Question

After years of steady growth in net income, Performance Drug Company reported a preliminary net loss in 2021. The CEO, Joe Mammoth, notices the following estimates are included in reported performance:

1. Warranty expense and liability for estimated future warranty costs associated with sales in the current year.
2. Loss due to ending inventory’s net realizable value (estimated selling price) falling below its cost. This type of inventory write down occurs most years.
3. Depreciation of major equipment purchased this year, which is estimated to have a 10-year service life.

Joe is worried that the company’s poor performance will have a negative impact on the company’s risk and profitability ratios. This will cause the stock price to decline and hurt the company’s ability to obtain needed loans in the following year. Before releasing the financial statements to the public, Joe asks his CEO to reconsider these estimates. He argues that (1) warranty work won’t happen until next year, so that estimate can be eliminated, (2) there’s always a chance we’ll find the right customer and sell inventory above cost, so the estimated loss on inventory write-down can be eliminated, and (3) we may use the equipment for 20 years (even though equipment of this type has little chance of being used for more than 10 years). Joe explains that all of his suggestions make good business sense and reflect his optimism about the company’s future. Joe further notes that executive bonuses (including his and the CFO’s) are tied to net income and if we don’t show a profit this year, there will be no bonuses.

Required:
1. Understand the reporting effect: How would excluding the warranty adjustment affect the debt to equity ratio? How would excluding the inventory adjustment affect the gross profit ratio? How would extending the depreciable life to 20 years affect the profit margin?

Debt to equity ratio: higher or lower?

Gross profit ratio: higher or lower?

Profit margin: higher or lower?

2. Specify the options: If the adjustments are kept, what will they indicate about the company’s overall risk and profitability?
Risk: more risk or less risk or no effect on risk

Profitability: more risk or less risk or no effect on risk

3. Identify the impact: Could these adjustments affect stockholders, lenders, and management?
YES or NO

4. Make a decision: Should the CFO follow Joe’s suggestions of not including these adjustments?
YES or NO

Answer 1

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Performance Drug Company
Answer 1
Debt to equity ratio
If warranty adjustment is excluded then it means there will not be any warranty liability or warranty expense.
If there is no warranty liability then debt will reduce by that amount.
If there is no warranty expense then equity will increase by that amount.
So debt to equity ratio will be			Lower
Gross profit ratio
If inventory is valued at cost then it means there will not be any valuation loss.
If there is no valuation loss then Gross profit will increase by that amount.
So Gross profit ratio will be			Higher
Profit margin
If asset life is increased to 20 years then it means depreciation expense will decrease.
If depreciation expense will decrease then profit margin will increase by that amount.
So Profit margin will be			Higher
Answer 2
Risk	More
Profitability	Less
Answer 3	Yes
Answer 4	No