Roy Den Hollander Red oct v. tootsie roll accntng

RUSSIAN v. U.S. ACCOUNTING POLICIES
Roy Den Hollander, 97-IA
Accounting 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
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
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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 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.
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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 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
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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 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
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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
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.
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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.
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
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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.
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 is also
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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;
- restrictions on the level of cash balances (possibly the result of a loan covenant);
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- 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
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%.
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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.
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.
17

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%.
18

Tootsie Roll Pro Forma Income Statement
(in thousands $)
1994 1995
Actual 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
19

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 Asset
Turnover 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 Brands and the Chicago plant, but
there are still some qualifications which will be taken into account.
20

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.
21

Tootsie Roll Common Size Balance Sheet - 1994
(Based on Estimated Total Assets of $322,511)
Assets
Current Assets:
Cash and Cash Equivalents Depends on Change in Cash Flow
Investments to Maturity 14.56
Accounts Receivable (Net) 7.01
Inventories:
Finished Goods & Work-in-Progress 5.30
Raw Materials & Supplies 3.96
Prepaid Expenses 1.00
Deferred Income Taxes .70
Property, Plant and Equipment:
Land 2.12
Buildings 8.56
Machinery & Equipment 34.73
Leasehold Improvements .002
Less - Accumulated Depreciation & Amortization (18.23)
Other Assets:
Excess Cost Over Net Tangible Assets
Net of Accumulated Depreciation 31.32
Other Assets 3.77
Liabilities & Shareholder’s Equity
Current Liabilities:
Notes Payable to Banks 0.00%
Accounts Payable 1.94
Dividends Payable .39
Accrued Liabilities 5.41
Income Taxes Payable .59
Noncurrent Liabilities:
Deferred Income Taxes 2.45
Post-Retirement Healthcare & Insurance 1.59
Industrial Development Bonds Same amount for 1994 & 1995
Term Notes Payable Same amount for 1994 & 1995
Other Long-Term Liabilities 1.00
Shareholders Equity:
Common Stock (par value) [Depends on
Class B Common Stock (par value) stock dividend
Capital Excess of Par Value issuance]
Retained Earnings 35.79
Foreign Currency Translation (2.49)
22

Tootsie Roll Pro Forma Balance Sheet - 1995
Assets
Current Assets:
Cash and Cash Equivalents Depends on Change in Cash Flow
Investments to Maturity $46,958
Accounts Receivable (Net) 22,608
Inventories:
Finished Goods & Work-in-Progress 17,093
Raw Materials & Supplies 12,771
Prepaid Expenses 3,225
Deferred Income Taxes 2,258
Total Current Assets 144,238
Property, Plant and Equipment:
Land 6,829
Buildings 27,618
Machinery & Equipment 112,018
Leasehold Improvements 6
146,471
Less - Accumulated Depreciation & Amortization 58,804
87,667
Other Assets:
Excess Cost Over Net Tangible Assets
Net of Accumulated Amortization 100,994
Other Assets 12,160
113,154
$345,639
Liabilities & Shareholder’s Equity
Notes Payable to Banks $0
Accounts Payable 6,268
Dividends Payable 1,248
Accrued Liabilities 17,448
Income Taxes Payable 1,916
26,880
Noncurrent Liabilities:
Deferred Income Taxes 7,898
Post-Retirement Healthcare & Insurance 5,111
Industrial Development Bonds 7,500
Term Notes Payable 20,000
Other Long-Term Liabilities 3,226
43,735
Common Stock (par value) 5,245
Class B Common Stock (par value) 2,513
Capital Excess of Par Value 159,198
Retained Earnings 114,632
Foreign 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.
23

Analytic Entries for Tootsie Roll Pro Forma Cash Flow Statement - 1995
1. Cash (Net Income) 41,152
Retained Earnings 41,152
2. Cash (Amortization Addback) 2,706
Net Intangibles 2,706
3. Retained Earnings 4,893
Cash (Dividends) 4,893
4. Accounts Receivable 521
Cash 521
5. Finished Goods 389
Cash 389
6. Raw Materials 307
Cash 307
7. Prepaid Expenses 131
Cash 131
8. Deferred Income Taxes 90
Cash 90
9. Land 157
Cash 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 5,032
Cash 5,032
12. Other Assets 5,280
Cash 5,280
13. Cash 144
Accounts Payable 144
24

14. Cash 29
Dividends Payable 29
15. Cash 402
Accrued Liabilities 402
16. Cash 44
Income Taxes Payable 44
17. Cash 182
Deferred Income Taxes 182
18. Cash 118
Post-Retirement 118
19. Cash 74
Other Long-Term Liabilities 74
20. Investments to Maturity 1,097
Cash 1,097
21. Foreign Currency Translation 185
Cash 185
22. Retained Earnings1 29,390
Stock 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.
25

Tootsie Roll T-Account Work Sheet
Investments to Maturity Accounts Receivable
45,861 22,087
(20) 1,097 (4) 521
46,958 22,608
Finished Goods/Work-in-Progress Raw Materials & Supplies
16,704 12,464
(5) 389 (6) 307
17,093 12,771
Prepaid Expenses Deferred Income Taxes
3,094 2,168
(7) 131 (8) 90
3,225 2,258
Land Buildings
6,672 143,098
(9) 157 (10) Purchases Depreciation
6,829 146,471
Net Intangibles Other Assets
98,668 6,880
(2) 2,706 (12) 5,280
(11) 5,032
100,994 12,160
26

Accounts Payable Dividends Payable
6,124 1,219
(13) 144 (14) 29
6,268 1,248
Accrued Liabilities Income Taxes Payable
17,046 1,872
(15) 402 (16) 44
17,448 1,916
Deferred Income Taxes Post-Retirement
7,716 4,993
(17) 182 (18) 118
7,898 5,111
Industrial Bonds Term Notes Payable
7,500 20,000
7,500 20,000
Other Long Term Liabilities
3,152
(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
27

Cash
Beginning Cash $16,509
Operations
521 (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
Investing
157 (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 21,455
Ending 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.
28

Tootsie Roll Pro Forma Cash Flow Statement - 1995
Cash Flow From Operations:
Net Earnings $41,152
Amortization 2,706
Accounts Payable 144
Dividends Payable 29
Accrued Liabilities 402
Income Taxes Payable 44
Deferred Income Taxes 182
Post-Retirement Benefits 118
Accounts 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 74
Dividends (4,819 )
Net Cash From Finances (4,819 )
Change in Cash 23,396
Cash at Beginning of Year 16,509
Cash at End of Year 39,905
29

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. The value of
30

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.
31

Red October Balance Sheet
(in thousands $)
The brackets below each account title and number provide an American definition of the account.
ASSETS
Current Assets: Translation 1993 1994
Financial 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, Other
Debtor 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 mean
exchange 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
nondeductible expenses related to fixed assets are written off to Use of Profit (81) or Directed Financing and
Allocations (96).
32

LIABILITIES
Translation 1993 1994
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 264.1 422.0
Medical Insurance Payables (69)
Bank & Other Loans (90) Monetary 0.0 1,690.1
Accrued & Other Liabilities:
Wages Payable (70) Monetary 196.9 246.0
Other Payables Monetary 2,722.7 237.7
Other Short Term Liabilities Monetary 11 .5 0 .0
Total Liabilities $6,874.6 $6,815.02
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.
33

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.
34

Red October Income Statement
(in thousands $)
1993 1994
Sales 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 70.03
Out of Sales Transaction Results2 607.0 474.0
Securities Transactions Gains4 257.0 385.6
Foreign Currency Exchanges Gains4 504 .6 1,465 .8
Earnings Before Taxes $35,659 .6 $48,963 .4
VAT and Special Tax5 7,039.9 11,782.4
Excise Taxes5 75.8 0.0
Profit Tax 8,394 .0 13,250 .0
Net Income $20,149 .9 $23,931 .0
Cash Dividends6 0.0 0.0
Stock 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.
35

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).
36

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 .06
Out of Sales Transaction Results .80 .41
Securities Transactions Gains .34 .33
Foreign 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
37

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.
38

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.
39

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.
40

Red October’s Pro Forma Balance Sheet (1995)
1994 Percentage 1994 Percentage
of Sales of Assets 1995
ASSETS
Current Assets:
Financial Means Depends on Cash Flow Change $15,275.0
Consumers’ Account 1.7% 2,963.7
Other Debtors & Advanced Expenses 0.2 348.7
Advances to Supplies & Contractors 12.0 20,920.5
Inventories 10.4 18,131.1
Other Assets 0.01 17 .4
Total Current Assets 57,656.4
Long-Term Assets:
Financial Long-Term Investments 0.7 1,220.4
Uncompleted Capital Investments 3.0 5,230.1
& Advances Other Vendors
Fixed Assets Net of Depreciation 10.4 18,131.1
Intangible Assets 0.002 3 .5
Total Long-Term Assets 24,585 .1
Total Assets $82,241 .5
LIABILITIES
Suppliers Account 1.2 2,092.0
Taxes Payable 2.5 4,358.4
Social, Pension & Medical Insurance Payables NA 0.99% 814.2
Bank & Other Loans NA 3.98 3,273.2
Wages Payable NA 0.6 493.5
Other Payables NA 0.6 493.5
Other Short-Term Liabilities NA 0.0 0 .0
Total Liabilities 11,529.8
Total Equity 70,716 .7
Total Liabilities & Equity $82,241 .5
41

Red October Pro Forma Cash Flow Statement - 1995
Cash Flows From Operations:
Net Income $29,698.4
Consumers 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 741.0
Taxes Payable 1,490.0
Social, Pension & Medical Payables 212.0
Wages Payables 122.0
Other 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 10,772.2
Cash Beginning 1995 4,502.8
Cash 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.
42

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 Savings
Average 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.
· 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.
43

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.
· 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.
44

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 Stock
Average 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 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.
45

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 = 4.53
26,261
Red October 1994 Current Ratio $32,606.9 = 4.78
6,815
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.
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
46

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 Liabilities
Total 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 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
47

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 Revenues
Receivables End of Year
and
Collection Period = 365 days
Turnover 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 days
13.44
Red October 1994 Receivables Turnover = $116,225 = 59.45
$1,955
Collection Period = 365 days = 6.14 days
59.45
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 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
48

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 = COGS
Average Inventory
Average Time Inventory on Hand = 365 days
Inventory 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 days
53.2
Red October 1994 Inventory Turnover = $69,657 = 6.23
$11,177.5
Average Time = 365 days = 58.59 days
6.23
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.
Plant Asset Turnover = Sales
Average 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
49

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 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
50

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
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
51

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:
· 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
52

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