10-K Navigation Guide

Chris Senyek, CFA, CPA (646) 845-0759

[email protected]

Adam Calingasan, CFA, CPA (646) 845-0757

[email protected]

Clinton Chang, CFA, CPA (646) 845-0756

[email protected]

ThisreportislimitedsolelyfortheuseofclientsofWolfeTrahan&Co.PleaserefertotheDISCLOSURESlocatedattheend ofthisreportforapplicabledisclosures.

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ACCOUNTING&TAXPOLICYFebruary28,2012

10KNAVIGATIONGUIDEA Primer on Reading Annual Reports

This report is our annual guide to understanding and interpreting annual 10-K disclosures. We believe a thorough reading and understanding of a companys annual report assists in identifying overlooked investment opportunities and potential risk exposures. 10-Ks provide a once-a-year comprehensive view of a companys business and detailed financial statement footnotes. As many 10-Ks now exceed 200 pages, to assist investors, we explain and interpret over 40 commonly found disclosures as applied in analyzing debt and equity investments. Annual Reports are Due on February 29th for Most U.S. Publicly Traded Companies. For

smaller companies with market capitalizations below $700 million (but above $75 million), annual 10-K reports are due on March 15, 2012.

Important Disclosures to Review Include: Cost capitalization, equity investments, depreciation,

derivatives/foreign currency, foreign cash, inventory, M&A accounting, operating leases, off-balance sheet entities, pensions, reserves, segment disclosures, and taxes.

Earnings Quality and Cash Flow Analysis. We highlight ways in which companies may manage earnings and cash flows and how to spot such practices when reading through 10-K filings. For our detailed earnings quality framework initiation report, please see our December 2011 report: Earnings Quality: Ideas and a Guide to Avoid Accounting Pitfalls.

U.S. and IFRS Key Differences Examined. Today, the investment landscape is global and,

accordingly, knowledge of more than one accounting language is necessary to compare companies across the globe. We highlight the key differences between U.S. GAAP and International Financial Reporting Standards (IFRS).

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TTAABBLLEEOOFFCCOONNTTEENNTTSS Introduction ................................................................................................................................................................................. 4 Filing Deadlines .......................................................................................................................................................................... 4 Annual Report Sections ............................................................................................................................................................. 5 Recent Accounting Pronouncements and Changes ............................................................................................................... 6 Review 10-K for Unresolved SEC Staff Comments ................................................................................................................. 9 Properties Section: Leased or Owned? ................................................................................................................................... 9 Managements Discussion and Analysis ............................................................................................................................... 10 Critical Accounting Policies .................................................................................................................................................... 15 Quality of Cash and Investments ............................................................................................................................................ 17 Accounting for Inventory ......................................................................................................................................................... 18 Property, Plant, and Equipment: Check Asset Lives and For Changes in Policies .......................................................... 22 Implications of Accelerated Depreciation .............................................................................................................................. 25 Bonus Depreciation .................................................................................................................................................................. 26 Hidden Asset Value .................................................................................................................................................................. 29 Accounting for Equity Investments: < 20% Ownership ........................................................................................................ 32 Accounting for Equity Investments: 20% to 50% Ownership .............................................................................................. 33 Mergers & Acquisitions ............................................................................................................................................................ 34 Acquisition Accounting Antics: The Perfect Storm .............................................................................................................. 40 Goodwill Impairments (FAS 141R, 142, and 144) .................................................................................................................. 42 Look for Related Party Transactions ...................................................................................................................................... 45 When Are Segment Disclosures Required? .......................................................................................................................... 46 Excessive Cost Capitalization on the Balance Sheet? ......................................................................................................... 50 Loss Reserves........................................................................................................................................................................... 54 Other Than Temporary Impairments ...................................................................................................................................... 55 Watch for Large Reserves and Reserve Reversals ............................................................................................................... 59 Warranty Reserves May be a Source of Earnings Growth ................................................................................................... 61 Are There Underreported Accrued Expenses / Accounts Payable ..................................................................................... 62 Accounting for Leases ............................................................................................................................................................. 63 Convertible Debt ....................................................................................................................................................................... 69 Debt and Debt Covenants ........................................................................................................................................................ 74 Other Assets and Liabilities .................................................................................................................................................... 75 Accumulated Other Comprehensive Income ......................................................................................................................... 76 Fair Value Measurements ........................................................................................................................................................ 79 Balance Sheet Relationships ................................................................................................................................................... 82 Revenue Recognition ............................................................................................................................................................... 84 Non-Recurring Items? .............................................................................................................................................................. 87 Comparability of Margins ......................................................................................................................................................... 89 Changes in Estimate Driven Expenses .................................................................................................................................. 90 Restructuring Costs ................................................................................................................................................................. 94


Reserve Reversal Gains included in Earnings - Do Not Overlook the Schedule II ........................................................ 95 Stock Based Compensation .................................................................................................................................................... 97 Economic Cost of Stock Based Compensation .................................................................................................................. 105 Incorporating Stock Based Compensation In Cash Flows and Valuation ........................................................................ 107 Modifications to Options and Vesting Periods .................................................................................................................... 108 Income Taxes .......................................................................................................................................................................... 109 Share Repurchases ................................................................................................................................................................ 119 Earnings Per Share & Diluted Share Count ......................................................................................................................... 120 Statement of Cash Flows ....................................................................................................................................................... 122 Material Non-Cash Activities / Supplemental Cash Flow Information .............................................................................. 126 Pension and Postretirement Plan Disclosures .................................................................................................................... 128 Key Pension Items: Funded Status = Pension Plan Assets Pension Liability .............................................................. 129 Key Pension Assumptions .................................................................................................................................................... 130 Pension Cost ........................................................................................................................................................................... 133 Pension Footnote Example 3M Company ......................................................................................................................... 135 Mark to Market Pension Accounting .................................................................................................................................... 142 Unfunded Multi-Employer Pension Plans ............................................................................................................................ 143 Pension Q&A ........................................................................................................................................................................... 145 Market Risk Disclosures ........................................................................................................................................................ 151 Hedging and Derivative Disclosures .................................................................................................................................... 154 Derivatives: An 8 Point Checklist To Analyze Disclosures ................................................................................................ 156 Analyzing Derivative Disclosures: Becton Dickinson Illustration ..................................................................................... 158 Subsequent Event Disclosures ............................................................................................................................................. 164 Dated Financial Statements ................................................................................................................................................... 166 Internal Controls ..................................................................................................................................................................... 167 Auditors Opinion ................................................................................................................................................................... 169 Differences Between U.S. GAAP and IFRS GAAP ............................................................................................................... 172 Appendix: Accounting Case Studies .................................................................................................................................... 187 Accounting & Tax Policy Research Library ......................................................................................................................... 202 Disclosures .............................................................................................................................................................................. 203


IINNTTRROODDUUCCTTIIOONNGraham and Dodds seminal book, Security Analysis, popularized financial statement analysis as a critical component of investing. It fostered the notion that a thorough reading and understanding of a companys annual report would lead to identifying overlooked investment opportunities and potential risk exposures. In short, reading an annual report increased the odds of producing alpha. We still believe the same holds true today, but 10-Ks are larger than ever before with complicated accounting principles underlying the figures and footnotes. To assist investors in navigating through these lengthy documents, this report explains and interprets essential financial statement disclosures and sections. Weve arranged this report by key sections, following the typical 10-K progression, and wrote each section in such a way that each topic may be read individually. FFIILLIINNGGDDEEAADDLLIINNEESSFor 10-K and 10-Q (quarterly reports) filing deadlines, the U.S. Securities and Exchange Commission (SEC) rules classify companies as large accelerated filers, accelerated filers, or non-accelerated filers. Companies that are classified as large accelerated filers have a worldwide common public equity float of at least $700 million and have filed reports with the SEC for at least 12 months. Worldwide common public equity float is measured on the last day of the most recently completed fiscal second quarter. The 10-K filing deadline for large accelerated filers is 60 days after year-end. Accelerated filers are defined as companies with a common public equity market float of $75 million to $700 million. The 10-K filing deadline for these companies is 75 days after year-end. Non-accelerated filers is the third category of companies and is defined as a company with a public common equity float of less than $75 million or a company completing an initial public offering (IPO) during the year. Non-accelerated filers 10-K deadline is 90 days after year-end. Sometimes a companys filing deadline falls on a Saturday or Sunday in which case the company has until the following Monday to file its 10-K. For a recent IPO, once a company has been subject to the Securities Exchange Acts reporting requirements for at least 12 calendar months and has filed at least one annual report, the company is eligible for either large accelerated or accelerated filing status. If a company cant file its annual report without unreasonable effort or expense, it may seek temporary relief under SEC rule 12b-25. In these circumstances, the SEC allows a 15-calendar-day extension to the companys 10-K filing deadline. When this happens, the company files a Form 8-K or NT-10-K, explaining the reason for delay. SEC Annual Report Filing Deadlines

SECClassification Definition(1) Form10KFilingDeadlineLargeAcceleratedFilers Publicfloatofatleast$700million 60daysafteryearend(Feb.29,2012forcalendaryearendcompanies)AcceleratedFilers Publicfloatbetween$75and$700million 75daysafteryearend(March15,2012forcalendaryearendcompanies)OtherFilers Publicfloatlessthan$75million;recentIPOs 90daysafteryearend(March30,2012forcalendaryearendcompanies)(1)Marketvaluefloatisbasedonthedateofthemostrecentsecondquarter(June30,2011forcalendaryearendcompanies).OnceacompanybecomesaLargeAcceleratedFiler,publicfloatmustfallbelow$500milliontoreturntoAcceleratedFilerstatus.ToexitAcceleratedFilerstatus,thepublicfloatmustdropbelow$50million. Source: Wolfe Trahan Accounting & Tax Policy Research; SEC.


AANNNNUUAALLRREEPPOORRTTSSEECCTTIIOONNSSThe 10-K is divided into four main parts, of which we focus on interpreting and reviewing the footnotes and related disclosures. We also delve into other specific sections of the 10-K if they are applicable to investment analysis.

Part I Item 1. Business Item 1A. Risk Factors Item 1B. Unresolved SEC Comments Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to Vote of Security Holders Part II Item 5. Market for Registrants Common Equity and Related Stockholder Matters Item 6. Selected Financial Data Item 7. Managements Discussion and Analysis of Financial Condition and Results Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data Item 9. Change in and Disagreements with Accountants on Accounting and Financial

Disclosure Item 9A. Controls and Procedures Item 9B. Other Information Part III (This section is usually included in a proxy statement and referenced in the Form 10-K) Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management and Related

Stockholder Matters Item 13. Certain Relationships and Related Transactions Item 14. Principal Accountant Fees and Services Part IV Item 15. Exhibits and Financial Statement Schedules


RREECCEENNTTAACCCCOOUUNNTTIINNGGPPRROONNOOUUNNCCEEMMEENNTTSSAANNDDCCHHAANNGGEESSDisclosure of the financial impact of newly issued accounting standards (those that have not yet been adopted) is required under SEC Staff Accounting Bulletin No. 74 (SAB 74). This information is typically located following the summary of significant accounting policies section. Under this SEC guidance, companies are required to describe the new accounting rule, adoption date, method of adoption (e.g. prospective/retrospective), known estimated financial statement impact, and related potential impact on other significant matters (e.g., debt covenants). We note that some companies voluntarily choose to list all recently issued accounting standards not yet adopted even if they do not expect a material impact. Many times, this disclosure may simply be boilerplate language that contains only general information about the pending change. However, as the effective date draws closer, analysts may find that the financial impact of adopting of adopting the new rule is disclosed. Below are recent and upcoming accounting rule changes that may impact companies. Recent FASB / SEC Accounting Pronouncements and Changes

New / Pending Change Description Effective Date / StatusASU No. 2010-26, Financial Services- Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (EITF Consensus)

Immediate changes to GAAP on costs that qualify as deferred acquisition costs. The changes tighten the rules on allowable capitalized costs since there is concern that companies are inappropriately and inconsistently capitalizing indirect and other marketing costs on balance sheet. DAC would only include costs that are directly related to the acquisition or renewal of an insurance contract. Only incremental direct costs of contract acquisition are allowed.

Effective Q1 2012 with a prospective transition (retrospective election would be allowed). Early adoption was allowed.

ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilties

Requires additional disclosures of derivative assets and liabilities that are offset for balance sheet purposes or are subject to master netting agreements. Additional information must be described pertaining to the gross amounts of assets / liabilities, the amounts offset within the balance sheet, and the amounts subject to master netting agreements (whether offset or not).

Effective 'Q1 2013 with retrospective comparison.

ASU No. 2011-09, Compensation - Retirement Benefits - Multiemployer Plans (Subtopic 715-80): Disclosures about an Employer's Participation in a Multiemployer Plan

Requires additional disclosures in tabular formats for each significant multiemployer pension plan: 1) Name and identifying EIN number;2) Level of employers participation (whether the employers contribution represents >5% of total contributions to the plan);3) Financial health of the plan based on the risk zone as indicated by the Pension Protection Act; any funding improvement plans pending or implemented; any surcharges imposed; and 4) Expiration date and information about the collective bargaining agreements underlying the required contributions to the plans. Importantly, certain information about plan withdrawal liabilities will still NOT be required.

Effective for 2011 10-Ks for calendar year companies.

ASU No. 2011-08, Intangibles- Goodwill and Other (Topic 350): Testing Goodwill for Impairment

Adds a preliminary qualitative assessment to the testing for goodwill impairment. Instead of proceeding directly to step 1 of the quantitative 2 part goodwill impairment test (determiing whether the carrying value of the reporting unit exceeds its fair value), a company may use a qualitative events or circumstances test to assess whether it's more likely than not (50% or greater) that the fair value of the reporting unit is less than the carrying value. These events and circumstances include macroeconomic conditions, industry & market considerations, input cost factors, financial performance, entity specific events such changes in management, customers, strategy, etc., or a sustained decrease in share price.

Effective 'Q1 2012.

ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income

Clarifies the presentation of items recognized in Other Comprehensive Income. Other Comprehensive Income and its components must either be presented as part of the income statement or in a immediately subsequent separate statement of comprehensive income. The option to present the components of comprehensive income in the statements of changes in shareholder's equity is no longer available. More closely aligns the US GAAP presentation to IFRS (differences still remaining in the measurement of comprehensive income).

Effective 'Q1 2012.

Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FASB.


FASB Proposals Topic Description Effective Date / StatusRevenue Recognition Joint FASB/IASB project. Intends to improve existing revenue recognition

standard, which contain inconsistencies and weaknesses. While direct impact will be to difficult to quantify, the new standard is likely to materially affect a number of industries.

Exposure draft document issued November 2011. FASB will receive comment letters through March 2012 and then begin re-deliberations. Effective date not before 2015.

Lease Accounting Joint FASB/IASB project. Will result in complete overhaul of current lease accounting policies. Operating lease commitments that are currently will be capitalized on the balance sheet as intangible right to use asset and related debt obligation. Will impact debt ratios, earnings and reported operating cash flow. Largest impact on retail, restaurants, airlines, air freight, and certain industrials. The decision whether to include option renewals and contingent rent continues to be a controversial topic that Board members cannot reconcile.

Significant changes have been made since the original exposure draft issued August 2010. New exposure draft will be issued in 'H2 2012. Any final standard will not likely be effective before 2015.

Financial Instruments Accounting Joint FASB/IASB project. Will result in overhaul of accounting for financial instruments (loans, securities etc.). FASB and IASB taking two different approaches to standard setting process . More items expected to be recorded at fair value on balance sheet as opposed to amortized cost (some items may be marked to market through earnings and some may be marked through OCI). Loans held for investment likley to retain amortized cost accounting model. Impairment (loan reserves) will be on a more expected basis vs. the current incurred basis model. Hedge accounting will be simplified and clarified.

There have been significant changes since FASB's exposure draft was issued in May 2010. Re-deliberations continue. A joint supplementary exposure draft on impairment was issued In January 2011. The FASB may re-expose in 'H2 2012. IASB has broken the project into 3 phases. Phase 1 (Measurement) has been completed but has delayed the effective date to 2015. Phase 2 (Impairment) ED released 'Q4 2009 but significant changes have been made since then. Initial Phase 3 (Hedging) ED was released 'Q2 2010. Any final standards will not likely be effective before 2014/2015.

Insurance Accounting Joint FASB/IASB project. Will overhaul and clarify the insurance contract accounting. Deferred acquisition costs (DAC) likely to continue to receive similar accounting treatment as is currently provided (e.g. capitalized, not immediately expensed).

Re-deliberations are ongoing based on FASB's informal discussion paper and IASB exposure draft (June 2010). FASB is targeting to release an exposure document "H2 2012 . We do not expect any changes to be effective before 2014.

Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings; FASB.


Tax Policy Changes Topic Description Effective Date / StatusCorporate Tax Reform "Presidents Framework for Business Tax Reform" includes proposals to reduce

the corporate tax rate to 28%, reform the US international tax system in an attempt to tax more foreign source income of US corporations pertaining to deferral, foreign tax credits and intangible property profits shifting. Other corporate tax reforms proposed in the budget include LIFO repeal, insurance industry taxation, oil & gas industry taxation, and taxation of carried interests (hedge funds and PE firms). The tax-advantaged status of many pass-through entities may also be at risk under any reform. Outlook for passing any major reform before this year's election remains unlikely in our opinion given Washington gridlock.

Under consideration

Bonus Depreciation 100% bonus depreciation expired at the end of 2011 and is 50% for 2012. All bonus depreciation provisions will expire and revert to standard MACRS beginning 2013.

Under consideration

Individual Tax Increases Expiration of lower individual Pre-Bush tax cut rates resulting in increased personal income tax rates (top bracket from 35 % to 39.6%). Dividend tax rate will revert to ordinary income tax rate (currently at lower capital gains rate). Capital gains tax rate to revert to 20%. Obama's budget retains the lower Bush tax rates for those not considered "high-earners" (


RREEVVIIEEWW1100KKFFOORRUUNNRREESSOOLLVVEEDDSSEECCSSTTAAFFFFCCOOMMMMEENNTTSS Analysts should review Item 1B, unresolved SEC staff comments, of the 10-K. Under the Sarbanes-Oxley Act of 2002, the SEC must review every public companys financial disclosures at least once every three years. The SEC will send companies comment letters based on these reviews, requesting additional disclosures or asking why certain disclosures were not included in 10-Ks or 10-Qs. SEC comment letters may also lead to a deeper SEC investigation into a companys accounting practices if questionable or non-Generally Accepted Accounting Principles (GAAP) are discovered. Unresolved SEC comments must be disclosed under the following circumstances:

The SECs written comment remains unresolved at the10-K filing date; The SEC written comments are material; and The SEC comments were issued more than 180 days before the end of the fiscal year to which

the annual report relates. At least 45 days after the SEC review is finished, comment letters are publicly available on the SEC website and other data provides such as Edgar. The filing type appears as CORRESP (the companys response to the SEC) or UPLOAD (the SECs letter to the company). PPRROOPPEERRTTIIEESSSSEECCTTIIOONN::LLEEAASSEEDDOORROOWWNNEEDD??Item 2 of the 10-K requires a description of the companys major properties and facilities, noting if they are leased or owned. This footnote will aid investors in understanding a companys mix of owned versus leased real estate and its physical location. It may also assist in identifying hidden asset values in land or other properties. There is no required standardized format and, therefore, disclosures do vary by company as some are several pages in length while others are one or two paragraphs.


MMAANNAAGGEEMMEENNTTSSDDIISSCCUUSSSSIIOONNAANNDDAANNAALLYYSSIISS SEC Regulation S-K requires a managements discussion and analysis (MD&A) section. The MD&A section, among other items, is a narrative on a companys financial condition, results of operations, liquidity, and capital resources. Since reading the MD&A for the results of operations is as much an art as it is a science, we discuss other important MD&A disclosures related to off-balance sheet entities, liquidity, and contractual obligations in the sections that follow. OOFFFF--BBAALLAANNCCEE SSHHEEEETT EEXXPPOOSSUURREESS Off-balance sheet entities and disclosures are particularly important to review for many reasons. They may require cash funding, consolidation, and/or some type of subordinated support and this might impact debt covenants, balance sheet liquidity, and capital ratios (and in turn credit ratings). Although uncommon, off-balance sheet entities may also be used to hide losses and manage earnings. Companies must disclose detail and terms of significant off-balance sheet arrangements in a separate section of MD&A. This section of the MD&A includes a discussion on joint ventures (JVs), debt guarantees, certain contract guarantees, retained interests, derivatives classified as equity, and variable interests (VIEs) in unconsolidated entities (e.g., CDOs, SIVs, and commercial paper conduits). Off-balance sheet arrangements may also be disclosed in the debt footnote. The accounting rules impart considerable subjectivity in assessing whether an entity should be consolidated and, therefore, allow flexibility in structuring entities for the desired off-balance sheet treatment. By finessing these complicated accounting rules, a company technically may not be required to consolidate an entity even though it retains a significant amount of risk. In 2010, companies adopted the Financial Accounting Standards Boards (FASB) new Financial Accounting Standards (FAS) 166 and FAS 167 rules. These stringent rules required consolidation of more off-balance sheet entities. The most important disclosures, in our view, evaluate the loss probabilities of off-balance sheet entities and guarantees, the underlying credit quality of the off-balance sheet arrangement, and the probability of liquidity support for either contractual or reputational reasons. Investors should also review any year-over-year language changes in the disclosures. Below are a few key questions and items that we believe investors should consider when analyzing off-balance sheet entities:

1. Contingent events: What circumstances must occur for the contingent obligations to become a liability of the parent company? Would any cash funding be required?

2. Potential losses: What is the off-balance sheet entitys maximum exposure to loss? What events would need to occur to trigger the maximum losses? Companies may disclose expected losses from off-balance sheet entities, but we dont give much weight to these amounts since they are full of management assumptions, generally only reflect current market conditions, and are not sensitivities to specific events. Also, note that the disclosure of maximum losses may not reflect losses currently deemed to be remote.

3. Liquidity: Reviewing the disclosure for liquidity triggers is important. We suggest reviewing the disclosures to see if there is a liquidity support agreement to the off-balance entity and if there are specific asset value triggers to fund it (asset values declining below a certain amount may require liquidity support). We also seek to identify if there are any additional cash funding requirements and, if available, review the credit quality of the underlying assets in the VIE.


4. Consolidation: Its important to review the off-balance sheet disclosures and/or use them as a basis in asking management for under what circumstances would the company be required to consolidate the off-balance sheet entity. Under the relatively new FASB consolidation rules, companies must evaluate off-balance sheet entities (e.g., variable interest entities) every quarter to assess whether they should be consolidated. When thinking about consolidation, we assess the following: o How would consolidation impact the financial ratios and position of the company?

o Would consolidation violate debt covenants?

o How would consolidation impact capital? (Under GAAP, if a reconsideration event occurs, a

company may be required to consolidate an off-balance sheet entity.)

5. Voluntary Rescue: Even if a company is not legally obligated to provide financial or other support to an off-balance sheet entity, there may be circumstance under which the company would voluntarily choose to provide it. This would occur if the entitys failure would hurt the parent companys reputation or limit its access to an important input to its business. As an example, a parent company may choose to guarantee JV debt that wasnt legally guaranteed previously to keep the entity afloat if it was a key source of raw material inputs.

The disclosures should be also viewed with some caution since they dont take into account any offsetting financial instruments used to hedge these risks. These may be noted in a table footnote, but weve found disclosures to be spotty in this area.


As an off-balance sheet disclosure example, weve reproduced a portion of Wells Fargos 2010 10-K, discussing the banks maximum loss exposure in unconsolidated VIEs. Wells Fargos MD&A Off-Balance Sheet Entities Disclosures

Note 8: Securitizations and Variable Interest Entities transfer assets to a VIE and account for the transfer as a sale, we are considered the transferor. We consider investments in securities held outside of trading, loans, guarantees, liquidity agreements, written options and servicing of collateral to be other forms of involvement that may be significant. We have excluded certain transactions with unconsolidated VIEs from the December 31, 2010, balances presented in the table below where we have determined that our continuing involvement is not significant due to the temporary nature and size of our variable interests, because we were not the transferor or because we were not involved in the design or operations of the unconsolidated VIEs. Other Total Debt and commitments VIE equity Servicing and Net (in millions) assets interests (1) assets Derivatives guarantees assets

December 31, 2010 Carrying value asset (liability)

Residential mortgage loan securitizations: Conforming $1,068,737 5,527 12,115 (928) 16,714 Other/nonconforming 76,304 2,997 495 6 (107) 3,391 Commercial mortgage securitizations 190,377 5,506 608 261 6,375 Collateralized debt obligations: Debt securities 20,046 1,436 844 2,280 Loans (2) 9,970 9,689 9,689 Asset-based finance structures 12,055 6,556 (118) 6,438 Tax credit structures 20,981 3,614 (1,129) 2,485 Collateralized loan obligations 13,196 2,804 56 2,860 Investment funds 10,522 1,416 1,416 Other (3) 20,031 3,221 43 377 (6) 3,635

Total $1,442,219 42,766 13,261 1,426 (2,170) 55,283

Maximum exposure to loss

Residential mortgage loan securitizations: Conforming $ 5,527 12,115 4,248 21,890 Other/nonconforming 2,997 495 6 233 3,731 Commercial mortgage securitizations 5,506 608 488 6,602 Collateralized debt obligations: Debt securities 1,436 2,850 7 4,293 Loans (2) 9,689 9,689 Asset-based finance structures 6,556 118 2,175 8,849 Tax credit structures 3,614 1 3,615 Collateralized loan obligations 2,804 56 519 3,379 Investment funds 1,416 87 1,503 Other (3) 3,221 43 916 162 4,342

Total $ 42,766 13,261 4,434 7,432 67,893

(1) Excludes certain debt securities held related to loans serviced for FNMA, FHLMC and GNMA. (2) Represents senior loans to trusts that are collateralized by asset-backed securities. The trusts invest primarily in senior tranches from a diversified pool of

primarily U.S. asset securitizations, of which all are current, and over 91% were rated as investment grade by the primary rating agencies at December 31, 2010. These senior loans were acquired in the Wachovia business combination and are accounted for at amortized cost as initially determined under purchase accounting and are subject to the Companys allowance and credit charge-off policies.

(3) Includes student loan securitizations, auto loan securitizations and credit-linked note structures. Also contains investments in auction rate securities (ARS) issued by VIEs that we do not sponsor and, accordingly, are unable to obtain the total assets of the entity.

Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings.


UUSSIINNGG OOFFFF--BBAALLAANNCCEE SSHHEEEETT VVEEHHIICCLLEESS TTOO HHIIDDEE DDEEBBTT,, IINNVVEENNTTOORRYY,, AANNDD//OORR EEXXPPEENNSSEESS To boost earnings or improve reported financial ratios, a company may choose to move inventory and debt into a joint venture or other off-balance sheet entity. A careful reading and analysis of joint venture disclosures will help identify whether a significant increase in inventory might have been shifted off-balance sheet. For example, a joint venture may produce and sell inventory to the parent company. The parent company may control the purchases of inventory from this entity. Therefore, financial analysis of the parent companys inventory balance may be obfuscated by inventory increasing on the balance sheet of the joint venture partner. A company may also finance a joint venture with debt or with a parent company guarantee for all or a portion of the joint venture debt. This debt amount or debt guarantee would not appear on the parent companys balance sheet, but may be a real obligation and very similar in substance to debt. An analyst would find these type of debt arrangements or guarantees typically in the MD&A section listed as an off-balance arrangement. Furthermore, JV arrangements typically mask underlying leverage levels at the parent company due to the equity method of accounting. In a JV arrangement, both companies usually account for an investment under the equity method of accounting instead of consolidating the JV entity. Under the equity method of accounting, the balance sheet contains a single line item, typically called investments or equity method investments, classified under other long-term assets. On the liability side of the balance sheet, the JVs debt is not reported under the equity method of accounting. On the income statement, the companys proportion of the JVs income is recorded as equity income/loss and usually reported in other income. For financial analysis and ratios, we suggest analysts consolidate the companys attributable portion (e.g., 50%) of the joint ventures off-balance sheet debt amount as well as their percentage of any JV debt guarantees. The creation of new JVs or off-balance sheet entities is another way to improve reported margins. If the business contributed to the new entity has lower overall margins, the remaining parent company will report higher margins since the business will be deconsolidated and be reported under the equity method of accounting. On the income statement, only one line equity income/loss is reported and typically shown separate from gross and operating income.

CCOONNTTRRAACCTTUUAALL OOBBLLIIGGAATTIIOONNSS AANNDD FFIIXXEEDD CCAASSHH FFLLOOWW CCOOMMMMIITTMMEENNTTSS Within the MD&A section, SEC rules require a table of contractual obligations. This table summarizes information usually contained in other sections of the 10-K and lists fixed debt and debt like commitments, such as long-term debt repayments, capital and operating lease payments, purchase obligations, and other long-term contractual liabilities. It should (but does not always) include material cash funding requirements for pension and OPEB plans, probable FIN 48 tax cash contingency payments, and cash interest expense. We find the disclosure to be a great summary of a companys future contractual cash outflows and a tool in evaluating a companys future liquidity needs. Analysts should be mindful that not all contractual-type fixed payment arrangements are included in the table of contractual obligations. If a contractual arrangement may be cancelled without any material penalties, it may be excluded. Furthermore, the table does not include such items as salaries to employees or dividend payments. The next exhibit is an example of a contractual obligations table.


Delta Air Lines (2011 Form 10-K): Contractual Obligations Table



CCRRIITTIICCAALLAACCCCOOUUNNTTIINNGGPPOOLLIICCIIEESS For financial reporting purposes, a critical accounting policy is one that requires significant and/or subjective management judgment. The summary of significant accounting policies section is a similar disclosure that overlaps with the critical accounting estimates section, typically located in the first or second 10-K footnote. The summary of significant accounting policies includes both critical accounting policies and other material accounting policies. Both of these sections are important to uncover any year-over-year changes in accounting policies that impact earnings or signal possible other business issues. A reading of this section may help identify companies under/over earning relative to other companies. For example, the section may describe a very conservative accounting policy that is reducing current period earnings. One of the first signs of a more aggressive accounting policy change may be a new one or two sentence disclosure in this section. Additionally, a companys accounting policies should be reviewed and compared against competitors policies since differences may impact reported earnings and comparability. Below is an example of the critical accounting policies for USG. USGs Critical Accounting Policies Excerpt (2011 Form 10-K)

PROPERTY,PLANTANDEQUIPMENTWeassessourproperty,plantandequipment forpossible impairmentwhenevereventsorchanges incircumstances indicate that thecarrying valuesof theassetsmaynotbe recoverableora revisionof remaininguseful lives isnecessary. Such indicatorsmay includeeconomicandcompetitiveconditions,changesinourbusinessplansormanagementsintentionsregardingfutureutilizationoftheassetsorchangesinourcommodityprices.Anassetimpairmentwouldbeindicatedifthesumoftheexpectedfuturenetpretaxcashflowsfromtheuseofanasset(undiscountedandwithoutinterestcharges)islessthanthecarryingamountoftheasset.Animpairmentlosswouldbemeasuredbasedonthedifferencebetweenthefairvalueoftheassetanditscarryingvalue.Thedeterminationoffairvalueisbasedonanexpectedpresentvaluetechnique,inwhichmultiplecashflowscenariosthatreflectarangeofpossibleoutcomesandariskfreerateofinterestareusedtoestimatefairvalue,oronamarketappraisal.INTANGIBLEASSETSWehave indefiniteanddefinite lived intangibleassetswithnetvaluesof$30millionand$40million,respectively,asofDecember31,2011. Intangibleassetsdetermined tohave indefiniteuseful lives,primarilycomprisedof tradenames,arenotamortized.Weperformimpairment tests for intangibleassetswith indefiniteuseful livesannually,ormore frequently ifeventsorcircumstances indicate theymightbe impaired.The impairmenttestsconsistofacomparisonofthefairvalueofan intangibleassetwith itscarryingamount. Ifthecarryingamountofan intangibleassetexceeds its fairvalue,an impairment loss is recognized inanamountequal to thatexcess.Anincomeapproach isused forvaluing tradenames.Assumptionsused in the incomeapproach includeprojected revenuesandassumedroyalty,longtermgrowthanddiscountrates.EMPLOYEERETIREMENTPLANSWemaintaindefinedbenefitpensionplans formostofouremployees.Mostoftheseplansrequireemployeecontributions inordertoaccruebenefits.Wealsomaintainplansthatprovidepostretirementbenefits(retireehealthcareand life insurance)foreligibleexistingretireesand foreligibleactiveemployeeswhomayqualify forcoverage in the future.Foraccountingpurposes, theseplansdependonassumptions made by management, which are used by actuaries we engage to calculate the projected and accumulated benefitobligations and the annual expense recognized for theseplans. The assumptionsused indeveloping the required estimatesprimarilyincludediscountrates,expectedreturnonplanassetsforthefundedplans,compensationincreaserates,retirementrates,mortalityratesand,forpostretirementbenefits,healthcarecosttrendrates.INCOMETAXESWe record income taxes (benefit) under the asset and liability method. Under this method, deferred tax assets and liabilities arerecognizedbasedonthefuturetaxconsequencestotemporarydifferencesbetweenthefinancialstatementcarryingamountsofexistingassetsandliabilitiesandtheirrespectivetaxbasesandattributabletooperatinglossandtaxcreditcarryforwards.Deferredtaxassetsandliabilitiesaremeasuredusingenacted tax ratesexpected toapply in theyears inwhich the temporarydifferencesareexpected toberecoveredorpaid.Theeffectondeferredtaxassetsandliabilitiesofachangeintaxratesisrecognizedinearningsintheperiodwhenthechangeisenacted.



BalanceSheet


QQUUAALLIITTYYOOFFCCAASSHHAANNDDIINNVVEESSTTMMEENNTTSS The composition and location of cash and investments are often overlooked by analysts. To be classified as cash under GAAP, the instrument must have a maturity date of 90 days or less. Investments are classified as short-term or long-term depending on their maturity date. Historically, auction rate securities (ARS) also met the GAAP definition of cash and equivalents since their interest rate was reset every 7, 21, or 28 days and there was an auction into which to sell the securities. CCAASSHH BBAALLAANNCCEESS AARREE OOFFTTEENN OOVVEERRSSTTAATTEEDD IINN VVAALLUUAATTIIOONN A significant portion of some multinational companies cash balances may be domiciled overseas and not accessible for distribution to shareholders or other payments. Therefore, its important to ascertain where the cash is located and if any additional taxes would be owed to access the cash. One common mistake we observe in valuations is valuing cash at 100% of its balance sheet value. To calculate distributable cash, the gross cash amount reported on companies balance sheets needs to be adjusted downward for any U.S. taxes expected to be owed upon cash repatriation. Unfortunately, not all companies disclose the percentage of cash residing overseas, but we have seen more companies begin to disclose this item after a higher level of SEC scrutiny. Current U.S. corporate tax law incentivizes companies to keep cash overseas as companies only pay foreign taxes on the foreign earnings in the current period insofar as the earnings are not repatriated to the U.S. This is often termed foreign deferral. To access overseas cash, a company would typically be required to pay incremental U.S. taxes on cash amounts repatriated, reaching as high as the 35% current U.S. corporate tax rate. To illustrate the repatriation and cash issue, assume Chris Corp. operates a foreign subsidiary in Ireland and earns $500 of foreign income that is taxed at 20%. In the current year, Chris Corp. would owe Ireland taxes of $100. This generates a $100 U.S. foreign tax credit and the remaining reported cash balance after foreign taxes would be $400. The earnings remain in Ireland and are neither distributed to the U.S. parent company nor included as income in Chris Corp.s consolidated U.S. income tax return. Additionally, under U.S. GAAP, it is very common for companies to deem their foreign earnings as permanently reinvested overseas, removing additional U.S. GAAP income taxes from earnings. Therefore, the company would report a 20% GAAP effective income tax rate ($100 income tax expense / $500 income). Assume that the company decides to repatriate and distribute the foreign cash domiciled in Ireland to the U.S. entity. To calculate U.S. taxable income on Chris Corp.s U.S. tax return, the companys foreign earnings are grossed-up to their pre-tax foreign amount ($500). Then U.S. corporate taxes are calculated at the current 35% corporate tax rate ($500 x 35% = $175). The foreign tax credit of $100 is applied to the U.S. corporate tax of $175, leaving $75 of incremental taxes due. As a result of these taxes, the companys cash balance available for U.S. activities is reduced from $400 to $325 ($400 less $75 in U.S. taxes).


AACCCCOOUUNNTTIINNGGFFOORRIINNVVEENNTTOORRYY The inventory 10-K footnote should be reviewed for: (i) changes in inventory accounting policies, (ii) inventory reserve changes, (iii) last-in, first-out (LIFO) liquidations, and (iv) inventory charges from reduced production levels. Two important disclosures in this footnote are details of the inventory balances (i.e., raw materials, work in progress and finished goods) and reserves. LLAARRGGEE IINNVVEENNTTOORRYY RREESSEERRVVEE CCHHAANNGGEESS MMAAYY IINNFFLLAATTEE PPRROOSSPPEECCTTIIVVEE GGRROOSSSS MMAARRGGIINNSS An analyst should review inventory for write downs to the lower of cost or market because in a quarter of poor results or at year-end, a company might excessively write-down its inventory as a one-time charge owing to a decrease in the inventorys selling prices. The inventory write-down is recorded in an inventory reserve account until the inventory is sold or scrapped (inventory reserves are required to be disclosed if material). If the sales price of inventory previously written-down recovers in value, and the product sells at the higher price, a company would record an inflated gross margin since it wrote-down the inventory in a prior quarter. The increase in gross margin is unsustainable since there is only a limited amount of inventory on the balance sheet at the lower value. The production of new inventory at its normal or higher cost will result in the company recording a lower, but normal gross margin in the income statement in the subsequent period. Inventory write-downs and subsequent recoveries in value are common after recessions and this is why we feel this issue has been more common in 2010 and 2011. Below is an illustration of an inventory write down and subsequent sale for CF Industries. Inventory Write-Downs Followed by Subsequent Sale

AtDecember31,2008,werecordeda$57.0millionnoncashchargetowritedownourphosphateandpotashinventoriesby$30.3millionand$26.7million,respectively,asthecarryingcostoftheinventoriesexceededtheestimatednetrealizablevalues.Netrealizablevaluesfor our phosphate and potash inventories are determined considering the fertilizer pricing environment at the time, aswell as ourexpectationsof futureprice realizations.The inventory thatwasheldatDecember31,2008 included inventory thatwasproducedorpurchased earlierwhen input costs and fertilizer priceswere higher.During the first quarter of 2009,we sold all of the higher costphosphateinventorythatexistedatDecember31,2008.AtSeptember30,2009,wereassessedthenetrealizablevaluesoftheinventoryheld.Basedonthisanalysis,noadditional inventoryvaluationreserveswerenecessaryforthephosphatefertilizer inventory.However,duringthefirstandsecondquartersof2009,additionalinventoryvaluationreservesof$24.3millionand$5.0million,respectively,wererecognizedrelatedtothepotashinventory.Duringthethirdquarter,wesoldallremainingpotashinventory.

Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings. AANNYY LLAARRGGEE CCHHAANNGGEESS IINN TTHHEE MMIIXX OOFF IINNVVEENNTTOORRYY RREELLAATTIIVVEE TTOO TTOOTTAALL IINNVVEENNTTOORRIIEESS?? A calculation of the percentage of each inventory category (raw materials, work in progress and finished goods) to total inventory will highlight any differences in the mix of inventory. While there are normal reasons for mix shifts, any large changes may suggest changes in the business. For example, if the finished goods balance materially increased relative to total inventory, it may presage slowing end demand for the companys product. At the same time, the total inventory balance may not have materially changed if the company decreased raw material purchases to offset slowing demand (finished goods increased and raw materials decreased). HHAAVVEE TTHHEERREE BBEEEENN MMAATTEERRIIAALL RREEDDUUCCTTIIOONNSS IINN TTHHEE LLIIFFOO IINNVVEENNTTOORRYY RREESSEERRVVEE?? Inventory is accounted for using one of several methods including first-in, first-out, average cost, last-in, first-out or specific identification. By far, the FIFO accounting costing method is the most common. However, to appease companies concerns over paying higher taxes on inflationary profits, LIFO accounting was created in a 1970s tax code change that allowed it to be used as an accounting cost flow assumption. Under the tax codes LIFO conformity rule, companies are required to use LIFO accounting for GAAP purposes if they use it for tax purposes. LIFO is not allowed under International


Accounting Standards and is one of the major differences between U.S GAAP and IFRS. In a period of rising prices, LIFO accounting generally results higher costs and, therefore, lower earnings. However, the reported earnings under LIFO are closest to economic reality and reflective of the current business conditions than a company using FIFO accounting, where their cost of sales could reflect the cost of inventory purchased many years ago. Analysts may adjust a company from LIFO accounting to FIFO to compare like kind margins. To adjust a company to FIFO, the LIFO companys cost of sales is decreased/(increased) by the increase/(decrease) in year-over-year (or quarter-over-quarter) LIFO inventory reserve balance. For balance sheet purposes, the FIFO inventory balance is an approximation of replacement cost and should be used for balance sheet ratios/analysis. The LIFO inventory balance is often outdated and may reflect prices paid for inventory many years ago.

The LIFO reserve and material amounts of LIFO liquidations are required 10-K disclosures. The LIFO reserve is the difference between the FIFO inventory balance and the LIFO inventory balance. It represents the cumulative difference between FIFO and LIFO inventory. Put another way, if the reserve is multiplied by the U.S. 35% corporate tax rate, it is the amount of cash taxes cumulatively saved by the company. The LIFO disclosures should be reviewed for items that may unsustainably increase gross margin: (i) LIFO liquidations/LIFO income and (ii) large changes in the LIFO reserve. The reason for a decrease in LIFO reserves should be closely examined. LIFO reserves will decline due to (1) a price decline or (2) inventory quantity reduction. A decline in the LIFO reserve reduces cost of sales and increases gross margins. As we discuss below, if a LIFO reserve decline is due to the quantity of goods sold, it is unsustainable and, therefore, lowers the quality of gross margins and earnings. Companies often refer to increases in the LIFO inventory reserve as a charge since recently purchased inventory items are placed into the inventory balance at a higher cost than inventory purchased in a prior period. We dont view these as necessarily one-time charges since they are the normal cost of doing business the company experienced higher costs in the current period and this reduced margins. A company with volatile raw material and/or other input costs using LIFO inventory will experience more volatile and immediate gross margins changes than a company using FIFO.

Below we present an example of a LIFO liquidation using Deere as an example. Deeres LIFO Liquidation (2011 Form 10-K)

MostinventoriesownedbyDeere&CompanyanditsU.S.equipmentsubsidiariesarevaluedatcost,onthelastin,firstout(LIFO)basis.Remaining inventoriesare generally valuedat the lowerof cost,on the firstin, firstout (FIFO)basis,ormarket. The valueof grossinventorieson theLIFObasis represented59percentofworldwidegross inventoriesatFIFOvalueatOctober31,2011and2010.ThepretaxfavorableincomeeffectfromtheliquidationofLIFOinventoryduring2009wasapproximately$37million.

Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings. If a reduction in inventory quantity is the cause of the LIFO reserve decline, similar to any reserve reduction, there is a positive impact on earnings (in this case gross margins) LIFO income or a gain. This gain is unsustainable since inventory quantities cannot be realistically reduced to zero. To normalize margins, we suggest removing the LIFO income effect by increasing reported cost of goods sold by the LIFO income amount. Conversely, if the decrease in the LIFO reserve is due to price changes, we dont advise in making any adjustments to normalize gross margins since input price changes are a normal part of the business.


However, we do believe margins should be adjusted if current input prices are viewed as unsustainable or short-term aberrations. IINNVVEENNTTOORRYY AACCCCOOUUNNTTIINNGG PPOOLLIICCYY CCHHAANNGGEESS ((EE..GG.. LLIIFFOO TTOO FFIIFFOO))?? A change in an inventory costing method accounting policy is rare and, therefore, we view them with a high level of skepticism. To boost earnings, a company may choose to change from LIFO to FIFO inventory and weve observed this as most common (but still uncommon) accounting policy change. Weve seen it among companies encountering rising raw material costs since earnings are higher under FIFO. A change in an inventory accounting policy is not generally allowed without good reason and requires a preferability letter from the companys auditor. Therefore, it piques our interest when we find them. As an example, in the next exhibit, Kodak changed their inventory method policy from LIFO to average cost at the beginning of 2006. Change of Inventory Method Eastman Kodak

On January 1, 2006, the Company elected to change its method of costing its U.S. inventories to the average cost method, which approximates FIFO, whereas in all prior years most of the Companys inventory in the U.S. was costed using the LIFO method. As a result of this change, the cost of all of the Companys inventories is determined by either the FIFO or average cost method. The new method of accounting for inventory in the U.S. is deemed preferable as the average cost method provides better matching of revenue and expenses given the rapid technological change in the Companys products. The average cost method also better reflects more current costs of inventory on the Companys Statement of Financial Position. As prescribed in SFAS No. 154, Accounting Changes and Error Corrections, retrospective application of the change in accounting method is disclosed below.

The effects of the change in methodology of costing U.S. inventories from LIFO to average cost on inventory and cost of goods sold for prior periods presented are as follows (in millions):

As of and for the Year

Ended December 31, 2005

As of and for the Year Ended

December 31, 2004

LIFO Method

Average Cost Method

LIFO Method

Average Cost Method

Inventory $ 1,140 $ 1,455 $

1,158 $ 1,506

Cost of goods sold $ 10,617 $ 10,650 $

9,582 $ 9,601

Source: Wolfe Trahan Accounting & Tax Policy Research; Company filing. AARREE IINNVVEENNTTOORRYY RREESSEERRVVEESS BBOOOOSSTTIINNGG MMAARRGGIINNSS?? Large reductions in inventory reserves may boost gross margins. Inventory reserves are recorded on obsolete, excessive, or returned inventory. As an example, selling previously written down inventory at a higher expected margin (than at the time of write-down) boosts margins. It is unsustainable as the cost of producing new inventory is higher than the previously written down amount. Another way margins may temporarily benefit is by deferring an inventory write-down into a future period.


IISS LLOOWWEERR PPRROODDUUCCTTIIOONN DDEEPPRREESSSSIINNGG MMAARRGGIINNSS FFRROOMM EEXXCCEESSSS OOVVEERRHHEEAADD?? FAS 151, Inventory Costs, clarified that abnormal amounts of idle facility expense, handling cost, freight, and spoilage must be expensed rather than capitalized as part of inventory on the balance sheet. One large fixed cost included in inventory is fixed overhead costs, namely facility depreciation expense. Allocation of fixed production overhead is calculated using the normal capacity of the plant or facility, where normal capacity is defined as the typical production expected over a number of periods or seasons. Prior to this guidance, companies accounted for these costs in different ways when there were low capacity levels. In a period of low or idled production, margins may receive a boost when production levels normalize as these currently expensed costs will be absorbed into inventory. IISS HHIIGGHHEERR PPRROODDUUCCTTIIOONN BBOOOOSSTTIINNGG MMAARRGGIINNSS?? Companies can overproduce inventory to increase gross margins by spreading the fixed overhead expenses across more units, thereby lowering the inventorys average cost per unit. Therefore, a company may boost margins simply by overproducing inventory for which there may not be enough end-market demand. Weve observed this particularly in high fixed cost businesses. Both rising gross margins and inventory balances (days of inventory or DOI, calculated as [inventory / annualized cost of sales x 365]) are suggestive of lower earnings quality. We'd prefer to see rising margins and a stable (or lower) DOI number. AARREE OOTTHHEERR CCOOSSTTSS CCAAPPIITTAALLIIZZEEDD IINNTTOO IINNVVEENNTTOORRYY?? A careful reading of the inventory footnote may identify other costs currently capitalized into inventory balances. Two examples of costs that are typically capitalized into inventory are pension and stock option expense. A portion of both expenses would be capitalized into inventory if its a labor cost of producing inventory. Separately, inventory is an area where companies in the same industry group may capitalize different costs into the inventory balance. IINNVVEENNTTOORRYY:: EEAARRNNIINNGGSS QQUUAALLIITTYY Below we summarize a number of inventory maneuvers used to improve a companys reported gross margins:

Change in inventory accounting methods; Gains from reversing inventory reserves; Delaying inventory write-downs by under-reserving for obsolete or old items; LIFO liquidations; Overproducing to lower average cost; and Large inventory write-downs in the current period followed by a recovery in the selling price in a

subsequent period. HHOOWW TTOO SSPPOOTT IINNVVEENNTTOORRYY IISSSSUUEESS We've found that the trend in, and peer company comparison of, DOI is the most predictive variable at identifying inventory related issues. A rise in DOI may presage slowing end demand and be an early warning signal. Changes in inventory reserves should also be reviewed for draw-downs or the lack of sufficient reserves.


PPRROOPPEERRTTYY,,PPLLAANNTT,,AANNDDEEQQUUIIPPMMEENNTT::CCHHEECCKKAASSSSEETTLLIIVVEESSAANNDDFFOORRCCHHAANNGGEESSIINNPPOOLLIICCIIEESS Companies may boost future earnings by changing PP&E depreciable lives, residual values, and/or depreciation methods. Over the years, weve found that these types of changes often signal trouble around the corner. Companies must disclose the depreciation period and method for each material asset group. GAAP requires that PP&Es cost to be allocated as depreciation expense in earnings over the assets estimated useful life in a systematic and rational manner. There are several allowable methods of depreciation including straight-line (most common) and other various forms of accelerated depreciation, such as sum of the years digits and double declining balance. Below are the formulas used to calculate depreciation expense under each method.

Straight line = (Original cost residual value) / depreciable life Double declining balance = Depreciation in Year X = 2 / depreciable life x (asset book value at the beginning of Year X) Sum of the years digits = Depreciation in Year X = (original cost salvage value) x (n X + 1) / sum of years digits

Another rarely used depreciation method is units of production (UOP). We highlight it in this section since Whirlpool switched to it in 2009. Under this method, an asset is depreciated based on the assumed total production units over the assets entire estimated life. Using this method will increase depreciation expense during periods of high production levels and reduce depreciation expense during low levels of production. In effect, it turns a fixed depreciation cost into a variable cost, reducing the volatility of gross margins and earnings. However, this method is likely to understate economic depreciation expense for a company in a mature industry or with a declining business as lower current year production defers depreciation expense into a future period. If product obsolescence or other items ultimately reduces the assets estimated production units, it will necessitate a PP&E write-down and indicate that prior periods earnings were overstated (too low depreciation expense). We suggest reviewing the 10-Ks accounting policy section for any changes or unusual depreciation policies. Over the years, weve observed that a change in an assets depreciable life has sometimes been a precursor to deterioration in the companys business fundamentals. GAAP also requires disclosure of any material changes in depreciable lives, residual values, or depreciation methods. Oddly, PP&Es residual value amounts are not required disclosures. Next, we highlight the disclosures of some companies with recent depreciation method changes. Examples of Depreciation Methodology Change: International Rectifier

Effective December 27, 2010, the Company changed its depreciation method for certain fabrication equipment from the unitsofproductionmethod to the straightlinemethod. The Company considers this change of depreciationmethod a change in accountingestimateaffectedbyachange inaccountingprinciple.Thischange inestimate isaccountedforprospectivelyasofthebeginningofthethirdquarteroffiscalyear2011.WhiletheCompanybelievestheunitsofproductionmethod,asafunctionofusage,reasonablyreflectsthematching of costs and revenues, it requires considerable effort tomonitor and track the usage of certain fabrication equipmentconsistentlyacrossallfabricationfacilities.TheCompanybelievesthestraightlinemethodofdepreciationrepresentsabetterestimateoftheuseof theequipmentover itsproductive lifeandbetter reflects thepatternofeconomicconsumption.Additionally, theCompanybelievestherevisedpracticeisconsistentwiththepredominantindustrypractice.



DDEEPPRREECCIIAATTIIOONN CCHHAANNGGEESS:: TTWWOO WWAAYYSS TTOO UUSSEE PPPP&&EE TTOO BBOOOOSSTT EEAARRNNIINNGGSS Changing assumptions used to calculate depreciation expense is one method used to increase earnings and has been the underlying reason for numerous historical accounting restatements. Two ways to lower annual depreciation expense are to extend an assets depreciation period or increase its residual value. Either of these changes should be viewed with a lot of skepticism. To calculate depreciation expense, there are three primary inputs: depreciation method (straight line, accelerated depreciation, etc.), assets residual value, and depreciable life. To lower annual depreciation expense and boost earnings, a company might change its assumptions by increasing residual values, extending depreciable lives or changing the depreciation method. Any such changes are red flags in our view. To identify these changes, we suggest reading through the financial filings as material changes in these items are required disclosures. The average depreciable life ratio is also helpful in spotting changes in assumptions (gross PP&E divided by LTM depreciation expense). Within a sector or industry group, comparing depreciation expense to sales assists in identifying companies with more lenient depreciation expense policies. Under GAAP, residual value or depreciable life changes are accounted for prospectively. Increasing an assets depreciable life does not change the total depreciation expense amount recognized. Instead, it defers a portion of current depreciation expense into future periods as a smaller annual amount of the asset is expensed over a longer time period. Similarly, an increase in an assets residual value will reduce the depreciable amount of the asset and, therefore, lower depreciation expense. The following exhibit is an illustration of a company increasing the salvage value of its equipment from $1,000 to $3,000 after owning it for two years. By changing the salvage value, annual depreciation expense declines from $1,800 to $1,133. Example: Decreasing Depreciation Expense by Altering Salvage Values

Originalcost 10,000 Originalcost 10,000Salvagevalue 1,000 Amountalreadydepreciated 3,600Asset'sdepreciableamount 9,000 Newsalvagevalue 3,000Depreciationperiod(years) 5 Asset'sdepreciableamount 3,400Annualdepreciation(a) 1,800 Remainingdepr.period(years) 3

Newannualdepreciation(b) 1,133

ChangeinDepr.Expense Year1 Year2 Year3 Year4 Year5Originaldepr.Schedule(a) 1,800 1,800 1,800 1,800 1,800Newlyadjusteddepr.Expense(b) n/a n/a 1,133 1,133 1,133Lowerdepr.expense n/a n/a (667) (667) (667)

NewlyAcquiredAssetwithanEstimated$1,000SalvageValue(StraightLineDepr.)

TwoYearsLater:NewSalvageValueEstimateof$3,000(StraightLineDepr.)

Source: Wolfe Trahan Accounting & Tax Policy Research.


Example of Depreciation Changes in Estimated Lives Archer Daniels Midland

During the second quarter of fiscal year 2011, the Company updated its estimates for service lives of certain of itsmachinery andequipmentassets inordertobettermatchtheCompanysdepreciationexpensewiththeperiodstheseassetsareexpectedtogeneraterevenue based on planned and historical service periods. The new estimated service liveswere established based onmanufacturingengineeringdata,externalbenchmarkdataandonnew informationobtainedasa resultof theCompanys recentmajor constructionprojects.Thesenewestimatedservice livesarealsosupportedbybiofuels legislationandmandates inmanycountries thataredrivingrequirementsovertimeforgreaterfutureusageandhigherblendratesofbiofuels.TheCompanyaccounted for this service lifeupdateasa change inaccountingestimateasofOctober1,2010 inaccordancewith theguidanceofASCTopic250,AccountingChangesandErrorCorrections,thereby impactingthequarter inwhichthechangeoccurredandfuturequarters.Theeffectofthischangeonaftertaxearningsanddilutedearningspersharewasanincreaseof$83millionand$0.13,respectively,fortheyearendedJune30,2011.

Source: Wolfe Trahan Accounting & Tax Policy Research; Company filings. Here are a few financial ratios that detect changing depreciation policies and residual values. Detecting Changes in Depreciation Methods and/or PP&E Residual Values

Gross PP&EAccumulated Depreciation

Accumulated DepreciationGross PP&E

. Gross PP&EDepreciation Expense

Net PP&EDepreciation Expense

Source: Wolfe Trahan Accounting & Tax Policy Research.


IIMMPPLLIICCAATTIIOONNSSOOFFAACCCCEELLEERRAATTEEDDDDEEPPRREECCIIAATTIIOONN A reading of a companys PP&E footnote and accounting policy section may identify a company with a variant depreciation policy. One example of this is a company using accelerated depreciation for GAAP. If a company depreciates PP&E on an accelerated basis, uses low residual values, or uses short depreciable lives, the companys true earnings power may be understated (accounting depreciation might exceed the assets true economic decline in value). In our review of 10-K disclosures over the years, we find this uncommon. However, other countries often use accelerated depreciation for GAAP (for tax reasons). The next exhibit is Northrop Grummans 2011 10-K disclosure of its accelerated depreciation policy for fixed assets. Northrop Grumman (2011 Form 10-K): Accelerated Deprecation



BBOONNUUSSDDEEPPRREECCIIAATTIIOONNIn recent years, in an effort to stimulate capital investment and growth, Congress has enacted bonus depreciation. Under bonus depreciation, companies may elect an additional first year tax depreciation deduction (usually 50%), thereby reducing the companys cash taxes. Bonus depreciation was originally enacted in 2008 and passed again through a series of extensions. In 2010, the 50% bonus depreciation was extended by the Small Business Jobs Act. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 allowed 100% bonus depreciation for equipment placed in service after September 8, 2010 through December 31, 2011 and 50% bonus depreciation for equipment placed in service after December 31, 2011 through December 31, 2012. It was unprecedented when Congress allowed 100% immediate expensing of most U.S. capital expenditures in 2011. Below we summarize bonus depreciation permitted in each year. Recent Periods of Bonus / Accelerated Deprecation

Bonus Depreciation Allowed Under U.S. Tax Law for Corporations

2000 2001 2002 2003 2004 2005 20060% 0% 30% 50% 50% 0% 0%

2007 2008 2009 2010 2011 2012 20130% 50% 50% 50% 100% 50% 0%

Source: Wolfe Trahan Accounting & Tax Policy Research; IRS. Based on the guidance in the most recent bonus depreciation legislation, in order to qualify for the initial bonus depreciation, companies must purchase and place the capital assets in use. A number of points to keep in mind when thinking about bonus depreciation:

1. The asset must be subject to Modified Accelerated Cost Recovery System (MACRS) tax depreciation with a maximum recovery period of 20 years. It also includes 25-year asset life water utility properties, software, and qualified leasehold improvement property. This qualifies most assets except real property/buildings.

2. Bonus depreciation typically only applies to capital expenditures by corporations in the U.S. and tax consolidated foreign corporations, excluding most non-U.S. capital expenditures. Bonus depreciation is also generally available for a foreign corporations U.S. capital expenditures, if it files a U.S. corporate tax return.

3. Some smaller capital expenditures may already be immediately expensed for tax purposes under the de minimis rule and, therefore, not subject to bonus depreciation as described next:

A. IRS De Minimis Rule: The tax code does not require the capitalization of all incidental costs as

long as the following requirements are met:

i. The company immediately expenses the costs in its GAAP financial statements. ii. The company has written accounting procedures in place at the beginning of the year

mandating the expensing of property with a purchase price below a certain amount. iii. The total aggregate amounts paid for property and not capitalized are not distortive to the

taxpayers income for the year (IRS safe harbor: amounts expensed are the lesser of 0.1%


of a companys gross receipts or 2% of a companys total depreciation and amortization expense).

B. Materials and supplies: if materials and supplies cost $100 or less, they may be expensed

immediately (subject to the IRS safe harbor rule mentioned herein).

4. Used equipment doesnt qualify. Per the legislation: original use of the property must commence with the taxpayer. Original use is the first use of the asset whether or not used by the taxpayer (e.g., purchasing new equipment with the intent of leasing would qualify as long as the company is the legal owner).

5. The asset must be purchased and placed into service during the relevant taxable year. Certain time extensions are available for assets with long production periods. For the 100% bonus depreciation, a one-year extension to January 1, 2013 (asset must be put into use by) is available for: A. Property with a production period in excess of one year, B. An asset life of at least 10 years (also includes transportation property which has a different

asset life); and, C. Purchase cost of at least $1 million.

The extension period also includes qualifying aircraft purchases. Aircraft purchases not considered transportation property (commercial airlines dont qualify for the extended place in service rules) qualify for the extension period if they have an estimated production period exceeding 4 months, a cost greater than $200,000 and, at the time of contract for purchase, the purchaser made a nonrefundable deposit of the lesser of 10% of cost or $100,000. For 50% bonus depreciation (allowed for companies in 2012) there is a one-year extension to January 1, 2014 for assets with long production periods.

BBOONNUUSS DDEEPPRREECCIIAATTIIOONN:: FFIINNAANNCCIIAALL SSTTAATTEEMMEENNTTSS IIMMPPAACCTT Depreciation deductions are just timing differences as the same total amount of the asset is depreciated over its life under GAAP and tax. Bonus depreciation pulls forward the depreciation tax shield to earlier periods than normally allowed under the tax code and as compared to GAAP depreciation (typically straight line). The real benefit to companies electing accelerated depreciation is the time value of money from cash tax savings in the current year. If an extension of 100% depreciation is not passed by Congress in 2012, companies will encountered higher cash taxes beginning in 2012 and continuing into 2013/2014 as the benefits of more immediate capital expenditure tax deductions reverse and companies use regular tax MACRS depreciation schedules. This will be a cash flow headwind for companies with material U.S. capital expenditures. Since bonus depreciation has occurred with increasing frequency over the past few years, historical cash tax rates (and cash flow) are distorted by this benefit and analysts should use caution when using historical cash tax rates to project future cash taxes. All else being equal, bonus depreciations impact on the financial statements are lower cash tax payments in the current period (e.g., 2011) and, therefore, higher operating and free cash flow. Accelerated bonus depreciation does not generally have an impact on a companys GAAP tax rate or EPS. The balance sheet impact of bonus depreciation is an increase in a deferred tax liability representing the tax effected difference between the current year tax depreciation (higher) and the current year GAAP depreciation (lower and typically straight line). A review of the companys table of deferred tax assets/liabilities in the tax footnote should reveal an increasing deferred tax liability for


property, plant and equipment depreciation at 2011 year-end. Technically speaking, a larger deferred tax liability has built-up on companies balance sheets in 2008 through 2011 that will begin to unwind (decrease) in 2012 (assuming Congress does not extend 100% bonus depreciation in 2012).


HHIIDDDDEENNAASSSSEETTVVAALLUUEE?? Companies may hold significant investments in other assets. Depending on ownership levels and whether the assets are publicly traded, these investments often are not reported on the balance sheet at fair market value. Therefore, investors may find hidden balance sheet value by reviewing the 10-K for these types of inter-corporate investments. Yahoo, Inc. is an example of a company with material equity investments accounted for using the equity method. The companys balance sheet does not reflect these investments at fair value. Below is Yahoos disclosure of its significant investments accounted for under the equity method. Yahoo (2010 Form 10-K): Investments in Equity Interests

AsofDecember31,investmentsinequityinterestsconsistedofthefollowing(dollarsinthousands):

EquityInvestmentinAlibabaGroup.OnOctober23,2005,theCompanyacquiredapproximately46percentoftheoutstandingcommonstockofAlibabaGroup,which representedapproximately40percentona fullydilutedbasis, inexchange for$1.0billion in cash, thecontributionoftheCompanysChinabasedbusinesses, including3721NetworkSoftwareCompanyLimited(Yahoo!China),anddirecttransactioncostsof$8million.Another investor inAlibabaGroup isSOFTBANK.AlibabaGroup isaprivatelyheldcompany.Through itsinvestment inAlibabaGroup, theCompanyhas combined its search capabilitieswithAlibabaGroups leadingonlinemarketplace andonlinepaymentsystemandAlibabaGroupsstronglocalpresence,expertise,andvisionintheChinamarket.ThesefactorscontributedtoapurchasepriceinexcessoftheCompanysshareofthefairvalueofAlibabaGroupsnettangibleandintangibleassetsacquiredresultingingoodwill.TheinvestmentinAlibabaGroupisbeingaccountedforusingtheequitymethod,andthetotalinvestment,includingnettangibleassets,identifiableintangibleassetsandgoodwill,isclassifiedaspartofinvestmentsinequityinterestsontheCompanysconsolidatedbalancesheets.TheCompanyrecordsitsshareoftheresultsofAlibabaGroupandanyrelatedamortizationexpense,onequarterinarrears,withinearningsinequityinterestsintheconsolidatedstatementsofincome.The Companys initial purchase pricewas based on acquiring a 40 percent equity interest in AlibabaGroup on a fully diluted basis;however,theCompanyacquireda46percentinterestbasedonoutstandingshares.InallocatingtheinitialexcessofthecarryingvalueoftheinvestmentinAlibabaGroupoveritsproportionateshareofthenetassetsofAlibabaGroup,theCompanyallocatedaportionoftheexcess to goodwill to account for the estimated reductions in the carrying value of the investment inAlibaba thatmay occur as theCompanysequity interest isdiluted to40percent.AsofDecember31,2009and2010, theCompanysownership interest inAlibabaGroupwasapproximately44percentand43percent,respectively.In the initial public offering (IPO) ofAlibaba.com onNovember 6, 2007,AlibabaGroup sold an approximate 27 percent interest inAlibaba.com through the issuanceofnewAlibaba.com shares, the saleofpreviouslyheld shares inAlibaba.com,and theexchangeofcertainAlibabaGroup sharespreviouslyheldbyAlibabaGroupemployees for shares inAlibaba.com, resulting inagainondisposalofinterestsinAlibaba.com.Accordingly,inthefirstquarterof2008,theCompanyrecordedanoncashgainof$401million,netoftax,withinearningsinequityinterestsrepresentingtheCompanysshareofAlibabaGroupsgain,andtheCompanysownershipinterestinAlibabaGroupincreasedapproximately1percentfrom43percentto44percent.



Accounting for an investment in another company is based on the parent companys level of influence or control. GAAP measures this influence and control using voting equity stock ownership. Below we summarize the different ways of accounting for inter-corporate investments. Accounting for Corporate Investments

AccountingMethod Ownership% Threshold AccountingStandardCostorMarket 50% Control FASNo.141(R)/FINNo.46(R)(1)

(1) FIN No. 46(R) superseded by FAS No. 167 effective Jan. 1, 2010 for calendar year-end companies. Source: Wolfe Trahan Accounting & Tax Policy Research. The above ownership percentages are guidelines and where influence and/or control isnt equivalent to the equity voting ownership percentages, a company may use a different method in accounting for the investment (still very uncommon). To be sure, significant management judgment is requ

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