Step 1: Review Financial Statements
As you start your second month of work at Maryland Creative Solutions, LLC (MCS), the senior partner, Frank Marinara, has been pleased with your work as an economic analyst. He would like to turn your attention to a corporate accounting project. Here are the details:
Dialogue with Frank Marinara
“I wanted to meet today about assigning you a corporate accounting project. It is necessary to understand the client’s accounting and strategy before we can consider recommendations.
Choice Hotels’ accounting is audited by Ernst & Young LLP. This same firm audits their internal controls. As a result of the Sarbanes-Oxley Act of 2002 (SOX), Choice Hotels must rely on a different firm for accounting advice, and it will likely use one of the other big four accounting firms.
I am handing down this assignment from our managing director, Elisa Izuki, who heads the accounting projects group in MCS. She has asked for a complete review and ratio analysis of the most recent 10-K annual financial statements for Choice Hotels International, Inc.
“Speaking of financial statements,” Frank adds, “the most common financial statements are the income statement, balance sheet, and statement of cash flows. While you are at it, you should know a bit about accounting conventions and standards in the United States.”
Your goal is to develop an understanding of the business of Choice Hotels using the 2018 annual report that the company files with the Securities and Exchange Commission (10-K). I recommend you analyze the 10-K financial reports using accounting and finance ratios after you read key parts of the Document.
Ratio analysis is especially difficult because Choice Hotels is one of the largest hotel franchisors in the world. The company does not sell any products and has no inventory, and because of this, some traditional analyses does not apply.
Also, the company has had and continues to have an aggressive Treasury stock repurchase program, and this has caused negative equity on the balance sheet. Many companies have had stock repurchase programs in recent history. Choice Hotels has been among the most aggressive in Treasury stock repurchase programs. The negative equity means that we cannot use ratios like Return on Equity and Debt to Equity. Fortunately, there are other ratios we can use.
Choice Hotels’ management recently completed a large acquisition. You need to understand what was acquired.
The first part of the 10-K Document has useful information that describes the business, the risk factors, and Management’s Discussion and Analysis of Financial Condition and Results of Operations. This information is beneficial to your analysis.
Analysts use the Notes to Consolidated Financial Statements in the 10-K Document to evaluate the riskiness of the debt. The notes also state that Choice Hotels has an investment grade credit rating. However, the interest rates seem high compared to our other clients. Both Standard & Poor’s and Moody’s rate Choice Hotels’ debt as the lowest investment grade BBB- and Baa3 with a stable outlook.
I’ll send over an Excel workbook with questions for you to complete. These questions require an understanding of the client, its strategy, and appropriate ratios. Please read the questions carefully and submit all deliverables. That is it for now. Please reach out should you have any questions.”
After you have completed your review of Choice Hotels’ financial reports, you will need to complete a horizontal analysis (see resources BELOW)
To complete your assignment for Elisa and Frank, perform the following tasks during Week 3:
- Download the Project 2 Excel Workbook (see attachment) that MCS developed in house, read the instructions page carefully, and review the most recent Choice Hotels’ 10-Q reports and two recent 10-K reports found on the SEC website. The link to the report is embedded within the Project 2 Excel Workbook.
- Perform a horizonal analysis by completing the Income Statement and Balance Sheet worksheets within the Project 2 Excel Workbook.
- Answer the questions in the Income Statement, Balance Sheet, and Cash Flow worksheets within the Project 2 Excel Workbook.
- Submit your Project 2 Excel Workbook for feedback to the submission folder located in the final step of this project.
Now that you have completed Step 1, proceed to Step 2, where you will evaluate business operations of Choice Hotels based on the completion of a ratio analysis.
Step 2: Evaluate Business Performance Using Ratio Analysis
MCS asks that analysts review the financial health of the client’s business by completing ratio analysis. Frank explains that Choice Hotels has an aggressive strategy to grow revenues and stock price. The company does this by accepting ratios that might be outside normal industry ranges.
Ratio analysis is an analytical tool for understanding financial results and trends over time, and for providing key indicators of organizational performance. Typically, ratios are calculated by using data from the income statement, balance sheet, and statement of cash flows. This information can be found in the 10-K Document. MCS uses a customized worksheet to report ratio calculations, results, analysis, and recommendations for clients.
Financial ratios are used for many types of businesses in various industries. For a hospitality business such as Choice Hotels, you have selected a set of financial accounting ratios that are most appropriate for the client.
Frank stops by your office to give a few pointers:
Dialogue with Frank Marinara
“Choice Hotels would like us to look at their balance sheet and provide them with guidance on what they should or should not do to better manage their assets.
Your ratio calculations should be completed in the Ratio Analysis worksheet in the Project 2 Excel Workbook.
Complete the workbook with data from the Income Statement, Balance Sheet, and Statement of Cash Flows worksheets. As part of your analysis of Choice Hotels’ strategy, you will also need to answer a few questions in the worksheet.
When you have completed Step 2, proceed to Step 3, where you will discuss accounting ethics.
Step 3: Participate in Discussion of Accounting Ethics
Choice Hotels requires high levels of integrity, honesty, and transparency in the development of financial reports. They must ensure compliance with the standards articulated by international bodies like the Financial Accounting Standards Board, Generally Accepted Accounting Principles (GAAP), and the International Financial Reporting Standards (IFRS) Board.
Before 2002 and prior to SOX there were a number of high profile frauds in public companies. Enron, WorldCom, Tyco, and Sunbeam come to mind. These companies had CEOs prosecuted for fraud under mail fraud and securities laws.
In 2002 SOX became law. During the following 8 to 10 years, Congress and dozens of accountants claimed that SOX had dramatically increased the penalties for fraud. That was true in theory but not in the real world.
Since SOX became law in 2002, only one CEO, Richard Scrushy, has been prosecuted under SOX. He was acquitted!
None of the CEOs who participated in mortgage securities fraud during the 2008 financial crisis, went to jail or even get prosecuted.
Event: MCS Special Retreat: Ethics in Focus
Location: Executive Room
Meeting Organizer: Elisa Izuki
The managing director, Elisa Izuki, would like you and your team of MCS consultants to develop an appreciation for ethical accounting standards and the need for objectivity in your analysis. With that in mind, she invites all the consultants working on the Choice Hotels project to an offsite company retreat. During the retreat, a considerable amount of time is devoted to a discussion of topics related to accounting ethics.
Assuming you and your colleagues are attending the retreat, complete the following tasks:
- Discuss why integrity, honesty, and transparency are essential in financial reporting. Give credit to any sources or real-world examples you use to support your statements.
- GAAP are the general rules, regulations, and guidelines that accountants in the United States follow to ensure their practices are legal and ethical. Explain to your colleagues why GAAP is so useful. Give credit to any sources or real-world examples you use to support your statements.
Submit one original posting of at least 250 words for this Discussion.
When you have finished Step 3, proceed to Step 4, where you will present your recent findings from Steps 1 to 3 in an executive summary.
Step 4: Prepare Executive Summary
INBOX (1 NEW EMAIL)
From: Frank Marinara, MCS Senior Partner
Now that you’re at the end of your project with Choice Hotels, please prepare an executive summary based on your analysis and recommendations from the previous steps. This executive summary, along with citations for any sources you use, should be about one page in length.
Post your executive summary in the submission folder located in the final step of this project.
The executive summary should demonstrate your ability to think critically. This is your chance to be recognized for your knowledge in the accounting and finance field.
Thanks for your continued efforts.
Step 5: Submit Your Work
Final Deliverable Instructions
Ratio Analysis worksheet
Complete workbook Project 2 workbook
Accounting ethics discussion
Complete Accounting Ethics Discussion
Complete executive summary
When you submit your project, your work will be evaluated using the competencies listed below. You can use the list below to self-check your work before submission.
- 1.3: Provide sufficient, correctly cited support that substantiates the writer’s ideas.
- 1.6: Follow conventions of Standard Written English.
- 1.7: Create neat and professional looking documents appropriate for the project or presentation.
- 3.1: Identify numerical or mathematical information that is relevant in a problem or situation.
- 3.2: Employ mathematical or statistical operations and data analysis techniques to arrive at a correct or optimal solution.
- 3.3: Analyze mathematical or statistical information, or the results of quantitative inquiry and manipulation of data.
- 3.4: Employ software applications and analytic tools to analyze, visualize, and present data to inform decision-making.
- 5.1: Develop constructive resolutions for ethical dilemmas based on application of ethical theories, principles and models.
- 10.2: Analyze financial statements to evaluate and optimize organizational performance.
RESOURCES FOR PROJECT
Horizontal analysis, also known as trend analysis, includes comparisons made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time, especially compared to the previous year.
Trend percentages, also referred to as index numbers, help you to compare financial information over time to a base year or period. You can calculate trend percentages using the following formula:
- selecting a base year or period
- assigning a weight of 100 percent to the amounts appearing on the base-year financial statements
- expressing the corresponding amounts on the other years’ financial statements as a percentage of base-year or period amounts
Compute the percentages using the equation analysis year amount / base year amount and then multiplying the result by 100 to get a percentage.
The following information for a sample company illustrates the calculation of trend percentages:
Cost of goods sold
Income before income taxes
We will calculate the trend percentages using 20Y3 as the base year, and everything in 20Y3 will be 100 percent. For net sales in 20Y4, take ($10,029.80 from 20Y4 minus $9,105.50 from 20Y3) / $9,105.50 from 20Y3 and multiply by 100 to get 10.15%. The same process continues for each account using the amount for each account in the base year 20Y3. The trend analysis would look like this (calculations added beside each column):
Trend Analysis with Calculation
($10,029 − $9,105.50) / $9,105.50
$10,498.80 / $9,105.50
Cost of goods sold
$5,223.70 / $4,696.00
$5,341.30 / $4,696.00
$4,806.10 / $4,409.50
$5,157.50 / $4,409.50
$4,369.90 / $3,353.60
$4,012.00 / $3,353.60
Income before income taxes
$436.20 / $1,055.90
$1,145.50 / $1,055.90
These trend percentages indicate the changes taking place in the organization and highlight the direction of these changes. In horizontal analysis, we find the percentage change from one year another one. For instance, the percentage of sales is increasing each year compared to the base year. Cost of goods sold increased at a lower rate than net sales in 20Y3 and 20Y5, causing gross profit to increase at a higher rate than net sales. Operating expenses in 20Y4 increased due to the provision for restructured operations, causing a significant decrease in income before income taxes. Percentages provide clues to an analyst about which items need further investigation or analysis. In reviewing trend percentages, a financial statement user should pay close attention to the trends in related items, such as the cost of goods sold in relation to sales. Trend analysis that shows a constantly declining gross margin (profit) rate may be a signal that future net income will decrease.
As useful as trend percentages are, they have one drawback. Expressing changes as percentages is usually straightforward as long as the amount in the base year or period is positive—that is, not zero or negative. Analysts cannot express a $30,000 increase in notes receivable as a percentage if the increase is from zero last year to $30,000 this year (remember, you cannot divide by zero). Nor can they express an increase from a loss last year of $10,000 to income this year of $20,000 in a realistic percentage term.
Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over several years. Such changes generally indicate areas worthy of further investigation and are merely clues that may lead to significant findings. Accurate predictions depend on many factors, including economic and political conditions; management’s plans regarding new products, plant expansion, and promotional outlays; and the expected activities of competitors. Considering these factors along with horizontal analysis, vertical analysis, and trend analysis should provide a reasonable basis for predicting future performance.
Check Your Knowledge
Comparative Balance Sheet with Horizontal Analysis
Cost of Goods sold
Total operating expenses
Income before income tax
In the above example we do horizontal analysis for the year 2008. Percentage changes from one year to another year are horizontal or trend analysis. What is the change in Gross Margin in 2008 in comparison to 2007?
Gross margin has increased 19.7 percent, but sales have increased 24.8 percent.
What was the total percentage change in gross margin? To determine the percentage change in gross margin, would you examine the change in sales or the change in cost of goods sold?
The gross margin in this case is 27.2 percent. This is determined by examining the change in cost of goods sold.
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