Proforma: Generally Accepted Accounting Principles and Judgmental Approach Essay

In addition to forecasting cash flows, managers and investors argon excessively interested in forecasts of the firms pecuniary line of reasonings. These professionalfessionaljected financial program lines are called pro forma financial statements. They give both the management and investors an pe makeration into what the financial statements give look like in the future and a head as to any need to raise long-term funds. The starting signal point in the creation of the pro forma financial statements is the construction of the pro forma income statement (do you remember why? ).Like the cash budget, it also relies heavily on the sales forecast. Significant illusions in the sales forecast go forth result in errors in the income statement which, in turn, entrust be stir errors on the pro forma relief planer. Pro Forma Income Statement There are both surfacees to creating the pro forma income statement the voice of sales method and what I will call the judgmental appro ach. The percentage of sales approach is simplistic and prone to error (estimating financial statements is tricky enough without compounding the error using an inferior technique).The percentage of sales method move intos that all items on the income statement except interest set down and tax expense parti-color in direct proportion to the change in sales. This is simply usually non true. Some items will change with sales, but others will not. deliberate the criticism of the percentage of sales approach at the top of rascal 116 in your text. My illustration will focus on the judgmental approach which allows the analyst to apply judgment to forecast the level of those items that are not expected to vary with sales. My vehicle for illustrating the creation of a pro forma income statement appears belowAssume that sales for the BMX Corporation are expected to be $12 million in 2008 and that sales in 2007 were $10 million. that assume that hail of goods sold can be divided into two parts a part that varies with sales and a part that does not (i. e. , cost of goods sold has both mulish and uncertain components). Further assume that operating expenses can also be divided a fixed portion and a variable portion. Further assume the firm plans to extend its borrowing in 2008 which will change magnitude interest expense on the income statement.The first look in the analysis is to determine the percentage increase in sales (2008 sales 2007 sales)/2007 sales = percentage change in sales ($12 million $10 million)/$10million 1 = . 2 or 20% The second step in the analysis is to construct the 2008 proforma income statement assuming those items that vary with sales will increase by the percentage change in sales (20%) and that those items that dont remain fixed. An model of this process is given on the Excel work opinion poll below. Double click on the worksheet to access it, then drum roll up or down as needed.Notice the variable expenses are found by taking the 2007 expense and ciphering by 1 + the percentage change in sales (1. 2). This increases those expenses by 120%. A common error students make is to simply multiply the variable expenses by the percentage change in sales. If we did that here, we would be multiplying the variable expenses by 20%. In other words, we would not be change magnitude variable expenses by 20%, we would be reducing them by 80%. Notice the pro forma net income for 2008 is $600,000. You may wish to analyze the raise using a strict percentage of sales approach would submit had on pro forma net income.Would net income be higher or lower as a result? You would be correct to sense datum the potential for an exam question here. Finally $200,000 in dividends are deducted from the $600,000 net income giving us a $400,000 addition to retained earnings. The third step is to use the $400,000 pro forma additions to retained earnings in addition to a number of other assumptions to compute the Pro Forma Balance Shee t. I will also use the judgmental approach in this step. The 2007 historical quietus sheet and the pro forma respite sheet for BMX Corporation appear in the Excel worksheet below.To access the worksheet, double click on it, then scroll up or down as needed to see location the worksheets. I will make the following assumptions regarding the pro forma balance sheet 1. The firm wants to continue to maintain a minimum cash balance of $100,000 2. Marketable securities will increase to $75,000 in 2008. 3. Accounts due have historically been 36. 5 days of sales. Since sales for 2008 are expected to be $12,000,000, accounts receivable will be $12,000,000 x (36. 5/365) = $1,200,000 (you could also do the following which is algebraically identical ($12,000,000/365) X 36.5). 4. Inventories have historically been 20% of cost of goods sold. Since cost of goods sold for 2008 are expected to be $9,000,000, inventories will be $9,000,000 x . 20 = $1,800,000. 5. Vectra will increase fixed assets by $750,000. dispraise expense for 2008 is estimated to be $200,000. dismiss fixed assets for 2008 will be Net fixed assets (2007) + additions to fixed assets depreciation expense 2008 $5,000,000 + $750,000 $200,000 = $5,550,000 6. Annual purchases (all on account) have historically averaged 60% of cost of goods sold.The accounts payable balance, in turn, is typically 20% of purchases. Accounts payable will therefore be $9,000,000 X . 60 X . 20 = $1,080,000 7. Taxes payable will be approximately one draw of the tax expense shown on the 2008 pro forma income statement. Taxes payable will check $400,000/4 = $100,000. 8. Notes payable will increase to $1,000,000. 9. There will be no change in other current liabilities, long-term debt, or common stock. 10. Retained earnings on the 2008 pro forma balance sheet will change by the additions to retained earnings ($400,000) shown on the pro forma income statement.Since the 2007 retained earnings was $1,000,000, the retained earnings fo r 2008 are expected to be $1,000,000 + $400,000 = $1,400,000. Notice the 2008 pro forma balance sheet did not initially balance e. i. , total assets ($8,725,000) did not equal the sum of total liabilities and equity ($8,332,500). In other words, the firms need to fund assets of $8,725,000 in 2008 will not be met at anticipated levels of debt and equity. This is the firms signal that it will have to raise funds by issuing spare debt or equity in the amount of $392,500.