RUSSIAN v. U.S. ACCOUNTING POLICIES

Roy Den Hollander, 97-IAAccounting B7023

Prof. Trevor S. Harris

THIS REPORT IS BASED ON INFORMATION AVAILABLE AS OF OCTOBER 1995.

Red October v. Tootsie Roll

I. INSTITUTIONAL ENVIRONMENT

Turmoil continues in Russia. The break up of the Soviet Union in 1991 unleashed

conflicting forces: those pushing for a quick transition from a centrally planned to a market

economy, others pressuring for a slow transformation and some even trying to drag the country

back into the totalitarian past.

Under the Communist Party, Russia was marked by arbitrary rule, a privileged

bureaucracy and the black market. All property belonged to the state, which built entire cities

around industrial complexes. State owned companies with credits from the Central Bank

supported the local population with apartments, utilities, schools, hospitals, transportation, food,

etc. Soviet central planning created a large bureaucracy with each industry sector run by a

ministry in Moscow. Centralized distribution inhibited horizontal relationships between

individual firms. Companies lacked competent management because ministry bureaucrats chose

CEOs willing to share the spoils of theft (sold on the black market) and do anything to meet

output quotas: the measure of success in Communist Russia since a functionary’s career and

bonus depended on output – not profit. If truck mileage measured output, managers directed

their truckers to spend the day driving in circles around Moscow. In addition, these

nomenklatura managers, many still in control of companies, did not view capital goods as an

investment that produced a return over the long run because the more capital goods ordered, the

more successful a manager appeared. Oil companies would leave a rig standing after drilling a

dry hole, then order another rig and move on to the next spot. Concentration on maximizing

capital input and product output made marketing, advertising, sales price, costs and budget

constraints irrelevant. Financing under the Soviet system occurred through only a few banks

that channeled credits at low interest rates from the government to industry. The government

often forgave repayment and provided subsidies to prevent bankruptcy.

The legacy of Communism continues to haunt Russia today. Many managers, including

those in privatized firms, do not understand that profit maximization, not volume, governs

production. Many other managers who understand the economics of capitalism do not support

it. Uralmash’s CEO says 45% of his executives oppose a market economy. Nomenklatura 2

managers, unrestrained by the disciplining influence of the former Communist Party, run up

accounts receivable and payable in collusion with other firms, then divert the goods and

materials to the black market for their own profit while invoicing each other’s firm as if the

products had been delivered.

The Soviet Union’s emphasis on industrialization left Russia overly industrialized.

Forty-six percent of the population works in the industrial sector as compared to 29% of the

population for OECD countries. Ironically, Russia needs to de-industrialize in order to increase

its living standard, while at the same time eliminating outmoded manufacturing equipment and

techniques, worker apathy and the plethora of different products inefficiently produced by many

firms. The World Bank estimates that most Russian companies need to cut 20 to 60% of their

product lines of which many are losing the competitive battle to higher quality imports. In

addition, the Soviet requirement that most of the population work made industry labor intensive,

which continues today due to the lack of capital investment and advanced technology.

Although inflation continues to fall from 3000% in 1992 to 900% in 1993 to 200% in

1994, the government’s continued monetization of its deficit by borrowing from the Central

Bank keeps Russia a hyperinflationary country. Government T-bills pay 18% per month and the

ruble continues to fall against the dollar. The deficit results from continued government

subsidies to industries such as agriculture, energy (especially coal) and the military-industrial

complex. Subsidies cause artificially low prices, especially in energy, which distort the cost and

price calculations of enterprises. Subsidies persist because most public officials believe the

government should support production rather than provide for a stable currency or regulate

markets.

Whether the mixture of change and intransigence have placed Russia’s economy in a

condition of stagflation, depression or growth remains unclear. Official figures show industrial

output declining by 50% since 1989. (More than the American contraction in the 1930’s.) But

many managers underreport their income to avoid taxes. The purpose of Russian accounting

methods are to provide tax information, so many companies keep the required tax books and

another set for running and often times embezzling from the firm (not unlike Al Capone). Some

estimate unrecorded transactions as accounting for 25% or more of the reported GDP. So the

Russian economy may be better off than generally believed. The vast shadow economy

increases consumer disposable wealth as a result of tax evasion. Privatization and reduced

subsidies forced formerly state-owned companies to shut down many value subtracting product

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lines, causing a decrease in output but an increase in national income because the inputs,

including subsidies, were worth more than the outputs. Even though Russia’s economy may be

growing, the huge cost of its universal welfare system and environmental clean-up will hinder

growth in the intermediate and long term.

The recently completed privatization process gave Russia a boost toward a market

economy. 16,000 medium and large sized firms and 95% of all retail shops are now privatized

and produce over 62% of the GDP. But evaluating Russian privatized companies is difficult.

Financial statements generally value a firm at old, highly deflated costs. Many of the privatized

conglomerates continue to include in their costs activities that local governments in developed

countries normally operate. Firms are trying to spin-off these unprofitable operations to the

municipalities. But the local governments, still run by former Communist bureaucrats, lack the

ability and the financing from taxes to operate public services. Even if the population could

afford and paid its taxes, many officials would embezzle the funds.

The future prospects of firms are clouded by the government’s significant minority

ownership in many firms and workers control of a majority or large minority of the shares.

Worker shareholders often still defer to the old line managers who continue to run their firms as

personal fiefdoms in contempt of new investors unless the investors are the banks and mutual

funds run by the same bureaucrats whom company managers dealt with in the past. The “good

old commie network” still exercises influence through personal contacts. The general public that

purchases shares through banks, mutual funds or directly via the privatization process exerts

little influence because of the absence of shareholder rights laws.

Privatization eliminated most subsidies for non-government owned firms, so many

Russian companies need to find new sources of capital for restructuring (which means laying off

large numbers of workers that could lead to social unrest) and modernizing to increase

productivity. Russians saved 33% of their GDP in 1994 but invested only 16%. The remainder

either stayed within Russia in the form of hard currency (essentially kept under the mattress) or

was transferred to safer places overseas -- $60 billion went overseas in the past four years.

Funds established by Western financial services companies, governments and multilateral

institutions, such as the European Bank for Reconstruction and Development, have invested little

due, in part, to insufficient accounting policies. Russia’s statutory accounting system fails to

provide meaningful numbers for investors and managers. The profit and loss account tells little

about a firm’s operating results while the balance sheet fails to indicate net worth. Under

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Russian accounting, Auto Vaz, one of Russia’s largest car makers, appears to have a high market

value, but IASC conventions show it is worth next to nothing. The lack of understanding of

economic concepts, such as the time value of money, opportunity costs and determination of

prices by a market, along with the emphasis on tax reporting keep financial statements from

providing insight into a company’s status and operations. As a result, financial markets cannot

effectively channel funds from lenders to borrowers because high information costs keep returns

too low for a given risk. Other problems also plague Russia’s embryonic financial markets such

as fraud, indeterminate shareholder rights, and the absence of law enforcement. Without secure

rights, potential investors fear that employees and managers, who own large percentages of

companies, will lessen any potential return by pursuing high wages and full employment rather

than restructuring. In addition, government instability and erratic actions also threaten

shareholder value by stripping a company’s cash through taxes, regulations, customs duties,

restrictions on layoffs and possible renationalization.

Financing intermediaries have not yet evolved as a significant source of capital. Of the

2500 commercial banks, most have no assets to speak of, no professional staff, 70% are

unstable, 30% are likely to go bankrupt and organized crime controls 80% of them. Many

private commercial banks were set up by government ministries or state-owned corporations for

the purpose of lending money to a private firm or group of firms (rather than to any creditworthy

customer) and for enriching a private company’s founders with government largesse. Many

commercial banks make money not through loans but by accepting ruble deposits that the banks

exchange for dollars then wait for the ruble to drop in value and pay the depositor interest or

principal with the bank realizing a significant gain on the exchange. High inflation, however,

hinders savings so this source of income is tenuous. Banks, therefore, also borrow rubles from

the Central Bank at negative interest rates, exchange the rubles for dollars provided by the

International Monetary Fund and import Western consumer goods, which they sell for rubles

that yield a high ruble profit after repaying the Central Bank loans. Banks also engage in other

complex financial manipulations with the aid of their associates in the government. Even if

Russian banks concentrated on loan portfolios, inflation, thin capitalization and the lack of

know-how in determining credit worthiness would prevent them from making intermediate or

long-term loans for capital investment. What loans the banks do make are monthly and for

working capital. The quality of these short-term loans is often unknown due to Russia’s

deficient accounting procedures. The lack of financial intermediaries has forced Russian firms

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to raise capital by stripping their assets, trying to sell equity or running up their accounts

payable. Intercompany debt now equals 16% of GDP.

The lack of the rule of law hinders business activities and increases investor risks. The

absence of land law and property registers raises questions over who owns the land on which a

company stands. As a result, firms cannot raise capital by mortgaging land. Failure to enforce

antitrust laws results in price fixing and market divisions, and the failure to enforce unfair trade

laws results in predatory pricing and infringement on patents, copyrights and trademarks.

Kiosks throughout Moscow are filled with bootlegged movies and music and goods with

counterfeit trademarks. The court system lacks capable judges and procedures for protecting

commercial property. Courts cannot effectively enforce civil judgments. In order to resolve

contract disputes, businesses hire organized crime groups, and when collection is involved, the

gang may charge up to 50% of the amount recovered. Any concerted effort by the government

to fight the organized bands of criminals will likely fail because government officials are very

amenable to bribes. Rather than a country ruled by law, Russia is essentially a land of RICOs

(Racketeer Influenced Corrupt Organizations).

In contrast to Russia’s absence of law, it does have an infrastructure more extensive than

other emerging markets: a nationwide electricity grid and railroad system. But Russia also

possesses many similarities with undeveloped nations such as archaic roads. The transportation

of goods requires the added cost of armed guards and takes much longer than in the civilized

world. A slow and unreliable telephone system needlessly delays communication, and

dangerous internal air travel coupled with vast distances deters business meetings.

Due to massive corruption, the government lacks the ability to redistribute some of the

noveau economic well-being that many of the former nomenklatura, aided by their younger

offsprings, have amassed by plundering state assets. The anger of the have-nots in a once

theoretically classless society grows and may result in the election of a president opposed to a

market economy. Under the 1993 constitution, a Russian president possesses more power than

any other elected head of state of a large nation. A future president could introduce price

controls, increase subsidies to boost output, renationalize industries and engage in war to recover

parts of the former Soviet Union. Or the noveau rich may ally with the army to form a banana

republic in order to keep the have-nots under control. In any event, the environment for Red

October presents tremendous risk.

Accounting and Tax Institutions

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All companies operating in Russia must adhere to the accounting policies issued by the

Ministry of Finance and the Tax Inspectorate under the authority provided the two government

agencies by the laws passed by Parliament and decrees issued by the President. The Ministry of

Finance also requires financial statements to be kept in accordance with the format of the Chart

of Accounts, which the Ministry designed. The Chart of Accounts has 97 accounts with

subaccounts. A company can add new subaccounts on its own.

Although Russian accounting is moving from a central planning model to a market based

model, accounting’s main purpose is still tax reporting. Tax policy continues to substantially

affect accounting rules, much more than financial reporting principles. Little difference,

therefore, exists between Russian accounting profits and taxable profits, assuming the company

does not hide income. Since financial statements are geared towards the taxing authorities,

Russian accounting has limited value for portraying a firm’s economic activities.

Russia’s extensive tax compliance system possesses numerous vagaries. The taxable

entity consists only of the legal organization as defined in the Law on Enterprises and not the

economic entity. Accounting rules do not permit tax consolidation, which factors out the impact

of intercorporate investments that investors may find useful. Until 1987, the only legal

organizations were state-owned companies, but now legal entities include joint ventures,

cooperatives, open (public) and closed joint stock companies. Russian legal entities are taxed on

their worldwide income with offsets for taxes paid in foreign countries, but the amount of offset

is based on Russian accounting methods for determining taxable income, not the standards used

by the foreign nation that collected the taxes. As a result, companies operating overseas will not

enjoy any tax breaks due to different accounting policies. For example, Russian policies more

severely limit deductions for expenses: the tax law prevents deducting hotel, entertainment,

advertising and voluntary insurance expenses, which many other nations permit.

Russia’s tax compliance system lacks many Western tax concepts, such as discounted

cash flow and a clear distinction between revenue and profit, in part, because the language

cannot distinguish the two. Tax rates and laws change often and with little or no notice, as do

the extent of the applicability of existing laws. One reason for tax law uncertainty is that the

Government must reduce its deficit in order to receive international loans, which has led to

higher tax rates and new taxes. As a result, tax planning is subject to nullification without

redress unless businesses evade taxation.

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Besides the Federal Government, Russia’s regions (states) and localities impose their

own rates on taxes the central government permits them to levy. The federal government’s key

taxes are profits, value-added and personal income, but it also levies excise, road, banking,

insurance, exchange, securities operations, inheritance, gift, customs, mineral extraction, stamp

and other taxes. The regions’ taxes apply to a business’ fixed and moveable assets and water

usage. Localities tax advertising, registration and the land used by a business. Respective

government officials review and verify a firm’s tax calculations based on its submitted financial

statements. The official assesses a tax that the company must pay whether it agrees or not. The

company still has recourse to win back some of its payment by appealing administratively and

ultimately to the dysfunctional courts. Naturally, the system encourages false financial

statements and bribing the tax official who determines the taxes owed.

The largest proportion of revenues for the federal government comes from the VAT,

which applies to the value added by each entity in the processing chain as measured by the

difference in purchase and sales price. The profit tax applies to all taxable income regardless of

its nature, which includes capital gains, interest income, unrealized exchange rate gains, sales

profits and any other gains. Most losses or expenses from transactions reduce taxable income as

do certain restricted payments made to the reserve funds. When a company, however, pays

wages or interest over a certain amount, that excess is not deductible. Russia has double taxation

on corporate profits paid to shareholders, but the tax on dividends is withheld by the payer

corporation and supposedly turned over to the government. The property tax on all assets of a

company applies to intangibles and inventories and is based on the annual average value of a

company’s fixed assets as classified by Russian accounting.

Tax law requires monetary assets and liabilities stated in foreign currencies to be

revaluated in rubles on the balance sheet date with any gain or loss included in computing

taxable income. As the ruble declines, cash and account receivables will cause taxable gains

whereas monetary liabilities such as account payables will provide tax deductions.

The accounting and auditing professions in Russia lack clearly defined standards and

objectives. Accountants serve mainly for determining tax liability, which, along with the

inadequate accounting systems, explains managers lack of appreciation for accounting as a basis

for decision-making. Auditors only verify that a transaction occurred and compile lists of

transactions classified according to tax requirements. Auditors need only three years work

experience and a higher education somehow connected with business to obtain certification.

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Recent laws on auditing are vague and unintelligible. The Ministry of Finance holds sway over

auditors and even determines their clients and fees. The problem with government control is

that it prevents clients from shopping around, which leads to inefficiencies due to a lack of

competition. A free market drives out inefficient auditors, but it also allows firms to choose

favorable auditors. At present, a government commission will try to bring the auditing

profession into the 20th century by developing standards, formulating methodologies and

regulating auditors’ activities.

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II. DIFFERENCES BETWEEN RUSSIAN AND U.S. ACCOUNTING PRACTICES

In an effort to approximate IASC standards, the Russian government continues to change

its regulations almost annually. Since the demise of the Soviet Union in 1991 up to the

preparation of Red October’s 1994 financial statements, key accounting changes provided for

accelerated depreciation;

FIFO and LIFO cost flow assumptions for inventories;

the write-off method for treating uncollectible accounts;

amortization of intangibles over the useful life of the asset or, when the life cannot be

estimated, 10 years; and

revaluation of fixed assets to compensate for inflation.

Significant differences , however, still exist between Russian and U.S. accounting principles:

Managerial accounting is little known in Russia, but widely used for decision-making in

the U.S.

The principle of conservatism does not exist in Russia while many American firms use

reporting procedures that reduce the possibility of overstating assets, income and equity

in order to avoid misleading investors and creditors.

Russians do not use fixed and variable cost classification for cost-volume-profit analysis.

Plant assets with a low value are classified as current assets in Russia even when their

useful life exceeds one year in which case they can be depreciated 50% when put into use

and 50% in the year they are disposed of, or 100% in the year when put into use.

Accelerated depreciation in Russia applies only to equipment, machines and vehicles

used for boosting output of new product lines.

In Russia, the interest paid on bank loans that have a rate within 3% of the rate quoted by

the Central Bank are deductible as expenses but amounts paid over the 3% are not. The

full amount of American interest payments are deductible before taxes.

Russian accounting allows companies to recognize revenues on an accrual or modified

accrual basis. Modified accrual provides for revenue recognition when cash is received

at which time expenses are also recognized. The majority of Russian companies use

modified accrual because it allows them to defer the payment of profit taxes until cash is

received. Americans businesses generally use accrual because it provides a more

accurate picture of the firm’s ability to create value within a period, but a pure cash basis

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is also used which differs from the Russian modified accrual in that expenses are

recognized when paid.

A Russian balance sheet requires a reserve fund in the equity section in the amount of at

least 10% of the capital required by law to register a company. The reserve account may

not correspond to the American meaning of equity since companies can allocate certain

amounts of pre-tax profits to the fund.

Russian accounting does not require reporting gains or losses from monetary assets or

liabilities denominated in rubles that result from hyperinflation whereas U.S. GAAP

does.

Capital gains calculations in Russia increase the net book value of a sold, depreciated

asset by an inflation index while America’s low inflation rate does not require indexing.

Russian regulations require revaluing monetary accounts that record hard currency

transactions. The accounts must be periodically revalued in rubles which results in ruble

gains or losses. The accounts revalued are Cash on Hand (50), Foreign Currency (52),

Special Bank Accounts (55), Cash Documents (56), Remittances in Transit (57), Short-

Term Financial Investments (58), Settlements with Suppliers and Contractors (60),

Advances Paid (61), Settlements with Buyers and Customers (62), Advances Received

(64), Property and Individual Insurance (65), Settlements with Founders (75), Debtors

and Creditors (76), Settlements with Subsidiaries (78), Short-Term Bank Credit (90),

Long-Term Bank Credit (92), Short-Term Loans (94) and Long-Term Loans (95).

Russian policies allow for the capitalization of research and development costs while

U.S. GAAP requires immediate expensing because future benefits are too uncertain and

writing them off in the year of incursion is more conservative.

The Ministry of Finance requires some expense and revenue accounts to be closed out at

the end of each month into other accounts. Indirect Expenses (repairs, maintenance, rent,

electricity, etc.) and General and Administrative Expense balances are transferred to

Direct Costs (20). Selling Expenses (transportation, sales commissions, storage,

advertising, etc.) are closed to Shipped Goods (45). Some revenue accounts are closed at

the end of each month to Profit (80). U.S. GAAP requires that expenses and revenues be

accumulated until the end of the year.

Russian accounting does not require disclosure of the following whereas US GAAP does:

- leaseholds and assets purchased under installment plans;

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- restrictions on the level of cash balances (possibly the result of a loan covenant);

- terms of loans in excess of one year;

- methods for determining retirement plan obligations;

- transactions with related parties;

- a related party’s controlling interest;

- associated and intercompany accounts receivable and payable;

- contingent liabilities that are probable or reasonably estimated; and

- any events significant to the reader even when they occur after the balance sheet date.

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III. DIFFERENT ACCOUNTING PRACTICES USED BY RED OCTOBER AND TOOTSIE ROLL

Red October’s annual report focuses the reader on changes in output while Tootsie Roll

emphasizes changes in profits.

Red October revalued its fixed assets (not the low value fixed assets) at the beginning of

1994 under a mandatory revaluation required by the Ministry of Finance because of a

yearly inflation rate of over 100%. The amount of adjustment was debited to Fixed

Assets (01) and credited to Additional Capital (85). Accumulated depreciation was also

revalued with a credit to Depreciation (02) and a debit to Additional Capital. The net

Additional Capital credit is posted to Accumulated Funds (88) but not included in taxable

profit. No asset revaluation is required for Tootsie Roll.

Red October records cost for intangibles in Uncompleted Capital Investments (08). After

accumulation of all relevant costs, the amount is written off to Intangible Assets

Acquisition Cost (04) and amortized in Intangible Depreciation (05). Tootsie Roll

records the cost of intangibles net of accumulated amortization under Other Assets in the

balance sheet and lists the yearly amortization cost in the income statement. Tootsie Roll

also discloses in the notes the method of amortization (straight line or accelerated) and

the time period. Red October discloses neither.

Some of Red October’s accounts combine both receivables and payables under one

heading such as Budget Settlements (68), which corresponds to Deferred Income Taxes

and Income Taxes Payable for Tootsie Roll.

Red October’s GAAP style income statement combines Current Expenses,

Administrative Expenses and Sales of Goods Expenses into Sold Products Prime Cost,

which is Russian for COGS. Russia considers period and indirect expenses as part of

COGS. Tootsie Roll distinguishes period and indirect expenses from COGS.

Red October uses modified accrual reporting by recognizing revenue on receipt of

payment whereas Tootsie Roll recognizes revenue when goods are shipped, which results

in significant, unsecured accounts receivable.

When sales are made on credit for Red October, the cost of the goods shipped is debited

to the Goods Shipped (45) account with a credit to either Finished Products Inventory

(40) or Goods for Sale (41). On receipt of payment, the entire sales price is credited to

Sales of Goods account on the profit and loss statement with a corresponding Cash

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account debit. Sold Goods Production Expenses is also debited by the cost of the goods

sold with a corresponding credit to Goods Shipped. The modified accrual’s cash basis of

sales recognition results in the postponement of both revenue and expense recognition,

which has the benefit of deferring the payment of the profit tax on any gain. Red

October, however, tries to avoid shipping goods before payment because of the declining

value of the ruble and effective inability to enforce contracts through the legal system.

Tootsie Roll recognizes sales revenues when products are shipped by crediting Sales

while debiting Accounts Receivable for the full sales price and debiting Cost of Goods

Sold while crediting Finished Goods for the direct costs of the item.

Red October’s hard currency transactions that enter monetary accounts are initially

recorded in rubles based on the Central Bank’s exchange rate at the time of the

transaction. At the end of each month, Red October must revalue its hard currency

accounts in rubles according to the exchange rate at that time. Realized gains or losses

(usually gains for assets and losses for liabilities since the ruble generally declines in

value) are posted at the end of the year to Profit of the Year Under Review (80). Tootsie

Roll reports foreign currency exchange gains or losses in a special account in the equities

section of its balance sheet.

Tootsie Roll uses a different method of depreciating capital assets for reporting taxes

than for financial results. For taxes, Tootsie Roll maximizes the present value of the

reductions in tax payments by using accelerated depreciation. For financial statements,

Tootsie Roll combines the conservative approach of accelerated depreciation with the

straight line method. Straight line depreciation increases income and is generally not as

accurate in measuring the expiration of an asset’s benefits. Since Red October’s accounts

primarily serve the taxing authorities, it does not have a set of books with one

depreciation method for taxes and another for financial statements. Russian regulation

classifies each of Red October’s fixed assets into a particular group with a statutorily set

depreciation method and rate that could be straight line, average cost or accelerated up to

double standard rates. Red October does not reveal which method is used for particular

assets. Tootsie Roll has a number of choices in depreciation rates for financial reporting,

but under the tax reporting Accelerated Cost Recovery System, the rates are set

according to an asset’s useful life.

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Low value assets with a useful life of more than one year are depreciated by Red October

at 100% in the year when they are put into use, which leads to a mismatching of expenses

and revenues. Tootsie Roll makes no such distinction.

Except for inventory cost-flow assumptions, Tootsie Roll can use different principles for

tax and financial reporting.

Red October’s repairs and maintenance costs that are material and extend the life of an

asset are accounted as expenses rather than an asset acquisition as with Tootsie Roll.

Russian regulations require Red October to maintain a Reserve Fund (86) to which it

allocates a restricted amount of pre-tax profit. The Reserve Fund can be used to cover

losses of the reporting year by debiting the Reserve Fund and crediting Accumulation

Funds (88). Tootsie Roll covers losses by debiting Retained Earnings directly.

Red October’s Accumulation Funds (88) includes subaccounts for special purpose funds

required by its charter or the Ministry of Finance. A certain amount of the reported total

on the Accumulation Funds line is designated for each special purpose fund, such as the

fund for the development of production facilities or to provide employee benefits, and

the money cannot be used for any other purpose. When a special purpose fund

transaction occurs, such as bonuses or payments for sanitorium stays, account 88 is

debited with a corresponding credit to an asset account, usually cash. The Accumulated

Funds account is overstated since it contains undeductible hidden expenses. Tootsie

Roll’s Retained Earnings are not restricted to any special uses or its assets partially

committed to some unquantified, undisclosed future use other than providing future

economic benefit to the firm.

Tootsie Roll discloses future rental commitments, some operating lease specifics, the

methods used to estimate the fair value of securities it holds along with their unrealized

gains or losses, details about its debt instruments, the method of inventory cost flow, its

use of futures and options investments for mitigating price swings in raw materials and

the financing for and the impact of acquisitions. Red October does not provide similar

disclosures. For example, Red October acquired distributors but did not disclose the cost

or who was acquired. It did not disclose the method for determining or the fair value of

its Financial Long-Term Investments (06) nor the specifics of its Short-Term Loans (94).

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Red October provides a breakdown of all tax expenses and a listing of the types of

shareholders (banks, individuals, etc.) with the number of shares held while Tootsie Roll

does not.

Red October does not provide for an allowance for uncollectible accounts at the time of

sale but writes off a bad debt when it is considered uncollectible.

Tootsie Roll reports the present value of postretirement health and life insurance

obligations incurred during the reporting period and pension and profit sharing expenses

while Red October pays the government to handle these obligations through Budget

Settlements (68) and Social Insurance and Welfare Settlement (69).

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IV. PRO FORMA FINANCIAL STATEMENTS(All dollar figures in thousands unless otherwise indicated.)

Tootsie Roll Pro Forma Income Statement

Sales: In October 1993, Tootsie Roll acquired the Cambridge Brands candy company,

which accounted for part of the increase in sales in 1993 and for most of the increase in sales in

1994. In note 2, Tootsie Roll presents estimates of sales for 1992 and 1993 based on the

assumption that Cambridge Brands had already been acquired. Since 1994 was the first full year

of operations with Cambridge Brands, the trend in sales represented by the 1992 and 1993

estimates and the actual results for 1994 are more indicative of 1995 sales as opposed to

extrapolating the actual sales figures of a pre-acquisition to a post-acquisition Tootsie Roll.

Using the estimates, Sales changed from $303,576 in 1992 to $306,584 in 1993 to

$296,932 in 1994: a 1% increase followed by a 3.1% decrease. The reduction in sales is due to

the decline in sales of newly introduced trend setting items to more normal levels. Since Tootsie

Roll operates in a mature market and most, if not all, of the decline in trend items sales is past, a

3% increase in sales is predicted for 1995.

Cost of Goods Sold as a percentage of sales increased in 1994 due largely to higher

ingredient and packaging costs. Higher packaging costs will continue for 1995 and will not be

as successfully mitigated as in 1994 due to the ending of many fixed price contracts. Assuming

the higher packaging costs will cause a one percent increase in COGS/Sales, then Tootsie Roll’s

1995 COGS/Sales will equal a little more than 52%, which is consistent with the 51%

COGS/Sales for 1994 when Cambridge Brands was fully integrated into the firm.

Marketing, selling and advertising increased a little in dollar amount as a result of the

integration of Cambridge Brands, but declined as a percentage of sales from 1993 due to the

higher sales level. Since the higher sales level will continue, no additional increases in staff or

overhead are likely to occur and the increase in advertising and promoting the Cambridge

products is reflected in the 1994 rate, so the percentage of marketing, selling and advertising to

sales for 1994 should approximate 1995: 15.15%.

Distribution and warehousing increased mainly due to the products acquisition, which

required increase use of refrigerated storage and transportation. Although the acquisition

occurred in late 1993 (October), most of the distribution and warehouse increase for 1993 was

due to the new product lines. The increase was greater for 1994 because the additional expenses

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covered the full year. The percentage of distribution and warehousing to sales for 1995,

therefore, is most accurately reflected in the 1994 percentage of 6.97%.

General and administrative expenses increased slightly as a result of some additional staff

and overhead due to the acquisition, but the increase was mitigated by ongoing expense

reduction programs. Assuming cost reduction programs will continue to reduce general and

administrative expenses, then 1995 general and administrative expenses will likely decrease by

approximately 2.65% from 1993 costs.

Amortization of intangibles increased by $1.2 million in 1994 to $2.706 million as a full

year of straight line, 40 year useful life, amortization was taken for Cambridge Brands’ goodwill

in addition to other intangibles. Assume no change for 1995.

Interest income declined in 1993 and 1994 as a result of Tootsie Roll liquidating part of

its short-term portfolio to help finance and pay down debt from the Cambridge Brands’

acquisition and the purchase of an office and plant in Chicago in 1993. Tootsie Roll, however,

continues to rebuild its financial resources, which indicates a policy to reach interest income

levels similar to 1992, or nearly 1% of sales. Since all the notes ($72 million) used to finance

the Cambridge Brands’ acquisition have been paid and the notes for the Chicago plant will not

mature until 1996, Tootsie Roll will probably increase its securities investments in 1995 but to a

level less than the pre-acquisition amount that generated interest of about 1% of sales. Interest

income in the amount of .5% of sales is assumed.

Dividend income declined in 1994 due to liquidation of part of Tootsie Roll’s short-term

investments to pay off the financing for its investment 1993 acquisitions. Since the firm is

rebuilding its portfolio, 1995 dividend income will probably increase to somewhat less than

1992 preacquisition levels of .66% of sales. Dividend income of .6% is assumed.

Interest expense for 1995 will fall significantly from 1994 because the $72 million in

notes for the Cambridge acquisition were repaid. However, the interest expense for the 1992

industrial development bonds, 3.55% on $20 million, and the 1993 Chicago plant notes, around

4% on $7.5 million, should continue for a full year in 1995, equaling $1.01 million, assuming no

further debt issues.

Foreign exchange loss for 1994 resulted mainly from the devaluation of the peso. The

peso has stabilized with U.S. Government assistance, so a similar devaluation appears unlikely in

1995.

18

Royalty income information for making a 1995 assumption is lacking in Tootsie Roll’s

annual report, so a mean for the past three years was used.

Miscellaneous income and expenses information for making 1995 assumptions is also

lacking, so a mean of the net for the past three years was taken.

Effective income tax rate has ranged from 38 to 38.6% over the past three years;

therefore, a mean of 38.3% was projected for 1995.

Cash dividends have been paid for 52 years in a row, so it is highly likely they will be

paid for the 53rd year. As a percentage of sales, cash dividends grew from 1.2% in 1992 to

1.45% in 1993 to 1.54% in 1994. Assuming a continuation of this trend in order to prevent

analysts from making dire predictions that will cause the stock price to fall, cash dividends in

1995 should be around 1.65% of sales.

A stock dividend will also probably be distributed for the fourteenth year in a row. It

creates the illusion of receiving something of value when it actually leaves the value of the

recipient’s holdings unchanged due to dilution or actually less since the firm incurs transaction

costs in issuance. Stock dividend amounts fluctuated over the past three years but Tootsie Roll

may try to reinstitute the increase in dividends from 1992 to 1993 with a stock dividend in 1995

set at 9.8% of sales, identical to 1993.

Retained earnings for 1995 equal retained earnings at the beginning of 1994 plus

projected net earnings for 1995 minus projected cash and stock dividends for 1995. Retained

earnings at end of year work out to 39.7% of sales which is consistent with the growth in

retained earnings since 1992 at 36.8% and 1993 at 37.2% and, discounting the charge against

retained earnings in 1994 due to the devaluation of the peso that reduced Mexican assets by $5

million, 1994 at 38%.

19

Tootsie Roll Pro Forma Income Statement(in thousands $)

1994 1995Actual Assumption Pro Forma

Sales $296,932 Growth Rate=3% $305,840

Cost of Goods Sold 155,565 52% of Sales 159,037

Gross Margin 141,367 146,803

Operating Expenses:

Marketing, Selling & Advertising 44,974 15.15% of Sales 46,335

Distribution & Warehousing 20,682 6.97% of Sales 21,317

General & Administrative 13,017 Growth Rate = -2.65% 12,672

Amortization of Cost over

acquired net tangible assets 2,706 No Change 2,706

81,379 83,030

Earnings from Operations 59,988 63,773

Other Income & Expenses:

Interest Income 1,288 .5% of Sales 1,529

Interest Expense 1,649 Continuing Debt 1,010

Dividend Income 1,509 .6% of Sales 1,835

Foreign Exchange Losses 255 No Loss 0

Royalty Income 149 Three Year Mean 357

Miscellaneous (Net) 107 Three Year Mean 213

1,179 2,924

Earnings Before Taxes 61,167 66,697

Provision for Income Taxes 23,236 Three Year Mean 25,545

Rate of 38.3%

Net Earnings 37,931 41,152

Retained Earnings Beginning 96,647 RE at End 1994 107,763

Year 134,578 148,915

Less:

Cash Dividends 4,580 1.6% of Sales 4,893

Stock Dividends 22,235 Three Year Mean 29,390

26,815 34,283

Retained Earnings End of Year1 107,763 114,632

20

Tootsie Roll Pro Forma Balance Sheet

There are generally four methods used for creating a pro forma balance sheet:

1. Assumes total assets turnover similar to the previous year.

Total AssetTurnover for = Pro Forma Sales

Pro Forma Year Average Total Assets

Total Asset= Pro Forma Sales = Turnover for

.5 (Prior Year Total Assets + x) Prior Year

Solving for x yields the firm’s total assets at the end of the projected year. With total

projected assets, a common size balance sheet can allocate the total to individual balance sheet

accounts.

2. Uses an historical growth rate of total assets to project total assets at the end of

the pro forma year. Once again, total assets are allocated to individual accounts using a common

size balance sheet.

3. Applies historical asset turnovers and historical growth rates to each balance sheet

item to determine projected amounts.

4. Determines which items on the balance sheet are likely to vary with sales and

calculates them as a percentage of sales based on the prior year’s percentages. Since assets

generally vary with sales, an estimate of total assets can be obtained. Many liabilities, such as

debt and stock accounts, do not vary with sales, but their projected total amount can be

determined since Assets = Liabilities + Ownership. The forecasters then has to estimate the

amounts for each item on the liability and equity side that does not vary with sales. This is done

based on the firm’s past actions and intentions for the future.

Since Tootsie Roll acquired Cambridge Brands and a plant in Chicago in 1993, the

truism of the past being prologue will not hold; therefore, the use of historical trends in methods

2 and 3 will not adequately indicate the future. Method 4’s sales approach requires reliance on

estimates for 1993 and 1992 that assume the Cambridge Brands acquisition had already

occurred. While useful for estimating sales given the alternative of using preacquisition

numbers, Method 4 appears less accurate than Method 1 for projecting the balance sheet.

Method 1’s reliance on just the previous year (1994) should approximate Tootsie Roll’s 1995

balance sheet because 1994 was the first full year of integrated operations with Cambridge

21

Brands and the Chicago plant, but there are still some qualifications which will be taken into

account.

Tootsie Roll’s total assets turnover for 1994 are assumed to equal its total assets

turnover for 1995.

Total Asset Turnover 19941 = $296,932 Sales.5 ($303,940 + $315,083) Average Assets

= .95936

Total Asset Turnover 1995 = $305,840 Sales.5 ($315,083 + x) Average Assets

x = Total Assets End 1995 = $322,511

Most assets and liabilities can be estimated as a percentage of total assets, but some,

depending on the firm, can be better estimated using other accounting items. For instance, cash

and shareholders equity are more dependent on net income than total assets. Tootsie Roll will

use net income that is not paid out in dividends to increase retained earnings, which will then be

reduced by issuance of stock dividends that increases Common Stock, Class B Common Stock

and Capital in Excess Par Value. Assuming a continuation of Tootsie Roll issuing a 3% stock

dividend yearly and no change in the stock prices, then by December 31, 1995, Common Stock

(par value) will increase to approximately $5,245, Class B Common Stock (par value) to about

$2,513 and Capital Excess of Par Value to $159,198. Another projection not based on a

common size balance sheet is retained earnings, which is calculated from the pro forma income

statement: net income minus cash dividends minus stock dividends equals the amount added to

retained earnings at the beginning of 1995. In addition, since Long Term Debt should not

increase, its value remains at the 1994 amount.

As a result, while all items except Cash, Long Term Debt, Common Stock (par), Class B

Stock (par) and Capital Excess are calculated as a percentage of method 1’s derivation of total

assets for 1995, the items that do not vary with total assets will have values that will ultimately

change the amount for total assets that was initially projected by Method 1.

_______________1 For 1994 to be comparable to 1995, the charge against retained earnings due to the peso devaluation that reduced Tootsie Roll’s net assets in Mexico by $5 million is netted out because it is assumed a similar devaluation will not occur in 1995. This was done by increasing Retained Earnings and Other Assets by $5 million each, which yielded Total Assets of $315,083.

22

Tootsie Roll Common Size Balance Sheet - 1994(Based on Estimated Total Assets of $322,511)

AssetsCurrent Assets:

Cash and Cash Equivalents Depends on Change in Cash FlowInvestments to Maturity 14.56Accounts Receivable (Net) 7.01Inventories:

Finished Goods & Work-in-Progress 5.30Raw Materials & Supplies 3.96

Prepaid Expenses 1.00Deferred Income Taxes .70

Property, Plant and Equipment:Land 2.12Buildings 8.56Machinery & Equipment 34.73Leasehold Improvements .002Less - Accumulated Depreciation & Amortization (18.23)

Other Assets:Excess Cost Over Net Tangible Assets

Net of Accumulated Depreciation 31.32Other Assets 3.77

Liabilities & Shareholder’s EquityCurrent Liabilities:

Notes Payable to Banks 0.00%Accounts Payable 1.94Dividends Payable .39Accrued Liabilities 5.41Income Taxes Payable .59

Noncurrent Liabilities:Deferred Income Taxes 2.45Post-Retirement Healthcare & Insurance 1.59Industrial Development Bonds Same amount for 1994 & 1995Term Notes Payable Same amount for 1994 & 1995Other Long-Term Liabilities 1.00

Shareholders Equity:Common Stock (par value) [Depends onClass B Common Stock (par value) stock dividendCapital Excess of Par Value issuance]Retained Earnings 35.79Foreign Currency Translation (2.49)

23

Tootsie Roll Pro Forma Balance Sheet - 1995

AssetsCurrent Assets:

Cash and Cash Equivalents Depends on Change in Cash FlowInvestments to Maturity $46,958Accounts Receivable (Net) 22,608Inventories:

Finished Goods & Work-in-Progress 17,093Raw Materials & Supplies 12,771

Prepaid Expenses 3,225Deferred Income Taxes 2,258

Total Current Assets 144,238Property, Plant and Equipment:

Land 6,829Buildings 27,618Machinery & Equipment 112,018Leasehold Improvements 6

146,471Less - Accumulated Depreciation & Amortization 58,804

87,667Other Assets:

Excess Cost Over Net Tangible AssetsNet of Accumulated Amortization 100,994

Other Assets 12,160113,154

$345,639Liabilities & Shareholder’s EquityCurrent Liabilities:

Notes Payable to Banks $0Accounts Payable 6,268Dividends Payable 1,248Accrued Liabilities 17,448Income Taxes Payable 1,916

26,880Noncurrent Liabilities:

Deferred Income Taxes 7,898Post-Retirement Healthcare & Insurance 5,111Industrial Development Bonds 7,500Term Notes Payable 20,000Other Long-Term Liabilities 3,226

43,735Shareholders Equity:

Common Stock (par value) 5,245Class B Common Stock (par value) 2,513Capital Excess of Par Value 159,198Retained Earnings 114,632Foreign Currency Translation (8,017)

281,588$344,186 (1)

_______________1 The difference between total assets and liabilities plus equity is probably due to rounding errors and using retained earnings from the pro forma income statement rather than as a percentage of assets, which at $115,421 would yield $344,975 for the bottom half of the balance sheet.

24

Analytic Entries for Tootsie Roll Pro Forma Cash Flow Statement - 1995

1. Cash (Net Income) 41,152Retained Earnings 41,152

2. Cash (Amortization Addback) 2,706Net Intangibles 2,706

3. Retained Earnings 4,893Cash (Dividends) 4,893

4. Accounts Receivable 521Cash 521

5. Finished Goods 389Cash 389

6. Raw Materials 307Cash 307

7. Prepaid Expenses 131Cash 131

8. Deferred Income Taxes 90Cash 90

9. Land 157Cash 157

10. I am unable to reconstruct the T account transactions for PROPERTY, PLANT and EQUIPMENT because there are no Income Statement figures for depreciation. The net cash flow for PROPERTY, PLANT and EQUIPMENT can be calculated by using beginning balance + purchases depreciation = ending balance.

143,098 + P D = 146,471 P D = 3,373= net cash flow for the PROPERTY, PLANT and EQUIPMENT account

11. Net Intangibles 5,032Cash 5,032

12. Other Assets 5,280Cash 5,280

13. Cash 144Accounts Payable 144

25

14. Cash 29Dividends Payable 29

15. Cash 402Accrued Liabilities 402

16. Cash 44Income Taxes Payable 44

17. Cash 182Deferred Income Taxes 182

18. Cash 118Post-Retirement 118

19. Cash 74Other Long-Term Liabilities 74

20. Investments to Maturity 1,097Cash 1,097

21. Foreign Currency Translation 185Cash 185

22. Retained Earnings1 29,390Stock Accounts 29,390

________________1 This is not a source or use of cash, but is included to show that Retained Earnings was debit as a result of the issuance of stock dividends.

26

Tootsie Roll T-Account Work Sheet

Investments to Maturity Accounts Receivable45,861 22,087

(20) 1,097 (4) 521

46,958 22,608

Finished Goods/Work-in-Progress Raw Materials & Supplies16,704 12,464

(5) 389 (6) 307

17,093 12,771

Prepaid Expenses Deferred Income Taxes3,094 2,168

(7) 131 (8) 90

3,225 2,258

Land Buildings6,672 143,098

(9) 157 (10) Purchases Depreciation

6,829 146,471

Net Intangibles Other Assets98,668 6,880

(2) 2,706 (12) 5,280(11) 5,032

100,994 12,160

27

Accounts Payable Dividends Payable6,124 1,219

(13) 144 (14) 29

6,268 1,248

Accrued Liabilities Income Taxes Payable17,046 1,872

(15) 402 (16) 44

17,448 1,916

Deferred Income Taxes Post-Retirement7,716 4,993

(17) 182 (18) 118

7,898 5,111

Industrial Bonds Term Notes Payable7,500 20,000

7,500 20,000

Other Long Term Liabilities3,152

(19) 74

3,226

Retained Earnings Foreign Currency Translation(3) 4,893 107,763 7,832

(22) 29,390 (1) 41,152 (21) 185

114,632 8,017

28

CashBeginning Cash $16,509

Operations521 (4)

(1) 41,152 389 (5)(2) 2,706 307 (6)

(13) 144 131 (7)(14) 29 90 (8)(15) 402 185 (21)(16) 44(17) 182(18) 118

Investing157 (9)

3,373 (10)5,032 (11)5,280 (12)1,097 (20)

Financing1

(19) 74 4,893 (3)

Source Total 44,851 Use Total 21,455Ending Cash 39,905

Net Change Cash $23,396

_______________1 The stock T accounts changed due to an issuance of stock dividends rather than the sale of stocks so there was no cash inflow.

29

Tootsie Roll Pro Forma Cash Flow Statement - 1995

Cash Flow From Operations:Net Earnings $41,152Amortization 2,706Accounts Payable 144Dividends Payable 29Accrued Liabilities 402Income Taxes Payable 44Deferred Income Taxes 182Post-Retirement Benefits 118Accounts Receivable (521)Finished Goods (389)Raw Materials (307)Prepaid Expenses (131)Deferred Income Taxes (90)Foreign Currency Translation (185 )

Net Cash From Operations 43,154

Cash Flow From Inventory:Land (157)Net Property, Plant, Equipment (3,373)Net Intangibles (5,032)Other Assets (5,280)Investments to Maturity (1,097 )

Net Cash From Investments (14,939 )

Cash Flow From Financing:Other Long Term Liabilities 74Dividends (4,819 )

Net Cash From Finances (4,819 )

Change in Cash 23,396Cash at Beginning of Year 16,509Cash at End of Year 39,905

30

The increase in cash seems large, but Tootsie Roll is a mature and stable company that

generates cash flow from operations that is more than sufficient for new plant and equipment. It

uses the excess cash flow to pay off financing from earlier periods. In 1994, Tootsie Roll paid

off the debt it incurred in purchasing Cambridge Brands. It appears that Tootsie Roll in 1995

will be lacking beneficial investment opportunities; therefore, it could best benefit its

shareholders by purchasing back its own shares. The firm will probably not do that, however,

because of management’s desire to build empires and their lack of realization that a higher debt

to total capital ratio can maximize the firm’s value.

The Cash Flow Pro Forma T Account does not provide details on any land, buildings or

machinery and equipment transactions that may have resulted in gains or losses because no such

information was available in the annual report.

Tootsie Roll Off Balance Sheet Projections

Employee benefit plan expenses have changed from 1992 to 1994. A fair amount of the

1994, and to a lesser degree the 1993 changes, resulted from the 1993 acquisition of Cambridge

Brands and the Chicago plant; therefore, the 1994 expenses to sales ratio probably best

approximates the expenses for 1995:

1994 Expense/Sales 1995

Defined Contribution $1,426 4.8% $1,440

Profit Sharing & Investment $420 .14% $424

Defined Benefit $352 .12% $356

Red October

Inflation in Russia reached 204% in 1994, down from 900% in 1993, with projected

inflation of 135% for 1995. Red October’s measurement of the value of non-monetary accounts

in rubles really amounts to mixing mediums of exchange representing different values because

the value of the ruble in one week differs from the value in the following week. For Red

October’s non-monetary accounts to accurately portray their historical values requires that at the

time of a transaction the ruble amount be converted to a hard currency, such as dollars, at the

then existing exchange rate and when the financial statements are prepared, the hard currency

balance is converted back into rubles at the exchange rate at that point in time. Otherwise, the

value of non-monetary assets (Finished Goods (40)), non-monetary liabilities (Advances from

Customers (64)) and equity investments will be understated, which is the case with Red October.

31

The value of monetary accounts, however, equal the ruble amount at the time of the financial

statement and can be converted to dollars based on the exchange rate at that time.

The creation of pro forma financial statements requires the comparison of prior financial

statement items, which means the items must be measured in units having the same approximate

value. Red October’s U.S. style balance sheet (p. 11) uses year ending exchange rates and its

income statement (p. 13) uses yearly mean exchange rates for both monetary and non-monetary

accounts. Red October does not provide information on transaction exchange rates or the dates

of transactions, so the actual value for non-monetary accounts needs to be estimated. Assuming

non-monetary account transactions occur uniformally over the year, a mean exchange rate is

used to determine values in dollars. A more refined approximation could be made if Red

October disclosed its method of inventory cost flow assumption. FIFO would require an

exchange rate weighted later in the year, and LIFO an exchange rate weighted earlier in the year.

For 1993, the year end exchange rate: $1 = 1247 Rb, mean: $1 = 932 Rb1. For 1994, the year

end exchange rate: $1 = 3550 Rb, mean: $1 = 2202 Rb.

_______________1 I realize that using the mean exchange rate for some balance sheet non-monetary accounts fails to account for the exchange rate for transactions that occurred prior to that particular year. For example, other assets purchased in 1992 and earlier.

32

Red October Balance Sheet(in thousands $)

The brackets below each account title and number provide an American definition of the account.

ASSETSCurrent Assets: Translation 1993 1994Financial Means Monetary $1,287.1 $4,502.8(50, 51, 52, 55, 56, 57)[Cash & Cash Equivalents]

Consumers’ Accounts Monetary 2,431.3 1,955.0(62, 76)[Accounts Receivable]

Other Debtors & Advanced Expenses Monetary 92.0 176.9(73, 78)[Subsidiaries, State, Employee, OtherDebtor Receivables]

Advances to Suppliers & Contractors Non-monetary 7,022.4 13,828.4(61) (mean exchange rate)

Inventories Non-monetary 10,223.0 12,132.0(assumed average cost flow, so used meanexchange rate)

Other Assets Non-monetary .54 11.8(mean exchange rate)________

_______ Total Current Assets $21,056.3 $32,606.9

Long Term Assets:Long Term Investments1

Financial Long Term Investments Monetary 869.5 771.3 (06)

[Stocks, Bonds, Loans]

Uncompleted Capital Investments Non-monetary 2,912.0 3,526.7& Advances to Other Vendors (mean exchange rate)(08)

Depreciated Cost [Net Fixed Assets] Non-monetary 4,589.8 5,599.6(mean exchange rate)

Intangible Assets Non-monetary .13 2.3(mean exchange rate)

Total Long Term Assets 8,371 .4 9,899 .9 Total Assets $29,427 .7 $42,506 .8

_______________1 Includes long-term securities, loans, advances to other vendors and initial information on procurement of fixed assets, intangible assets, land, buildings and construction costs. When these fixed assets and intangible assets are put into use, the costs are written off to Fixed Assets (01), or Intangible Assets (04). Subsequent

33

nondeductible expenses related to fixed assets are written off to Use of Profit (81) or Directed Financing and Allocations (96).

34

LIABILITIESTranslation 1993 1994

Current Liabilities:Suppliers Account (60, 76) Monetary 2,849.4 1,351.0[Accounts Payable to Suppliers, Contractors & Other Creditors]

Taxes Payable (68) Monetary 830.0 2,868.2

Mandatory Social, Pension & Monetary 264.1 422.0Medical Insurance Payables (69)

Bank & Other Loans (90) Monetary 0.0 1,690.1

Accrued & Other Liabilities:Wages Payable (70) Monetary 196.9 246.0Other Payables Monetary 2,722.7 237.7Other Short Term Liabilities Monetary 11 .5 0 .0 Total Liabilities $6,874.6 $6,815.0

Shareholders’ Equity3 22,553 .1 35,691 .8 $29,427 .7 $42,506 .8

_______________2 There appears to be an adding error in Red October’s Balance Sheet.3 Each account in this section contains significant amounts of rubles from years prior to 1993 so the assumption that the rubles can be valued at the mean exchange rate for 1993 and 1994 respectively is inaccurate. Rubles from earlier years have values significantly higher than 1993 and 1994 rubles. In addition, Russian accounting requires the equity section to include a Reserve Fund account (86) into which profits before taxes are allocated, a Supplementary Capital account (87) that records fixed asset valuation, additional paid in capital and donation of fixed assets and Retained Earnings/Unrecovered Losses accounts (88), which records gains and losses, dividends and special purpose funds that are restricted to certain uses. For example, the Consumption Fund is restricted to providing employee benefits which are essentially expenses for which Red October receives no tax breaks. Red October does not provide any projections of the present value of future expenses that will transfer certain amounts in this fund into liabilities. A more informative method of accounting would be to debit the fund and create a liability in the present value amount. As a result, I have combined all these accounts into a shareholders equity account and determined the amount by Assets Liabilities Shareholders Equity.

35

Red October’s U.S. GAAP style income statement translated rubles into U.S. dollars using

the average yearly exchange rate, which makes sense since most revenues and expenses result

from transactions recorded during the year. The transactions, of course, do not necessarily occur

evenly throughout the year so the translation as a representation of actual value is only an

approximation. For depreciation, however, the use of an average exchange rate is contrary to

FASB No. 52 for operations in hyperinflationary countries. In 1994, Red October invested large

amounts from earnings in capital improvements. Since depreciation expenses represent an

allocation of cost based on purchase price, the depreciation expenses should translate at the

historical exchange rate at the time of the purchase. Red October does not separately list its

depreciation expenses by equipment for the year nor indicates the transactions during the year

that acquired the depreciable assets; therefore, depreciation is translated at the year’s mean

exchange rate.

36

Red October Income Statement(in thousands $)

1993 1994Sales Gross Revenue $76,106.0 $116,225.0

Sold Products Prime Cost1 [COGS and Period Expenses] 41,920.0 69,657.0

Other Income:Other Sales Results2 105.0 70.0Out of Sales Transaction Results2 607.0 474.0Securities Transactions Gains4 257.0 385.6Foreign Currency Exchanges Gains4 504 .6 1,465 .8

Earnings Before Taxes $35,659 .6 $48,963 .4

VAT and Special Tax5 7,039.9 11,782.4Excise Taxes5 75.8 0.0Profit Tax 8,394 .0 13,250 .0

Net Income $20,149 .9 $23,931 .0

Cash Dividends6 0.0 0.0Stock Dividends7 12,266.3 1,851.6_______________1 Russian accounting requires all costs relating to the production of goods or services be closed to COGS when a sale is recognized. This includes amounts in Direct Production Costs (20); Costs of Sub-products Manufactured by the Company (21); Costs of Supplementary Production Facilities (23); Indirect Costs (depreciation, repairs, rent, utilities, etc.) (25) that are closed to Direct Expenses (20) or Supplementary Production Facilities (23) and then to Finished Products (40); General and Administrative Costs (audit and consulting fees, management salaries and expenses, etc.) (26) that are closed to account 20 or 23; Service Sector Costs (29); Non-Capital Works (30); Completed Stages of Unfinished Projects (36); Circulation Costs (44); and Selling Expenses (transportation, commission, storage, advertising, etc.) (43). When Red October receives cash, the sale is recognized and all the above costs relating to the items sold are considered COGS. Without information on the individual accounts, GAAP product and periodic costs cannot be separated out. COGS also includes the cost of repairs that extends an assets useful life, which Tootsie Roll would account for by capitalizing the cost.2 Other Sales Results or Sales of Other Assets (48) and Out of Sales Transactions Results or Sales and Other Disposals of Fixed Assets (47) are used to record the sale, disposal or writing off of fixed assets. In the Russian system, the net gain or loss from both accounts is transferred to Gains & Losses (80), but, apparently, were separated out for purposes of the U.S. GAAP Income Statement. Figures for 1993 probably overstated the gain since the net book value used to calculate sales gain is measured in older, higher value rubles.3 The U.S. Income Statement forgot to include in 1994 Other Sales Results of $70.4 Securities Transactions and Foreign Currency Exchange results were not originally included in the Income Statement but were included in Red October’s Financial Results (p. 12). I have included them in the income statement because they represent realizable gains. An interesting point in Red October’s accounting is that the Profit & Loss figures in the Financial Results Statement (p. 12) do not include Securities Transactions and Foreign Currency Exchanges even though their presentation would imply that they do.

37

5 I have relocated the Receipt Taxes account after all income items even though the taxes are determined by gross sales revenues. I have also broken down Receipt Taxes into VAT and Special Tax, and Excise Taxes using the information from the Financial Results Statement (p. 12).6 Red October was strapped for cash in 1994 which required it to issue equity. Given the lack of financial markets in 1993 and 1994 and the need for cash to modernize, I have assumed Red October did not pay any cash dividends in 1993 or 1994.7 Red October issued stock dividends for 1993: 2.24 million shares valued at 10,000 Rb per share for 22.4 Rb billion in March 1994. Assuming an exchange rate at the time of 1,826 Rb per dollar (if I remember correctly) the amount is $12,266.3 million. I have no information of stock dividends for 1994 but assume 1,851.6 which equals the difference between Net Income and the sum of the Reserve, Accumulation and Consumption Funds from the Financial Results Statement (p. 12).

38

Red October’s Pro Forma Financial Statements

The income statement is projected using the common size income statements for 1993 and

1994.

Red October’s Common Size Income Statements for 1993 & 1994

1993 1994

Sales Gross Revenue 100.00% 100.00%

Sold Products Prime Cost 55.08 59.93(COGS & Period Expenses)

Other Income:

Other Sales Results .14 .06Out of Sales Transaction Results .80 .41Securities Transactions Gains .34 .33Foreign Currency Exchanges Gains .66 1.26

Earnings Before Taxes 46.86 42.13

VAT & Special Tax 9.25 10.14

Excise Taxes .10 0.00

Profit Tax 11.03 11.40

Net Income 26.48 20.59

Cash Dividends 0.00 0.00

Stock Dividends 16.12 1.6

39

Red October’s Pro Forma Income Statement - 1995

Assumptions:

Sales increased by 52.7% in 1994 due to increasing demand and prices since a large

number of Russians have more funds available to purchase consumer goods as a result of the

failure of the tax system. Consumers are using these funds to satisfy pent up desires long

suppressed by an economy that concentrated on military goods. Red October met demand by

beginning to create a modern market distribution system, opening its own retail stores,

modernizing its plants with substantial capital investments, entering new product lines such as

roasted salt nuts, building an additional plant, obtaining licenses to manufacture additional

sweets and cutting back the production of unpopular products (responding to consumer wishes:

an alien concept in the former Russia). It appears sales will continue to grow dramatically as

Red October pursues its transition to a capitalist firm and the Russian economy moves towards a

market system (a significant assumption). Earnings alone are not sufficient to fuel such growth.

Red October will have to raise capital externally, by issuing more stock since other sectors of the

financial markets cannot provide funds for capital investments. Red October faces competition

from more efficient foreign firms, but their understandable caution in entering Russia and the

somewhat different taste preferences of Russians will delay Red October’s loss of market share.

Weighing these factors, Red October’s sales should grow by around 50% once again in 1995,

financed by earnings and the issuance of equity.

Cost of goods sold and period expenses will continue their upward trend until Red October

begins focusing on cost reductions by laying off unnecessary employees and eliminating dental

care, kindergartens, children’s vacations in the country, provisions of meals, cultural events and

employee interest-free loans. In 1995, operating expenses will probably reach 64% of sales but

could jump higher if state subsidized energy is reduced or eliminated, which is unlikely for the

near term because many Russians would simply freeze to death in the winter.

Other income comprises gains and losses from asset disposal, securities and foreign

currency. Given the dramatic changes that have occurred in Russia since 1991, the wild east

nature of the securities markets, manipulation of ruble exchange rates and inefficient markets,

any reliable trend in these accounts cannot be determined. A mean percentage over 1993 and

1994 is used for the 1995 projections.

Earnings before taxes falls another 4% in 1995 due largely to the assumed increase in costs

as a percentage of sales.

40

Taxes in Russia can change quickly and without notice, often depending on who bribes

whom with the most. Amid such uncertainty, using a mean of the two years percentages appears

as good as any assumption.

Net Income as a percentage of sales drops mainly due to increasing costs in 1995.

Stock dividends are assumed to be the same percentage of Net Income as in 1994.

41

Red October’s Pro Forma Income Statement - 1995

1994 Assumption 1995

Sales Gross Revenue $116,225 Growth Rate = 50% $174,337.5

Sold Products Prime Cost 69,657 64% of Sales 111,576(COGS & Period Expenses)

Other Income

Other Sales Results 70 0.10% of Sales 174.4

Out of Sales Transaction Results 474 0.60% of Sales 1,054.7

Securities Transactions Gains 385.6 0.33% of Sales 575.3

Foreign Currency Exchange 1,465.8 0.96% of Sales 1,673 .6

Earnings Before Taxes 38.0% of Sales 66,239.5

VAT & Special Tax 11,782.4 9.7% of Sales 16,902.0

Excise Taxes 0.0 .05 87.2

Profit Tax 13,250 .0 11.22% of Sales 19,552 .0

Net Income $23,931 17.04% of Sales $29,698 .4

Cash Dividends 0.0 All Cash for Growth 0.0

Stock Dividends 1,851.6 7.74% of Net Income 297.8

Red October’s Pro Forma Balance Sheet Assumptions

To determine the forecasted balance sheet, a percentage of sales approach is used for items

that will vary with sales and estimations are made for other accounts.

Items noted with NA means they probably do not vary with sales. Current liabilities that

do not vary with sales are considered to vary directly with assets, so percentages are the same as

for 1994. The account Shareholders Equity is assumed to make up the differences between

Assets and Total Liabilities. Since it is unlikely that cash dividends will be paid in 1995,

retained earnings in this account will increase by the Net Income amount of $29,698.4 and be

reduced by $297.8 in stock dividends, which will increase the authorized capital and additional

capital in the Shareholders’ Equity account by a total of $297.8.

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Red October’s Pro Forma Balance Sheet (1995)

1994 Percentage 1994 Percentage of Sales of Assets 1995

ASSETSCurrent Assets:

Financial Means Depends on Cash Flow Change $15,275.0Consumers’ Account 1.7% 2,963.7Other Debtors & Advanced Expenses 0.2 348.7Advances to Supplies & Contractors 12.0 20,920.5Inventories 10.4 18,131.1Other Assets 0.01 17 .4

Total Current Assets 57,656.4Long-Term Assets:

Financial Long-Term Investments 0.7 1,220.4Uncompleted Capital Investments 3.0 5,230.1

& Advances Other VendorsFixed Assets Net of Depreciation 10.4 18,131.1Intangible Assets 0.002 3 .5

Total Long-Term Assets 24,585 .1 Total Assets $82,241 .5

LIABILITIESCurrent Liabilities:

Suppliers Account 1.2 2,092.0Taxes Payable 2.5 4,358.4Social, Pension & Medical Insurance Payables NA 0.99% 814.2Bank & Other Loans NA 3.98 3,273.2Wages Payable NA 0.6 493.5Other Payables NA 0.6 493.5Other Short-Term Liabilities NA 0.0 0 .0

Total Liabilities 11,529.8Shareholders Equity:

Total Equity 70,716 .7 Total Liabilities & Equity $82,241 .5

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Red October Pro Forma Cash Flow Statement - 1995

Cash Flows From Operations:Net Income $29,698.4Consumers Account (1,008.7)Other Debtors & Advanced Expenses (171.8)Advances to Suppliers & Contractors (7,092.1)Inventories (5,999.1)Other Assets (5.6)Suppliers Accounts 741.0Taxes Payable 1,490.0Social, Pension & Medical Payables 212.0Wages Payables 122.0Other Payables 131 .1

18,117 .2

Cash Flows From Investing:Financial Long-Term Investments (449.1)Uncompleted Capital Investments & Advances

Other Vendors (1,703.4)Net Fixed Assets (6,046.1)Intangible Assets (1 .2)

(8,199 .8)

Cash Flows From Financing:Bank & Other Loans 854 .8

Net Change in Cash 10,772.2Cash Beginning 1995 4,502.8Cash Ending $15,275.0

(Red October provided no information on Sales of Assets.)

Since Red October is growing rapidly, it probably will not keep its cash account at $15,275

but will use most of it to reinvest in working capital and capital assets. The pro forma balance

sheet was modified to reflect these investments. The dramatic increase in equity over 1994 is

consistent with Red October’s intention to obtain funds for growth through issuance of shares

since the other sources of capital are nearly non-existent in Russia.

Red October does not disclose key off-financial statement items; therefore, there is no

information to make projections.

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V. USEFULNESS OF TOOTSIE ROLL AND RED OCTOBER’S FINANCIAL STATEMENTS TO INVESTORS AND MANAGERS

Investors

Investors want information that accurately measures a firm’s profitability, debt-paying

ability, risk and efficient use of assets before lending funds or purchasing a part or all of a

company. Financial ratios can provide useful information to investors and indicate areas that

require further investigation. Ratios, however, depend on financial statement data, which in turn

depend on the permissible accounting policies that a firm chooses from a range of accepted

principles. A firm may use accounting methods that put it in a favorable light rather than those

that most accurately measure the economic effects of transactions and events. The usefulness of

ratios also depends on their comparability to a benchmark such as the same firm at a different

time, another company or the industry as a whole. In order to compare ratios, financial

statement data must be adjusted for the different accounting methods used. Firms, however,

rarely disclose sufficient information about the application of particular accounting principles to

permit financial statement users to assess the degree of comparability.

Measures of Profitability

ROA measures how well a firm used its assets to generate earnings independent of how the

assets were financed.

ROA = Net Income + Interest Expense Net of Interest Income Tax SavingsAverage Total Assets

Since ROA excludes the impact of financing methods, interest expense minus the amount

of tax savings interest provided, is added back to net income. Tootsie Rolls’ financial statement

notes provide an interest expense of $1,649 in 1994 and a tax rate of 38%. Interest tax savings =

$626.6. The amount of interest expense net of income tax savings added back to net income

equals $1,022.4. Red October’s interest expenses that do not exceed statutory limits are entered

into Indirect Expenses (25) but closed out each month to Direct Expenses (20), which is

partitioned among Work-in-Progress, Finished Products or COGS accounts. Red October does

not provide separate tax deductible interest expense data, so interest expense net of income tax

savings cannot be calculated.

Other anomalies between Red October and Tootsie Roll’s accounting policies make it

impossible for me to approximate comparable ROAs.

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Net income for both companies depends largely on sales. Tootsie Roll recognizes income

when goods are shipped while Red October recognizes income with receipt of payment.

Since neither Tootsie Roll nor Red October are declining companies, Red October’s sales for

a period will be understated when compared with Tootsie Roll because some sales that

Tootsie Roll would recognize during a period would not be recognized by Red October until

the following period.

Tootsie Roll uses the allowance method for accounts receivable uncollectibles while Red

October uses direct write-off. The allowance method more accurately matches revenues and

expenses and is less subject to manipulation, assuming there exists a prescribed manner

based on history for estimating the amount of uncollectibles. Tootsie Roll provides the

allowance amounts but not how they were determined, so they are open to manipulation.

Red October’s write-off method, however, provides room for the most manipulation. The

company can arbitrarily decide when an account goes bad in order to influence net income in

the direction desired. In addition, Red October’s balance sheet provides little information on

what an investor might expect in uncollectible receivables. As a result, both companies’

reported assets may not reflect economic reality. Since both Tootsie Roll and Red October

are growing, Red October’s write-off method results in greater expected income and more

assets currently as compared to Tootsie Roll’s allowance method that implies smaller

earnings and assets.

Red October does not state the cost flow assumption it uses for inventories, so the inventory

accounting impact is unknown. Tootsie Roll uses LIFO for domestic (most of its inventory)

and FIFO for foreign. In the rising price environment of the U.S., LIFO enables Tootsie

Roll to report smaller earnings (as long as it does not dip in the LIFO layers), which results

in tax reductions, than if it used FIFO or average cost. LIFO also reports an asset base lower

in value than the market would reflect.

Red October does not report the depreciation method used while Tootsie Roll employs both

straight line and accelerated, but does not indicate the extent of each. Since Tootsie Roll’s

depreciable assets generally increase over time, straight line depreciation results in higher

earnings and values for assets for any period while the accelerated method reduces earnings

and assets. The economically appropriate method depends on the amount of the asset used in

producing revenue for a particular period.

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Another income and asset distortion between the two companies results when Red October

expenses material and life extending repairs, which decreases income and fixed assets, as

compared to Tootsie Roll which capitalizes such costs, causing increased income and fixed

asset values.

Because of the above differences in accounting policies and lack of information from

Tootsie Roll and Red October their ROAs are not comparable because net income, average

assets, and interest expense are not comparable.

1994 ROA for Tootsie Roll equals $37,931 + $1,022.4 = .127.5($303,940 + $310,083

1994 ROA for Red October equals $23,931 = .67.5 (29,427.7 + 42,506.8)

Rate of Return on Common Shareholder Equity also measures a firm’s performance in

using its assets but factors financing into the measurement. The ratio has primary interest to

investors in a firm’s common stock.

ROE = Net Income - Dividends on Preferred StockAverage Common Shareholder Equity

To determine earnings assignable to common shareholders, the cost of other provisions of capital

such as preferred stock and loans, is netted out. Neither Tootsie Roll nor Red October have

preferred stocks so the numerator consists of the net income for each. However, the same

problems indicated in the ROA analysis for determining and comparing the two firms’ net

incomes exist. In addition, difficulty arises in comparing average common shareholders equity,

which consists of average par value of common stock, capital contributed in excess of par and

retained earnings for 1994 because Russian accounting includes in the equity section special

purpose funds with pre-tax dollars that have restricted uses.

Once again, the following ratios are not comparable:

1994 ROE for Tootsie Roll equals $37,931 = .168.5 (14,848 + 244,105 + 193,851)

1994 ROE for Red October equals $23,931 = .82.5 (22,553.1+ 35,691.8)

Tootsie Roll provides some quality of earnings information by segmenting its sales,

earnings and assets by geographic market but not by product. Red October provides a more

detailed segmentation of sales, but not earnings, by geographic region but no useful segment

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information by product. The lack of more segment information makes it difficult to analyze

quality of earnings for the two companies.

Debt Paying Ability and Risk

Risk to a lender means the uncertainty in receiving the amount due on time while to an

equity investor, it equals the uncertainty incorporated in calculating an estimated rate of return.

Firms face risks from economy-wide factors, industry factors and firm specific factors. Ratio

analysis provides some assessment of firm specific risks by focusing on a firm’s liquidity. Cash

and near-cash assets provide a firm with the resources to deal with various types of risk over

different time spans.

Current Ratio provides some indication of a firm’s ability to meet its short-term obligations

by measuring the relationship between assets that include cash and those a firm expects to use

within one year and obligations that will require cash within one year.

Tootsie Roll 1994 Current Ratio $118,887 = 4.5326,261

Red October 1994 Current Ratio $32,606.9 = 4.786,815

The current ratio can mislead investors since a firm that has an insufficient level of current assets

may pay down some of its current liabilities which would increase the ratio. Management can

also deliberately manipulate the current ratio by maintaining an inflated level of current assets

when it delays routine purchases on account until the following period.

A difficulty in comparing Tootsie Roll and Red October’s current ratios is that Red

October did not reveal its costing of inventories. Tootsie Roll largely uses LIFO but if Red

October uses FIFO or average costing then it will have a higher inventory historical cost in a

rising price environment such as Russia and the U.S., which will increase its current ratio as

compared to LIFO costing of inventory. Other problems are that Red October makes no

allowance for uncollectibles in its accounts receivable, which inflates receivables and increases

the current ratio, it fails to provide sufficient information on the write-off trend for bad debts, so

the amount of bad debts cannot be estimated. In addition, Other Assets provide no indication of

how readily transferable into cash these resources may be, which illustrates another problem

with the current ratio’s comparability in that one firm’s current assets composition may enable

that firm to more readily transfer its assets into cash to meet obligations than another firm.

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The quick ratio mitigates inventory comparability problems because it excludes inventory.

Red October, however, does not provide sufficient details on its short-term marketable securities

to calculate a quick ratio. Another problem with both the quick and current rations is that

current assets and liabilities can change dramatically over time and the amounts calculated from

year end statements may fail to reflect normal conditions. For example, Tootsie Roll’s Notes

Payable declined from $22,601 in 1993 to 0 in 1994, changing the current ratio from 2.2 to 4.53.

In sum, the current and quick ratios do not fully account for the degree of liquidity of short-term

assets, a firm’s ability to replace or renew maturing short-term obligations nor the likelihood that

a firm could liquidate part of its short-term assets without harming its operations.

Cash flow from operations ratios provide the most accurate indication of whether a firm’s

activities enable it to meet its obligations as they come due. Cash flow ratios can show the

relationship between the amount of cash generated by the firm’s operations and its current or

total liabilities. Still, such cash flow ratios are probably not comparable between Tootsie Roll

and Red October given the extensive assumptions and approximations made in deriving Red

October’s U.S. style income statement and balance sheet from the limited information provided

by Red October’s financial statements.

The Debt-Equity ratio provides another measure of a firm’s ability to meet its obligations

but on a long-term basis.

Current and Noncurrent LiabilitiesTotal Liabilities + Shareholders Equity

Tootsie Roll 1994 Debt-Equity $69,622 = .225$310,083

Red October 1994 Debt-Equity $6,815 = .16$42,506.8

Assessing these ratios for an individual firm also requires a conclusion as to the stability of

a firm’s earnings and cash flows from operations because the greater the stability the more debt a

firm can incur without threatening insolvency. Given the environment in which Red October

operates, a low ratio appears appropriate while Tootsie Roll’s environment and firm history

imply a higher ratio as acceptable. As previously indicated, however, Tootsie Roll and Red

October have some different policies effecting balance sheet accounts which make the ratio

comparisons suspect. For example, Red October includes advances from customers in the equity

section while Tootsie Roll would include it in liabilities, probably current. Red October’s

49

Wages Payable (70) in its Liability section may include dividends paid to employee owners

which would be listed in the equity section of Tootsie Roll’s balance sheet.

Interest Coverage ratio partially indicates the extent to which a firm’s operating profits can

cover interest expenses. The numerator consists of income from operations divided by interest

expense.

Tootsie Roll 1994 Interest Coverage Ratio $59,988 = 36.3$1,649

Red October’s 1994 Interest Coverage Ratio cannot be calculated because its statements provide

no information on interest expenses, which are included in the COGS account. A more accurate

measure of a firm’s long-term liquidity risk would use cash flows from operations rather than

earnings since firms pay interest with cash

Measures of Efficiency

Accounts receivable turnover ratio and collection period indicate the liquidity and quality

of receivables and a firm’s credit and collection policies; that is, how efficiently it uses

receivables to stimulate sales and produce cash.

Turnover Ratio = Sales RevenuesReceivables End of Year

and

Collection Period = 365 daysTurnover Ratio

which is the number of days the average receivable is outstanding before the firm collects cash.

Tootsie Roll 1994 Receivables Turnover = $296,932 = 13.44$22,087

Collection Period = 365 days = 27.16 days13.44

Red October 1994 Receivables Turnover = $116,225 = 59.45$1,955

Collection Period = 365 days = 6.14 days59.45

The ratios and periods for both firms lack precision and comparability. Because of

Russia’s hyperinflation and its legal system’s inability to enforce debts, the overwhelming

amount of Red October’s revenues come from cash sales while Tootsie Roll receives a

50

significantly larger proportion of revenues from credit sales. The receivables turnover ratio uses

sales revenues as an estimate for credit sales. For Tootsie Roll, sales revenues include cash and

credit sales but for Red October sales revenues include essentially cash. Tootsie Roll does not

provide information for determining credit sales in 1994. Red October provides some more

information in the Receivable and Payable Debt Statement (p. 16), but it does not delineate

Receivable Debt due to credit sales. While sales revenues may approximate Tootsie Roll’s

credit sales, it will not approximate the amount of sales on credit for Red October. In addition,

Red October does not account for uncollectible amounts at the time of sale, which overstates the

quality of its receivables. Non-comparability aside, the ratios would provide better information

with respect to their own markets by using an aging of receivables to provide a more accurate

indication of quality and a weighted average to provide a more accurate turnover and collection

period.

Inventory Turnover Ratio tells how frequently a firm sells inventory and in turn, the time

that capital is tied up in inventories.

Inventory Turnover = COGSAverage Inventory

Average Time Inventory on Hand = 365 daysInventory Turnover

The ratios fail to take into account inventory quality, seasonal variations and are effected by cost

flow assumptions.

Tootsie Roll 1994 Inventory Turnover = $155,565 = 5.32$29,231

Average Time = 365 days = 68.58 days53.2

Red October 1994 Inventory Turnover = $69,657 = 6.23$11,177.5

Average Time = 365 days = 58.59 days6.23

Since Red October incorporates period expenses into COGS, comparison cannot be made with

Tootsie Roll.

Plant Asset Turnover Ratio provides a relationship among property, plant and equipment

used to generate sales.

51

Plant Asset Turnover = SalesAverage Plant Assets

Caveats for interpretation include that a low rate may result from a firm preparing for growth

since investment in plant assets often occur well in advance of the sales of the products

generated by the investment. On the other hand, a firm with a poor near term outlook may cut

back capital expenditures resulting in a high ratio.

Tootsie Roll 1994 Plant Asset Turnover = $296,932 = 3.45$86,173.5

Red October’s fixed assets that are yet to be placed into use or not fully constructed reside in the

Uncompiled Capital Investments account, which partially resolves the problem of attributing

sales to plant assets not yet in operations; however, Tootsie Roll does not provide such

information so to compare the ratios between the two firms would require adding the

Uncompleted Capital Investments (08) for each year to the corresponding Fixed Assets

Accounts, but Red October combines Uncompleted Capital Investments with Advances to Other

Vendors.

Manager Concerns

Managers need accounting principles that accurately depict events and transactions so as to

determine the amount of assets used in a period and the amount of economic resources

remaining. Firms, however, choose accounting principles for other reasons, including tax

minimization that locks a firm into LIFO inventory costing, resulting in reduced earnings and

assets regardless of the economic reality. Tootsie Roll chose this course for its domestic

operations, and assuming it avoids dipping into LIFO layers, the method will reduce reported

assets and cumulative earnings. Depreciation methods, therefore, can maximize earnings and

assets or minimize them. Managers, whose compensation depends on reported profits,

obviously prefer profit maximization over the actual economic benefits produced by the firm’s

assets.

Firms may also choose accounting policies to provide a steady increase in earnings over

time in order to reduce the perceived risk of investing in the firm’s stock, which will lead to a

higher stock price. By pushing purchases or sales recognition into periods in which they

economically do not occur, managers can manipulate earnings for a time. In addition, straight

line depreciation can provide a regular periodic expense that may help avoid variability in

income. Tootsie Roll uses a combination of accelerated and straight line depreciation; perhaps in

52

an effort to smooth out its earnings. Red October’s cost depreciation method is not reported.

Furthermore, its financial statements use policies established for tax reporting purposes, so even

without accounting manipulation, the statements probably fail to reflect economic reality, as

such, they have limited use for managers.

Lawsuits and governmental action in America can pose significant future costs for a firm

that a manager would want to know the estimated present value of. Both Tootsie Roll and Red

October do not provide any off-statement information on potential environmental liabilities. A

Red October manager, however, need not worry over environmental obligations because the

Russian government does not enforce environmental regulations. In fact, recent tests of a wide

range of foods, including candies, have found unusually high levels of heavy metals and

radioactive isotopes, but the government has not taken any action.

Red October’s financial statements fail to provide managers with sufficient information for

planning future activities or judging the performance of operations, which would enable

instituting controlling operations. By incorporating period expenses into one item, COGS, Red

October eliminates a basis for developing an annual budget that segregates marketing, selling,

advertising, distribution, warehousing general and administrative expenses. In order to make

profitable decisions, managers use incremental analysis to choose between alternative actions but

to determine the benefits and costs of an action requires data on individual expenses. (To avoid

confusing sunk costs with variable costs also requires segregated expenses.) Tootsie Roll

provides more operating expense segregation, but it still combines marketing, selling and

warehousing; distribution and warehousing; and general and administrative costs.

Cash is the only resource management can use to acquire economic resources and reward

shareholders so in measuring the impact of a decision, incremental analysis also requires a

comparison of the estimated cash flows for each alternative. Red October does not provide a

cash flow statement that could be used in estimating the cash flows from different actions.

Furthermore, the lack of a cash flow statement and analysis of cash flows prevents Red October

from determining whether its budget planning decisions will create a cash surplus or deficit.

Tootsie Roll, with the aid of its prior cash flow statements, can develop a somewhat useful

tentative cash budget that will enable it to decide in which accounts it should alter the cash

flows; thereby, refining its incremental analysis decisions.

After the formulation of budget plans, managers require information on the successful or

unsuccessful implementation of the plans in order to evaluate managerial performance and

53

economic performance, that is, whether certain activities produce sufficient income and cash to

justify their investments. This requires a comparison of results to plan expectations and an

analysis of internal or external reasons for any variance. However, accounting practices may

lessen or obscure the economic information financial statements should provide managers.

The Rate of return on assets measures the success of production and marketing personnel

in creating and selling goods to customers, but Red October’s practices do not provide interest

expense information for a manager to calculate ROA. In addition, Red October’s direct write-

off method for uncollectibles makes it more difficult for a manager to assess the impact of credit

policy on sales and ultimately profit as compared to the allowance method used by Tootsie Roll.

And the allowance method, in turn, is less accurate than aging of receivables for determining the

economic benefit of credit sales. Tootsie Roll’s domestic LIFO cost flow assumption will report

a lower amount of assets in a rising price environment and a higher amount in a falling price

environment. When combined with Tootsie Roll’s straight line and accelerated depreciation, a

manager will lack information on the actual amount of economic resources remaining or used to

generate a particular profit.

Rate of return on equity summarizes the managers decisions about operations, investments

and finances. Managers for Tootsie Roll or Red October face problems in interpreting ROE

because cost flow assumption and depreciation methods may yield net income skewed from

economic reality. In addition, both Tootsie Roll and Red October’s equity are carried at

historical cost (factoring out hyperinflation), which results in comparing net income expressed in

units that differ in value from the units in which equity is expressed.

For a firm to achieve profit maximization requires knowing approximately when marginal

cost equals marginal revenue. Since marginal cost equals the change in variable cost per unit of

output, an understanding of which activities comprise fixed costs and variables costs and how

variable costs change with output will enable a manager to pursue profit maximization. It will

also allow an estimate of average cost (the sum of average variable and average fixed cost) for a

particular output from which total profit can be determined. Neither Tootsie Roll, nor Red

October provide sufficient information in their financial statements to firmly distinguish variable

from fixed costs and the amounts of each. By comparing Tootsie Roll’s operating expenses

between 1992 and 1993 (in which the impact of Cambridge Brands new products was for only

2.5 months) the following expenses appear essentially fixed although the specific amounts for

each are not given:

54

Marketing and selling, which increased only a little even in 1994 when the acquisition was

fully integrated.

Advertising, since the increases in 1993 and 1994 were probably attributed to advertising

new products rather than increasing Tootsie Roll’s already extensive advertising.

General and administrative increased slightly in 1994 due to the addition of the Cambridge

Brands product line and not because of increased sales.

Amortization costs for an intangible will not fluctuate with changing output although the

intangible will probably increase output.

The following expenses appear to be variable for Tootsie Roll:

Most COGS expenses will vary with output.

Interest expense can vary with output when paid on loans for financing other variable costs.

Although mixing together some costs, Tootsie Roll’s statements provide some aggregate

data on variable and fixed costs and total revenues, but no information on the amount of product

units sold or the costs and revenues attributed to each product line. Profit maximization requires

marginal cost and revenue data for each product line.

Red October provides a per ton breakdown of its different outputs but no information on

the costs or revenues associated with each. In addition, it mixes period costs of which some are

probably fixed with product costs that generally vary with output level making even an

aggregate distinction impossible.

Market Valuation

Both investors and managers use financial statements to assess the market value of a firm.

The three key methods of valuation consist of:

1. projecting the net cash flow a firm generates from operations and investments for a

number of years into the future then determining the present value of those cash flows by using a

firm’s cost of capital as the discount rate;

2. multiplying a firm’s current earnings times a market multiple derived from similar

firms recently acquired; and

3. determining the ratio between market value and book value of common shareholders

equity for similar firms recently acquired, which varies less over time than earnings.

Tootsie Roll acquired the Cambridge Brands candy company in 1993 for $81.3 million at

which time Cambridge had sales of $62 million. The market multiple under method two using

55

sales instead of earnings equals 1.3113.1 This market multiple for Tootsie Roll provides a value

in 1994 of $389,366 and in 1995 of $401,048. For Red October, provides a value in 1994 of

$152,406 and in 1995 of $228,669. The problem with this valuation method is that sales may

fluctuate more than earnings and both sales and earnings generally fluctuate more than common

shareholders equity. Furthermore, multiples for American companies will only grossly apply to

Russian companies due to the dramatically different environments. Secret dealings and the lack

of a market system also make any multiple based on a Russian transaction suspect, even if

details of the transaction could be discovered.

Conclusion

Overall, Tootsie Roll’s statements provide more clearly understandable information for

investors and managers but lack sufficient economic accuracy to solely base a managerial or

investment decision on. They do, however, help formulate the questions that an investor or

manager need answered.

1 I used this method because time constraints deterred my spending extended hours in the library searching for purchases of publicly-owned companies for which I could obtain shareholder equity or earnings information, and I do not have the knowledge to use method 1.

56