Thiel machinery: the case of the disappearing LIFO.(Instructor's Note)

Jesswein, Kurt R.

CASE DESCRIPTION

This case requires the student to examine how a significant change in accounting principle will likely affect the financial condition and future funding situation of Thiel Machinery. Specifically, the student will examine how the probable abolition of the LIFO inventory costing method (as the U.S. moves towards acceptance of the International Financial Reporting Standard) will affect various financial ratios of the company, most notably the Altman Z-score. The student must make pro forma adjustments to the company's existing financial statements that account for the elimination of LIFO and calculate the expected change in the Z-score. Because the company is currently privately-held, the student will also need to estimate the market value of the company's equity using a free cashflow valuation model and examine how reduced cash flows from higher tax payments affect not only financial ratio calculations but potentially the value of the company itself.

CASE SYNOPSIS

Thiel Machinery, a successfully growing machinery company, is grappling with the potential impact of losing the ability of using LIFO inventory costing methods on its current and future funding sources. The student is placed in the role of a recently-hired assistant to the president and founder of the company. The student is charged with providing an analysis and summary report of the likely implications for the company's current financing situation and its upcoming stock issue.

INSTRUCTORS' NOTES

Pedagogy

The primary focus of the case is the financial statement adjustments and then re-calculation of the Altman Z-score for Thiel Machinery because of its inability to continue using LIFO. The student must take the perspective of a company analyst needing to not only be able to make the proper calculations but also be able to sufficiently explain to a supervisor the implications of his or her findings. The case would be appropriate for senior-level and graduate students with some prior exposure to inventory costing methods and financial statement analysis. The case i designed to be taught in two class hours and is expected to require two hours of outside preparation by students.

Teaching Plan

Class discussion should begin with a review of LIFO and FIFO inventory costing methods and the Altman Z-score model. Instructors may wish to structure the case discussions as follows:

1. Summarize the differences between LIFO and FIFO.

2. Describe the use of the Altman Z-score, both from a calculation and an interpretive perspective.

3. Summarize the use of free cash flow models to estimate the market value of a company's equity.

4. Calculate the Altman Z-score based on the reported financial statement data and an estimate of the market value of the company's equity.

5. Summarize the balance sheet and income statement adjustments associated with the abolition of LIFO-based accounting.

6. Recalculate the Altman Z-score after having made the adjustments to the financial statements and interpret the results.

7. Present a short report or memorandum on the assessment of the switch away from LIFO on the current financing situation of the company as well on its prospective issuance of common stock.

1. Summarize the differences between LIFO and FIFO.

Although a brief summary of LIFO and FIFO is presented in the case, a more thorough review may be necessary. LIFO (last-in, first-out) and FIFO (first-in, first-out) are both methods for allocating the total costs of inventory between the costs associated with inventory items sold during a period and the costs remaining in the unsold inventory. (There are other methods, most notably average-cost and specific identification, but these are not germane to the case). Both methods are acceptable under U.S. Generally Accepted Accounting Principles (GAAP) and U.S. tax regulations (Congress first approved the use of LIFO for tax purposes in the Revenue Act of 1939), but LIFO is not acceptable under the International Financial Reporting Standards (IFRS) to which the U.S. is currently moving towards.

LIFO associates the costs of the most recently acquired inventory with the inventory items sold (with the older inventory costs remaining on the balance sheet and reported as inventory on hand). Because prices and costs generally rise over time because of inflation, the LIFO method typically reports higher costs of goods sold and thereby lower profits, and, more importantly, lower amounts of taxes paid. Because more of the costs are assigned to the inventory sold, the remaining inventory on hand tends to be undervalued. Companies using LIFO are required to report an estimate of how much the inventory is likely undervalued relative to the current costs of replacing that inventory. In contrast, FIFO associates the older inventory costs with the inventory sold, reporting higher profits but also inventory that more closely resembles current market values.

2. Describe the use of the Altman Z-score, both from a calculation and an interpretive perspective.

The Altman Z-score is a model for predicting financial difficulties of companies based on readily available finance and accounting data. It was first developed over forty years ago (Altman, 1968) yet remains a widely-used tool in assessing the credit risk of borrowers. Through his use of discriminant analysis, Altman was able to isolate five ratios, which, when weighted in the proper proportions, combines to produce a score that is useful in determining which publicly-traded companies were likely to suffer financial defaults and which were not.

The five variables used in the formula are as follows: working capital to total assets ([X.sub.1]); retained earnings to total assets ([X.sub.2]); EBIT, or earnings before interest and taxes, to total assets ([X.sub.3]); market value of equity to book value of liabilities ([X.sub.4]); and sales to total assets ([X.sub.5]). The formula itself is as follows: Z = 1.2[X.sub.1] + 1.4[X.sub.2] + 3.3[X.sub.3] + 0.6[X.sub.4] + 0.999[X.sub.5]. Z-scores above 3.0 are typically associated with companies that are not expected to suffer financial defaults and Z-scores below 1.8 with companies expected to suffer such defaults. Scores between 1.8 and 3.0 were found to be in a zone of uncertainty but common sense would lead one to assume higher Z-scores are preferred over lower ones.

Note: More recently Altman (2002) has proposed a similar model applicable to privately-held firms. In this iteration, the model replaces the market value of equity with the book value of the equity in calculating a value for the [X.sub.4] variable and then reweights the variables in the updated formula as follows: Z = 0.717[X.sub.1] + 0.847[X.sub.2] + 3.107[X.sub.3] + 0.420[X.sub.4] + 0.998[X.sub.5]. The interpretation of the results remains the same. Although it would seem to be more appropriate to use this formulation of the model because Thiel is a privately-held company, students (and instructors) will not likely have been exposed to this version of the formula so it is not recommended except in situations where the calculation of ratios is a significant component of the course (e.g., a course in financial statement analysis or in credit analysis).

3. Summarize the use of free cash flow models to estimate the market value of a company' equity.

Many basic stock valuation models are variations of traditional dividend valuation models where the price of the stock can be estimated as the present value of a perpetual dividend as in the case of preferred stock or the present value of a constantly-growing perpetuity for common stock. Because Thiel does not pay dividends nor is it publicly-traded, such a model would not be applicable. A variation of this type of model instead is based on the company's free cash flows and is therefore more useful in a greater variety of situations such as this one.

Free cash flows are typically defined as the amount of cash generated by the company's operations that is available for future investment opportunities, after having made any required investments in fixed assets or working capital to sustain current operations. Given a base amount and some assumption of the future growth of those cash flows, the present value is calculated in a similar fashion to the dividend valuation models. After valuing the total amount of free cash generated by the operations, the amount necessary to pay off existing holders of the company's debt is subtracted, leaving the remaining value to the equity holders.

4. Calculate the Altman Z-score based on the reported financial statement data including the estimate of the market value of Thiel' equity.

Five of the values used in the formula (total assets, retained earnings, EBIT, total liabilities, and sales) are found on the balance sheet and income statement. Working capital is found as the difference between the company's current assets and its current liabilities, or, in this case, $161.1--$74.6 = $86.5 million. The remaining variable, market value of equity, would need to be found using the free cash flow methodology. The free cash flow for 2008 is given in the case ($25.0 million). Assuming a constant growth rate of three percent per year [any growth rate could be assumed but three percent is often assumed in many undergraduate textbooks], and then discounting the future cash flows at ten percent (the required rate of return of similar publicly-traded companies discussed in the case), the present value of the company's free cash flows is found as follows: [FCF x (1 + g)) / (r - g)], or [($25.0 million x 1.03) / (0.10--0.03)] = $367.9 million. Subtracting the $125.1 million of outstanding short-term and long-term debt leaves $242.8 million as the estimated market value of the company's equity.

The variables in the formula would then be determined as follows:

[X.sub.1] = working capital / total assets = $86.5 / $400.6 = 0.2591

[X.sub.2] = retained earnings / total assets = $125.1 / $400.6 = 0.4372

[X.sub.3] = EBIT / total assets = $65.6 / $400.6 = 0.1638

[X.sub.4] = market value of equity / total liabilities = $242.8 / $244.5 = 0.9929

[X.sub.5] = sales / total assets = $486.4 / $400.6 = 1.2142

The Z-score itself is then calculated as Z = 1.2 (0.2591) + 1.4 (0.4372) + 3.3 (0.1638) + 0.6 (0.9929) + 0.999 (1.2142) = 3.05. Because the score if above the 3.0 threshold, Thiel is in compliance with the loan covenant.

Note that if the book value variation of the Z-score model was used instead (substituting the book value of equity of $156.1 for the market value of $242.8), the Z-score would instead be calculated as Z = 0.717 (0.2591) + 0.847 (0.4372) + 3.107 (0.1638) + 0.420 (0.6384) + 0.998 (1.2142) = 2.41, which is considerably below the 3.0 threshold.

5. Summarize the balance sheet and income statement adjustments associated with the abolition of LIFO-based accounting.

The focus of the adjustments will be the found in the LIFO reserve balance that the company reported because of its use of LIFO. This amount (Thiel reported $42.8 million in 2008) would be added to the inventory value reported on the balance sheet as it would more closely approximate the replacement value or FIFO value of that inventory. Adding this amount to the inventory would result in similar increases to the amount of current assets and total assets, two of the variables used in the Z-score calculation.

The opposite side of the balance sheet would also need to be adjusted by the same amount (to keep the balance sheet balanced). This would be accomplished by accounting for the amount of taxes that would now be owed on the undervalued inventory (35 percent of the LIFO reserve to be reported as additional liabilities) and the remaining amount (65 percent) reported as additional retained earnings. Because of the current U.S. Treasury Department' recommendation that the previously deferred taxes be paid up over eight years, only one-eighth of the increased tax liability would be accounted for as a current liability with the remaining seven-eighths as a long-term liability. The adjustments to current liabilities, total liabilities, and retained earnings adjustmets would all affect the Z-score calculation.

Furthermore, the increase in the LIFO reserve during the year ($8.6 million) can be seen as an approximation of how much the cost of goods sold was overstated (and gross profits and operating profits understated) during the year. Increasing the operating profits (EBIT) by this amount will affect the Z-score calculation. In addition, given the tax rate of 35 percent, the company would also have reported and paid higher taxes of $3.0 million, leaving $5.6 million in additional net income for the year. These additional taxes would likely have decreased the free cash flows of the company by $3.0 million, with a resulting reduction in the market value of the company's equity, which would in turn affect the Z-score calculation.

A summary of the calculations is as follows:

1) Inventory as-reported + LIFO reserve = Adjusted inventory $116.8 million + $42.8 million = $159.6 million

2) Current assets as-reported + LIFO reserve = Adjusted current assets $161.1 million + $42.8 million = $203.9 million

3) Total assets as-reported + LIFO reserve = Adjusted total assets $400.6 million + $42.8 million = $443.4 million

4) Current liabilities as-reported + (LIFO reserve x 35% tax rate) / 8 years = adjusted current liabilities

$74.6 million + ($42.8 million x 35%) / 8 = $76.5 million

5) Adjusted working capital = Adjusted current assets--adjusted current liabilities

$203.9 million--$76.5 million = $127.4 million

6) Total liabilities as reported + (LIFO reserve x 35%) = adjusted total liabilities

$244.5 million + $15.0 million = $59.5 million

7) Retained earnings as-reported + (LIFO reserve x 65%) = adjusted retained earnings

$125.1 million + $27.8 million = $152.9 million

8) EBIT as-reported + Change in LIFO reserve = adjusted EBIT

$65.6 million + $8.6 million = $74.2 million

9) Adjusted market value of equity = [(Adjusted free cash flows x (1 + g)) / (r-g)]--value of debt

[(($25.0--$3.0) x (1.03)) / (0.10--0.03)] = $340.3 million--$125.1 million = $215.2 million

6. Recalculate the Altman Z-score after having made the adjustments to the financial statements and interpret the results.

The recalculated or adjusted variables in the Z-score formula would be as follows:

[X.sub.1] = working capital / total assets = $127.4 / $443.4 = 0.2874

[X.sub.2] = retained earnings / total assets = $152.9 / $443.4 = 0.3449

[X.sub.3] = EBIT / total assets = $74.2 / $443.4 = 0.1673

[X.sub.4] = market value of equity / total liabilities = $215.2 / $259.5 = 0.8294

[X.sub.5] = sales--total assets = $486.4 / $443.4 = 1.0959

The adjusted Z-score would be Z = 1.2 (0.2874) + 1.4 (0.3449) + 3.3 (0.1673) + 0.6 (0.8294) + 0.999 (1.0959) = 2.97. So despite the improvements to the ratio caused by the increased amount of working capital and EBIT, the lower market value of the equity and lower amount of retained earnings and of sales as a percentage of total assets causes the Z-score to fall below the 3.0 threshold and Thiel would not be in compliance with the loan covenant. This might be very significant, possibly jeopardizing its current financing arrangement. Note that if the book value variation of the Z-score model was used instead, the Z-score would have been Z = 0.717 (0.2874) + 0.847 (0.3449) + 3.107 (0.1673) + 0.420 (0.8294) + 0.998 (1.0959) = 2.37, slightly lower than originally calculated.

7. Present a short report or memorandum on the assessment of the switch away from LIFO on the current financing situation of the company as well on its prospective issuance of common stock.

As documented by the calculations asked for, losing the ability to use LIFO accounting can have negative effects to a company's financial ratios. Thiel could possibly be facing a short-term financing crisis if it is deemed that that company is no longer meeting its loan covenant of maintaining a Z-score above 3.0. Likewise, given the increased amount of taxes the company is likely facing, the reduction in free cash flows may have a detrimental impact on the amount of money the company might be expected to generate through a stock offering. The market value of the equity falls more than ten percent (from $242.8 million to $215.2) million using the free cash flow valuation model. If prospective investors use similar valuation models, the company will not be able to raise as much money per share. Thiel will either need to issue more shares than i had anticipated which will dilut the ownership share that Mr. Minnie was expected to maintain, or reduce its expansion plans.

RESOURCES

Altman, E.I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. Journal of Finance, 23:4, 589-609.

Altman, E.I. (2002). Revisiting credit scoring models in a Basel 2 environment. NYU Working Paper No. FIN-02-041. Available at SSRN: http://ssrn.com/abstract=1294413.

Bloom, R. & W.J. Cenker (2009). The dath of LIFO? Journal of Accountancy. January, 44-49.

Comiskey, E.E., C.W. Mulford & J.A. Thomason (2008). The ptential cnsequences of the eimination of LIFO as a prt of IFRS cnvergence. Working Paper, Georgia Tech Financial Analysis Lab, available at www.mgt.gatech.edu/finlab.

Federal Register (2008). Roadmap for the ptential ue of fnancial satements pepared in acordance wth iternational fnancial rporting sandards by U.S. isuers. Vol. 73, No. 226, Friday, November 21, 70816-56.

Guenther, D.A & M.A. Trombley (1994). The 'LIFO reserve' and the value of the firm: theory and empirical evidence. Contemporary Accounting Research, 10(2), 433-452.

Hoffman, M.J.R. & K.S. McKenzie (March, 2009). Must LIFO g to mke wy for IFRS? The Tax Adviser, 156-161.

Kieso, D.E., J.J. Weygandt, & T.D. Warfield (2007). Intermediate Accounting, Twelfth Edition. New York: John Wiley & Sons.

U.S. Department of the Treasury (2009). General eplanations of the aministration's fscal yar 2010 rvenue poposals. Available at www.ustreas.gov/offices/tax-policy/library/grnbk09.pdf. Accessed September 2, 2009.

Kurt R. Jesswein, Sam Houston State University