PROBLEM 11–4 Canada Steel, Ltd., produces steel castings and metal fabrications for sale to manufacturers of heavy construction machinery and agricultural equipment. Early in Year 3 the company’s president sent the following memorandum to the financial vice president:

TO: Robert Kinkaid, Financial Vice President FROM: Richard Johnson, President SUBJECT: Accounting and Financial Policies Fiscal Year 2 was a difficult year, and the recession is likely to continue into Year 3. While the entire industry is suffering, we might be hurting our performance unnecessarily with accounting and business policies that are not appropriate. Specifically:
(1) We depreciate most fixed assets over their estimated useful lives on a “tonnage-ofproduction”
method. Accelerated methods and shorter lives are used for tax purposes. A switch to straight-line for financial reporting purposes could:

(a) eliminate the deferred tax liability on our balance sheet, and

(b) leverage our profits if business picks up.
(2) Several years ago you convinced me to change from the FIFO to LIFO inventory method. Since inflation is now down to a 4% annual rate, and balance sheet strength is important in our current environment, I estimate we can increase shareholders’ equity by about $2.0 million, working capital by $4.0 million, and Year 3 earnings by $0.5 million if we return to FIFO in Year 3. This adjustment is real—these profits were earned by us over the past several years and should be recognized.
(3) If we make the inventory change, our stock repurchase program can be continued. The same shareholder who sold us 50,000 shares last year at $100 per share would like to sell another 20,000 shares at the same price. However, to obtain additional bank financing, we must maintain the current ratio at 3:1 or better. It seems prudent to decrease our capitalization if return on assets is unsatisfactory. Also, interest rates are lower (11% prime) and we can save $60,000 after taxes annually once our $3.00 per share dividend is resumed.
These actions would favorably affect our profitability and liquidity ratios as shown in the pro forma income statement and balance sheet data for Year 3 ($ millions):
Year 3 Year 1 Year 2 Estimate Net sales................................... $50.6 $42.3 $29.0 Net income (loss) ...................... $ 2.0 $ (5.7) $ 0.1 Net profit margin ...................... 4.0% — 0.3%
Dividends.................................. $ 0.7 $ 0.6 $ 0.0 Return on assets....................... 7.2% — 0.4%
Return on equity........................ 11.3% — 0.9%
Current assets .......................... $17.6 $14.8 $14.5 Current liabilities...................... $ 6.6 $ 4.9 $ 4.5 Long-term debt ......................... $ 2.0 $ 6.1 $ 8.1 Shareholders’ equity ................. $17.7 $11.4 $11.5 Shares outstanding (000s) ....... 226.8 170.5 150.5 Per common share Book value............................ $78.05 $66.70 $76.41 Market price range ............... $42–34 $65–45 $62–55*

Required:
Assume you are Robert Kinkaid, the financial vice president. Appraise the president’s rationale for each of the proposals. You should place special emphasis on how each accounting or business decision affects earnings quality. Support your response with ratio analysis.