Rawhide Brewery

5 Pages   |   1,645 Words

Accounting Implications of Proposal #1

The first proposal put forward by Upson will raise the manufacturing output of Rawhide. The increase in manufactured units will be attributed to the sales made to Tabby. This outsourced project can have vital implications for the firm. Let’s look at them one by one.

Effects on Balance Sheet

The payment terms are not explicitly mentioned. However, it can be assumed that the A/R of Rawhide can increase a little bit. But the possibility of default from this creditor is very remote because of its viable financial position. The capital structure of the company will remain the same. However, inventory turnover will be affected as now Rawhide has to make sure that the demand from the Tabby perspective is met, and it may maintain a high inventory to cater for this need. If inventory holding is increased, the current ratio of the company will also increase.

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Effects on Income Statement

Income statement will be effected in many ways. Firstly, the revenues of the company will increase. Secondly, the exact cost implications for Rawhide are not cited. Therefore, depending upon the nature of cost structure (labour, material and overhead), the gross margin ratio of the company can alter. If Rawhide offers low margin on these new outsourced sales, the relative profitability of the company will decrease. If you keep the assets and the equity constant, these sales can possibly negatively affect various key ratios including ROA, ROE, gross margin and ROCE etc.

Effects on Cash flow Statement

There will not be any disposal or addition of assets in the current situation as it is assumed that the current plant can cater to the needs of the increased sales. However, depending on the credit policy of Rawhide towards Tabby, the operating cash flow of the company can either increase or decrease.

Accounting Implications of Proposal #2

The second proposal encompasses the creation of special purpose entity or SPE. As Newco will be a subsidiary of Rawhide, therefore, the accounts of the subsidiary will be merged with Rawhide at the end of the year. Hence, at the end of the year, the net change in financial statement will not be immense. As a group, the ratios may or may not change. However, as a single entity, Rawhide will see extensive reshuffling in the financial statements. The following effects are measured on an individual basis without taking into account the financial statements of the subsidiary. The accounting implications of this proposal are as follows:

Effects on Balance Sheet

Total assets and the debt level of Rawhide would decrease. Major portion of Rawhide 'property, plant and equipment' will be transferred to Newco. Let’s assume that Rawhide employs fair value accounting and also that the current carrying cost of property, plant and equipment is equal to its current fair market value. In that case, the PP&E will be reduced to $775000. At the same time due to long-term note receivable, the non-current assets of the company will increase by $1500000. The net decrease in assets will be equal to $3500000. This is equal to the value of debt that will be removed from the balance sheet of Rawhide and transferred to Newco. After this transaction, Rawhide will be an all equity firm with debt to equity ratio of 0. As the cost of production will either remain the same or it will decrease, it can be safely assumed that ROA and ROE will be increased to quite an extent in the next five years. There will not be any change in way inventory is valued as the cost will remain almost the same. The company will also report a $50000 minority interest in the equity section. The company will also have to create a special account of investments in subsidiary or associates. On the equity section of the balance sheet, the company will also report this investment in the equity capital and raise it by $950000.

Effects on Income Statement

This proposal also affects Income statement in many ways. First of all, as full plant capacity will be utilized, the fixed costs can decrease. Let’s assume that the prices are constant. This decrease in cost will yield a comparatively high gross margin. Depreciation expense will decrease to just $56000. The implied tax rate is 32.9% (79/240). With this rate and a $365000 decrease in depreciation, company has to pay an additional tax of $119982. The interest rate will also decrease. Due to the removal of interest expense, the Company will have to pay additional tax of $743916 in its income statement.  Additionally, any income from Newco will also be added on the income statement. Firstly, the interest income from Newco will be added to company’s balance sheet. Secondly, the portion of profits from Newco will also be added to the income statement. In the case of a loss from the Newco, the net income of Rawhide will also decrease because of accounts consolidation.

Effects on Cash Flow Statement

Due to a huge decrease in depreciation, company will be reporting a massive decrease in its income from operating cash flows. Even though Rawhide guarantees the long term debt of Newco, it will not appear on the individual balance sheet of Rawhide. The long term debt can be considered as being paid because the debt has been transferred with full privileges to the new special purpose entity. Therefore, this payment of the long term debt will increase the cash flow from financing activities to $3.5 million.

Accounting Implications of Proposal #3

In this case, the treatment of entity depends on the level of control of Rawhide over Newco. If the decision to control the board of the company remains with Rawhide, it will be a subsidiary. However, if all the decisions are sought out together, then practically Newco will not be a subsidiary due to lack of control. However, for the purpose of this analysis, it is assumed that consensus will only be required in small matters, not in the board selection. Therefore, in regard with the assumption, Newco qualifies as a subsidiary of Rawhide.

Effects on Balance Sheet

The effects on the balance sheet will be identical as in the proposal # 21 with the exception of three accounts. The minority interest, equity section and associate’s investment will be altered. Now a large portion of minority interest will be written down in the equity section. Also, the total investment in associate will amount to $2500000.

Effects on Income Statement

The effects on the income statement will also be replicating the results of the previous proposal. The company will pay more taxes due to decrease in depreciation and interest expense.  However, there will be a slight difference. Rawhide will only be the recipient of 60% of net income of Newco. The rest of 40% will be going to Tabby.

Effects on Cash Flow Statement

Cash flow statement will also be the same as it was in the previous case. The operating and financing cash flows will decrease and increase respectively.

Which Option is the Most Feasible

If the deal 2 is carried out with the prevalent terms, Rawhide will be the sole decision maker of the activities and issues of Newco. Therefore, it can control the financial and non financial activities of its leading competitor, Tabby. On the other hand, in the 3rd proposal, Newco will still be the subsidiary of Rawhide. But the decision making capabilities of Rawhide will be limited. In the case of a dispute, Tabby can effectively ‘veto’ or nullify the decision. In the first proposal, the company can increase its revenues without altering its financial statements to a great extent. However, considering the fact that the current debt to equity ratio of Rawhide is very high, option 2 or three will be feasible. Rawhide can also stick to the third proposal only if Tabby changes its criteria of ‘joint decision making’. Neither option 2 nor option 3 will be feasible if Rawhide don’t have the majority power.

GAAP Constraints Related to Case

The international financial reporting standards and the local FRS in the UK are mostly similar in their treatment with a certain type of transactions and events. However, in certain cases they differ from each other. In the case of a subsidiary, the IAS 27 states that if dominant control is not clear or obvious in the situation, then, the relevant entity is not a subsidiary of the concerned parent organization. On the other hand, according to FRS 2, ‘Accounting for subsidiary undertakings’, this measure is only applied when the need of control or voting rights is exercised. In this respect, Rawhide can record a subsidiary in its financial statements, in scenario 3 in which, in spite of the high voting rights, its control over the subsidiary was limited. In the current case, the scenario 3 is dubious in the sense of the real parent of the entity. AT the same time, FRS 2 states clearly that, in the case where severe long term restrictions hinder and obstruct the ability of a company to control the assets or management of the subsidiary, the subsidiary should not be consolidated into parents account. If someone takes into consideration this criterion, neither Rawhide nor Tabby is the parent of the newly created subsidiary, Newco. Therefore, essentially, Newco appears to be an independent entity with no one party to control its decisions. This constraint criterion put forward by the GAAP is problematic in the current scenario. If this rule is followed, then, neither of the companies will report a subsidiary on the balance sheet. This problem can be solved in only one way. The control over the entity, its assets and management, should clearly be delegated to one party. In this way, either Rawhide or Tabby will appear out as the real owner, i.e., parent, and the other one will have a minority interest.

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