Analyzing and Interpreting Trends in Earnings and Earnings Components

Income statements of Ferro Corporation, along with its note 7 on income taxes and selected information from its Form 10-K, are reproduced below:

CONSOLIDATED STATEMENT OF INCOME

Years Ended December 31, Year 6 and Year 5

($ thousands) Year 6 Year 5

Net sales$376,485 $328,005

Cost of sales266,846 237,333

Selling and administrative expenses 58,216 54,140

Research and development 9,972 8,205

Operating expenses 335,034 299,678

Operating income 41,451 28,327

Other income

Equity in net earnings of affiliated companies 1,394 504

Royalties710 854

Interest earned 1,346 1,086

Miscellaneous1,490 1,761

Total other income 4,940 4,205

Other charges

Interest expense4,055 4,474

Unrealized foreign currency translation loss 4,037 1,851

Miscellaneous 1,480 1,448

Total other charges9,572 7,773

Income before taxes 36,819 24,759

U.S. and foreign income taxes (note 7)16,765 11,133

Net income$ 20,054 $ 13,626

Notes to Financial Statements

Income tax expense is comprised of the following components ($ thousands):

Year 6 U.S. Federal Foreign Total

Current$5,147 $11,125 $16,272

Deferred353 140 493

Total $5,500 $11,265 $16,765

Year 5U.S. Federal Foreign Total

Current$2,974 8,095 $11,069

Deferrred180 (116) 64

Total $3,154 $3,154$ 7,979 $11,133

Deferred income taxes were mainly the result of using accelerated depreciation for income tax purposes and straight-line depreciation in the consolidated financial statements. State and local income taxes totaling approximately $750,000 and $698,000 in Year 6 and Year 5, respectively, are included in other expense categories. A reconciliation between the U.S. federal income tax rate and the effective tax rate for Year 6 and Year 5 follows:

Year 6Year 5

U.S. federal income tax rate 48.0% 48.0%

Earnings of consolidated subsidiaries taxed at rates less than

the U.S. federal income tax rate (5.3) (5.3)

Equity in after-tax earnings of affiliated companies (1.4) (0.8)

Unrealized foreign exchange translation loss 5.3 3.6

Additional U.S. taxes on dividends from subsidiaries and affiliates 0.8 1.0

Investment tax credit (1.5) (0.9)

Miscellaneous (0.4) (0.6)

Effective tax rate 45.5% 45.0%

The following information from Ferro Corporation's Form 10-K is available:

Year 6 Year 5

Cost of sales includes ($ thousands)

Repairs and maintenance$15,000 $20,000

Loss on disposal of chemicals division 7,000

Selling and administrative expenses include ($ thousands)

Advertising$ 6,000 $7,000

Employee training program 4,000 5,000

Required:

a. Recast Ferro's income statements for Years 5 and 6. Show computations.

b. Identify factors causing income tax expense to differ from 48% of pretax income. Identify any random or unstable factors.

c. What significant changes can you identify in Ferro's operating policies for Year 6? (Hint: Limit your analysis to outlays for repairs and maintenance, advertising, and employee training programs.)

CHECK Recast operating income, Year 6 # $20,520; Year 5 # $17,215

Note: This Problem taken from The Book of Financial Statement Analysis by K. R. Subramanyam Eleventh Edition Chapter 11 Equity Analysis and Valuation Case 11.1 Page-645-646.