Booker Jones Authors: Philip Larson Booker Jones – Philip Larson 1) Calculate the effect on the financial statements in Tables 1 and 2 if the accounting system were changed to incorporate the cost of barrels ($31.50 each) into the inventory accounts. a. What would pretax profit be in 1961? Booker Jones “other operating costs” increased from 1960 to 1961 primarily because of the cost of the barrels used, the occupancy costs and the warehousing costs. This is understandable because Booker Jones decided to increase production which would require 20,000 more barrels. If the cost of barrels is $31.50, then these 20,000 barrels would have cost $630,000. This is precisely why the cost of barrels used went up from 1960 to 1961. If these barrels were not considered an “Other Operating Cost” but instead were considered to be inventory as an asset. It would be taken off the income statement and would only be put back on when the whisky was sold years later. Then, the barrels would be a cost of whisky sold rather than “other operating costs”. As a result of taking this off the income statement, the net profit before tax would be $630k-407k = $223k. b. If the change were made retroactively as of July 1, 1959 (by adding the cost of barrels to all whiskey in inventory), what would be the effect on i. The balance sheet at the end of 1960? If the change were made retroactively in 1959, then the 1960 balance sheet would look different. Basically, the balance sheet in 1959 wouldn’t show any inventory for barrels while the 1960 balance sheet would account for all the barrels in inventory. As of July 31, 1959 the number of barrels of whisky were 172,000 at a cost of $31.5 for a total inventory of $5.4M. Therefore, the 1960 balance sheet would see inventory go up by $5.4M. Since this asset class would go up with no corresponding increase in liabilities, shareholders equity would increase by the same amount. ii. The balance sheet at the end of 1961? In 1961, as discussed, Booker Jones would increase the number of barrels in inventory from 172,000 to 192,000 per the statement of operations. Assuming that aside from the increase in production that the number of barrels in inventory stays constant, this would lead to a barrel inventory of 192000*$31.5 = $6.05M. This would make the total inventory go up $6.05M and would go up by this amount as well. iii. The operating statement for 1960? The retroactive change would have “no effect” on the income statement of 1960. The calculations required for question 1 are not massive (it takes more thinking than pencil‐pushing). Working those calculations will help solidify your understanding of the relationship between inventory and cost of goods sold in a manufacturing company. You’ll know you’re on the right track if you conclude that the answer to part b(3) is “no effect.” 2) Do you believe that Jones went from a profit in 1960 to a loss for 1961, despite the fact that sales were the same and production increased? I do not belief Jones went from a profit to a loss from 1960 to 1961. Jones is simply investing in his future business by increasing production today so that he can increase his revenue a few years down the line. If he had decided not to increase production, his profits would have been very comparable to the year before. Therefore, he chose to invest at a time when he had ample cash in the bank, increasing receivables, etc. Nothing has really changed except a strategic decision to increase production in the hopes of chasing future sales numbers. 3) What method of accounting would you recommend that Jones use in preparing the annual financial statements for submission to Ridgeview Bank and the family shareholders? Booker Jones – Philip Larson Jones should capitalize the barrels and put them in inventory. This makes the financial accounting numbers look more palatable because the loss changes to a profit and it is arguably a better reflection of the business’s economics. 4) Based on the accounting method you think best approximates “economic reality,” calculate the Return on Equity for the business for 1960. How are they doing? Are they earning their cost of capital? Return on Equity = Net Income/Shareholder's Equity Net income in 1960 is $462,000 and shareholder’s equity is the common stock plus the retained earnings (1,800,000 + 3,256,000. Therefore, return on equity = 9.14%. This return on equity seems to be pretty decent. For most of the twentieth century, the S&P 500, a measure of the biggest and best public companies in America, averaged ROE's of 10% to 15%. In the 1990's, the average return on equity was in excess of 20%. So by those measures, I suppose the 9% isn’t that great. I’m not sure what their cost of capital is so it is difficult for me to say whether they are earning their cost of capital. It is suggested that you spend no more than one half your preparation time on Questions one through four. 5) Can you estimate the cash flows for the business for 1961? What about for the 3 year period, 1962, 1963, 1964, combined? (Assume Jones does not change its tax accounting method.) Now, so what? 6) Can you estimate the economic return for the expansion decision? I’m not sure how to do this. I struggled with a number of approaches but did not get very far. Booker Jones – Philip Larson 7) Is the loan to expand production “bankable?” That is, do you believe Ridgeview Bank should be willing to lend Booker Jones the money they need now to complete the four year inventory buildup? I think this loan should be “bankable. The company has a strong history of profits and therefore will be unlikely to default. They have a number of assets that could be liquidated if necessary to pay back the loan including the barrels, the whisky, the buildings and equipment, etc. The current manager successfully doubled sales in 10 years. 8) What recommendations do you have for Mr. Jones regarding the business problems he faces (product positioning; production expansion; capital structure; working capital management; etc.)? Jones’ product positioning appears to be solid. He manages a single rand that is well known in the industry. The market for straight bourbon whisky appears to be growing rapidly which supports the decision to increase production. I recommend that Mr. Jones continue with production expansion but change the way that he reports the barrels from expensing them to capitalizing them and including them on inventory which will increase the likelihood that he can secure the loans he needs to move forward. Preparation Hint: This is a very rich case which begins with an important question about accounting policy choices for financial reporting. There are many other important issues in the case as well. Don’t stop with the accounting policy issues. How many other issues do you see? Do you see why we consider this more a comprehensive business policy case than an accounting case?