ii - SMBHC Thesis Repositorythesis.honors.olemiss.edu/902/1/Thesis--Cole McCall.pdfChapter 11:...

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Transcript of ii - SMBHC Thesis Repositorythesis.honors.olemiss.edu/902/1/Thesis--Cole McCall.pdfChapter 11:...

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© 2017 Nathan Cole McCall

ALL RIGHTS RESERVED

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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.

24

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.

29

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,

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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.

50

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

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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.

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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

58

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.

74

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.

77

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.