A.6) is provided. Exhibit A.7 contains the tentative set of decisions being considered for adoption by management. They are used in constructing the set of pro forma statements.
The account items that affect the pro forma statements will be presented in approximately the same order as initially examined in Chapter 4. This will enable the game participant to refer back to the underlying rules and conditions affecting the specific account items covered. The participant can also find reference locations by using the tearout summary of instructions included at the end of Chapter 4.
The effect of a transaction on each pro forma statement will be presented concurrently. The full effects of a transaction on liquidity, performance, and the firm's position can then be more fully realized than if the effects were covered in three separate locations with each financial statement prepared independently of the other two.
Double entry accounting underlies the construction of pro forma statements. Every transaction will have a debit and credit effect on the set of pro forma statements. The appendix notes the type of entry, [debit] or [credit], in brackets after describing the account title and financial statement where the entry is reported.
Revenues
Product sales and interest on marketable securities are the only sources of company revenues.
177
Product Sales
Production and Goods Available or Sale
The firm has an inventory of 12,426 units at the start of quarter 2, as shown in Exhibit A.1. The decision to produce 100,000 units (Exhibit 7); will then lead to 112,426 total units available for sale.
Estimating Unit Sales and Per Unit Sales Price
The total unit sales and sales price per unit for quarter 2 must be estimated by the manager preparing the pro forma statements. Forecasts of price per unit and estimated unit demand
178
Exhibit A.1 F i n G a m e C o . 1 Q u a r t e r l y P e r f o r m a n c e R e p o r t Q u a r t e r N u m b e r 1
Sales Revenue ( 97,383 units at $100.00) $9,738,300Income from Securities 2,575 $9,740,875 -----------Cost of Goods Sold: Beginning Inventory ( 9,809 AT $74.79) $733,567 Materials $1,500,000 Direct Labor 3,500,000 ----------- Total Direct Costs $5,000,000 Warehousing Costs $60,408 Depreciation: Mach. & Equip. 478,125 Plant 1,300,000 Other Overhead Costs 200,000 ----------- Total Indirect Costs 2,038,533 ----------- Production Costs ( 100,000 AT $70.39) 7,038,533 ----------- Goods Available for Sale ( $70.78 per unit) $7,772,100 Less: Ending Inventory ( 12,426 units) 879,492 -----------Cost of Goods Sold 6,892,608 -----------Gross Profit $2,848,267Selling and Administrative Expenses $1,486,915Financial Expenses: Short-term Bank Interest $0 Penalty Loan Interest 0 Intermediate Term Loan Interest 92,750 Bond Interest 33,600 Bond Redemption Costs 0 -----------Total Financial Charges 126,350 1,613,265 ----------- -----------Operating Income Before Extraordinary Items $1,235,002Extraordinary Items 0 -----------Income Before Taxes $1,235,002Income Tax (rate is 40%) 494,001 -----------Income After Taxes $741,001Preferred Stock Dividend 0 -----------Earnings to Common Stockholders $741,001Common Stock Dividends ( $0.10 per share) 100,000 -----------Net Income Transferred to Retained Earnings $641,001 ===========
179
Exhibit A.2
F i n G a m e C o . 1 P r o F o r m a P e r f o r m a n c e R e p o r t Q u a r t e r N u m b e r 2
Sales Revenue ( 99,342 units at $100.00) $9,934,200Income from Securities 9,240 $9,943,440 -----------Cost of Goods Sold: Beginning Inventory ( 12,426 AT $70.78) $879,492 Materials $1,500,000 Direct Labor 3,500,000 ----------- Total Direct Costs $5,000,000 Warehousing Costs $65,672 Depreciation: Mach. & Equip. 478,125 Plant 1,300,000 Other Overhead Costs 200,000 ----------- Total Indirect Costs 2,043,797 ----------- Production Costs ( 100,000 AT $70.44) 7,043,797 ----------- Goods Available for Sale ( $70.48 per unit) $7,923,289 Less: Ending Inventory ( 13,084 units) 922,103 -----------Cost of Goods Sold 7,001,187 -----------Gross Profit $2,942,254Selling and Administrative Expenses $1,496,710Financial Expenses: Short Term Bank Interest $0 Penalty Loan Interest 0 Intermediate Term Loan Interest 112,656 Bond Interest 33,600 Bond Redemption Costs 0 -----------Total Financial Charges 146,256 1,642,966 ----------- -----------Operating Income Before Extraordinary Items $1,299,288Extraordinary Items 0 -----------Income Before Taxes $1,299,288Income Tax (rate is 40%) 519,715 -----------Income After Taxes $779,573Preferred Stock Dividend 0 -----------Earnings to Common Stockholders $779,573Common Stock Dividends ( $0.10 per share) 100,000 -----------Net Income Transferred to Retained Earnings $679,573 ===========
180
Exhibit A.3
F i n G a m e C o . 1 P o s i t i o n S t a t e m e n t Q u a r t e r N u m b e r 1
ASSETS
Current Assets Cash $120,546 Marketable Securities 200,000 Accounts Receivable 6,524,661 Inventory( 12,426 units at $ 70.78/UNIT) 879,492 ----------- Total Current Assets $7,724,699Fixed Assets (net of depreciation) Machinery and Equipment $2,008,125 Plant 7,165,250 ----------- Total Fixed Assets 9,173,375 ----------- Total Assets $16,898,074 ===========
LIABILITIES AND OWNER EQUITY
Current Liabilities Accounts Payable $520,000 Short-term Loans Payable 0 Short-term Penalty Loan 0 Intermediate Term Debt Maturing 1,850,000 Bonds Maturing 1,200,000 ----------- Total Current Liabilities $3,570,000
Long-term Liabilities Intermediate Loans: 2 years $937,500 3 years 0 Bonds 1,200,000 ----------- Total Long-term Liabilities 2,137,500 ----------- Total Liabilities $5,707,500
Owners Equity Preferred Stock( 0 shares) $0 Common Stock ( 1,000,000 shares) 8,000,000 Retained Earnings 3,190,574 -----------Total Equity 11,190,574 ----------- Total Liabilities and Equity $16,898,074 ===========
181
Exhibit A.4 F i n G a m e C o . 1 P r o F o r m a P o s i t i o n S t a t e m e n t Q u a r t e r N u m b e r 2
ASSETS
Current Assets Cash $2,366,880 Marketable Securities 700,000 Accounts Receivable 6,655,914 Inventory( 13,084 units at $ 70.48/UNIT) 922,103 ----------- Total Current Assets $10,644,897Fixed Assets (net of depreciation) Machinery and Equipment $1,530,000 Plant 5,865,250 ----------- Total Fixed Assets 7,395,250 ----------- Total Assets $18,040,148 ===========
LIABILITIES AND OWNER EQUITY
Current Liabilities Accounts Payable $520,000 Short Term Loans Payable 0 Short Term Penalty Loan 0 Intermediate Term Debt Maturing 2,050,000 Bonds Maturing 1,200,000 ----------- Total Current Liabilities $3,770,000
Long Term Liabilities Intermediate Loans: 2 years $625,000 3 years 875,000 Bonds 900,000 ----------- Total Long Term Liabilities 2,400,000 ----------- Total Liabilities $6,170,000
Owners Equity Preferred Stock( 0 shares) $0 Common Stock ( 1,000,000 shares) 8,000,000 Retained Earnings 3,870,149 -----------Total Equity 11,870,148 ----------- Total Liabilities and Equity $18,040,148 ===========
182
Exhibit A.5
F i n G a m e C o . 1 S u m m a r y D a t a Q u a r t e r 1
HISTORICAL INFORMATION Common share price $35.57 Accumulated wealth $35.67 Quarterly EPS 0.74 Dividend yield 1.10% Price earnings ratio 12.00 Marketable security yield 1.29% Actual unit price 100.00 Actual unit demand 97,383 Preferred Stock Price 32.15 Preferred dividend yield 3.11 Return on investment 17.54% Return on equity 26.49% Call premium: preferred 8.00% Bond call premium 8.00% Common tender or sell/sh $0.00 Unpaid preferred div./sh $0.00 Outstanding debt yields: short-term 2 year loan 3 year loan bonds penalty loan 2.98% 3.11% 2.50% 1.40% 8.00%
INFORMATION FOR FUTURE QUARTERS Quarter 2 3 4 5
Units forecast 105,721 103,295 123,736 117,872 Price per unit forecast $100.80 $103.73 $104.02 $102.85 Units of plant capacity 100,000 100,000 100,000 80,000 Units of machine capacity 100,000 100,000 75,000 60,000 Other overhead $200,000 $200,000 $200,000 $200,000 Depreciation:Machinery 478,125 478,125 384,375 311,250 Projects 0 0 0 0 Plant 1,300,000 1,300,000 1,300,000 989,000
Principal repayment on debt: Short-term 0 0 0 2 year 312,500 312,500 312,500 312,500 3 year 300,000 300,000 0 0 bonds 300,000 300,000 300,000 300,000
Warehouse fees:units First 2000 Next 5000 Over 7000 cost/unit $1.00 $3.00 $8.00 Production costs per unit next quarter: Materials $15.00 Machinery $47.00 Plant $322.00 Units First 60,000 Next 40,000 Next 20,000 Over 120,000 Labor cost $39.00 $29.00 $25.00 $33.00 Rates on funding in quarter 2: Short-term 2 year loan 3 year loan bond Preferred 1.98% 1.92% 1.85% 1.75% 2.62% Interest due next quarter: Short-term $0 Intermediate $83,031 Bonds $33,600
Capital budgeting projects for next quarter: Life Cost Unit Overhead Unit labor Change/qtr. capacity saving sav. qtr. 2 labor sav. A 2yr $658,800 100,000 $15,000 $0.82 $0.04 B 3yr $518,400 120,000 -$8,000 $0.86 -$0.01
183
Exhibit A.6Q u a r t e r l y C a s h B u d g e t Q u a r t e r N u m b e r 2
CASH INFLOWS Cash Sales $3,278,286 Accounts Receivable Collected 6,524,661 Income from Securities ____ 9,240 Extraordinary Gain __________ Sale of Marketable Securities __________Issuance of: Short-term Loans __________ Penalty Loans __________ Two-Year Loans __________ Three-Year Loans 1,500,000 Long Term Debt __________ Preferred Stock __________ Common Stock __________ TOTAL INFLOWS $11,312,187 CASH OUTFLOWSProduction Cash Flows: Materials $1,350,000 Direct Labor 3,150,000 Warehousing Fees ___65,672 Other Overhead Charges __180,000 Accounts payable Payments __520,000 Financial Expanses: Short-Term Loan Interest: Bank __________ Shark Loan __________ Intermediate-Term Loan Interest ___112,656 Bond Interest ___ 33,600 Bond Redemption Costs __________Selling and Administrative Expanses _1,496,710 Machinery Purchased __________Capital Budgeting Projects Purchased __________Plant Additions Purchased __________Extraordinary loss __________ Income Tax ___519,715 Preferred Stock Dividends __________Common Stock Dividends ___100,000 Purchase of Marketable Securities ___500,000 Payments and Retirement of: Short-Term Bank Interest __________ Penalty Loans __________ Two-Year Loans ___312,500 Three-Year Loans ___425,000 Bonds ___300,000 Preferred Stock __________ Common Stock __________ TOTAL OUTFLOWS $9,065,853 Net Flow (Total Inflows - Total Outflows) $2,246,334 Beginning Cash Balance ___120,546 Ending Cash Balance $2,366,880
Exhibit A.7184
F i n G a m e C o . 1 D e c i s i o n I n p u t s f o r Q u a r t e r N u m b e r 2
Pro forma sheet number 1 Units demanded 99,342S-T investment rate 1.32% Capital gains rate 0.00%Short-term loan rate 1.98% Two-year loan rate 1.92%Three-year loan rate 1.85% Long-term loan rate 1.85%Preferred stock yield 2.62%
Units to be produced 100,000 Per unit price $100.00Div. per common share $0.10 Advertising cost $0Demand/price forecast $0 Sales discount 0%
Short-term investment $500,000 Risk of S-T investment 0Machine units bought 0 Units of plant bought 0Project A no Project B no
Short-term loan $0 Preferred shares 0Two-year loans $0 Common shares 0Three-year loans $1,500,000 Common tender price $0.00Ten-year bonds $0 Strike settlement(per hr.) $0.00
185
on the Summary Sheet (Exhibit A.5) are used to derive possible pro forma statement numbers.
The adopted production strategy, inventory stocking policy, and Unit Price of Product decision can lead to a Units To Be Produced decision that is materially different from the forecast of units demanded provided on the Summary Sheet.
A sales volume of 99,342 and a sales price of $100.00 per unit are the estimates (Exhibit A.7) used in preparation of this set of pro forma statements.
Accounting impacts:
SALES REVENUE: Pro Forma Performance Report (Exhibit A.2) equals $9,934,200 (99,342 x $100.00) [credit].
ACCOUNTS RECEIVABLE: Pro Forma Position Statement (Exhibit A.4) equals $6,655,914 ($9,934,200 x 67) [debit] percent with a zero discount policy. Managers will have to determine the percentage of sales on account if the Sales Discount on Receivables, page __, is used.
CASH SALES: Cash Budget (Exhibit A.6) equals $3,278,286 ($9,934,200 x 33 percent) [debit]. Again, collection will be different if a sales discount is offered to customers.
ACCOUNTS RECEIVABLES COLLECTED: Cash Budget (Exhibit A.6) equals $6,524,661 [debit].
ACCOUNTS RECEIVABLE: Position Statement (Exhibit A.3) equals $6,524,661 [credit]. This is the prior balance that is paid off.
ShortTerm Investment
186
The marketable securities balance is increased by $500,000 on Exhibit A.7. The investment is in the safest shortterm investment. A prior balance of $200,000 (Exhibit A.3) was outstanding at the beginning of the quarter.
Accounting impacts:
MARKETABLE SECURITIES: Pro Forma Position Statement (Exhibit A.4) equals $700,000 [debit].
PURCHASE OF MARKETABLE SECURITIES: Cash Budget (Exhibit A.6) equals $500,000 [credit].
MARKETABLE SECURITIES: Position Statement (Exhibit A.3) equals $200,000 [credit].
Alternatively, if a sale of $100,000 of marketable securities had taken place the following entries would have been initiated.
MARKETABLE SECURITIES: Pro Forma Position Statement (Exhibit A.4) equals $100,000 [debit].
SALE OF MARKETABLE SECURITIES: Cash Budget (Exhibit A.6) equals $100,000 [debit].
MARKETABLE SECURITIES: Position Statement (Exhibit A.3) equals $200,000 [credit].
The entire $700,000 will earn interest for quarter 2. The interest rate on marketable securities in quarter 2 must be estimated by the manager since it is not given on quarter 1 statements. A 1.32 percent rate is assumed for the pro forma statements. From the investment, $700,000, and the interest rate, 1.32 percent, the interest earned in quarter 2 is estimated to be $9,240.
Accounting impacts:
187
INCOME FROM SECURITIES: Pro Forma Performance Report (Exhibit A.2) equals $9,240 [credit].
INCOME FROM SECURITIES: Cash Budget (Exhibit A.6) equals $9,240 [debit].
Production Costs
Materials
Materials, together with labor and other production costs, directly affect both period production and inventory costs. With production of 100,000 units and materials cost of $15.00 per unit, the following quarter 2 entries occur.
Accounting impacts:
MATERIALS: Pro Forma Performance Report (Exhibit A.2) equals $1,500,000 [debit].
MATERIALS: Cash Budget (Exhibit A.6) equals $1,350,000 (90% x $1,500,000) [credit].
ACCOUNTS PAYABLE: Pro Forma Position Statement (Exhibit A.4) equals $150,000 (10% x $1,500,000) [credit]. Note: 10% of both labor costs and other overhead will also be part of the final accounts payable balance.
Direct Labor
The Summary Sheet (Exhibit A.5) lists current per unit labor costs of $39.00 for the first 60,000 units produced and $29.00 for the next 40,000 units. Per unit labor costs are lower if either capital budgeting project A or B is acquired in quarter 2. Procedures for adjusting direct labor costs for capital budgeting project effects are covered in detail on page ___.
With a quarter 2 production of 100,000 units, labor costs will be $3,500,000 ($39.00 x 60,000 + $29.00 x 40,000).
188
Accounting impacts:
DIRECT LABOR: Pro Forma Performance Report (Exhibit A.2) equals $3,500,000 [debit].
DIRECT LABOR: Cash Budget (Exhibit A.6) equals $3,150,000 (90% x $3,500,000) [credit].
ACCOUNTS PAYABLE: Pro Forma Position Statement (Exhibit A.4) equals $350,000 (10% x $3,500,000) [credit].
Warehousing Fees
From the warehousing fee per unit schedule of the Summary Sheet (Exhibit A.5), the total warehousing fees on the units of quarter 2 ending inventory are calculated. The ending inventory of 13,084 units was derived in the previous "Product Sales" section. The total warehousing fee is $65,672 ($1.00 x 2,000 + $3.00 x 5,000 + $8.00 x 6,084).
Accounting impacts:
WAREHOUSING FEES: Pro Forma Performance Report (Exhibit A.2)equals $65,672 [debit].
WAREHOUSING FEES: Cash Budget (Exhibit A.6) equals $65,672 [credit].
Machinery
Depreciation on Machinery
Both purchases of additional machinery and depreciation on previously purchased machinery affect the pro forma statements. The quarter 1 Summary Sheet (Exhibit A.5) presents the quarter 2 depreciation on machinery $478,125. The rules about machinery
189
given in Chapter 4 indicate that quarter 2 purchase of machinery will not affect quarter 2 depreciation charges.
Accounting impacts:
DEPRECIATION: MACH. & EQUIP.: Pro Forma Performance Report (Exhibit A.2) equals $478,125 [debit].
MACHINERY AND EQUIPMENT: Pro Forma Position Statement (Exhibit A.4) equals $1,530,000 (quarter 1 balance of $2,008,125 less the depreciation $478,125 [credit]).
If there are capital budgeting project depreciation charges, they would also be included on the DEPRECIATION: MACH. & EQUIP. line. Since the capital budgeting project depreciation charges from previous quarters, shown on the Summary Sheet, are zero, the final line total remains $478,125. If capital budgeting projects are purchased in the current quarter, the first quarterly depreciation on the new equipment would have to be added to the DEPRECIATION: MACH. & EQUIP. line.
Purchases of Machinery
The purchase of machinery and equipment affects both the MACHINERY AND EQUIPMENT account of the Pro Forma Position Statement (Exhibit A.4) and the Cash Budget (Exhibit A.6).
Example: assume 10,000 units of machinery were purchased in quarter 2 at the quarter 1 Summary Sheet (Exhibit A.5) stated cost of $47.00 per unit. The total cost would be $470,000.
Accounting impacts:
MACHINERY AND EQUIPMENT: Cash Budget (Exhibit A.6) equals $470,000 [credit].
190
MACHINERY AND EQUIPMENT: Pro Forma Position Statement (Exhibit A.4) equals $2,000,000 (quarter 1 balance of $2,008,125 less the depreciation $478,125 plus the purchase $470,000[debit]).
Capital Budgeting Projects
Capital budgeting projects affect the pro forma financial statements only if purchases are made. They then affect cash flow, depreciation, and the firm's financial position in the period of purchase. To judge the affects, the purchase of Project A will be assumed even though the pro forma statements for quarter 2 are constructed with no additions of capital budgeting projects.
Purchase and Depreciation
First, if A were purchased, there would be a cash flow of $658,800 from the Summary Sheet (Exhibit A.5).
Accounting impacts:
CAPITAL BUDGETING PROJECTS PURCHASED: Cash Budget (Exhibit A.6) equals $658,800 [credit].
MACHINERY AND EQUIPMENT: Pro Forma Position Statement (Exhibit A.4) would be $2,106,450 ($1,530,000 + $658,800 [debit] $82,350 [credit]).
DEPRECIATION: MACH. & EQUIP: Pro Forma Performance Report (Exhibit A.4) equals $82,350 ($658,800/8) [debit].
Labor and Overhead Cost Savings
The affect of capital budgeting projects on both total costs and other overhead charged must also be considered. The labor savings is estimated at $0.82 (Exhibit A.5) times the
191
production of 100,000 units, a total savings of $82,000. Other overhead savings (Exhibit A.5) is $15,000.
Accounting impacts:
DIRECT LABOR: Pro Forma Performance Report (Exhibit A.2) equals $3,418,000 ($3,500,000 [debit] $82,000 [credit]).
DIRECT LABOR: Cash Budget (Exhibir A.6) equals $3,076,200 (90% x $3,418,000) [credit].
ACCOUNTS PAYABLE: Pro Forma Position Statement (Exhibit A.4) equals $341,800 (10% x $3,418,000) [credit].
OTHER OVERHEAD COSTS: Pro Forma Performance Report (Exhibit A.2) equals $185,000 ($200,000 [debit] $15,000 [credit]).
DIRECT LABOR: Cash Budget equals $166,500 (90% x $185,000) [credit].
ACCOUNTS PAYABLE: Pro Forma Position Statement (Exhibit A.4) equals $18,500 (10% x $185,000) [credit].
Plant
The procedure for projecting the account and line item balances for plant is the same as for machinery. The following occur if no new plant is purchased:
Depreciation of Plant
Accounting impacts:
DEPRECIATION: PLANT: Pro Forma Performance Report (Exhibit A.2) equals $1,300,000 [debit] found on the Summary Sheet (Exhibit A.5).
192
PLANT: Pro Forma Position Statement (Exhibit A.4) equals $5,865,250 ($7,165,250 quarter 1 balance less $1,300,000 [credit] depreciation).
Purchase of New Plant Capacity
Two events occur if plant is added. Assume 20,000 units are purchased. The quarter 1 Summary Sheet (Exhibit A.5) stated cost is $322 per unit. Thus, a total cost of $6,690,000 ($322 x 20,000 + $250,000[fixed fee]) is incurred.
Accounting impacts:
PLANT: Pro Forma Position Statement (Exhibit A.4) equals $12,555,250 ($5,865,250 [above] + $6,690,000) [debit].
PLANT ADDITIONS PURCHASED: Cash Budget (Exhibit A.6) equals $6,690,000 [credit].
Other Overhead and Accounts Payable
The Summary Sheet (Exhibit A.5) gives the quarter 2 other overhead charges of $200,000. The charge of $200,000 can be modified only by capital budgeting decisions (page __).
Accounting impacts:
OTHER OVERHEAD COSTS: Pro Forma Performance Report (Exhibit A.2) equals $200,000 [debit].
OTHER OVERHEAD COSTS: Cash Budget (Exhibit A.6) equals $180,000 (90% x $200,000) [credit].
ACCOUNTS PAYABLE: Pro Forma Position Statement (Exhibit A.4) equals $20,000 (10% x $200,000) [credit].
193
The 10 percent, or $20,000, is added to the $150,000 unpaid materials balance and the $350,000 in unpaid labor costs to derive the ACCOUNTS PAYABLE balance of $520,000 on the Pro Forma Position Statement (Exhibit A.4). A more appropriate procedure would place the labor costs in a separate wages payable or accrued wages account. In FG, they are joined both for convenience and to save space on the financial statements.
Old Accounts Payable Balance is Paid
The quarter 1 balance of ACCOUNTS PAYABLE given on the Position Statement (Exhibit A.3) is paid in quarter 2.
Accounting impacts:
ACCOUNTS PAYABLE: Position Statement (Exhibit A.3) of $520,000 [debit] is paid off..
ACCOUNTS PAYABLE PAYMENTS: Cash Budget (Exhibit A.6) equals $520,000 [credit].
Beginning Inventory
The beginning inventory enters operations.
Accounting impacts:
BEGINNING INVENTORY: Pro Forma Performance Report (Exhibit A.2) equals $879,492 [debit].
INVENTORY: Position Statement (Exhibit A.3) of $879,492 [credit] enters operations.
Ending Inventory
194
At this point, all the pro forma production costs and revenues are derived and entered on the Pro Forma Performance Report (Exhibit A.2). The PRODUCTION COSTS line balance of $7,043,797 is added to the BEGINNING INVENTORY of $879,492 from Exhibit A.3 to determine the GOODS AVAILABLE FOR SALE of 112,426 units at a total value of $7,923,289. The ending inventory of 13,084 was already calculated in the Product Sales section. With this information, the value of the ending inventory for quarter 2 is calculated to be $922,103 [$7,923,289 x (13,084/112,426)].
Accounting impacts:
INVENTORY: Pro Forma Position Statement (Exhibit A. 4) equals $922,103 [debit].
LESS: ENDING INVENTORY: Pro Forma Performance Report (Exhibit A.2) equals $922,103 [credit].
The COST OF GOODS SOLD and GROSS PROFIT can now be calculated.
Selling and Administrative Expenses
Selling and administrative expenses for quarter 2 are $1,496,710 ($1,000,000 + .05 x $9,934,200).
Accounting impacts:
SELLING AND ADMINISTRATIVE EXPENSES: Pro Forma Performance Report (Exhibit A.2) equals $1,496,710 [debit].
SELLING AND ADMINISTRATIVE EXPENSES: Cash Budget (Exhibit A.6) equals $1,496,710 [credit].
Other decisions can add to the total quarterly Selling And Administrative Expense charge. Penalty charges entered by the game administrator, advertising expense and the cost of purchasing demand and price forecasts require additional adjustments to the total selling and administrative expenses and cash flows.
195
Debt Balances, Payments, and Interest Costs
Externally obtained debt not directly generated by the operations of the company's business includes shortterm loans, intermediateterm loans, bonds, and penalty loans. This section considers the impact of these external funding sources on the pro forma statements.
ShortTerm Loans
Interest Expense
The Position Statement (Exhibit A.3) confirms that shortterm debt is not outstanding, while the tentative decision input (Exhibit A.7) indicates that shortterm loans are not to be issued in quarter 2. Therefore, the SHORTTERM BANK INTEREST line of both the Pro Forma Performance Report (Exhibit A.2) and the Cash Budget (Exhibit A.6) have a zero balance.
Issuance and Account Balances
Example: Assume that $1,000,000 of shortterm loans were or issued. The interest charge would be estimated by taking the total of the original outstanding SHORTTERM LOANS PAYABLE from the Position Statement (Exhibit A.3) which is $0, adding the shortterm loans issued in Exhibit A.7, $1,000,000, and multiplying this balance by the manager's estimate of the quarter 2 interest rate on shortterm loans. Adopt the assumption that the only other financing is $1,500,000 in threeyear loans. From the Summary Sheet (Exhibit A.5) the shortterm interest rate of 1.98 percent is adjusted upward by the size of offering premium of 0.375 (0.125% x 3) percent to 2.325 percent. Given this, the following would occur.
Accounting impacts:
196
SHORTTERM LOANS PAYABLE: Pro Forma Position Statement (Exhibit A.4) equals $750,000 ($1,000,000 first payment of $250,000) [credit].
SHORTTERM LOAN: Cash Budget (Exhibit A.6) equals $726,750 (proceeds of $1,000,000 beginning of period less $250,000 first principal payment at the end of the period and less the end of period interest expense of $23,250) [debit].
SHORTTERM BANK INTEREST: Pro Forma Performance Report (Exhibit A.2) equals $23,250 ($1,000,000 x 2.325%) [debit].
If shortterm loans had been outstanding, the prior balance in the ShortTerm Loans Payable line of the Position Statement would have to be reduced by the current installment due on the shortterm loan shown on the Summary Sheet. Consequently, the ShortTerm Loans line in the cash outflow section of the Cash Budget would also the current quarter 2 installment on previously outstanding shortterm loans.
IntermediateTerm Debt and Bonds
Loan Balances with No New Issues or Retirements
The procedure for calculating interest expense is basically the same for twoyear, threeyear, or longterm debt. First, the total amount of debt outstanding must be calculated for each class of debt. This is done by taking the sum of the next four quarterly repayment installments given in the PRINCIPAL REPAYMENT ON DEBT section of the Summary Sheet (Exhibit A.5) and adding this to the balance in the account in the LONGTERM LIABILITIES section of the Position Statement (Exhibit A.3).
For the twoyear loans, the next four quarterly installments from Exhibit A.5 sum to $1,250,000 ($312,500 x 4). Added to the LONGTERM LIABILITIES for INTERMEDIATE LOANS: 2 YRS of $937,500, twoyear loans outstanding total $2,187,500.
Before the new issuance in quarter 2 of additional threeyear loans, $600,000 of threeyear loans are outstanding. Using the same procedure, bonds outstanding total $2,400,000.
197
Derivation of Interest Expense and Cash Flow. With the total debt of a given class known, the interest expense is easily calculated. The OUTSTANDING DEBT YIELDS section of the Summary Sheet (Exhibit A.5) indicates the historical weighted cost of each type of debt. Thus, for the twoyear debt, the interest for quarter 2 is $68,031 ($2,187,500 x .0311). If a further issue of threeyear debt was not made in quarter 2, the cost on the originally outstanding threeyear debt would be $15,000 ($600,000 x .0250). Without a new issue, the intermediateterm debt interest costs would be $83,031 ($68,031 + $15,000). This interest expense is given in the INTEREST DUE NEXT QUARTER section of the Summary Sheet.
With $2,400,000 in bonds outstanding and no issuance of bonds in quarter 2, the interest cost of $33,600 ($2,400,000 x .01400) shown on the Summary Sheet is correct.
Accounting impacts:
INTERMEDIATETERM LOAN INTEREST: Pro Forma Performance Report (Exhibit A.2) equals $83,031 [debit].
INTERMEDIATETERM LOAN INTEREST: Cash Budget (Exhibit A.6) equals $83,031 [credit].
BOND INTEREST: Pro Forma Performance Report (Exhibit A.2) equals $33,600 [debit].
BOND INTEREST: Cash Budget (Exhibit A.6) equals $33,600 [credit].
An additional intermediateterm debt interest expense and cash flow will be required since additional threeyear loans are issued in quarter 2. This impact is covered under the New Issuance subsection that comes next.
Account Balances on the Pro Forma Position Statement (Exhibit A.4) are constructed from the prior Position Statements and the Summary Sheet. Also, the debt repayment installments due in quarter 6 must be known. (In Chapter 4, all future installments were stated to be $312,500 on the twoyear loans and $300,000 for bonds.)
198
Generally accepted accounting principles are used in recording debt balances. The following events occur for each debt class (2 year, 3 year, and bonds).
Accounting impacts:
The current quarter 2 principal installment on outstanding debt is paid.
INTERMEDIATE TERM DEBT MATURING: Pro Forma Position Statement (Exhibit A.4) $612,500 (quarter 2 installments of 2 year debt $312,500 + 3 year debt of $300,000) [debit].
PAYMENTS AND RETIREMENTS OF: TWO YEAR LOANS: Cash Budget (Exhibit A.6) equals $312,500 [credit].
PAYMENTS AND RETIREMENTS OF: THREE YEAR LOANS: Cash Budget (Exhibit A.6) equals $300,000 [credit]. A new issue will add to this effect in the next subsection.
BONDS MATURING: Pro Forma Position Statement (Exhibit A.4) $300,000 (quarter 2 installments of bonds $300,000) [debit].
PAYMENTS AND RETIREMENTS OF: BONDS: Cash Budget (Exhibit A.6) equals $300,000 [credit].
The quarters 3 through 6 installments are classified as a shortterm liability on the quarter 2 pro forma statements since they will be repaid within one year. The remainder of any outstanding debt is longterm. The quarter 2 installments have already been subtracted from the shortterm maturing debt account above. Quarters 3, 4, and 5 are still in these accounts ($312,500 x 3 for 2 year debt, $300,000 for 3 year debt, and $300,000 x 3 for bonds). The quarter 6 payment must now be moved from the longterm account to the shortterm account.
INTERMEDIATE TERM DEBT MATURING: Pro Forma Position Statement (Exhibit A.4) $312,500 (quarter 6 installments of 2 year debt $312,500) [credit]. There is no 3 year longterm debt outstanding until the new issue is made in the next sub
199
section. The current balance in the account is $1,550,000(4 x $312,500 twoyear and $300,000 threeyear loans)[credit].
BONDS MATURING: Pro Forma Position Statement (Exhibit A.4) $300,000 (quarter 6 installments of bonds $300,000) [credit]. The balance in the account is now $1,200,000(installments for quarters 3 through 6)[credit].
LONG TERM LIABILITIES: INTERMEDIATE LOANS: 2 YEAR: Pro Forma Position Statement (Exhibit A.4) $312,500 (quarter 6 installment on 2 year loans $312,500) [debit]. The balance in the account is now $625,000 ($937,500 quarter 1 balance $312,500)[credit].
LONG TERM LIABILITIES: BONDS: Pro Forma Position Statement (Exhibit A.4) $300,000 (quarter 6 installments of bonds $300,000) [debit]. The balance in the account is now $900,000 ($1,200,000 quarter 1 balance $300,000)[credit].
New Issues
First, an issue provides a cash inflow equal to the total offering size. Next, the first installment is paid. Our entry will also keep the shortterm maturing versus longterm distinction used above.
Accounting impacts:
ISSUANCE OF: THREEYEAR LOANS: Cash Budget (Exhibit A.6) equals $1,500,000 [debit].
PAYMENTS AND RETIREMENTS OF: THREE YEAR LOANS: Cash Budget (Exhibit A.6) equals $125,000 ($1,500,000/12) [credit]. A new issue will add to this effect in the next subsection.
INTERMEDIATE TERM DEBT MATURING: Pro Forma Position Statement (Exhibit A.4) $500,000 (quarters 3 through 6 installments of new 3 year debt) [credit]. The final balance in the account is $2,050,000(4 x $312,500 twoyear, $300,000 threeyear old loan, and $500,000 from the new 3 year loan)[credit].
200
LONG TERM LIABILITIES: INTERMEDIATE LOANS: 3 YEAR: Pro Forma Position Statement (Exhibit A.4) $875,000 (quarters 7 through 13 installments of $125,000) [debit]. The balance in the account is $875,000 [credit].
Next, interest costs on the new threeyear debt are calculated. The interest cost on the originally outstanding threeyear loans is $15,000 ($600,000 x .0250). In the RATES ON FUNDING IN QUARTER 2 section of the Summary Sheet, an estimated 3YEAR LOAN rate of 1.85 percent is given. The manager must determine the interest rate premium paid for an offering of $1,500,000. With issues from 1,000,000 to less than 2,000,000, the stated size of offering premium is 0.125 percent. Cost on the new issue is thereby 1.975 percent (1.85 + 0.125).
Applying the rate to the new offering, the estimated interest on the new threeyear loan is $29,625 ($1,500,000 x .01975).
Accounting impacts:
INTERMEDIATE TERM LOAN INTEREST: Pro Forma Performance Report equals $29,625 [debit]. Given the prior intermediate interest charge of $83,031 on already outstanding intermediateterm debt, the total interest on the Pro Forma Performance Report (Exhibit A.2) equals $112,656
INTERMEDIATETERM LOAN INTEREST: Cash Budget (Exhibit A.6) equals $29,625 [credit].
If a bond was issued, a derived estimate of interest and the flotation cost of $50,000 would have to be included in both the bond interest expense and cash flow.
Retirements
Retirement before maturity of the two and threeyear debt starts with the next installment after the currentquarter installment; as the retirement size increases, quarterly installments
201
further away are retired. With bond retirement, the most distant installments are retired first.
Example: If $1,250,000 of the twoyear loans was retired on the Decision Form (Screen 5 Chapter 2), the installments due in quarters 3 through 6 would be retired and the installments for quarters 7 and 8 would remain outstanding. The marginal impact of this decision on the financial statements follows. The marginal savings in interest expense for twoyear loans in quarter 2 would be $38,875 ($1,250,000 x 3.11%), where 3.11 percent is the historical yield on twoyear loans, presented on the YIELDS ON OUTSTANDING DEBT section of the quarter 1 Summary Sheet (Exhibit A.5).
Accounting impacts:
INTERMEDIATE TERM LOAN INTEREST: Pro Forma Performance Report (Exhibit A.2) equals $38,875 [credit or reduction]. Given the prior intermediate interest charges of $112,656 on all intermediateterm debt, the total interest on the Pro Forma Performance Report would equal $73,781 [debit] if this transaction had occurred.
INTERMEDIATETERM LOAN INTEREST: Cash Budget (Exhibit A.6) equals $38,875 [debit or increase] if the 2 year debt of $1,250,000 had been retired.
INTERMEDIATE TERM DEBT MATURING: Pro Forma Position Statement (Exhibit A.4) $1,250,000 (quarters 3 through 6 installments of 2 year debt $312,500 are retired) [debit]. The account balance would be $800,000 (prior balance of $2,050,000 minus 4 x $312,500 twoyear installments retired)[credit].
LONG TERM LIABILITIES: INTERMEDIATE LOANS: 2 YEAR: Pro Forma Position Statement (Exhibit A.4) is unchanged since only the first four installments of $312,500 were retired and no long term payments were prepaid.
PAYMENTS AND RETIREMENTS OF: TWOYEAR LOANS: Cash Budget (Exhibit A.6) decreases by $1,250,000 [credit].
202
An additional entry is required if a bond is refunded. The percentage redemption cost times the dollar amount refunded would be on the BOND REDEMPTION COSTS line of both the Pro Forma Position Statement and Cash Budget statements.
The penalty loan is the only remaining type of loan not covered. Since taxes and equity decisions affect cash flows, the penalty loan could not be determined until all other cash flows for quarter 2 occurred. If this does occur, the account balances and interest costs will be calculated according to the instructions given page __ in Chapter 4.
Extraordinary Items
The instructor can impose either an extraordinary loss or gain. The amount appears on the EXTRAORDINARY ITEMS line of the Pro Forma Performance Report (Exhibit A.2). The amount is also a cash flow. A cash inflow from a gain is entered on the EXTRAORDINARY GAIN line and a loss on the EXTRAORDINARY LOSS line of the Cash Budget (Exhibit A.6).
Taxes
The line items on the Pro Forma Performance Report (Exhibit A.2) derived in previous sections of this appendix are all necessary to calculate taxes. The SELLING AND ADMINISTRATIVE EXPENSES are first added to the TOTAL FINANCIAL CHARGES. The total is deducted from GROSS PROFITS and, with no extraordinary items in quarter 2, carried to INCOME BEFORE TAXES $1,299,288 in Exhibit A.2. With the given tax rate of 40 percent applied to taxable income, the following tax effects occur. INCOME TAX is $519,715.
Accounting impacts:
203
INCOME TAX: Pro Forma Performance Report (Exhibit A.2) equals $519,715 (40% x $1,299,288) [debit].
INCOME TAX: Cash Budget (Exhibit A.6) equals $519,715 [credit].
The INCOME AFTER TAXES line $779,573 in Exhibit A.2 is then calculated. Preferred and common stock dividends are deducted from this figure to derive common stockholder reinvestment of earnings in the company.
Equities
Preferred Stock
There are no effects on the pro forma statements during quarter 2, since preferred stock is neither issued nor outstanding.
Preferred Stock Outstanding
If preferred stock were outstanding, several items would have to be considered.
Example: Adopt the assumption that 200,000 shares were outstanding on the quarter 1 Position Statement.
Accounting impacts:
PREFERRED STOCK DIVIDENDS: Pro Forma Performance Report (Exhibit A.2) would equal $200,000 ($1.00 x 200,000) [debit].
PREFERRED STOCK DIVIDENDS: Cash Budget (Exhibit A.6) would equal $200,000 [credit].
204
PREFERRED STOCK: Pro Forma Position Statement (Exhibit A.4) would contain the same balance [credit] as the same line item on the Position Statement (Exhibit A.3) [debit].
Preferred Stock Issuance
Additional effects occur if preferred stock is issued in the quarter. First, dividends are paid on the new total number of shares outstanding. Second, the manager's estimate of the net proceeds of the offering is added with the PREFERRED STOCK account balance of the quarter 1 Position Statement (Exhibit A.3) to derive the balance [credit] of the Pro Forma Position Statement's PREFERRED STOCK account. Third, the net proceeds are a cash inflow [debit] entered on the ISSUANCE OF: PREFERRED STOCK line of the Cash Budget.
Preferred Stock Retirement
Preferred stock is retired at the start of the quarter. Therefore, dividends are paid on only the net remaining preferred shares. To calculate the effects on the position statement, the average book value of preferred must be determined.
Example: Assume 10,000 shares are outstanding and the PREFERRED STOCK account of the Position Statement (Exhibit A.3) has a balance of $400,000. The book value per share is $40.00 ($400,000/10,000). 3,000 shares are retired at a purchase price of $50.00 per share.
Accounting impacts:
PREFERRED STOCK: Pro Forma Position Statement (Exhibit A.4) would decrease $120,000 (3,000 x $40.00) [debit] to a new balance of $280,000 ($400,000 3,000 x $40.00).
COMMON STOCK: Pro Forma Position Statement (Exhibit A.4) would decrease by $30,000 [($50.00 $40.00) x 3,000] [debit]. The COMMON STOCK account
205
would be affected when the retirement price per share is not equal to the book value per share ($50.00 versus $40.00) in this example .
PAYMENTS AND RETIREMENT OF: PREFERRED STOCK: Cash Budget (Exhibit A.6) would equal $150,000 (3,000 x $50.00) [credit].
If the repurchase price was $20.00, then the pro forma statement's COMMON STOCK account would increase by $60,000 [($40.00 $20.00) x 3,000] [credit].
Common Stock
The effects on the pro forma statements are quite simple if neither an issue is made nor retirement occurs during the quarter. This condition is indicated in the decision inputs (Exhibit A.7). The dividends per share of common stock decision (Screen 3 Chapter 2) results in the payment of a 10 cents per share dividend on quarter 2 outstanding common stock. With 1,000,000 shares outstanding, from Exhibit A.3, the total dividends paid will be $100,000.
Accounting impacts:
COMMON STOCK DIVIDEND: Pro Forma Performance Report (Exhibit A.2) equals $100,000 ($0.10 x 1,000,000) [debit].
COMMON STOCK DIVIDEND: Cash Budget (Exhibit A.6) equals $100,000 [credit].
The balance of the COMMON STOCK account on the Pro Forma Position Statement would contain the same balance, $8,000,000, given on the quarter 1 Position Statement (Exhibit A.3).
Retention of Earnings
The NET INCOME TRANSFERRED TO RETAINED EARNINGS balance of $679,573 ($779,573 $100,000) is added to the RETAINED EARNINGS on the Position Statement (Exhibit A.3) of $3,190,574 to give the new balance of $3,870,147 on the Pro Forma
206
Position Statement (Exhibit A.4). Now the Pro Forma Performance Report is complete; all line items are derived.
Note: rounding error on partial dollars may lead to minor errors in the accounts of no more than a few dollars. The assets and liabilities and equity on Exhibit A.4 each have a $1.00 rounding error that can be confirmed by adding the account numbers. The errors are closed out to Retained Earnings which is $2.00 greater than the above balance of $3,870,147.
Common Stock Issuance
The manager must first estimate the net proceeds that will be received.
Example: Assume a decision was entered to issue 10,000 shares with expected proceeds to the company of $32.00 per share. First, the dividends paid would be for the entire number of shares outstanding after the offering. In the example, $101,000 (10 cents x 1,010,000) would be paid. Next, the total estimated proceeds of $320,000 would be recorded.
Accounting impacts:
ISSUANCE OF: COMMON STOCK: Cash Budget (Exhibit A.6) would equal $320,000 [debit].
COMMON STOCK: Pro Forma Position Statement (Exhibit A.4) would increase by $320,000 [credit] to a revised balance of $8,320,000 ($8,000,000 + $320,000) [credit].
Common Stock Repurchase Through a Tender Offer
Repurchase of common stock occurs at the start of the quarter. Dividends are not paid on these shares since they are paid only on the shares outstanding at the end of the quarter.
207
The repurchase is treated as a retirement. To calculate the effects on the position statement, the adjustment to the COMMON STOCK account and RETAINED EARNINGS must be determined. The repurchase price is allocated to the accounts according to the dollar weight each account contributes to total common equity.
Example: A quarter 2 repurchase of 100,000 shares at $40.00, for a total disbursement of $4,000,000, would be apportioned to the accounts: 71.4887 percent [$8,000,000/($8,000,000 + $3,190,574)] to the COMMON STOCK account and 28.5113 percent ($3,190,574/$11,190,574) to the RETAINED EARNINGS account.
Accounting impacts:
RETAINED EARNINGS: Pro Forma Position Statement (Exhibit A.4) would be reduced by $1,140,451 ($4,000,000 x .285113) [debit].
COMMON STOCK: Pro Forma Position Statement (Exhibit A.4) would be reduced by $2,859,549 ($4,000,000 x .714887).
PAYMENTS AND RETIREMENT OF: COMMON STOCK: Cash Budget (Exhibit A.6) would equal $4,000,000 [credit].
Rounding errors can cause differences of $2 or $3 in the calculations. The above procedure is a nonstandard accounting treatment for retirements. In the game, no option is available to have the repurchase of common stock treated as a Treasury stock repurchase.
The manager also needs to consider the possible effects if the repurchase attempt is only partially successful. There is a charge of $1.00 per share sought but not tendered. This results in both a cash outflow on the Cash Budget (Exhibit A.6) and a reduction in the earnings to common stockholders on the Pro Forma Performance Report (Exhibit A.2).
Cash Balances and Completion of Pro Forma Statements
208
All line items in the Cash Budget (Exhibit A.6) have been entered. TOTAL INFLOWS and TOTAL OUTFLOWS are calculated and the NET FLOW $2,246,334 is determined. The BEGINNING CASH BALANCE is the CASH balance on the Position Statement (Exhibit A.3) equal to $120,546. The ENDING CASH BALANCE of $2,366,880 ($2,246,334 + $120,546) is the CASH balance entered on the Pro Forma Position Statement (Exhibit A.4). Summing the subsections and sections results in the completion of the Pro Forma Position Statement.
The entire set of pro forma statements is now complete!
Decision Changes
The set of derived pro forma statements often will not conform to what was originally anticipated in terms of desired liquidity, performance, and company position. This occurs when:
• A problem's size is misestimated.
• The ability of a certain action to overcome the problem is misestimated
• The consequence of a given decision is not fully recognized in advance of making the pro forma statements.
The manager may decide to use a new set of decision inputs. A new set of pro forma statements is then needed to account for all the effects of a revised set of decisions. The old set of pro forma statements are unusable since they do not incorporate the revised set of decisions. Often the manager can incorporate most of the material derived in the original set of statements in constructing the new set. This is especially the case if the new set of decisions requires changes in only a few accounts and line items.
The set of decisions underlying the pro forma statements just prepared does not necessarily represent effective company management. The company has an excess of uninvested cash, fairly large inventories, and questionable capital budgeting decisions. The managers of the Exhibit A.7 decisions are also not seeking additional information on their firm and the
209
environment in which it operates. Additional information is not sought on estimates of future demand and price and the impact of some controllable decision variables. The firm with more information sooner in the game will operate in a world of more certainty and thereby face less risk in its decisions in future quarters.
Conclusion
Managers will have a more thorough understanding of the current and future position of their firm if pro forma financial statements are derived each quarter. The pro forma financial statements are the main planning and control device to provide managers with estimates of the effects of certain decisions on performance, position, and liquidity. A fairly comprehensive view of the firm is gained because environmental factors, previous company position, and the manager's tentative set of decisions are all combined to derive the pro forma statements.
The statements and schedules are maintained by managers who operate actual firms. Due to divergence among companies, the actual structure of the schedules and forms can be quite different from firm to firm. The information is needed to successfully plan and control the company.
210