Question ID#: 28812 T-Table F-Table 5% F-Table 2.5% Chi-Table Durbin-Watson Z-Table Z-Table Alt -------------------------------------------------------------------------------- Great Plains Grains (GPG) reported the following 2003 year-end data: Net income $45 million Dividends $10 million Total long-term liabilities $100 million Total shareholder’s equity $200 million Effective tax rate 40 percent Following the release of this data, GPG discovered that the service and interest costs related to their pension fund accounting had been miscalculated. The new estimates are $5 million and $8 million higher than the original estimates. What is the impact on the debt to equity ratio? The new debt/equity ratio is: A) 56.5%. B) 61.7%. C) 56.1%. D) 62.2%. Your answer: A was incorrect. The correct answer was C) 56.1%. The increases in the service and interest costs will decrease net income by $7.8 million ((5 + 8) × (1 - 0.40)). Due to the reduction in income retained earnings will fall by the same amount reducing equity to $192.2 million (200 – 7.8). Moreover, the new calculations will increase net liabilities by $7.8 million. Therefore, the new debt/equity ratio is 56.1% ((100 + 7.8) / (200 – 7.8)). So when you are adjusting the Balance Sheet for adjusted expenses you are always supposed to add them after-tax?
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Schweser gave a bad explanation. You would reduce equity by (8+5)(1-tax) because the remaining (8+5)(tax) would go into decreasing your deferred tax liability.
thepinkman, I’m not an accountant, but here’s what I learned from John Harris workshop. Under the “New” U.S. GAAP standard (SFAS No. 158), when making a pension asset or liability adjustments, the offsetting entries are made to OCI and deferred taxes. So in this question, SC and IC were increased. If you’ll remember, SC and IC are part of Pension Expense calculation. So when you increase both SC and IC, you are essentially increasing your pension expense. Hence, the two offsetting entries will be OCI and deferred taxes in this case. So here’s a little trick that John taught us: Remember, A = L + E 1) You’ve just increased your Liability amount by 13 for pension expense. 2) Now, what do you have to do to make your B/S balance? You now have to DECREASE the Equity section. BUT not by the entire 13, but rather by 13*(1-tax rate), which is 40% in this question. So you will decrease your equity on the B/S by 7.8. This amount is a direct to equity adjustment (a.k.a OCI). 3) So now, you will need to adjust your liability again. Remember, in step 1 above, you increased your liability by 13, but now you’ve only decreased your equity by 7.8. So you must decrease your liability by 5.2 to for net increase of 7.8. This 5.2 adjustment, which is a plug figure, is the decrease in your deferred tax liability. 4) Now you’re in balance and everyone is happy. Thus, your new debt figure is (100+7.8) and your new equity is (200-7.8). Divide the two numbers, and there’s your 56.1%. I hope I didn’t confuse you here. And I’ll give all the credit here to John Harris again. He was awesome.
I use the same formula L2Djae: A = L + E Now you know your costs were understated so your PBA has to go down by 13 on the asset side. Since the balance sheet has to balance, a decrease in assets of 13 would be balanced by a decrease in DTL by (13*tax rate) with a decrease of (13)(1-tax rate) in equity. that way the two sides will balance out. It does not matter how you look at it, the key thing is that the balance sheet must balance.
l2djae good stuff, thanks T/G