Merrimack Tractors

5 Pages   |   2,118 Words

1)What are the issues the CEO is facing; I.E.; what are his concerns? 

Merrimack Tractors and mowers is a company that makes large commercial mowers. Initially it had its own manufacturing plant in Nashua but later as time passed and developments occurred and outsourcing the manufacturing plant became a better option it was adopted. The basic reason to go by it was the cost cutting benefit it provided. The company began importing the mowers from China and itself specialized as a machine part designer and distributor. The labor costs were quite low. Though the shipping costs were considerable yet they were comparatively much lower than the variable costs the company had to bare if the manufacturing plant and continued its operations. This cost cutting gave them a great benefit to price competitively in its market where there were huge Multinational competitors.
In 2008 the macroeconomic scenario began to change becoming unfavorable for Merrimack. The costs (energy and labor) began to rise because of economic development. The growing economy of China led to the appreciation of its currency (Yuan) in comparison to the United States dollar. Therefore the suppliers began to charge more. The shipping costs hiked due to drastic inflation in oil prices. With the sales remaining at the same level and costs continuously rising deteriorated the company’s position. On the other hand the competitors were in increasing profits. The reason backing it was the same of depreciation of Dollar in the Asian market which was the target market in which they competed. The stakeholders pressurized the Chief Executive Officer to make the earnings grow irrespective of anything. Moreover his position itself was at stake and he desperately needed a solution to secure it.
 

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The three solutions presented were analyzed. First to open the manufacturing plant in Nashua again but it required huge initial investment and in such depressing incomes that was not possible. Second they could change the supplier which if adopted at this time would put pressure on earnings more. The third solution which was suggested by the Chief Financial Officer was to change the accounting principle of inventory accounting from Last in First out (LIFO) to First in First out (FIFO). The Chief Executive Officer had concerns about this too as he could not understand that how just changing an accounting principle could be a solution.
So the concerns of the Chief Executive Officer are as follows: 1) he has to fully understand the idea which was based on changing the method of accounting for inventories of tractors, mowers and parts, 2) he has to make sure that they make no violation by changing the rules of accounting to increase reported income and finally 3) get appropriate additional disclosures made in the notes of the financial statements explaining why it was changing its method of accounting for inventory.
Now Chief Executive Officer has the task at hand to improve the company’s earnings and that is his major concern. He has to make sure that whatever solution he comes up with does not hinder company’s future growth. It should not create financial problems in later years.
 

1)Explain the effect of what the CFO is suggesting on

The financial statements
The users of the financial information
Currently the company is using Last in First out (LIFO) inventory valuation method for both financial reporting and tax purposes. It effect on the balance sheet is that the inventory is reported in past price as the company holds the oldest inventory it had bought. Therefore inventory carries a low value and therefore less total assets. On the other hand the cost of good sold have a high figure as it is the product of the current price into the units of inventory. High cost of goods sold lead to low pretax income resulting in less income tax expense. It lowers the income tax liability and delays paying taxes. The company has taken advantage of this tax reduction since 1980.
Now if they shift to first in first out (FIFO) inventory adjustment. Then this will affect all the financial statements. The two basic results will be (1) an increase in inventory, (2) an increase in pretax income resulting in an increase of income tax expense. The inventory reported in the balance sheet will carry a high value as the recently purchased inventory is kept in stock and the earlier purchased one is sold. This will result in higher total assets for the year 2007. Increase in the liabilities will also occur due to income tax liability. This will also effect the cash flow statement where increase in income tax liability causes cash from operations to increase. On the other hand in the income statement the cost of goods sold will have a low amount as earlier purchased inventory is sold out. It leads to greater pre-tax income and finally greater income tax expense.
When a company changes its accounting principle from Last in First out (LIFO) to first in first out (FIFO) then according to Generally Accepted Accounting Principles (GAAP) standards it has to present its previous year’s financial statements again showing a retrospective change. This will lead to revaluation of the inventory which is 5.5 million (Last in First out (LIFO) reserve given in the case study). Moreover an adjustment to retained earnings would have to be made to balance the effect of the increase in net income. It will also cause an immediate $2 million income tax liability. So Merrimack has to make this payment to fill up the liability. But it is not preferred as it is not good for the company to expense out the entire $2 million in one year. Its better they use the capitalization approach and account the change over a number of years which keep their income positive. This is only possible if IRS grants permission (Internal Revenue Service).
If we analyze this scenario in numerical terms it would be approximately be like this. In mathematical terms, first of all if we assume that the sales and expenses figures of 2007 remains same for 2008 except cost of goods sold and taxes then we can estimate a figure for net income. Using the last in first out (LIFO) method makes the cost of goods sold for year 2008 as $62000 resulting in negative $5000 earnings before taxes and finally a negative net income. This will totally disrupt the outlook of the firm. The inventory reported in the balance sheet would be $13500. Therefore total assets will be less reflecting a small asset size firm. On the other hand in the first in first out (FIFO) method is used then the cost of goods sold for the year 2008 is $50500 which gives a positive earnings before tax with $2275 as tax expense and a positive net income which is a lot better for the firm in comparison to a negative number.
To include this change the previous statements will affect all the three major financial statements of the firm: the income statement, balance sheet and the cash flow statement. The year 2007 statement of income shows a $46000 cost of goods sold with income taxes of $3850. As Merrimack have previously used the last in first out (LIFO) method for both the financial reporting and tax purposes therefore the have paid this amount of $3850 in taxes. The resulting net income is $7150. If the year 2007 is made in terms of first in first out (FIFO) method then cost of goods sold goes down by the amount of last in first out (LIFO) reserve that is $5500 leads to an increased pretax income of $16500. The difference between the tax expense incurred due to first in first out method in 2007 and that which has been paid under last in first out (LIFO) method in 2007 creates an income tax liability of $1925 in year 2007. This appears as an increase in liabilities in the balance sheet. The inventory is also revalued at $19000 and finally the increase in net income due to the accounting principle change is adjusted in the retained earnings of $3757.
All these adjustments give a balanced balance sheet. All the previous cash flow statements are effected too. The increase in inventory of $5500 leads to a reduction in cash by the same amount. An increase in the income tax liability of $1925 increases cash by the same amount. These changes affect the cash flow from operations. So finally making changes in all the previous years’ financial statements since 1980 will bring in a cumulative effect of $5.5 million revaluation of inventory and $2 million of income tax liability.
The company will get the issue of low income resolved by adopting this accounting principle. A high income would result in higher profitability and liquidity ratios. Many of a firm’s ratios are directly affected by its choice of inventory cost flow method. The increase in net income will cause the earning per share to increase making it quite profitable for the existing shareholders and also the potential investors. Moreover the return on equity (ROE) and return on assets (ROA) both are profitability ratios which have net income in its numerator. So greater the net income the higher these ratios will become. A decrease in cost of goods sold will result in higher gross operating and net operating margins as compared to Last in First out (LIFO).
Compared to Last in First out (LIFO), first in first out (FIFO) results in a higher inventory value on the balance sheet. As inventory (a current asset) is higher in first in first out (FIFO), the current ratio, a popular measure of liquidity is also higher under first in first out (FIFO) than under Last in First out (LIFO). Working capital is higher in first in first out (FIFO) because current assets are higher. The creditors will find it as a healthy company who has good liquidity position and can easily pay off debt. On the other hand financial institutions can extend loans to them on easy terms and lax debt covenants if they later plan to put up a manufacturing plant which at this point in time is not feasible.

2)Write up the above along with your decision as to what should be done for hand-in and be prepared to discuss.

 In my opinion it is a good time to change the accounting principle from Last in First out (LIFO) to first in first out (FIFO). Initially Merrimack is not a company which rapidly evolves with technology or is a fast moving consumer good therefore the use of first in first out (FIFO) method suits it best. Moreover it is good way of showing a positive net income supported by healthy ratios to temporarily adjust in the changing macroeconomics conditions.
But they have to be quite careful in the income tax liability portion. Though it is true that it is not an additional cost rather was just a tax delay advantage by the timings of payment and had to be paid anyway at liquidation but still if the entire $2 million is expensed in a year it will lower net income and cash flow from operations drastically. These two measures (net income and cash flow from operations) are those which are closely monitored by the users of financial statements. Net income is used to calculate the earnings per share (EPS) which is important to be maintained to keep the shareholders happy and satisfied.  Greater net income by first in first out method (FIFO) will therefore lead to greater earnings per share (EPS). Less net income by last in first out method (LIFO) will therefore lead to less earnings per share (EPS).
It is better if the liability is capitalized over a few years equally. Therefore they should try taking permission of Internal Revenue Service (IRS). This will cause smoother earnings through out the years and furthermore would earn them time to find a way to permanently deal with the problems arising from the changing global situation.

Appendix
  2007 (LIFO) 2007 (FIFO) CHANGE       2007 (LIFO) 2007 (FIFO)
sales 67000 67000 0          
cogs 46000 40500 -5500     cogs 46000 40500
gross margin 21000 26500       ENDING INV 13500 19000
S&GA 10000 10000 0          
income before taxes 11000 16500            
Income taxes (35%) 3850 5775 1925     income tax liability 0 1925
net income 7150 10725 3575     adjustment in retained earnings 0 3575
 
income statement (thousand of dollars)              
  2008 (LIFO) 2008 (FIFO) CHANGE       2008 (LIFO) 2008 (FIFO)
sales 67000 67000 0     cogs 62000 50500
cogs 62000 50500 -11500     END INV 13500 25000
gross margin 5000 16500            
S&GA 10000 10000 0          
income before taxes -5000 6500            
Income taxes (35%) 1750 2275 525          
Net income -6750 4225 10975          

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