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Weis Markets Inc.—Measurement Concepts & Valuation

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Weis Markets Inc.—Measurement Concepts & Valuation Weis Markets Inc.—Measurement Concepts & Valuation Teaching Notes: The first part of this case centers on fundamental accounting concepts and includes questions about specific FASB Concepts Statements. The definitions of assets, liabilities and other components of the financial statements are essential building blocks for an understanding of current U.S. financial reporting and an understanding of its shortcomings. Instructors can supplement textbooks that do not cover the Concepts Statements with excerpts from the Concepts Statements themselves or from the very readable FASB Financial Accounting Series monograph by Reed Storey and Sylvia Storey. The concepts covered tie in nicely with those of the International Accounting Standards Board, too. Later, the case offers students the opportunity to value a company that owns a number of grocery chains. We make a number of simplifying assumptions, but in class discussion instructors should encourage students to challenge the assumptions and discuss how to arrive at more precise values. The case illustrates the important differences between book and market values. It also illustrates the difference between balance sheet and income statement-based valuation approaches. The case instructs students to assume a long-term growth rate of 3.87%. The case does not require it, but instructors can challenge students to independently come up with the rate. The easiest way to estimate g is to consider the growth in residual earnings [Bt(ROEt+1 - re)] over the three-year horizon period. That is, the numerator in the valuation model terms for years 1-3 is growing at 3.87%. The theoretical way to arrive at the rate is to note that ROE × (1 – dividend payout ratio – repurchase ratio + stock issuances) = Growth in equity. The term (1 - dividend payout ratio – repurchase ratio + stock issuances) is labeled the “plowback ratio” in some textbooks. For the Weis case: 9% × 43% = 3.87%. An active learning approach to this case involves splitting the class into three groups: buyers, sellers, and arbitrators. Have each group work independently to arrive at a valuation. Then have the groups negotiate. The arbitrators can determine what they feel is a “fair” price based on the arguments presented. Finally, have each group report back to the class. (Several sets of negotiations can take place. Depending on class size you may need to split them into 6 or 9 groups. An ideal group size is 3-5 students). Weis Markets Inc.—Measurement Concepts & Valuation 1 © Copyright 2012 by Cambridge Business Publishers, LLC. All rights reserved. No part of this publication may be reproduced in any form for any purpose without the written permission of the publisher. Weis Markets Inc.—Measurement Concepts & Valuation a. i. Users of Weis Markets, Inc., (Weis) financial statements include stockholders, financial analysts, creditors, Weis’s managers, and employees. Stockholders and financial analysts would like to know the relative “financial health of the company.” Creditors are interested in whether Weis can pay their debts as they come due. Weis’s management likely has access to more timely information than periodic external reports. However, to the extent that year-end bonuses or other contingent outcomes are based on reported results, managers would be interested in the final audited financials. The employees would like to know how much money the company made in the previous year when it comes time to negotiate their contracts. a. ii. If a company uses accrual-basis accounting, it records the effects of economic events as the events occur and not as cash (or its equivalent) is received or paid. Accrual-based accounting provides a better measure for assessing a firm’s performance because cash flows can be lumpy and not indicative of the firm’s true, underlying performance. Weis uses accrual- basis accounting. For example, Weis records wage expense as wages are earned regardless of whether employees are paid in advance or will be paid in some future period. Weis records these as “Accrued expenses” on the balance sheet. That is one indication that the company uses accrual accounting. a. iii. The going concern assumption is perhaps the most critical assumption underlying accrual accounting. Invoking the assumption, one assumes that the entity will operate beyond the current year, that is, indefinitely into the future. The going concern assumption must be met whenever a company capitalizes costs or records assets on the balance sheet. For example, Weis capitalizes “Prepaid expenses” which represent costs such as rent and insurance paid in advance. Rather than expense these costs immediately, Weis capitalizes the costs and amortizes them over the rental period. If the company was not expected to operate in the future, there would be no basis for calling such costs assets and allocating them over the rental periods. Thus, the going concern assumption is critical to the definition of an asset (from which the definitions of liability, revenue, and expense derive). Similar arguments can be made for the Property and equipment, Intangibles, and Goodwill accounts. In other words, there would be no expected future economic benefit because there is no future expected for the company. b. i. Typically, companies report the financial position of the company every quarter. The audited annual report is typically more detailed than the non-audited quarterly reports but the quarterly reports are made public on a more timely basis. b. ii. There is a trade-off between frequency of financial reports and their reliability. Whenever measurements need to be made prior to the settling of a transaction or residual uncertainty is resolved for an event, management will need to exercise judgment. The shorter the period between measurements, the less new information will be available, and therefore the more uncertain will be the adjustments. The remeasurement of assets and liabilities is what leads to the measurement of income. So, although there may be a demand for more timely performance reporting, users must recognize the trade-off between timeliness and reliability. Weis Markets Inc.—Measurement Concepts & Valuation 1 © Copyright 2012 by Cambridge Business Publishers, LLC. All rights reserved. No part of this publication may be reproduced in any form for any purpose without the written permission of the publisher. b. iii. More timely release of financial information enhances relevance. However, this often means that information may be less reliable. The more quickly a firm publicly releases its financial statements, the less time there is to verify the information. For example, one way to ascertain the accounts receivable balance at year-end is to observe collections after year- end. The shorter the period between year-end and the release of the financial statements, the fewer A/R collections will be observed—the balance must then be estimated. The trade-off between relevance and reliability is something firms and their auditors have long grappled with. The benefit to managers of increased reliability and relevance of financial reports is reduced cost of capital. Investors and creditors assess the riskiness of a company, in part, by the reliability of its reported financial information. The less risky a company is perceived, the lower the expected returns or the cost of debt. For investors, reliable information enhances investment decisions and reduces risk. c. i. Assets are probable future economic benefits obtained or controlled by the company as a result of past events or transactions. Assets are disclosed on the balance sheet. Some of Weis Markets’ assets include cash, prepaid expenses, accounts receivable, property and equipment, and intangibles like brand names they have acquired. c. ii. Liabilities are probable future economic sacrifices arising from present obligations to transfer assets or provide services to another entity as a result of past events or transactions. Liabilities are disclosed on the balance sheet with the exception of contingent liabilities whose amount cannot be measured. Weis Markets has liabilities in the form of accounts payable, accrued expenses, and income taxes payable. c. iii. Owners’ equity is the residual interest in the company – the difference between assets and liabilities. Some examples of owners’ equity at Weis Markets are common stock and retained earnings. c. iv. Investments by owners refers to any increase in the equity of the firm resulting from something valuable being transferred to the firm by shareholders. Transfers are found on the statement of stockholders’ equity and on the statement of cash flows. Weis issued shares each year as evidenced by the line item, “Proceeds from issuance of common stock” on the statement of cash flows. c. v. Distributions to owners are decreases in the equity of the firm owing to the transfer of assets or services to the shareholders. A common distribution to owners is the payment of dividends which are included on the statement of stockholders’ equity and statement of cash flows in the financing section. Weis Markets paid dividends to shareholders for the past three years. Another distribution is the repurchase of shares by the company from its shareholders. Weis has repurchased shares each of the past three years. c. vi. Revenues are increases in assets or decreases in liabilities due to the firm performing activities (delivering goods or performing services) that are considered central to the firm’s operations. Revenues are found on the income statement. At Weis, they are referred to as Net sales. Weis Markets Inc.—Measurement Concepts & Valuation 2 c. vii. Expenses are decreases in assets or increases in liabilities that result from the performing activities (delivering goods or performing services) that are considered central to the firm’s operations. Expenses are found on the income statement. Weis’ expenses include cost of goods sold for merchandise, operating, general, and administrative expenses, and income tax expense. c. viii. Gains are increases in assets or decreases in liabilities that are peripheral or incidental to the firm’s central operations.
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