SECTION A
1.1 Describe how common-size financial statements can be used to evaluate a firm's
financial performance.
Common-size financial statements can be used to evaluate a firm's financial
performance by allowing the user to look at trends and the organization's potential
for future growth and by comparing financial statements from various time
periods. The percentages from two or more years are compared to assess financial
stability, income usage, and cash flow. It may also give insight into companies'
strategies. If a company wants to gain more market share, it can be prepared to
sacrifice margins in order to increase total sales at the expense of operating, net or
gross profit margins. Ideally, a firm that targets lower margins would have quicker
growth. Comparing the financial accounts of different companies and industries
becomes considerably simpler with the help of vertical analysis. This is due to the fact
that account balance proportions are visible. In time series analysis, where quarterly
and yearly numbers are compared across several years to obtain an understanding of
whether performance indicators are increasing or declining, it also facilitates the
comparison of prior periods. Meanwhile, investors and analysts can identify trends
and growth patterns by using horizontal analysis to determine what has been driving
a company's financial success over a period of years. Analysts can evaluate the
relative changes in various line items over time and project them into the future with
this kind of analysis. A thorough understanding of operational outcomes may be
obtained by analyzing the cash flow, balance sheet and income statements over time.
This analysis also shows the factors that influence a company's performance and
helps determine if it is running profitably and efficiently.
1.2-1.3 Analyze the common-size income statements, commenting on percentages
for individual years as well as trends over the three-year period.
Revenue
Total Net
Sales
Cost
of
Sales
Gross Profit
Operating
Expenses
Technology
and
Content
12/31/20
17
Percen
t
12/31/20
16
Percen
t
12/31/20
15
Percen
t
$177,866
100.0%
$135,987
100.0%
$107,006
100.0%
111,934
62.9%
88,265
64.9%
71,651
67.0%
$65,932
37.1%
$47,722
35.1%
$35,355
33.0%
$22,620
12.7%
$16,085
11.8%
$12,540
11.7%
Selling,
General and
38,992
21.9%
27,284
20.1%
20,411
19.1%
Administrat
ive
Other
Operating
214
0.1%
167
0.1%
171
0.2%
Expenses
Total
Operating
61,826
34.8%
43,536
32.0%
33,122
31.0%
Expenses
Operating
Income
$4,106
2.3%
$4,186
3.1%
$2,233
2.1%
(Loss)
Interest
Expense,
300
0.2%
294
0.2%
665
0.6%
net
Income
3,806
2.1%
3,892
2.9%
1,568
1.5%
Before Tax
Income Tax
773
0.4%
1,521
1.1%
972
0.9%
Expense
Net Income
(Loss) from
$3,033
1.7%
$2,371
1.7%
$596
0.6%
Continuing
Operations
We can see from the common-size income statement that for the three-year
period, Amazon.com's largest expense is cost of sales, roughly two-thirds of sales.
Though cost of sales is large, Amazon.com has done a good job of controlling the cost
over the three-year period. Cost of sales has gone from just under 67% of sales in
2015 to just under 63% of sales in 2017, increasing gross profit from 33% of sales to
37% of sales in the same period.
Although gross profit has increased, both operating income and net income
from continuing operations are essentially flat for the three-year period. Operating
income went from 2.09% to 3.08% to 2.31% of sales from 2015 to 2017, while net
income from continuing operations went from 0.56% to 1.74% to 1.71% of sales over
the same period. This can be attributed to the increase in operating expenses over
the three-year period. While technology and content has increased modestly over the
time period, the largest increase is in selling, general and administrative expenses,
increasing from 19% of sales in 2015 to just under 22% of sales in 2017.
During the three-year period, Amazon.com decreased its interest expense
as a percent of sales for each year. Amazon.com's income tax expense is a very low
percentage of sales for each year of the three-year period.
Stockholders' Equity
Period Ending
12/31/20
17
Perce
nt
12/31/20
16
Perce
nt
12/31/20
15
Perce
nt
$20,522
15.6%
$19,334
23.2%
$15,890
24.3%
10,464
8.0%
6,647
8.0%
3,918
6.0%
13,164
10.0%
8,339
10.0%
6,423
9.8%
16,047
12.2%
11,461
13.7%
10,243
15.7%
$60,197
45.8%
$45,781
54.9%
$36,474
55.7%
48,866
37.2%
29,114
34.9%
21,838
33.4%
13,350
10.2%
3,784
4.5%
3,759
5.7%
8,897
6.8%
4,723
5.7%
3,373
5.2%
$131,310
100.0
%
$83,402
100.0
%
$65,444
100.0
%
$34,616
26.4%
$25,309
30.3%
$20,397
31.2%
18,170
13.8%
13,739
16.5%
10,384
15.9%
5,097
3.9%
4,768
5.7%
3,118
4.8%
$57,883
44.1%
$43,816
52.5%
$33,899
51.8%
24,743
18.8%
7,694
9.2%
8,235
12.6%
20,975
16.0%
12,607
15.1%
9,926
15.2%
$103,601
78.9%
$64,117
76.9%
$52,060
79.5%
Current Assets
Cash
and
Cash
Equivalents
Market
able Securities
Net
Receivables
Invento
ry
Total Current
Assets
Propert
y, Plant and
Equipment, net
Goodwil
l
Other
Assets
Total Assets
Liabilities and Equity
Current Liabilities
Account
s Payable
Accrued
Expenses and
Other
Unearn
ed Revenue
Total Current
Liabilities
Long
Term Debt
Other
Liabilities
Total Liabilities
Common Stock
$5
0.0%
$5
0.0%
$5
0.0%
Retained
Earnings
Treasury Stock
8,636
6.6%
4,916
5.9%
2,545
3.9%
-1,837
-1.4%
-1,837
-2.2%
-1,837
-2.8%
Additional Paid- 21,389
16.3% 17,186
20.6% 13,394
20.5%
in Capital
Other
-484
-0.4% -985
-1.2% -723
-1.1%
Stockholder
Equity
Total
$27,709
21.1% $19,285
23.1% $13,384
20.5%
Stockholder
Equity
Total Liabilities $131,310 100.0 $83,402
100.0 $65,444
100.0
and
%
%
%
Stockholder
Equity
In current assets, the cash and cash equivalents have decreased in the
percentage from 2015 to 2017, suggesting a reduction in liquidity. The marketable
securities' percentage has increased. The net receivables increase in the percentage,
possibly due to improved receivables management. The inventory's percentage has
decreased, which may signify better inventory management. Current assets have
decreased, with varying trends in cash, marketable securities, receivables and
inventory from 2015 to 2017. The property, plant and equipment (PPE),
net's percentage has increased, indicating a larger proportion of total assets invested
in PPE. There is a substantial increase in the percentage of goodwill. The percentage
of other assets has increased, indicating a higher proportion of other assets within
the total assets. The company has experienced growth in total assets, driven by
increases in PPE, goodwill and other assets. Meanwhile, the percentage of accounts
payable has decreased, indicating better management. The percentage of accrued
expenses and other has decreased, reflecting potential improvements in expense
management. The unearned revenue's percentage has decreased, possibly due to
changes in revenue recognition. Current liabilities have decreased as a percentage of
total liabilities, indicating potential improvements in short-term obligations
management. Long-term debt has increased as a percentage of total liabilities,
suggesting a shift in the capital structure towards more long-term financing. The
percentage of other liabilities has also increased. This means that the percentage of
total liabilities has increased, primarily driven by higher long-term debt and other
liabilities. In stockholders' equity, the retained earnings' percentage has increased.
This means that the net income is stable and the company is growing and most
successful in 2017. The additional paid-in capital's percentage is not stable since it
has increased in 2016 then decreased in 2017. Thus, stockholders' equity is not stable,
driven by increases in retained earnings and decreases in additional paid-in capital.
The percentage of total liabilities and stockholder equity has increased, reflecting the
overall growth in both liabilities and equity. In general, this analysis highlights areas
of strength and possible areas for development while offering insights into how the
balance sheet's composition changed over the course of the three-year period.
Define the concepts of liquidity and solvency. How are the concepts similar and
different?
The capacity of a business to quickly convert its assets into cash without incurring
large losses is referred to as liquidity. It measures a company's ability to pay shortterm debts quickly and effectively. Marketable securities, cash equivalents, cash, and
accounts receivable are examples of liquid assets. Repaying short-term loans,
meeting daily operating expenses, and taking advantage of investment possibilities
all depend on a company's ability to maintain sufficient liquidity. The quick and
current ratios are two examples of liquidity ratios that are frequently used to
evaluate a company's liquidity. Meanwhile, a company's solvency refers to its
capacity to fulfill its long-term financial commitments, such as paying off all of its
loans and other long-term responsibilities. It evaluates a company's long-term
viability and overall financial health. Metrics like the debt-to-equity ratio and interest
coverage ratio are frequently used to assess solvency. For a business to be viable in
the long run, it must be stable. It shows if a company can afford to pay off its longterm obligations, withstand economic downturns, and sustain expansion without
having to rely too heavily on borrowed funds. In conclusion, the concepts of solvency
and liquidity both pertain to the financial well-being of an organization. They evaluate
a company's capacity to pay its debts, although over varying periods of time. When
evaluating the risk connected to a company's financial situation, both concepts are
crucial. While insolvency poses a serious threat to the company's survival, a shortage
of liquidity might cause temporary financial difficulty. Financial ratios are frequently
used to measure liquidity and solvency.
Calculate the current ratio, quick ratio, cash ratio, cash flow ratio and net working
capital ratio for both Walmart Inc. and TJX Companies.
Selected financial information for Walmart Inc. and TJX Companies follow.
The Walmart Inc. balance sheet 1/31/2018 (partial) and selected financial
information (all numbers in thousands) is shown here.
Current Assets
Cash
and
Equivalents
Cash
$ 6,756,000
Current Liabilities
Accounts Payable
$46,092,000
Short-Term Investments
0
Net Receivables
5,614,000
Inventory
43,473,000
Other Current Assets
Total Current Assets
Other Information
Operating Cash Flow
Total Assets
132,000
$55,975,000
Short/Current LongTerm Debt
Other
Current
Liabilities
Total
Current
Liabilities
46,673,000
2,662,000
$95,427,000
$28,894,000
$202,712,000
Walmart Inc.
Interpret the ratios computed in the following:
Current Ratio = current assets/current liabilities
= $55,975,000/$95,427,000
= .59:1
Quick Ratio = (cash + marketable securities + accounts receivable)/current liabilities
= ($6,756,000 + 0 + 5,614,000/$95,427,000
= .13:1
Cash Ratio = (cash + marketable securities)/current liabilities
= ($6,756,000 + 0)/$95,427,000
=.07:1
Net Working Capital Ratio = (current assets – current liabilities)/total assets
= ($55,975,000 - $95,427,000)/$202,712,000
= -19.5%
1. Current Ratio = 0.59:1
The current ratio is a measure of a company's short-term liquidity, indicating its
ability to cover immediate obligations with current assets. A current ratio of 0.59:1
suggests that the company has $0.59 in current assets for every $1 in current
liabilities. A current ratio below 1 indicates potential liquidity concerns, as the
company may face challenges meeting its short-term obligations.
2. Quick Ratio = 0.13:1
The quick ratio, also known as the acid-test ratio, is a stricter measure of liquidity
that excludes inventory from current assets. A quick ratio of 0.13:1 indicates that
the company has only $0.13 in highly liquid assets for every $1 in current
liabilities. A low quick ratio suggests a limited ability to cover short-term obligations
without relying on the sale of inventory.
3. Cash Ratio = 0.07:1
The cash ratio is an even more strict measure that focuses only on cash and
marketable securities. A cash ratio of 0.07:1 indicates that the company has $0.07
in cash and marketable securities for every $1 in current liabilities. A very low cash
ratio suggests a high dependency on non-cash current assets to cover short-term
obligations.
4. Net Working Capital Ratio = -19.5%
The net working capital ratio measures the efficiency of capital utilization and is
expressed as a percentage. A negative net working capital ratio of -19.5% indicates
that current liabilities exceed current assets, suggesting potential financial stress. A
negative net working capital ratio may signal a need for improved working capital
management and it could indicate potential difficulties in meeting short-term
obligations.
The ratios collectively suggest that the company may be facing challenges in terms
of liquidity and working capital management. The current ratio, quick ratio and cash
ratio are all below 1, indicating potential difficulty in covering short-term
obligations.
The TJX Companies balance sheet 2/3/2018 (partial) and selected financial
information (all numbers in thousands) is shown here.
Current Assets
Cash
and
Cash
Equivalents
Short-Term Investments
$2,758,477
506,165
Net Receivables
327,166
Inventory
4,187,243
Other Current Assets
Total Current Assets
Other Information
Operating Cash Flow
Total Assets
2,217
$7,791,268
Current Liabilities
Accounts Payable
Short/Current LongTerm Debt
Other
Current
Liabilities
Total
Current
Liabilities
$2,488,373
2,452,524
1,428,136
$6,369,033
$3,120,116
$13,370,114
TJX Companies
Current Ratio = current assets/current liabilities
= $7,791,268/$6,369,033
= 1.22:1
Quick Ratio = (cash + marketable securities + accounts receivable)/current liabilities
= ($2,758,477 + 506,165 + 327,166/$6,369,033
= .56:1
Cash Ratio = (cash + marketable securities)/current liabilities
= ($2,758,477 + 506,165)/$ 6,369,033
= .51:1
Net Working Capital Ratio = (current assets – current liabilities)/total assets
= ($7,791,268 – $6,369,033)/ $13,370,114
= 10.6%
1. Current Ratio = 1.22:1
For every $1 of current liabilities, the company has $1.22 in current assets. This
suggests that the company has more than enough short-term assets to cover its
short-term obligations, indicating a healthy liquidity position. A current ratio above
1 indicates that the company has a strong ability to meet its short-term obligations.
However, a very high current ratio may also suggest that the company has excessive
idle assets that could be invested more efficiently.
2. Quick Ratio = 0.56:1
For every $1 of current liabilities, the company has $0.56 in highly liquid assets
(cash, marketable securities and accounts receivable). This ratio provides a more
conservative measure of liquidity, excluding inventory. A quick ratio below 1
indicates potential difficulty in meeting short-term obligations without relying on
selling inventory. It is important to assess whether the industry and business model
justify a lower quick ratio.
3. Cash Ratio = 0.51:1
For every $1 of current liabilities, the company has $0.51 in the most liquid assets
(cash and marketable securities). This ratio is even more conservative than the quick
ratio. A cash ratio below 1 suggests a relatively lower level of liquidity. It may
indicate a need for careful management of short-term obligations, especially in the
absence of readily available cash.
4. Net Working Capital Ratio = 10.6%
Net working capital, expressed as a percentage of total assets, is 10.6%. This ratio
indicates the proportion of total assets represented by net working capital (current
assets minus current liabilities). A positive net working capital ratio is generally
considered favorable as it implies that the company has more current assets than
current liabilities. The 10.6% figure suggests a reasonable proportion of working
capital within the total asset mix.
The company appears to have a sound liquidity position, as indicated by the current
ratio exceeding 1. The quick ratio and cash ratio, while lower, still provide a
reasonable level of liquidity, although caution may be needed to manage short-term
obligations effectively. The positive net working capital ratio suggests that the
company is contributing positively to the overall financial health.
In general, TJX Companies' current, quick and cash ratios are higher than
Walmart Inc.'s which suggests that it has a healthier short-term liquidity position
compared to Walmart Inc. Walmart Inc.'s lower quick, cash and current ratios suggest
that it may have trouble fulfilling its short-term obligations. TJX has positive net
working capital, while Walmart has a negative net working capital ratio, further
emphasizing TJX's better short-term liquidity position and it has sufficient working
capital to cover its short-term obligations.
SECTION B
1. Define operating leverage and describe how the operating leverage created by
the expansion will affect the company’s return and business risk.
Operating leverage is the use of fixed operating costs by the firm to increase
profitability. Operating leverage affects the level and variability of the firm’s after-tax
earnings, and hence the overall risk and return of the firm. Operating leverage is
present any time a firm has fixed operating costs that don’t change as volume
changes. A change in the volume of sales results in a more than proportional change
in operating profit.
In this scenario, if the company opens more locations, it will have an increase
in sales without an increase in the fixed costs of the human resources, accounting,
information technology, and legal departments, so these fixed costs are leveraged
across more locations and should create a higher return, which lowers the firm’s risk.
2. Describe financial leverage.
Financial leverage is similar to operating leverage in that it uses fixed costs
to increase profitability. By borrowing or undertaking long-term leases, the company
is committed to paying these fixed financing costs. But if operating profits (e.g., EBIT)
are high enough to permit debt service or lease payments, remaining operating
profits flow to shareholders. The shareholders have less of their money at stake, as
some of the investment is paid for with borrowed money or is leased. Thus, the ROE
is high. But if operating income is not enough to cover debt service or lease payments,
the lenders can take control, wiping out the shareholders.
3. Define and identify two characteristics of common stock and preferred stock.
Common stocks are securities that represent the ultimate ownership and
risk position in a corporation. Their liability is restricted to the amount of their
investment. In the event of liquidation, these stockholders have a residual claim on
the assets of the company after the claims of all creditors and preferred stockholders
are settled in full. It has no maturity date, and shareholders can liquidate their
investments by selling their stocks in the secondary market. Common stock dividends
are not fixed or guaranteed; it is at the discretion of the company to offer them and
depends on various factors, such as profitability, cash sufficiency, and future
operating strategy. Common stock dividends are not tax deductible as interest or
lease payments.
Preferred stock is a hybrid form of financing, combining features of debt and
common stock. In the event of liquidation, preferred stockholders’ claim on assets
comes after that of creditors but before that of common stockholders. Preferred stock
carries a stipulated dividend; the actual payment of a dividend is a discretionary
rather than a fixed obligation of the company. The maximum return to preferred
stockholders is usually limited to the specified dividend and these stockholders do
not share in the residual earnings of the company. Most preferred stock is held by
corporate investors.
4. Describe the maturity, par value, and coupon rate for a bond.
A bond is a long-term debt instrument with a final maturity date, generally
it is 10 years or more.
The maturity is the time when the company is obligated to pay the
bondholder the par value of the bond.
The par value is the amount to be paid to the lender at the bond’s maturity.
Par value is also called face value or principal. Most bonds pay interest that is
calculated based on the bonds’ par value.
The coupon rate is the stated rate of interest on a bond. The indenture is the
legal agreement, also called the deed of trust, between the corporation issuing bonds
and the bondholders, establishing the terms of the bond issue and naming the
trustee.
5. Identify and explain one advantage and one disadvantage of raising capital
through common stock, preferred stock, and bonds.
Common stock does not have a maturity date or require a regular interest
payment. However, the cost of capital of common stock is generally higher than that
of a bond, and the current stockholders’ voting power will be diluted. If the company
is not publicly traded, an initial public offering is expensive, complex, and timeconsuming, and it will be subject to more regulations.
Preferred stock does not have a maturity date and will not dilute the current
shareholders’ voting power. However, the cost of capital of preferred stock is
generally higher than that of a bond and is not as attractive to investors.
Bonds generally have a lower cost of capital and have tax benefits on interest
payments. However, making regular interest payments can be a burden to the
company and there might be a bond covenant that prohibits the issuer from
undertaking certain activities or requires the issuer to meet specified requirements.
SECTION C
Define contribution margin and explain its significance.
Contribution margin is equal to sales minus all variable costs. Contribution
margin represents the portion of revenues that are available to cover fixed costs. It
can be expressed on a per-unit basis or as a ratio (percentage) of revenue.
Lettam Company manufactures plastic dolls that each sell for $15.00. Each
doll requires $1.60 in materials and 0.20 hours of labor. The average wage rate for
direct labor is $12.00 per hour. Variable overhead is $0.75 per unit while fixed
overhead is $4,200 per month. Variable selling and administrative costs are $1.25 per
unit, and fixed selling and administrative costs are $3,300 per month. Lettam
Company has hired a new staff accountant to help produce financial performance
reports and to set income targets.
1. Calculate the breakeven point in number of units per month.
The total labor cost per unit = 0.2 hours × $12 per hour = $2.40 per unit
The total variable cost per unit = $1.60 + $2.40 + $0.75 + $1.25 = $6.00 per unit
The total fixed cost = $4,200 + $3,300 = $7,500.
The breakeven point in number of units = fixed cost ÷ unit contribution margin
Unit contribution margin = selling price − total variable cost per unit = $15.00 − $6.00
= $9.00 per unit
Breakeven point in number of units = $7,500 ÷ 9.00 = 833.33 units, rounded to 834
units (always round up using CVP analysis)
2. Calculate the dollar sales needed to achieve a target income of $15,000 per
month.
Dollar sales to achieve a target income = (fixed cost + target income) ÷ contribution
margin percentage
Contribution margin percentage = (price − variable cost per unit) ÷ price
Contribution margin percentage = ($15 − $6) ÷ $15 = $9 ÷ $15 = 0.60
Dollar sales to achieve $15,000 income = ($7,500 + $15,000) ÷ 0.60 = $37,500
3. Define the concept of margin of safety. Then, calculate the margin of safety in
units if the firm was able to achieve the target income of $15,000 per month.
Margin of safety is the difference between the current sales level and the
breakeven point. That is, the margin of safety indicates how much sales volume (in
units) or revenue (in dollars) can decrease before operating income becomes
negative.
In this problem, at $15,000 in income, the firm would sell 2,500 units
($37,500 in sales from part C / $15 per unit sales price). The breakeven point in units
from part B was 834. Thus, the firm's margin of safety would be 2,500 minus 834 =
1,666 units.
Buckeye Grain, a corn and wheat processing company, has decided to
introduce a new product that can be manufactured by either a capital-intensive
method or a labor-intensive method. The method chosen will have no effect on the
quality of the finished product. Estimated costs for the two methods are as shown
here.
Capital-intensive
Labor-intensive
Direct raw materials per unit
$10.00
$11.20
Direct labor ($24/hour) per
12.00
14.40
unit
Variable overhead ($12/hour)
6.00
9.60
per unit
Total fixed costs
$4,880,000
$2,640,000
Buckeye Grain sells the new product at $60 per unit during its initial stage of
product lifecycle. The incremental selling expenses are estimated to be $1,000,000
annually plus $4 for each unit sold, regardless of the manufacturing method. Fixed
costs are all directly traceable incremental costs.
When deciding which manufacturing method to use, the company's
management team take into account the operating leverage.
1. Calculate the estimated breakeven point in annual unit sales of the new product
if the company uses the capital-intensive manufacturing method and laborintensive manufacturing method, respectively. Show your calculations.
Unit contribution margin:
Capital-intensive
Labor-intensive
Selling price
$60.00
$60.00
Less: Raw materials
10.00
11.20
Direct labor
12.00
14.40
Variable overhead
6.00
9.60
Variable selling
4.00
4.00
Contribution margin
$28.00
$20.80
Capital-Intensive Breakeven = ($4,880,000 + $1,000,000) ÷ $28.00 = 210,000 units
Labor-Intensive Breakeven = ($2,640,000 + $1,000,000) ÷ $20.80 = 175,000 units
SECTION D
2. Calculate the annual unit sales volume at which the company would be
indifferent between the two manufacturing methods. Show your calculations.
Jen Shapiro and Bari Westwood are friends who met in college. After working
for a year at a CPA firm, they decided to leave and start their own company. Together
they began ChatFlix, an iPhone and Android app which allows users to create and
send short videos to their friends.
Indifference point occurs where total costs are equal
($60 − $28) X + $5,880,000 = ($60.00 − $20.8) X + $3,640,000
$7.20X = $2,240,000
X = 311,111 units
3. Explain how the level of sales can affect the company's choice of manufacturing
method.
If sales are expected to be greater than 311,111 units, the capital-intensive
method should be chosen, as each unit has a greater contribution margin and fixed
costs have been covered. If sales are expected to be less than 311,111 units, Buckeye
Grain should select the labor-intensive method as there is less business risk.
4. Identify the four stages of the product lifecycle.
The product lifecycle is the time span between the initial concept of a
product or service and the time when the entity no longer produces the product. The
four stages are Introduction, Growth, Maturity, and Decline.
Sales in the first year were slow. Early in the second year, Bari hired a social
media manager and sales began to take off. The second year they gained 25,000 new
users, and now, in their third year of operations, they are on track to exceed
$1,000,000 in revenue.
Bari is anxious to expand operations to offer varying levels of subscription
services and in-app purchases. Jen is more cautious and is concerned about enterprise
risk management (ERM). She would like to hire a consultant to assist with risk
mitigation. Bari is skeptical and does not see the need for risk mitigation at this time.
1. Identify the different types of risks ChatFlix might be subject to, including
business risks, hazard risks, financial risks, operational risks, and strategic risks, and
explain how each might apply to the company.
The different types of risks that ChatFlix might be subject to are:
•
5. Identify the pricing strategy that the company might use when the new product
is in its second stage of the product lifecycle. Explain your answer.
When selling a product in its growth stage, competitors might release the
same product at a lower price, or they might work on making the product better. The
company might need to work on getting more customers. This could require more
marketing and possibly lowering the price. The company might adopt a competitive
pricing strategy.
•
6. Explain operating leverage and its relationship with business risk.
Operating leverage is the extent to which a firm’s operations employ fixed
operating expenses. The greater the proportion of fixed expenses used to produce a
product, the greater the degree of operating leverage. Thus, Buckeye Grain’s capitalintensive method utilizes a greater degree of operating leverage. The greater the
degree of operating leverage, the greater the change in operating income relative to
a small fluctuation in sales volume. The greater the operating leverage and the
resultant variability in operating income, the greater the degree of business risk.
•
Business risk is the possibility of a loss (or insufficient profits) due to
uncertainties related to the business, its customers, and its competitors.
ChatFlix is subject to many such uncertainties. Preferences of users could
change to new technologies or competitors’ products. Failing to upgrade the
hardware or software could lead to system failures. Ineffective marketing
could lead to a loss of users. Loss of talent within the organization could
cause systems to fail. Inadequate accounting and budgeting could cause
financial failure even when sales are rising.
Hazard risks are those that pose threats to the customers of the company,
its employees, the assets of the company, or the general environment. The
greatest hazard risk facing ChatFlix is hacking of its systems. User information
could be compromised, and systems invaded through a cyberattack. ChatFlix
could also suffer a loss from its physical systems, either through sabotage or
system failure.
Financial risk has several different components. One component of financial
risk is market risk, which involves changes in the market in general and the
specific market for the company’s goods and services. In terms of general
market risk, purchases of entertainment items are heavily dependent upon
market conditions. Consumers are not willing to spend a lot on
entertainment when the stock market is low, and unemployment is high. In
•
•
terms of the specific market, changes in technology or consumer
preferences could make it economically unfeasible to market or upgrade the
company’s products. Another component of financial risk is credit risk. Since
ChatFlix receives payment at the time of sale, there is no risk in terms of
accounts receivable. ChatFlix must ensure that it has enough cash flow to
pay its employees, accounts payable, and bills in a timely fashion. A third
component of financial risk is liquidity risk. Liquidity risk is the chance that a
company, even though it has sufficient assets, will not have access to cash in
order to pay its bills as they come due.
Operational risks arise from the company’s day-to-day activities. Operational
risks include unlawful use of the services by customers, risk of
embezzlement or fraud, problems with personnel, bottlenecks, and
breakdowns of assets.
Strategic risk is the chance that business decisions could lead to the failure,
or even bankruptcy, of the company. ChatFlix could face a number of
strategic risks. Failure of the governance process could lead to bad planning,
control, and/or monitoring. ChatFlix could incur substantial reputational risk
from users and social media. Failure to stay competitive could lead to loss of
customers. Operational inefficiencies could cause ChatFlix to be unprofitable
over the long term.
2. Define legal risk, compliance risk, and political risk, and explain how each might
apply to ChatFlix.
Other risks ChatFlix might be subject to are:
•
•
•
Legal risk, which is the loss that can result from failure to follow laws and
regulations which apply to the business. Legal risk can result from either a
lack of awareness of the legal environment of the business, or a willful
indifference to following established laws and regulations. Legal risk can
result in fines, lawsuits, or even criminal action against the company or its
principals.
Compliance risk is the chance of penalties, or financial or other loss due to
failure to act in accordance with established procedures. Those established
procedures can come from the government, for example, failure to file a 10K
with the SEC, industry laws and regulations, employee safety laws, and even
internal controls and procedures.
Political risk is the chance of a loss due to changes or instability in the
political structure of a company. Political risk can arise from instability such
as protests, changes in the leadership of the company, changes in the legal
or regulatory environment, and changes in government or military control.
3. Identify and explain the benefits of enterprise risk management.
The major benefit of enterprise risk management (ERM) is to identify and
mitigate potential problems before they even occur. ERM has many other benefits,
including:
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•
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The prompt identification of regulatory and compliance issues which pose a
threat to the company.
Protection of the safety of employees and stakeholders and security of the
physical assets.
Identification of internal control and compliance issues to make the auditing
process more streamlined.
Improved strategic decision-making with a thorough understanding of the
future events which create uncertainty.
Supporting value creation through elimination of activities which pose a
significant risk to the organization.
Likeliness to achieve stated goals and objectives due to awareness of
possible risks and mitigation strategies.
Robin Rightman was able to form an investor group to begin operating an
airline between Mexico and the U.S. The airline primarily provides charter flights to
vacation groups, corporations, and wealthy individuals. After performing a risk
assessment, it was determined that the two major sources of financial risk for the
company are: the volatility of fuel prices and exchange rate risk relating to payments
and receipts in Mexican pesos.
While Robin tends to be risk-seeking, the remainder of the investor group has
proven to be riskaverse. They have asked Robin to investigate three risk-avoidance
techniques-forward contracts, futures, and options-and to explain the advantages
and disadvantages of each.
1. Explain how the company can use forward contracts, futures, and options to
mitigate the risk of fuel prices and foreign exchange.
With a forward contract, the company can contract today to either purchase
or sell an asset (in this case fuel or Mexican pesos) for future delivery, but “lock in”
the price today. For example, if the company knows it needs 100,000 gallons of fuel
in six months, it can enter into a forward contract to purchase the fuel today but take
delivery and make payment six months in the future, with a price set at the time the
contract was written. Similarly, if the company knows it will receive Mexican pesos in
30 days, it can enter into a forward contract today to deliver the currency in the future
at a price set today.
Futures contracts are similar to forward contracts in that they both involve
the purchase or the sale of an asset at a stated price with delivery at a future date.
One difference is that with a forward contract, delivery and payment happen on
settlement date, while futures contracts are marked to market on a daily basis.
Another difference is that forward contracts are private arrangements between two
parties, while futures contracts trade on exchanges.
With an option, the company would purchase the right, but not the
obligation, to purchase or sell an asset in the future at a specified price (called the
“strike price”). Unlike forward or futures contracts, options cost money to enter into.
But, also unlike forward or futures contracts, the company has the option to walk
away and not honor the contract if the transaction can be done more profitably on
the spot market.
2. Explain the benefits and risks of each method.
A benefit of using either a forward contract or a futures contract instead of
an option is that they do not require any upfront payment. Another benefit of a
forward contract is that it is a private contract, so any underlying asset can either be
purchased or sold. Futures contracts are negotiable securities that trade on
exchanges, so therefore only certain assets can be hedged using futures contracts.
With a forward contract all payments occur at settlement date, while settlement of a
futures contract occurs on a day-to-day basis as the price of the underlying asset
changes making the futures contract less risky. The benefit of an option, as opposed
to forward or futures contracts, is that payment of the settlement of the contract is
not required. If a better price can be achieved on the spot market, there is no
requirement to use the option.
The major risk of using either a forward contract or a futures contract is the
opportunity cost. If the company has contracted to purchase Mexican pesos in 30
days at a price of $0.052 using either a forward contract or futures contract, the
company is required to settle the contract, even if the spot rate on settlement date is
$0.049. Therefore, if the company had not hedged, it could have purchased the
currency at a lower rate. The main risk of using an option to hedge risk is the loss of
the cost of the option. If the company owns an option to purchase Mexican pesos at
$0.052 while the spot price is $0.049, it is free to walk away from the contract and
purchase the currency on the spot market. Therefore, using an option, the maximum
loss is the cost of the option.
3. Name at least one alternative method the company can employ to reduce the
financial risk of either fuel prices or foreign exchange.
To reduce the risk of fuel costs, the company can purchase large amounts of
fuel and store it for future use. While this strategy could involve an opportunity cost,
it would reduce the short-term volatility in fuel costs. To reduce the foreign exchange
risk, the company could open an administrative office in Mexico to handle payments
and receipts in the local currency.
4. Explain how the differing attitudes toward risk might affect risk management.
Since Robin is risk-seeking, she would probably prefer not to hedge the risk
at all. Hedging reduces the possibility of a loss, but also limits the possibility of
benefitting from swings in asset prices. An option would be Robin’s second choice, as
it allows using a more favorable price and limits the loss to the amount paid for the
option. For the investor group, being risk-averse they would most probably choose a
futures contract. Futures contracts involve no actual losses; only opportunity costs
arise from their use. Because they are traded on exchanges, liquid, and require daily
settlement, futures contracts are less risky than forward contracts.
SECTION E
Focused Solution Inc. is a management consulting company. As part of its
annual planning process, the company is reviewing proposed capital projects. Staffgenerated investment project proposals consistent with the company's strategic
objectives have been submitted, and the executive team has narrowed the proposals
down to two proposed projects as described below.
Proposal I: The first project relates to opening a new office in either New York or
Chicago. The company had purchased a building in Chicago several years ago for this
purpose and has already partially rehabilitated the building. The company is also
working with a client with some projects in New York which it may not be able to take
if the company does not build the New York office.
Proposal II: The other project includes a technology upgrade of the latest mini-tablet
computers for all consultants and an expansion of the headquarters in San Francisco.
The president selected Proposal II as he believes that the consultants need to
project a professional image and could continue to travel to both New York and
Chicago. The CFO requested that additional criteria be reviewed before the project
selection was finalized. The CFO noted that there were several projects undertaken in
the past that did not generate the expected cash flows or anticipated return on
investment. He also wanted to ensure that the selected projects met the company's
hurdle rate. The president agreed to post-audits on the projects from the prior year
and for additional capital budgeting analysis on each of the proposed projects.
The remaining steps in capital budgeting that the executives should undertake
include:
1. Identify and describe three steps in the capital budgeting process.
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1. Identify and Define Projects
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•
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•
- In this initial step, the company needs to identify potential investment
opportunities or projects. This can be done through various means, such as soliciting
project proposals from different departments or business units, considering
expansion plans, technological upgrades, or other initiatives aligned with the
company's strategic objectives.
- For Focused Solution Inc., this involved the submission of investment project
proposals related to opening a new office in New York or Chicago (Proposal I) and a
technology upgrade with headquarters expansion (Proposal II). The projects should
align with the company's strategic goals and objectives.
2. Evaluate and Select the Project
Estimating after-tax incremental operating cash flows for investment
projects
Evaluating project incremental cash flows
Selecting projects based on a value-maximizing acceptance criterion
Secure project financing, either internally or externally
Revaluating implemented investment projects continually and performing
post-audits for completed projects
2. Identify and explain the role of the post-audit in the capital budgeting process.
A post-completion audit is a formal comparison of the actual costs and
benefits of a project with original estimates. A key element of the audit is feedback,
meaning that results of the audit are given to relevant personnel so that future
decision-making can be improved.
- Once project proposals are identified, a thorough evaluation is necessary to assess
their feasibility, profitability, and alignment with the company's strategic goals. This
involves conducting a capital budgeting analysis, considering factors such as
anticipated cash flows, return on investment (ROI), payback period, and the project's
contribution to shareholder value.
Post-completion audits allow management to determine how close the
actual results of an implemented project have come to its original estimate. When
used properly, progress reviews and post-completion audits can help identify
forecasting weakness and any important factors that were omitted. With a good
feedback system, any lesson learned can be used to improve the quality of future
capital budgeting decision-making.
- Focused Solution Inc. is in the process of evaluating Proposal I (New York or Chicago
office) and Proposal II (technology upgrade and headquarters expansion). The CFO's
concerns about past projects not meeting expectations and the importance of
meeting the hurdle rate highlight the need for a comprehensive analysis to guide the
selection of the most viable project.
Post-audit also exerts discipline in the investment planning and control
process. If managers are aware that post-completion audits are to be undertaken,
they may take more care when developing initial assumptions and estimates and
when making investment decisions. They may also take more care when managing an
investment project through to completion.
3. Monitor and Review the Project
3. Define hurdle rate, sunk cost, and opportunity cost. Explain how each is relevant
to capital budgeting.
- After a project is selected and implemented, it's crucial to monitor its progress and
review its performance against the initial projections. This step involves tracking
actual cash flows, comparing them with the forecasted values, and assessing whether
the project is delivering the expected returns.
- In Focused Solution Inc.'s case, the president agreed to post-audits on the projects
from the prior year, indicating a commitment to evaluating the outcomes of past
projects. Additionally, ongoing monitoring and review processes should be
established to ensure that the chosen project continues to align with the company's
strategic objectives and delivers the anticipated financial results.
Hurdle rate is the minimum acceptable rate of return on a capital
investment. It represents the cost of capital or the minimum rate of return that a
company requires before undertaking an investment project. The hurdle rate serves
as a benchmark to evaluate the feasibility and attractiveness of potential projects.
Projects with returns exceeding the hurdle rate are generally considered acceptable,
while those falling below it may be rejected.
Sunk cost refers to costs that have already been incurred and cannot be
recovered. In the context of capital budgeting, sunk costs are irrelevant to decisionmaking because they do not affect future cash flows. Managers should focus on
prospective cash flows and potential returns rather than dwelling on past
expenditures. Ignoring sunk costs ensures that decisions are based on the project's
future profitability rather than past investments that cannot be recouped. In this case,
the building cost in Chicago is a sunk cost.
Opportunity cost is the potential value foregone when one alternative is chosen over
another. In capital budgeting, it involves considering the next best alternative that
could have been pursued instead of the chosen investment. Assessing opportunity
costs helps decision-makers understand the trade-offs associated with their choices.
By evaluating the potential returns and benefits of alternative projects, managers can
make more informed decisions about where to allocate resources, ensuring that the
chosen projects offer the highest value to the organization. Here, the loss of the New
York work could be an opportunity cost of going with a different option.
4. Should the company use cash flows or accounting profits in its capital budgeting
analysis? Explain
In capital budgeting analysis, it is generally recommended that companies
focus on cash flows rather than accounting profits. The reason for this preference lies
in the fundamental principle that cash flows represent the actual cash movements in
and out of the business, providing a more accurate reflection of a project's impact on
the company's financial position. Cash flows consider the timing of cash inflows and
outflows, accounting for factors such as depreciation that might affect accounting
profits but do not involve actual cash transactions.
Accounting profits, on the other hand, may be influenced by non-cash items
such as depreciation and amortization, which can distort the economic reality of a
project's performance. By relying on cash flows, a company can better assess its
ability to generate positive cash inflows and meet its financial obligations, ultimately
aiding in making more informed investment decisions. In the case of Focused Solution
Inc., evaluating the proposed projects based on their respective cash flows will offer
a clearer understanding of their impact on the company's financial health and the
potential for achieving the desired return on investment.
Cash, not accounting income, is central to all decisions of the firm. Benefits
expected from a project should be expressed in terms of cash flows rather than income
flows. The firm invests cash now in the hope of receiving even greater cash returns in
the future. Only cash can be reinvested in the firm or paid to shareholders in the form
of dividends.
5. Should the company consider total amounts or incremental amounts in its capital
budgeting process? Explain.
Incremental costs should be used so that only the differences between the
cash flows of the firm with and without the project are analyzed. For example, if a
firm contemplates a new project that is likely to compete with existing projects, it is
not appropriate to express cash flows in terms of estimate total sales of the new
project. If cash flows will erode if they do not invest, they must factor this into the
analysis. The key is to analyze the situation with and without the new investment and
make sure all relevant costs and benefits are brought into play. Only incremental cash
flows matter.
6. Describe how the company should be considering the impact of income taxes and
inflation on their cash flows.
The initial investment outlay, as well as the appropriate discount rate, will be
expressed in after-tax terms. Thus, all forecast flows need to be stated on an
equivalent, after-tax basis. The method of depreciation is an important consideration
of the impact of income taxes because depreciation lowers taxable income.
Everything else being equal, the greater the depreciation charges, the lower the taxes
paid. Although depreciation itself is a non-cash expense, it does affect the firm’s cash
flow by directly influencing the cash outflow of taxes paid.
Anticipated inflation must also be considered. Often there is a tendency to
assume, erroneously, that price levels will remain unchanged throughout the life of a
project. If the required rate of return for a project to be accepted embodies a
premium for inflation as it usually does, then estimated cash flows must also reflect
inflation. Such cash flows are affected in several ways; if cash inflows ultimately arise
from the sale of a product, expected future prices affect these inflows. As for cash
outflows, inflation affects both expected future wages and material costs.
7. Explain the decision criteria used to determine acceptable projects when using
net present value (NPV) and internal rate of return (IRR), respectively.
When NPV is used to determine if a project is acceptable, the company must
estimate a “hurdle rate,” often the weighted average cost of capital (WACC). This
hurdle rate may be adjusted based on the riskiness of the proposed project. Each
year’s cash flow of the proposed project is estimated and then discounted back to
present using the hurdle rate. NPV is calculated by adding discounted future cash
flows together and subtracting initial cash outlay in the present. If NPV is positive, the
decision rule says go ahead; if the NPV is negative, the decision rule says do not go
ahead.
Using the IRR decision rule starts the same way: find a hurdle rate and
estimate the cash flows of the project. Instead of discounting future cash flows using
the hurdle rate, an internal rate of return is calculated for the proposed project. This
IRR is the rate at which the discounted future flows equal the (undiscounted) initial
investment. IRR is compared to the hurdle rate. If IRR is greater than the hurdle rate,
go ahead; if IRR is less than the hurdle rate, do not go ahead. In nearly all real-life
examples, the NPV decision rule leads to the same go/no go answer as the IRR
decision rule. In the rare case when the two decision rules lead to different decisions,
the analyst should examine if the cash flow pattern shifted more than once. If so, the
analyst can explain why the IRR rule is not appropriate.
Encino Company, a diversified manufacturer, is considering three potential
projects. To evaluate capital projects, the finance department uses the net present
value method (NPV) and the payback period method. The company has a hurdle rate
of 13%. Capital projects are acceptable under the payback period if the initial
investment is recouped in three years. For the upcoming fiscal year, the Board of
Directors has approved a capital projects budget of up to $8,000,000. Data on the
various projects under consideration are shown here.
Project 1
Project 2
Project 3
Initial Outlay
($4,840,000)
($4,200,000)
($4,550,000)
Annual Net
Cash Inflows
Year 1
1,600,000
1,400,000
1,900,000
Year 2
1,500,000
1,500,000
1,500,000
Year 3
1,800,000
1,900,000
1,550,000
Year 4
1,200,000
1,850,000
1,420,000
Net
Present
(265,880)
665,090
251,200
Value
1. Identify and explain two advantages and two disadvantages of using the payback
period method and NPV, respectively
Advantages of the payback period:
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Simple to use, as it does not involve any accrual accounting conventions
Easily identifies projects that will recoup the company’s investment quickly
Useful in case of uncertainty
Disadvantages of the payback period:
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Does not consider the time-value of money
Does not consider cash flows after the payback period
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Does not consider a project’s return on investment
Ignores project profitability and risk
Advantages of NPV:
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Considers the time-value of money
Considers the impact of all cash flows associated with the project
Discloses whether a project will create value for the company or investors,
and by how much in terms of dollars
Disadvantages of NPV:
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Does not fully account for opportunity costs
Is very sensitive to the discount rate, which is subject to estimation
Is not useful for comparing two projects of different sizes
2. Which project(s) should Encino select based on the payback period method?
Explain your answer.
With a budget of $8,000,000, the company should select Project 2 under the
payback method because it has the fastest payback period and is below the threeyear maximum identified by management. Project 3 could not be accepted due to
capital budget limitations, even though the payback period is below the three years
stipulated by management.
3. Which project(s) should Encino select based on the net present value method?
Explain your answer.
With a budget of $8,000,000, the company should select Project 2 under the
NPV method because its NPV is positive and higher than that for Project 3.
4. Assume the Board of Directors revises the capital budget upward to $10,000,000.
Which project(s) should the company select based on the payback period method
and which project(s) should the company select based on the net present value
method? Explain your answer.
With a budget of $10,000,000, the company should select both Project 2 and
Project 3 under the payback method because they have the fastest payback period
and are below the three-year maximum identified by management.
With a budget of $10,000,000, the company should select both Project 2 and
Project 3 under the NPV method because the NPV is positive for both.
5. Define sensitivity analysis and explain how management could use sensitivity
analysis in its capital budgeting process.
Sensitivity analysis is a “what-if” technique used to examine how results will
change if the predicted financial outcomes are not achieved or if the underlying
assumptions change. Management could use sensitivity analysis in the estimate of
the initial investment by assuming the project is delayed and incurs more costs or by
adjusting the expectations of the amount of cash inflows. The discount rate could also
be adjusted, as well.
6. Discuss two qualitative factors that Encino should consider when making capital
budgeting decisions.
Qualitative factors play a crucial role in capital budgeting decisions for Encino
Company. Two important qualitative factors that the company should consider are
culture and ethics.
Firstly, culture is a qualitative factor that encompasses the values, beliefs,
and practices within the organization. When evaluating capital projects, it is essential
to ensure that the proposed projects align with Encino's organizational culture. For
instance, if the company places a high value on innovation and sustainability, it should
consider projects that contribute to these aspects. The compatibility of a project with
the existing organizational culture can impact employee morale, engagement, and
overall success.
Secondly, ethics is another critical qualitative factor that should be taken into
account during capital budgeting. Ethical considerations involve assessing whether
the proposed projects adhere to moral and social standards. Encino should evaluate
whether the projects align with ethical business practices, environmental
sustainability, and social responsibility. A project that complies with ethical standards
can enhance the company's reputation, customer trust, and long-term success.
Conversely, overlooking ethical considerations may lead to reputational damage and
potential legal issues.
Nonfinancial considerations include:
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The impact on the environment. An option may not have the highest return
but might benefit the environment.
Additional job opportunities may be created within the community.
The overall growth strategy for the company might be enhanced by
accepting a project that will initially generate a loss or a lower gain than the
alternatives.
SECTION F
Cameron Matthews is a senior at Albany State University studying
accounting. He is currently taking the capstone course in his program, which includes
a section on business ethics. His professor has assigned a paper on how ethics applies
to business decisions, and Cameron has been very busy on the Internet looking up the
answers to the following questions.
1. Define business ethics.
Business ethics is the collection of rules, principles, policies, standards, and
practices that are used to set norms of behavior for individuals in the organization.
Business ethics covers a variety of subjects including, but not limited to, bribery,
abuse of power, discrimination, social responsibility, fiduciary responsibilities,
dangerous products, tax evasion, and law breaking.
Business ethics govern how decisions, both big and small, are carried out on
a daily basis by the employees of the organization. The overriding goal of most
organizations is to maximize corporate wealth or maximize shareholder wealth.
Individuals are governed by their own personal code of conduct, engrained into them
over years by their background, faith, family, traditions, and personal preferences.
Employees can sometimes be placed in an ethical conundrum due to a conflict
between their own personal feelings and the goals of the organization.
Because what is “right” and “wrong” behavior varies from individual to
individual, businesses often have a published Code of Ethics, or Code of Conduct,
which delineates standards of behavior expected of all employees.
2. Define the following moral philosophies and explain how they are used in making
business decisions:
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Teleology
Utilitarianism
Deontology
Relativism
Virtue ethics
Justice
Definitions of moral philosophies:
Teleology is the explanation of an occurrence through the lens of its end
result, goal, or purpose. In terms of business, teleology is a moral obligation to
produce a desirable end result. An example of this would be a project that is both
profitable and legal but would hurt the environment.
Utilitarianism is a philosophical theory which ranks right and wrong
behavior. It states that the morally best action or behavior is that which maximizes
the utility (defined as “happiness”) of the greatest number of people. Utilitarianism
includes not only current consequences, but all future consequences of the action.
Utilitarianism would prevent an organization from taking an action which would harm
the environment in the future.
Integrity means that the individual adheres to strong moral and ethical
principles. A person with integrity is regarded as honest, truthful, reliable, and
accurate. A leader with integrity builds strong relationships with his or her team and
outsiders, and others know that this person is dependable. When an employee has a
moral dilemma, he or she would probably choose to go to the manager with the most
integrity.
Deontology is the theory that an action should be judged by whether the
action itself is “right” or “wrong” based upon a set of norms or rules, as opposed to
being judged by the consequences of the action. Deontology would consider a bribe
to be an unethical act, even if it leads to the opening of a plant which would employ
many people.
Due diligence is the ethical standard which holds people to the exercise of
reasonable care in conducting business or entering into contracts. A business that
exhibits due diligence would not accept a contract that it is unsure it can complete
successfully due to either time or resource constraints. Due diligence is similar to the
“reasonable man” standard to which professionals are held.
Relativism is a philosophy which states that ethics has no absolute truth.
Very often, “right” and “wrong” behavior are defined relative to the situation,
individual, group, or culture. A bribe in the United States would be considered
unethical, while in other countries bribery might be considered normal business
practice.
Fiduciary responsibility is a concept that arises when a business or an
individual is supposed to act in the best interest of another party, as opposed to his
or her own best interest. Businesses and managers have a fiduciary responsibility
because they control the investments of the owners (represented by the assets of the
business). Misappropriating or wasting assets might benefit the managers personally,
but ethically they are supposed to act in the best interest of the investors, as opposed
to their own best interest.
Virtue ethics in business is when the organization promotes desirable traits
such as honesty or compassion, as opposed to a set of rules to govern behavior. An
example of virtue ethics would be a statement in the Code of Ethics that diversity
should be valued and respected.
Justice in business ethics is a broad concept that states that treatment
should be fair and equitable. Justice applies to a wide range of business situations
including treatment of employees, customers, vendors, and other stakeholders. An
example of business justice would be to evaluate an employee’s performance fairly
even if there is some personal animosity.
3. Define how the following concepts impact ethical decision-making:
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Fairness
Integrity
Due diligence
Fiduciary responsibility
Concepts that impact ethical decision-making include the following.
Fairness is a concept where decisions are based upon certain moral
standards which are agreed upon. In essence, fairness means to apply the same sets
of rules, standards, and criteria to similar business situations. When a manager does
not exhibit fairness, it makes it difficult for employees to know the consequences of
their actions. If an action was unethical last time, it should still be unethical.
Cathy Connors is a CMA and a CPA who completed three years as an auditor
in a CPA firm. After deciding she did not like public accounting, she took a job as an
assistant controller at a paper manufacturing company called Brock Industries. She
reported to the controller, Jim Burrows, who reported to the CFO, Ariana Logan.
Almost immediately, Cathy noticed irregularities which aroused her
suspicions as a former auditor. Jim and Ariana seemed to be very friendly, going to
lunch together often, spending a lot of time together in the office and often socializing
after work hours. Jim often talked about his own personal finances. He complained of
an ex-wife receiving alimony, college tuition bills, and costs of caring for elderly
parents. Ariana was always dressed beautifully in designer clothes and drove a very
expensive car.
During the first month-end close, Cathy discovered some very unusual
journal entries that were posted during the month. Sales orders were being booked
as sales in advance of the company shipping the goods, or even confirming the
quantity and price. Cathy also discovered that various selling, general and
administrative (SG&A) expenses (such as salaries of marketing staff) were being
misclassified as product costs, leading to some of the costs being inventoried as
opposed to expensed.
Cathy took her concerns to Jim, her immediate supervisor. Jim told her that
these entries were common practice for the company because of their unique
management accounting systems. He assured Cathy that there was a process to
reverse the specialized entries during the month-end closing process.
Cathy decided to do her own investigating. She looked at the last six months
of accounting records. She saw many similar journal entries where revenue was
booked prior to it being earned and many SG&A expenses miscategorized as product
costs. She saw no month-end reversing entries during this time period. All month-end
closing entries were approved by both Jim and Ariana. Cathy estimated that income
was overstated between $200,000 and $400,000 each month, and Jim and Ariana
both received bonuses based upon total company profitability.
1. Identify the three components of the fraud triangle and how they relate to
Cathy’s situation.
The three components of the fraud triangle are:
Opportunity, which arises from weak internal controls, collusion, or from the
position of the perpetrator. In this situation, it appears there is a combination of
collusion and position. When there is collusion in committing a fraud, it is more
difficult to detect and correct. When both the controller and the CFO are colluding,
there are few employees with the authority to challenge their work. Also, there are
very few employees higher up in the organization chart to either notice the fraud, or
to report it.
Motive, which makes the perpetrator want to commit the act. Motive
usually comes from financial pressure but can also arise from other emotions such as
resentment (for example, if passed over for a promotion), feeling that one has not
been treated fairly (for example, feeling underpaid), or even a desire for expensive
products. In Cathy’s case, she has observed clear financial pressure from Jim, who
often talks about the poor state of his personal finances. Cathy has also noted that
Ariana appears to have a taste for expensive items.
Rationalization, which makes the perpetrator justify the act. Rationalization
is often the most difficult to observe, because it involves how the fraudster thinks and
feels about the act. Rationalization is often closely related to motive. An employee
with financial pressure might feel justified in stealing because the money is going for
a good purpose or may be paid back soon. An employee who feels underpaid might
feel justified in stealing because he or she is only taking what he or she thinks is
deserved. Rationalization is also very closely related to the individual’s own ethical
framework. An individual with high ethical standards would find it more difficult to
justify an unethical act, even with a good outcome.
2. Identify and describe the relevant standards which may have been violated in the
situation described above.
In this situation, Cathy feels that two relevant accounting standards were
violated.
The revenue recognition principle was violated when sales were recorded
before the goods were shipped, and
The expense recognition principle was violated when selling, general and
administrative expenses were capitalized instead of being treated as period expenses.
In addition, several ethical standards were violated by Jim and Ariana. First,
they violated their fiduciary responsibilities because they are exposing the company
to restatements and possible action by the SEC and IRS for fraudulent filings. They
have also violated the principle of due diligence as they are not carrying out the
responsibilities of their positions. Also violated is the principle of integrity, as they
have not acted with honesty.
3. Keeping in mind the standards outlined in IMA’s Statement of Ethical Professional
Practice, recommend a course of action that Cathy should consider taking.
Using the standards outlined in IMA’s Statement of Ethical Professional Practice,
Cathy should consider the following actions in the following order:
First, Cathy should try to report the ethical violation within her own
organization. This situation is complicated because Cathy suspects both her
immediate supervisor, and the person to whom that supervisor reports. Cathy would
need to examine the organization chart and attempt to report the violation to the
person to whom Ariana reports. Failing that, Cathy should investigate whether Brock
Industries has accommodations for whistleblowers. Many large organizations offer
means for whistleblowers to report anonymously, such as drop boxes, bulletin boards,
or email.
Cathy could also call the anonymous helpline offered by the IMA to request
how key elements of the IMA Statement of Ethical Professional Practice could be
applied to her specific ethical issue.
Cathy should also consider retaining her own lawyer. Should government
agencies or banks take action against the company due to fraudulent financial
statements, Cathy could have some legal responsibility. Her lawyer would advise her
of her legal obligations, rights, and risks concerning the fraudulent actions.
If Cathy’s resolution efforts are not successful, she should consider resigning
from the organization. Cathy could face significant legal and personal risk related to
the fraud, even though she was not a party to it.
Beginning in 2016, a number of ethical lapses by one of the nation's oldest and bestknown banks came to light.
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In September 2016, the bank admitted in a settlement with regulators that
it had created up to two million accounts without customers' permission,
agreeing to pay $185 million in fines and penalties.
Whistleblowers were ignored, punished, or even fired, despite the bank's
Code of Ethics and Business Conduct stating that the bank does not tolerate
retaliation.
The CEO of the bank appeared before Congress and accepted "full
responsibility" yet blamed the fraud on low-level bankers and tellers.
The bank had illegally repossessed automobiles from military veterans.
The bank modified mortgages without customer authorization.
The bank charged 570,000 customers for auto insurance that was not
needed.
The bank charged excessive credit card fees to small business customers.
The bank fined more than 100,000 mortgage clients with late fees though
the delay was the fault of the bank.
By September 2017, the bank paid a total of $414 million in settlements and
refunds, along with $108 million paid to the Department of Veterans Affairs,
and untold millions more in attorney fees and other costs.
By April 2018, the bank had paid another $1 billion fine for abuses in
mortgage and auto lending.
The American Federation of Teachers cut all ties with the bank due to its
practices.
After the CEO was fired, a new CEO took over the reins of the bank. The new
CEO, after learning that employees were suffering stress, panic attacks, and other
symptoms apologized for the toxic corporate culture and cultural weaknesses.
As a result of the problems described above, the bank has fired many
employees, reduced or curtailed executive bonuses, replaced many of its directors,
and dismantled its sales incentive system.
Adapted from: Ethics Unwrapped: McCombs School of Business Case
https://ethicsunwrapped.utexas.edu/case-study/wells-fargo-and-moral-emotions
1. Define corporate culture and explain how the culture at the bank influenced the
ethics in the decision-making process.
Corporate culture is the collection of shared values, outlooks, norms of
behavior, and beliefs that apply to one organization in particular. Corporate culture
helps to define the nature of an organization, and is closely aligned with corporate
strategies, structure, and approaches to business dealings with the community.
Corporate culture tends to flow downward from management and permeate
the organization. Corporate culture also affects a firm’s day-to-day operations. We
saw this with the bank, where decisions were made at many levels across many
departments that were designed to hurt or penalize the customer and benefit the
company. Corporate culture can become so ingrained that new employees identify
and acquire the corporate attitudes quickly. Corporate culture can also be very
difficult to change because it permeates all areas of the organization.
It is clear that the bank had a culture which did not discourage, and possibly
encouraged, unethical behavior. Behaviors like creating accounts without customers’
permission, illegally repossessing automobiles, and charging excessive fees to small
business customers were allowed to continue until the organization became a target
of federal investigations. Not only were these behaviors not punished, but
whistleblowers became the target of corporate retaliation.
2. Explain the importance of core values and how they promote ethical behavior
and ethical decision-making.
Core values are those activities, attitudes, and behaviors that the
corporation believes are the most important to successful operations. Core values
influence behavior in many ways. Core values communicate what is important to the
company to employees. Once employees know what is important, whether it is
excellent customer service, high quality, or cost leadership, they make decisions
which support those core values. Because of this, core values inspire employees into
action.
Core values make your company different from your competitors. Core
values dictate how your customers, and even your employees, view you. Because
they are so pervasive, core values shape the organizational culture.
It is imperative that ethical behavior and decision-making be a part of the
core values of an organization. That way, managers and employees make decisions
that are in alignment with not only the core values of the organization, but their own
personal core values. We can see with the bank that the toxic corporate culture
caused cognitive dissonance in the employees.
3. Explain the importance of a Code of Conduct and how it contributes to an
organization’s ethical culture.
A Code of Conduct gives employees a guide in supporting their decisionmaking processes on a day-to-day basis. Ideally, a Code of Conduct should make clear
to every employee the organization’s mission, values, and principles. These values
and principles are then linked with standards of conduct. A Code of Conduct
contributes to an organization’s ethical culture by clearly stating behaviors that are
acceptable in the workplace versus behaviors that are unacceptable.
4. Analyze the impact of groupthink on ethical behavior.
Groupthink is defined as a pressure from a group that leads to poor decisionmaking, alternate realities, and poor judgment. Groupthink causes individuals to
value conforming to a group more than their own personal beliefs. Group members
often suspend their own judgment in favor of the judgment of the group and avoid
speaking out for fear of expulsion from the group or other punishments.
5. Explain the importance of a whistleblowing framework in maintaining an ethical
culture and explain how this relates to the employees of the bank.
Though the bank had a statement condemning retaliation of whistleblowers,
it is clear that the bank did not have a whistleblowing framework in place. A
whistleblowing framework communicates the whistleblowing policy to the entire
organization, emphasizing bans on retaliation. Top management must commit to the
inclusion of whistleblowing in the culture, including thorough investigations of all
whistleblowing events with protection for the whistleblower.
It is clear that the bank did not have a whistleblowing framework in place,
since employees were ignored or even faced retaliation. A whistleblowing framework
would have taken the reports seriously, begun investigations into the proposed
wrongdoing, and, most importantly, protected the whistleblower from punishment.
6. Define ethical leadership and identify the traits of ethical leaders.
Ethical leadership is where individuals at the top of the organization
demonstrate conduct that is acceptable and appropriate for a wide variety of
business situations. Ethical leaders exhibit the following traits:
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Justice, which means that all individuals are treated equally, and no
employee should fear any bias from the leader.
Respect, which means that the leader values all team members, listens to
them attentively, and shows compassion and generosity.
Honesty, which makes employees trust the leader.
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Encouraging initiative, which makes employees flourish and value their
positions. Initiative encourages employees to solve problems.
Leadership by example, which shows employees that high expectations are
not just for the employees, they are for all members of the organization.
No tolerance for ethical violations, which encourages employees to take
ethical actions at all times.
7. Discuss the bank’s corporate responsibility for ethical conduct.
An early version of management science stated that the goal of corporations
is to maximize profit (or shareholder wealth). A more modern version states that
corporations must seek to maximize stakeholder wealth. Stakeholders include not
only the owners or investors in the corporation, but many other interested parties
including employees, customers, vendors, the community, and the public at large.
Unethical behavior puts many stakeholders at risk, and exposes the company to fines,
negative public opinion, and increased government oversight.
It is clear that the bank violated its corporate responsibility for ethical
conduct. Many stakeholders were harmed by the actions taken throughout the
organization, including customers, employees, and the community. The unethical
behavior caused the organization to pay hundreds of millions of dollars in fines,
settlements, and restitutions, which harmed the investors.