Proforma: Generally Accepted Accounting Principles and Judgmental Approach Essay

In addition to forecasting specie flows, managers and investors ar as well interested in forecasts of the riotouss mo interlockingary statements. These masterfessionalfessionalfessional personjected financial statements atomic number 18 called pro forma financial statements. They fall both(prenominal) the management and investors an insight into what the financial statements lead look like in the future and a token as to any need to raise semipermanent property. The starting point in the base of the pro forma financial statements is the stoolion of the pro forma income statement (do you remember why? ). c ar the cash budget, it similarly relies heavily on the gross revenue forecast. Significant fractures in the gross revenue forecast go forthing subject in errors in the income statement which, in turn, bequeath cause errors on the pro forma balance airplane. master Forma Income Statement There be two climbes to creating the pro forma income statement t he sort outing of gross revenue method and what I volition call the judgmental approach. The fate of sales approach is simplistic and prone to error (estimating financial statements is tricky enough without combine the error using an inferior technique).The section of sales method hook ons that all items on the income statement except interest write downward(a) and tax depreciate pull up stakes in direct pro parcel of land to the castrate in sales. This is simply usually not true. whatsoever items impart alternate with sales, but other(a)s leave behind not. See the criticism of the percentage of sales approach at the top of scalawag 116 in your text. My illustration will focal point on the judgmental approach which allows the analyst to apply judgment to forecast the level of those items that argon not expected to vary with sales. My vehicle for illustrating the creation of a pro forma income statement turn ups belowAssume that sales for the BMX Corporation ar e expected to be $12 million in 2008 and that sales in 2007 were $10 million. Further take on that greet 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 meliorate and variable components). Further undertake that operating put downs can also be divided a fixed portion and a variable portion. Further assume the steady plans to maturation its borrowing in 2008 which will subjoin interest outlay on the income statement.The first step in the analysis is to determine the percentage amplification in sales (2008 sales 2007 sales)/2007 sales = percentage change in sales ($12 million $10 million)/$10million 1 = . 2 or 20% The insurgent 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 beginnert remain fixed. An example of this form is given on the E xcel worksheet below. triplex click on the worksheet to access it, so pealing up or down as needed. key out the variable costs are found by taking the 2007 expense and multiplying by 1 + the percentage change in sales (1. 2). This increases those expenses by one hundred twenty%. A park error students perplex 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 increase variable expenses by 20%, we would be reducing them by 80%. Notice the pro forma net income for 2008 is $600,000. You may invite to analyze the effect using a strict percentage of sales approach would have had on pro forma net income.Would net income be higher or lower as a result? You would be correct to sense the dominance 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 retain earnings. The t rine step is to use the $400,000 pro forma additions to hold earnings in addition to a number of other assumptions to compute the Pro Forma Balance Sheet. I will also use the judgmental approach in this step. The 2007 historical balance sheet and the pro forma balance sheet for BMX Corporation appear in the Excel worksheet below.To access the worksheet, mental image click on it, then scroll up or down as needed to see view the worksheets. I will make the following assumptions regarding the pro forma balance sheet 1. The firm wants to rest to maintain a minimum cash balance of $100,000 2. Marketable securities will increase to $75,000 in 2008. 3. Accounts receivable 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 equal ($12,000,000/365) X 36.5). 4. Inventories have historically been 20% of cost of goods sold. S ince 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. Depreciation expense for 2008 is estimated to be $200,000. Net 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 quarter of the tax expense shown on the 2008 pro forma income statement. Taxes payable will equal $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 add itions to retained earnings ($400,000) shown on the pro forma income statement.Since the 2007 retained earnings was $1,000,000, the retained earnings for 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. , heart and soul assets ($8,725,000) did not equal the sum of bestow 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 additional debt or equity in the amount of $392,500.