(Determining the effect of a big bath on future earnings and financial ratios, LO 1, 2) Vogar Ltd. (Vogar) is a public company that manufactures machine parts.

In its most recent financial statements Vogar wrote down $20,000,000 of its capital assets. The assets will continue to be used by Vogar. The new president and CEO of Vogar announced that the write-downs were the result of competitive pressures and poor performance of the company in the last year. The write-downs were reported separately in Vogar’s income statement as a “non-recurring” item. The write-off is not included in the calculation of operating income. In addition, Vogar wrote down its inventory in fiscal 2004 by $2,000,000. The amount is included in cost of sales.

Vogar’s summarized income statement for the year ended December 31, 2004 is

(amounts in millions of dollars):

The write-downs will reduce the amortization expense by $2,500,000 per year for each of the next eight years. After the announcement and release of the income statement, analysts revised their forecasts of earnings for the next three years to:
Year ended December 31, 2005 $ 4,000,000 Year ended December 31, 2006 $ 9,000,000 Year ended December 31, 2007 $12,000,000 You also obtained the following information from Vogar’s December 31 2003 and 2004 balance sheets:

Required:

a. What would net income be in each of 2004 through 2007 had Vogar not written off the assets and continued to amortize them? Assume that the operations of Vogar do not change regardless of the accounting method used. Interpret the differences in net income under the two scenarios.

b. What would Vogar’s gross margin, profit margin, debt-to-equity ratio, return on assets, and return on equity be in 2004 assuming (i) that the assets had been written off and (ii) assuming that the assets had not been written off and they were continuing to be amortized? Interpret the results under each assumption.

c. How would the write-downs in 2004 affect Vogar’s gross margin, profit margin, debt-to-equity ratio, return on assets, and return on equity in 2005 through 2007? How is your ability to analyze and interpret the financial statements affected?

Transcribed Image Text:

Revenue Operating expenses: Cost of sales Amortization Selling general and administrative costs Operating income Other expenses: Non-recurring item Interest expense Income tax expense Net income $95 $52 14 18 84 11 5 27 ($16)