ii - SMBHC Thesis Repositorythesis.honors.olemiss.edu/902/1/Thesis--Cole McCall.pdfChapter 11:...
Transcript of ii - SMBHC Thesis Repositorythesis.honors.olemiss.edu/902/1/Thesis--Cole McCall.pdfChapter 11:...
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Abstract
Thispaperisacompilationofseveralanalysesofvariousaccounting
methodsandpractices.Eachchaptertakesadifferentareaofaccountingandusesa
well-knowncompanytoexplainthetheorybehindaspecificmethodorareaof
accounting.Throughreferencetothesecompanies,thepaperattemptstosimplify
somecomplexaccountingprocesses.Therealbusinessexampleshelpillustrate
theseconceptsinareaderfriendlyformat.Thegoalofthispaperistoconveybasic
accountingprinciplestothosewithoutpriorknowledgeinaccounting,allowing
themtograspthemainconceptsandunderstandthetheorybehindthestandardsof
thisprofession.
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TableofContents
TableofFigures vChapter1:FinancialAnalysis—GlenwoodHeatingvs.EadsHeaterInc. 1Chapter2:FinancialAnalysis—MolsonCoorsBrewingCompany 12Chapter3:StatementofCashFlows—GoldenEnterprises 19Chapter4:Accounts—ReceivablePearson 29Chapter5:GAAPReporting--GraphicApparelCorporation 37Chapter6:DepreciationMethods—AirplaneIndustry&WasteManagement 42Chapter7:RecordingLiabilities—GAAPvs.IFRS 50Chapter8:LongTermLiabilities—RiteAid 57Chapter9:Shareholders’Equity—Merck&Co.,Inc.andGlaxoSmithKlineplc. 68Chapter10:MarketableSecurities—StateStreetCorporation 76Chapter11:RevenueRecognition—Groupon 85Chapter12:CurrentandDeferredIncomeTaxes—ZAGGInc. 95Chapter13:PensionLiabilities—Johnson&Johnson 105
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TableofFigures
1-1 GlenwoodRatioAnalysis 21-2 EadsRatioAnalysis 21-3 GlenwoodIncomeStatement 31-4 EadsIncomeStatement 41-5 GlenwoodStatementofChangesinStockholders'Equity 61-6 EadsStatementofChangesinStockholders'Equity 61-7 GlenwoodStatementofCashFlows 71-8 EadsStatementofCashFlows 81-9 GlenwoodBalanceSheet 101-10 EadsBalanceSheet 112-1 SalesvsMarketing,GeneralandAdministrationExpenses 132-2 NetOperatingIncomevs.PersistentIncome2013 142-3 NetOperatingAssets 162-4 RNOACalculations2013 173-1 GoldenEnterprisesStatementofCashFlows--Condensed 203-2 GoldenEnterprisesStatementofCashFlows 224-1 PearsonPLCAccountsReceivableAgingSchedule 324-2 PearsonPLCAccountsReceivableRatios 366-1 DifferencesinDepreciationandtheEffectsonDisposal 458-1 EffectiveInterestRate 628-2 StraightLineAmortization 638-3 InterestExpenseComparison 648-4 RiteAidDebtRatios 669-1 KeyFinancialFigures2007 749-2 DividendAnalysis2007 7511-1 AmazonRevenuesvsStockPrices 8911-2 GrouponCommonSizeIncomeStatement 9011-3 GrouponProfitabilityandActivityRatioComparison 9112-1 DeferredTaxAdjustments 10413-1 PBOInterestTable 111
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1.FinancialAnalysis—GlenwoodHeatingInc.
vs.EadsHeaterInc.
ExecutiveSummaryGlenwood and Eads had nearly identical years as far as overall operations are
concerned.However, theirdifferingmethodsof reporting itemssuchas Inventory
andDepreciationexpensecausedamajorvarianceinNetIncomes:Eads’hadanet
income of $70,515 while Glenwood’s was $92,742. While this may seem like
Glenwoodhadabetteryear,deeperanalysisshowsthatEadsactuallyhadgreater
cash flows (by over $7,000) and will be more financially stable in the future.
Because of Eads’ accounting methods and investment decisions, explained in
analysisbelow,itwillbeamoreprofitablecompanyinthelongrun.InvestinEads.
RatioAnalysisAt first glance of Figures 1-1 and1-2, Glenwood seems to be in a better financial
positionthanEads.Becauseofthedifferentreportingofinventoryandthusoverall
varianceincurrentassets,Glenwoodappearstobeinabetterliquiditypositionthan
Eads.Glenwood’s current ratio ofQuickRatio of 23.93% looksbetter to potential
CreditorswhencomparedtoEads’QuickRatioof20.60%.
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Figure1-1
GlenwoodRatioAnalysis
Liquidity Profitability
CurrentRatio 39.13% GrossProfitMargin 55.58%AcidTest(QuickRatio) 23.93% ProfitMargin 0.23AccountsReceivableTurnover 4.01 ReturnonAssets 14.43%DaystoCollectReceivables 91.04 ReturnonOwner'sEquity 40.40%InventoryTurnover 2.82 EarningsPerShare $28.98DaystoSellInventory 129.50 DebtRatio 0.64OperatingCycle 220.55 TimesInterestEarned 5.47
As the reporting of credit sales was identical for both companies, related
ratios were identical for the two, at 4.01 for Accounts Receivable Turnover and
91.04forDaystoCollectReceivables.Foracompanysellingmoreexpensiveitems
suchasheatingunitsinthiscase,thesenumbersarereasonable.
Figure1-2
EadsRatioAnalysis
Liquidity Profitability
CurrentRatio 463.18% GrossProfitMargin 52.62%AcidTest(QuickRatio) 309.05% ProfitMargin 17.70%AccountsReceivableTurnover 4.01 ReturnonAssets 10.02%
DaystoCollectReceivables 91.04ReturnonOwner'sEquity 34.01%
InventoryTurnover 3.70 EarningsPerShare $22.04DaystoSellInventory 98.60 DebtRatio 0.05OperatingCycle 189.64 TimesInterestEarned 3.69 As far as profitability is concerned, Glenwood reports better Gross Profit
Margin (55.58%) and better Profit Margin (23%) than Eads’ Gross Profit Margin
(52.62%) and ProfitMargin (18%). However, because sales and production costs
were identical, thevariation in theprofitabilityagain isbased solelyonhoweach
companydifferentlyreportedinventorycosts.ItalsoappearsthatGlenwoodismore
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efficiently using its assets and invested capital to bring shareholder wealth. Its
ReturnonEquity,akeyratioforinvestors,isover6%higherthantheROEofEads.
Ataglanceoftheseratios,Glenwoodseemstobethesureinvestment,noquestions
asked.However, the financial statements reveal thatEads is abetter company for
investorsinthelongrun.
IncomeStatements
Eachcompanyachievedthesamelevelofsaleswithidenticalamountsofinventory
soldandoperatingexpensesincurred.Thevariationinnetincomebetweenthetwo,
showninFigures1-3and1-4,isaresultofdifferinginventoryvaluationmethods.
Figure1-3
GlenwoodIncomeStatement
ForYearEndedDecember20X1
SalesRevenue $398,500CostofGoodsSold -177,000GrossProfit 221,500OperatingExpenses RentExpense -16,000DepreciationExpense -19,000
BadDebtExpense -994OtherOperatingExpenses -34,200
IncomefromOperations 151,306InterestExpense -27,650
IncomeBeforeTaxes 123,656IncomeTax(25%) -30,914NetIncome $92,742 Pershareofcommonstock(3200sharesoutstanding) EarningsPerShare $28.98
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Glenwood, using FIFO, reported lower costs of goods sold, as it expensed
inventorybasedontheorderinwhichitwaspurchased.Thisboostsprofitmargin,
but also leaves a higher remaining inventory thatmust be carried over into next
period.Therefore,withsaleskeptconstantintheupcomingyear,Glenwoodwould
reporthighercostofgoodssoldforthatyear.
Figure1-4
EadsIncomeStatement
ForYearEndedDecember20X1
SalesRevenue $398,500CostofGoodsSold -188,800GrossProfit 209,700OperatingExpenses RentExpense -DepreciationExpense -41,500
BadDebtExpense -4,970OtherOperatingExpenses -34,200
IncomefromOperations 129,030InterestExpense -35,010
IncomeBeforeTaxes 94,020IncomeTax(25%) -23,505NetIncome $70,515 Pershareofcommonstock(3200sharesoutstanding) EarningsPerShare $22.04
Eadstooktheoppositeapproach.UsingLIFO, thecompanyreportedhigher
costofgoodssoldwhichreducedgrossprofitmarginbutalsoreducedthevalueof
unsoldassetsonthebalancesheetattheendoftheaccountingperiod.Becauseof
this,Eadswillbeabletoreportahighergrossprofitmarginforthenextyear,with
allelseheldconstant.
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Glenwood’s approach is beneficial in the short term in order to boost
earnings and keep investors and potentially attract new ones. However, Eads’
approachtoreporting incomewillbebetter for thecompany inthe longrun,as it
couldpotentiallyreportgreaterincreasesinprofitmarginsfortheupcomingyear.
Another important itemon these Income Statements to pay attention to is
thedepreciationexpense.Thisexpenseworksverysimilarlytotheexpenseofcost
ofgoodssold,asexpensingmorenowwillmeanlowerexpenseslaterwithallelse
heldconstant.
Glenwood, using Straight Line Depreciation on its assets, reports such
expense at a steady and predictable rate each year, while Eads, using Double
DecliningBalanceDepreciation,reportsdepreciationexpenseatanacceleratedrate
during the early years of the asset. The company thendecreases thedepreciation
expenseeachyear,creatinggreaterOperatingIncomewithallelseheldconstant.
StatementofChangesinStockholder’sEquity This statement shows financial statement users a company’s activity in
Equity, whether there be an increase in the number of share’s outstanding, or
dividendspaidfortheyear.
Becausecommonstockanddividendspaidisidenticalforthetwocompanies
in 20X1, the only variation in this statement for each company is the amount of
retainedearningsaddedtoequity.Thisvariationisshownonthefollowingpagein
Figures1-5and1-6.
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Figure1-5
Glenwood
StatementofChangesinStockholder'sEquity
ForYearEndedDecember20X1
CommonStock RetainedEarnings TotalBalanceJanuary1,20X1 $- $- $-IssuanceofOrdinaryShares 160,000
160,000
TotalComprehensiveIncome
92,742 92,742Dividends
-23,200 -23,200
BalanceDecember31,20X1 $160,000 $69,542 $229,542
For Glenwood, retained earnings increases significantly due to reasons
mentionedaboveintheIncomeStatementAnalysis—lowcostofgoodssoldandlow
depreciationexpenseboostednetincome,whichincreasedearnings.
Figure1-6
Eads
StatementofChangesinStockholder'sEquity
ForYearEndedDecember20X1
CommonStock RetainedEarnings TotalBalanceJanuary1,20X1 $- $- $-IssuanceofOrdinaryShares 160,000 160,000TotalComprehensiveIncome 70,515 70,515Dividends -23,200 -23,200BalanceDecember31,20X1 $160,000 $47,315 $207,315
For Eads, retained earnings increased but not nearly at the rate of that of
Glenwood, for the same reasonsmentioned above. Eads reported a higher cost of
goods sold and higher depreciation expense for the year, which decreased net
incomeand,therefore,loweredretainedearnings.
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StatementofCashFlowsInthepreviousstatements,Glenwoodusesdifferentexpensingmethodstoincrease
its net income in the short run. This makes Glenwood appear to be superior
financially.However, thestatementsof cash flows,Figures1-7and1-8, show that
Eadsmaybethemoreprofitablecompany.
Figure1-7
Glenwood
StatementofCashFlows
ForYearEndedDecember20X1
NetIncome $92,742 AdjustmentstoReconcileCash IncreaseinAccountsReceivable -99,400IncreaseinInventory -62,800IncreaseinAllowanceforDoubtfulAccounts 994IncreaseinAccountsPayable 26,440IncreaseinInterestPayable 6,650DepreciationExpense 19,000
NetCashFlowprovidedbyOperatingActivities -16,374 CashFlowsfromInvestingActivities PurchaseofLand -70,000PurchaseofEquipment -80,000PurchaseofBuilding -350,000IncreaseinNotesPayable -
NetCashUsedbyInvestingActivities -500,000 CashFlowsfromFinancingActivities IssuanceofCommonStock 160,000PaymentofDividends -23,200
NetCashProvidedbyFinancingActivities 136,800 NetIncreaseinCash -$379,574 CashJanuary1,2014 $-CashDecember31,2014 $379,574
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BecauseGlenwoodisreportinghighernetincome,itisforcedtopayahigher
incometax.Whencomparingthe incomestatements fromthetwocompanies, this
maybeoverlookedifaninvestorisfocusingonthebottomline.However,whenthe
companiesreconciletheirexpensestoshowactualflowofcash,Eadsreportshigher
cashflows,asitslowerreportedincomeresultedinlowerataxexpense.
Figure1-8
Eads
StatementofCashFlows
ForYearEndedDecember20X1
NetIncome $70,515AdjustmentstoReconcileCash IncreaseinAccountsReceivable -99,400IncreaseinInventory -51,000IncreaseinAllowanceforDoubtfulAccounts 4,970IncreaseinAccountsPayable 26,440IncreaseinInterestPayable 6,650DepreciationExpense 41,500
NetCashFlowprovidedbyOperatingActivities -$325CashFlowsfromInvestingActivities PurchaseofLand -$70,000PurchaseofEquipment -80,000
PurchaseofBuilding -350,000SubtractLeasedEquipment -92,000IncreaseinEquipmentPayable 83,360IncreaseinNotesPayable 380,000
NetCashUsedbyInvestingActivities -$128,640CashFlowsfromFinancingActivities IssuanceofCommonStock $160,000PaymentofDividends -23,200
NetCashProvidedbyFinancingActivities $136,800NetIncreaseinCash $7,835CashJanuary1,2014 $-CashDecember31,2014 $7,835
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Furthermore, higher depreciation expenses and higher allowance for
doubtful accounts allow Eads to add back those noncash expenses, further
increasing its cash flows. However, Eads didmake a different assetmanagement
decisionthanGlenwoodbyoptingforaCapitalLeaseofEquipmentratherthanjust
renting it.Morewill be discussed about this in the next section, but as far as the
Statement of Cash Flows is concerned, this decision causes an $8,640 increase in
newcashusedbyinvestingactivitiesforEadscomparedtoGlenwood.
This extra cash flow could potentially benefit shareholders in a number of
ways. It could allow for repayment of long term debt, increased payment of
dividends, investment intreasurystock,aswellaspayoff interestona loan.With
thisinmind,Eadsholdsagreatadvantagewithitssuperiorcashflow.
BalanceSheetLike the Statement of Cash Flows, the Balance Sheet provides insight that might
push investors more towards Eads. As explained above, inventory and retained
earningsaregoingtodiffer,aswellasaccumulateddepreciationandallowancefor
baddebt.However, these are itemswhosedifferenceswill decrease over time, as
variancescausedbydifferingreportingmethodstendtoaverageoutoveralonger
period.
A couple itemson theBalance Sheets, shown inFigures1-9 and1-10hold
much more significance for the two companies’ future. The first, cash on hand,
allows the company to pay off creditors or investors and puts the company in a
betterpositionifunexpectedexpensesarise.
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Figure1-9
Glenwood
ClassifiedBalanceSheet
ForYearEndedDecember20X1
Assets Liabilities
CurrentAssets: CurrentLiabilities CashandCashEquivalents -$426 AccountsPayable $26,440AccountsRecievable -99,400 InterestPayable 6,650Inventory -62,800 AllowanceforBadDebts 994 LongTermLiabilities TotalCurrentAssets -$161,632 NotePayable 380,000
TotalLiabilities: $413,090FixedAssets: Land -$70,000 Building -350,000 Accum.Depr.Building 10,000 EquityEquipment -80,000 CommonStock $160,000Accum.Depr.equipment 9,000 RetainedEarnings 69,542LeasedEquipment - TotalEquity: $229,542Accum.Depr.LeasedEquip. -
TotalNon-currentAssets: -$481,000 TotalAssets: -$642,632 TotalLiabilitiesandEquity: $642,632
Inadditiontoextracash,EadsalsoincreaseditsassetsbytakingonaCapital
LeaseofEquipment (shown inFigure1-10)asopposed to rentingequipment like
Glenwood.Thisincreasedthecompany’snetworthaswellasprovidedstabilityand
predictabilityforoperatingexpensesinthefuture.Thisisbecausethepaymentfor
theEquipmentis$16,000annuallyfor8years.
Glenwood,ontheotherhand,doesnothavethiscertainty,asit iscurrently
rentingequipmentfor$16,000.But,sadlythispriceisnotdefinite.Thesupplierof
thisequipmentcannotguaranteethispricepastthesecondyearofrental.Thiscould
potentiallybeadetriment to future incomes if thepriceof renting theequipment
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increasessignificantlyinyearstocome.Therefore,asshowninFigure1-10,Eadsis
inamorestablepositionregardingitsassetsandfutureexpenses.
Figure1-10
Eads
ClassifiedBalanceSheet
ForYearEndedDecember20X1
Assets Liabilities
CurrentAssets: CurrentLiabilities CashandCash
Equivalents -$7,835 AccountsPayable $26,440AccountsRecievable -99,400 InterestPayable 6,650Inventory -51,000 TotalCurrentLiabiites: $33,090AllowanceforBadDebts 4,970 TotalCurrentAssets -$153,265 LongTermLiabilities
LeasePayable $83,360FixedAssets: NotePayable 380,000Land -$70,000 TotalLongTermLiabilities: $463,360Building -350,000 Accum.Depr.Building 10,000 TotalLiabilities: $496,450Equipment -80,000 Accum.Depr.equipment 20,000 EquityLeasedEquipment -92,000 CommonStock $160,000Accum.Depr.LeasedEquip. 11,500 RetainedEarnings 47,315
TotalNon-currentAssets: -$550,500 TotalEquity: $207,315 TotalAssets: -$703,765 TotalLiabilitiesandEquity: $703,765
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2.FinancialAnalysis—MolsonCoorsBrewing
Company
ExecutiveSummaryMolsonCoors ismuchmore thanabeerbrewing company. It experiences several
significant transactions that have little or nothing to do with the selling of beer.
Theseitemsprovideasolidincomeviaextraordinaryandnonrelateditems,leaving
thecompany’sconsistentincomeandoperationalincomewithmajordiscrepancies.
Nonetheless,MolsonCoors’RNOAin2013variesfrom4%to34%dependingonthe
calculationmethods.Withallfactorsconsidered,asdiscussedintheanalysisbelow,
a fair calculation of the company’s true RNOA is 11.52%, which is extremely
agreeable.Withreturnslikethis,MolsonCoorshasshownthattheyhavetoability
toeffectivelymanagetheirassetstobeveryprofitable.Furthermore,diggingalittle
deeperintothecompany’s long-termfinancialposition,thePrice-Earnings-Growth
rate was calculated to be 1.14 (see Appendix). As anything below 1 is generally
consideredagreatbuy,thiscompanyholdsanimpressiveratio.WithasolidRNOA
andagoodPEGratio,thiscompanycanbeconsideredasafeandqualityinvestment.
IncomeStatementAnalysisMolsonCoorshasexperiencedsignificantgrowthinsalesandgrossprofitoverthe
pastthreeyears.Thisisapromisingsign.Itcouldpotentiallymeanthatthebrandis
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gainingpopularity,andthecompanyisgrowingalargercustomerbase.Thisgrowth
could potentially be due to the increased spending on marketing and general
administration.Increasedspendinginthisareaisnotaconcernatthispoint,asitis
expectedwith higher revenues. However, due to the slight decrease in Operating
IncomeProfitMargin,itmaybesomethingtokeepaneyeonforthefuture.Belowis
a table that compares sales, gross profit, and primary operating expenses for the
pastthreeyears.
Figure2-1
SalesvsMarketing,GeneralandAdministrationExpenses
InThousands 2013 2012 2011
Sales $6,000 $5,615 $5,170NetSales 4,206 3,917 3,516COGS 2,546 2,353 2,049GrossProfit 1,661 1,564 1,467Mktg,Gen.andAdmin.Expenses 1,194 1,126 1,019OperatingIncomebeforeTaxes $467 $438 $448OperatingIncomeProfitMargin 7.8% 7.8% 8.7%
Delving deeper into the Income Statement, treatment of Special Items and
OtherIncomeisagrayarea.Bothofthesearesubtotalsthatcontainnon-operating
activities. However, Molson Coors includes Special Items in its Operating Income
figure.ThereasoningbehindthismaybethatSpecialItemscontainsitemssuchas
GainsonDisposalof Investments,whileOther Incomeincludes itemssuchasGain
fromOtherForeignExchangeandDerivativeActivity.Thekeydifferencebetween
these two is thatOther Income includes transactions thathavenothingtodowith
thebrewingandsellingofbeer,whileSpecialItemsareinfrequentorunusualitems
thathave some relation to the functionofMolsonCoors as abeer company.With
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thisestablished—thatSpecialItemsandOtherIncomearenotincludedinOperating
Income—OperatingandPersistentIncomecanbecalculated.
TheequationforNetOperatingProfitisshownbelow.
NetOperatingProfit=Netincome–aftertaxnonoperatingitems(Specialitems,
Equity income inMillerCoors, Interest income, Interest expense,Other income,&
DiscontinuedOperations).
Persistent Income, however, can be calculated: Income from continuing
operationsbeforetaxes–Other income+Special itemsexpense=Persistent
income from continuing operations before tax – income tax = Persistent
Income.Belowisatabletoshowthecomparisonbetweenthetwo.
Figure2-2
NetOperatingIncomevs.PersistentIncome2013
InThousands NetOperating
Income
Persistent
Income
NetIncome$567 Incomefromcont.op.
pretax $655SpecialItems* 176 Otherincome -19EquityincomeMiller
Coors* -474 SpecialItems 200InterestIncome* -12 PersistentIncomefrom
cont.op.pretax
InterestExpense* 162 836OtherIncome* -17 IncomeTax(12.8%) -107DiscontinuedOperations* -2 NoncontrollingInterest* -5 NetOperatingIncome $395 PersistentIncome $728
*Allitemsnetof12%tax.
Aftercomputingtheseincomes,itisimportanttodecidewhichoneisabetter
determinant of future cash flows. Considering the make up of the two income
calculations,Persistentincomewasdeterminedtobeabetterrepresentationofthe
company’s financialpositionbecause it includes itemsthatconsistentlymakeupa
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bigportionofthecompany’sincome,suchasEquityincomefromMillerCoors.This
isagoodsign,asitshowsthatthecompanyhasconsistentcashflowsthataremore
than sufficient. However, The since the majority of this income results from
investment in MillerCoors, Net Operating Profit is a better determinant of the
company’sincomefromsellingbeer.Whilethisisamorefocusedincomeandbetter
forupcomingratios,Persistent Income is stillworthnotingwhendecidingoverall
wellbeing of the financial state of this company. In the next section, the Balance
sheetandNetOperatingAssetsarediscussed.
BalanceSheetAnalysisWhenanalyzingthebalancesheet,themostimportantelementstoconsiderforthis
analysis is the value of net operating assets. This is calculatedwith the following
formula:
NetOperatingAssets=OperatingAssets–CurrentOperatingLiabilities
Operating Assets for this analysis are made up of Current Assets (minus
Deferred Tax Assets), Properties, and Intangibles. These accounts are labeled as
operatingbecause theyare items that arenecessary for and involved in everyday
business. Operating Liabilities in this case are made up solely of one account:
Accounts Payable andOther Current Liabilities. The reasoning behind this is that
thisistheonlyaccountthatchangeswithdailyoperationswhiletheotherliability
accounts aremade up of a fixed amount of debt or discontinued operations. The
tableonthefollowingpageshowsthecalculationsofNetOperatingAssetsfor2012
and2013.
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Included at the bottom of this table is the calculation of Net Operating
Assets excluding Intangible Assets. The reason for this calculation is that
Intangible Assets include things such as licenses and patents that are necessary
tools for running a business; however, operating assets are often computed as
physical equipment or accounts that change with day-to-day operations. Also,
intangiblesforthiscompanyaresignificantlylargeandthussignificantlydilutethe
RNOA. Thus, both of these ways of computing Net Operating Assets have been
provided in order to provide some analysis sensitivity. These will be used to
calculateRNOAinthenextsection.
Figure2-3
NetOperatingAssets
InThousands 2013 2012
CurrentAssets $1,538 $1,748DeferredTax -50 -39Properties 1,970 1,996Intangibles 6,825 7,235AccountsPayableandOtherCurrent
Liabilities
1,336 1,187
NetOperatingAssets
$8,946
$9,753
NetOperatingAssets-Intangibles $2,121 $2,518RatioAnalysisAfter calculating Net Operating Assets and Net Operating Profit, we can now
calculateReturnonNetOperatingAssets,orRNOA.Thisratiowilltellinvestorshow
efficiently Molson Coors is using its assets to produce income. As discussed
previously,wewillalsousepersistentincomeasanalternatewaytocalculatethis
ratio. Furthermore, we will show the effect that including Intangibles in Net
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OperatingAssetshasontheRNOAratio.Figure2-4showstheresultsof thisratio
manipulation.
Figure2-4
RNOACalculations2013
NetOperating
Income/Net
OperatingAssets
PersistentIncome/
NetOperatingAssets
WithIntangibles 4.4% 8.1%WithoutIntangibles 18.6% 34.3%
Asthistabledepicts,dependingonwhichaccountsarechosenasOperating
AssetsandOperatingIncome,RNOAcanvarytremendously.Thelowvalue,4.41%,
providesaveryconservativeratio,asitisextremelynarrowinitscomputationsof
incomeandbroadwithitscomputationsofoperatingassets.Themiddletwovalues,
8.14% and 18.62%, result from a mixture of narrow income and wide range of
assetsaswellasabroadincomeandbroadsumofoperatingassets.Thehighvalue,
34.34%,representsanoptimistic,yetunrealistic,figure,asitusesthemostamount
ofincometotheleastamountofoperatingassetspossible.
For trueRNOA, the columnusingNetOperating Profit in the numerator is
believed to be more accurate. However, as the nature of the Intangibles are not
disclosed,itishardtosaytowhatextenttheyshouldbeincludedinNetOperating
Assets.Therefore,itisestimatedthatthecompany’strueRNOAfallsbetween4.41%
and18.62%.Usingtheaverageofthesetwo,11.52%,thisRNOAisveryrespectable,
and could be considered the characteristic of a profitable company. Nonetheless,
before making an investment decision on this ratio alone, other ratios must be
analyzedtodeterminetheinvestmentqualityofthiscompany.Next,wewillbriefly
discussMolsonCoors’Price-Earnings-GrowthRatio.
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Price-Earnings-Growthratioisusedtodetermineastock’svaluewhiletaking
the company’s growth rate into account. Essentially, this gives investors a
measurementofwhetherornotthisstockisworthbuying.MolsonCoors’P-E-Gis
1.14. (The appendix includes calculations for this ratio). In the investingworld, a
stockthatisconsideredtobeagreatbuyhasaPEGratio<1.However,1.14isstilla
solidratio,andwiththecompany’sgivenRNOA,MolsonCoorswouldbeacompany
whosestockhassomegreatpotential.
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3.StatementofCashFlows—GoldenEnterprises
StatementofCashFlowsIntroductionThe Statement of Cash Flows is a financial statement that provides users with
information on all the inflows of cash from continuing operations and external
investments, while also showing the outflows from investing and financing
activities. This information allows users to see the difference between the net
incomea company reports and theactual amountof cash it gainsor loses for the
year.Suchinformationisimportantindecidingifacompanyisactuallyasprofitable
andliquidasitsincomestatementandbalancesheetreveal.Figure3-1onthenext
pagegivesacondensedversionofGoldenEnterprises’StatementofCashFlowsfor
2012and2013.
Inthisexample,NetIncomeisshownsolelyforthepurposeofcomparingit
to actual cash flows. In a full Statement of Cash Flows, Net Income is used in
calculatingNet Cash Provided byOperating Activities. Thiswewill discuss in the
nextsection.
There are three major areas of the Statement of Cash Flows. These are
Operating Section, Investing Section, and Financing Section. It is common for the
OperatingSectiontohaveapositivecashflowwhiletheothershavenegativecash
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flows.Ideally,therewillbeanetincreaseincash,butforthiscompany,theexample
wewillusetoexplainthestatementofcashflows,thereisanetdecreaseincash.
Figure3-1
GoldenEnterprises
StatementofCashFlows--Condensed
ForYearEndedDecember 2013 2012
NetIncome $1,134,037 $2,207,623AdjustmentstoReconcileNetIncometoCash: NetCashProvidedbyOperatingActivities $4,607,029 $5,747,290 NetCashUsedbyInvestingActivities -$4,075,164 -$4,991,653 NetCashUsedbyFinancingActivities -$1,668,570 -$1,583,459 NetDecreaseinCash -$1,136,705 -$827,822
CashJanuary1 $1,893,816 $2,721,638CashDecember31 $757,111 $1,893,816
Another important featureof theStatementofCashFlows is thepostingof
beginning and ending balances of cash for the year. These can be found on the
balancesheet,wherethebeginningbalanceisthefinalcashbalancefortheprevious
year and the ending balance is the final cash for the current year. Next, we will
discusstheOperatingSectionandmethodsofcalculatingit.
TwoMethods—DirectandIndirectBeforewecandiscuss thecalculationofCashFlows fromOperatingActivities,we
mustfirstestablishthemethodologyfordoingso.Therearetwomethodsthatare
accepted for such computations. The first is Direct, which ismore preferred, but
muchhardertocalculate.ThesecondisIndirect,whichismucheasiertocalculate,
andthusmorewidelyused.Wewillnowdiscusseachindetail.
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Underthedirectmethod,youwouldsimplylistinflowsandoutflowsofcash
fromoperatingactivities i.e. cash received fromcustomers, cashused topurchase
supplies, etc. However, as easy as this sounds, thanks to the accrual basis of
accounting,whichthemajorityofcompaniesarerequiredtofollow,mostcompanies
donotsetuptheirbooksinsuchawaythatthisinformationisreadilyavailable.To
listsuch informationwouldrequirediggingthrough invoicesandbankstatements
andcheckstubs—averytedioustask.Therefore,asidefromthosewhoareprimarily
acashbusiness,i.e.ahotdogvendor,companieschoosetousetheindirectmethod.
The indirect method involves indirectly computing cash flows by starting
with a base figure, net income, andmakingnecessary adjustments from there.As
this is themethod thatourexamplecompany,GoldenEnterprises, chooses touse,
thiswillbethemethoddiscussedinthenextsection:OperatingActivities.
OperatingActivitiesThe Operating Section of the Statement of Cash Flows provides a detailed
explanationoftheamountofcashusedorprovidedfromeveryday,normalbusiness
activities. On the next page is the Operating Section from Golden Enterprises’
StatementofCashFlowsin2013.
Tocalculatethecashflowfromthissection,westartwithnetincome,asthis
isessentiallythenetamountofoperatingincome(withafewexceptions.)However,
this figure does not account for changes in current asset and current liabilities
accountsthatwouldhaveaneffectontotalcashfromoperations. Thus,thisisthe
reasonforthestatementofcashflows.
22
WithNet Income,wemust add back noncash expenses and losses such as
Depreciation, and subtract noncash revenues and gains, such as Gain on Sale of
Equipment. These items are found directly on the income statement. Figure 3-2
showstheOperatingsectionofStatementofCashFlows,asmentionedabove.
Figure3-2GoldenEnterprises
StatementofCashFlowsForYearEndedDecember2013
CashFlowfromOperatingActivities NetIncome $1,134,037AdjustmentstoReconcileCash
Depreciation 3,538,740DeferredIncomeTaxes -185,939GainonSaleofPropertyandEquip. -61,040
ChangeinReceivablesNet 106,367ChangeinInventory 200,985ChangeinPrepaidExpenses 200,137ChangeinCashSurrendervalueofInsurance 62,906ChangeinOtherAssets--Other -191,298ChangeinAccountsPayable -1,216,399ChangeinAccruedExpenses 954,938ChangeinSalaryContinuationPlan -49,774ChangeinAccruedIncomeTaxes 113,369
NetCashFlowprovidedbyOperatingActivities $4,607,029
Next, we must adjust for changes in current assets and current liabilities
accounts that occur from operations. Typically assets are listed first, followed by
liabilities. This enables the formatting to be followed similarly to a balance sheet.
Firstwewilldiscusseffectsfromchangesinassetaccounts.
Changesinassetshaveaninverseeffectonchangesincash.Forexample, if
AccountsReceivabledecreases,thatoftenmeansthatcustomershavepaiduscash
todecrease theamount theyoweus.Because therevenue fromthissalehasbeen
recordedduringapriorperiodduringwhich theoriginal transactionoccurred,on
23
theprincipleofAccrualBasisAccounting,thisinflowofcashwillnotbeincludedin
netincome.So,wemustadditbacktonetincome,aswedidinthestatementabove.
All currentassetswork thesameway; if theiraccountbalancedecreases,youadd
thechangebacktonetincome.Iftheiraccountbalanceincreases,yousubtractthe
change from net income. To explain, if accounts receivable increases, thatmeans
someofthesalescontributingtowardsnetincomewereoncredit.Thismeansthat
thoughwerecordedtherevenue,wedidnotactualreceivecash.Thus,wehaveto
theoreticallysubtractthisamountfromrevenuesbyreducingnetincome.
Current Liabilities work the opposite way. If a current liability, such as
accounts payable, increases, thismeans thatwe transacted an expense on credit.
Therefore, we would record an expense, reducing net income, but wewould not
actuallygiveupanycash.Therefore,wehavetoaddbackcash intheamountthat
thecurrentliabilityincreases.Oppositely,ifaccountspayabledecreases,thismeans
we used cash to pay off the item we bought with credit. Therefore, if a current
liabilityaccountdecreases,itscorrespondingeffectoncashisadecreaseaswell.
Asyoucansee,themajorityoftheaccountsusedinthissectionareclassified
as current, as they are the ones that most commonly change with operating
activities.However,thereareacoupleaccounts,suchasSalaryContinuationPlanin
thiscase,thatarenotcurrentbutarestillusedincomputingOperatingCashFlows.
Thisisbecausethenatureoftheseaccountsisthatofanoperatingitem.Whenthe
accountsarenotclearly labeledasoperatingornon-operating,thiscanbeanarea
whereyouwillhave touseyour judgment inwhichaccounts to include.Next,we
willdiscusshowtocalculatethecashflowsfromInvesting.
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InvestingActivities
Investing activities are considered transactions that are external from daily
operatingandnormalbusinessevents.Theseareitemsthatmayincludeinvestingin
other companies, purchasing and selling Property, Plant and Equipment, and
revenues related to investments. It is important tonote thata companywhosells
equipmentorlandasaprimarybusinessactivitywouldreconcilesuchtransactions
toOperatingCashFlows.Suchitemsinthissenseareonesthatthecompanyusesto
carry out its normal business activities, such as a machine produces the final
producttheysell.
In the Investing Section of Golden Enterprises’ Statement of Cash Flows,
shown below, we see that they simply record cash spent and received from
purchasingandsellingfixedassets.Thisisfairlystraightforward.Iftheyspentcash,
it’sanegativecashflow,andiftheyreceivedcash,itisapositivecashflow.
CashFlowsfromInvestingActivities PurchaseofProperty,Plant,andEquipment -$4,149,678ProceedsonSaleofProperty,Plant,andEquipment 74,514
NetCashUsedbyInvestingActivities -$4,075,164
Essentially, this section shows the inflows and outflows of cash related to
activities thatare intendedtogenerate incomeandcash flows in the future. If the
cashflowisnegativefromthissection,isoftentruethatthecompanyisexpanding
theirproductioncapacitybypurchasingmorerevenuegeneratingassetsthanthey
are selling. If the cash flows are positive from this section, it could be that the
companyisattemptingtogeneratecashbydownsizingorgettingridofoldorexcess
assets.Next,wewilldiscusstheFinancingSection.
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FinancingThe final section of this financial statement involves cash flows related to
stockholdersandcreditors,orfinancingactivities.BelowistheFinancingSectionfor
GoldenEnterprises.
CashFlowsfromFinancingActivities DebtProceeds $38,361,200.00DebtRepayments -38,287,529.00ChangeinChecksOutstandinginExcessofBankBalances -267,502.00PurchasesofTreasuryShares -6,860.00CashDividendsPaid -1,467,879.00
NetCashUsedbyFinancingActivities -$1,668,570.00Theseactivities,muchlikeinvestingactivities,areverystraightforward.Ifwe
receivedcashfromincreasingourdebt,thenweaddittothecashflows.Ifwespent
cashtopayoffdebt,paydividends,orbuybackstock,thenwesubtractthese
amountsfromthecashflows.
Financing activities are important for gaining the cash to use for investing
andoperatingactivities.Furthermore,outflowsinthissectionareimportanttokeep
good relations with creditors and investors. A negative cash flow in this section,
oddlyenough,isoftentimesbetterthanapositivecashflow.Theformerrepresents
the fact that you are able to use cash to repaydebt, pay investors, etc. The latter
mightimplythatyouaretakingoutmoredebtthanyouareabletopayback.Forthe
beginningyearsof thecompany, thissituation isacceptable.However,asolddebt
beginstomatureandinvestorswanttheirdividends,ifthesetypesofpaymentsare
notoutflowing,thenthecompanycouldpotentiallybeintrouble.
26
Golden Enterprises is able to pay off nearly asmuch debt as they acquire,
alongwithbuyingbackstock,whichtheyhopetosellatahigherpriceandcreate
morecash flow.Theyarealsoable topaydividends to their investors,whichmay
serveasanattractionfornewinvestors.
StatementofCashFlowsAnalysisOncewehavecalculatedthecashflowsfromeachsection,andsummedthemupto
reachNet Change in Cash,we have finally completed an entire statement of Cash
Flows.Onthenextpageisanexampleofthefinishedproductalongwithanexample
analysis.
By comparing the cash flow statements of two consecutive years, we can
makeassumptionsaboutthecompany’songoingsuccessordecline.Wecansee in
Figure 3-3 that Golden Enterprises experienced both declining net income and
increasingdeficitincashflowsin2013.
In the operating section, there is a major fluctuation in accounts payable,
accrued expenses, and accrued income taxes. These accounts deal with expenses
thatwehave recognizedon thebalance sheetbuthavenot spentany cash topay
them off. In 2012, net cash spent to pay off accounts payablewas approximately
$300,000,whilethatof2013wasover$1.2million.Thiscouldbeseenasamoveby
GoldenEnterprises topaydowncurrentdebts inorder tohavebetter liquidity in
the future. However, accrued expenses in 2012 decreased throughout the year,
causinga$132,524deductionfromcashflowsfortheyear,whilethissameaccount
increasedbyover$900,000in2013,creatingalargeinflowofoperatingcash.This
27
change counterbalances the activity in accounts payable from a cash flow
standpoint. This could be a strategy bymanagement to have a better estimate of
costsinordertoplanforthefuture.Thiscouldindicatemoreaccruedexpensesand
lessaccountspayable. Inaddition to thisactivity,Accrued IncomeTaxesprovided
$800,000lesscashinflowin2013thanitdidin2012.Amajorcauseofthisislikely
thatlessincomemeansfewertaxes.Therefore,thecompanyexpensedlessaccrued
taxesandthuscouldnotaddthembacktocashflows.
Ontheinvestingsection,theGoldenEnterprisespurchasedsignificantlyless
property,plant,andequipment,butthisislikelyduetothefactthattheygenerated
lessrevenues,andtheycouldalsobegearingupforthe20%expansionmentioned
inthecasestudythattheyareplanningfor2014,apurchaseof$5,000,000.Bybeing
a little more conservative with such spending this year, they are allowing
themselves tohaveabetter capabilityofaffording thisexpansion in the following
year.
In financing activities,more debtwas paid off,more treasury shareswere
purchased,andmoredividendswerepaidin2013thanin2012.Thoughthisseems
like a poor management decision—paying out more money when the company
made lessnet income—itcanbeseenasadecisionwhosebenefitswillbereaped
longterm.Bypayingoffmoredebtnow,therewillbelessinterestexpenseinfuture
periods. Furthermore, by purchasing treasury stock, theremay be opportunity to
resellitatahigherpriceandgenerateaniceprofitfromthestockturnover.Also,the
paying out of more dividends may be an encouragement to investors that this
28
companyisthinkinglong-termexpansionandsimplyusedthisyeartopreparefor
increasedprofitsinthefuture.
By analyzing such activities within the statement of cash flows, we can
deducethecompany’smindsetandplansforthefuture.Afterbuildingandanalyzing
thisfinancialstatementforGoldenEnterprises,itseemsthattheywouldbeagood
company to invest in, as stockpriceswill likelydipnowdue todecreased income
butwillsurelyincreasenextyearwhenthebigexpansionbegins.
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4.AccountsReceivable—Pearson
ExecutiveSummaryBetween2008and2009,Pearson’ssalesincreasedsignificantly(byover16%).Due
to the nature of their business, all of Pearson’s sales are on account. Therefore,
credit policy must be a major concern for the company, to ensure that they are
receivingpaymentsinatimelymanner.Accordingtoanindustrystandard,normal
time to collect a receivable is around 79 days.With this inmind, Pearson needs
somemajor improvement in their collection time, as such abilities havebeen sub
parforconsecutiveyears.
Pearson’saverageDaysSalesOutstanding(DSO)wasover97days in2008.
In the following year, gross receivables increased along with sales, as was to be
expected.However,averagereceivablesincreasedataslightlylowerratethansales,
meaninganincreaseinARturnoverandadecreaseintheaveragecollectionperiod.
Yetwhilethingsimprovedfor2009,theiraverageof93daystocollectreceivables
stilllaggedfarbehindthenorm.
InordertomakePearsonbetterabletocompetewiththoseintheirindustry,
managementshouldreallyworktobringtheDSOtoamuchmorereasonablelevel.
Theyhaveacoupleoptionsthatcouldpotentiallyhelpthemachievethis.First,they
couldoffermorecashdiscountstocustomerswhopaywithinagiventimeperiod,
30
suchas10daysafterthesale.Thiscouldincentivizecustomerstotakeadvantageof
the discount, saving themselves money and providing the company with quicker
payments.AnothermethodPearsoncouldusewouldbetopenalizethosewhodon’t
paywithinthedueperiod.Forinstance,ifanaccountgoesunpaiduntilitsdeadline
has passed, Pearson could start compounding interest on that account for every
perioditgoesunpaid.Oppositethefirstmethod,thiswouldmotivatecustomersto
paytheirbillsontimetoavoidgreaterexpenses.ThiswouldalsoprovidePearson
with compensation for holding receivables longer than they were due. By
implementingsomeofthesesmallchanges,PearsoncouldlikelybringdownitsDSO
toanindustrystandardlevelwithintwotothreeyears.
AccountsReceivable
Anaccountreceivable isgenerallyacurrentassetaccount forrecordingpayments
that you are owed but have not yet received. There are two types of receivables,
tradeandnon-trade.Tradereceivablesinvolveaccountsfromcustomerswhohave
receivedaproductorserviceandhavegivenyouaverbalcommitmenttopayyou
for such items.Non-trade receivables involve accounts that you are owed that do
notdirectly relate toyoursaleofgoodsor services, suchas traveladvances toan
employee.
Accounts Receivable differ from Notes Receivable by their maturity and
repaymentterms.NotesReceivablearetypically,thoughnotalways,heldforlonger
periodsof timeandearn interestduring theseperiods,whileAccountsReceivable
areusuallyheldforshorterperiodsoftimeandaretypicallynon-interestbearing.
31
Sometimes,accountsreceivablearenotcollectedinfulloratall.Customers
maynotbeabletoornotwillingtopay,leavingyouwithabaddebt.Becauseofthis,
GAAPstatesthataccountsreceivablearetobereportedatNetRealizableValue,or
attheamountyoureasonablyexpecttocollect.Therefore,contraaccountsexistto
offsetthebaddebtsorsalesreturnsthatyouwilllikelyencounter.UsingPearsonas
ourexample,wewilldiscussthetwomajorcontraaccountsforaccountsreceivable
inthenextsections.
ProvisionforBadDebtsProvision forbaddebtsessentiallydealswith thescenariomentionedabove:non-
payingcustomers.Thisprovision,orallowanceasitiscommonlyknown,servestwo
purposes. First, it allows actual collectable receivables to be more accurately
recorded, and it allows companies, such as Pearson in this case, to expense bad
debts in the same period the corresponding account receivablewas created. This
simply keeps the companies books consistent with the expense recognition
principle.
An important thing to note about this provision is that it is simply an
estimate.Inreality,acompanycannotaccuratelypredicteveryaccountthatwillnot
be paid, therefore the management team would use past trends to determine a
reasonableallowanceforbaddebtsinthefollowingperiod.Therearetwowaysto
calculate thisestimate.The first is computedasapercentageofgross receivables,
and the second is calculatedbyusingapercentageof sales.Usingapercentageof
grossreceivableshasthebenefitofrecordingmoreaccuratenetARbalances,while
32
percentageof salesmethod focusesmoreonprovidinga realistic expense forbad
debts during the period. Both are acceptable by GAAP. Below is a table that uses
percentageofgrossreceivablesbyageoftheaccount.
Figure4-1
PearsonPLCAccountsReceivableAgingSchedule
FiguresinMillions
Trade
Receivables
balance
Estimated%
Uncollectible
Accounts
Estimated
Uncollectible
Withinduedate £1,096 2% £21Upto3mopastdue 228 4% 93-6mopastdue 51 25% 136-9mopastdue 20 50% 109-12mopastdue 4 60% 2Morethan12mopastdue 20 90% 18Total £1,419 £74
Essentiallythismethodtakesintoaccountthattheolderareceivableis,the
less likely it is to be recovered. Therefore, managers will put together an aging
schedule to calculate how old each receivable is and what percentage of it is
reasonablyuncollectible.Thetablethentotalseachoftheindividualamountstofind
thefinalestimateduncollectiblesandusesthistocreatetheallowancefordoubtful
accounts.To illustrate the activity involving this account, on thenextpage is aT-
accountshowingPearson’sadjustmentstothisaccountthroughouttheyear.
The “72” at top represents the beginning balance of £72 million at the
beginningof theyear.The5and3dealwith changes inexchangedifferencesand
acquisitions, respectively. These activities are important but are slightly
unnecessary for the basic explanation of this contra account. Therefore, we will
focusonthe£26millioncreditandthe£20milliondebitthatalsotookplaceduring
thisperiod.
33
PearsonPLC
ProvisionforBadandDoubtfulDebts
(Figuresin£Millions)
725 2620 3 76
Thejournalentryforthe£26millioncredittothisaccountwastoaddtothe
provisionandrecordtheexpense formorebaddebts thatwereexpectedtooccur
fortheperiod.Theentry(alongwiththefinancialstatementitaffects)wasentered
asfollows:
BadDebtExpense 26,000,000 IncomeStatementProvisionfor… 26,000,000 Bal.Sheet
The£20million debit to the Provision account occurred as accountswere
actually deemed uncollectible and were written off the books. By lowering the
provision account, you’re basically showing that the expenses you provided for
actually tookplaceand thus theallowancecanbereduced. Inaperfectworld, the
allowanceaccountwouldalwaysendupatzerobecauseallthebaddebtsthatwere
providedforwouldequaltheaccountsactuallywrittenoff.However,thisisalmost
neverthecase.Hereistheentrycorrespondingtothisactivity:
AccountsReceivable 20,000,000 Bal.Sheet
Provisionfor… 20,000,000 Bal.SheetAsshownonthepreviouspage,thisprovisionaccountincreasesasmorebad
debts are estimated and decreases bad debts are realized. Next, we will discuss
anothercontraaccountthatdealswithallowingforsalesreturns.
34
ProvisionforSalesReturnsWith anybusiness that sells tangible goods, sales returns are inevitable. Products
arefaulty;thecustomergotthewrongsize,etc.Becauseofthisfact,businessesare
requiredtoallowforreturnsiftheycanbereasonablyestimated.Todoso,theyuse
anallowance forSalesReturnsaccount,or inPearson’scase,aProvision forSales
Returns. By recording such information, receivables aremore closely recorded at
theirnetrealizablevalue.
Sales returns provisions are calculated similar to provisions for bad debts.
Companies find an estimate using percentage of sales or percentage of accounts
receivable.Theythencredittheallowancefortheestimatedreturnsfromtheyear.
BelowisaTaccountshowingactivityintheProvisionforSalesReturnsaccountfor
Pearson.
PearsonPLC
ProvisionforSalesReturns
(Figuresin£Millions)
372 425
443 354
The 372 credit represents the beginning balance in the provision of£372
million. The 425 credit comes from estimating this year’s Sales Returns and
providing accordingly. The 443 debit shows the actual sales returns that Pearson
experienced thisyear, to the tuneof£443million.Finally, the354 represents the
endingbalance in thisprovisionaccount for theyear endedDecember31st, 2009.
35
Belowarethejournalentriesregardingthetwoeventsrecordedinthisaccountin
2009.
SalesReturnsandAllowances 425ProvisionforSalesReturns 425
ProvisionforSalesReturns
443AccountsReceivable
443
Justlikeprovisionforbadanddoubtfuldebts,thisprovisionforsalesreturns
account increasesas thecompanyestimatesreturns foraperiodanddecreasesas
thecompanyrealizesthesereturnsforthegivenperiod.
RatioAnalysisLikewithmostfinancialanalyses,agreatwaytocompareprogressinacertainarea
fromoneperiodtothenextisthroughfinancialratios.Thesegivemorecomparable,
easiertounderstandnumbersthatgiveanalystsaprettygoodideaaboutthestatus
ofagivenitemwithinthefirm.Forexample,ratiosthatcorrespondwithAccounts
ReceivableareARTurnoverandDaysSalesOutstanding.Theformercomparessales
with average accounts receivables to see howmany times per year the company
actuallycollectsoutstandingaccountsandissuesnewreceivables.Thelatterrefers
to the amount of time, indays, that it takes the company to collect all themoney
fromagivenaccount.Withtheseratios,analystscandetermineifacompaniescredit
policies are effective, if their collection rate is causing cash flow issues, andother
relatedcharacteristics.Figure4-2,shownonthenextpage,portraysthecalculation
oftheseratiosforPearson.
36
Figure4-2
PearsonPLCAccountsReceivableRatios
2009 2008
CreditSales,net £5,624 £4,811Avg.GrossTradeReceivables £1,447 £1,282AccountsReceivablesTurnover 3.89 3.75Avg.CollectionPeriod 93.88 97.30
From 2008 to 2009, Pearson’s sales and trade receivables significantly
increased,whichisagoodsignthatthecompanyiscontinuingtogrowandexpand.
Another good sign for Pearson is that accounts receivable turnover increased
slightly,meaning that they are able tohold turn their receivables into cash about
3.89 full times a year. Because of this increased turnover ratio, the average
collectionperiodwent downbynearly four days. This is a great step in the right
direction.However,inordertomatchtheircompetitor,Pearsonstillneedstobring
its DSO down below 80 days. If this were to happen, Pearson would experience
bettercashflows,whichisveryimportantforexpansion.
37
5.GAAPReporting—GraphicApparelCorporation
Thischapteriscomposedofanemailtoaclient.Inthisscenario“TheAccounting
Firm”isreachingouttotheirclientNickiinresponsetosomequestionsabout
properreportingmethods.Toserveasarealisticinteractionbetweenclientand
firm,thischapterisinemailformat.
Subject:GettingBackOnTrackTo:[email protected]
From:[email protected] 12:34P.M.(10HoursAgo)
Nicki,Howareyou?IhopealliswellatGraphicApparelCorporation!We,TheAccountingFirm,havebeenabletothoroughlyanalyzeyourbookkeeping
practicesandcomeupwithacouplesolutionsthatwillhelpgetyourcompanyback
up to GAAP standards. Up to this point, your accountant has been recording
transactions in a logical, functional manner. However, for the new creditor’s
standards,wewillhavetoimplementafewminorchanges.
Below, I have attached all of the necessary journal entries regarding these
changes,aswellasspecificanswerstoeachofthequestionsyousentus last
week.
38
Thefirst issuethatcameupduringouranalysiswas intheareaofrevenue
recognition.Itistomyunderstandingthatthecustomshirtbranchofyourbusiness
isrelativelynew,yetthriving.WhilethisisgreatforGAC,itisimportanttonotethat
you cannot recognize the revenue from custom orders, or any orders, until your
customers have received your product. This follows the assumption that revenue
should be recognized in the periodwhich it is earned. Furthermore, because you
havealreadyreceivedpartialpayment,youmustrecord thisasunearnedrevenue
untiltheshirtsareactuallysenttothecustomer.Forinformationonhowtohandle
thissituationasfarasbookkeepinggoes,seetheattachments.
Thenextminorfixthatneedstotakeplacedealswiththeaccountingforyour
newcustomers.Accordingtotheinformationyouprovidedus,itseemsthatsomeof
your new customers are likely to default on their payments. Because you can
reasonably estimate this “bad debt,” GAAP say that you must account for it by
creating an “Allowance for Doubtful Accounts” account. This account is a contra
assetwithacreditbalancethatessentiallyreducesyourAccountsReceivablebythe
amountthatyoureasonablyestimatewillnotbecollected.Forinstance,ifyourAR
balanceisat$10,000andyouestimatethatyouwillnotcollect$500worthofyour
receivables,thenyouwouldrecordyourNetAccountsReceivableas$9,500—where
GrossARisadebitbalanceof$10,000andAllowanceforDoubtfulAccountshasa
creditbalanceof$500.Thisprovidesmoreaccurateinformationtothebankabout
thenetrealizablevalueofyourreceivables.
39
Another area to focus our attention is the recording of sales returns.
Accordingtoyourrecentsurveys,itseemsthatnearly$15,000ofyourgraphictees
are still out at retail stores, yetmost of the stores no longer have your shirts on
display. Though it seems likely that most will be returned, you have not had a
situation like this in the past, and therefore, you cannot reasonably estimate the
amount of sales returns you will have. Therefore, you need to reduce the sales
revenuefromtheseshirtsandputthembackonyourbooksasinventory.Thisway,
youarenotunderstatingyourinventorybynotincludingshirtsthatcouldeasilybe
returned. Of course, you must remember that you would not increase your
inventory by the $15,000 selling price of these shirts. Rather, you would record
thematthelowerofcostormarket.Again,seetheattachmentsformoredetailson
howtohandlethischange.
Thefinalproblemweneedtoaddressisthewaterdamagethatyourplaint-
shirts incurred during themonth ofMay. Although itwas very creative of you to
work thedamage into yourdesign, according toGAAP standards, these shirts are
damaged andmust be impaired to bring them back to their net realizable value.
Now,sadlythiswill involveyourecordingalossonyourincomestatement,asthe
value of your inventory has decreased. However, if you continue to get normal
sellingpricefortheseshirtsthenthisinventoryimpairmentwillnotimpactyournet
income. We just want to implement this change so GAC is not overstating its
inventoryandthusoverstatingitscurrentratio.
This brings us to the final topic: the impact on your relationshipwith the
bank.Aswehavediscussed above, there are quite a few changes that need to be
40
madeinorderforyourbookstobereportedcorrectlyaccordingtheGAAPstandard.
Of course, these changes are going to have some effect on your balance sheet,
namely on your current assets and liabilities. The attachments will give you the
exactnumbers,butthesechangeswillultimatelyreduceyourcurrentratioenough
thatyouwillhavetoreachouttoequityinvestorsinordertogetyourratiosbackup
to the bank’s minimum requirement. To be safe, you should reach for about
$10,000inequityfunding,andthenyourcurrentratiowillbebacktoanacceptable
level.
Ifgatheringthatmuchcapitalisanissue,youcouldexpeditetheproduction
of your customshirts, send thoseoff, andupdate yourunearned revenue to sales
revenue. This would reduce your current liabilities (unearned revenue) and
increase your current assets (Accounts receivable) enough to bring your current
ratiobackto1.01,anappropriatelevel.
I hope our solutionswere helpful, and please feel free to contact us via email or
phoneifyouhaveanyquestions.
Respectfully,ColeMcCall,CPAAssurancePartnerTheAccountingFirm
41
Attachment1:JournalEntriesSolution1
Requiredjournalentry:SalesRevenue 10,000 UnearnedRevenue 7,500 AccountsReceivable2,500*Toreducesalesrevenuefromunfulfilledcustomorder,establishunearnedrevenuecorrespondingtocashreceived,andtoreduceaccountsreceivablefromsalesnotyetmade.Solution2
Requiredjournalentry:BadDebtExpense 3,000 AllowanceforDoubtfulAccounts 3,000*Tobringaccountsreceivabletonetrealizablevaluebyaccountingforaccountsthatarelikelytodefault.Solution3
Requiredjournalentries:SalesRevenue 15,000 AccountsReceivable 15,000*Toreducesalesandaccountsreceivablebyamountinwhichreturnsareexpectedbutunknown.Inventory 7,800 CostofGoodsSold 7,800*Toincreaseinventoryandreducecostofgoodssoldbycostamountofunknownbutexpectedsalesreturnsinentryabove.7800=15,000*(1-.48),where.48=profitmargin.Solution4
Requirejournalentries:Lossoninventorydamage 5,100 Inventory 5,100*Toimpairinventorytonetrealizablevalue,where5,100=.5*10,200,thereportedamountofplainshirtsandinkatcost.Thisnumberischosenbasedonthefactthathalfoftheinventorywasdamagedandnocircumstancesleadustobelieveotherwisethatdamagedshirtsareheldinotherinventories.
42
6.DepreciationMethods—AirplaneIndustry&
WasteManagementExecutiveSummaryDepreciationisanecessaryandeffectivewayofmatchinganasset’sexpenseswith
the revenues it produces. There are several ways to compute depreciation rates,
which generally differ from company to company and between different types of
assets.Inthefirstpartofthisreport,theairlineindustryisusedtoshowtheeffects
of different depreciation rates on disposal of assets. Because the depreciation
method used on a particular asset ultimately affects its carrying value, using one
methodoveranothercanresultingainsorlossesdependingonthesalepriceofthe
asset.Becauseof this, it is important forcompanies todepreciate theirassets ina
systematic and rational manner that best aligns with their intended use of a
particularasset.Failuretodosocanresultinmaterialunder-oroverstatementsof
netincome,whethermanagementintendstoornot.
As shown in part II of this report, misrepresentations of a company’s
financialreportscanhavedisastrouseffects.Toillustratethis,theincidentinvolving
Waste Management and Arthur Andersen is discussed. In this example, Waste
Management’s executives use questionable accounting methods, including
depreciation techniques, to inflate the company’s net income and ultimately line
43
their ownpockets. Looking out for their own financial interest, the auditing firm,
ArthurAndersen,issuedunqualifiedapprovalofthesefalsereports.Becauseofthis,
both Waste Management officials and Arthur Andersen faced severe penalties
involvingincreasedregulationandheftyfines.
PartI-DepreciationDepreciation is amethodof allocatingexpenseswith theuseof assets toproduce
revenues.Forexample,whenacompanypurchasesamachinethattheywillusefor
thenextfiveyears,iftheychargedittoanexpenseaccountuponthepurchase,then
the entire expense for that machine would be charged to the current year, even
though the machine will be used over several. This would cause a mismatch
between the expense for that machine and the revenue it will bring in by
manufacturingproducts.Accordingtheexpenserecognitionprinciple,allexpenses
mustbematchedtorevenues inthesameperiod.Therefore,depreciatinganasset
providesawaytoachievethis.
The four major components necessary to compute depreciation are the
original cost of the asset, the salvage value, the estimated useful life, and the
depreciationmethod.Thecostoftheassetisobviouslytheimpliedcashpriceorthe
valueoftheassetrecordedonthecompany’sbooks.Thesalvagevalueistheamount
thecompanybelievestheycanrecoverupondisposalofthisasset.Itisnotcommon
for assets to have a salvage value of zero, as they are simply discardedwhen the
companyisfinishedwiththem.Estimatedusefullifecandependonseveralthings,
whichwill bediscussed in thenext section.However, this is thenumber of years
44
that a companybelieves that the assetwill beused forproductionor to generate
revenues.Finally,thedepreciationmethodisoneofthegenerallyacceptedmethods
that GAAP suggests. However, if a method is rational and systematic, then
companies are free to come up with a method that best suits their business
activities.Next,themostcommonmethodsofdepreciationwillbediscussed.
There are several types of depreciationmethods and rates that companies
use.These includestraight-line,doubledecliningbalance, sumof theyear’sdigits,
and theactivitymethod.Eachof thesemethods,besidesdoubledecliningbalance,
uses thedepreciablebaseof anasset (costminus salvagevalue) and thendivides
this number by useful life, estimatedunits of production, or another depreciation
rate,dependingonthemethod.Doubledecliningbalancediffersinthatitusestwice
therateofa straight-linemethod,anddepreciates theasset from itsoriginal cost,
untilitsbookvalueisequaltoitssalvagevalue.Forthemostpart,thesedifferences
aredeterminedbymarketstandardsorindividualcompanyactivities.Toillustrate
theeffectsthatusingdifferentdepreciationratescanhaveonacompany’sfinancial
statements,theairlineindustrywillbeanalyzedinthenextsection.
AirlineIndustryIn the following example, three major airline companies, Northwest, Delta, and
UnitedallmakethesameexactpurchaseforaBoeing757in2005,atapriceof$75
million. According the each company’s policy, they all use the same residual
(salvage)valueequalto5%ofsales,or$3,750,000.However,thesethreecompanies
allusedifferingdepreciationrateonthisspecifictypeofasset.Thereasonsforthese
45
differingrateswillbediscussedinthenextportionofthisanalysis.However,before
delving into the differences, below is a table that summarizes the purchase,
depreciation,anddisposalofthisairplaneforeachofthethreecompanies.
Figure6-1
DifferencesinDepreciationandtheEffectsonDisposal
Northwest Delta United
BookValueJanuary1,2005 $75,000,000 $75,000,000 $75,000,000Residual 3,750,000 3,750,000 3,750,000DepreciableAmount 71,250,000 71,250,000 71,250,000UsefulLife(Years) 15 20 28AnnualDepreciation 4,913,793 3,562,500 2,590,909AccumulatedDepreciationat
December31,2008 19,655,172 14,250,000 10,363,636BookValueatDecember31,
2008 55,344,828 60,750,000 64,636,364SalePriceI 55,000,000 60,000,000 65,000,000Gain(Loss)onSaleI (344,828) (750,000) 363,636
SalePriceII 60,000,000 60,000,000 60,000,000Gain(Loss)onSaleII $4,655,172 -$750,000 -$4,636,364
Asshownabove,eachcompanyusesadifferentusefullifeforthesameexact
asset. Northwest estimates a useful life of 14.5 years, while Delta and United
estimate20and27.5years,respectively.Thereareacouplereasonsastowhysome
variancesinthisestimationmayoccurfromcompanytocompany.First,companies
mayestimatetheasset’susefullifeonthebasisthattheyarelookingfortaxbreaks.
Forexample,ifthecompanyusesalowerusefullife,theywillbeabletoexpensethis
assetmore quickly, and thus report lower taxable incomes. Therefore, given they
have thesametaxrateasanothercorporation, theywillbeable torealizegreater
taxbenefits sooner.Aplansuchas thiswouldalso induce thecompanies tousea
method such as double declining balance,where themajority of the depreciation
expensecomesinthefirstfewyearsoftheasset’susefullife.
46
Another reason that companies are likely to use different useful lives for
their assets could be due to their businessmodel. For example, some companies
maybelievethattheircompetitiveadvantageisalwayshavingthenewest,mostup-
to-dateplanes,whileothercompaniesmayfocustheirbusinessmodelonlong-term
useoftheseexpensiveassets.Therefore,theformerwillnotestimateanextensive
useful life if theyknowthattheywillbedisposingoftheasset ina fewyears.And
viceversa, the latterwillnotestimateashortuseful life if theyplantouseit fora
great lengthoftime.Thus,companiesdepreciateassetsatdifferentrates.Thiscan
haveasignificanteffectonthefinancialstatements.
Asshowninthetableabove, inSaleI,companiesdepreciatetheirplanesat
differentrates,whichleadstovaryingsalepriceswhenitcomestimefordisposal.
Basedonthecarryingvalueofthatasset,themannerinwhichthecompanyrecords
thesaleonitsbookscanhaveanumberofdifferentoutcomes.ForNorthwest,the
carryingamountoftheplaneatthetimeofdisposalis$55,344,828.Becauseofthis,
Northwest is offered$55,000,000 for theplane. IfNorthwest takes this deal, they
will have to recorda lossof $344,828, as the sellingpricewouldbe less than the
book value. Oppositely, because of their depreciation rate, United’s plane at this
sametimehasacarryingvalueof$64,636,364andasalespriceof$65,000,000.In
thissituation,United’shighercarryingvaluebringsahigherprice,whichresultsin
the recordingof a gainondisposal.While theSale I situation couldbedue to the
companies’ varying use of the planes, the large fluctuation in these sale prices is
veryunlikely.
47
Mostofthetime,assetsaresoldattheirfairvalue,whichcanbedetermined
bymarketprice, appraisal value, or other valuationmethodof a given asset. This
fair value amount is essentially what the asset is deemed to be worth, given the
conditionitisin.Consideringthefactthatallthreeoftheseplaneswerepurchased
for identical prices and have been used for identical amounts of time, it is more
likelythatasituationsimilartoSaleIIwouldoccur.Inthisscenario,alloftheplanes
havethesamesalesprice,despitetheircarryingvalues.Thisresultsintheopposite
outcomecomparedtothefirstscenario.Forinstance,Northwestwouldnowrecord
againof$4,655,172,asithasacarryingvaluelowerthanthisuniformsalesprice.
However,Unitedwouldnowrecorda lossof$4,636,364sinceitscarryingvalueis
abovethis fairvaluepricing.Delta’s$750,000 lossdoesnotchange,as it faces the
samesalepriceforbothscenarios.
PartII–EarningsManagement WhileGAAPencouragesauseofdepreciationmethodthatcoincideswiththebestfit
ofthebusiness,sometimesmanagementmanipulatesthesecalculations,alongwith
others, inorder toenhance theappearanceof thecompany’s financial statements.
This“windowdressing”isknownasearningsmanagement,andisexemplifiedinthe
followingexample.
WasteManagementwas, quite obviously, a garbage hauling companywho
wasconvictedofseveralcountsoffraud.Theirchargesconsistedoffailingtorecord
expenses for impairments and depreciation, establishing inflated environmental
reserves (liabilities) in connection with acquisitions, improperly capitalizing a
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varietyofexpenses,andfailingtoestablishsufficientreserves(liabilities)topayfor
incometaxesandotherexpenses.Essentially, thiscompany foundseveralways to
overstatetheirbottomlineandthusartificially inflatetheirearnings.Endorsedby
ArthurAndersen,theaccountingfirmresponsibleforauditingthiscompany,Waste
Management continued with this fraudulent activity, until they were eventually
caughtbyanewCEO,whoquestionedtheaccountingmethodsused.Atthispointin
time,theirstockpricesdroppedtremendously,leavingtheirshareholderstofacea
burdenofnearly$6billioninlosses.
AsdiscussedinPartI,depreciationmethodscanbeillegallymanipulatedfor
financialreportingpurposes.Aspartofthismajorscandal,WasteManagementused
aparticularlyphonymethodofdepreciatingtheirassets.Theyavoideddepreciation
expensesby extending the estimateduseful lives of their garbage truckswhile, at
the same time, making unsupported increases to the trucks' salvages values.
Essentially,thismeantthattheolderandmoreusedtheassetwas,themoreitwas
worthon thebooks.Bydoing this, executivesofWasteManagementwereable to
overstatenetincomeandmakethecompanyappearmoreattractivetoinvestors.
These executives committed such blatant fraud for a number of reasons.
First, their compensationwas tied toearnings, so theywere looking to report the
bestnumberpossible.Furthermore,theywantedthecompanytoappearprofitable
so they could retain their high level positions and also reap greater retirement
benefits.
Of course, management could not have gotten away with this without the
help of their auditors. Arthur Andersen, motivated by under-the-table
49
compensation,cameupwithaplantohide fraudfromallyears ithadtakenplace
and then signed off on the company’s financial reports, verifying their validity.
When they were exposed, they took a couple measures to save their reputation.
These included an agreement to pay a $7 million antifraud injunction and also
complyingtobecensuredundertheSEC’sruleofpractice.However,thisobedience
wasshort-lived.
Only a few years later, Arthur Andersen was involved in another scandal.
This time the penalties weremuchmore severe. After aiding Enronwith several
countsoffraud,ArthurAndersenultimatelyhadtogiveupitslicensetopracticeasa
CertifiedPublicAccountingfirm.Whilethecompanywasnotentirelybannedfrom
operating, the effects of its fraudulent involvement have kept the firm from
recoveringevenslightly.
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7.RecordingLiabilities—GAAPvs.IFRS
ExecutiveSummaryConstructisaconstructionmaterialsmanufacturingcompanythatexperiencedalot
ofunwantedEPAinvolvementandlitigationduetotheir2007purchaseofapieceof
property from BigMix, a concrete manufacturer. This land was expected to have
potential environmental hazards; however, Construct believed that holding an
escrowaccountbecauseofthiswouldnegativelyaffectthesalesnegotiations.Thus,
noindemnificationprovisionwasreserved.
A year later, BigMix declared bankruptcy, and Construct attempted to gain
ownership in part of the failing company. Construct was not successful in this
endeavor.However,thisseemedtohavenoeffectontheirfinancialstatements.
In 2009, the EPA began looking into this tract of land for potential water
contamination.Constructwasgivenanestimatedprobability thatpenaltieswould
arise from this investigation. However, a liability relating to this could not be
recordedduetoinadequateprobabilityaccordingtoGAAPstandards.Accordingto
IFRS, the liabilitywouldhavebeenrecorded,as itwasmore likelytohappenthan
not.
Aftermore investigation, theEPAdeterminedthat therewould in factneed
to be environmental remediation, and given BigMix’s financial status, the cost
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burden of this remediation was placed on Construct. The costs were reasonably
estimable and probable, necessary criterion for GAAP and IFRS, so the liability of
thesecostswasrecordedonConstruct’sbooks.In2011,morecostsaroseandwere
subsequentlyaddedtotheexistingenvironmentalliability.
Alsoduring2011,ConstructhadfiledsuitagainstBigMixtohelpmitigatethe
losses fromthisremediation.By2012,Constructexpectedthat theycouldrecover
up to $1 million from BigMix and believed this was very probable. However,
according to GAAP and IFRS, no gain contingency could be recorded for this
expectation,as itwould report revenuesbefore theyoccurred.Thus, thepotential
settlementcouldonlybedisclosedinthefootnotes.
There are several differences between GAAP and IFRS. Some of these
differenceswouldhavesignificanteffectsonacompany’sfinancialreporting,ifthey
weretouseoneinsteadoftheother.Inthiscase,theonlysignificantdifferencethat
Construct would have incurred by using IFRS over GAAP is the expected loss
contingencyin2009.However,asactualfigureswererevealedin2010,theoriginal
differencewouldhavebeensmoothedoutbyyear-endadjustingentries.
2007-IndemnificationProvisionattimeofpurchase
GAAP: Because the amount for this loss contingency is not reasonably estimable,
norisitprobable,itcanbeconsideredanuncertainty,andtheliabilityshouldnotbe
recorded. However, GAAP encourages the disclosure of this uncertainty in the
footnotes.Thecodificationdiscussesthis:
52
50-9:Uncertainties associated with environmental remediation loss contingencies arepervasive, and they often result in wide ranges of reasonably possible losses withrespect to such contingencies. Further, resolution of the uncertainties and the cash-flow effects of the loss contingencies often occur over a span of many years.Accordingly, this Subtopic encourages, but does not require, additional specificdisclosureswith respect to environmental remediation loss contingencies thatwouldbeusefultofurtherusers'understandingoftheentity'sfinancialstatements.
IFRS:IFRSdoesnotspecificallymentionenvironmentalremediation.Rather,itgives
abroadstandard for losscontingencies tobe reported.Essentially, IFRS takes the
sameapproachasGAAPonthisevent:
21.4Anentityshallrecogniseaprovisiononlywhen:(a)theentityhasanobligationatthereportingdateasaresultofapastevent;[Refer:paragraph21.5](b)it isprobable(iemorelikelythannot)thattheentitywillberequiredtotransfereconomicbenefitsinsettlement;[Refer:AppendixtoSection21,particularlyexample9]and(c)theamountoftheobligationcanbeestimatedreliably.
In this situation, Construct cannot reliably estimate an amount of this potential
obligation,norcanitprovethatsuchlossassociatedisevenprobable.Therefore,no
liabilityisrecorded.
2008–Liabilityincurredfromcreditor’sbankruptcyGAAP:Inthiscase,BigMixisthecreditorofConstruct,meaningthatBigMix’sfiling
for bankruptcywould cause no potential losses for Construct. Thus, no liabilities
needtobeaccrued.
IFRS: Again, BigMix owes no money to Construct at this point in time, so their
declarationofbankruptcywouldnotresultinincreasedliabilitiesforConstruct.
53
2009–ContingentLiabilitiesandtheirprobability
GAAP: According to GAAP, in order for a contingent liability to be recorded, the
event causing the loss must be probable and the amount of the loss must be
reasonablyestimable.Inthiscase,thereisa60%chancethatthepenaltiesfromthe
EPA will occur. However, it can be argued that 60% is closer to the accounting
measureof “reasonablypossible” than it is to “probable.”Therefore, thispotential
losswouldbedisclosedbutnotaccrued.
ASC450-20-20defines"probable"as"likelytooccur."Whiletheassessmentofthesetermsissubjecttoanentity'sjudgment,"likely"underU.S.GAAPtypicallyisconsideredamuchhigherthreshold(i.e.,approximately80percent)than"more likelythannot"underIFRSs(i.e.,greaterthan50percent).
IFRS: IFRShasalowerstandardthanthatofGAAP.Foracontingentliabilitytobe
recorded, its probability of happening simply has to be more likely than not.
Because there isa60%chance that thiswillhappen(40%chance that itwillnot)
thelossof$250,000andthecorrespondingliabilityshouldberecorded.
RecognitionofaprovisionAnentitymustrecogniseaprovisionif,andonlyif:[IAS37.14]
• apresentobligation(legalorconstructive)hasarisenasaresultofapastevent(theobligatingevent),
• paymentisprobable('morelikelythannot'),and• theamountcanbeestimatedreliably.
IAS 37.23 defines probable as "more likely than not to occur" (i.e., "the probabilitythattheeventwilloccurisgreaterthantheprobabilitythatitwillnot").
2010–EnvironmentalObligationsGAAP:Accordingtothecodification:
Theestimationofanentity'sallocableshareofthejointandseveralremediationliability(seeparagraph410-30-55-4)forasiterequiresanentitytodoallofthefollowing:
• a.Identifythepotentiallyresponsiblepartiesforthesite• b.Assessthelikelihoodthatotherpotentiallyresponsiblepartieswillpaytheirfull
54
allocableshareofthejointandseveralremediationliability• c.Determinethepercentageoftheliabilitythatwillbeallocatedtotheentity.
In this case, both Construct and BigMix are considered potentially
responsibleparties(PRPs),butgiventhefinancialstatusofBigMixafteritsChapter
11bankruptcy,theEPAplacedtheburdenoftheremediationonConstruct.Theydid
sobyissuingaunilateraladministrativeordertoConstruct,whichessentiallystates
that Constructmust either front the costs to fix the problem, or they face severe
penalties and fines for non-compliance. Thus, Construct immediately began the
processofremediating.
In 2010, the entire costs of this remediation effort are not reasonably
estimable.However,someofthecostsincludinglegalfeesandthecostofRI/FSare
estimable and are considered part of the remediation effort. Therefore, these
amounts,$100,000and$300,000respectively,shouldbeaccrued.Thecodification
supportingthisisasfollows:
30-11Theremediationeffortisconsideredonasite-by-sitebasis;itincludesthefollowing:
• a.Precleanupactivities,suchastheperformanceofaremedial investigation,riskassessment,or feasibility studyandthepreparationofaremedialactionplan and remedial designs for a Superfund site, or the performance of aResource Conservation and Recovery Act of 1976 facility assessment, facilityinvestigation,orcorrectivemeasuresstudies
• b.PerformanceofremedialactionsunderSuperfund,correctiveactionsundertheResourceConservationandRecoveryAct of 1976, andanalogous actionsunderstateandnon-U.S.laws
• c.Governmentoversightandenforcement-relatedactivities• d.Operation and maintenance of the remedy, including required
postremediationmonitoring.
30-12Determininganyofthefollowingispartoftheremediationeffort:
• a.Theextentofremedialactionsthatarerequired• b.Thetypeofremedialactionstobeused• c.Theallocationofcostsamongpotentiallyresponsibleparties.
Thecostsofmakingsuchdeterminations,includinglegalcosts,shallbeincludedinthe
55
measurementoftheremediationliability.
Whilealsoworkingtofixtheissueathand,ConstructfiledsuitagainstBigMixforan
unspecified amount. This was essentially to recoup some of the costs of this
remediation. However, according to the codification, these cannot be considered
partofthecostsoftheeffort.Therefore,theywouldnotbeaccruedasapartofthe
environmentalliability.
30-13The costs of services related to routine environmental compliance matters andlitigation costs involved with potential recoveries are not part of the remediationeffort.
IFRS:BecauseIFRSdoesnothaveaspecificmethodofaccountingforenvironmental
remediation,thegeneralaccountingforprovisionswouldbeusedtodeterminethe
necessary actions for this event. Because the total obligation of $400,000 is
reasonably estimable, probable, andhas risen froma past event, this is a liability
thatshouldbeaccrued.
Measurementofprovisions
Theamountrecognisedasaprovisionshouldbethebestestimateoftheexpenditurerequiredtosettlethepresentobligationatthebalancesheetdate,thatis,theamountthatanentitywouldrationallypaytosettletheobligationatthebalancesheetdateortotransferittoathirdparty.[IAS37.36]Thismeans:
• Provisions for one-off events (restructuring, environmental clean-up,settlementofalawsuit)aremeasuredatthemostlikelyamount.[IAS37.40]
Aprovisionisrecognisedascontaminationoccursforanylegalobligationsofcleanup,orforconstructiveobligationsifthecompany'spublishedpolicyistocleanupevenifthere is no legal requirement to do so (past event is the contamination and publicexpectationcreatedbythecompany'spolicy)[AppendixC,Examples2B]
2011–EnvironmentalObligations(cont.)
GAAP:Accordingtothecodificationexcerptsabove,thisadditionalestimated$1.5
millioncostfortheremediationwouldbeaddedtothealreadyaccruedliability.
56
IFRS: As with GAAP, IFRS would also add this new $1.5 million cost of the
remediationplantothetotalremediationprovision.
2012–GainContingenciesGAAP:ThechancethatConstructwillreceivethe$1millionsettlementisestimated
at75%,making it aprobableevent.However,gaincontingenciesdonotwork the
sameaslosscontingencies.Accordingtothecodification:
25-1A contingency that might result in a gain usually should not be reflected in thefinancial statements because to do so might be to recognize revenue before itsrealization.50-1Adequate disclosure shall bemade of a contingency thatmight result in a gain, butcare shall be exercised to avoid misleading implications as to the likelihood ofrealization.Therefore, no gain contingency can be recorded. However, Construct can
disclosethisgainaslongasitisnotmisleadingtofinancialstatementusers.
IFRS: IFRStakesthesameapproachtothissituation.Eventhougha75%chanceis
veryhigh,itwouldnotbeconsidered“virtuallycertain,”makingitacontingentgain
andthus,notrecorded.IAS37speaksonthisissue:
ContingentassetsContingentassetsshouldnotberecognised–butshouldbedisclosedwhereaninflowof economicbenefits isprobable.When the realisationof income is virtually certain,thentherelatedassetisnotacontingentassetanditsrecognitionisappropriate.[IAS37.31-35]
57
8.Long-termLiabilities—RiteAidExecutiveSummary In this analysis,we discuss themany types and characteristics of long-termdebt.
UsingRiteAid,anationwidedrugstore,weareabletodelveintoseveralinstancesof
debt including secured and unsecured notes, convertible and callable bonds, and
other elements that define a given debt instrument. Furthermore,we explain the
discount amortization process, the difference between straight-line amortization
andeffectiveinterest,andhowthisaffectsthecompany’sbooks.
As with most debt instruments, the recognizing and recording of interest
expense,througheitheranon-interestbearingortraditionalnote,isamajorpartof
the accounting for debt.With this inmind, this paperwalks through the varying
journal entries that accompany different scenarios of this nature, along with
amortizationtablestodemonstratehowcompaniescancreateschedulesofinterest
expenseandthecashoutflowsrelatedtothem.
Finally, having defined a vast array of long-term notes, we take the
discussion a step further with an analysis and comparison of Rite Aid’s financial
positionregardingdebtandthatoftheindustryaverage.Here,weseethatRiteAid’s
debtratiofarexceedsthedrugstoreindustryaverage,asthecompany’sstockholder
equityhasadebitbalance.Wethenelaborateonwhatthismeansforthecompany
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andhowthistranslatestotheS&Pcreditratingsystem,givinganestimatedrating
basedonStandard&Poor’spredefinedcriteria.
Debt and Indebtedness Inorder to conductbusinessand thrive in themarketplace, companiesoftenseek
externalfunding.Whilemanycompaniesraisesuchcapitalthroughsaleofequity,or
ownershipinthebusiness,nearlyeverycompanyobtainsthemoneytheyneedvia
issuanceofdebt.Now,debtcancome inallshapesandsizes,so inordertogivea
glimpse into theworld of debt financing, this paperwill analyze Rite Aid and its
financialstatementsforthefiscalyear2009.
RiteAid,apopulardrugstorefranchise,isrecognizedthroughoutthenation.
Many people shuffle through a given store on a daily basis, making it seem that
businessisthriving.However,RiteAidseemstohavegottenintoquiteabitofdebt.
Before discussing the negative effects from too much debt, this paper will first
describeanddefinesomeofthetermsrelatedtoRiteAid’sfinancialobligations.
There are many key terms used to distinguish the different types and
elementsofdebt.Forexample, foradebt tobeguaranteed thismeans that if the
financial obligation cannot be met by the debtor, then it will become the legal
financial obligation of the guarantor. This is essentially away tomitigate risk, by
holdingmultiplepeopleresponsibleforthedebt.Othertermsincludesecuredand
unsecured debt, where secured debtmeans that the loan or other instrument is
backedbyassetsorothercollateral.Therefore,unsecureddebthasnosuchsafety
feature. Senior debt means that in the case of liquidation, its repayment takes
59
priorityoverother“junior”debt.Afixed-rateloanisonewheretheannualinterest
rate is locked in forthetermof the loan,despitechanges inmarket interestrates.
Convertiblebondsareonesthatcanbetradedinforcommonstockattheendof
theterm,ratherthancashingthemout.Acouplefinalimportanttermsforthispaper
arepar,discount,andpremium.Whenabond(ornote)issoldtoinvestors,there
areanumberoffactorsthatdetermineprice.First,thereisthecouponrate,which
is the stated rate of interest that the debt holder will receive each year as a
compensationforallowingtheborrowingoffunds.Next,thereisaneffectiverate,
whichisalsoknownastheacceptedmarketrateofreturnonagiventypeofloan.
When these tworatesareequivalent, thedebt is said tobesoldatpar.When the
effective rate is lower than the coupon rate, thismeans the debt is paying out a
higher interest rate than the acceptedmarket rate, so the debtmust be sold at a
premium,orabovethefacevalue.Oppositely,whenthecouponrateislessthanthe
marketrate,itissaidtobesoldatadiscount.Whensoldatpar,noadjustingentries
are necessary. However, when sold at a premium or a discount, these must be
amortizedoverthetermoftheloantobringthecarryingvalueevenwiththeface
value.Thiswillbemorediscussed later.With these terms inmind, thediscussion
willnowturntospecificexamplesofRiteAid’sdebtandtheircharacteristics.
Rite Aid’s Many Forms of Debt Rite Aid’s total debt for fiscal year 2009 is $6,370,899,000. This is made up of
$51,502,000 in currentmaturities of long-termdebt, $6,166,706,000 in long-term
debt, and $152,691,000 in lease financing obligations. This may seem like an
60
excessive amount of debt. This is true, and Rite Aid is not in a good position.
However,moreonthisanalysiswillcomelater.Fornow,afewofthedifferenttypes
ofRiteAid’sloansandtheirrelatingjournalentrieswillbeillustrated.
The first major type of debt to discuss is a 7.5% senior secured note due
March2017.Fromthekeytermsexplanationabove,itisclearthatthisnoteisone
thatisbackedbythecompany’scollateral,andishighontherepaymentprioritylist.
The7.5%denotestherateofinterestthatmustbepaidinreturnforborrowingthis
moneyeachyear.Thisnotehasa facevalueof$500,000. Itwassoldatpar,as its
carryingvaluedoesnotchangefromFY2008toFY2009.Belowisthejournalentry
torecordtheissuanceofthisnote.
Cash
500,000
NotesPayable
500,000
Thisnoteissoldatparvalue,asthereisnopremiumordiscountrecorded,
and no discrepancy between cash received and the face value of the note. Now,
becausethemajorityoflong-termdebtsincludesemi-annualinterestpayments,the
followingentriesmustbedonetwiceayeartorecordpaymentsofinterest.
InterestExpense 37,500
Cash
37,500
Here, the$37,500expensecomes fromthe facevalueof thenote times the
coupon rate multiplied by the fraction of the year that the interest expense is
covering,or$500,000*7.5%*6/12.Thesesemiannualpaymentswilloccuruntil
the timeofmaturity,orMarch2017.Uponretiring thenote, the following journal
entrywouldberequired.
61
NotesPayable 500,000
Cash
500,000
Note:TheremayalsobeanentryforaccruedinterestfromJanuary2017toMarch2017.
Thenexttypeofnoteisaguaranteedunsecurednotewithacouponrateof
9.375%and a face value of $410,000. This note is sold at a discount,meaning its
couponrateislowerthanitseffectiveyield.Thecurrentcarryingvalueofthisnote
is$405,951,meaningthecurrentunamortizeddiscountmakesupthedifference,or
$4,049.Thisisimportantwhenitcomestorecordinginterestexpense.Becausethe
discount has to be amortized over the life of the note to bring it to face value at
maturity, it isreducedduringeveryinterestpayment.Essentially, itraisesinterest
expenseabovetheactualcashpaymentinordertoaccountforthefactthatthenote
was bought at a discounted price from face value. The entry to do so is shown
below:
InterestExpense 39,143
Cash
38,438
DiscountonNP 705
The$38,438cashpaymentiscalculatedbymultiplyingthefacevaluebythe
statedinterestrate($410,000*9.375%).ThediscountonNPisfoundbycalculating
the difference between the unamortized discount fromFY2008 to that of FY2009
($4,754 -$4,049).Thus, combining those twomakesup the total interestexpense
fortheperiod.Usingtheratefunctionofexcel,wefindthattheeffectiveinterestrate
forthisnoteis9.66%.
Thenextnoteunderanalysisisa9.75%seniorsecurednotealsowithaface
value of $410,000, due June 2016. This note, like the previous one,was sold at a
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discount. Inaccounting terms, itwas soldat98.2,or98.2%of the facevalue.The
journalentrytorecordthistransactionisasfollows:
Cash
402,620DiscountonNP
7,380
NP
410,000
Usingtherate functionofexcel,wethenfindthat thisnotehasaneffective
yieldof10.1%.Weusethisinformationtocreateanamortizationtabletoshowthe
schedule and amounts of interest expense and the cash payments and discount
amortizationsthatmakethemup.
Figure8-1
EffectiveInterestRate
Date
Interest
Payment
Interest
Expense
BondDiscount
Amortization
NetBook
ValueofDebt
Effective
Interest
Rate
6/30/09 $- $- $- $402,620 10.12%6/30/10 39,975 40,750 775 403,395 6/30/11 39,975 40,828 853 404,248 6/30/12 39,975 40,915 940 405,188 6/30/13 39,975 41,010 1,035 406,223 6/30/14 39,975 41,115 1,140 407,363 6/30/15 39,975 41,230 1,255 408,618 6/30/16 $39,975 $41,357 $1,382 $410,000
Thetableaboveshowstheamortizationprocessofbringingthenotetoface
value,sowhenitispaidoffatmaturity,therewillbenodiscrepancyonthebooks.
To give an example of how this table translates into journal entries for a given
interestpayment,thefollowingentryforFebruary27,2010isshownbelow:
InterestExpense 27,167
DiscountonBP 517
InterestPayable 26,650
The discrepancy between this interest expense and the one listed on the
tablefor6/30/2010isduetothisbeinganaccrualofinterestatfiscalyearend.In
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other words, the interest owed at the end of February is $27,167, but when the
actualpaymentcomesdueinJune,fourmoremonthswillhavepassed,andthetotal
amountofinterestexpensewillbe$40,750,asshownonthetable.AlsoonFebruary
27,2010,thecarryingvalueofthenotewouldbeequaltotheoriginalcashpurchase
priceplustheamortizeddiscount,or$402,620+$517,whichgivesus$403,137.
Sometimes,companiesuseadifferentmethodtoamortizethediscountona
note payable. This second method is called straight-line amortization, which
essentially involves amortizing it equally over all periods, rather than using an
effectiveinterestmethodshownabove.Thefollowingtableillustratesthisstraight-
linemethod.
Figure8-2
StraightLineAmortization
Date
Interest
Payment
Interest
Expense
BondDiscount
Amortization
NetBook
ValueofDebt
Effective
Interest
Rate
6/30/09 $- $- $- $402,620 6/30/10 39,975 41,029 1,054 403,674 10.19%6/30/11 39,975 41,029 1,054 404,729 10.16%6/30/12 39,975 41,029 1,054 405,783 10.14%6/30/13 39,975 41,029 1,054 406,837 10.11%6/30/14 39,975 41,029 1,054 407,891 10.08%6/30/15 39,975 41,029 1,054 408,946 10.06%6/30/16 $39,975 $41,029 $1,054 $410,000 10.03%
With this method, all interest payment, interest expenses, and discount
amortizations are identical for every period. This seems like a fairway to record
thesetransactions.However,doingsoinvolvesusingvaryingeffectiveinterestrates,
asshownintheEffectiveInterestRatecolumn.Thus, it isgenerallypreferredthat
companiesusetheeffectiveinterestratemethod,thoughifnotmateriallydifferent,
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itisacceptabletousethestraight-linemethod.Tounderstandthedifferencesinthe
twomethods,refertofigure8-3:
Figure8-3
InterestExpenseComparison
Date StraightLine EffectiveInterest Difference
6/30/09 $- $- $-6/30/10 41,029 40,750 2796/30/11 41,029 40,828 2016/30/12 41,029 40,915 1146/30/13 41,029 41,010 196/30/14 41,029 41,115 -856/30/15 41,029 41,230 -2016/30/16 $41,029 $41,357 -$328
Inthisexample,thelargestdifferencebetweenthetwomethodsresultsina
mere$328discrepancy,whichisnotmateriallydifferent.Thereforeeithermethod
is acceptable in this case. However, in other cases, typically involving noteswith
longertermstomaturity,thedifferencescanbesubstantial.Insituationswherethis
isthecase,theeffectiveinterestmethodmustbeused.
RetiringDebtBeforeMaturityUpuntil thispoint, thenotesthathavebeendiscussedwerealldonesounderthe
assumption that they would be held until maturity. However, often times,
companieswill retire theirdebtsbeforematurity,oftendue tochanges in interest
ratesoraneedforfuturecashflows.Theabilitytodosoisgenerallystatedinthe
termsofthenoteasacalloption,meaningthedebtorcanchoosetorepurchaseits
debtatacertaindatebeforematurity.Whenthissituationarises,thereisgenerally
a gain or loss involved for the debtor, depending on the reacquisition costs. For
example, supposeRiteAidwasholdinga9.5%seniornotewith an$810,000 face
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valuedue June2017,butdecided to repurchase thisdebtduring fiscalyear2010.
Assuming a repurchase price of $797,769, the following journal entry would be
recorded.
NotesPayable 810,000
DiscountonBP 8,481
Cash
797,769
Gainonrepurchase 3,750
As shown above, Rite Aidwas not required to pay face value for this note
because it stillhadanunamortizeddiscountbalanceof$8,481.Mentionedearlier,
thereasonforrepurchase isgenerallyduetoachange inthemarket interestrate.
Here,wecanseethatthecurrentmarketrateishigherthanthecouponrate,hence
thediscount.Also,thecurrentmarketrateishigherthantheeffectiveyield,whichis
thereasonthatRiteAidrecordedagainonrepurchase.Therefore,inthiscase,Rite
Aidmadeawisedecisiontorepurchasedebtandmakeasavingsofnearly$4,000.It
isimportanttonote,however,thatthisisnotalwaysthecase.Infact,ifacompanyis
repurchasing debt to free up their cash flows from interest payments and not
becauseofmarketratechanges,itislikelythattheywillincuralossfordoingso.
Anothertypeofdebtthatdiffersfromatraditionalnoteisaconvertibledebt.
Thissimplymeansthatuponmaturity,insteadofreceivingacashpayment,thedebt
holderhasarighttoconvertitsloanintoequityinthedebtorcompany.Aninvestor
mightbeattractedtothistypeofnoteiftheybelievethereispotentialforsignificant
growth instockprices for thedebtorcompany.Asituation like this for thedebtor
companywouldsimplybringadebittothecompany’sliabilitiesandacredittotheir
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commonstock.Dependingonthefairvalueoftheirstock,thereisgenerallyagainor
lossalsoassociatedwiththistransaction.
Ratio Comparison with Industry Now that we have explained various types of debt, we will compare Rite Aid’s
financial position to that of the drugstore industry average. Figure 8-4 includes
commonratiosassociatedwithdebtthatinvestorsusewhenanalyzingthesolvency
andliquidityofacompany.
Figure8-4
RiteAidDebtRatios
Ratio Definition
Industry
Average
RiteAid
FY2009
RiteAid
FY2008
Common-sizeDebt
Totalliabilities/Totalassets 43.8% 120.8% 114.4%
Common-sizeinterestexpense
Interestexpense/NetSales 0.4% 2.0% 1.8%
DebttoassetsTotallong-term
debt/Totalassets
14.4% 76.8% 69.7%
Long-termdebttoequity
Totallong-termdebt/Total
shareholders'equity
26.0% -369.6% -483.6%
Proportionoflong-termdebtdueinoneyear
Totallong-termdebtdueinone
year/Totallong-termdebt
6.1% 0.8% 0.7%
Times-interest-earned(interestcoverage)
(Pretaxincome+interestexpense)/
Interestexpense
3344.0% -1893.5% -884.4%
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Itiscommonforcompaniestohavelargeoutstandingdebt,asthisisamain
sourceoffundsforoperations.However,comparedtotheindustryaverage,RiteAid
hasalargeamountofdebt.Toexplain,let’stakealookatsomeoftheratios.
RiteAid’scommonsizedebtpercentagewas120.8%inFY2009.Thismeans
thattheyhadmoreliabilitiesthanassets,oranegativestockholderequity.Thisisa
very bad sign. Furthermore, their interest expense in comparison to net sales is
nearly six timesmore than the average,meaning thatRiteAid pays out six times
more in interest due to their high levels of debt outstanding. Furthermore, their
times-interest-earnedisnegativeduetotheirlackofincomeproduction.
RiteAid holdsmuchmore debt than the average drugstore. This is a good
indicator of pending bankruptcy. ToRiteAid’s benefit, their currentmaturities of
debtis lessthanonepercentof itstotaldebt,comparedtotheindustryaverageof
over six percent. This means that most of Rite Aid’s debt has longer terms to
maturity,givingthemmoretimetoimprovetheirbusiness,recoverfromnetlosses,
andmakeenoughmoneytorepaytheirdebtswhentheycomedue.
In order to determine a company’s borrowing rate, debtors refer to a
company’sdebtrating.Essentially,thisratingassessesthecompany’sriskinessand
theirabilitytorepaytheirdebts.ThisratingrangesfromDtoAAA,withDbeingthe
lowest,ormostrisky,andAAAbeingthehighest,orsafestrating.Duetohighdebt
ratios, consistent net losses, and negative stockholder equity, Rite Aid’s
creditworthinessratingwouldlikelyrangefromCtoCCC-.Thisisaterriblerating,
consideringthata“junkbond”isconsideredtobeanythingbelowBBB-.However,
givenRiteAid’sperformance,thisratingisfairandreasonablyassigned.
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9.Shareholders’Equity—Merck&Co.,Inc.and
GlaxoSmithKlineplc.ExecutiveSummaryIn thisanalysis,wediscuss themanyaccountsandcharacteristicsofstockholders’
equity. By comparing and contrasting this area of the balance sheet of two
companies,Merck&Co., Inc. andGlaxoSmithKlineplc.,weareable toexplainand
exemplify such accounts, the transactions involved with them, and their overall
effectonthecompany.Furthermore,weexplainthedividenddistributionprocess,
thedifferencebetweenrecordingtreasurystockatcostandatparvalue,andhow
theseinstancesaffectthecompany’sbooks.
When comparing the two companies, a variety of important equity figures
arediscussed.First,weconsiderwhat itmeanstoauthorizestocks, theprocessof
issuingstocks,andhowtocalculatestocksoutstanding.Wealsoexploretheequity
smoothing account of Treasury Stock and examine the many reasons companies
may choose to repurchase this stock from their shareholders. Furthermore, we
discussthemethodofretiringstockandhowthisaffectsthedifferentcategoriesof
stockmentionedabove.
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Finally,havingcomparedthetwocompanies’equitysectionsextensively,we
contrast the accounting methods each company uses. Merck & Co, Inc. is an
Americancompany,thusfallingundertherecordingguidelinesofUSGAAP.GSKon
theotherhand, isaBritishcompanywhoaccounts for theirbusiness transactions
using IFRS. Because of the differing methods, the two show some discrepancies
whenenteringsomeofthesametypesoftransactionsintotheirrespectivejournals.
Thesearediscussedat lengthbeforegivingananalysisof thecompaniesdividend
performance for FY2007. According to this analysis, Merck offered nearly three
times the dividends per share and over five times the dividend yield for its
shareholdersthandidGSK.Amorethoroughanalysisonthesefiguresandmoreis
givenattheendofthisreport.
Shareholders’EquityShareholders’Equityissometimesreferredtoasnetassets.Putsimply,itrepresents
theworthofthecompanywhencomparingallofthethingsthecompanypossesses
(assets) to all of the things it owes to others (liabilities). Themain accounts that
makeupthisportionofthebalancesheetincludeCommonStock,AdditionalPaidin
Capital, Preferred Stock, Retained Earnings, and Treasury Stock (a contra equity
account).Thefirstthreerepresenttheinitialvalueoftheshareholders’ownership
in the company, the second stands for the amount of earnings that have been
accumulatedovertheyears,andfinallythetreasurystockresemblesareductionof
equityviabuyingbackof stock.Therearemanyunique rules to implementwhen
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dealing with different transactions related to these accounts, so a comparison of
Merck&Co.,Inc.andGSKplcwillbeusedtoelaborateonthese.
Merck&Co.,Inc.Merck&Co. Inc.,orMerck forshort, isanAmericanpharmaceuticalcompanyand
one of the largest in the world. According to its financial statements, it has
authorized 5.4 billion shares, meaning that upon its incorporation, the founders
decidedthatthisisthemaximumnumberofsharesofthiscompanythatcanenter
themarket place. As of December 31, 2007, only 2.98 billion had been issued, or
soldtothepublic.Thiscanbeconfirmedbymultiplyingtheamountofsharesissued
bytheparvalueofeachshare,wheretheparvalueisgenerallylessthan$1.Inthis
case, the par value is $.01, sowhenmultiplying this by 2.98 billion, the result is
$29.8million,whichistheamountofCommonStocklistedonthebalancesheet.
In addition to authorized, and issued shares, a company can also have
treasury stock,mentionedabove,which represent sharesof stock thata company
has bought back from its shareholders. Merck, as of the end of 2007, held 811
million treasury shares. Treasury shares are usually accounted for using the cost
method,whichwillbediscussedlater.However,treasurysharesreducethenumber
ofsharesoutstanding,whichhasaneffectondividendpaymentsandearningsper
share. To calculate shares outstanding, simply take shares issued and subtract
treasuryshares.Indoingso,thedifferencecomesto2.17billionsharesoutstanding.
Withthenumberofsharesoutstandingknown, thetotalmarketcapitalizationcan
be calculated. Essentially, market capitalization represents the total value of all
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outstanding stock for a given company. Therefore, it is calculated bymultiplying
current stockpriceby thenumberof sharesoutstanding. ForMerck,with a stock
price of $57.61 as of December 31, 2007, themarket capitalization equaled $125
billion,averyimpressivenumber.
These are basic facts and figures regarding Merck’s common stock. More
regardingthiscompanyanditsequityactivitywillbediscussedafteranalyzingGSK.
GSKplc.GlaxoSmithKline, or GSK, is a British Pharmaceutical company that, likeMerck, is
alsoamongoneofthebiggestintheworld.Havingalreadydefinedamajorityofthe
following terms, we will proceed to give GSK’s stock information in a curtailed
manner.ForGSK,10billionshareswereauthorized—nearlydoublethatofMerck.
AsofDecember2007, totalshares issuedequaled6.01billion.However,only5.37
billionwere free issued, the equivalent ofGAAP’s shares outstanding. Thismeans
thatthedifference,approximately604million,washeldintreasury.
BecauseGSKisaBritishcompany,someoftheaccountingterminologyused
in their financial statements differs from that of Merck, as seen with “free issue
shares.” Two terms that fall under this discrepancy are share capital and share
premium. Share capital is essentially the equivalent of a Common Stock account;
thatis,theparvalueofsharesissued.SharepremiumisthesameasPaidInCapital
inExcessofPar,whichwasbrieflymentionedabove.Tounderstand this account,
refertothefollowingexample.SupposeCompanyXwouldliketoissue1,000shares
withaparvalueof$1.However,becauseparvalue issimply theminimumselling
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price,CompanyX isgoing to issue theseshares for$10each.Thismeans that the
totalCommonStockwouldequal1,000x$1or$1,000,whiletheremaining$9,000
from the transactionwouldbe recorded intoPaid InCapital inExcessofPar. It is
clearfromthisexamplethatthisPaidInCapitalaccountissimplyaplacetorecord
thedifferenceinproceedsbetweenparvalueandmarketvalue.Next,thepaperwill
discussthepaymentofdividends,anotherimportanttransactionaffectingequity.
DividendsAdividend isadistributionofearnings the shareholders,or sometimesofPaid In
Capital if profits are low. Companies pay dividends to show good faith to their
investors,and togive themanacceptablereturnon their investment.Stockprices
generally decrease immediately after a dividend is paid, as investors understand
theyhavemissedoutontherecentdividend.
Both Merck and GSK paid dividends in 2007. The following entries for
dividenddisbursementfromthesecompanieswereasfollows.
Merck(in$)DividendsDeclared 3,310,700,000
Cash
3,307,300,000
DividendsPayable
3,400,000
GSK(in£)DividendsDeclared 2,793,000,000
Cash
2,793,000,000
Quickanalysisof the twoshows thatMerckdeclareda largerdividend,yet
didnotpayallof it in2007.This ispossiblydueto lackofcashavailableorsome
other liquidity issue. While it may seem that GSK is the better company for not
73
leaving any shareholders waiting on their dividends, it is important to note that
underIFRS,theiraccountingstandards,dividendsareonlyrecordedwhentheyare
physically paid out. This means that it would be impossible for GSK to have a
dividends payable balance. Also worth noting, this Dividends Declared account
would be closed out at the end of the year by crediting Dividends Declared and
debiting Retained Earnings. In fact, it is acceptable to debit retained earnings
initiallywithouteverrunningthemoneythroughadividendsaccount.
TreasuryStockThe last significant account in Shareholders’ Equity is the contra equity account,
Treasury Stock. Treasury Stock, or shares repurchased by the company, is often
boughttofreeupfuturecashflowsfrompayingdividends,tomakethecompany’s
return on equity more appealing, to increase earnings per share, or to resist a
takeover.ThoughTreasuryStockisoftenboughtwithcash, it isnotconsideredan
asset. It simply takes on a role similar to unissued stock. Merck and GSK both
purchasedlargeamountsofTreasuryStockin2007.Herearethefactsandfigures
involvedinthesepurchases.
Merckrepurchased26.5millionsharesin2007,paying$1.43billionintotal,
or $53.95 per share. This represents an outflow in financing activities on the
statement of cash flows. The journal entry to record this would involve debiting
TreasuryStockandcreditingCash.TreasuryStockisgenerallyrecordedatcostand
nettedagainstShareholders’Equity.However,itcanalsoberecordedatparvalue,
whichwouldinsteadreduceonlytheamountofCommonStockoutstanding.
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GSKrepurchasedasignificantlyhigheramountofshares,equalingover285
million.Oftheseshares,only269millionwereheldintreasurywhiletheremaining
shareswere retired, or removed from the total shares authorized. GSK paid over
£3.7 billion to repurchase these shares, putting the average share price around
£13.09. Informationregardingthisequitytransactionandothersmentionedabove
were found in the Movements in Equity statement. For Merck, who follows U.S.
GAAP,theequivalentstatementwouldbeStatementofStockholders’Equity.
AnimportantfactortodistinguishbetweenGAAPandIFRS,asportrayedby
thesetwocompanies,isthatGAAPrecordsTreasurySharepurchasesintoanactual
TreasuryStockaccount,whileIFRSdirectlyreducesRetainedEarningsandholdsno
suchaccount.
RatioAnalysisNowthat theEquitysectionsof these twocompanieshavebeen fullydiscussed, it
maybe interesting to compare the two in termsofdividendactivity to seewhich
company would be the better investment. The Figures 9-1 and 9-2 provide this
information.
Figure9-1
KeyFinancialFigures2007InMillions Merck Glaxo
DividendsPaid $3,307 £2,793.00SharesOutstanding 2,173 5,374NetIncome 3,275 6,134TotalAssets 48,351 31,003OperatingCashFlows 6,999 6,161Year-endStockPrice $58 £97.39
75
Figure9-2
DividendAnalysis2007
Merck Glaxo
DividendsPerShare $1.52 £0.52DividendYield(dividendspersharetostockprice) 2.6% 0.5%DividendPayout(dividendstonetincome) 101.0% 45.5%DividendstoTotalAssets 6.8% 9.0%DividendstoOperatingCashFlows 47.3% 45.3%
This table shows that Glaxo’s stock price and shares outstanding are far
superiortothatofMerck.However,Merckpaidoutmoredividendsandpossessed
moreassets.Furthermore,Merckexperiencedhigheroperatingcashflowsdespitea
lower net income. Perhaps it is these cash flows, which provided for higher
dividends. The following table compares dividend factors between the two
companies.
In 2007, Merck clearly dominated in the area of dividend distribution.
DividendspershareforMerckwerenearlythreetimesthatofGlaxo.Furthermore,
the dividend yield and dividend payout ratio for Merck far surpassed Glaxo’s.
BecauseGlaxoholdssignificantlyfewerassetsatthispointintime,theyhadahigher
Dividends-to-TotalAssets ratio.However, this is irrelevantwhen comparing all of
the other statistics listed on this table. It is likely that Merck paid out more
dividends than income tomaintain itsprioryeardividendpershare.Nonetheless,
investors inMerckreceivedmuchhigherreturnsthanthose inGlaxo for the fiscal
year2007.
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10.MarketableSecurities—StateStreetCorporation
ExecutiveSummaryInthisanalysis,wediscussthethreetypesofinvestmentsecuritiesthatacompany
may hold. These include securities that are trading, available-for-sale, or held-to-
maturity. Using State Street Corporation as a realworld example,we analyze the
effects of these securities from the standpoint of the P&L statement, the balance
sheet,andthestatementofcashflows.Eachofthesehasitsownimportantrolein
the company’s investment activities. In this discussion, we delve thoroughly into
eachoftheseroles.
An important element to consider when accounting for these securities is
howtoreporttheirvaluefromyeartoyear.Giventhatmarketconditionsfluctuate
frequently,itisessentialthatthecarryingvalueofthesesecuritiesreflectsthat.For
tradingsecurities,investmentsthatareboughtandsoldtypicallywithinaveryshort
period,allchangesinvaluemustbereflectedintheircarryingvalueonthebalance
sheetandreportedasanunrealizedholdinggain(loss),thusincreasing(decreasing)
netincomefortheperiod.Thesamegoesforavailable-for-salesecurities,withone
exception. Rather than increasing (decreasing) net income, the fair value
adjustments for these securities are reported as other comprehensive income.
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Unliketheprevioustwo,held-to-maturitysecuritiesdonotneedtobeadjustedfor
changesinfairvalue,astheseinvestmentsareessentiallylocked-inuntilthetimeof
maturity.Withthatsaid,itisimportanttorecordagain(loss)onthesesecuritiesat
thetimeofsale—thesamegoesfortradingandavailable-for-salesecurities.
Asthesethreesecuritiesareclassifiedasinvestments,theyhaveaneffecton
the investingsectionofacompany’sstatementofcash flows.Forsomecompanies
whosemainoperationsdealwithfinancing,banking,orinvesting,thesecashflows
willtypicallybemuchmoresignificantthanthatofacompanyinanotherindustry
i.e.manufacturing. A couple things are important to remember. Gains (losses) on
changes invalueof tradingsecuritiesmustbetakenoutofnet income—operating
activities—and reported in the investment section. Gains (losses) on fair value
adjustmentsforavailable-for-salesecuritieswillhavenoeffectonthecashflows,as
theyarereportedinothercomprehensiveincome.Finally,allgains(losses)onthe
saleofanyofthesesecuritieswillhaveaneffectthestatementofcashflows.Aswe
sawwithStateStreet,thesetypesofactivitiescaneitherfreeupalotofcashforthe
company,orcauseamajorrestriction.
StateStreetBank In order to efficiently use excess cash to supplement income from operations,
companies often invest in either debt or equity securities. These investments can
varyinsize,type,andcharacteristics.However,therearethreemaincategoriesthat
these fall into: trading securities, securities held-for-sale, and securities held to
maturity. In order to discuss each of these investments and distinguish between
78
them,wewillanalyzeStateStreetBank,afinancialinstitutionwhosebalancesheet
ismadeupofmostlythesesecurities.First,wewillbeginwithtradingsecurities.
Trading Securities Trading securities, on a very basic level, are investments purchased with the
expectations of making a quick profit from short-term price changes. These can
consistofbothdebtandequitysecurities.Whilebeingheldinhopesofprofitfrom
capitalgain,thesesecuritiescanalsoprovideinterestordividendincome.Reported
inOther Incomeon theP&L, the journalentry to recordonedollarof this typeof
incomeisasfollows:
Cash 1Interest(Dividend)Revenue 1
Astheirdefinitionsuggests,theseinvestmentstypicallyhaveahighturnover
rate,which hardly allows them to bring in excessive amounts of income. For this
reason, companiesgenerallyholdasmallerproportionof thesecompared to their
total investments. State Street Corporation’s balance sheet exemplifies this. Their
balance for Trading Account Assets is a $637 million. This may seem like an
exorbitant amount; however, for a financial institution whose total assets are
upwardsof$222billiondollars,thisisasmalldropinthebucket.
An important fact toknowabout thesesecurities is that theyarecarriedat
fairvalue.Becausetheyarefrequentlyboughtandsoldinthemarket,itonlymakes
sense to keep them up-to-date with the current prices. When making such
adjustments, the company would record an unrealized holding gain or loss
79
equivalent to the change in the asset’s fair value for the period. For a one-dollar
increaseinfairvalue,thefollowingjournalentrywouldneedtooccur.
FairValueAdjustment-Trading 1UnrealizedHoldingGain 1
Thisfairvalueadjustmentaccountwouldbeatemporaryaccount,servingas
anadjunctorcontraassetaccount,dependingonthemovementsinthemarket.The
unrealizedholdinggainwouldbecarried in theequity sectionuntil theassetwas
sold,inwhichcasetheunrealizedholdinggainaccountwouldbedebited,andagain
on disposal accountwould be credited for the difference between purchase price
and selling price. The same process would be done for unrealized and realized
losses.
To use State Street’s activities as an example, we might assume that the
unadjustedtrialbalancefortradingaccountassetscouldhavehadadebitbalanceof
$552millionat year-end.Given that these securitieshaveamarketvalueof $637
million,therequiredentrywouldbeasfollows.
FairValueAdjustment-Trading 85,000,000UnrealizedHoldingGain 85,000,000
With this entry, the assets would be properly reported, and State Street would
experiencean$85millionboosttowardtheirnetincome.
HeldforSaleSecuritiesSecurities that areavailable/held for saleareessentially ina catchall category for
those that are not considered trading securities but that will also not be held to
maturity.Anexampleofthismayincludeanequitysecuritypurchasedinhopesof
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long-term appreciation, or perhaps a twenty-year bond purchased with
expectations of the interest rates falling in the next five years, thus potentially
creating capital gains. Securities held for sale can provide dividend or interest
revenue, which would be recorded identically to that of trading securities.
Furthermore, these too should be carried at fair value; however, because of their
semi permanent nature, any unrealized holding gains or losses should not be
consideredintheIncomeStatement.Rather,thesefluctuationsshouldberecorded
as Other Comprehensive Income and as a separate component of Shareholders’
Equity.Asamplejournalentrycouldbethefollowing:
FairValueAdjustmentAFS 1UnrealizedHoldingGain--Equity 1
For State Street Corporation, the ending balance of these securities is
significantly greater than that of the trading securities. With a carrying/market
value of nearly $110 billion, these securities have experienced significant price
increases during the past year. According to the note accompanying investment
securities, thegrossunrealizedholdinggains forallsecurities in thisclassification
was approximately $2 billion while the unrealized holding losses experienced by
these typesofsecuritieswasamere$882million.Thismakes thenextunrealized
gain,andthustotalshareholders’equity,increasebyover$1.1billionin2012.
In addition to this unrealized gain, State Street also sold a number of
Available-for-sale securities. These disposals resulted in gains of $101million, as
wellaslossesof$46million,nettingatagainof$55million.Thisgainwouldinfact
be reported on the income statement. However, in a statement of cash flows, the
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gainondisposalwouldbesubtractedfromtheoperatingsection,andaddedtothe
investingsection.Thisisbecausethistransactionisconsideredaninvestingactivity
rather than one of the company’s operations. However, for State Street, this
differentiationseemstobelessintuitive,asoneofthecompany’smainoperationsis
investing.
SecuritiesHeldtoMaturity The final type of investment involves securities held to maturity. For obvious
reasons,equitysecuritiescannotfallunderthiscategory,astheyhavenomaturity
date.However,assets likebonds,mortgages,notesreceivable,andother loanscan
allfallintothiscategory.
Thesesecurities,becausetheyarehelduntilmaturityatagiveninterestrate,
experiencenogainsorlossesinvalue,andthusarecarriedatthebookvaluefrom
theoriginal transaction.Ofcourse, theseassetscouldhaveapremiumordiscount
attached to them, depending on their interest rate relative to that of themarket.
This extra premium (or less discount) would be amortized over the life of the
security,beingreducedwitheachreceiptofinterestrevenue.StateStreetrefersto
these assets’ carrying value, or the net value of the investment and its
correspondingpremiumordiscount,astheiramortizedcostamount.
The amortized cost amount for State Street’s held tomaturity securities is
$11.38billion,while themarketvalue for these sameassets is $11.66billion.The
difference between these two values represents the gain that State Street would
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incuriftheyweretosellthesesecuritiesatfairvalue.Thisincreaseinpriceislikely
derivedfromadecreaseininterestrates,asthetwohaveaninverserelationship.
In the case that StateStreetneeds to increase their cash flowsor liquidate
entirely, these assets may be sold. However, it is generally in a company’s best
interest to hold on to these investments and receive their interest payments,
assuming major fluctuations in the market interest rate have not caused drastic
pricechanges.
StatementofCashFlows
Whenanyofthesesecuritiesaresoldorpurchased,theeffectsaregenerallyseenon
thestatementofcashflows.Duetothenatureoftheseassets,thesecorresponding
cash flows canbe foundon the investing sectionof this statement.Formostnon-
financial companies, the amount of cash used or provided by the sale of these
investmentsmightnotbeassignificantas,say,sellingoldmachinery.However,for
StateStreet,afinancialcompany,thetransactionsrelatingtoinvestmentsecurities
arequitelarge.Thiscanbeseenthroughananalysisofthiscompany’sStatementof
CashFlows.Accordingtothisstatement,StateStreetpurchasedover$60billionof
available-for-saleinvestmentsecuritiesin2012.Belowisthecorrespondingjournal
entry.
InvestmentSecuritiesAFS 60,812,000,000Cash 60,812,000,000
Thisisamajorcashoutflowproportionaltothebusiness,astotalassetsfor
State Street are around $222 billion. If these assets fail to meet their yield
expectations,thiscouldbedevastatingforthecompany.
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Inadditiontothislargepurchase,StateStreetalsosoldaround$5billionin
these typesof securities.Thereareacoupleof interestingelements involvedwith
thisjournalentry,however.First,inordertoselltheseassets,theymustbewritten
back to original cost, or historical book value. Thus, the asset would need to be
credited for itscurrent fairvalue,and theunrealizedholdinggainsaccountwould
need to be debited. This results in a net credit of the asset’s historical cost. Also,
there will generally be cash associated with the purchase, unless it is traded for
anotherasset,andtheremaybeanadditionalgainorlossonthesale.Thegainfrom
salewouldbe included innet income for theperiod.The journalentrybelowwill
demonstratetheexplanationabove.
Cash 5,399,000,000UnrealizedHoldingGains 67,000,000InvestmentSecuritiesAFS 5,411,000,000GainfromSaleofSecurities 55,000,000
This entry depicts the investing activities providing cash flows in a very
generalsense.Wecanusethisentrytodeterminetheoriginalcostofthisasset.As
mentionedabove, ifwetakethenetdifferencebetweentheInvestmentSecurities’
fairvalueatthetimeofthesaleanditsunrealizedholdinggain,wewillfindthatthe
historical cost for this investment was $5,411,000,000 - $67,000,000 =
$5,344,000,000. (If the asset had a balance in unrealized holding losses, then the
originalcostwouldbe foundwiththesumof the fairvalueandtheamount inthe
lossaccount.)The$55milliongainfromsaleisderivedfromthedifferencebetween
thecashreceivedandthehistoricalcostofthisasset.
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The following T account helps demonstrate State Street’s activity for 2012
regardingheld-for-salesecurities.
NetUnrealizedHoldingGain(loss)onAFSSecurities
181,000,000 67,000,000
1,367,000,000 1,119,000,000
Thistablecanbeexplainedwiththreeevents.Thefirst,isthat$181,000,000
simplycomesfromtheendingbalancein2011.Thedebitof$67,000,000wasshown
above during the sale of securities. The credit of $1,367,000,000was done as an
adjustingentryatyear-endtobringthesecuritiestofairvalue.Thejournalentryfor
thisadjustmentwasasfollows.
FVAdjustmentAFS 1,367,000,000UnrealizedHoldingGain 1,367,000,000
Thus, the ending balance is $1,119,000,000, which can be reconciled with
theirnoteson InvestmentSecurities.Thisadjustmentwouldhavenoeffecton the
Statement of Cash Flows. This is because changes in fair value for securities
available-for-salearereportedasOtherComprehensiveIncome,notNetIncome.
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11.RevenueRecognition—Groupon
ExecutiveSummaryIn thisanalysis,wediscuss themajor implicationsof recognizing revenueand the
risksassociatedwiththistopic.Weassesstheserisksatanindustrywidelevelfor
retailcompaniessuchasWalmart,Amazon,andGroupon.Thisinvolvescomparing
and contrasting theirbusinessmodels andexperiencesandhow thesedifferences
affectthelevelsofrisktheyexperience.
Furthermore, we delve into an analysis on revenues vs. stock prices and
attempt to derive trends from Amazon’s financial position regarding these two
items.Lookingatoveradecadeofdata,wedrawaconclusionthatstockpricestend
to bemore positively correlatedwith revenues thanwith net income.We further
discusspossiblereasonsforthiscorrelation.
Finally,wereviewsomeoftheaccountingerrorsthatGrouponmadeduring
its first few years as a public company. We go into the criteria necessary for
reporting gross revenue versus a simple reporting of net revenue. We then
elaborate on the necessity for allowance accounts to bring revenue to a more
accurateamountwhenaccountingforrisksofreturneditems.WeshowGroupon’s
faultyreasoningrelatingtothistopicandhowitaffectedtheirfinancialstatements.
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Lastly,wediscusshowitispossibleforreportingcorrectionstosignificantlyreduce
acompany’srevenueandnetincome,allwhilehavingzeroeffectontheirstatement
ofcashflows.
RevenueRecognition Oneof thebiggestriskareas inacompany’s financialstatements is theamountof
revenuetheyrecord.Thenumberofrulesandexceptionsforproperlyrecordingthe
amount of sales a company truly completed can create gray areas, which the
companiesoftentimestrytoexploit.Inthisanalysis,wewillfocusonGrouponand
its revenue recognitionmethods,while also touchingonother companies and the
riskstheyfaceinrelationtothistopic.Furthermore,wewillincorporateananalysis
oftheeffectofreportedrevenuesonacompany’sstockpricesbyshowingtrendsin
the amounts of these respective items for Amazon.We use Amazon in this case,
rather thanGroupon, as their shares havebeen trading on the openmarket for a
muchlongertimethanthatofGrouponandwill,therefore,provideamorethorough
analysisofthisrelationship.
Industry-wideRisksBefore delving in to the various issues that Groupon experienced with revenue
recognition,itisimportanttofirstgiveanoverallviewoftherisksthatcompaniesin
this industryfacewhenrecordingrevenue.Toillustratethis,wewilldiscussother
companiesintheretailbusinesssuchasWal-MartandAmazon.
First,wemustdistinguish thebusinessmodelsof eachof thesecompanies.
Wal-Martisinthebusinessofsellingproductsdirectlytotheircustomersviaretail
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centers.Amazonalsosellsproductstotheircustomers,thoughitiscompletelyweb-
basedandholdsallofitsinventoriesinwarehouses.Grouponholdsnoinventories,
but rather sells its customers the rights to buy products from other vendors at
discounted prices. With the differing strategies and experience between each of
thesecompanies,risklevelsvarygreatly.Nonetheless,thereareseveral itemsthat
mustbetakenintoconsiderationbeforefilingtheyear-endfinancialstatements.
Wal-Mart has been in business a lot longer than the other two companies.
However, it continues to face the threat of over reporting its sales and thus
misleadingitsinvestors.Wal-Mart,liketheothercompanies,musttakeintoaccount
anumberofelementswhendecidingwhatthetoplineofitsincomestatementcan
include. In fact, each of these companies has a number of risk factors in common
that its internalcontrolsmustconsider.Theseincludethefollowing:salesreturns,
baddebtexpenses,andevensystemfailures.
According to GAAP, whose official standards will be discussed later,
companies must account for returns of their products and incorporate this
allowanceintoareductionoftheirrevenue.Inotherwords,thesecompaniescannot
record100%of their salesasprofit if theyhaveaprovenhistoryof receivingsay
15%of their itemsreturned.Therefore, theymust take this intoconsideration.Of
course, forWal-Mart, this estimatemaynot benearly as difficult to produce as it
would for Groupon who is constantly growing and reaching uncharted territory.
Amazon’suncertaintywouldlikelyfallintothemiddleofthesetwocompanies,asit
has established a solid inventory base. However, as it continues to offer an
increasingnumberofproducts,thenewitemswillcallfornewestimates.
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Thesamecanbesaidforbaddebtsandsystemfailures.Therewillalwaysbe
customerswhobuyitemsoncreditandfailtopayforthem,muchliketherealways
be malfunctions in technology that could cause a failure to record an item that
shouldhavebeencountedassold.Ofcourse,ascompaniesworkto improvethese
systems,thisriskbecomesincreasinglysmaller.
RevenuesandStockPrices
We have briefly discussed how recognizing revenues correctly can have a major
impact on a company’s financial statements. We have yet to discuss why this is so
important. In order to understand the significance of this topic, we must consider the
users of these financials: stockholders. Stockholders, or investors, rely on a corporation’s
financial statements to determine if the company is a good investment or one to avoid.
With that said, one of the most important items that these investors use in their analysis is
the total revenue. It is this number with which they calculate intrinsic values of the
companies’ stock prices, so they must be reliable. The analysis on the next page shows
trends for Amazon’s revenues and stock prices for the years 1997-2010.
In this analysis, net income is also included in an effort to show whether investors
put more significance on earnings rather than gross sales. According to this chart, there
are several years—1998, 1999, 2007, 2009, and 2010—where stock prices and revenues
both increased, despite reductions in net income. With this in mind, it is clear that there is
a stronger correlation with stock prices and revenues than that of stock prices and net
income. This is relevant because it brings us back to the fact that recognizing revenues
correctly is essential for servicing the stock market fairly.
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Figure11-1
Amazon
RevenuesVsStockPrices
ReportedonDecember31from1997to2010
Year Revenue%
Change
Net
Income
%
Change
Stock
Price
%
Change
1997 $148 $(31) $5.0 1998 610 312.2 (125) -303.2 53.5 966.51999 1,640 168.9 (720) -476.0 76.1 42.22000 2,762 68.4 (1,411) -96.0 15.6 -79.62001 3,122 13.0 (567) 59.8 10.8 -30.52002 3,933 26.0 (149) 73.7 18.9 74.62003 5,264 33.8 35 123.5% 52.6 178.62004 6,921 31.5 588 -1580.0 44.3 -15.82005 8,490 22.7 359 38.9 47.2 6.52006 10,711 26.2 190 47.1 39.5 -16.32007 14,835 38.5 476 -150.5 92.6 134.82008 19,166 29.2 645 -35.5 51.3 -44.62009 24,509 27.9 902 -39.8 134.5 162.32010 $34,204 39.6 $1,152 -27.7 $180.0 33.8
Groupon’s Dilemma As we discussed above, there can be some major gray areas involved when it comes to
reporting revenues. Groupon capitalized on one of these gray areas, resulting in largely
overstated revenues for FY2009 and FY2010. Before discussing their errors in reporting,
let us first detail the operational flow of Groupon’s business.
Groupon works with vendors around the country to sell coupons for discounted
services or products from such vendors. For example, Groupon may have an offer for a
customer to buy a $20 groupon that is redeemable at their local barbershop for a $40 hair
cut. So, the customer would exchange their $20 dollars with Groupon and get this
voucher in return. Groupon would then remit $12 (60%) to the vendor and retain the
remaining $8.
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Groupon’s problem was that, in reference to the previous example, they were
recording $20 as revenue instead of the $8 that they actually retained. This led to severe
overstatements of revenue. Before discussing the SEC’s comments on such reporting, we
will first look at the effects this method of reporting had on Groupon’s financial
statements.
Figure11-2Groupon
CommonSizeIncomeStatementForYearsEnded2009&2010
2009 2010 Gross Net Gross NetRevenue 100% 100% 100% 100%CostofGoodsSold 64.1 30.3 60.7 10.4GrossProfit 35.9 69.7 39.3 89.6MarketingExpense 15.1 33.8 36.9 90.9GeneralandAdmin.Expense 24.7 44.1 32.8 68.2OtherExpenses
28.5 64.9
NetProfit(Loss) -4.4 -7.5 -57.9 -134.3
When evaluating this common size income statement, we can see that
Grouponexperiencedamajorshiftintheweightoftheirexpensesasatotaloftheir
overallrevenues.Thisessentiallymeansthatreportinghigherrevenuesmadetheir
expensesseemmuchlessburdensomethantheydidunderthenetmethod.Inother
words,althoughbothmethodsresultinthesamenetincome,beginningtheincome
statementwithhigherrevenuesgivestheappearancethatthecompany’sexpenses
andlossesweremuchlessseverethantheywereinactuality.
Another comparison to consider is the profitability and activity ratios that
weremajorlyaffectedbythiscorrectioninreporting.Thetablebelowshowsratios
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forGrossMarginandAssetTurnoverforthetwoyears,includingthoseunderboth
thegrossandnetmethods.
Figure11-3Groupon
ProfitabilityandActivityRatioComparison
2009 2010 Gross Net Gross NetGrossMarginPercentage 35.9% 69.7% 39.3% 89.6%AssetTurnoverRatio 2.0 1.0 3.6 1.6
Eventhoughthisreportingcorrectionresultedinmuchlargerprofitmargins,
theassetturnoverforbothyearswasreducedbynearly50%.Thismeansthatthe
companymay have had a lower cost of sales, but theywere using their assets to
generateincomeinaveryinefficientmanner.
QuestioningbytheSECIn order tomore fully understand the common size income state on theprevious
page,letusgivesomeactualfiguresforthedifferencesintheirrevenues.Originally,
GrouponreportedTotalRevenuesof$30.4millionin2009,whentheyshouldhave
reported$14.5million.Similarly, in2010,Grouponclaimedtohave$713.4million
inrevenues,whilethetrueamountofthisnumberwasmorelike$312.9million.
Iftheirnetincome(loss)wouldultimatelybethesame,whywouldGroupon
choose to report their revenues in this manner?We answered this earlier when
analyzingAmazon:stockprices.Becauseinvestorsoftentimesuserevenueasabase
for their valuation models, the higher this number, the more likely for the
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company’sstocktoincreaseinvalue.Therefore,itisclearthatGrouponpreferredto
reportrevenuesthatwereaslargeaspossible.
When the SEC began to question their methods of recording all of the
revenue, despite the obligation to remit 60% to the vendor, Groupon responded
withanattempttojustifytheirapproach:
TheCompanybelievesthat,byvirtueofthecreditriskitbearsandtheGrouponPromise, it is both a seller and an issuer of vouchers. The Company is theprimary obligor when it issues a Groupon voucher on behalf of a merchant,whichinturnissolelyresponsibletodelivergoodsorperformservices.Here, Groupon claims that the risk they take by offering a largely encompassing
return policy should give them the rights to claim all of the revenue as their own.
However, according to the ASC 605-45-45, there are flaws in their argument. Key
qualifications for reporting gross revenue under this standard require that: the entity
“(4)changestheproductorperformspartoftheservice,(5)hasdiscretioninsupplierselection,(6)is involvedinthedeterminationofproductorservicespecifications,(7)hasphysicallossinventoryrisk—aftercustomerorderorduringshipping.”
When assessing the business model of Groupon and their method of
operations, it is clear that they donot change the product or performpart of the
service,nordotheychoosethesupplier,getinvolvedintheservicespecifications,or
take on risk of physical inventory loss. In fact, their only risk is refunding the
customerswhen they are dissatisfiedwith a product. Therefore, Groupon did not
meetthequalificationstorecordgrossrevenue.
OtherReportingIssuesIn addition to recording gross revenue, Groupon also recorded 100% of sales,
withoutadequatelyaccountingforsalesreturns—ariskwediscussedthatWal-Mart
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andAmazonalsofaced.Thisledtoseverereportingissues,whenvoucherstheyhad
sold inpriorperiods, and recordedas revenue,werebeing returned for a refund.
This was a result of Groupon’s expansion into a new market, selling high-ticket
items,suchasvouchersforLasikeyesurgery.Whenitwasdiscoveredthatmanyof
the customers who purchased this voucher were not physically eligible for the
surgery, they allwanted a refund of theirmoney. Groupon had been unable, and
thusfailed,toaccountforsuchahighlevelofreturns.However,theyrecordedthe
revenueson thesepricy items, andexperiencedquite adisasterwhenall of these
customerscamebackdemandingtheirmoney.
According toU.S. GAAP inASC 605-15-25, revenue can only be recognizedwhen:
“The amount of future returns can be reasonably estimated (see paragraphs605-15-25-3 through 25-4). Because detailed record keeping for returns foreach product line might be costly in some cases, this Subtopic permitsreasonableaggregationsandapproximationsofproductreturns.Asexplainedin paragraph 605-15-15-2, exchanges by ultimate customers of one item foranotherofthesamekind,quality,andprice(forexample,onecolororsizeforanother)arenotconsideredreturnsforpurposesofthisSubtopic.”
Because Groupon was in this newmarket, which with they were unfamiliar and
couldnotreasonablyestimatetheirsalesreturns,theyshouldnothaveimmediately
recognizedrevenueon thesaleof these items.Rather, theyshouldhavecreateda
largerreturnsandallowancesaccount,thusreducingtheirtotalsalesrevenue.
UnchangingCashFlowsAn item that we have not discussed in this analysis is the effect of all of these
reportingerrorsonthecompany’sstatementofcashflows.Surprisinglyenough,the
totalcashflowsfortherestatementofincomein2011—areductionof$14.3million
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in revenueandaneven largerdecrease inoperating incomeof$30million.These
reductions came from the implementation of larger reserve accounts for these
returns. In essence, Groupon just reduced their revenues by debiting an expense
accountandcreditingatypeofpayable,orliabilityaccount,fortheinevitablecash
outflow that would arise from such returns. However, as these returns were not
experienceduntilthefollowingyear,noadditionalcashoutflowswereexperienced,
even when the corresponding revenues and net income were required to be
reduced.
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12.CurrentandDeferredIncomeTaxes—ZAGGInc.
ExecutiveSummaryThemain topic for this discussion is accounting for deferred taxes. Be it a larger
corporationorasmall,familybusiness,thepaymentofincometaxesisrequiredby
all. Thus, it is important to be able to compute differences in book income and
taxableincome.Thisanalysisattemptstoexplainsuchcomputationsandhowthey
affectacompany’sbooks.
Using ZAGG Inc., a mobile device accessories company, we explore the
differentcumulativedifferences invariousaccountsthatgiverisetotherecording
ofdeferredtaxassetsanddeferredtaxliabilities.Wethenworkanoppositeangleby
showing methods of computing cumulative differences by using the deferred tax
balanceandthetaxrate.
Finally, we discuss the potential issues that can result from changes in
Federaltaxrates.Wealsoshowhowtoadjustthedeferredtaxaccountsaccording
to these tax rate changes in order to accurately report the expected benefits or
expensesfromtheseDTA’sandDTL’s,respectively.
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BookIncomevs.TaxableIncome Bookincome,alsoknownasPretaxFinancialIncome,istheamountofincomefrom
continuing operations that companies report on their income statement before
including a provision for income taxes. Taxable income, however, is the excess of
revenuesoverexpensesthat the IRSrecognizesas taxable for theyear.Thesetwo
amounts are almost never equal due to varying factors. Because of this, special
accountingmethods exist for recording these deferred taxes.Wewill analyze the
financial statements of ZAGG Inc. to further explain current and deferred income
taxes.
KeyTermsforUnderstandingDeferredTaxesBefore exploring ZAGG’s financial performance for fiscal year 2012,wemust first
defineafewimportanttermsthatwillbeusedinourdiscussion.Theseinclude:
1) Permanent tax differences-- a business transaction that is reporteddifferently for financial and tax reporting purposes, and for which thedifferencewill never be eliminated. A permanent difference that results inthe complete elimination of a tax liability is highly desirable, since itpermanentlyreducesthetaxliabilityofabusiness.Somecommonexamplesinclude:i) InterestRevenueonMunicipalBondsii) Finesorfeesforbreakinggovernmentregulationsiii) Expensesincurredtoattainnon-taxableincome
2) Temporarytaxdifferences—arisewhenthetaxbasisofanassetorliability
differs from the reported amounts in the financial statements. In otherwords,an incomeorexpense item isrecognized inoneyearon the incomestatementandanotheryearonthetaxreturn.Somecommonexamplesare:i) Differentmethodsofdepreciationii) Unearnedrentiii) Warrantycostsiv) Installmentsalesv) Prepaidinsurance
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3) Statutory tax rate--Under the federal income tax, the statutorycorporatetaxraterangesfrom15percentonthefirst$50,000oftaxableincometo35percentonincomeover$18.3million,withhigherrates(upto39percent)insome income ranges that phase out the benefits of the lower rates. Mostcorporateincomeistaxedatthe35percentrate.
4) Effective taxrate--Theeffectivetaxrateforindividualsistheaveragerateatwhichtheirearnedincomeistaxed.Theeffectivetaxrateforacorporationis the average rate at which its pre-tax profits are taxed. An individual'seffective tax rate is calculated by dividing total tax expense by pretaxfinancialincome.
Of these terms, the single most important to understand is temporary
differences, as thesewill give rise todeferred tax assets (DTA’s) anddeferred tax
liabilities (DTL’s). These amounts of deferred taxes are included in the reported
incometaxexpense,astheycauseincreasesordecreasesintheoverallexpensedue
to activities that occurred in the current period. In other words, reporting these
deferred amounts follows the accountingprinciple ofmatching expenseswith the
periodsincurred.
Inordertodeterminewhetheratemporarydifferencecreatesanincreasein
thebalanceofeitherDTA’sorDTL’s,thefollowingequationshouldbereferenced.
Ifthetemporarydifferencescauses:
• Pretax financial income > Taxable incomeà Record aDTL (Future TaxableAmountxTaxrate)
• Pretaxfinancialincome<TaxableincomeàRecordaDTA (FutureDeductibleAmountxTaxrate)
Thekeypointtorememberhereisthatthisequationislookingfortheeffect
onthebottomline.Foritemsinvolvingrevenues,thisisnotsotricky.However,for
items involving expenses, applying the equation can seem counterintuitive. For
example,agreaterdepreciationexpensefortaxpurposesthanbookpurposeswould
havetheeffectofalessertaxableincomethanbookincome.
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Onelastitemtorecognizeisthevaluationallowancefordeferredtaxassets.
Thisissimplyacontraassetaccountthattakesintoconsiderationthefactthatsome
of these tax assets will go unused, as they often expire before the company has
enough taxable income to realize these. This will be discussed more thoroughly
later.Withthesetermsandprinciplesestablished,wecannowexaminehowthese
applytoZAGGInc.’soperations.
ZAGGInc.ZAGG Inc., an acronym for “Zealous About Great Gadgets,” is a market leader in
mobile device accessories. They serve as a great company to analyze when
discussing deferred income taxes, as they have millions of dollars of DTA’s and
DTL’s. InFY2012, ZAGGmade the following entry to record income tax expense
andadjustthebalancesoftheirdeferredtaxes.(Inthousands.)
IncomeTaxExpense 9,393NetDeferredIncomeTaxes 8,293
IncomeTaxesPayable
17,686
Thisentry,thoughacceptable,couldalsoberecordedusingthegrosschanges
inDTA’sandDTL’s,asfollows.(Inthousands.)
IncomeTaxExpense 9,393DeferredTaxAssets 8,001DeferredTaxLiabilities 292
IncomeTaxesPayable
17,686
Here,wecanseethattheDeferredTaxAssetsincreased,whiletheDeferred
TaxLiabilitiesdecreased,mostlikelyduetoareversal.(Areversaltakesplacewhen
apreviouslyrecordeddeferredtaxamountisrealizedi.e.bookdepreciationexceeds
taxdepreciationinfutureyearsafteraDTLhadoriginallybeenrecorded.)
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When breaking down the net deferred income taxes from the first journal
entry,wecansee that theDTA’sarevaluedat$15,015 lessanallowanceof$713,
whiletheDTL’sarevaluedat$794.Thisresultsinanetof$13,508.Asthebalancein
theprioryearwas$5,214,thechangeinthisaccount,andthustheamountrecorded
intheentryabove,is$8,293.
On this disclosure of deferred taxes, the total balance for deferred taxes is
$13,508,000. Because deferred tax assets and deferred tax liabilities must be
classified as either currentornon-current—dependingon the classificationof the
correspondingassetorliabilityfromwhichthesedeferredtaxesarose,orbasedon
date of realization of these deferrals— and then netted together, some of these
assetsarereportedinthecurrentassetssectionandsomeintheothernon-current
assets section. On ZAGG’s balance sheet, we find that current net DTA’s have a
balanceof$6,912,000,whilenon-currentnetDTA’shaveabalanceof$6,596,000—
thesumofthetwoequaling$13,508,000.IncaseswheretheDTL’shavecumulative
balanceslargerthantheDTA’s,thenthenetbalancewouldbereportedaseithera
currentorLong-termliabilityorboth,dependingontheclassification.
UsingtheamountrecordedforIncomeTaxExpense,$9,393,000,wecanfind
theeffectivetaxrateforZAGGInc.bydividingthisexpensebythepretaxfinancial
(book) income of $23,898,000. This results in an effective tax rate of 39.3%. The
differenceinthe35%statutorytaxrateandthis39.3%effectiverateiscausedbya
numberof adjustments including state tax, not-deductible expenses, the return to
provisionadjustment,andanincreaseinthevaluationallowance.
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UsingDeferredTaxestoFindCumulativeDifferencesIn some situations, if we want to find the differences between taxable and book
income,wemusttakethecorrespondingdeferredtaxaccountanddividebythetax
rate.Thiswillgiveusthecumulativedifferencebetweenthetwoincomes.Let’suse
ZAGG’sPP&ErelatedDTLasanexample.
AsofDecember31,2012,thebalanceintheDTLforPropertyandEquipment
was $794,000. Because this cumulative difference between tax depreciation and
bookdepreciationhascreatedaDTL,wecaninferthatthelargertotaldepreciation
expenseofthetwohasbeenchargedtotaxableincome.Usingtheequationgivenin
the previous section,wewill see that this is because this expense caused taxable
income to be lower and thus a DTL was born. In order to estimate the dollar
magnitudeofthecumulativedifferencebetweentheseitems,wewilltakethetotal
balance for this DTL ($794,000) and divide it by the statutory income tax rate
(35%+3%). Below is a table that shows the relationship between the cumulative
difference,thetaxrate,andthedeferredtaxliability.
(inthousands$) CumulativeDifferenceinBookandTaxDepreciationExpense
2089
XStatutoryIncomeRate
38%
=DeferredIncomeTaxLiabilityRelatingtoPropertyandEquipmentat12/31/2012
794
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Given this information and the current book balance of Property and
Equipment of $4,862,000,we can estimate that if ZAGGdepreciated its assets for
bookpurposesusing thesamemethodas itdid for taxpurposes, thenthecurrent
balanceforthisaccountwouldactuallybe$2,773,000($4,862,000-$2,089,000).If
thiswasthecase,thenZAGGwouldhavetonotonlyreportmuchlowerincomefor
theperiodsduringwhichitheldthispropertyandequipment,butitwouldalsohave
toreportlowertotalassetsonitsbalancesheet.
To show how this works for DTA’s we might consider ZAGG’s cumulative
differencerelatedtoallowancefordoubtfulaccounts.AsofDecember31,2012,the
DTArelatedtothisaccounthasabalanceof$1,020,000.ThereasonthataDTAwas
recorded for thisdifference isbecause it isanaccruedexpense.Accruedexpenses
are simply estimates of losses that a company expects to incur but have not yet
actually had to pay out. In order to match costs with revenues, accruals are
absolutely necessary. However, for tax purposes, these types of expenses are not
deductible until actually incurred. This results in lower reported income than
taxableincome,thusformingaDTA.
Calculating the total dollar amount for the cumulativedifference related to
thisallowanceaccountworksexactlythesameasthepreviousexample.Wesimply
divide the DTA balance by the statutory tax rate. The figure on the next page
exemplifiesthisrelationship.
A separate element of DTA’s that doesn’t pertain to DTL’s is the valuation
allowance.Similartoanallowancefordoubtfulaccounts,thisallowanceisacontra
assetthatreducesdeferredtaxassetsbyamountsthattheybelievearemorelikely
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than not to go unrealized. The balance in this valuation allowance for ZAGG at
December31,2012 is$713,000.Thecompanyrecordeda fullvaluationallowance
againstaDTAgeneratedby losseson itsequitymethod investment inHzO.Given
the uncertainty of future profitability of this investment, management has
determinedthatitismorelikelythannotthattheDTAwillnotberealizable.
(inthousands$) CumulativeDifferenceinBookandTaxBadDebtExpense
2684
XStatutoryIncomeRate
38%
=DeferredIncomeTaxLiabilityRelatingtoAllowanceforDoubtfulAccountsat
12/31/2012
1020
Thoughwedonotconsideritinanyofthepriorexamples,itisimportantto
remember that sometimes future enacted tax rates are subject to change, thus
dividing the totalrecordeddeferredtaxbyonesingleratewouldnotgiveyouthe
true cumulative difference. Instead, there may be an included schedule for the
reversalofsuchdeferrals.
AdjustingforChangesinTaxRatesAswe briefly discussed above, some times the government enacts changes in tax
rates,causingthevaluationofourdeferredtaxestobeinaccurate.Inthisinstance,
we must adjust these balances to reflect an accurate amount of deferred tax
liabilities and assets thatwill be realized given the new tax rates. To do this,we
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mustsimplytakethecumulativedifferencesandmultiplythembythenewtaxrates
to find the new balances of DTA’s and DTL’s. The difference between these new
amountsandtheamountswepreviouslyrecordedwillshowushowmuchweneed
to either decrease or increase such accounts. For ZAGG,we are assuming that on
January1,2013,anewfederalstatutorytaxrateof30%wasenacted.However,the
3%stateincometaxratewasunchanged.Thisbringsourtotalstatutorytaxrateof
38%down to33%.Below is a table that adjusts eachaccountunder thedeferred
taxesandshowstheeffectoneachoftheseduetothenewtaxrates.
The bold numbers in Figure 12-1 on the following page represent the
amountsbywhichZAGGmustadjustitsbooks.Thefollowingjournalentryservesas
anexplanationfortheseboldamounts.
IncomeTaxExpense 1,777DTL
104
ValuationAllowance 94
DTA
1,975
As you can see, because the tax ratewas lowered, this reduced the future
taxableanddeductibleamounts.BecauseDTA’swerereducedbymorethanDTL’s,
this means that their benefit will not be realized in the future, and thus their
reductionmustbeconsideredanexpenseorlossofthisfuturebenefit.
104
Figure12-1
DeferredTaxAdjustments
Account Beg.
Balance
OldTax
Rate
Total
Dif.
NewTax
Rate
End.
BalanceDifference
AllowforDA $1,020 38% $2,684 33% $886 -$134Def.Rev. $27 38% $71 33% $23 -$4Inventories $2,317 38% $6,097 33% $2,012 -$305Stock-basedComp $1,420 38% $3,737 33% $1,233 -$187SalesRet.Accr. $2,456 38% $6,463 33% $2,133 -$323NetAcq.Costs $282 38% $742 33% $245 -$37Intangibles $4,372 38% $11,505 33% $3,797 -$575Goodwill $1,801 38% $4,739 33% $1,564 -$237HzoInvest. $713 38% $1,876 33% $619 -$94ReserveonNR $569 38% $1,497 33% $494 -$75OtherLiab. $38 38% $100 33% $33 -$5
DTA
$15,015 38% $39,513 33% $13,039 -$1,976
Allowance -$713 38% 33% -$619 -$94
TotalDTA
$14,302 38% $37,637 33% $12,420 -$1,882 PP&E $794 38% $2,089 33% $690 -$104TotalDTL $794 38% $2,089 33% $690 -$104
NetDTA
$13,508 38% $35,547 33% $11,731 -$1,777
105
13.PensionLiabilities—Johnson&Johnson
ExecutiveSummaryIn this analysis, we discuss the various elements involved in accounting for
retirementobligationplans.Wediscuss thedifferent typesof theseplans,defined
benefitanddefinedcontribution.Wethenpointoutthedifferencesandexplainwhy
the accounting for defined benefit plans is themore complex of the two.We also
provide a brief discuss as towhy these futurepayable retirementbenefits canbe
classifiedasaliability(orasset)onthebalancesheet.
Beforediscussing the specific reportingof this obligation,we showhow to
computebothof its components—planassetsandpensionbenefitobligations.We
then explain how plan assets, quite obviously, make up the asset portion of this
retirementfund,whilepensionbenefitobligations(PBO)constitutetheliabilityside.
Thesetwoarenettedtogethertocomeupwiththetotalbalanceforwhatiscalled
the funded status, which is the amount reported as an asset (or liability) on the
financialstatements.
Finally, we discuss how each of these factors affects Johnson & Johnson’s
financial reporting and related schedules. By analyzing this company’s financial
statements, we find that in 2007, their PBO exceeds their plan assets by $1,533
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million, resulting in a funded status liability. However, this balance decreased
significantly fromthepreviousyear,whichreassuresanalystsandemployees that
thisisnotaproblemareaforthecompany.
RetirementObligations Inmostpublicandprivatefirms,employeesarecompensatedfortheireffortsatthe
companybybeingawardedcertainbenefitsuponretirement.Therearetwotypesof
retirement plans that companies often follow to accomplish this. First, there are
definedcontributionplans,whereboththeemployerandtheemployeescontribute
money to this fund eachmonth, typically in the form of a 401k. Then, there are
defined benefit plans where the employer is the sole beneficiary of this fund
reservedforretirement.Thispaperfocusesmainlyonthelatterduetotheintricate
accounting methods involved in up-keeping such a fund. We will use Johnson &
Johnsontoprovideathoroughanalysisofthisbenefitplan.
WhyRetirementPlansareLiabilitiesWhencompaniescreateretirementobligations,theyareessentiallyrecognizingthe
factthatatsometimeinthefuture,theywillusethefundtopayoutbenefitstotheir
prioremployees.Inotherwords,theyexpectfuturepayableamounts,andthusmust
recordsuchobligationsascurrentandlong-termliabilitiesaccordingtotheirdateof
realization.
Someassumptionsnecessaryforaccountingfortheseobligationsincludethe
life expectancyof the employees after retirement, thenumberof years employed,
and the future projected salary. Because companies determine the amount of
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benefitsthatagivenemployeewillreceiveduringretirement,theymustbeableto
reasonably estimate these figures while the employees are still working. For
example, Johnson& Johnsonmustcalculatenotonlyhow long theybelieveoneof
theiraccountantswillworkuntiltheyretire,butalsowhathisorhersalarywillbe
at that point and how long they will have to fund his or her retirement. Using
historical data and certain requirements such as a minimum age to retire, the
companiesareable toobtainsomecertaintyof these futureobligations.With that
established, let us look at thekey components of these retirement funds: pension
benefitobligationsandplanassets.
PensionBenefitObligationsThePensionBenefitObligation(PBO)ofagivencompanyultimatelycomprisesthe
present valueof future expected liabilities. It ismadeupof service costs, interest
costs,actuarialgainsandlosses,andbenefitspaidtoretirees.
Service costs are the amount of benefits that employees have accrued for
theirservicesrenderedduringthecurrentyear.TheseareaddedtothePBO,asthey
representfutureamountsthatwillhavetobepaidouttotheemployeeswhoearned
them.
Interest costs are essentially an amortization of the PBO based on the
discountrate.Becausetheseliabilitiesarerecordedatpresentvalue,theymustbe
broughtto“facevalue”bythetimetheyarepaidout.
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ActuarialGainsandLossesaresimplyadjustmentsmadebytheactuarywho
oversees the account. Changes inmarket interest rates and the general economy
maygiverisetotheneedforareductionoradditionofliabilitiestothePBO.
BenefitspaidtoretireesreducethePBO,astheyrepresentthefulfillmentof
the outstanding liabilities. Like all liabilities, once they are paid off, they need no
longertobeheldasanobligation.
PlanAssetsContrarytoPBO,planassetsserveastheinvestmentfundfromwhichassetswillbe
used to pay off these obligations. Plan assets are affected by actual returns on
pensioninvestments,contributionsfromtheemployer,andbenefitspaidout.
Thisplanassetfundisusedtoinvestandearnareturnwhilewaitingtopay
employeeretirementbenefits.Thus,anyreturns for theyearareputdirectlyback
into the fund, causing it to increase. This is not to be confusedwith the expected
return, or the return that the actuary estimates that the fund will receive. The
expectedreturnisusedforcalculatingpensionexpense,whichwewilldiscusslater.
In order to have enough funding for these obligations, the employermust
regularlycontributecashtotheinvestment.Thus,anytimeacontributionismade,
thecompanyreducesitscashandincreasesitsplanassets.Theactualjournalentry
andrelatedaccountswillbedisplayedinthenextsection.
Justasthepaymentofbenefitsreducesliabilities,italsocausesadecreasein
the funds available.Thus, theplan assets are reducedby the sameamount as the
PBOwheneverbenefitsarepaidout.
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ReportingRetirementObligationsontheBalanceSheet
Although records of the PBO and Plan Assets must be recorded timely and
accurately, theseareactuallynotaccountsthatcanbe foundonthebalancesheet.
Instead,GAAPcallsforaconsolidationofthetwointoaPensionAsset/Liability,also
known as the Funded Status. If the plan assets are larger than the PBO, then the
funded status is reported as a long-term asset. If the PBO is larger, then the net
amount is reported as a long-term liability. Supporting notes and schedules are
necessarytodiscloseeachof theaforementionedelementsthatgo intocalculating
thebalanceofthisaccount.
PensionExpenseWhen preparing financial statements, the company must record an expense for
theseretirementpensions.Thisissimilartoasalariesandwagesexpense.However,
this pension expense is made up of many separate items. These include service
costs,interestcosts,expectedreturnsontheasset,andactuarialgainsorlosses.
These elements have been explained during discussion of PBO and plan
assets. However, the expected returns can differ from actual returns, causing an
adjustment to the pension expense. These expected returns are estimated by the
actuary for theplanassets, andarecreditedagainst thispensionexpense,as they
serveasdirectcashinflowsthatgotowardsthepaymentofthesepensionbenefits.
When the expected returns equal the actual returns, then there is no concern.
However,when these twonumbers vary, the actual return is credited against the
pensionexpense,butanunexpectedgainisdebited,resultinginacreditofthenet
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expected returns. For example, if the company expects that the $1,000,000 plan
assetswillprovideareturnof8percent,basedonexpecteddividendand interest
receipts, then their expected return is $80,000.However, if due to changes in fair
value, theplan assets increaseby$100,000, then the $20,000 resultingdifference
wouldbeconsideredanactuarialgain.Thus,whilethe$100,000wouldbecredited
against the pension expense, the $20,000 gain would be reduced, bring the net
creditfromreturnonplanassetsto$80,000.Inthenextsection,wewilldiscussthis
pensionexpenseandotherrelateditemsforJohnson&Johnson.
Johnson&JohnsonJohnson&Johnson,amanufacturerofproductsinthehealthcarefield,offersboth
typesofretirementobligationplans,directbenefitanddirectcontribution.Sofarin
thisdiscussion,wehavedefinedthekeyelementsofadirectbenefitplan.Wewill
nowseehowtheseaffectthebalancesheetofJ&J.
In 2007, J&J reported a pension expense of $646 million. Included in this
expense were $597 million in service costs and $656 million in interest costs.
However, the expected return on plan assets was $809 million, so this offset a
majority of the expense. To record the pension expense portion of the first two
items,J&Jwouldhavehadanentrysimilartothefollowing:
InMillions PensionExpense 1253
PensionA/L
1253
Here, the liabilityportionof the funded status is increasedbecauseof the related
accruedexpense.
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Directlyaffectedbytheseserviceandinterestcosts,thecompany’sPBOhada
value of $12,002 million at 12/31/07. This represents the fair value of future
amountsthatJ&Janticipatespayingouttoitsretirees.Thisvalueisfairlyreliable,as
itisadjustedeveryyearforchangesinfairvaluesandinterestrates.Althoughthis
endingvalueisimportantforbalancesheetpurposes,thebeginningamountofthe
PBO is important for calculating interest expense. The following chart shows
interestratecalculationsforthePBO.
Figure13-1
PBOInterestTable
InMillions 2007 2006
PBOBegBalance $11,660 $10,171InterestCost $656 $570InterestRate 5.63% 5.60%
Here,wecanseethatforFiscalYears2006and2007,J&Jappliedanaverage
interestrateof5.6percenttocomputeinterestcostsfortheyear.Whencomparing
tosomeoftheirdirectcompetitors, thisseemstobeareasonable interestratefor
thecompany.(Pfizerhadratesaround6percentduringthistime.)
J&J’s PBOwas reduced slightly during theperiodby thebenefits theypaid
out.Thesetotaledto$481million.It is importanttorememberthatthesebenefits
donotrepresentacashoutflowforJ&J.Rather,thesebenefitscomefromthefunds
reserved for this retirement obligations—the plan assets. Thus, these benefits do
notdirectlyaffectthebalanceofthefundedstatus,asboththePBOandplanassets
arereducedbythesameamount.Forexample, if thePBOhasavalueof$100, for
simplicity,andtheplanassetshaveabalanceof$80,thenthefundedstatusis$20
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liability.So, if$10ofbenefitsarepaid, then thePBOnowhasavalueof$90,plan
assetshaveavalueof$70,andthefundedstatusremainsaliabilityof$20.
Asmentionedabove, Johnson&Johnson’splanassetswerealsoaffectedby
these benefits. The value of these plan assets—the fair value of total invested
funds—at 12/31/07, was $10,469 million. As this amount is affected by actual
returnsontheassets,itisimportanttokeeptrackofexpectedversusactualreturns,
toseeiftheactuaryneedstoadjustitsestimates.For2006,expectedreturnswere
$701millionwhileactualreturnswere$966million.Oppositely,in2007,expected
returns of $809 million exceeded the actual returns of $743 million. These
differencesseemsignificantatfirstglance,buttheyrepresentvaryinginterestrates
oflessthan1percent.Thus,itishardtodeemthattheyarematerial.
Another significant factor affecting the value of these plan assets are the
contributions. From 2006 to 2007, contributions from the company and its
employeesincreasedbynearly24percent,from$306millionto$379million.This
seems to be a good sign for the company, as it shows that not only does it have
enough cash on hand to contribute to this fund, but also that its employees are
investedenoughinthecompanytocontributetotheplan.
GiventhedataforJ&J’sPBOandplanassets,wecanfindthetotalbalancefor
this funded status for both 2006 and 2007. These were credit balances $2,122
million and $1,533million, respectively. Thismeans that Johnson& Johnson held
significant long-term liabilities related to retirement obligations. However, due to
thedecrease in this liability from2006 to2007 and the increase in contributions
betweenthetwoyears,thisaccountisnotalong-termconcernforthecompany.