Project 2: Accounting for Managers

Step 1: Review Financial Statements

As you start your second month of work at Maryland Creative Solutions, LLC (MCS), the senior partner, Frank Marinara, has been pleased with your work as an economic analyst. He would like to turn your attention to a corporate accounting project. Here are the details:

  

Dialogue   with Frank Marinara

“I   wanted to meet today about assigning you a corporate accounting project. It   is necessary to understand the client’s accounting and strategy before we can   consider recommendations.

Choice   Hotels’ accounting is audited by Ernst & Young LLP. This same firm audits   their internal controls. As a result of the Sarbanes-Oxley Act of 2002 (SOX),   Choice Hotels must rely on a different firm for accounting advice, and it   will likely use one of the other big four accounting firms.

I   am handing down this assignment from our managing director, Elisa Izuki, who   heads the accounting projects group in MCS. She has asked for a complete   review and ratio analysis of the most recent 10-K annual financial statements   for Choice Hotels International, Inc. 

“Speaking   of financial statements,” Frank adds, “the most common financial statements   are the income statement, balance sheet, and statement of cash flows. While you   are at it, you should know a bit about accounting conventions and standards   in the United States.”

Your   goal is to develop an understanding of the business of Choice Hotels using   the 2018 annual report that the company files with the Securities and Exchange   Commission (10-K). I recommend you analyze the 10-K financial reports using   accounting and finance ratios after you read key parts of the Document.

Ratio   analysis is especially difficult because Choice Hotels is one of the largest   hotel franchisors in the world. The company does not sell any products and   has no inventory, and because of this, some traditional analyses does not   apply.

Also,   the company has had and continues to have an aggressive Treasury stock   repurchase program, and this has caused negative equity on the balance sheet.   Many companies have had stock repurchase programs in recent history. Choice   Hotels has been among the most aggressive in Treasury stock repurchase   programs. The negative equity means that we cannot use ratios like Return on   Equity and Debt to Equity. Fortunately, there are other ratios we can use.

Choice   Hotels’ management recently completed a large acquisition. You need to   understand what was acquired. 

The   first part of the 10-K Document has useful information that describes the   business, the risk factors, and Management’s Discussion and Analysis of   Financial Condition and Results of Operations. This information is beneficial   to your analysis. 

Analysts   use the Notes to Consolidated Financial Statements in the 10-K Document to   evaluate the riskiness of the debt. The notes also state that Choice Hotels   has an investment grade credit rating. However, the interest rates seem high   compared to our other clients. Both Standard & Poor’s and Moody’s rate   Choice Hotels’ debt as the lowest investment grade BBB- and Baa3 with a   stable outlook.

I’ll   send over an Excel workbook with questions for you to complete. These   questions require an understanding of the client, its strategy, and   appropriate ratios. Please read the questions carefully and submit all   deliverables. That is it for now. Please reach out should you have any   questions.”

After you have completed your review of Choice Hotels’ financial reports, you will need to complete a horizontal analysis (see resources BELOW)

To complete your assignment for Elisa and Frank, perform the following tasks during Week 3:

• Download      the Project 2 Excel Workbook (see attachment) that      MCS developed in house, read the instructions page carefully, and review      the most recent Choice Hotels’ 10-Q reports and two recent 10-K reports      found on the SEC website. The link to the report is embedded within      the Project 2 Excel Workbook.
• Perform      a horizonal analysis by completing the Income Statement and Balance Sheet      worksheets within the Project 2 Excel Workbook.
• Answer      the questions in the Income Statement, Balance Sheet, and Cash Flow      worksheets within the Project 2 Excel Workbook.
• Submit      your Project 2 Excel Workbook for feedback to the submission folder      located in the final step of this project.

Now that you have completed Step 1, proceed to Step 2, where you will evaluate business operations of Choice Hotels based on the completion of a ratio analysis. 

Step 2: Evaluate Business Performance Using Ratio Analysis

MCS asks that analysts review the financial health of the client’s business by completing ratio analysis. Frank explains that Choice Hotels has an aggressive strategy to grow revenues and stock price. The company does this by accepting ratios that might be outside normal industry ranges.

Ratio analysis is an analytical tool for understanding financial results and trends over time, and for providing key indicators of organizational performance. Typically, ratios are calculated by using data from the income statement, balance sheet, and statement of cash flows. This information can be found in the 10-K Document. MCS uses a customized worksheet to report ratio calculations, results, analysis, and recommendations for clients.

Financial ratios are used for many types of businesses in various industries. For a hospitality business such as Choice Hotels, you have selected a set of financial accounting ratios that are most appropriate for the client.

Frank stops by your office to give a few pointers:

  

Dialogue   with Frank Marinara

“Choice   Hotels would like us to look at their balance sheet and provide them with   guidance on what they should or should not do to better manage their assets.

“Balance   sheet ratios like the fixed-asset   turnover ratio are   commonly used in the valuation   of inventory,”   he adds. Other balance sheet ratios include working   capital.”

Your ratio calculations should be completed in the Ratio Analysis worksheet in the Project 2 Excel Workbook.

Complete the workbook with data from the Income Statement, Balance Sheet, and Statement of Cash Flows worksheets. As part of your analysis of Choice Hotels’ strategy, you will also need to answer a few questions in the worksheet.

When you have completed Step 2, proceed to Step 3, where you will discuss accounting ethics.

Step 3: Participate in Discussion of Accounting Ethics

Choice Hotels requires high levels of integrity, honesty, and transparency in the development of financial reports. They must ensure compliance with the standards articulated by international bodies like the Financial Accounting Standards Board, Generally Accepted Accounting Principles (GAAP), and the International Financial Reporting Standards (IFRS) Board.

Before 2002 and prior to SOX there were a number of high profile frauds in public companies.  Enron, WorldCom, Tyco, and Sunbeam come to mind. These companies had CEOs prosecuted for fraud under mail fraud and securities laws. 

In 2002 SOX became law.  During the following 8 to 10 years, Congress and dozens of accountants claimed that SOX had dramatically increased the penalties for fraud. That was true in theory but not in the real world.

Since SOX became law in 2002, only one CEO, Richard Scrushy, has been prosecuted under SOX. He was acquitted! 

None of the CEOs who participated in mortgage securities fraud during the 2008 financial crisis, went to jail or even get prosecuted.

  

Calendar   Invite

Event: MCS   Special Retreat: Ethics in Focus

Location: Executive Room

Meeting   Organizer: Elisa   Izuki

The   managing director, Elisa Izuki, would like you and your team of MCS   consultants to develop an appreciation for ethical accounting standards and   the need for objectivity in your analysis. With that in mind, she invites all   the consultants working on the Choice Hotels project to an offsite company   retreat. During the retreat, a considerable amount of time is devoted to a   discussion of topics related to accounting ethics.

Assuming you and your colleagues are attending the retreat, complete the following tasks:

• Discuss why integrity, honesty,      and transparency are essential in financial reporting. Give credit to any      sources or real-world examples you use to support your statements.
• GAAP are the general rules,      regulations, and guidelines that accountants in the United States follow      to ensure their practices are legal and ethical. Explain to your      colleagues why GAAP is so useful. Give credit to any sources or real-world      examples you use to support your statements.

Submit one original posting of at least 250 words for this Discussion.

When you have finished Step 3, proceed to Step 4, where you will present your recent findings from Steps 1 to 3 in an executive summary.

Step 4: Prepare Executive Summary

  

INBOX   (1 NEW EMAIL)

From: Frank   Marinara, MCS Senior Partner

To: You

Now   that you’re at the end of your project with Choice Hotels, please prepare an   executive summary based on your analysis and recommendations from the   previous steps. This executive   summary,   along with citations for any sources you use, should be about one page in   length. 

Post   your executive summary in the submission folder located in the final step of   this project.

The   executive summary should demonstrate your ability to think critically. This   is your chance to be recognized for your knowledge in the accounting and   finance field.

Thanks   for your continued efforts.

Best,

Frank

Step 5: Submit Your Work

Final Deliverable Instructions

  

Step 2

Ratio   Analysis worksheet

Complete   workbook Project 2 workbook

 

Step 3

Accounting   ethics discussion

Complete   Accounting Ethics Discussion

 

Step 4

Executive   Summary

Complete   executive summary

When you submit your project, your work will be evaluated using the competencies listed below. You can use the list below to self-check your work before submission.

• 1.3:      Provide sufficient, correctly cited support that substantiates the      writer’s ideas.  
• 1.6:      Follow conventions of Standard Written English.  
• 1.7:      Create neat and professional looking documents appropriate for the project      or presentation.    
• 3.1:      Identify numerical or mathematical information that is relevant in a      problem or situation.
• 3.2:      Employ mathematical or statistical operations and data analysis techniques      to arrive at a correct or optimal solution.
• 3.3:      Analyze mathematical or statistical information, or the results of      quantitative inquiry and manipulation of data.
• 3.4:      Employ software applications and analytic tools to analyze, visualize, and      present data to inform decision-making.
• 5.1:      Develop constructive resolutions for ethical dilemmas based on application      of ethical theories, principles and models.
• 10.2:      Analyze financial statements to evaluate and optimize organizational      performance.

RESOURCES FOR PROJECT

Horizontal Analysis

Horizontal analysis, also known as trend analysis, includes comparisons made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time, especially compared to the previous year.

Trend percentages, also referred to as index numbers, help you to compare financial information over time to a base year or period. You can calculate trend percentages using the following formula:

• selecting      a base year or period
• assigning      a weight of 100 percent to the amounts appearing on the base-year      financial statements
• expressing      the corresponding amounts on the other years’ financial statements as a      percentage of base-year or period amounts

Compute the percentages using the equation analysis year amount / base year amount and then multiplying the result by 100 to get a percentage.

The following information for a sample company illustrates the calculation of trend percentages:

   

(USD millions)

20Y3

20Y4

20Y5

 

Net sales

$9,105.50

$10,029.80

$10,498.80

 

Cost of goods sold

$4,696.00

$5,223.70

$5,341.30

 

Gross profit

$4,409.50

$4,806.10

$5,157.50

 

Operating expenses

$3,353.60

$4,369.90

$4,012.00

 

Income before income taxes

$1,055.90

$436.20

$1,145.50

We will calculate the trend percentages using 20Y3 as the base year, and everything in 20Y3 will be 100 percent. For net sales in 20Y4, take ($10,029.80 from 20Y4 minus $9,105.50 from 20Y3) / $9,105.50 from 20Y3 and multiply by 100 to get 10.15%. The same process continues for each account using the amount for each account in the base year 20Y3. The trend analysis would look like this (calculations added beside each column):

   

Trend Analysis with Calculation

 

20Y3

20Y4

20Y5

 

Net Sales

100.0%

10.15%

($10,029 − $9,105.50) / $9,105.50

115.30%

$10,498.80 / $9,105.50

 

Cost of goods sold

100

111.2

$5,223.70 / $4,696.00

117.7

$5,341.30 / $4,696.00

 

Gross profit

100

109

$4,806.10 / $4,409.50

117

$5,157.50 / $4,409.50

 

Operating expenses

100

130.3

$4,369.90 / $3,353.60

119.6

$4,012.00 / $3,353.60

 

Income before income taxes

100

41.3

$436.20 / $1,055.90

108.5

$1,145.50 / $1,055.90

These trend percentages indicate the changes taking place in the organization and highlight the direction of these changes. In horizontal analysis, we find the percentage change from one year another one. For instance, the percentage of sales is increasing each year compared to the base year. Cost of goods sold increased at a lower rate than net sales in 20Y3 and 20Y5, causing gross profit to increase at a higher rate than net sales. Operating expenses in 20Y4 increased due to the provision for restructured operations, causing a significant decrease in income before income taxes. Percentages provide clues to an analyst about which items need further investigation or analysis. In reviewing trend percentages, a financial statement user should pay close attention to the trends in related items, such as the cost of goods sold in relation to sales. Trend analysis that shows a constantly declining gross margin (profit) rate may be a signal that future net income will decrease.

As useful as trend percentages are, they have one drawback. Expressing changes as percentages is usually straightforward as long as the amount in the base year or period is positive—that is, not zero or negative. Analysts cannot express a $30,000 increase in notes receivable as a percentage if the increase is from zero last year to $30,000 this year (remember, you cannot divide by zero). Nor can they express an increase from a loss last year of $10,000 to income this year of $20,000 in a realistic percentage term.

Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over several years. Such changes generally indicate areas worthy of further investigation and are merely clues that may lead to significant findings. Accurate predictions depend on many factors, including economic and political conditions; management’s plans regarding new products, plant expansion, and promotional outlays; and the expected activities of competitors. Considering these factors along with horizontal analysis, vertical analysis, and trend analysis should provide a reasonable basis for predicting future performance.

Check Your Knowledge

   

Comparative Balance Sheet with    Horizontal Analysis

 

Increase or

Decrease

 

2008 ($)

2007($)

Amount

Percent

 

Sales

1,498,000

1,200,000

298,000

24.8%

 

Cost of Goods sold

1,043,000

820,000

223,000

27.2%

 

Gross profit

455,000

380,000

75,000

19.7%

 

Selling expenses

191,000

147,000

44,000

29.9%

 

General expenses

104,000

97,400

6,600

6.8%

 

Total operating expenses

295,000

244,400

50,600

20.7%

 

Operating income

160,000

135,600

24,400

18.0%

 

Other income

8,500

11,000

(2500)

(22.7)%

 

Other expenses

168,500

146,600

21,900

14.9%

 

6,000

12,000

(6,000)

(50.0)%

 

Income before income tax

162,500

134,6000

27,900

20.7%

 

Income tax

71,500

58,100

13,400

23.1%

 

Net income

91,000

76,500

14,500

19.0%

 

Question 1

In the above example we do horizontal analysis for the year 2008. Percentage changes from one year to another year are horizontal or trend analysis. What is the change in Gross Margin in 2008 in comparison to 2007?

Gross margin has increased 19.7 percent, but sales have increased 24.8 percent.

Question 2

What was the total percentage change in gross margin? To determine the percentage change in gross margin, would you examine the change in sales or the change in cost of goods sold?

The gross margin in this case is 27.2 percent. This is determined by examining the change in cost of goods sold.

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