Canada Steel Co. produces steel casting and metal fabrications for sale to manufacturers of heavy construction machinery and agricultural equipment. Early in Year 3, the company's president sent the following memorandum to the financial vice president: TO: FROM: SUBJECT: Robert Kinkaid, Financial Vice President Richard Johnson, President Accounting and Financial Policies Fiscal Year 2 was a difficult year for us, and the recession is likely to continue into Year 3. While the entire industry is suffering we might be hurting our performance unnecessarily with accounting and business policies that are not appropriate. Specificaly (1) We depreciate most fixed assets (foundry equipment) over their estimated useful lives on the "tonnage- of-production" method. Accelerated methods and shorter lives are used for income tax purposes. A switch to straight-line for financial reporting purposes could (a) eliminate the deferred tax liability on our balance sheet, and (b) leverage our profits if business picks up in Year 4. (2) Several years ago you convinced me to change from the FIFO to LIFO inventory method. Since inflation is now down to a 4 percent annual rate, and balance sheet strength is important in our current environment, I estimate we can increase shareholders' equity by about $2.0 million, working capital by S4.0 million, an adjustment is real-these prbfits were earned by us over the past several years and should be recognized d Year 3 earnings by $0.5 million if we return to FIFO in Year 3. This (3) If we make the inventory change, our stock repurchase program can be continued. The same shareholder who sold us 50,000 shares last year at $100 per share would like to sell another 20,000 shares at the same price. However, to obtain additional bank financing, we must maintain the current ratio at 3:1 or better. It seems prudent to decrease our capitalization if return on assets is unsatisfactory and our industry is declining. Also, interest rates are lower (11 percent prime) and we can save $60,000 after taxes annually once our $3.00 per share dividend is resumed These actions would favorably affect our profitability and liquidity ratios as shown in the pro forma income statement and balance sheet data for Year 3 (S millions).
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