OOK INANCIAL TATEMENT NALYSIS

Readings and Learning Outcome Statements 3

Study Session 5 9

Study Session 6 165

Study Session 7 213

Old Question Review 309

Formulas 323

Index 326

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BOOK 3 – FINANCIAL STATEMENT ANALYSIS

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READINGS

The following material is a review of the Financial Statement Analysis principles designed to address the learning outcome statements set forth by CFA Institute.

STUDY SESSION 5

Reading Assignments1. The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C.

Sondhi, and Dov Fried (Wiley, 2003)A. “Analysis of Inventories,” Ch. 6, pp. 198–220, including Box 6-2 page 9B. “Analysis of Long-Lived Assets: Part II—Analysis of Depreciation and Impairment,”

Ch. 8, pp. 257–266 page 30C. “Analysis of Income Taxes,” Ch. 9, pp. 301–314 page 38D. “Analysis of Financing Liabilities,” Ch. 10, pp. 322–332, 337–352 page 57E. “Leases and Off-Balance-Sheet Debt,” Ch 11, pp. 371–376 and 386–391 page 72F. “Analysis of Intercorporate Investments,” Ch. 13, pp. 454–483 page 91

2. Detecting Earnings Management, Gary Giroux (Wiley, 2004)A. “Business Combinations and Related Issues,” Ch. 9, pp. 216–224 and pp. 232–235 page 114B. “Corporate Governance, Compensation, and Other Employee Issues,” Ch. 10,

pp. 256–271 page 129C. “Risk Management, Derivatives, and Special Purpose Entities,” Ch. 11, pp. 289–297 page 157

STUDY SESSION 6

Reading Assignments1. “Analysis of Multinational Operations,” Ch. 15, pp. 546–574, The Analysis and Use of

Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003) page 165

2. “Similarities and Differences – A Comparison of IFRS and U.S. GAAP” (PricewaterhouseCoopers, October 2004) page 201A. “Consolidated Financial Statements.” pp. 21-25B. “Business Combinations,” pp. 26-31C. “Capitalisation of Borrowing Costs,” pp. 47-48D. “Inventories,” p. 49E. “Financial Assets,” pp. 50-53F. “Financial Liabilities,” pp. 60-62

STUDY SESSION 7

Reading Assignments1. Financial Shenanigans, 2nd edition, Howard Schilit (McGraw-Hill, 2002)

A. “Seek and Ye Shall Find,” Ch. 2 page 213B. “Searching for Shenanigans,” Ch. 3 page 213C. “Shenanigan No. 4: Shifting Current Expenses to a Later or Earlier Period,” Ch. 7 page 221

READINGS AND

LEARNINGS OUTCOME STATEMENTS

©2006 Schweser Study Program

Financial Statement AnalysisReadings and Learning Outcome Statements

D. “Shenanigan No. 5: Failing to Record or Improperly Reducing Liabilities,” Ch. 8 page 229E. “Analyzing Financial Reports,” Ch. 12 page 236

2. “The Income Statement, Part II-Expenses, Nonoperating Items,” Ch. 6, Detecting Earnings Management, Gary Giroux (Wiley, 2004) pp.145–149 page 242

3. The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003)A. “Foundations of Ratio and Financial Analysis,” Ch. 4, pp. 149–153 page 250B. “Analysis of Financial Statements: A Synthesis,” Ch. 17 page 256

4. “Analysis of Financial Statements,” Ch. 10, Investment Analysis and Portfolio Management, 7th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2003) page 279

LEARNING OUTCOME STATEMENTS (LOS)

The CFA Institute Learning Outcome Statements are listed below. These are repeated in each topic review; however, the order may have been changed in order to get a better fit with the flow of the review.

STUDY SESSION 5

The topical coverage corresponds with the following CFA Institute assigned reading:1. A. “Analysis of Inventories”

The candidate should be able to compare and contrast the LIFO, FIFO, and average cost inventory methods, and describe the effect of the different methods on balance sheet accounts, reported earnings, tax obligation, and financial ratios and evaluate a firm’s future sales and earnings prospects, given changes in inventory balances. (page 11)

The topical coverage corresponds with the following CFA Institute assigned reading:B. “Analysis of Long-Lived Assets: Part II—Analysis of Depreciation and Impairment”

The candidate should be able to compare and contrast the different depreciation methods and analyze how the selection of or change in depreciation method, depreciable lives, or salvage values affects a company’s financial statements, financial ratios, and comparability with other companies. (page 31)

The topical coverage corresponds with the following CFA Institute assigned reading:C. “Analysis of Income Taxes”

The candidate should be able toa. analyze disclosures relating to deferred tax items and the effective rate reconciliation. (page 41)b. discuss how these disclosures affect a company’s financial statements and financial ratios and

compare and contrast a company’s deferred tax items and effective rate reconciliations between reporting periods and/or to other companies. (page 41)

The topical coverage corresponds with the following CFA Institute assigned reading:D. “Analysis of Financing Liabilities”

The candidate should be able toa. analyze the disclosures relating to financing liabilities, and discuss the advantages/disadvantages to

the company of selecting a given instrument and the effect of the selection on a company’s financial statements and ratios and estimate the effects of changing interest rates on the market value of debt and on financial statements and ratios. (page 58)

b. analyze the impact of debt covenants on a company’s financial statements and ratios. (page 63)



The topical coverage corresponds with the following CFA Institute assigned reading:E. “Leases and Off-Balance-Sheet Debt”

The candidate should be able to analyze the disclosures relating to leases to determine the appropriate lease classification and how such classification affects the lessee’s and lessor’s financial statements and ratios. (page 72)

The topical coverage corresponds with the following CFA Institute assigned reading:F. “Analysis of Intercorporate Investments”

The candidate should be able toa. determine whether a debt security or equity security should be classified as held-to-maturity,

available-for-sale, or as a trading security. (page 91)b. compute and discuss the effect of marketable securities classification on the financial statements

and financial ratios under SFAS 115. (page 92)c. compute the mark-to-market investment return on a marketable securities portfolio under SFAS

115. (page 95)d. determine, given various ownership and/or control levels and relevant accounting standards,

whether the cost method, equity method, proportionate consolidation method, or consolidation method should be used and compute and compare the effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios. (page 96)

The topical coverage corresponds with the following CFA Institute assigned reading:2. A. “Business Combinations and Related Issues”

The candidate should be able toa. compare and contrast the purchase and pooling of interest methods of accounting for business

combinations and identify which method is required under US GAAP and construct consolidated balance sheets using the purchase method. (page 114)

b. compare and contrast the three different price allocation strategies that a company might use in a business combination and analyze the impact of each of these strategies on a company’s income statement and financial ratios. (page 117)

c. explain the accounting treatment for goodwill. (page 118)d. analyze the impact on a company’s financial statements and ratios under the pooling of interest and

purchase (both cash and equity exchange) methods. (page 118)e. interpret the specific earnings management concerns for business combinations or divestitures and

explain possible detection strategies. (page 120)f. calculate financial ratios for segments reported by a company and analyze the resulting information

and interpret the specific earnings management related to segment reporting and explain possible detection strategies. (page 121)

The topical coverage corresponds with the following CFA Institute assigned reading:B. “Corporate Governance, Compensation, and Other Employee Issues”

The candidate should be able toa. differentiate between APB 25 and SFAS 123 expensing and pro forma disclosure methods of

accounting for stock options, analyze disclosures for stock compensation plans, and interpret the impact of these plans on a company’s reported net income, cash from operations, diluted earnings per share, and leverage and return ratios, and interpret the specific earnings management involving stock options and explain possible detection strategies. (page 130)

b. explain the differences in accounting for defined contribution and defined benefit pension plans and how such differences affect a company’s financial statements. (page 135)

c. define projected benefit obligation (PBO) and identify and explain the four key items of PBO and calculate and discuss the funded status of a pension plan and compare and contrast the funded status with the net asset (liability) recognized in a company’s financial statements. (page 135)



d. interpret the total pension expense (income) and its components to be reported on a company’s income statement under U.S. GAAP, compare and contrast the actual return on plan assets with the income (expense) recorded in a company’s income statement under U.S. GAAP, interpret the specific earnings management concerns posed by benefit plans and explain possible detection strategies, and compare and contrast the three actuarial assumption rates disclosed in a company’s pension footnote. (page 139)

The topical coverage corresponds with the following CFA Institute assigned reading:C. “Risk Management, Derivatives, and Special Purpose Entities”

The candidate should be able toa. discuss the major uses of special-purpose entities (SPES). (page 157)b. interpret the specific earnings management concerns posed by SPES and explain possible detection

strategies and analyze disclosures relating to SPES that achieve off-balance-sheet financing activities, calculate the impact of such disclosures on a company’s financial statements and ratios, and discuss the significance of these activities on a company’s financial performance and condition. (page 157)

STUDY SESSION 6

The topical coverage corresponds with the following CFA Institute assigned reading:1. “Analysis of Multinational Operations”

The candidate should be able toa. determine the impact of changes in local currency sales and changes in exchange rates on the

translated sales of the subsidiary and parent company. (page 165)b. distinguish among the local currency, functional currency, and the reporting currency. (page 166)c. distinguish between the all-current (translation) method and the temporal (remeasurement)

method, explain the effects of each on the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios. (page 167)

d. calculate the translation effects, and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s currency, using the all-current (translation) method and the temporal (remeasurement) method, determine how the translation of a subsidiary’s financial statements will affect the subsidiary’s financial ratios, and determine how using the temporal (remeasurement) method versus the all-current (translation) method will affect the parent company’s financial ratios. (page 172)

e. discuss alternative accounting methods for subsidiaries operating in hyperinflationary economies. (page 190)

The topical coverage corresponds with the following CFA Institute assigned reading:2. “Similarities and Differences – A Comparison of IFRS and U.S. GAAP”

The candidate should be able to compare and contrast the IFRS and U.S. GAAP treatment for each of the following, and calculate and interpret the impact of any differences on the financial statements and ratios:• consolidated financial statements• business combinations• capitalisation of borrowing costs• inventory• financial assets• financial liabilities. (page 201)



STUDY SESSION 7

The topical coverage corresponds with the following CFA Institute assigned reading:1. A. “Seek and Ye Shall Find”

The candidate should be able to discuss the techniques used by management to distort a company's reported financial performance and financial condition and discuss why such “shenanigans” exist and under what conditions they are most likely to occur. (page 213)

The topical coverage corresponds with the following CFA Institute assigned reading:B. “Searching for Shenanigans”

The candidate should be able to evaluate a company’s financial statements and other public information to detect early signs that financial shenanigans are being used to cover underlying problems. (page 216)

The topical coverage corresponds with the following CFA Institute assigned reading:C. “Shenanigan No. 4: Shifting Current Expenses to a Later or Earlier Period”

The candidate should be able to discuss the costs that are most often improperly capitalized, and estimate the impact on the financial statements and financial ratios of such capitalization and analyze disclosures relating to amortization/depreciation of assets to identify situations that distort financial performance and/or condition. (page 221)

The topical coverage corresponds with the following CFA Institute assigned reading:D. “Shenanigan No. 5: Failing to Record or Improperly Reducing Liabilities”

The candidate should be able to discuss the situations in which a company is most likely to misstate liabilities with respect to• commitments and contingencies• unrecorded stock option liabilities• changes in pension assumptions• releases of reserves into income• recording revenue. (page 229)

The topical coverage corresponds with the following CFA Institute assigned reading:E. “Analyzing Financial Reports”

The candidate should be able to analyze the sources of information to• evaluate whether accounting policies are aggressive or conservative• identify items that should alert an analyst to potential problems• create common-size financial statements• compare cash flow from operations and net income• identify potential warning signs and the deceptive technique used. (page 236)

The topical coverage corresponds with the following CFA Institute assigned reading:2. “The Income Statement, Part II—Expenses, Nonoperating Items”

The candidate should be able to compare and contrast the three categories of nonrecurring items and other unusual or infrequent items and give examples of each category and discuss how to conduct a quantitative analysis of nonrecurring items and other unusual items. (page 242)

The topical coverage corresponds with the following CFA Institute assigned reading:3. A. “Foundations of Ratio and Financial Analysis”

The candidate should be able to calculate weighted average shares outstanding and basic and diluted earnings per share (EPS) for a company with a complex capital structure, differentiate between basic and diluted EPS and between weighted average shares outstanding and shares outstanding per the balance sheet, and explain why diluted EPS is more suitable for valuation purposes than basic EPS. (page 250)



The topical coverage corresponds with the following CFA Institute assigned reading:B. “Analysis of Financial Statements: A Synthesis”

The candidate should be able toa. modify the balance sheet for assets and liabilities that are not recorded. (page 256)b. modify the balance sheet for the current value of assets and liabilities. (page 257)c. compute a company’s normal operating earnings and comprehensive income. (page 262)d. determine and interpret 1) the effect on reported financial results and ratios of a company’s choices

of accounting methods and assumptions (e.g., inventory methods, depreciation methods, lease or purchase of long-term assets), 2) the effect on reported financial results and ratios of changes in accounting methods and assumptions (e.g., depreciation methods or assumptions, employee benefit plan assumptions), and 3) the effects of balance sheet modifications and earnings normalization on a company's financial statements, financial ratios, and overall financial condition. (page 265)

e. identify indicators of high and low earnings quality. (page 268)f. calculate free cash flow using the statement of cash flows. (page 268)

The topical coverage corresponds with the following CFA Institute assigned reading:4. “Analysis of Financial Statements”

The candidate should be able toa. describe some of the important accounting choices (typically explained in the footnotes of financial

statements) that companies must make when constructing financial statements using generally accepted accounting principles (GAAP). (page 279)

b. describe how a company’s accounting choices make comparability among companies difficult. (page 280)

c. distinguish among “cash flows from operating activities” (from the statement of cash flows), “traditional cash flow,” and “free cash flow.” (page 280)

d. calculate and interpret financial ratios in the following categories: common size, internal liquidity, operating efficiency, operating profitability, business risk, financial risk, external liquidity, and growth potential and prepare, using financial ratios, a comparative analysis of a company over time and relative to its industry or to the market. (page 281)

e. compute and interpret the components of return on equity (ROE) using the original DuPont system and the extended DuPont system. (page 291)

f. discuss business risk and financial risk. (page 286)g. discuss the challenges of international ratio analysis. (page 299)h. contrast the ratios that are most likely to be useful for valuing common stock, establishing bond

ratings, and forecasting bankruptcy. (page 299)


The following is a review of the Financial Statement Analysis principles designed to address the learning outcome statements set forth by CFA Institute®. This topic is also covered in:

ANALYSIS OF INVENTORIES

Study Session 5

EXAM FOCUS

This topic review discusses specific analyticalprocesses for inventory. The complication in analyzinginventory is that firms can use three different methodsto account for inventory—FIFO, LIFO, and average

cost. You should be able to explain how the choice ofinventory method affects the firm’s reported financialresults.

WARM-UP: INVENTORY ACCOUNTING

The choice of accounting method used to account for inventory affects the firm’s income statement, balance sheet, and related financial ratios. More importantly, the choice of inventory accounting method impacts cash flow because taxes paid by the firm are affected by the choice of inventory method for tax reporting.

U.S. generally accepted accounting principles (GAAP) require inventory valuation on the basis of lower of cost or market (LCM). That means that if replacement cost is rising, the holding gains in the value of inventory are ignored, and the inventory is valued at cost. However, losses in the value of inventory due to obsolescence or deterioration are recognized, and inventory is written down to its new market value.

In general, cost represents reasonable and necessary costs to get the asset in place and ready to use.

• Merchandise inventories include costs of purchasing, transporting, receiving, and inspecting.• Manufactured inventories include costs of direct materials, direct labor, and manufacturing overhead (i.e., all

other indirect costs).

The basic inventory formula relates the beginning balance, purchases, and cost of goods sold (COGS) to the ending balance. Memorize and understand the relationships in the following equation:

This is easy to remember and can be manipulated to calculate any missing piece:

beginning inventory purchases ending inventory cost of goods sold

cost of goods available for sale where they ended up at the end of the period(still on hand or sold)

+ +=

ending inventory beginning inventory purchases – COGS

what you end up with what you had available to sell – what you sold

= +

↓ ↓ ↓=


Study Session 5Cross-Reference to CFA Institute Assigned Reading – White et al., Chapter 6

WARM-UP: METHODS OF INVENTORY ACCOUNTING

Three methods of inventory accounting are:

1. First in, first out (FIFO):• The first costs incurred (beginning inventory and early purchases) are assigned to the cost of goods sold

for the period.• Most recently incurred costs are assigned to ending inventory.

2. Last in, first out (LIFO):• Most recently incurred costs are assigned to cost of goods sold first.• The costs of beginning inventory and earlier purchases go to ending inventory.

3. Weighted average costing:Weighted average costing calculates an average cost per unit by dividing total cost of goods available for sale by total units available for sale. This average cost is used to determine both cost of goods sold and ending inventory by applying the cost per unit to the number of units sold and/or to ending inventory. A summary of inventory accounting methods appears in Figure 1.

Inventory accounting methods are alternatives for reporting the “flow” of “costs” from the inventory account on the balance sheet to cost of goods sold on the income statement. The three basic cost flow alternatives (FIFO, LIFO, and weighted average) are not to be confused with the actual movement of goods. For example, a grocer would obviously want goods to move on a first-in, first-out basis, while costs could be flowing on a last-in, first-out basis. Keep the focus on cost flows, and remember this is arbitrary: cost assignment has nothing to do with actual costs, prices paid, or revenues. The real cash consequence is the effect on taxes and the preservation of capital in that respect when using LIFO versus FIFO in an inflationary period.

Professor’s Note: The LIFO method is not permitted according to IFRS.

The Relationship Between LIFO and FIFO

Professor’s Note: The presumption in this section is that prices are rising and inventory quantities are stable or increasing. For the exam, you should understand that if prices are decreasing (deflation), the opposite relationships between FIFO and LIFO hold.

Figure 1: Inventory Method Comparison

Method Assumption COGS consists of...Ending inventory consists

of...

FIFOFirst costs incurred are the

first to be assigned to COGS as units are sold

Old costs Recently incurred costs

LIFOMost recent costs incurred

are the first to be assigned to COGS as units are sold

Recently incurred costs Old costs

Weighted average cost

All costs are combinedWeighted average cost

per unit × # of units sold

Weighted average cost per unit × # of units in

ending inventory



During periods of rising prices and stable or increasing inventory quantities, LIFO cost of goods sold is greater than FIFO cost of goods sold. Therefore, LIFO net income will be less than FIFO net income, all else equal, and LIFO inventory will be less than FIFO inventory (smaller reported net income, lower reported assets). This should make intuitive sense because during periods of rising prices, the last units purchased are more expensive. Under LIFO, the last in (more costly) is the first out (to cost of goods sold). This results in LIFO profitability ratios being smaller than under FIFO. When prices are rising, LIFO inventory is reported at a lower cost than under FIFO, so the firm’s current ratio will be lower and inventory turnover higher.

During periods of rising prices, LIFO results in higher COGS, lower net income, and lower inventory costs. This decreases the current ratio (current assets to current liabilities) and increases inventory turnover (COGS to average inventory). If prices do not change during the year, the different inventory valuation methods do not affect the financial statements.

By selling more than what was produced or purchased during the year (ending inventory < beginning inventory), the old “cheap” costs are allowed to flow out of the balance sheet and into COGS. Now COGS under LIFO will be low and profits high. This is called a LIFO liquidation. If there is LIFO liquidation (e.g., the firm sells more items than it purchased during the period), LIFO COGS and income are distorted. In addition, COGS does not reflect current costs.

Most U.S. firms use LIFO on their financial statements. This is because IRS rules state that firms must use the same inventory accounting method (LIFO, FIFO, or average cost) for tax purposes as they do for financial reporting purposes. (This is an exception to the general rule that firms can use different methods in computing tax and financial income). During the last 40 years of rising prices, firms have saved money by using LIFO on their tax returns, since their reported net income is lower than if they had used FIFO. This results in the peculiar situation where lower reported income is associated with a higher cash flow from operations.

FINANCIAL STATEMENT EFFECTS OF CHOICE OF INVENTORY METHOD

LOS 1.A: Compare and contrast the LIFO, FIFO, and average cost inventory methods, and describe the effect of the different methods on balance sheet accounts, reported earnings, tax obligation, and financial ratios and evaluate a firm’s future sales and earnings prospects, given changes in inventory balances.

Professor’s Note: For more information on the differences in the accounting for inventory under IFRS versus U.S. GAAP, see Study Session 6.

During periods of stable prices, all three inventory valuation processes will yield the same results for inventory, COGS, and earnings. During periods of rising prices and stable or increasing inventory quantities, the key points to remember are that FIFO will provide the most useful estimate of the inventory value (current costs are reported in inventory), and LIFO will provide the most useful estimate of the cost of goods sold (current costs are reported here instead). A summary of the financial statement effects of the LIFO vs. FIFO decision is shown in Figure 2.



Figure 2: LIFO and FIFO Comparison—Rising Prices and Increasing or Stable Inventories

Balance Sheet Effects

Generally accepted accounting principles (GAAP) require that firms use the lower of cost or market (LCM) when valuing inventory. But GAAP does not tell the firm how to measure the cost of the inventory. This allows them to use FIFO, LIFO, or average cost. Applying LCM to the inventory calculated under any cost flow assumption would decrease income and inventory on the balance sheet if market is lower than cost. GAAP allows LIFO with LCM for financial statements, but for tax purposes LIFO cannot be used with LCM to obtain tax write-down benefits.

If assigned cost to ending inventory using one of the cost flow assumptions (LIFO, FIFO, or average cost) is greater than the replacement market cost of that inventory, that ending inventory must be written down to market. This rule is applied individually to each major classification of inventory. Inventory is not changed if market price is greater than cost. IFRS allows reversals on inventory write-downs; U.S. GAAP does not.

Income Statement Effects

From a purely conceptual perspective, the going-concern assumption implies that income should be measured in terms of profits after providing for the replacement cost of inventory. But GAAP is based on historical cost and not replacement cost. LIFO, however, allocates the most recent prices to the cost of goods sold. Hence, for income statement purposes, LIFO is the most informative accounting method and provides a better measure of current income.

In practice, firms frequently use more than one inventory method. They may use different methods for their foreign operations since LIFO is rarely used outside the U.S., or they may use different methods for particular business segments. This will disguise the impact of reported inventory on the income statement and balance sheet.

The quandary is that FIFO provides the better balance sheet measure and LIFO the better income statement measure. What can be done? Restate the financial statements. From an analyst’s perspective, there is often information available to permit restatement of one method to another to provide a better analysis.

The preceding discussion assumes the value for purchases is known, but this too may be affected by management choice. For example, in a manufacturing business with raw materials, work in process, and finished goods inventories, the allocation of overhead, such as rent and utilities, to various classes of inventory is a problem.

Professor’s Note: The presumption in this section is that prices are rising and inventory quantities are stable or increasing.

LIFO results in… FIFO results in…

higher COGS lower COGS

lower taxes higher taxes

lower net income (EBT & EAT) higher net income (EBT & EAT)

lower inventory balances higher inventory balances

lower working capital higher working capital

higher cash flows (less taxes paid out) lower cash flows (more taxes paid out)



Cash Flow Effects

In the absence of taxes, there would be no difference in cash flow between LIFO and FIFO. With taxes, however, LIFO causes reported income to be lower, causing actual taxes paid to also be lower. This causes operating cash flow to be higher. The U.S. Internal Revenue Code requires the same method of inventory accounting be used in both GAAP and tax accounting.

FINANCIAL STATEMENT ADJUSTMENTS

Often, an analyst wants to compare a company to other companies in the same industry. When two companies use different methods of accounting for inventory, the inventory of one of the firms must be adjusted in order to make the comparison relevant. There are two types of conversion: LIFO to FIFO and FIFO to LIFO.

LIFO to FIFO Conversions

This conversion is relatively simple because U.S. GAAP requires all companies that use LIFO to also report a LIFO reserve, which is the difference between what their ending inventory would have been under FIFO accounting and its value under LIFO. The LIFO reserve is typically shown in the footnotes to the financial statements.

Figure 3: LIFO Reserve

If you add the LIFO reserve to the LIFO inventory, you will get the FIFO inventory, as shown in Figure 3. An alternative expression is:

LIFO reserve = InvF – InvL

where:InvF = inventory value under FIFOInvL = inventory value under LIFO

To convert LIFO inventory balances to a FIFO basis, simply add the LIFO reserve to the LIFO inventory:

InvF = InvL + LIFO reserve

The conversion from LIFO COGS to FIFO is only slightly more complicated. There are two ways of doing this conversion: the quick way, which requires memorization of a formula, and the long way, which requires an understanding of the basic inventory accounting equation.

The quick way to convert COGS from LIFO to FIFO is to use the formula:

COGSF = COGSL – change in the LIFO reserve = COGSL – (LIFO reserveE – LIFO reserveB)



where: COGSF = the cost of goods sold under FIFOCOGSL = the cost of goods sold under LIFOLIFO reserveE = the reserve at the end of the periodLIFO reserveB = the reserve at the beginning of the period

The long way to convert COGS is to calculate purchases, convert both beginning and ending inventory to FIFO levels, and then calculate COGS using the FIFO inventory levels and purchases:

purchases = EIL – BIL + COGSL

EIF = EIL + LIFO reserveE

BIF = BIL + LIFO reserveB

COGSF = purchases + BIF – EIF

where:EIF = the ending inventory level under FIFOEIL = the ending inventory level under LIFOBIF = the beginning inventory level under FIFOBIL = the beginning inventory level under LIFO

Example: Converting from LIFO to FIFO

Sipowitz Company, which uses LIFO, reported end-of-year inventory balances of $500 in 2003 and $700 in 2004. The LIFO reserve was $200 for 2003 and $300 for 2004. COGS during 2004 was $3,000. Convert 2004 ending inventory and COGS to a FIFO basis.

Answer:

Inventory:

InvF = InvL + LIFO reserve = $700 + $300 = $1,000

COGS:

Quick way: COGSF = COGSL – (LIFO reserveE – LIFO reserveB)= $3,000 – ($300 – $200) = $2,900

Long way: Purchases = EIL – BIL + COGSL = $700 – $500 + $3,000 = $3,200EIF = EIL + LIFO reserveE = $700 + $300 = $1,000BIF = BIL + LIFO reserveB = $500 + $200 = $700

COGSF = Purchases + BIF – EIF = $3,200 + $700 – $1,000 = $2,900

Balance sheet adjustments:

1. Add the LIFO reserve to LIFO inventory. This transforms LIFO inventory to FIFO.



2. Now, since you changed inventory on the left side of the balance sheet to current cost, the left side of the balance sheet doesn’t balance with the right side. You must then increase retained earnings by the LIFO reserve. Retained earnings increases because accumulated FIFO profits would be greater than LIFO profits.

Professor’s Note: When calculating FIFO equity, assume that the entire LIFO reserve is reflected in equity. Oftentimes, you’ll see analysts increase equity by (1 – tax rate) × LIFO reserve and deferred taxes by tax rate × LIFO reserve. However, this is only appropriate if there’s a liquidation of LIFO layers. Furthermore, for minor liquidations the tax effect is likely to be very small, and the probability of significant LIFO liquidations is low for going concerns. Therefore, we recommend that on the exam you ignore tax effects when making the LIFO reserve adjustment to equity, unless the question specifically tells you to include it because the probability of a large LIFO liquidation is high.

Cost of goods sold adjustment:

1. The next step is to adjust the LIFO income statement to an approximation of a FIFO income statement. The COGS adjustment uses the difference in the beginning and ending LIFO reserves. The change in the LIFO reserve between two years represents the impact of using LIFO during that year.

2. During periods of rising prices, LIFO COGS will be greater than FIFO COGS. To convert LIFO COGS to FIFO COGS, you must reduce the LIFO COGS by the current year’s increase in the LIFO reserve. This will, in turn, cause after-tax income to increase by the change in the LIFO reserve times one minus the tax rate.

3. Note that if the LIFO reserve should fall, the analysis above would be reversed.

FIFO to LIFO Conversions

When FIFO accounting is used, there is typically no desire to calculate what inventory would have been under LIFO, since inventory under LIFO is not a reflection of true economic value. However, it may be useful to consider what COGS would be under LIFO. The adjustment process is completely different than the process of converting COGS from LIFO to FIFO. There is no precise calculation; an analyst must estimate what the costs would have been under LIFO.

The estimate of COGS is equal to:

COGSL = COGSF + (BIF × inflation rate)

The inflation rate should be an inflation rate appropriate for that firm or industry, not a general inflation rate for the economy. It can be determined by two methods:

• Industry statistics.• The increase in the LIFO reserve for another company in the same industry divided by that company’s

beginning inventory level converted to FIFO accounting.

An analyst can also estimate what the COGS would have been under the LIFO method for a company that uses the average cost method. The logic is that because the average cost method always reports inventory values and costs of goods sold between values reported under LIFO and FIFO, the adjustment for the COGS estimate should be half of the adjustment that was used for FIFO accounting:

L W W

W

W

1COGS COGS BI inflation rate

2

where:COGS the COGS under the average cost methodBI the beginning inventory under the average cost method

⎛ ⎞= + × ×⎜ ⎟⎝ ⎠

==



Example: Calculating LIFO COGS

Logan Company is in the same industry as Sipowitz Company from the previous example. Logan uses FIFO accounting and has COGS of $2,000, ending inventory of $500, and beginning inventory of $350. Recall that Sipowitz had a beginning LIFO reserve of $200, an ending LIFO reserve of $300, and a beginning FIFO inventory of $700. Estimate Logan’s COGS under LIFO accounting.

Answer:

First estimate the inflation rate using data from Sipowitz. The increase in the LIFO reserve for Sipowitz is $300 – $200 = $100. The beginning inventory converted to FIFO is $700. That means the inflation rate is ($100 / $700) = 14.3%.

Now the estimate of COGS can be calculated as:

COGSL = COGSF + (BIF × inflation rate) = $2,000 + ($350 × 0.143) = $2,050

The Impact of LIFO vs. FIFO on Financial Ratios

Professor’s Note: The presumption in this section is that prices are rising and inventory quantities are stable or increasing. The implications when inventories or prices decline will be discussed later.

Since the choice of inventory accounting method has an impact on income statement and balance sheet items, it will have an impact on ratios as well. In general, an analyst should use LIFO values for income statement items and FIFO values for balance sheet items.

Profitability. Compared to FIFO, LIFO produces COGS balances that are higher and that are a better measure of true economic cost. Consequently, we have seen that LIFO produces income values that are lower than FIFO, and LIFO figures are a better measure of future profitability. Profitability ratios, such as gross margin and net profit margin, are lower under LIFO than under FIFO, and ratios calculated using LIFO figures are better for comparison purposes. For firms that use FIFO, income ratios should be recalculated using estimates of what COGS would be under LIFO.

Liquidity. Compared to LIFO, FIFO produces inventory figures that are higher and that are a better measure of economic value. LIFO inventory figures use prices that are outdated and have less relevance to the economic value of inventory. Liquidity ratios, such as the current ratio, are higher under FIFO than under LIFO, and ratios calculated using FIFO figures are better for comparison purposes. For firms that use LIFO, liquidity ratios should be recalculated using inventory balances that have been restated using the LIFO reserve.

Activity. Inventory turnover makes little sense for firms using LIFO due to the mismatching of costs (the numerator is largely influenced by current or recent past prices, while the denominator is largely influenced by historical prices). Using LIFO when prices are rising causes the inventory turnover ratio to trend higher even if physical turnover does not change. FIFO-based inventory turnover ratios are relatively unaffected by price changes and are a better approximation of actual turnover. However, the ratio itself can still be misleading because the numerator does not reflect COGS as well as LIFO accounting does. The preferred method of turnover analysis is to use LIFO COGS and FIFO average inventory. In this way, current costs are matched in the numerator and denominator. This method is called the current cost method.

Some firms use an economic order quantity (EOQ) model to determine optimal inventory ordering policies. For these firms, the level of sales will greatly influence the inventory turnover: the lower the sales, the lower turnover will be. Other firms utilize just-in-time inventory policies and keep no inventory (at most, very little) on hand. This results in very large inventory turnover ratios. For these firms, the LIFO or FIFO choice has little meaning since there would be virtually no difference between the two methods. LIFO firms tend to carry larger quantities



of inventory than comparable FIFO firms. This can most likely be explained by the tax advantages (i.e., lower taxes due to higher COGS) of LIFO.

Solvency. FIFO produces higher inventory figures that are more relevant than under LIFO. To reconcile the balance sheet, stockholders’ equity must also be adjusted by adding the LIFO reserve. Solvency ratios such as the debt ratio and debt-to-equity ratio will be lower under FIFO because the denominator is higher. For firms that use LIFO, ratios should be calculated using asset and equity figures restated by using the LIFO reserve.

Professor’s Note: It may seem inconsistent to use LIFO figures for net income and FIFO figures for stockholders’ equity. Nonetheless, that is exactly what an analyst should do.

Example: Converting LIFO to FIFO

Figure 4 shows a balance sheet for a company for 2004 and 2005, along with its income statement for 2005.

Figure 4: Sample Balance Sheet and Income Statement

Year 2005 2004

Assets

Cash $105 $95Receivables 205 195Inventories 310 290

Total current assets 620 580

Gross property, plant, and equipment $1,800 $1,700Accumulated depreciation (360) (340)Net property, plant, and equipment 1,440 1,360

Total assets $2,060 $1,940

Liabilities

Payables $110 $90Short-term debt 160 140Current portion of long-term debt 55 45Current liabilities $325 $275

Long-term debt $610 $690Deferred taxes 105 95Common stock 300 300Additional paid in capital 400 400Retained earnings 320 180Common shareholders equity 1,020 880

Total liabilities and equity $2,060 $1,940



Part A: Convert inventory for 2004 and 2005 and COGS for 2005 into FIFO.

Part B: Calculate the net profit margin, current ratio, inventory turnover (using average inventory), and long-term debt-to-equity ratio using the accounting figures that are most appropriate to compare to industry norms.

Answer:

Part A:

2004: InvF = InvL + LIFO reserve = 290 + 90 = $3802005: InvF = InvL + LIFO reserve = 310 + 100 = $410COGSF = COGSL – (LIFO reserveE – LIFO reserveB) = 3,000 – (100 – 90) = $2,990

Part B:

net profit margin

current ratio

inventory turnover

Year 2004

Sales $4,000

Cost of goods sold 3,000

Gross profit $1,000Operating expenses 650

Operating profit 350Interest expense 50

Earnings before taxes 300Taxes 100

Net income 200

Common dividends $60* Footnote: The company uses the LIFO inventory

cost-flow assumption to account for inventories. As compared to FIFO, inventories would have been $100 higher in 2005 and $90 higher in 2004.

net income under LIFO 2005.0%

sales 4,000= = =

current assets under FIFO

current liabilities

105 205 4102.2

325

=

+ += =

( )

COGS under LIFO

average inventory under FIFO

3,0007.6

380 4102

=

= =+



long-term debt-to-equity

LIFO Reserve Declines

The preceding analysis assumed that prices and inventory were stable or rising. Stable or rising prices and stable or increasing inventory quantities are a typical situation for a business. In these cases, the LIFO reserve will not decline. However, the LIFO reserve will decline if either the inventory balance or prices are falling.

• Declining inventory quantity. A LIFO liquidation refers to a declining inventory balance for a company using LIFO (sales exceeds production for the period, and ending inventory is less than beginning inventory). In this case, the cost of goods being sold do not reflect current cost and can be many years out of date. This would make COGS appear to be very low and gross and net profits to be artificially high. An analyst must adjust COGS and pre-tax income for the decline in the LIFO reserve that is caused by the decline in inventory quantity. This amount is typically listed in the footnotes of the financial statements.

• Declining prices. If prices decline, the differences in the values of inventory and COGS under LIFO and FIFO are the opposite of what was stated before. Specifically:

If prices are declining, the value of inventory under FIFO will be lower than the value of inventory under LIFO (more recently purchased goods have a lower value relative to goods purchased earlier).If prices are declining, the COGS under LIFO will be lower than the COGS under FIFO.

However, even when prices decline, FIFO still provides a more accurate estimate of the economic value of inventory, and LIFO still provides a more accurate estimate of the economic COGS. The decline in the LIFO reserve does not have to be adjusted if it occurs because of a price decline.

CHANGES IN INVENTORY ACCOUNTING METHODS

Initial LIFO Adoption

According to U.S. GAAP, a retroactive restatement or disclosure of cumulative effect are not required when a firm changes to LIFO. The firm is only required to disclose in its footnotes the effect on current period net income and net income before extraordinary items.

Change From LIFO

A change from LIFO to another method requires a retroactive restatement of prior years’ earnings. The cumulative effect is reflected in retained earnings for the earliest restated year.

ANALYSIS OF CHANGES IN INVENTORY BALANCES

Suppose you notice that a company you have been following closely reports an unexpected increase in inventory balances (measured at current cost). Perhaps you detected this because you noticed a decrease in inventory turnover. The question is, what might this tell you about the firm’s future sales and earnings?

long-term debt

equity under FIFO

long-term debt

equity under LIFO + LIFO reserve

61054.5%

1,020 100

=

=

= =+



There are actually two possible, very different, interpretations:

• Bad News: It might mean that demand for the company’s product is declining unexpectedly, which should be a warning signal to you of decreased future demand.

• Good News: Instead, it could indicate that management expects demand to increase and is planning for it by boosting production and building inventories.

Bernard and Noel (1991)1 suggest that the way you interpret the increase in inventory depends on the industry the firm is in and the specific components of inventory that are increasing. We’ll examine three cases:

A Retailer Experiences an Increase in Inventory Balances

Bernard and Noel (1991) found that an increase in the inventory balances of retailers signals future lower short-term demand, higher short-term sales, and lower short-term earnings and profit margins. This occurs because retailers will aggressively cut prices to reduce excess inventory back to normal levels in response to the drop in demand, which results in higher revenues but lower profit margins. Once the excess inventory is sold off, sales growth and profit margins tend to return to “normal” levels.

A Manufacturer Experiences an Increase in Finished Goods Inventory Balances

The short-term effect for manufacturers of an increase in finished goods inventory is the same as it is for retailers—an increase in future sales and lower profit margins until the extra inventory is sold off. However, with manufacturers, the long-term effect is also negative because the drop in demand appears to be permanent: sales growth declines and profit margins continue to fall. Profit margins are also negatively affected by the slow down in production. Fixed costs don’t decrease with the decrease in production, so average total cost per unit increases and gross margin falls.

A Manufacturer Experiences an Increase in Raw Materials/WIP Inventory Balances

The results are different, however, if the increase in the manufacturer’s inventory balances result from increases in raw materials or work-in-process (WIP). In this case, the higher inventory levels signal an increase in future demand and higher long-term sales growth. The effect on average total costs and profit margins is also different. Higher production in anticipation of increased demand reduces the average total cost per unit and increases gross profit margins.

1. Bernard, Victor L. and James Noel, “Do Inventory Disclosures Predict Sales and Earnings,” Journal of Accounting, Auditing and Finance, March 1991, pp. 145-182.



KEY CONCEPTS

1. The three methods of accounting for inventory are FIFO, LIFO, and average cost. FIFO provides the more useful estimate of inventory and balance sheet information. When analyzing a company using LIFO, all inventory, current asset, total asset, and equity figures should be restated by adding the LIFO reserve. LIFO provides the more useful estimate of COGS. When doing financial analysis on a company that uses FIFO, all COGS and income figures should be restated by using the FIFO COGS figure adjusted to LIFO.

2.

3. FIFO inventory = LIFO inventory + LIFO reserveLIFO COGS = FIFO COGS + (FIFO beginning inventory × inflation rate)

4. When prices are falling, inventory levels under FIFO will be lower than levels under LIFO, and COGS will be lower under LIFO than COGS under FIFO. However, FIFO still provides the more useful estimate of inventory, and LIFO still provides the more useful estimate of COGS.

5. U.S. GAAP requires a retroactive restatement of prior years’ earnings when a firm changes from LIFO to another method. However, when a firm changes to LIFO, only a disclosure of the effect on current period net income and net income before extraordinary items is required.

6. An increase in inventory balances has two possible interpretations for future sales and earnings prospects:• Bad news: It might mean that demand for the company’s product is declining unexpectedly, which should

be a warning signal to you of decreased future demand.• Good news: Instead, it could indicate that management expects demand to increase and is planning for it

by boosting production and building inventories.The analyst should interpret the change in inventory balance in context of the industry.

If prices are rising and inventory quantities are stable or increasing:

LIFO results in... FIFO results in...

higher COGS lower COGS

lower taxes higher taxes

lower net income (EBT & EAT) higher net income (EBT & EAT)

lower inventory balances higher inventory balances

lower working capital higher working capital

higher cash flows (less taxes paid out) lower cash flows (more taxes paid out)



CONCEPT CHECKERS: ANALYSIS OF INVENTORIES

Use the following data to answer Questions 1 through 6.

Kerklaan Sports (Kerklaan) sells bowling balls. The following information is relevant for the year ended December 31, 2005.

Purchases Sales40 units at $30 13 units at $3520 units at $40 35 units at $4590 units at $50 60 units at $60

Assume that beginning inventory consists of 20 units at $25. Tax rate is 40 percent.

1. Which of the following statements is TRUE? The year-end inventory balance under FIFO is:A. lower by $820 than under LIFO.B. higher by $820 than under LIFO.C. lower by $1,320 than under LIFO.D. higher by $1,320 than under LIFO.

2. Using LIFO and information for the entire period, gross profit for the year-end is closest to:A. –$870.B. $410.C. $910.D. $1,730.

3. Suppose that Kerklaan was previously using LIFO and wants to switch to FIFO in 2005. Ignore any retroactive restatement of prior period results. If Kerklaan uses FIFO in 2005, taxes payable in 2005 is closest to:A. $692.B. $760.C. $1,220.D. $1,730.

4. Based on the information in this question, which of the following statements is TRUE? Compared to FIFO, the weighted average method results in (assume that any change in equity is insignificant): A. lower working capital and lower return on equity than FIFO.B. lower working capital and higher return on equity than FIFO.C. higher working capital and lower return on equity than FIFO.D. higher working capital and higher return on equity than FIFO.

5. Assume that the market price for bowling balls is $45 on December 31, 2005. What is the effect (if any) on Kerklaan’s financial statements?A. Under LIFO, inventory must be written up by $1,010 to reflect current market value.B. Under LIFO, no writeups or writedowns are necessary.C. Under FIFO, inventory must be written down by $210 to reflect current market value.D. Under FIFO, no writeups or writedowns are necessary.



6. Based on the information in the question, which of the following statements is TRUE? Compared to LIFO, the use of the FIFO method results in:A. higher debt-to-equity ratio and higher cash flow.B. higher debt-to-equity ratio and lower cash flow.C. lower debt-to-equity ratio and higher cash flow.D. lower debt-to-equity ratio and lower cash flow.

7. Which of the following financial implications will generally NOT result from adjusting reported financial statements from FIFO to LIFO?A. A decrease in earnings.B. A decrease in inventory.C. A decrease in total assets.D. A lower debt-to-equity ratio.

8. The choice of inventory accounting method has direct cash flow effects because of its effect on:A. purchases.B. sales.C. taxes.D. cost of goods sold.

9. From the analyst’s perspective, how should inventories and current income be valued on the financial statements?

Inventories Current IncomeA. FIFO FIFOB. FIFO LIFOC. LIFO FIFOD. LIFO LIFO

10. Which of the following statements is inconsistent with a declining LIFO reserve?A. Gross margin appears artificially high. B. Declining inventory quantity may result in a declining LIFO reserve. C. If prices are declining, the value of inventory under FIFO will be lower than the value under LIFO. D. An analyst should adjust for the decline in the LIFO reserve if the decline is the result of falling prices.

11. An analyst is evaluating a company after a period of time in which prices have fallen. The company uses LIFO accounting. Which of the following is TRUE?A. The analyst must restate COGS because it is lower than what it would be under FIFO accounting.B. Income will be lower than it would have been under FIFO accounting.C. Inventory need not be restated because the LIFO reserve will have decreased. D. COGS need not be restated because LIFO COGS is always an accurate measure of current cost as long

as inventory quantity does not decline.


The beginning-of-period LIFO reserve is $50,000, and the end-of-period LIFO reserve is $60,000. What are the financial statement adjustments if the firm’s tax rate is 40 percent?

12. To adjust end-of-period LIFO inventory to FIFO inventory:A. add $10,000.B. subtract $10,000.C. add $60,000.D. subtract $60,000.



13. To adjust end-of-period retained earnings from LIFO-based to FIFO-based inventory accounting:A. add $10,000.B. add $26,000.C. add $50,000.D. add $60,000.

14. To adjust end-of-period accounts payable from LIFO-based to FIFO-based:A. make no adjustment.B. add $24,000.C. add $36,000.D. subtract $36,000.

15. To adjust COGS from LIFO to FIFO, you must adjust the LIFO COGS by:A. increasing it by $10,000.B. decreasing it by $10,000.C. increasing it by $60,000.D. decreasing it by $60,000.

16. To adjust LIFO pre-tax income to FIFO pre-tax income:A. increase it by $6,000.B. decrease it by $6,000.C. increase it by $10,000.D. decrease it by $10,000.

17. Which of the following statements concerning a comparison between FIFO and LIFO in the U.S. is FALSE?A. For analysis purposes, there is no reason to convert inventory to LIFO because LIFO inventory is less

reflective of current value. B. If prices are rising and inventory levels are stable, the use of LIFO will result in a lower current ratio

compared to the use of FIFO.C. If prices are rising and inventory levels are stable, the use of FIFO will result in higher inventory value

than the use of LIFO. D. If prices have been falling and inventory levels are stable, taxes payable would be lower under LIFO than

under FIFO.



18. Ben Knowlin is analyzing the financial statements of Outdoor Machinery Inc., a manufacturer of construction equipment. Outdoor uses the FIFO method of inventory accounting. In the footnotes to the financial statements he finds the following reconciliation of inventory (in millions of dollars):

Knowlin has read the work of Bernard and Noel (1991) and, using their research, makes the following short- and long-term forecasts for Outdoor Machinery:

(1) Short-term forecast: Lower demand, higher sales revenue, lower profit margins, and lower earnings.

(2) Long-term forecast: Lower demand, lower sales revenues growth, lower profit margins, and lower earnings.

Based on Bernard and Noel’s findings, Knowlin’s short-term forecast:A. and his long-term forecast are incorrect.B. is correct, but his long-term forecast in incorrect.C. is incorrect, but his long-term forecast is correct.D. and his long-term forecast are correct.

19. Ben Knowlin is also analyzing the financial statements of another construction equipment manufacturing company, Ridgeway Equipment. Ridgeway uses the LIFO method of inventory accounting. Knowlin calculates inventory turnover and gross profit margin without making the proper adjustments to the financial statements. Ridgeway’s LIFO reserve increased from $1,000 to $1,200 during the year. What has been the effect of Knowlin’s analysis on his estimates of adjusted inventory turnover and adjusted gross profit margin?

Inventory turnover Gross profit marginA. Underestimated Properly estimatedB. Underestimated OverestimatedC. Overestimated Properly estimatedD. Overestimated Overestimated

Use the following information for Questions 20 through 22.

Jonorton Inc. uses the LIFO method of accounting for its inventories. Arnold Van Braun, CFA, has adjusted the statements from LIFO to FIFO, and compiled the following financial ratios for Jonorton Inc. using both the original LIFO based financial statements, and the adjusted FIFO financial statements.

2004 2003

Raw materials $5,000 $5,000

Work-in-process $12,000 $11,000

Finished goods $20,000 $13,000

Total inventory $37,000 $29,000

LIFO FIFO

Current ratio 1.23 1.48

Inventory turnover 3.11 2.08

Gross margin 30.0% 37.5%



20. The most meaningful current ratio number that Van Braun should use for comparative analysis purposes is:A. 1.23.B. 1.48.C. the average of 1.23 and 1.48.D. current assets from the LIFO statements divided by current liabilities from the FIFO statements.

21. The most meaningful inventory turnover number that Van Braun should use for comparative analysis purposes is:A. 3.11.B. 2.08.C. cost of goods sold from the LIFO statements divided by inventory from the FIFO statements.D. cost of goods sold from the FIFO statements divided by inventory from the LIFO statements.

22. The most meaningful gross margin number that Van Braun should use for comparative analysis purposes is:A. 30.0%.B. 37.5%.C. the average of 30.0% and 37.5%.D. gross margin from the FIFO statements divided by sales from the LIFO statements.

23. Marvinson Doors has recently issued long-term debt, and its bond indenture includes the following covenants:• The company must maintain a net profit margin greater than 5%. • The company must maintain a current ratio greater than 1.8 times. • The company must maintain an inventory turnover ratio greater than 6.0 times. • The company must maintain a cash flow from operations to long-term debt ratio (CFO-to-LTD) greater

than 1.0 times.

The ratios for all covenants are based on the company’s financial statements as prepared according to U.S. GAAP. Assume prices will continue to increase, and inventory amounts are stable or increasing.

The inventory method that would enable Marvinson to most easily avoid violating the related covenant is:A. LIFO for net profit margin.B. FIFO for inventory turnover.C. LIFO for current ratio.D. LIFO for CFO-to-LTD.



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF INVENTORIES

1. D 108 units were sold (13 + 35 + 60), and 170 units (beginning inventory of 20 plus purchases of 40 + 20 + 90) were available for sale, so there are 170 – 108 = 62 units in ending inventory.

Under FIFO, units from the last batch purchased would remain: 62 × $50 = $3,100. Under LIFO, the first 20 units in beginning inventory plus the first 42 units purchased would be in inventory: (20 × $25) + (40 × $30) + (2 × $40) = $1,780. FIFO inventory is larger than LIFO inventory by $3,100 – $1,780= $1,320.

The difference between FIFO and LIFO = $3,100 less $1,780 = $1,320; that is, the balance under FIFO is $1,320 higher than under LIFO.

2. B Revenue = (13 × $35) + (35 × $45) + (60 × $60) = $5,630Purchases = (40 × $30) + (20 × $40) + (90 × $50) = $6,500COGSL = purchases + beginning inventory – ending inventory = 6,500 + 500 – 1,780 = $5,220Gross profitL = $5,630 – $5,220 = $410

3. A COGSF = 6,500 + 500 – 3,100 = $3,900Gross profitF = $5,630 – $3,900 = $1,730Tax payableF = 0.40(1,730) = 692

4. A COGSF = $3,900

COGSWA:170 units in total (20 units in beginning inventory plus 150 units purchased this year)Total cost = (20 × 25) + (40 × 30) + (20 × 40) + (90 × 50) = $7,000Average cost = 7,000 / 170 = $41.18COGSWA = 108 units sold @ $41.18/each = $4,447

Since COGS is higher under the weighted-average method, gross profit (and net income) is lower under weighted-average. ROE = net income / equity. Assuming no change in equity, the lower net income under weighted-average suggests that the ROE is lower under weighted-average.

EIF = $3,100EIW = $41.18 × 62 = $2,553Inventory is a working capital item; therefore, all other things being equal, working capital is lower under weighted-average.

Note that because prices are rising and inventory quantities are increasing, you know that COGS under the weighted average method must be greater than FIFO COGS, and ending inventory must be lower. Therefore, you can determine that A is the only possible choice without doing any calculations.

5. B The year-end inventory balance of 62 units is costed at $3,100 under FIFO and $1,780 under LIFO. Year-end market value of 62 units at $45 per unit is $2,790. Using the lower of cost or market principle, there would be a $3,100 – $2,790 = $310 (not $210, as suggested in choice “C”) writedown required if FIFO were used and no writedown required if LIFO were used. Inventory may never be written up beyond its original cost underlower-of-cost-or-market.

6. D Under FIFO, the denominator (equity) is higher than under LIFO due to the higher net income, so the debt-to-equity ratio is lower. Under FIFO, the net income is higher; therefore, taxable income is higher, more taxes are paid, and cash flows are lower than under LIFO.

7. D An adjustment from FIFO to LIFO will generally result in decreased inventory and total assets. The decrease in earnings (due to higher COGS) will decrease the retained earnings, thereby increasing the debt-to-equity ratio.



8. C The choice of inventory accounting method flows through the income statement ultimately to affect taxes.

9. B For balance sheet purposes, inventories based on FIFO are preferable because these values most closely resemble current cost and economic value. For income statement purposes, LIFO is the most informative accounting method and provides a better measure of current income because LIFO allocates the most recent costs to the cost of goods sold.

10. D The decline in the LIFO reserve does not have to be adjusted if it occurs because of a price decline. Even when prices decline, FIFO still provides a more accurate estimate of the economic value of inventory, and LIFO still provides a more accurate estimate of the economic COGS. The other choices are consistent with a declining LIFO reserve.

11. D LIFO COGS is the better measure of economic cost as long as inventory levels have not declined.

12. C LIFO inventory is lower than FIFO; add the ending period LIFO reserve of $60,000.

13. D Because inventory is $60,000 higher, so is retained earnings. (The increase in total assets and the increase in total liabilities is the same, since here TA = TL).

14. A Accounts payable is not impacted by inventory accounting methods, so no adjustment is necessary.

15. B Decrease LIFO COGS by the change in the LIFO reserve of $60,000 – $50,000 = $10,000.

16. C Because costs decrease by $10,000, pretax income would increase by $10,000.

17. D Under LIFO, cost of goods sold consists of the last purchased items. Since prices are falling, the cost of goods sold figure will be lower than under FIFO. This will result in a higher taxable income under LIFO and therefore higher taxes payable under LIFO.

18. D Knowlin is correct in both of his forecasts. Bernard and Noel (1991) found that an increase in the inventory balances of a manufacturer signals lower short-term demand, but higher short-term sales and lower short-term earnings and profit margins. The reason this occurs is that the manufacturer will aggressively cut prices to reduce excess inventory back to normal levels in response to the drop in demand, which results in higher sales revenue but lower profit margins and lower earnings. In the long-term, Bernard and Noel (1999) find that the drop in demand appears to be permanent because long-term sales growth declines and profit margins and earnings continue to fall.

19. C LIFO cost of goods sold (COGS) is greater than FIFO cost of goods sold (by the change in the LIFO reserve, or $200), and LIFO inventory balance is less than FIFO inventory by the amount of the LIFO reserve ($1,200). The proper analysis is to use LIFO COGS and FIFO inventory balance to calculate financial ratios. Knowlin has used LIFO COGS and LIFO inventory, so he has properly estimated gross profit margin, but he has overestimated inventory turnover (COGS divided by inventory) because he used the correct figure in the numerator (LIFO COGS) but the incorrect, lower LIFO inventory figure in the denominator.

20. B For comparative ratio analysis the analyst should use the FIFO inventory figure and the LIFO cost of goods sold figure. The appropriate current ratio number is FIFO current assets divided by current liabilities, which is 1.48 from the figure. Notice that current liabilities are the same under LIFO and FIFO.

21. C For comparative ratio analysis the analyst should use the FIFO inventory figure and the LIFO cost of goods sold figure. The appropriate inventory turnover number is cost of goods sold from the LIFO statements divided by inventory from the FIFO statements.

22. A For comparative ratio analysis the analyst should use the FIFO inventory figure and the LIFO cost of goods sold figure. The appropriate gross margin number is LIFO gross profit divided by net sales, which is 30.0% from the figure. Notice that sales are the same under LIFO and FIFO.



23. D Net profit margin will be higher under FIFO than LIFO, because LIFO cost of goods sold (COGS) is larger than FIFO COGS. Therefore FIFO net profit margin is preferred to LIFO net profit margin.

Inventory turnover will be higher under LIFO than FIFO, because the numerator (cost of good sold) will be larger and the denominator (inventory) will be smaller. Therefore LIFO inventory turnover is preferred to FIFO inventory turnover.

Current ratio will be higher under FIFO than LIFO, because FIFO inventory is larger than LIFO inventory, which means FIFO current ratio will be greater than LIFO current ratio. Therefore FIFO current ratio is preferred to LIFO current ratio.

CFO will be higher under LIFO than FIFO, because cash taxes paid is lower under LIFO, which means LIFO CFO-to-LTD will be higher than FIFO CFO-to-LTD. Therefore LIFO CFO-to-LTD is preferred to FIFO CFO-to-LTD.



ANALYSIS OF LONG-LIVED ASSETS: PART II—ANALYSIS OF DEPRECIATION AND IMPAIRMENT

Study Session 5

EXAM FOCUS

Depreciation is the process of allocating the cost of anasset to expense over time. In reality, depreciation isan allocation of past cash flows; depreciation expenseappears on the income statement but has no impact onthe statement of cash flows. There are multipleacceptable methods of calculating depreciation, andthe method the firm chooses is its own decision. On

the Level 2 exam, be prepared to analyze how changesto depreciation methods and assumptions affect thefinancial statements. You should also understand howmanagement can manipulate earnings by its choice ofmethods and assumptions. This topic is addressedagain in our topic review of financial shenanigans inStudy Session 7.

WARM-UP: DEPRECIATION

The underlying principle of depreciation is that cash flows generated by an asset over its life cannot be considered income until provision is made for the asset’s replacement. This means that the definition of income requires a subtraction for asset replacement.

Depreciation is a real and significant operating expense. Even though depreciation doesn’t require current cash expenditures (the cash outflow was made in the past when the company invested in the depreciable assets), it is an expense that is just as important as labor or materials. Therefore, analysis should not exclude depreciation expense.

The accounting problem is how to allocate the cost of the asset over time. Depreciation is the systematic allocation of the asset’s cost (in the balance sheet) to expense (in the income statement) over time.

Professor’s Note: We’ve started our discussion of the analysis of long-lived assets with a complete review of depreciation methods from Level 1. Take some time to review this material if you need to brush up on the basics. At Level 2, you’re expected to extend your knowledge so you can analyze the firm’s financial statements and detect earnings manipulation.

There are several key terms that you should know:

• Book value. The net value of an asset or liability as it is listed on the balance sheet. For property, plant, and equipment, book value equals historical cost minus accumulated depreciation.

• Historical cost. The original purchase price of the asset including installation and transportation costs. The gross investment in the asset is the same as its historical cost.



ANALYSIS OF DEPRECIATION METHODS AND ASSUMPTIONS

LOS 1.B: Compare and contrast the different depreciation methods and analyze how the selection of or change in depreciation method, depreciable lives, or salvage values affects a company’s financial statements, financial ratios, and comparability with other companies.

Depreciation Methods

Straight-line (SL) depreciation is the dominant method of computing depreciation. It allocates the cost of the asset equally each year over the asset’s depreciable life:

There are two accelerated depreciation methods, sum-of-years’ digits (SYD) and double-declining balance (DDB), which recognize greater depreciation expense in the early part of an asset’s life and less expense in the latter portion of its life. The economic justifications of accelerated methods include increasing repair and maintenance costs, decreasing revenues and operating efficiency, and greater uncertainty of revenues due to obsolescence over the life of the asset.

Accelerated depreciation methods are usually used on tax returns (when allowed) because greater depreciation expense in the early portion of the asset’s life results in less taxable income and a smaller tax payment. This initial saving on taxes is a deferral, since a greater tax payment will be required in the latter part of the asset’s life.

The sum-of-years’ digits (SYD) method applies more depreciation in the early years of an asset’s life than the later years. The formula to calculate SYD depreciation is:

where:n = depreciable life SYD = 1 + 2 + … + (n – 1) + n

A quick way to calculate the sum is to use the formula: . Therefore, the sum for a 5-year useful life

is and for a 10-year useful life is

The double-declining balance (DDB) method is another accelerated method. The formula to calculate DDB depreciation is:

Note that the salvage value is not used in the formula. The remaining book value is not allowed to go below the salvage value. If the amount of depreciation in year x would take the book value below the salvage value, the depreciation in year x is equal to the difference between book value at the beginning of the year and the salvage value.

original cost – salvage valueSL depreciation expense =

depreciable life

( ) ( )original cost – salvage value n – x 1SYD depreciation in year x =

SYD

× +

( )n n 1sum

2

+=

5 615

2

× = 10 1155.

2

× =

2DDB depreciation in year x = book value at beginning of year x

depreciable life×



• The use of a declining balance results in a constant percentage of undepreciated asset cost being depreciated each period (i.e., 200 percent of the straight-line rate).

• The constant percentage can be any rate, but the most common are 200DB (a.k.a. double declining balance or DDB) and 150DB. The rate is stated as a percent of the straight-line rate. If the asset has a 10-year life, the straight-line rate is 10 percent per year and the 200DB rate is 20 percent; if the asset has a 20-year life, the straight-line rate is 5 percent and the 150DB rate is 150 percent of 5 percent, or 7.5 percent.

The units-of-production method and service hours method apply depreciation at the rate at which the asset is being used. Either the production capacity or the service life of the asset is estimated when the asset is put into service. The cost of the asset minus the salvage value is divided by either the production capacity or service life to achieve either a rate per unit or a rate per hour. Depreciation is then charged off based on the year’s production or usage. Depreciation is not charged once the asset’s book value reaches its estimated salvage value.

Note that these methods make depreciation a variable cost, rather than a fixed cost (as it is with straight-line and accelerated methods). The result is lower earnings volatility when firms use units-of-production and service hours methods.

Depletion is the allocation of the cost of a natural resource. The cost of natural resources is allocated to inventory or expense on the basis of the amount of those resources extracted from the mine or well. This is similar to the units-of-production method of depreciation in that the cost of the natural resource is assigned to each unit of the resource extracted.

For example, suppose an oil deposit costs $1,000,000, and it is estimated that 100,000 barrels of oil will be extracted. The rate of depletion is $10 per barrel ($1,000,000 / 100,000). If 5,000 barrels of oil are pumped out of the well, then the depletion is (5,000)($10) = $50,000.

Amortization is the expensing (straight-line) of intangibles over their useful economic (e.g., software) or legal (e.g., patent) life.

Effect of Changes in Depreciation Method

Since firms can use many depreciation methods, useful life assumptions, and residual value estimates, analysis of the financial statements is needed when comparing firms. The analyst should be aware that the disclosed useful life, salvage value, and the depreciation method are chosen by management. This allows for the possibility of income manipulation.

Impact on cash flow. The choice of depreciation method for financial statement purposes has no impact on the statement of cash flows under U.S. GAAP because MACRS is required for tax purposes. Cash flows will be affected by the choice of the tax method of depreciation, but under U.S. law, MACRS is required for tax purposes. Therefore, cash flow will not be affected by choices made by management. It is important for the analyst to consider the capital expenditures to better understand the impact of the choice of depreciation methods.

Impact on earnings. A firm that chooses an accelerated depreciation method (e.g., DDB) instead of using straight-line will tend to have greater depreciation expense and lower net income. This will persist if the firm is investing in new assets such that the lower depreciation on old assets is more than offset by the higher depreciation on new assets. (If the firm is not investing in new assets, then the higher depreciation expense and lower net income are reversed in the later part of the asset’s life.)

Changing from straight-line to units-of-production and service hours methods for existing assets is a red flag indicating lower earnings quality that should be carefully analyzed. Firms facing increased competition from new entrants experience higher economic depreciation on their obsolete production facilities as well as falling operating margins. The common response is to boost net income by switching from straight-line to units-of-



production or service hour methods, which reduces depreciation expense as production rates fall, and net income increases. Eventually, the asset will be impaired, and the resulting impairment loss will be reported as a non-recurring charge. In effect, the company has moved current period operating expenses into future periods, and converted them into non-operating items that may be incorrectly ignored by analysts focusing on recurring earnings.

Impact on operating performance. In the early years of an asset’s life, accelerated methods tend to depress net income and retained earnings. The result is lower return measures [return on equity (ROE) and return on assets (ROA)] because the effect on net income is usually greater than the effect on equity. At the end of the asset’s life, the effect reverses. For firms with stable or rising capital expenditures, the early year effect will dominate, and depreciation expense on the total firm basis will be higher using accelerated methods. These relationships are summarized in Figure 1 assuming the firm is investing in new assets as the old ones wear out.

Professor’s Note: Since U.S. companies are required by IRS tax code to use MACRS (an accelerated depreciation method) for tax purposes, taxes payable will be the same regardless of the depreciation method used for financial reporting purposes. However, the balance sheet may be affected by the deferred tax asset or liability created by using different methods for tax purposes than for financial statement purposes.

Effect of Changes in Depreciable Lives and Salvage Value

Earnings can be manipulated via useful life and salvage value estimates as follows:

• The utilization of a longer useful life will result in higher net asset value, lower depreciation expense, and increased net income over the years being applied. Management can then write down the overstated assets in a restructuring.

• Management might also write down assets—taking an immediate charge against income—and then record less future depreciation expense based upon the written-down assets. This results in higher future net income in exchange for a one-time charge to current net income.

• A company estimates the salvage value of an asset at the time the asset is placed into service. For the SL and SYD methods, salvage value is deducted from the purchase price to calculate the amount that is depreciated each year. The higher the salvage value, the lower the amount of depreciation expense applied each year. Consequently, management can increase reported income by estimating higher salvage values for its assets. This will also result in an overstatement of loss when the asset is retired.

Figure 1: Impact of Depreciation Methods for Financial Statement Purposes Under U.S. GAAP

Straight-Line Accelerated (DDB & SYD)

Depreciation expense Lower Higher

Net income Higher Lower

Assets Higher Lower

Equity Higher Lower

Return on assets Higher Lower

Return on equity Higher Lower

Turnover ratios Lower Higher

Cash flow Same Same

Note: The relationships indicated in the preceding table are reversed in the latter years of the asset’s life if the firm’s capital expenditures decline.



KEY CONCEPTS

1. There are several types of depreciation methods, including SL, SYD, DDB, units-of-production, and service hours. Sum-of-years’ digits and double-declining balance methods are accelerated methods.

2. Accelerated depreciation methods will make depreciation larger and earnings smaller, as long as capital expenditures are increasing over time.

3. The choice of depreciation method for financial statement purposes has no effect on cash flow in the U.S. because MACRS is required for tax purposes. Straight-line methods result in higher income, higher assets, and higher equity than accelerated methods, and generally report more favorable financial results.

4. The higher the estimated salvage value and the longer the estimated depreciable life, the lower depreciation expense will be and the higher reported earnings will be.



CONCEPT CHECKERS: ANALYSIS OF LONG-LIVED ASSETS: PART II—ANALYSIS OF DEPRECIATION AND IMPAIRMENT

Professor’s Note: Questions 1 through 6 are more suited for Level 1 than Level 2 because it is unlikely that you’ll have to do much number-crunching on the Level 2 exam. However, they are a good review of the basic depreciation methods and may help with the Level 2 questions that follow.


Tofu Products, Inc., has purchased a new soybean processor for $300,000 (shipping and installation included).

• The processor has a useful life of 15 years.• The expected salvage value is $10,000.• The corporate tax rate is 39%.• Tofu expects to earn $500,000 before depreciation and taxes.• The machine is estimated to last 15,000 hours and will be operated at the rate of 1,200 hours per year.

1. Which of the following methods will produce the highest net income in year 1?A. Straight-line.B. Sum-of-years’ digits.C. Double-declining balance.D. Service hours.

2. Using the sum-of-years’ digits method (SYD), depreciation expense for year 4 is closest to:A. $19,333.B. $24,167.C. $25,000.D. $29,000.

3. Assume that starting at the beginning of year 3, the estimated remaining useful life is revised to 18,000 hours. Furthermore, assume that there is no change in the amount of use each year and no change in the salvage value at the end of the processor’s useful life. Using the service hours method, the amount of the net book value at the end of year 3 is closest to:A. $62,640.B. $65,733.C. $234,267.D. $237,360.

4. Using the straight-line method, the amount of accumulated depreciation at the end of year 8 is closest to:A. $140,000.B. $145,333.C. $154,667.D. $160,000.

5. Using the double-declining method, the amount of depreciation expense in year 2 is closest to:A. $33,511.B. $34,667.C. $38,667.D. $40,000.



6. Assume that at the beginning of year 3 the estimated remaining useful life is revised to 10 years and the expected salvage value is revised to $5,000. Using the straight-line method, the amount of depreciation expense in year 3 is closest to:A. $19,333.B. $25,633.C. $26,000.D. $26,133.

7. Which of the following will NOT enable a firm to report higher income in the future?A. Changing from sum-of-years’ digits (SYD) to straight-line while capital expenditures are increasing.B. Declaring an asset impairment.C. Resetting the salvage values of all of its assets to zero.D. Increasing the depreciable life of all of its assets.

8. Compared to firms using the sum-of-years’ digits (SYD) method, a firm using straight-line depreciation will initially report earnings that are:A. lower.B. equal.C. greater.D. dependent on usage.

9. A change in depreciation method is considered a change in accounting:A. estimates, and the cumulative effect on past income should be reported.B. estimates, and the cumulative effect on past income need not be reported.C. principles, and the cumulative effect on past income should be reported.D. principles, and the cumulative effect on past income need not be reported.



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF LONG-LIVED ASSETS: PART II—ANALYSIS OF DEPRECIATION AND IMPAIRMENT

1. A The straight-line method will depreciate the asset over the useful life of 15 years. The next two depreciation methods are accelerated depreciation methods and will depreciate the asset over periods less than 15 years. The service hours method will depreciate the asset over 12.5 years (15,000 / 1,200). Therefore, straight-line reports the lowest depreciation expense and the highest income in year 1.

2. D

3. D

4. C

5. B Note that the double-declining method does not consider salvage value.

6. B

7. C Decreasing salvage values to zero would result in higher depreciation expense and, thus, decreased income. To increase income, the company would need to increase salvage values. The other choices would result in less depreciation expense and, thus, higher income.

8. C The sum-of-years’ digits method will report greater depreciation early on, thus reporting lower earnings. A firm using straight-line depreciation will report greater earnings. Neither method considers usage.

9. C. The cumulative effect of the change on past income will be shown net of tax on the income statement.

( )

( )( )

15 15 1SYD 1 2 3 4... 15 120 or 120

2$300,000 – $10,000 15 – 4 1

Depreciation expense in year 4 = $29,000120

+= + + + + = =

+=

$300,000 – $10,000Depreciation in years 1 and 2 = 1,200 $23,200

15,000

$300,000 – 23,200 – 23,200 –10,000Depreciation in year 3 = 1,200 $16,240

18,000

Net BV year 3 $300,000 – $23,200 – $23,200 – $16,240 $237,360

× =

× =

= =

$300,000 – $10,000Accumulated depreciation in year 8 = 8 $154,667

15× =

( )

2Depreciation expense in year 1 $300,000 $40,000

15

2Depreciation expense in year 2 $300,000 – $40,000 $34,667

15

= × =

= × =

$300,000 – $10,000Total depreciation expense in years 1 and 2 2 $38,667

15

Net book value at the end of year 2 (beginning of year 3) $300,000 – $38,667 $261,333

$261,333 – $5,00Depreciation expense in year 3

= × =

= =

=( )0

$25,63310

=



ANALYSIS OF INCOME TAXES

Study Session 5

EXAM FOCUS

Be prepared to analyze the deferred tax disclosures,adjust the financial statements, and assess the impacton the ratios and future cash flows. Firms are alsorequired to disclose a reconciliation of their effective

and statutory tax rates. You should be able to interpretthe reconciling items to aid in understanding pastearnings trends, predict future tax rates, and predictthe impact on future earnings.

WARM-UP: REVIEW OF DEFERRED TAX LIABILITIES AND DEFERRED TAX ASSETS FROM LEVEL 1

Tax Return Terminology

• Taxable income. Income subject to tax based on the tax return.• Taxes payable. The tax liability on the balance sheet caused by taxable income. This is also known as current

tax expense, but do not confuse this with income tax expense (see below).• Income tax paid. Actual cash flow for income taxes, including payments or refunds for other years.• Tax loss carryforward. The current net taxable loss that can be used to reduce taxable income (thus, taxes

payable) in future years.

Financial Reporting Terminology

• Pretax income. Income before income tax expense.• Income tax expense. The expense recognized on the income statement that includes taxes payable and deferred

income tax expense. Note that income tax expense is composed of cash taxes plus noncash items like the change in deferred taxes.

• Deferred income tax expense. The difference between taxes payable and income tax expense. This results from changes in deferred tax assets and liabilities.

• Deferred tax asset. Balance sheet amounts that result from an excess of taxes payable over income tax expense that are expected to be recovered from future operations. Deferred tax assets are created when less expense is shown on the tax statements, which leads to higher taxable income and taxes payable relative to the expense, income, and tax that is shown on the income statement.

• Deferred tax liability. Balance sheet amounts that result from an excess of income tax expense over taxes payable that are expected to result in future cash outflows. Deferred tax liabilities are created when more expense is applied to the tax return relative to the income statement (e.g., more depreciation). This results in lower taxable income and lower taxes payable on the tax return relative to the pretax income and income tax expense that is shown on the income statement.

• Valuation allowance. Reserve against deferred tax assets based on the likelihood that those assets will not be realized.

• Timing difference. The difference between the treatment of expenditures on the tax return and for financial reporting.



• Temporary difference. The differences between tax and financial reporting that will reverse in the future and will affect taxable income when they reverse, including the differences in the carrying cost of depreciable assets on tax and accounting records.

• Permanent difference. The differences between tax and financial reporting that are not expected to reverse in the future.

Deferred Tax Liability

A deferred tax liability is created when an income or expense item is treated differently on the financial statements than it is on the company’s tax returns, and that difference results in greater income tax expense on the financial statements than taxes payable on the tax return.

Deferred tax liabilities are accounted for because the differences arising from unique accounting treatments for tax and financial reporting purposes are expected to reverse themselves (i.e., they are temporary differences) and they result in future cash outflows related to the payment of taxes.

The most common way that deferred taxes are created is when different depreciation methods are used on the tax return and the income statement.

Deferred Tax Asset

A deferred tax asset is created when an income or expense item is treated differently on the financial statements than it is on the company’s tax returns, and that difference results in lower income tax expense on the financial statements than taxes payable on the tax return.

Similar to deferred tax liabilities, deferred tax assets are expected to reverse themselves through future operations and provide tax savings and, therefore, are accounted for on the balance sheet.

Warranty expenses and tax-loss carryforwards are typical causes of deferred tax assets.

The Liability Method

The liability method of accounting for deferred taxes starts from the premise that differences between income tax expense based on the firm’s financial statement (i.e., prepared according to U.S. GAAP) and taxes payable from the tax returns will be reversed at some future date. In a case where income tax expense based on U.S. GAAP is more than taxes payable from tax-based accounting rules, a deferred tax liability in the amount of the difference is entered on the balance sheet. The principle at work here is that activities in the current period have caused the company to incur a tax liability that will be reversed, and therefore must be paid, in a future period.

If a company has an expense item (e.g., estimated warranty expense) on its financial statements that is not currently deductible for tax purposes, a deferred tax asset will be created. This represents the future tax savings that will result when the deduction is taken (e.g., when warranty expense is actually paid).

Both deferred tax assets and liabilities are adjusted for changes in the tax rate expected for the period(s) in which the deferred tax asset/liability is expected to be reversed (usually the current tax rate). Additionally, deferred tax assets are adjusted for the probability that they will actually be realized in future periods by reporting a valuation allowance which reduces the deferred tax asset.

Illustration of Deferred Tax Liabilities

To illustrate how deferred tax liabilities are created, we present a simple example. For illustration purposes, suppose we are given the following information for a firm for the next three years. The firm just purchased a $10,000 asset with a 3-year life and a salvage value of $1,000. For tax reporting purposes, the firm uses an accelerated depreciation method. For financial reporting purposes, the firm uses straight-line depreciation.



Notice that, over the three years, the cumulative total revenue, depreciation, and net income are the same under both methods, and income tax expense equals taxes payable.

The important difference is the timing of the recognition of the tax liability. For tax reporting purposes, the accelerated depreciation choice delays the recognition of the taxes. For financial reporting, the straight-line depreciation method results in the tax liability being evenly distributed over the 3-year life of the asset. It is this difference that gives rise to a deferred tax liability. As long as the calculated income tax expense (financial reporting) is greater than the calculated taxes payable (tax reporting) the firm will incur deferred tax liabilities. For example, in the first year, income tax expense is $2,450, and taxes payable are $1,167. The difference, $1,283, shows up as a deferred tax liability on the balance sheet. In year 2, the calculated taxes payable is greater than the income tax expense, and the balance sheet liability is reduced by the difference of $272. Finally, in year 3 the difference is completely reversed, and the balance sheet value of the deferred tax liability is zero. Note: In Figures 1, 2, and 3, some columns and rows might not add up due to rounding.

Illustration of Deferred Tax Assets

Next we will consider deferred tax assets with a simple example. Suppose our sample firm expects to incur warranty expenses of 7.5 percent of sales annually. However, actual cash outflows associated with warranty claims are as follows: year 1 = $0, year 2 = $500, and year 3 = $1,750. As shown in Figures 4, 5, and 6, our cumulative totals ($2,250) are the same under each accounting methodology. The timing difference between the expected warranty expense (for financial reporting) and the actual warranty cash flows (for tax reporting) gives rise to a

Figure 1: Tax Reporting for Deferred Tax Liability Example

Year 1 Year 2 Year 3 Total

Revenue $10,000 $10,000 $10,000 $30,000

Depreciation expense (6,667) (2,222) (111) (9,000)

Taxable income 3,333 7,778 9,889 21,000

Taxes payable (35%) (1,167) (2,722) (3,461) (7,350)

Net income $2,166 $5,056 $6,428 $13,650

Figure 2: Financial Reporting for Deferred Tax Liability Example


Revenue $10,000 $10,000 $10,000 $30,000

Depreciation expense (3,000) (3,000) (3,000) (9,000)

Pretax income 7,000 7,000 7,000 21,000

Income tax expense (35%) (2,450) (2,450) (2,450) (7,350)

Net income $4,550 $4,550 $4,550 $13,650

Figure 3: Deferred Tax Liability

Year 1 Year 2 Year 3

Income tax expense $2,450 $2,450 $2,450

Less: Taxes payable (1,167) (2,722) (3,461)

Annual deferred income tax expense 1,283 (272) (1,011)

Balance sheet deferred tax liability $1,283 $1,011 $0



deferred tax asset. That is, because taxes payable is initially greater than income tax expense, the firm recognizes a deferred tax asset in the amount of $263—the difference between the two measures. In year 2, taxes payable again exceed income tax expense. The difference of $88 is added to the previous year’s difference for a total balance sheet deferred tax asset of $350. In the final year, the differences reverse and the deferred tax asset is extinguished. Note: In Figures 4, 5, and 6, some columns and rows might not add up due to rounding.

ANALYZING INCOME TAX DISCLOSURES: IMPORTANT ISSUES

LOS 1.C.a: Analyze disclosures relating to deferred tax items and the effective rate reconciliation.

LOS 1.C.b: Discuss how these disclosures affect a company’s financial statements and financial ratios and compare and contrast a company’s deferred tax items and effective rate reconciliations between reporting periods and/or to other companies.

At Level 1 your primary focus was to understand how deferred tax assets and liabilities are created and how they are reported on the financial statements. At Level 2 we are concerned with analyzing the footnote disclosures related to income taxes.

Figure 4: Tax Reporting for Deferred Tax Asset Example


Revenue $10,000 $10,000 $10,000 $30,000

Warranty expense 0 (500) (1,750) (2,250)

Taxable income 10,000 9,500 8,250 27,750

Taxes payable (35%) (3,500) (3,325) (2,888) (9,713)

Net income $6,500 $6,175 $5,363 $18,038

Figure 5: Financial Reporting for Deferred Tax Asset Example


Revenue $10,000 $10,000 $10,000 $30,000

Warranty expense (750) (750) (750) (2,250)

Pretax income 9,250 9,250 9,250 27,750

Taxes expense (35%) (3,238) (3,238) (3,238) (9,713)

Net income $6,013 $6,013 $6,013 $18,038

Figure 6: Deferred Tax Asset

Year 1 Year 2 Year 3

Taxes payable $3,500 $3,325 $2,888

Less: Tax expense (3,238) (3,238) (3,238)

Annual deferred tax asset 263 88 (350)

Balance sheet deferred tax asset $263 $350 $0



Extensive disclosure requirements according to SFAS 109 include separate disclosure of the following information:

• Deferred tax liabilities, deferred tax assets, any valuation allowance, and the net change in the valuation allowance over the period.

• Any unrecognized deferred tax liability for undistributed earnings of subsidiaries and joint ventures.• Current-year tax effect of each type of temporary difference.• Components of income tax expense.• Reconciliation of reported income tax expense and the tax expense based on the statutory rate.• Tax loss carryforwards and credits.

Factors Affecting the Future Cash Effects of Deferred Taxes

The most important thing to consider when analyzing deferred tax assets and liabilities is whether or not they are likely to reverse. If they aren’t likely to reverse, they probably won’t have future cash flow effects, which means they are not “assets” or “liabilities” and should be removed from the balance sheet with an offsetting entry to equity.

The cash effects of deferred tax assets and liabilities depend on a number of factors, including tax law changes, accounting changes, firm growth, and other nonrecurring items and equity adjustments.

• Tax law changes. If tax rates increase, future taxes will be higher than previously expected, giving rise to an increase in a deferred tax liability. A simultaneous increase in current-period income tax expense on the income statement will decrease equity by the same amount, maintaining balance on the balance sheet. An increase in tax rates will also cause an increase in a deferred tax asset (future deductions will create larger tax savings). In this case, a decrease in current-period income tax expense will cause equity to increase by the same amount. If tax rates are declining, the opposite will be true.

• Accounting changes. Deferred taxes are also affected by changes in U.S. and IAS GAAP standards. For example, many companies recorded a deferred tax asset upon the adoption of SFAS 106 in 1992. SFAS 106 required companies to switch from cash-basis to accrual accounting for postretirement benefit obligations. Because tax reporting for those obligations remained on a cash basis, a temporary difference related to the postretirement benefit expense was created.

• Firm growth. The reversal event from the viewpoint of total deferred tax assets and liabilities may be postponed indefinitely if the firm is growing, either in nominal or real terms. For example, if the firm continues to invest in new assets, total accelerated depreciation used for tax purposes can indefinitely exceed total straight-line depreciation on the financial statements. Thus, the deferred tax liability will grow over time and never reverse (e.g., it will never be paid). Similar effects of growth hold for deferred tax assets and liabilities related to installment sales and warranty expense.

• Other items. Nonrecurring items (e.g., restructuring charges) can impact current and future taxes and need to be analyzed on a case-by-case basis. Extraordinary items are reported net of taxes, with descriptions in the footnotes. Equity adjustments not found on the income statement may have current and deferred tax consequences. Examples of these adjustments include unrealized gains and losses on marketable securities and the cumulative translation adjustment.



Analyzing Deferred Tax Liabilities

If deferred tax liabilities are expected to reverse in the future, they are best classified as liabilities. If, however, they are not expected to reverse in the future, they are best classified as equity. The key question is, “when or will the total deferred tax liability be reversed in the future?” In practice, the treatment of deferred taxes for analytical purposes varies. An analyst must decide on the appropriate treatment on a case-by-case basis. Some guidelines follow:

• In many cases, it is unlikely that deferred tax liabilities will be paid. For example, if a company has deferred tax liabilities occurring solely because of the use of accelerated depreciation for tax purposes, and the company’s capital expenditures are expected to continue to grow for the foreseeable future, the deferred tax liability will not reverse and should be considered as equity. However, if growth is expected to stop or slow considerably, the portion of the liability attributable to depreciation will reverse, and it should be considered a true liability. In that case, the liability reported on the adjusted balance sheet should be the present value of the portion of the deferred tax liability that is expected to reverse.

• Companies are required under U.S. GAAP to disclose the components of the deferred tax liability. The analyst should analyze the trend in each component over time to determine which items tend to reverse and which do not.

• If it is determined that deferred taxes are not a liability (i.e., non-reversal is certain), the deferred tax liability should be reduced and stockholders’ equity increased by the same amount. This decreases the debt-to-equity ratio, sometimes significantly.

• Sometimes, instead of reclassifying deferred liabilities as stockholders’ equity, the analyst might just ignore deferred taxes altogether. This is done if non-reversal is uncertain or financial statement depreciation is deemed inadequate and it is therefore difficult to justify an increase in stockholders’ equity. Some creditors, notably banks, simply ignore deferred taxes. The analyst must decide on the appropriate treatment of deferred taxes on a case-by-case basis.

Analyzing Deferred Tax Assets

Deferred tax assets can have a valuation allowance, which is a contra account (offset) against deferred tax assets based on the likelihood that these assets will not be realized.

For deferred tax assets to be beneficial, the firm must have future taxable income. If it is likely that a portion of the deferred tax assets will not be realized (i.e., there is insufficient future taxable income to take advantage of the tax asset), the deferred tax asset must be reduced by a valuation allowance according to U.S. GAAP.

It is up to management to defend the recognition of all deferred tax assets and valuation allowances. If a company has order backlogs or existing contracts that are expected to generate future taxable income, a valuation allowance would not be necessary. However, if a company has cumulative losses over the past few years or has not demonstrated an ability to use tax credit carryforwards, the company is required under U.S. GAAP to use a valuation allowance to reflect the likelihood that the deferred tax asset will never be used.

The establishment of a valuation allowance reduces income from continuing operations. Because an increase (decrease) in the valuation allowance will decrease (increase) operating income, changes in the valuation allowance are a common means of managing earnings.

Whenever a company reports substantial deferred tax assets, an analyst should review the company’s financial performance to determine the likelihood that those assets will be realized. Analysts should also scrutinize changes in the valuation allowance to determine whether those changes are economically justified.

Professor’s Note: The conservative approach is to offset some or all of the deferred tax assets with a valuation allowance. A more aggressive approach is to not offset any of the deferred tax assets with a valuation allowance. On the exam,



consider the absence of a valuation allowance, or reductions in the valuation allowance, as “red flags” to be investigated further.

Analyzing Effective Tax Rates

The firm’s effective tax rate is an important input to valuation models because the forecast of future after-tax cash flows depends on the tax rate applied to those cash flows. The reported effective tax rate uses income tax expense and pretax income from the firm’s financial statements (f/s):

There are two alternatives to this measure, however, which use items in the numerator derived from the firm’s tax returns: taxes payable or income tax paid. Taxes payable is the tax liability on the balance sheet caused by taxable income. Income tax paid is the actual cash flow for income taxes, including payments or refunds from other years. These measures may be more useful for analysis purposes because they are less affected by management’s choice of accounting methods.

Low effective tax rates according to either of these measures relative to effective tax rates of comparable companies is a potential red flag signalling earnings manipulation.

Temporary Versus Permanent Differences

Temporary differences are differences in taxable and pretax income that will reverse in future years. That is, current lower (higher) taxes payable will mean future higher (lower) taxes payable. These differences result in deferred tax assets or liabilities.

Permanent differences are differences in taxable and pretax incomes that are never reversed:

• Examples include the proceeds from (and the interest income on) life insurance on key employees, neither of which are not taxable but are recognized on the financial statements.

• Tax-exempt interest expense and premiums paid on life insurance of key employees are examples of expenses on the financial statements, but they are not deductions on the tax returns.

These differences are never deferred but are considered decreases or increases in the effective tax rate. If the only difference between taxable and pretax incomes were permanent differences, tax expense would equal taxes payable.

Indefinite Reversals

There is uncertainty about whether some differences will reverse in the future. The most common of these differences is the undistributed earnings of unconsolidated subsidiaries or joint ventures. If income is earned but not distributed back to the parent company in the form of dividends, the income will be reflected on the income statement as pretax income but will not appear on the tax return. The parent may consider this income to be

( )( )

=income tax expense from the f/s

reported effective tax ratepretax income from the f/s

( )( )

( )( )

=

=

taxes payable from the tax returneffective tax rate measure #1

pretax income from the f/s

income tax paid from the tax returneffective tax rate measure #2




permanently reinvested in the subsidiary. In that case, the difference will never be reversed. The company can treat this difference as permanent if the parent controls the subsidiary or joint venture.

Other Things to Watch Out For

When you’re doing an analysis of the firm’s income tax disclosures, watch for these warning signals:

• Companies that generate significant pretax income on their financial statements while reporting low taxes payable (i.e., low effective tax rates as measured with the alternative definitions previously discussed) are likely to be employing aggressive accounting methods and have low quality earnings.

• A decrease in capital spending may signal a reversal of past temporary differences related to depreciation methods, resulting in higher taxes payable.

• Restructuring charges typically have no tax cash flow effects in the year they are recorded but may have significant effects in future years as the restructured operations and impaired assets are sold.

• Temporary differences may reverse because of changes in tax law, causing higher taxes payable.

ANALYZING INCOME TAX DISCLOSURES: SOME EXAMPLES

Analyzing the Effective Rate Reconciliation

Some firms’ reported income tax expense differs from the amount based on the statutory income tax rate. This is referred to as the difference between the effective tax rate and the statutory rate. The differences are generally the result of:

• Different tax rates in different tax jurisdictions (countries).• Permanent tax differences: tax credits, tax-exempt income, nondeductible expenses, and tax differences

between capital gains and operating income.• Changes in tax rates and legislation.• Deferred taxes provided on the reinvested earnings of foreign and unconsolidated domestic affiliates.• Tax holidays in some countries (watch for special conditions such as termination dates for the holiday or a

requirement to pay the accumulated taxes at some point in the future).

Accounting standards require a disclosure reconciling the difference between reported income tax expense and the amount based on the statutory income tax rate. Understanding this difference will enable the analyst to better estimate future earnings and cash flow.

When estimating future earnings and cash flows, the analyst should understand each element of the reconciliation, including its relative impacts, how each has changed with time, and how each is likely to change in the future. Often the analyst will need additional information from management to determine the future direction of each element.

In analyzing trends in tax rates, it is important to only include reconciliation items that are continuous in nature rather than those that are sporadic. There are no general rules for the kinds of items that are continuous or sporadic. The disclosures of each financial statement should be reviewed based on the footnotes and management discussion and analysis.

Nevertheless, items including different rates in different countries, tax-exempt income, and non-deductible expenses tend to be continuous. Others items are almost always sporadic, such as the occurrence of large dollar amounts of asset sales and tax holiday savings.



Example: Analyzing the tax rate reconciliation

Novelty Distribution Company (NDC) does business in the United States and abroad. The company’s reconciliation between effective and statutory tax rates for three years is provided in Figure 7.

Analyze the trend in effective tax rates over the three years shown.

Answer:

For some trend analysis, the analyst may want to convert the reconciliation from percentages to absolute numbers. However, for this example, the trends can be analyzed simply by using the percentages. Nevertheless, both percentages and the absolute numbers are provided.

The effective tax rate is upward trending over the 3-year period. Contributing to the upward trend is an increase in the state income tax rate and the loss of benefits related to taxes on foreign income. In 2003, a loss related to the sale of assets partially offset an increase in taxes created by special items. In 2003 and 2005, the special items and the other items also offset each other. The fact that the special items and other items are so volatile over the 3-year period suggests that it will be difficult for an analyst to forecast the effective tax rate for NDC for the foreseeable future without additional information. This volatility also reduces comparability with other firms.

Figure 7: Statutory U.S. Federal Income Tax Rate Reconciliation

2003 2004 2005

Statutory U.S. federal income tax rate 35.0% 35.0% 35.0%

State income taxes, net of related federal income tax benefit 2.1% 2.2% 2.3%

Benefits and taxes related to foreign operations (6.5%) (6.3%) (2.7%)

Tax rate changes 0.0% 0.0% (2.0%)

Capital gains on sale of assets 0.0% (3.0%) 0.0%

Special items (1.6%) 8.7% 2.5%

Other, net 0.8% 0.7% (1.4%)

Effective income tax rates 29.8% 37.3% 33.7%

2003 2004 2005

Taxable income $2,330.00 $1,660.00 $2,350.00

Statutory U.S. federal income tax 815.50 581.00 822.50

State income taxes, net of related federal income tax benefit 48.93 36.52 54.05

Benefits and taxes related to foreign operations (151.45) (104.58) (63.45)

Tax rate changes - - (47.00)

Capital gains on sale of assets - (49.80) -

Special items (37.28) 144.42 58.75

Other, net 18.64 11.62 (32.90)

Effective income taxes $694.34 $619.18 $791.95



Analyzing the Disclosure of Deferred Tax Items

Companies are required to disclose details on the source of the temporary differences that cause the deferred tax assets and liabilities reported on the balance sheet. Changes in those balance sheet accounts are reflected in deferred income tax expense on the income statement. Here are some common examples of temporary differences you may encounter on the exam.

• A long-term deferred tax liability results from using the MACRS depreciation schedule for the tax returns and straight-line depreciation for the financial statements. The analyst should consider the firm’s growth rate and capital spending levels when determining whether the difference will actually reverse.

• Impairments generally result in a deferred tax asset since the write-down of assets is recognized immediately for financial reporting, but not for tax purposes until the asset is sold.

• Restructuring generates a deferred tax asset because, for financial reporting purposes, the costs are recognized when restructuring is completed, but not expensed for tax purposes until actually paid. Note that restructuring usually results in significant cash outflows (net of the tax savings) in the years following when the restructuring costs are reported.

• In the U.S., firms that choose to use LIFO for financial statement purposes are required to use LIFO for tax purposes, so no temporary differences result. However, in countries for which this is not a requirement, temporary differences can result from the choice of inventory accounting method.

• Post employment benefits and deferred compensation are both recognized when earned by the employee for book purposes but not expensed for tax purposes until actually paid. This will result in a current deferred tax asset or liability.

• A deferred tax adjustment is made to stockholder’s equity to reflect gains or losses from carrying available-for-sale marketable securities at market value.

Example: Analyzing deferred tax item disclosures

WCCO Inc. income tax expense has consistently been larger than taxes payable over the last three years. WCCO disclosed in the footnotes to its 2005 financial statements the major items recorded as deferred tax assets and liabilities (in millions of dollars), as shown in Figure 8.

Use Figure 8 to explain why income tax expense has exceeded taxes payable over the last three years. Also explain the effect of the change in the valuation allowance on WCCO’s earnings for 2005.

Figure 8: Deferred Tax Disclosures in Footnotes to WCCO Inc. Financial Statements

2005 2004 2003

Employee benefits $278 $310 $290

International tax loss carryforwards 101 93 115

Subtotal 379 403 405

Valuation allowance (24) (57) (64)

Deferred tax asset 355 346 341

Property, plant and equipment 452 361 320

Unrealized gains on available-for-sale securities 67 44 23

Deferred tax liability 519 405 343

Deferred income taxes $164 $59 $2



Answer:

The company’s deferred tax asset balance results from international tax loss carryforwards and employee benefits (most likely pension and other post-retirement benefits) offset by a valuation allowance. The company’s deferred tax liability balance results from property, plant, and equipment (most likely from using accelerated depreciation methods for tax purposes and straight-line on the financial statements) and unrealized gains on securities classified as available-for-sale (because the unrealized gain is not taxable until realized).

Income tax expense is equal to taxes payable plus deferred income tax expense. Because the deferred tax liabilities have been growing faster than the deferred tax assets, deferred income tax expense has been positive, resulting in income tax expense being higher than taxes payable.

Management decreased the valuation allowance by $33 million in 2005. This resulted in a reduction in deferred income tax expense and an increase in reported earnings for 2005.

Estimating Taxable Income from Deferred Tax Expense

Recall that deferred tax expense results from the difference between taxable income on the tax returns and pretax income on the financial statements. We can use the deferred tax expense and the statutory tax rate to estimate the difference between taxable income and pretax income attributable to specific temporary differences:

Example:

In 2005 WCCO reported depreciation expense on the statement of cash flows of $426 million. The deferred tax liability related to depreciation increased from $361 million in 2004 to $452 million in 2005. Assuming a statutory tax rate of 35 percent, compute the tax basis depreciation for 2005 and the cumulative financial reporting tax difference for net property, plant, and equipment as of fiscal year end 2005.

Answer:

The additional depreciation expense under tax reporting is equal to the change in the deferred tax liability divided by the statutory rate: ($452 – $361) / 0.35 = $260. Total tax basis depreciation for 2005 was $426 + $260 = $686.

The reporting difference in accumulated depreciation is approximately $1,291 ($452 / 0.35). The tax basis for property, plant, and equipment is $1,291 million less than the net amount reported on the balance sheet.

Effect of Disclosures on Financial Statements and Ratios

If the deferred tax liability or asset is expected to reverse, it is valued for accounting purposes at its undiscounted value. Because the payments may occur far into the future, an analyst should revalue the liability or asset at its present value. The difference between the stated value and the present value of deferred taxes should be treated as equity.

Example: Adjusting deferred taxes

Company A and Company B each have debt of $1,000,000, deferred tax liabilities of $200,000, and equity of $2,000,000. The deferred tax liabilities were created as a result of depreciation for tax purposes being greater than depreciation for financial reporting purposes. For Company A, there is no slow down in capital

( )− = deferred tax expensepretax income taxable income

statutory tax rate



expenditures expected, while for Company B, the growth in capital expenditures will stop. Therefore, it is reasonable to expect $75,000 of Company B’s deferred tax liabilities to reverse. These deferred tax liabilities have a present value of $50,000.

Analyze the effect of the deferred liabilities on the financial statements and debt-to-equity ratio for both Company A and Company B.

Answer:

Analysis of Company A:

The unadjusted debt-to-equity ratio for Company A is:

Since the deferred tax liabilities are not expected to reverse, they should be treated as equity. Therefore, the revised debt-to-equity ratio is:

This is a significant improvement over the unadjusted debt-to-equity ratio.

The right-hand side of the balance sheet (liabilities plus equity) stays constant. There is no additional wealth created or lost, and there has only been a reclassification between liabilities and equity.

Analysis of Company B:

The initial debt-to-equity ratio is also 0.60, as for Company A. Since some of the deferred tax liabilities are expected to reverse, the portion expected to reverse will be treated as a liability and the remaining amount treated as equity. Therefore, $50,000 of the deferred tax liability will remain as a liability, and $150,000 will be reclassified as equity. The revised debt-to-equity ratio is:

As with Company A, there is no change to the total value of the right-hand side of the balance sheet because it still has to equal the total value of the assets. However, the reclassification of the deferred tax liabilities under present value assumptions means that the analyst has to increase the value of the equity by the amount of deferred tax liabilities that are not expected to reverse plus the difference between the absolute value and the present value of the deferred tax liabilities that are expected to reverse. Therefore, the value of equity is $2,000,000 + $125,000 + ($75,000 – $50,000) = $2,150,000.

Generally, if a company’s deferred tax liabilities are not expected to reverse (and are therefore reclassified as equity), there will be a corresponding reduction in the firm’s debt-to-equity ratio.

$1,000,000 $200,000unadjusted debt-to-equity for Company A 0.60

$2,000,000

+= =

$1,000,000adjusted debt-to-equity for Company A 0.45

$2,000,000 $200,000= =

+

$1,000,000 $50,000adjusted debt-to-equity for Company B 0.49

$2,000,000 $125,000 $25,000

+= =+ +



KEY CONCEPTS

1. Deferred tax liabilities may be treated in one of two ways by the analyst:• If the liabilities are likely to be reversed in the future, they should be discounted to present value and

treated as liabilities. The difference between the reported value and the present value should be recorded as equity. The adjustment would cause a decrease in the debt-to-equity ratio.

• If the liabilities are unlikely to reverse, they should be treated as equity (without discounting). This adjustment would lower the debt-to-equity ratio, sometimes significantly.

2. Deferred tax assets that are unlikely to be reversed are offset by a valuation allowance which effectively reduces equity. Increases in the valuation allowance increase the debt-to-equity ratio.

3. Deferred liabilities imply reductions in cash flows in future years when they reverse; deferred assets imply increased cash flows upon reversal.

4. Firms are required to disclose a reconciliation between a company’s effective income tax rate and the applicable statutory rate in the country where the business is domiciled. Looking at the trend of the individual items of the reconciliation can aid in understanding past earning trends and in predicting future tax rates. Where adequate data is provided, they can also be used to predict future revenue trends, cash flow, and financial ratios.



CONCEPT CHECKERS: ANALYSIS OF INCOME TAXES

1. Which of the following will NOT give rise to a permanent difference between taxable income and pretax income?A. Premiums on key-man life insurance.B. Income on tax-exempt bonds.C. Interest income on key-man life insurance policies.D. Expensing postretirement benefits.

2. All other things being equal, an analyst notices that a firm has taken a full valuation allowance against $1,000,000 of deferred income tax assets. In valuing the firm, which of the following adjustments will an analyst most likely consider?A. No adjustment in valuation.B. An upward adjustment in valuation.C. A downward adjustment in valuation.D. The amount of the adjustment to valuation is uncertain.

3. Which of the following will NOT give rise to a difference between a firm’s effective and statutory tax rate?A. Changes in tax rates.B. Accrual of warranty expenses.C. Firms operating in different tax jurisdictions.D. Proceeds from life insurance on key employees.

4. An analyst determines that a firm’s capital expenditures will likely grow indefinitely. The firm has recorded a deferred tax liability solely as a result of utilizing accelerated depreciation methods for tax purposes. After the analyst makes the appropriate adjustments, which of the following are the effects on the debt-to-equity (D/E) ratio and the return on equity (ROE), respectively? The D/E ratio will:A. decrease and ROE will decrease.B. decrease and ROE will increase.C. increase and ROE will decrease.D. increase and ROE will increase.

5. Which of the following is the best item to analyze in order to estimate future earnings?A. Statutory tax rate.B. Effective tax rate.C. Deferred tax expense.D. Temporary differences.

6. Which statement best describes tax loss carryforwards? Tax loss carryforwards:A. can only be recognized if the firm intends to continue operations for at least three additional years.B. must always be offset by a valuation allowance.C. are always considered an asset.D. are considered an asset only if future income is assured.

7. Which of the following statements regarding valuation allowances is correct?A. An increase in the valuation allowance will cause a decrease in the debt-to-equity ratio, all else equal.B. A decrease in the valuation allowance will have no effect on the debt-to-equity ratio, all else equal.C. An increase in the valuation allowance will cause an increase in the debt-to-equity ratio, all else equal.D. A decrease in the valuation allowance will cause an increase in the debt-to-equity ratio, all else equal.



8. Which of the following statements regarding disclosure of deferred taxes is FALSE? Firms should:A. offset deferred tax liabilities and assets between tax-paying components and jurisdictions.B. disclose any unrecognized deferred tax liability for undistributed earnings of subsidiaries and joint

ventures.C. separate deferred tax liabilities and deferred tax assets into current and noncurrent portions.D. disclose components of income tax expense.

9. If a deferred tax liability and a deferred tax asset are both expected to reverse, what is the anticipated impact on future cash flows?

Liability AssetA. Increase IncreaseB. Decrease IncreaseC. Increase DecreaseD. Decrease Decrease

Use the following information to answer Questions 10 through 14.

Anova Corp. reported the following information for its first two years of operations.

In addition, the following information was given for the end of year 1:

• Deferred tax asset = $175• Debt = $2,000• Deferred tax liability = $875• Equity = $3,000• Dividend payout ratio = 0%

10. The year-end balance sheet value of the deferred tax asset for Anova Corp. for year 2 is closest to:A. $87.50.B. $175.00.C. $262.50.D. $350.00.

11. The year-end balance sheet value of the deferred tax liability for Anova Corp. for year 2 is closest to:A. $175.00.B. $700.00.C. $787.50.D. $1,050.00.

Tax Reporting Financial Reporting

Year 1 Year 2 Year 1 Year 2

Revenue $8,000 $8,000 Revenue $8,000 $8,000

Depreciation expense (4,000) (2,000) Depreciation expense (1,500) (1,500)

Warranty expense 0 (750) Warranty expense (500) (500)

Taxable income 4,000 5,250 Pretax income 6,000 6,000

Taxes payable (35%) (1,400) (1,838) Taxes expense (35%) (2,100) (2,100)

Net income $2,600 $3,413 Net income $3,900 $3,900



12. Assume that the deferred tax asset and the deferred tax liability are reversing, the value of the debt at the end of year 2 is $2,000, and the present value of the deferred tax liability is $760. The debt-to-equity ratio (D/E) for Anova Corp. at the end of year 2, based on financial reporting figures and the adjusted financial reporting figures, is closest to:

Unadjusted D/E Adjusted D/EA. 0.29 0.29B. 0.29 0.38C. 0.44 0.38D. 0.44 0.29

13. Assume that the deferred tax asset and the deferred tax liability are reversing, the value of the debt at the end of year 2 is $2,000, and the present value of the deferred tax liability is $760. Anova Corp. decides to recognize a valuation allowance of $87.50 at the end of year 2, effectively offsetting the entire deferred tax asset. The adjusted D/E ratio based on this new information is closest to:A. 0.37.B. 0.38.C. 0.39.D. 0.40.

14. Which of the following combinations of events is most likely to result in a nonreversal of the deferred tax liability for Anova Corp.?A. An increase in the tax rate and an increase in the growth rate of the firm.B. An increase in the tax rate and a decrease in the growth rate of the firm.C. A decrease in the tax rate and an increase in the growth rate of the firm.D. A decrease in the tax rate and a decrease in the growth rate of the firm.

15. An analyst is reviewing a company with a large deferred tax asset on its balance sheet. In reviewing the company’s performance over the last few years, the analyst has determined that the firm has had cumulative losses for the last three years and has a large amount of inventory that can be sold only at sharply reduced prices. Which of the following adjustments should the analyst make to account for the deferred tax assets?A. Record a deferred tax liability to offset the effect of the deferred tax asset on the firm’s balance sheet and

decrease earnings by the amount of the valuation allowance.B. Recognize a valuation allowance to reflect the fact that the deferred tax asset is unlikely to be realized.C. Do nothing. The difference between taxable and pretax income that caused the deferred tax asset is

likely to reverse in the future.D. Decrease tax expense by the amount of the deferred tax asset unlikely to be realized.

16. In 2005, Bethel Security Inc. reports pretax income of $180 million and an effective tax rate of 15 percent. It is the first time in four years that the company has reported a profit. In the footnotes to the financial statements the company also discloses that the valuation allowance associated with a deferred tax asset decreased from $87 million to $32 million as a result of the utilization of tax-loss carryforwards. Net income appropriately adjusted for the change in the valuation allowance is closest to:A. $0 million.B. $55 million.C. $74 million.D. $98 million.

17. Two companies domiciled in the United States with the same U.S. federal statutory tax rate can have different effective tax rates because of differences in each of the following factors EXCEPT:A. permanent tax differences.B. deferred taxes on the reinvested earnings of certain subsidiaries.C. changes in the deferred tax asset valuation allowance.D. statutory tax rates in international jurisdictions.



18. An analyst incorrectly assumes that a deferred tax liability will never reverse and makes the balance sheet adjustment consistent with his assumption, when in fact it is reasonable to assume that a significant portion of the liability will reverse at some point in the near future. What will be the effect on the analyst’s estimate of the firm’s current leverage and his forecasts of future operating cash flow (OCF), assuming he is incorrect in his assumption but makes the adjustment and forecast that are consistent with his assumption?

Current Leverage Future OCFA. Overestimate UnderestimateB. Overestimate OverestimateC. Underestimate UnderestimateD. Underestimate Overestimate



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF INCOME TAXES

1. D The expensing of postretirement benefits only gives rise to a temporary difference because such a deduction is permissible for both accounting and tax purposes; only the timing of the deduction differs. The other items give rise to permanent differences where there is an effect for accounting purposes but none for tax purposes.

2 C A full valuation allowance suggests that a firm will generate insufficient future taxable income to take advantage of the tax asset. Lower amounts of future income suggest a relatively lower value should be assigned to the firm.

3. B The difference between statutory and effective tax rates is not a result of temporary differences. Temporary differences that result from items like the accrual of warranty expenses will merely result in a reallocation between deferred tax expense and current tax expense. All the other items will have a direct impact on the effective tax rate.

4. A Based on the facts, there is no likelihood of reversal of the deferred tax liability. Therefore, it should be reclassified as equity. The increase in the equity base will cause both the D/E ratio and ROE to decrease.

5. B The effective tax rate is generally more realistic to use than the statutory tax rate, since the effective tax rate represents the “actual” course of events. The other two items, although potentially useful in determining future earnings, are not as directly related as the effective tax rate.

6. D Tax loss carryforwards are considered an asset only if future income is assured.

7. C An increase in the valuation allowance will cause an increase in the debt equity ratio, all else equal, because the increase will reduce total assets and equity.

8. A Firms may not offset deferred tax liabilities and assets between tax-paying components or jurisdictions. However, offsets within tax-paying components or tax jurisdictions are allowed.

9. B If the tax liability is expected to be reversed, a reduction in future cash flow estimates is anticipated. If the tax asset is expected to be reversed, an increase in future cash flow estimates is anticipated.

10. A The deferred tax expense related to warranty expense for year 2 can be calculated as ($500 – $750) × 0.35= –$87.50. Therefore, with this reversal the balance sheet value will decline to $175 – $87.50 = $87.50.

11. D The deferred tax expense related to depreciation for year 2 can be calculated as ($2,000 – $1,500) × 0.35 = $175. Therefore, the balance sheet value will increase to $875 + $175 = $1,050.

12. C Since the deferred tax assets are reversing there is no need to make an adjustment on the asset side. The equity balance at the end of year 2 is the equity balance at year 1 plus net income in year 2: $3,000 + $3,900 = $6,900. The deferred tax liability at the end of year 2 is $1,050 (from question #11). The present value of the deferred tax liability at the end of year 2 is $760. The unadjusted D/E ratio at the end of year 2 is:

The adjusted D/E ratio incorporating the present value of the deferred tax liabilities is:

13. C The adjusted D/E ratio is:

14. A An increase in the tax rate will cause the deferred tax liability to increase. An increase in the growth rate of the firm will reduce the chances of the deferred tax liability reversing at some point in the future.

$2,000 $1,0500.44

$6,900

+ =

( )$2,000 $760

0.38$6,900 $1,050 $760

+ =+ −

( ) ( )$2,000 $760

0.39$6,900 $87.50 $1,050 $760

+ =− + −



15. B The valuation allowance is used to offset deferred tax assets if it is unlikely that those assets will be realized. Because the company has a history of losses and inventory that is unlikely to generate future profits, it is unlikely the company will realize its deferred tax assets in full. Income tax expense will increase, and earnings will decrease, by the amount of the valuation allowance.

16. D Reported net income is equal to ($180 million)(1 – 0.15) = $153 million, and income tax expense is ($180 million)(0.15) = $27 million. Adjusted income tax expense is $27 million plus the decrease in the valuation allowance ($87 – $32 = $55 million), or $27 + $55 = $82 million. Adjusted net income is $180 – $82, or $98 million.

17. C Differences between statutory and effective tax rates result from one or more of the following:• Different tax rates in different tax jurisdictions (countries).• Permanent tax differences: tax credits, tax-exempt income, nondeductible expenses, tax differences between

capital gains, and operating income.• Changes in the tax rates and legislation.• Deferred taxes provided on the reinvested earnings of foreign and unconsolidated domestic affiliates.• Tax holidays in some countries

Therefore, any differences in the effective tax rates of two companies with the same statutory rate must result from differences in one of these five factors. Changes in the valuation allowance associated with deferred tax assets will not result in differences in the effective tax rates of the two companies.

18. D The balance sheet adjustment for a deferred tax liability that is not expected to reverse is to convert the liability into equity. By incorrectly converting the entire liability to equity, the analyst will underestimate current leverage because the adjusted balance sheet will have too little debt and too much equity. The appropriate adjustment is to only convert to equity the portion of the liability that is not expected to reverse.

Furthermore, a deferred tax liability that isn’t expected to reverse will have no future cash flow effects. The reversal of a deferred tax liability, however, increases income tax expense and taxes payable, and reduces operating cash flow. By assuming that it will never reverse, he has failed to take into account the potential future cash taxes to be paid when the liability does reverse, and will therefore overestimate future operating cash flow.



ANALYSIS OF FINANCING LIABILITIES

Study Session 5

EXAM FOCUS

After reading this topic review you should be able toanalyze disclosures relating to financing liabilities todetermine the impact of these liabilities on thecompany’s balance sheet, its cash flows fromoperations and financing, and its ratios. The financing

liabilities discussed in this review include fixed-rateand zero-coupon debt, and debt with equity features(convertibles, warrants, commodity bonds, perpetualdebt, and preferred stock).

WARM-UP: TYPES OF BALANCE SHEET DEBT

Current liabilities are defined as those liabilities due within one year or the operating cycle, whichever is longer. They are reported on the balance sheet at their full maturity value according to their (1) order by maturity, (2) descending order by amount, or (3) order in the event of liquidation.

Current liabilities may result from operating activities (e.g., trade credit) or from financing activities(e.g., current portion of long-term debt):

• Operating and trade liabilities are the result of credit granted to the company by its suppliers.• Advances from customers occur when customers pay in advance and when the firm must deliver the service

or good in the future. These should be viewed favorably as a prediction of future revenues and profit rather than a prediction of cash outflows, assuming price is greater than cost.

• Short-term debt from the credit markets.• Current portion of long-term debt payable within the year.

The first two categories (operating and trade liabilities, and advances) are consequences of operating decisions and arise in the normal course of business. The last two categories (short-term debt and current portion oflong-term debt) are consequences of financing decisions and indicate a future need for cash or refinancing.It is necessary to monitor the relative levels of these two categories. A shift from operating to financing sources may indicate the beginning of a liquidity crisis, and the inability to repay short-term credit is a sign of financial distress.

Long-term debt contracts are obligations that are expected to result in the use of future expected benefits and result from present obligations not payable within one year or one operating cycle, whichever is longer.

Long-term debt may be obtained from many sources and may differ in the structure of interest and principal payments and the claims creditors have on the assets of the firm. Some creditors may have a claim on specific assets and other creditors may have only a general claim. Some creditors may have claims that rank below (are subordinated to) the claims of other creditors whose claims have priority (are senior to the other claims).

Debt is equal to the present value of the future interest and principal payments. For book values, the discount rate is the interest rate in effect when the debt was incurred. For market values, the rate is the current market interest rate. Interest expense is the amount paid to the creditor in excess of the amount received. Although the total amount of interest to be paid is known, the allocation to specific time periods may be uncertain.



Bonds are a contract between the borrower and the lender that obligates the bond issuer to make payments to the bondholder over the life of the bond. Two types of payments are involved:

• Periodic payment of interest.• Repayment of principal at maturity.

Professor’s Note: Bonds in the U.S. typically have semiannual coupon payments, whereas most international bonds typically provide annual payments. For bond calculations, assume that coupon payments are semiannual unless otherwise noted. Most of the examples in this review use annual coupon payments.

The interest expense of bonds issued at a discount rises over time because of the increasing value of the liability. The interest expense of bonds issued at a premium will fall over time because of the decreasing value of the liability, and the interest expense of par bonds will remain constant.

ANALYZING FINANCING LIABILITY DISCLOSURES

LOS 1.D.a: Analyze the disclosures relating to financing liabilities, and discuss the advantages/disadvantages to the company of selecting a given instrument and the effect of the selection on a company’s financial statements and ratios and estimate the effects of changing interest rates on the market value of debt and on financial statements and ratios.

Professor’s Note: It’s not clear exactly what is meant by “advantages and disadvantages” in this LOS. I would interpret it to mean that you should be able to discuss the features of each that make the issuer’s financial statements look better (advantages) or worse (disadvantages). Keep that in mind as you read through this topic review. Please see the figure in the Key Concepts for a concise presentation of these effects.

Long-Term Debt

The balance sheet liability is the present value of the remaining cash payments using the market rate when the bonds were issued. At maturity, the value of the liability will equal the par value of the bond. The bond contract does not determine the amount the borrower receives or the allocation between interest and principal. That depends on the current market rate of interest. The market interest rate depends on the maturity and risk of the bond and may be equal to, less than, or greater than the coupon rate on the date of issue.

• When the market rate equals the coupon rate, the bond is called a par bond. • When the market rate is greater than the coupon rate, the bond is called a discount bond.• When the market rate is less than the coupon rate, the bond is called a premium bond.

Par bonds. When a bond is issued at par, its effects on the financial statements are very straightforward.

• Balance sheet impact. Bonds are always initially listed as a liability in the amount of the proceeds received upon issuance. In the case of par value bonds, the value carried on the books throughout the bond’s life will be equal to face value.

• Income statement impact. Interest expense is always equal to the book value of the bonds at the beginning of the period multiplied by the market rate of interest at issuance. In the case of par value bonds, this is the same as the coupon rate of the bond.

• Cash flow statement impact. Cash flow from operations includes a deduction for interest expense. For bonds issued at par, the interest expense is equal to the coupon payment. Cash flow from financing (CFF) is increased by the amount received. Upon repayment of the bond at maturity, CFF is reduced by the bond’s par value.



Premium and discount bonds. When the market rate of interest is not equal to the coupon rate, the present value of the coupon payments plus the present value of the face value is not equal to par value, and the bond is issued at a premium or a discount. The premium or discount is usually relatively small for coupon-paying bonds.

If the market rate of interest is less than the coupon rate, the proceeds received will be greater than face value, and a premium results. Recall from our basic bond valuation that if the market rate of interest is less than the coupon rate, investors will pay more to obtain the higher coupon payment attached to the bond in question. Hence, the bond will sell at a premium.

If the market rate of interest is greater than the coupon rate, the proceeds received will be less than the face value, and a discount results. Here, the coupon rate is low relative to bonds that are being issued at par value. Hence, individuals will pay less than face value for bonds with low coupons relative to the current market rate. These are called discount bonds.

• Balance sheet impact. Bonds are always initially listed as a liability based on the proceeds received from the bonds, which is the present value of all future payments. At any point in time, the book value of the bonds can be calculated as the present value of all future payments at the market rate of interest.

Professor’s Note: The market rate of interest used in all calculations for book values is the market rate at the time the bonds were issued. This is an extremely important point.

Bonds that were originally sold at a premium will always be shown at a premium on the balance sheet. This premium will be amortized toward zero over the life of the bond. Bonds that were originally sold at a discount will always be recorded on the balance sheet at a discount. This discount will be amortized toward zero over the life of the bond. Hence, the book value of both premium and discount bonds will converge to the bonds’ par or face value upon their maturity dates.

• Income statement impact. Interest expense is always equal to the book value of the bonds at the beginning of the period multiplied by the market rate of interest. Remember that this terminology, market rate of interest, is referring to the rate that applied on the issuance date of the bonds.

In the case of premium bonds, the interest expense will be lower than the coupon. The amortization of the bond’s premium will serve to reduce the interest expense that is shown on the income statement. In general, interest expense will equal the coupon payment less the premium amortization. In the case of discount bonds, the interest expense will be higher than the coupon. Here, amortization of the bond’s discount will serve to increase the interest expense that is reported on the income statement. In general, interest expense will equal the coupon payment plus the discount amortization.

Professor’s Note: In the case of a discount bond, the coupon is too low relative to the market’s required rate of return. The purpose of amortizing the discount is to (1) increase the bond’s book value over time and (2) increase interest expense in a way that the coupon + discount amortization is approximately equal to the interest expense that would have prevailed had the bond been issued at par with a higher coupon. This argument is easily reversed for premium bonds.

• Cash flow statement impact. The coupon represents the cash flow component of the bond and is the amount deducted in calculating cash flow from operations (CFO) for accounting purposes. However, from an analytical perspective, the interest expense and the amortization of the premium or discount should be separated. Amortization should be included in CFF, not CFO.

For premium bonds, the cash coupon is higher than interest expense; consequently, CFO is understated and CFF is overstated relative to a company that does not have premium bonds in its capital structure. For discount bonds, the cash coupon is lower than interest expense; consequently, CFO is overstated and CFF is understated relative to a company that does not have discount bonds.



Analysts can make adjustments to CFO by correcting for the difference between the coupon payment and the interest expense—this adjustment will be positive for premium bonds and negative for discount bonds. From an economic perspective, this approach is desirable because it separates investment decisions from financing decisions and gives a clearer picture of the profitability of operations. Upon issuance, CFF is increased by the amount of the proceeds and upon repayment at maturity, CFF is reduced by the par value or payoff amount.

Figures 1 and 2 summarize the effects on the statement of cash flows of issuing bonds.

Zero-coupon debt. Zero-coupon bonds do not make periodic payments of interest, and they pay back principal with one lump sum payment upon maturity. Zero-coupon bonds are also known as pure discount instruments because they are issued at a deep discount from par value; their interest expense is implied and is paid upon maturity when the bonds are paid off at their par value. The effects of zero-coupon debt on financial statements are identical to the impact of discount debt—only the impact is much larger because the discount is larger.

• Cash flow statement impact. For discount bonds, the coupon understated the cash component of interest expense, and CFO was overstated. With zero-coupon bonds there is no coupon, so for operating cash flow purposes there is no interest expense deducted. This severely understates interest expense (and CFF, if considering analytical adjustments), and severely overstates CFO.

Debt With Equity Features

Convertible bonds. A convertible bond is a bond that may be converted into common stock by the investor. Upon conversion, the investor exchanges her bond for a prespecified number of common shares (the conversion rate). For example, a bond issued with a 10-to-1 conversion factor may be exchanged for ten shares of common equity. Convertible bonds trade at lower yields than otherwise identical nonconvertible bonds, so interest expense is lower.

The equity option or conversion feature embedded in convertible bonds is not detachable—you can’t trade or act on this option separately. You either hold a bond or you convert that bond into common stock by exercising the conversion feature. The convertibility feature of a bond is ignored when the bond is issued, thus the entire proceeds of the bond are recorded as a liability [Accounting Principles Board (APB) 14]. When a convertible bond is converted into equity, the entire proceeds will be reclassified from debt to equity. This conversion will dramatically affect the company’s leverage ratios.

Figure 1: Cash Flow Impact of Issuing a Bond

Cash Flow from Financing Cash Flow from Operations

Issuance of debt Increased by cash received(Present value of the bond at the

market interest rate)No effect

Periodic interest payments

No effectDecreased by interest paid

[(coupon rate) × (face or par value)]

Payment at maturity Decreased by face (par) value No effect

Figure 2: Economic or Analytic Perspective of Interest Payments

Cash Flow from Financing Cash Flow from Operations

Premium bonds Overstated Understated

Discount bonds Understated Overstated



Professor’s Note: The treatment of convertible debt is different under IFRS: the value is allocated between debt and equity. See Study Session 6 for more information.

When analyzing a company with convertible bonds, there are three situations to consider.

• Stock price is significantly higher than conversion price (in-the-money). In this case, the bond should be treated as equity for analysis purposes because it is highly likely that the bonds will be converted into common stock.

• Stock price is significantly lower than conversion price (out-of-the-money). In this case, the bond should be treated as debt for analysis purposes because unless the stock price rises, investors will not convert their bonds into common stock.

• Stock price is close to or at the conversion price (at-the-money). In this case, it is uncertain as to whether investors will convert or not. An analyst may look at the convertibles from two perspectives:

Calculate ratios both ways—first treating the convertibles as bonds and then treating them as equity.Value the conversion feature using option pricing methods, separating the debt and equity components.

Exchangeable bonds. If the bondholder has the option to convert the bond into shares of a firm other than the issuing firm, it is called an exchangeable bond. Notice that the issuer holds the shares of the other firm as an asset on its balance sheet.

When the holder exercises the conversion option, there are three financial statement effects on the issuer:

• Liabilities decrease as the exchangeable debt is removed.• Assets decrease as the investment in the shares of the other firm are eliminated.• A gain or loss (equal to the difference between the asset and liability amounts) resulting from the sale of the

debt is recorded on the income statement.

There are a number of advantages to the issuing firm from using exchangeable debt.

• Generating cash while retaining control of the shares or avoiding legal restrictions on selling the shares.• Reducing the market impact of selling the shares all at once.• Lowering interest expense relative to straight debt.• Delaying the income tax impact of a potential gain from selling the shares, and allowing management to

choose the timing of the gain (if the bonds are also callable, and management calls the bonds to force exchange).

• Hedging the investment in the shares with an offsetting liability.

Bonds with warrants. Warrants are long-term equity call options and are typically issued with bonds as a sweetener to make the company’s bonds more attractive to potential investors. Warrants are detachable from the bonds they are issued with. Hence, the proceeds from the issuance of bonds with warrants must be split into two components—the pure bond value is treated as debt, and the option is treated as equity.

Bonds with warrants are issued at a discount, and the discount is amortized in the same way other bond discounts are treated. Because the discount is amortized, the interest expense will be higher than the interest expense of convertibles.

There are three advantages from the issuer’s perspective to issuing bonds with equity features versus issuing straight debt:

• Interest expense is lower.• Operating cash flow is higher.• The balance sheet liability is the same or smaller.



Compared to convertibles and regular bonds (all else the same):

• Balance sheet value. Bonds with warrants < convertibles = regular bonds. This is due to the separation of the equity and debt components of bonds issued with warrants.

• Interest expense. Convertibles < warrants < regular bonds. Interest expense will be higher for bonds with attached warrants than for convertibles because of the amortization of the bond discount. Recall that bonds issued with attached warrants are shown on the balance sheet at a discount. The amortization of this discount will increase interest expense. Note, however, that the cash interest payments will be the same for the convertibles and warrants.

• Operating cash flow. Warrants = convertibles > regular bonds. Since we assumed all else the same, the cash coupons on the warrant bonds and convertible bonds are identical. Operating cash flow for the warrant bonds and convertible bonds will exceed that of a straight bond, because the cash interest expense of the warrants and convertibles will be lower than that of a regular bond. Remember, the regular bond was not issued with any kind of sweetener, so investors will expect the regular bond to carry a higher coupon (all else the same).

Commodity bonds. Commodity bonds are bonds that link interest and principal payments to the price of a commodity such as gold or oil. Commodity bonds are typically issued as part of a hedging strategy by companies that produce the commodity. The advantage to the issuer of issuing commodity bonds is that it converts interest expense from a fixed cost to a variable cost.

Perpetual debt. Perpetual debt is debt with no maturity or an exceptionally long maturity, such as 100 years. The analyst should classify these securities as preferred equity, unless outstanding debt covenants exist which may force the issuer to repay the debt.

Preferred stock. Preferred shares generally have a fixed dividend payment and a priority over common shares in the event of sale or liquidation. Dividend payments are almost always cumulative. If they are not paid when due, they remain an unrecorded liability. Preferred shares are almost always callable by the issuer (that is, the issuer has a call option, an option to buy the shares from the investors).

Remember the following analytical issues related to preferred stock:

• Some shares may also be redeemable by the shareholder over a period of years. Redeemable preferred stock should be treated as debt for purposes of analysis. These shares are more closely related to debt than equity and should be included as debt in solvency ratios. Moreover, the dividend payments should be treated as interest for analysis purposes only.

Professor’s Note: The SEC does not require redeemable preferred shares to be classified as debt in financial statements and does not permit them to be included in shareholders’ equity.

• In calculating the net worth of a company, the analyst should subtract the liquidating value of other-than-redeemable preferred stock, plus any dividend arrearage, from stockholders’ equity.

• Preferred shares that pay a variable dividend (such as auction rate preferred) should be treated as short-term liabilities for analysis purposes.

EFFECT OF CHANGING INTEREST RATES

Debt is required to be valued using the market rate on the date of issuance. Changes in market interest rates lead to changes in the market values of debt. Increases (decreases) in the market rate of interest decrease (increase) the market value of debt. These gains (from the decrease in market value of debt) or losses (from the increase in market value of debt) are not reflected in the financial statements. Hence, the book value of debt will not equal the market value.



For purposes of analysis, market values may be more appropriate than book values. The appropriate offsetting entry is to equity. For example, firms that issue debt when interest rates are low are relatively better off when interest rates increase, and this increase should be reflected in a higher value of equity and a lower value of debt. Adjusting the firm’s debt down to market value (with an offsetting increase in equity) will result in the amount that would have to be paid to retire the debt and will decrease the debt-to-equity ratio. If interest rates decrease, the opposite effects will occur from adjusting debt to its market value.

Professor’s Note: The use of market value of debt in free cash flow to the firm (FCFF) models is recommended in Study Session 12.

U.S. and IAS GAAP require disclosures about the fair value of outstanding debt based on year-end or quarter-end prices. These disclosures are made in the notes to the financial statements.

Estimating market value. The analyst may want to provide his own estimate of market value if 1) rates have changed since the last reporting date, 2) the company does not use U.S. or IAS GAAP standards to report its results, or 3) there is a question about the accuracy of the disclosed valuation estimate for complex, difficult-to-value securities.

DEBT OF FIRMS IN FINANCIAL DISTRESS

There are two issues to consider when analyzing firms in financial distress.

• If credit quality declines, the market value of the debt will fall. The most reasonable offsetting adjustment is to reduce assets, NOT to increase equity. In other words, the decrease in the market value of the debt is more likely a result of asset impairment rather than a gain to shareholders.

• If the firm’s debt is impaired or restructured, the present value of the future debt payments falls. However, the balance sheet liability is written down (and a gain recognized) only if the carrying amount is greater than the undiscounted cash flows. The loan is then amortized at the new, lower implicit rate of the loan. In effect, the “gain” from the reduction in the value of liability is recognized over time as lower interest expense. For analysis purposes, however, restate impaired and restructured debt to market value.

BOND COVENANTS

LOS 1.D.b: Analyze the impact of debt covenants on a company’s financial statements and ratios.

These are restrictions imposed by the bondholders on the issuer in order to protect the bondholders’ position. The bondholder can demand repayment of the bonds after a violation of one of the covenants (this is called a technical default). An analysis of the bond covenants is a necessary component of the credit analysis of a bond. Bond covenants are typically disclosed in the footnotes.

Professor’s Note: See the topic review of credit analysis of debt securities in Study Session 14 for more information on the analysis of bond covenants.

Examples of covenants include restrictions on:

• Dividend payments and share repurchases.• Mergers and acquisitions, and sale, leaseback, and disposal of certain assets.• Issuance of new debt.• Repayment patterns (e.g., sinking fund agreements and priority of claims).

Other covenants require the firm to maintain ratios or financial statement items at certain levels, such as equity, net working capital, current ratio, or debt-to-equity ratio.



KEY CONCEPTS

1. The following table summarizes the key issues related to financing liabilities in this topic review.

2. Market values of fixed-rate debt change as interest rates change, but reported book values do not. Use market values for analysis and valuation purposes, with the offsetting adjustment to equity.

3. “Gains” resulting from declining credit quality and impaired or restructured debt are likely the result of asset impairments, not true gains to shareholders.

4. Evaluation of a firm’s credit risk and growth prospects should include an analysis of bond covenants.

Financing Liability Advantages (from the perspective of the issuer)

Key Analytical Issues

Discount/zero-coupon debt

• CFO overstated • Increase interest expense and decrease CFO by amount of discount amortization

Convertible debt Versus straight debt: • Lower interest expense• Higher operating cash flow• Same balance sheet liability

• Treat as equity if stock price > conversion price

• Treat as debt if stock price < conversion price

Exchangeable debt • Lower interest expense• Generate cash without selling

investment• Reduce market impact of selling

investment• Delay tax impact of gain and

control timing of gain• Hedge investment

• Management can control timing of gain

Bonds with warrants Versus straight debt: • Lower interest expense• Higher operating cash flow• Lower balance sheet liability

• Classify bond value as debt, warrant value as equity

Commodity bonds • Converts interest expense from fixed to variable cost

• See Study Session 8 for details on fixed vs. variable costs and operating and financing leverage

Perpetual debt • Lock in long-term rates when rates are low

• Classify as preferred equity

Preferred stock • Create a debt/equity hybrid security

• Classify redeemable preferred shares as debt and dividends as interest

• Subtract out liquidating value of non-redeemable shares and dividend arrearage to calculate net worth

• Classify variable-rate shares as short-term liabilities



CONCEPT CHECKERS: ANALYSIS OF FINANCING LIABILITIES


The consolidated balance sheet for Novak Industries, Inc., follows (in thousands of $):

December 31, 2003Current assets:

Cash $836Accounts receivable $4,286Inventories $713

Total current assets $5,835

Property, plant and equipment at cost, net $3,799Other assets $1,213Total assets $10,847

Current liabilities:Accounts payable $1,710Advances from customers $1,069Current portion of long-term debt $85

Total current liabilities $2,864

Long-term debt:5.35% convertible subordinated debenturesdue 2013, convertible into common stockat a rate of 40 shares of stock for eachbond (face value $1,000, 642 bonds issuedand outstanding) $642Unamortized discount $(55)

Total long-term debt $587

Preferred stock, issued 10,000, 4% cumulative,liquidation value $110, callable at $115,redeemable at shareholder option at par value of $100 $1,000

Common stock and paid-in capital $4,751Retained earnings $1,645Total liabilities and stockholders’ equity $10,847

Additional information:The unamortized discount was $63, and the net long-term debt was $579 on 12/31/2002.There were 2,000,000 common shares authorized, 1,500,000 issued, and 1,000,000 outstanding.The fair market value of the common stock on 12/31/2003 was $50 per share.



1. When analyzing Novak’s current liabilities:A. a shift from financing debt to operating debt may signal a liquidity crisis.B. advances from customers are different from trade liabilities because they are not expected to require a

future cash outflow.C. advances from customers are viewed favorably because they are a prediction of future cash inflows.D. only the amount of the debt and not the sources of debt are important for purposes of liquidity analysis.

2 The accounting for Novak’s convertible bonds differs from the accounting of bonds issued with warrants because:A the entire proceeds from issuing convertible debt are recorded as a liability, whereas the entire proceeds

received from bonds issued with warrants are recorded as equity.B. a portion of the proceeds from issuing convertible debt is recorded as a liability and a portion is recorded

as equity, whereas the entire proceeds received from bonds issued with warrants are recorded as debt.C. the entire proceeds from issuing convertible debt are recorded as a liability, whereas a portion of the

proceeds received from bonds issued with warrants is recorded as debt and a portion is recorded as equity.

D. a portion of the proceeds from issuing convertible debt is recorded as a liability and a portion is recorded as equity, whereas the entire proceeds received from bonds issued with warrants are recorded as equity.

3. When calculating leverage ratios, the analyst should treat Novak’s preferred stock as:A. debt because it can be exchanged for common shares of another company.B. debt because it can be converted into a commodity.C. debt because it can be redeemed by the preferred shareholders.D. equity.

4. The effective interest rate on Novak’s convertible subordinated debentures is closest to:A. 5.35%.B. 7.31%.C. 9.58%.D. 10.62%.

5. The unadjusted and the adjusted book value debt-to-equity (D/E) ratios (assume debt includes long-term debt and the current portion of long-term debt) are closest to:

Unadjusted D/E Adjusted D/EA. 9.1% 15.5%B. 9.8% 15.5%C. 9.1% 16.2%D. 9.8% 16.2%

6. The book value of debt equals the present value of interest:A. payments at the current discount rate.B. payments using the discount rate at the time of issue.C. and principal payments using the current discount rate.D. and principal payments using the discount rate at the time of issue.

7. Interest expense is the:A. sum of all the coupon payments.B. amount paid to creditors in excess of par.C. amount paid to creditors in excess of the amount received.D. total amount paid to creditors in excess of the total promised coupon payments.




A firm issues a $10 million bond with a 6 percent coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7 percent.

8. The initial book value of the bonds is:A. $9,400,000.B. $9,661,279.C. $10,000,000.D. $10,338,721.

9. For the first period the interest expense is:A. $600,000.B. $676,290.C. $700,000.D. $723,710.

10. How much will cash flow from operations in year 1 be understated or overstated by these bonds?A. Overstated by $76,290.B. Overstated by $100,000.C. Understated by $76,290.D. Understated by $100,000.

11. Interest expense reported on the income statement is based on the:A. market rate that applied on the date the bonds were issued.B. coupon payment.C. amortized discount.D. unamortized discount.

12. The actual coupon payment on a bond is reported as:A. operating cash outflow.B. financing cash outflow.C. financing cash inflow and operating cash outflow.D. not reported since only the interest expense is reported.

13. A 2-year bond is carried on the books at a premium because it was issued at a coupon rate 1/4 percent higher than the market rate. After one year, market rates have gone up by 1/2 percent. The bond will now be listed on the books as having:A. the same premium it had when originally issued.B. a lower premium than when it was originally issued.C. par value.D. a discount.

14. In comparing two companies, an analytical team discovers that Company A uses zero-coupon bonds for debt financing, while Company B uses traditional debt. Analyst 1 feels that Company A’s operating cash flow should be reduced by the amount of its interest expense to compare it to Company B. Analyst 2 feels that Company B’s operating cash flow should be increased by the amount of its interest expense to compare it to Company A. Analyst 3 feels that no adjustments should be made. Which analyst(s) is taking appropriate action?A. Analyst 1.B. Analyst 2.C. Analyst 3.D. Analyst 1 and Analyst 2.



15. A company has convertible bonds on its books with a conversion price of $20 per share. The stock price is currently $40 per share. For analytical purposes, the bonds should be treated as:A. debt.B. preferred stock.C. common equity.D. a hybrid of debt and common stock.

16. The relative effects on degree of operating leverage and degree of financial leverage from using commodity bonds instead of conventional fixed-rate “straight” bonds (assuming all else equal) are:

Degree of Operating Leverage Degree of Financial LeverageA. Decrease DecreaseB. Decrease No changeC. No change DecreaseD. No change No change

17. The relative effects on interest expense and operating cash flow from issuing convertible bonds versus conventional fixed-rate “straight” bonds are:

Interest Expense Operating Cash FlowA. Lower LowerB. Lower HigherC. Higher HigherD. Higher Lower

18. Which of the following is not a typical motivation for issuing exchangeable debt?A. The issuing firm reports an immediate gain when the debt is issued.B. Interest expense is lower than issuing conventional fixed-rate “straight” debt. C. The market impact of selling the underlying shares all at once is mitigated.D. The issuing firm generates cash while retaining control of the underlying shares.

19. High Priority Marketers has 3-year, $5 million zero-coupon notes outstanding. Cash flow from operations (CFO) for 2005 was $3.2 million, which included $1.1 million in interest expense reported on the income statement. Cash flow from investing was –$4.7 million, which included $0.3 million in amortization of discount on zero-coupon notes. After making the appropriate adjustments, High Priority’s CFO to interest expense ratio is closest to:A. 2.1.B. 2.3.C. 2.6.D. 2.9.



Use the following information for Questions 20 through 22.

Outside Contracting Inc. disclosed the fair market values of its long-term debt in the footnotes to the 2005 financial statements. The description of each of the instruments has been deleted and replaced with “Issue #1,” “Issue #2,” and “Issue #3.” All amounts are in millions.

20. Which of the three issues is most likely to be variable rate debt?A. Issue #1.B. Issue #2.C. Issue #1 and #2.D. Issue #3.

21. Based on the market value disclosures, during 2005 the level of interest rates used to determine fair value most likely:A. increased relative to the beginning of 2005.B. stayed level relative to the beginning of 2005.C. decreased relative to the beginning of 2005.D. decreased relative to historical levels but increased relative to the beginning of 2005.

22. Assume for this question only that the coupon rates on Issue #1 and Issue #2 were 9.7% and 9.4%, respectively. At the end of 2005, the interest rate used to determine the fair market value of Issue #2 was:A. between 9.4% and 9.7%.B. below 9.4%.C. equal to 9.4%.D. above 9.4%.

2005 2004

Carrying Value Fair Market Value

Carrying Value Fair Market Value

Issue #1 $48 $62 $52 $50

Issue #2 100 119 116 116

Issue #3 24 24 24 24

Total $172 $205 $192 $190



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF FINANCING LIABILITIES

1. B Advances from customers are different from trade liabilities because they are not expected to require a future cash outflow. A shift from operating debt to financing debt may signal a liquidity crisis. Advances from customers are viewed favorably because they are a prediction of future revenue and future profit (but not future cash inflows), assuming the sale is made at a price greater than cost. The sources of debt are important for purposes of liquidity measures.

2. C The entire proceeds from issuing convertible debt are recorded as a liability, whereas a portion of the proceeds received from bonds issued with warrants is recorded as debt and a portion is recorded as equity.

3. C An analyst should treat Novak’s preferred stock as debt when calculating leverage ratios, because the preferred stock can be redeemed by the preferred shareholders.

4. B

5. A There would be two adjustments. The convertible debt would be reclassified as equity because the conversion price ($1,000 / 40 = $25) is substantially below the market value ($50). Conversion is highly probable in this case. The preferred stock would be reclassified as debt rather than equity because of the redemption feature.

6. D The book value of debt is equal to the present value of interest and principal payments. Book value is based on the market interest rate in effect at the time the debt was issued.

7. C Interest expense is the amount paid to creditors in excess of the amount received.

8. B The present value of a 4-year annuity of $600,000 plus a 4-year lump sum of $10 million, all valued at a discount rate of 7%, which equals $9,661,279. Note: Through process of elimination, C and D can be eliminated because the bond is selling at a discount.

9. B The market interest rate multiplied by the book value = 7% × $9,661,279 = $676,290.

10. A The true interest expense is $676,290, while the coupon being deducted to calculate cash flow from operations is only $600,000. This means cash flow from operations is overstated by the difference of $76,290.

11. A Interest expense reported on the income statement is based on the market rate on the issuance date and reflects the coupon rate plus or minus the amortization of the discount or premium.

12. A The actual coupon payment on a bond is reported as operating cash outflow.

13. B The premium will be lower because of the amortization of the premium over time. The change in interest rates has no impact.

14. D Either the operating cash flow for Company A can be adjusted down, or the operating cash flow of Company B can be adjusted up.

15. C The bonds should be treated as common equity because the embedded option is deep in-the-money.

( )

( ) ( )

+ ×=

− + ×= =

2003 discount amortization coupon rate face valueEffective interest rate

beginning net debt

$63 55 0.0535 $6427.31%

$579

+= =+ +

+= =+ +

$85 $587Unadjusted D/E 9.1%

$1,000 $4,751 $1,645

$85 $1,000Adjusted D/E 15.5%

$587 $4,751 $1,645



16. C Commodity bonds link interest and principal payments to the price of a commodity and convert interest expense from a fixed cost to a variable cost. In general, lower operating fixed costs lead to lower operating leverage (which measures the sensitivity of earnings before interest and taxes (EBIT) to changes in sales), all else equal. Interest expense is a financing cost, not an operating cost, so degree of operating leverage will not be affected by converting interest expense from fixed to variable. However, the degree of financial leverage (which measures the sensitivity of earnings before taxes (EBT) to changes in sales) will decrease by converting interest expense from fixed to variable. For more information on degree of operating leverage and degree of financial leverage, see Study Session 8.

17. B Issuing bonds with equity features (like convertible bonds) instead of straight bonds reduces interest expense (because convertibles carry lower yields, all else equal) and increases operating cash flow.

18. A One of the advantages of issuing exchangeable debt is to delay the income tax impact of a potential gain from selling the shares until the investors exercise the option and exchange the shares, not report an immediate gain. The other three choices are motivations for issuing exchangeable debt.

19. A The appropriate adjustment is to subtract the amortization of the discount from CFO and add it to interest expense:

20. D The coupon rate on variable rate debt is reset to the current market rate, so the market value of variable rate debt should not vary significantly from book value. The market value of Issue #3 is equal to book value in both years, suggesting Issue #3 is most likely to be variable rate debt.

21. C At the end of 2004 the firm’s long-term debt was trading at a slight discount to book value, while at the end of 2005 the debt was trading at a significant premium to book value. This suggests that interest rates used to calculate fair value decreased during 2005.

22. B The fair market value of Issue #2 was greater than book value at the end of 2005, which means the interest rate used to determine the fair market value of the bonds must be less than the coupon rate of 9.4%.

− =+

$3.2 $0.32.1

$1.1 $0.3



LEASES AND OFF-BALANCE-SHEET DEBT

Study Session 5

EXAM FOCUS

The key to this topic review is differentiating betweenan operating lease and a capital lease. With anoperating lease, there is no recognition of an asset orliability on the balance sheet. The lease payment ischarged to the income statement as rent expense andreduces cash flow from operations. With a capitallease, a depreciable asset and a liability are reported onthe balance sheet. Each lease payment is composed of

interest expense and amortization of the lease liability.Be prepared for questions asking for the differences infinancial statements and ratios depending on whetheran operating lease or a capital lease is used. You shouldbe able to analyze the lease disclosures of the lessee(the entity that leases the asset for its use) and of thelessor (the entity that originally owns the asset andrents the asset to the lessee).

LOS 1.E: Analyze the disclosures relating to leases to determine the appropriate lease classification and how such classification affects the lessee’s and lessor’s financial statements and ratios.

Professor’s Note: Candidates often get confused as to who is the lessee and who is the lessor. The lessor owns the asset and rents it to the lessee. The first portion of this review focuses on capital and operating leases from the lessee’s perspective.

ANALYSIS OF LESSEES

Leases are classified as either capital leases or operating leases. A lease must be classified as a capital lease if any one of the following criteria is met:

• The title to the leased asset is transferred to the lessee at the end of the lease period.• A bargain purchase option exists. A bargain purchase option is a provision that permits the lessee to purchase

the leased asset for a price that is significantly lower than the fair market value of the asset on the date that the purchase option becomes exercisable.

• The lease period is at least 75% of the asset’s economic life.• The present value of the lease payments is equal to or greater than 90% of the fair value of the leased asset. The

interest rate used to discount the lease payments is the lower of the lessee’s incremental borrowing rate or the interest rate implicit in the lease.

Professor’s Note: The implicit interest rate in the lease is the discount rate that the lessor used to determine the lease payments. It is the lease’s internal rate of return because it is the interest rate that equates the present value of lease payments to the fair value of the leased asset. Using the lower of the two discount rates increases the present value of the lease payments and increases the likelihood that the lease will satisfy the 90 percent criterion and therefore be classified as a capital lease.

A lease not meeting any of these criteria is classified as an operating lease and the lease payments made by the lessee are reported as rent expense.

Factors That Favor Capital or Operating Leases for Lessee

Professor’s Note: Most of the “incentives” below favor the operating lease. There are very few (if any) incentives for the lessee to classify a lease as a capital lease.



The incentives for structuring a lease as an operating lease are:

• If the lessor is in a higher marginal tax bracket than the lessee, the lease should be structured as an operating lease so that the lessor can take advantage of the depreciation of the leased equipment to reduce its taxable income and, thereby, the taxes it pays.

• An operating lease avoids recognition of an asset and a liability on the lessee’s balance sheet. Relative to a company that uses capital leases, the operating lease company will have higher profitability ratios (e.g., return on assets) and lower leverage ratios (e.g., the debt-to-equity ratio).

• The lessee has bond covenants governing its financial policies (e.g., a maximum debt-to-equity ratio).• Management compensation is linked to returns on invested capital.• The lease term is shorter than the asset’s life. In this case, the lessor can more easily sell the asset after use as

it has a greater remaining useful life.

Capital leases involve the effective transfer of all the risk and benefits of the property to the lessee. Capital leases are economically equivalent to sales (i.e., economically equivalent to a purchase with a transfer of title) and for accounting purposes are treated as sales. Advantages of a capital lease (to the lessee) include the following:

• In the early years of the lease, total expense is greater, potentially leading to tax savings.• Operating cash flow is higher under a capital lease relative to an operating lease.

Financial Reporting by Lessees—Capital vs. Operating Leases

Operating lease (remember that this discussion is for the lessee): At the inception of the lease, no entry is made. During the term of the lease, rent expense, the lease payment, is charged to income and to cash flow from operations. Footnote disclosure of the lease payments for each of the next five fiscal years is required.

Capital lease: At the inception of the lease, the present value of minimum lease payments is recognized as an asset and as a liability on the lessee’s balance sheet. During the term of the lease, the leased asset is depreciated on the income statement. (The depreciation period is the lease period if there is no title transfer or bargain purchase option; if there is a title transfer or bargain purchase option, the leased asset is depreciated over its estimated economic life.)

• The lease payment is separated into interest expense (the discount rate times the lease liability at the beginning of the period) and principal payment on the lease liability (the lease payment less the interest expense).

• Cash flow from operations is reduced by the interest expense and cash flow from financing is reduced by the principal payment on the lease liability.

Professor’s Note: The focus of this analysis is on the lessee (the entity that leases the asset from the lessor).

Example: Effects of a capital lease

Affordable Leasing Company leases a machine for its own use for four years with annual payments of $10,000. At the end of the lease, the lessor regains possession of the asset, which will be sold for scrap value. The lessor’s implicit rate on the lease is 6 percent, and Affordable Leasing’s incremental borrowing rate is 7 percent. Calculate the impact of the lease on Affordable Leasing’s balance sheet and income statement for each of the four years, including the immediate impact. Affordable Leasing depreciates all assets on a straight-line (SL) basis. Assume the lease payments are made at the end of the year.

Answer:

The lease is classified as a capital lease because the asset is being leased for at least 75 percent of its useful life (we know this because at the end of the lease term the asset will be sold for scrap). The discount rate that should be used to value the lease is 6 percent, which is the lower of the lessor’s implicit rate on the lease and



Affordable Leasing’s incremental borrowing rate. The present value of the lease payments at 6 percent is $34,651.

N = 4; I/Y = 6; PMT = 10,000; FV = 0; CPT → PV = $34,651

This amount is immediately recorded as both an asset and a liability.

Over the next four years, depreciation will be $34,651 / 4 = $8,663 per year.

The asset value will decline each year by the depreciation amount and will be: $25,988; $17,326; $8,663; and $0 at the end of each of the next four years, respectively.

The interest expense and liability values are shown in Figure 1. Note that the principal repayment equals the lease payment minus interest expense.

Column 5 contains the annual book value of the asset. Notice that because the asset is being depreciated at a rate that is different from the rate of amortization for the liability, the two values are equal only at the inception and termination of the lease.

Financial Statement and Ratio Effects of Operating and Capital Leases

Balance sheet. Capital leases create an asset and a liability. Consequently, turnover ratios that use total or fixed assets in their denominator will appear lower for capital leases relative to operating leases. Return on assets will also be lower for capital leases. Most importantly, leverage ratios such as the debt-to-assets ratio and the debt-to-equity ratio will be higher with capital leases because of the recorded liability. The next lease payment is recognized as a current liability on the lessee’s balance sheet. This reduces the lessee’s current ratio and its working capital (current assets minus current liabilities).

Since operating leases do not affect the lessee’s liabilities, they are sometimes referred to as off-balance-sheet financing.

Income statement. All else held constant, operating income will be higher for companies that use capital leases relative to companies that use operating leases. This is because the depreciation expense for a capital lease is lower than the lease payment. Interest expense is not included in the calculation of operating income.

Figure 1: Affordable Leasing Example: Capitalized Lease Calculations

Year

(1)

Beginning Leasehold Value

(2)

Interest Expense(1) × 6%

(3)

Lease Payment

(4)Ending Leasehold

Value(1) + (2) – (3)

(5)

Book Value of the Asset

0 $34,651 $34,651

1 $34,651 $2,079 10,000 26,730 25,988

2 26,730 1,604 10,000 18,334 17,326

3 18,334 1,100 10,000 9,434 8,663

4 9,434 566 10,000 0 0



Let’s assume Affordable Leasing can treat the lease as either an operating or a capital lease. The table in Figure 2 compares the income statement (IS) effects for operating and capital leases.

Total expense over the life of the lease will be the same for operating and capital leases because the sum of the depreciation plus the interest expense will equal the total of the lease payments. However, although the lease payments and depreciation are constant, the interest expense is higher in the first few years (this behavior of interest expense is typical of an amortizing loan). Consequently, net income in the first few years of the lease will be lower for capital leases because the sum of depreciation and interest expense exceeds the lease payment early in the lease’s life.

Cash flow. Total cash flow is unaffected by the accounting treatment of a lease as either a capital or operating lease. In our example, total cash outflow is $10,000 per year. However, if the lease is an operating lease (rent expense = $10,000), then the total cash payment reduces cash flow from operations. If the lease is a capital lease, then only the portion of the lease payment that is considered interest expense reduces cash flow from operations. The part of the lease payment considered payment on principal reduces cash flow from financing activities. The data in Figure 3 illustrate that if a lease is a capital lease, there is greater cash flow from operations (CFO) and less cash flow from financing (CFF).

For example, assume that Affordable Leasing reports CFO of $15,000. If it reports the lease as a capital lease, CFO equals $12,921 (15,000 – 2,079). If it reports the lease as an operating lease, CFO equals $5,000 (15,000 – 10,000). Hence, companies with capital leases will show higher levels of CFO relative to firms that use operating leases (all else the same).

Figure 2: Affordable Leasing: Leasing Decision Impact on Cash Flow

Operating Lease Capital Lease

Operating Expense = Total Expense

Operating Expense

Nonoperating Expense

Year Rent Depreciation Interest Total Expense

1 $10,000 $8,663 $2,079 $10,742

2 10,000 8,663 1,604 10,267

3 10,000 8,663 1,100 9,763

4 10,000 8,663 566 9,229

Total 40,000 40,000

Figure 3: Affordable Leasing: Leasing Decision Impact on Cash Flow

Capital Lease Operating Lease

Year CF Operations CF Financing CF Operations

1 –$2,079 –$7,921 –$10,000

2 –1,604 –8,396 –10,000

3 –1,100 –8,900 –10,000

4 –566 –9,434 –10,000



The tables in Figure 4 and Figure 5 summarize the differences between the effects of capital leases and operating leases on the financial statements of the lessee.

In sum, all the ratios in Figure 5 are worse when the lease is capitalized. The only improvements in financial statement items and ratios from capitalization are an improvement in EBIT (because interest is not subtracted), an increase in CFO (because principal reduction is CFF), and higher net income in the later years of a lease (because interest plus depreciation is less than the lease payment in the later years).

ANALYSIS OF LESSORS

A lessor must classify a lease as a capital lease if any of the four criteria used for a lessee hold and the following two criteria hold:

• The collectiblity of lease payments is predictable.• There are no significant uncertainties about the amount of unreimbursable costs yet to be incurred by the

lessor.

The incentive for structuring a lease as a capital lease is that the lessor will have earlier recognition of revenue and income by reporting a completed sale even though the substance of the transaction is similar to an installment sale or financing. The lessor will have higher profitability and turnover ratios.

Figure 4: Financial Statement Impact of Lease Accounting

Financial Statement Totals Capital Lease Operating Lease

Assets Higher Lower

Liabilities (current and long term) Higher Lower

Net income (in the early years) Lower Higher

Net income (later years) Higher Lower

Total net income Same Same

EBIT (operating income) Higher Lower

Cash flow from operations Higher Lower

Cash flow from financing Lower Higher

Total cash flow Same Same

Figure 5: Ratio Impact of Lease Accounting

Ratios Capital Lease Operating Lease

Current ratio (CA/CL) Lower Higher

Working capital (CA – CL) Lower Higher

Asset turnover (Sales/TA) Lower Higher

Return on assets* (EAT/TA) Lower Higher

Return on equity* (EAT/E) Lower Higher

Debt/assets Higher Lower

Debt/equity Higher Lower

* in the early years of the lease



Sales-Type and Direct-Financing Leases

If the lease is a capital lease and the lessor is a dealer or seller of the leased equipment, then the lease is a sales-type lease on the books of the lessor. This means that the implicit interest rate is such that the present value of the minimum lease payments is the selling price of the leased asset. Thus, at the time of the lease’s inception, the lessor recognizes a gross profit equal to the present value of the minimum lease payments (MLPs) less the cost of the leased asset. Interest revenue is equal to the implicit interest rate times the net lease receivable at the beginning of the period.

If the lease is a capital lease and the lessor is not a dealer in the leased asset (e.g., a finance company), then the lease is a direct financing lease. No gross profit is recognized at lease inception, and all profit is interest revenue. The implicit rate is such that the present value of the minimum lease payments equals the cost of the leased asset. Interest revenue equals the implicit interest rate times the net lease receivable at the beginning of the period.

Professor’s Note: The lessor always uses the implicit rate on the lease to calculate the interest revenue and determine the net investment in the lease. The lessee uses the lower of the lessor’s implicit rate and the lessee’s incremental borrowing rate.

Accounting for Sales-Type Leases

Accounting at sale. When the sale is made, two transactions are set up.

• First, the sale is recorded as the present value of the lease payments, with the cost of goods sold being equal to the net difference between the cost of the asset being leased and the present value of the estimated future salvage value of the asset (its terminal value). The profit shows up on the income statement. That same amount is reported as an operating cash inflow and an investment cash outflow, so net cash flow is zero.

• The second transaction sets up an asset account called the net investment in the lease, which is the present value of all future lease payments and the estimated salvage value.

Periodic transactions. Interest income is calculated each year by multiplying the year’s beginning value of the net investment in the lease by the discount rate on the lease. The interest income affects both the income statement and cash flow from operations. The net investment in the lease at the end of each year is calculated by subtracting the difference between the lease payment and interest income from the beginning net investment balance. The reduction in net investment on the lease is an investing cash flow, not an operating cash flow.

Ending balance. After the lease is completed, the salvage value remains as an asset. If the asset is sold, this cash inflow is an investing cash flow.

Sales-Type vs. Operating Lease

Balance sheet effect. As shown in Figure 6 (assuming a 4-year lease), leased assets are larger at lease inception (by the amount of the gross profit on sale), under a sales-type lease versus an operating lease, but at the end of the lease both methods report the asset at its salvage value.



Figure 6: Balance Sheet Effect of Sales-Type Versus Operating Lease

Income statement effect. As shown in Figure 7 (assuming a 4-year lease), total income over the life of the lease will be the same under both methods, but income will be “front-loaded” under the sales-type lease because the gain on sale will be reported at the inception of the lease. After the inception, only interest expense is reported under the sales-type lease. Under the operating lease, income each year is rental revenue less depreciation.

Figure 7: Income Statement Effects of Sales-Type Versus Operating Lease

Cash flow statement effect. As shown in Figure 8 (assuming a 4-year lease), total cash flow over the life of the lease will be the same under both methods, but cash flow from operations (CFO) will be “front-loaded” under the sales-type lease because the gain on sale is reported at the inception of the lease but offset by an outflow classified as cash flow from investing (CFI).



Figure 8: Cash Flow Statement Effects of Sales-Type Versus Operating Lease

In the detailed example that follows, we will demonstrate these effects, but keep the big-picture perspective and don’t get lost in the details of the calculations.

Example: Analyzing the financial statement effects on lessor

Silvio Leasing Company leases a machine to an oil company. The lease is for the oil company’s own use for four years with annual payments of $10,000. It cost Silvio $30,000 to produce the machine. Silvio estimates it will be able to sell the machine in four years for $6,000. At the end of the lease, Silvio regains possession of the asset, which will be sold for scrap value. The collectability of the lease payments is predictable, and there are no significant uncertainties about Silvio’s unreimbursable costs. The implicit discount rate on the lease is 6 percent. Assume the lease payments are made at the end of the year.

• Determine whether the lease should be classified by Silvio as a sales-type capital lease or an operating lease.

• Analyze the effects on Silvio’s financial statements of classifying the lease as a sales-type capital lease versus an operating lease.

Answer:

The lease should be classified by Silvio as a sales-type capital lease because the asset is being leased for at least 75 percent of its useful life (we know this because at the end of the lease term the asset will be sold for scrap) and because it meets the other two criteria for a sales-type capital lease.

The present value of the lease payments at 6 percent is $34,651.

N = 4; I/Y = 6; PMT = 10,000; FV = 0; CPT → PV = $34,651

The present value of the salvage value is $4,753.

N = 4; I/Y = 6; PMT = 0; FV = 6,000; CPT → PV = $4,753

The cost of goods sold is then $30,000 – $4,753 = $25,247.



The profit on the sale is $34,651 – $25,247 = $9,404.

The net investment in the lease is $34,651 + $4,753 = $39,404.

The lease amortization schedule is shown in Figure 9 (remember that Silvio is the lessor).

The effects on Silvio’s balance sheet, income statement, and cash flow statement are shown in Figures 10, 11, and 12.

Let’s assume that the company owned the asset prior to the lease and reported it on the balance sheet at a cost of $30,000. In that case, if the lease is categorized as a sales-type capital lease, it is reported on the balance sheet at $39,404, and total assets increase by $9,404. If it’s recorded as an operating lease, the asset remains at $30,000,

Figure 9: Silvio Lease Amortization Schedule

Year Payment Interest income Reduction in net investment

Net investment in lease

0 $39,404

1 $10,000 $2,364 $7,636 $31,768

2 $10,000 $1,906 $8,094 $23,674

3 $10,000 $1,420 $8,580 $15,094

4 $10,000 $906 $9,094 $6,000

Total $40,000 $6,596 $33,404

Figure 10: Effect on Silvio’s Balance Sheet

Sales-Type Capital Lease Operating Lease

Net Investment In Lease: Assets under lease

Accumulated depreciation

Net assets under leaseYear Current Long-term Total

0 $7,636 $31,768 $39,404 $30,000 $ - $30,000

1 $8,094 $23,674 $31,768 $30,000 $6,000 $24,000

2 $8,580 $15,094 $23,674 $30,000 $12,000 $18,000

3 $9,094 $6,000 $15,094 $30,000 $18,000 $12,000

4 $6,000 $0 $6,000 $30,000 $24,000 $6,000



and total assets don’t change. Prior to the termination of the lease, assets are higher with the sales-type capital lease versus the operating lease.

Total income over the life of the lease ($16,000) will be the same for operating and capital leases. However, recognition of much of the income for a capital lease will be reported immediately at the initiation of the lease as a gain on sale ($9,404). Income will be recognized earlier for the sales-type capital lease than for the operating lease, but in this example net income is higher under the operating lease in years 1 through 4.

For a capital lease, only the gain on sale and interest income are reported as cash flow from operations, whereas all of the lease payments for an operating lease are considered operating cash flows. Total cash flow from operations over the life of the lease will be higher for an operating lease ($40,000) than a capital lease ($16,000), but total cash flows (including cash flows from investing of $24,000) will be the same under both methods ($40,000).

Accounting for Direct Financing-Type Leases

There is no sales or manufacturing profit in a direct financing-type lease, so the only profit element is interest income.

Example: Direct financing type leases

Assume Johnson Company purchases an asset for $69,302 to lease to Carver, Inc. for four years with an annual lease payment of $20,000 at the end of each year. At the end of the lease, Carver will own the asset for

Figure 11: Effect on Silvio’s Income Statement


Year Income Revenue Depreciation Income

0 Gain on sale $9,404

1 Interest $2,364 $10,000 $6,000 $4,000

2 Interest $1,906 $10,000 $6,000 $4,000

3 Interest $1,420 $10,000 $6,000 $4,000

4 Interest $906 $10,000 $6,000 $4,000

Total $16,000 $40,000 $24,000 $16,000

Figure 12: Effect on Silvio’s Cash Flow Statement


Year CFOCash from investing Total CFO

0 $9,404 ($9,404) $0 $0

1 $2,364 $7,636 $10,000 $10,000

2 $1,906 $8,094 $10,000 $10,000

3 $1,420 $8,580 $10,000 $10,000

4 $906 $9,094 $10,000 $10,000

Total $16,000 $24,000 $40,000 $40,000



no additional payment. The implied discount rate on the lease is therefore 6 percent (N = 4, PV = –69,302, PMT = 20,000, I/Y = 6). Determine how Johnson should account for the lease payments from Carver.

Answer:

Because ownership of the asset transfers for no additional payment at the end of the lease, Johnson (the lessor) treats this as a direct financing-type capital lease. Johnson would record an asset—net investment in the lease—in the amount of $69,302. The lease payments would be recorded as follows:

Interest income received each year would increase income and cash flow from operations as lease payments are received. The principal reduction amount (column 3 – column 2) reduces the asset net investment in lease and is treated as an inflow to CFI.

KEY CONCEPTS

1. A lease is classified as a capital lease by a lessee if any one of the following holds:• If the title is transferred to the lessee at the end of lease period.• A bargain purchase option exists.• The lease period is at least 75% of the asset’s life.• The present value of the lease payments is at least 90% of the fair value of the asset.Otherwise, it is classified as an operating lease.

2. Capital leases are recorded on the lessee’s financial statements as assets and liabilities—the assets are depreciated, and the lease payments are split into principal repayments and interest expense. The recorded liability is amortized over the life of the lease.

3. Relative to operating leases, capital leases provide a lessee with higher assets, higher liabilities, deferred net income, and higher operating cash flow.

4. A lessor must classify a lease as a capital lease if any of the four criteria used for a lessee hold and the following two criteria hold:• The collectability of lease payments is predictable.• There are no significant uncertainties about the amount of unreimbursable costs yet to be incurred by the

lessor.5. Capital leases are sales-type leases if the lessor is a manufacturer or retailer of the asset being leased. Capital

leases allow the lessor to record the sale at the beginning of the lease, while operating leases force the lessor to wait until the lease payments are received to recognize any revenue.

6. Relative to operating leases, sales-type leases provide a lessor with earlier recognition of profit and operating cash flow, higher assets, but the same total cash flow and income over the term of the lease.

7. Capital leases are direct-financing leases if the lessor is not a dealer in the leased asset. No gross profit is recognized at lease inception, and all profit is interest revenue.

Figure 13: Accounting for Lease Payments to Lessor

Year

(1)Beginning Investment in

Lease

(2)Interest Income

(1) × 6%

(3)Lease Payment

(4)Ending Investment in

Lease(1) + (2) – (3)

0 $69,302

1 $69,302 $4,158 $20,000 53,460

2 53,460 3,208 20,000 36,668

3 36,668 2,200 20,000 18,868

4 18,868 1,132 20,000 0



CONCEPT CHECKERS: LEASES AND OFF-BALANCE-SHEET DEBT

1. Compared to a capital lease, a firm with an equivalent operating lease will show higher:A. return on assets if a lessee and higher profitability ratios if a lessor.B. initial leverage ratios if a lessee and avoid recognition of debt on the balance sheet.C. profitability ratios if a lessee and avoid recognition of debt on the balance sheet, and higher cash flow

from operations if a lessor.D. return on assets if a lessor, higher profitability ratios and initial leverage ratios if a lessee, and avoid

recognition of debt on a lessee’s balance sheet.

2. Which of the following statements about leases is FALSE?A. A lease is considered a capital lease if the lease period is at least 75% of the asset’s economic life.B. In a capital lease, substantially all benefits and risks of ownership are transferred to the lessee.C. The lessee should book capital leases to the leased asset and lease obligation accounts, and then amortize

the lease obligation and depreciate the leased assets.D. To record leased assets, the lessee determines the present value of the lease payments using the greater of

the implicit rate in the lease or the lessee’s incremental borrowing rate.

3. A firm leases a machine for 10 years.• Lease payments are $3,500 per year at the end of each year.• The firm has an option to buy the machine for $15,000 at the end of the lease term.• The fair market value of the machine is $30,000.• The machine’s economic life is 15 years.• There will be zero salvage value in 15 years.• The implicit rate in the lease is 8.25%.

The firm should:A. treat the lease as an operating lease.B. capitalize the lease because it involves a bargain purchase.C. capitalize the lease because the lease term is less than 75% of the economic life of the asset.D. capitalize the lease because the present value of future lease payments exceeds 90% of fair market value.

4. For a lessee:Operating leases are Operating lease paymentsaccounted for like: are reported as:

A. contracts lease expenseB. asset purchases lease expenseC. contracts interest expenseD. asset purchases interest expense

5. For a lessee, a capital lease results in:A. an asset.B. a short-term liability.C. a long-term liability.D. all of the above.



6. Which of the following statements about capital and operating leases is FALSE for a lessee?A. Total cash flows are not affected by the accounting treatment of the lease.B. When a capital lease is initiated, the present value of the leased asset is treated as a financing cash flow.C. As compared to an operating lease, a capital lease will report higher operating cash flows and lower

financing cash flows.D. Over the life of a capital lease the total expenses will equal those of a similar operating lease; but the

operating lease will have lower expenses in the earlier years, while the capital lease will have lower expenses in the later years.

7. A capital lease results in the following net income to a lessee compared to a comparable operating lease:Early Years Later Years

A. Lower LowerB. Lower HigherC. Higher LowerD. Higher Higher

8. For a lessee, capital lease interest expense is equal to the: A. interest rate multiplied by the beginning leasehold liability.B. interest rate multiplied by the lease payment.C. lease payment.D. depreciation expense.

9. Compared to an operating lease, the lessee’s debt-to-equity ratio for a capital lease is:A. higher.B. lower.C. not affected.D. higher in the early years and lower in the later years.

10. As compared to an operating lease, a capital lease will result in a:A. lower debt-to-equity ratio.B. higher financing cash flow.C. lower cash flow from operations.D. lower net income in the earlier years of the lease.

11. Which of the following statements concerning a lessee is FALSE?A. All else equal, when a lease is capitalized, income will rise over time.B. Lease capitalization increases a firm’s operating cash flows and decreases the firm’s financing cash flows

relative to cash flows for an operating lease.C. In the first years of a capital lease, the firm’s debt-to-equity ratio will be greater than if the firm had used

an operating lease.D. In the first years of a capital lease, the firm’s current ratio will be greater than it would have been had the

firm used an operating lease.


• A firm has just signed a 5-year lease on a new machine.• Lease payments are $20,000 per year, payable at the end of the year.• The machine has no salvage value at the end of the lease term.• The machine has a 5-year useful life.• The firm’s incremental borrowing cost is 11%.• The lessor’s implicit rate on the lease is 10%.• The lease is classified as a capital lease.



12. What will be the leasehold asset at the inception of the lease?A. $0.B. $20,000.C. $73,918.D. $75,816.

13. What will the firm report as interest expense in the first year?A. $7,582.B. $8,131.C. $12,418.D. $20,000.

14. What will be straight-line (SL) depreciation expense in the first year?A. $10,000.B. $12,418.C. $15,163.D. $20,000.

15. How much of the first-year lease payment will be deducted from cash flow from operations?A. $0.B. $7,582.C. $12,418.D. $20,000.

16. How much of the first-year lease payment will be deducted from cash flow from financing?A. $0.B. $7,582.C. $12,418.D. $20,000.

Use the following data to answer Question 17.

On December 31, 2002, Central Airlines signed a 10-year lease for an airplane.

• The lease requires ten payments of $100,000 each December 31 beginning December 31, 2003.• The economic life of the airplane is 12 years.• There was no bargain purchase option.• Central has an incremental borrowing rate of 10% and is aware of the lessor’s 12% implicit rate.• Central treats the lease as an operating lease.• Central reports net income of $200,000 for the year ended December 31, 2003.

17. Best Manufacturing Company is the manufacturer and lessor of the airplane leased to Central Airlines on December 31, 2002. It appears that the lease payments will be collectible and that there are no uncertainties regarding unreimbursable costs. A footnote to Best’s financial statements indicates that the plane leased to Central Airlines cost $400,000 to manufacture and has an expected salvage value of $250,000 when the plane is returned to the lessor on December 31, 2012. Best reported the lease as an operating lease and recorded no revenue from the lease and no expenses related to the airplane’s manufacture in its 2002 financial statements. After any required analyst adjustments are made for the Central Airlines lease, Best’s net income will:A. be unchanged because no lease payments were received in 2002.B. increase by $165,022.C. increase by $245,515.D. increase by $261,408.




Kent, Inc., signs an agreement on January 1, 2005 to lease equipment from Christopher, Inc. It costs Christopher $175,000 to produce the equipment. The term of the lease is six years, and Christopher estimates that it will be able to sell the equipment in six years for $51,000. The agreement requires equal annual payments of $50,000, with the first payment due on January 1, 2005. The collectability of the lease payments is predictable, and there are no significant uncertainties about Christopher’s unreimbursable costs. Christopher’s implicit rate on the lease is 10%, and Kent’s incremental borrowing rate is 9%. Assume Christopher treats the lease as a capital lease.

18. The total present value of the lease payments to be received by Christopher over the term of the lease is closest to:A. $217,763.B. $224,296.C. $239,539.D. $244,483.

19. The amount of cost of goods sold (COGS) that Christopher should record at the inception of the lease is closest to:A. $144,590.B. $146,212.C. $203,788.D. $205,410.

20. The balance in the investment in lease account that will appear on the balance sheet of Christopher on December 31, 2005 is closest to:A. $208,493.B. $211,986.C. $240,160.D. $245,160.

21. The balance in the investment in lease account that will appear on the balance sheet of Christopher on December 31, 2008 is closest to:A. $96,363.B. $96,790.C. $137,603.D. $138,798.

22. The amount of interest revenue that will appear on the income statement of Christopher in 2007 is closest to:A. $11,460.B. $12,509.C. $14,642.D. $15,918.

23. The amount of profit that Christopher should recognize at the inception of the lease is closest to:A. $64,539.B. $69,483.C. $93,327.D. $99,893.



24. Florestan leases specialized manufacturing equipment to Eusebius under a direct-financing lease for ten years. At the end of the lease, the equipment has no residual value, and Eusebius will take possession of the equipment at no additional charge. Florestan wants to earn a 7 percent rate of return over the ten-year period. The current fair market value of the equipment is $470,600. Also, the present value of an annuity due of $1 at 7 percent for ten years is 7.515, and the current market rate of interest is 8 percent.

Which of the following amounts is closest to the total amount of interest revenue that Florestan should record on its financial statements over the life of the lease?A. $67,000.B. $155,610.C. $329,400.D. $376,500.

25. Nadine Enterprises is considering leasing a piece of equipment from Ronald Enterprises for the next five years. Nadine’s incremental borrowing rate with the bank for a five-year loan is 6 percent, the risk-free rate in the market is 4 percent, the average five-year lease rate in the market is 5 percent, and the implicit rate on the lease is 7 percent. Assume the lease meets the criteria for a sales-type (capital) lease by Ronald. Which discount rate should be used by Ronald to calculate the amount of the investment in lease?A. 4%.B. 5%.C. 6%.D. 7%.

26. Which of the following statements about sales-type leases and operating leases (from the lessor’s perspective) is FALSE?A. Both types of leases result in the same total cash flows.B. Operating leases result in no profit recognized at inception.C. Cash flow from operations is lower under operating leases.D. At inception, higher assets are recognized under sales-type leases.

27. Assume Tara Enterprises purchases an asset for $80,000 and then leases it to Marc Enterprises for eight years as a direct financing type lease. Annual lease payments of $15,000 are required at the end of each year. Ignore any salvage value remaining at the end of the lease term. Marc’s incremental borrowing rate is 9 percent, and the implicit discount lease is 10 percent. At the beginning of year 4, the amount of the beginning investment in lease for Tara is closest to:A. $48,185.B. $56,830.C. $59,616.D. $62,116.



ANSWERS – CONCEPT CHECKERS: LEASES AND OFF-BALANCE-SHEET DEBT

1. C Structuring a lease as an operating lease results in higher profitability ratios for the lessee and avoidance of recognition of debt on the lessee’s balance sheet, and higher cash flow from operations for the lessor. The other statements each have an incorrect component. As compared to a capital lease, an operating lease results in lower profitability ratios for a lessor, lower initial leverage ratios for the lessee, and a lower return on assets for the lessor.

2. D Lease payments are valued using the lower of the implicit lease rate or lessee’s incremental borrowing rate.

3. A The purchase option is not a bargain because it is one-half the original price when only one-third of the asset life remains; title is not transferred at the end of the lease term; lease period is only 2/3 of the asset’s life; 90% of fair value is $27,000, while the present value of lease payments at the implicit rate is $23,222. Because none of the capital lease criteria hold, the lease is treated as an operating lease.

4. A Operating leases are accounted for like contracts (capital leases are like purchases), and operating lease payments are reported as lease expense.

5. D For a lessee recording a capital lease, both a long-term asset and long-term liability will be recognized, as well as a short-term liability being recognized for next year’s lease payment.

6. B The accounting treatment of a lease affects the classification of cash flows but not the total cash flows. Also, a capital lease will report higher operating cash flows and lower financing cash flows than an operating lease. For a lessee there is typically no cash flow at initiation. The principal portion of each lease payment is treated as a cash flow from financing.

7. B In the early years, a capital lease results in lower net income because interest plus depreciation expense is greater than rent expense under an operating lease. This effect reverses in the later years of the lease.

8. A Interest expense is calculated each year by multiplying the year’s beginning value of the leasehold liability by the discount rate on the lease. This interest expense is charged to income and operating cash flow.

9. A A capital lease will cause the debt-to-equity ratio to increase due to the ratio’s denominator effect when adding assets and liabilities to the balance sheet. No debt is booked related to the operating lease.

10. D A capital lease results in lower net income in the early years of the lease due to the capital lease recognizing interest expense and depreciation expense. A capital lease will also have a higher operating cash flow due to payments being split between operating and financing cash flows.

11. D A firm’s current ratio will be less when using a capital lease due to the next year’s lease payment being classified as a current liability.

12. D The appropriate discount rate is the 10% rate implicit in the lease (it’s less than the lessee’s incremental borrowing rate of 11%). The present value of the lease payments at a 10% discount rate is $75,816. Using a financial calculator:

I/Y = 10; PMT = 20,000; N = 5; CPT → PV = $75,816

13. A Interest expense is the leasehold value multiplied by 10%, which is $7,582.

14. C Depreciation is the leasehold value divided by 5, or 75,816 / 5.

15. B Only the interest expense is deducted from CFO.

16. C The financing cash flow is the principal component of the lease, which is the lease payment of $20,000 less the interest component of $7,582.



17. C Because the airplane’s 10-year lease is longer than 75% of its 12-year estimated economic life, and because there are no problems with lease payment collectability or unreimbursable costs, this lease should be recorded as a capital lease by the lessor. Because Best is a manufacturer and a profit is expected on the transactions involving its products, the lease is a sales-type lease. With a sales-type lease, profit is recognized at lease inception, and the interest or financing profit is recognized as the lease payments are earned. The profit that should be recorded in 2002 is the present value of the expected lease payments (at the lessor’s implicit interest rate of 12%) of N = 10; I/Y = 12; PMT = 100,000; CPT → PV = $565,022, less the COGS (manufacturing cost of $400,000 reduced by the present value of the expected salvage value at the end of the lease of N = 10; I/Y = 12; PMT = 0; FV = 250,000; CPT → PV = $80,493). The profit to be recorded in 2002 is $565,022 – ($400,000 – $80,493) = $245,515.

18. C From the lessor’s perspective, the lessee’s borrowing rate is irrelevant, so we should use the implicit rate on the lease to calculate the present value of the lease payments for the lessor. In this case, we use Christopher’s implicit rate on the lease of 10% (rather than Kent’s borrowing rate of 9%).

Be sure to set the calculator to beginning-of-period payments.N = 6; I/Y = 10; PMT = 50,000; FV = 0; CPT → PV = 239,539.

19. B COGS = Cost to produce equipment – PV of salvage valueCost = $175,000PV of salvage value: N = 6; I/Y = 10; PMT = 0; FV = 51,000; CPT → PV = 28,788COGS = 175,000 – 28,788 = $146,212

The following table summarizes the answers to questions 20 through 22.

Note: Since lease payments are received at the beginning of the period, the interest revenue for the year is calculated on the beginning investment in the lease minus the lease payment times the relevant interest rate of 10%. Numbers might not add due to rounding.

20. C Net investment in the lease = PV of lease payments + PV of salvage valuePV of lease payments = $239,539 (from a previous question)PV of salvage value = $28,788 (from a previous question)Net investment in lease = 239,539 + 28,788 = $268,327Annual payments of $50,000 occur at the beginning of the period, so the interest revenue in 2005 is calculated on $218,327.Interest revenue = $218,327 × 0.10 = $21,833Ending investment in lease in 2005 = 218,327 + 21,833 = $240,160

21. C See table in Question 19.

22. D See table in Question 19.

Year Beginning Investmentin Lease

Lease Payment Interest Revenue(Note)

Ending Investmentin Lease

1 (2005) $268,327 $(50,000) $21,833 $240,160

2 (2006) 240,160 (50,000) 19,016 209,176

3 (2007) 209,176 (50,000) 15,918 175,093

4 (2008) 175,093 (50,000) 12,509 137,603

5 (2009) 137,603 (50,000) 8,760 96,363

6 (2010) 96,363 (50,000) 4,636 51,000



23. C Profit = PV of lease payments – COGSPV of lease payments = $239,539 (from a previous question)COGS = $146,212 (from a previous question)Profit = 239,539 – 146,212 = $93,327

24. B There is no sales nor manufacturing profit in a direct-financing-type lease, so the only profit element is interest.

The annual lease payment received is $62,621($470,600 / 7.515), so after ten years, the total lease payments received will be $626,210 (10 × $62,621).

The total interest revenue over the life of the lease equals total lease payment less the fair market value of the leased asset ($626,210 – $470,600 = $155,610).

25. D Both the risk-free rate and the average five-year lease rate are irrelevant in this case. Also, the lessee’s (Nadine’s) incremental borrowing rate is irrelevant to the lessor (Ronald). Therefore, Ronald should use the implicit rate on the lease, which is 7%.

26. C Cash flow from operations is higher under operating leases because it includes the entire amount of the lease payment. Under sales-type leases, cash flow from operations only includes the gain and the interest income; principal payments received are included in cash flows from investing.

27. B The relevant interest rate to use to calculate interest income is the implicit discount rate on the lease (10%). At the beginning of year 1, the beginning investment in lease is $80,000, and this amount is increased by the interest income ($80,000 × 10% = $8,000) accrued throughout the year and then decreased by the lease payment received ($15,000) at the end of the year. Therefore, the ending investment in lease at the end of year 1 is $73,000, which is equal to the beginning investment in lease at the beginning of year 2. Continuing in this manner, the beginning investment in lease at the beginning of year 3 will be $65,300 [($73,000 × 1.10) – $15,000] and at the beginning of year 4 will be $56,830 [($65,300 × 1.10) – $15,000].



ANALYSIS OF INTERCORPORATE INVESTMENTS

Study Session 5

EXAM FOCUS

Unfortunately, there are no shortcuts here. Spend thetime necessary to learn how and when to use eachmethod of accounting for intercorporate investmentsbecause the probability of this material being tested ishigh. Know how to determine the effects of eachmethod on financial statements to calculate financial

ratios under each method. Pay particular attention tothe examples illustrating the difference between theequity method and the consolidation method. Youshould be able to calculate and determine the effectsof marking-to-market securities held for investment.

WARM-UP: ACCOUNTING METHODS FOR INVESTMENT SECURITIES

There are three accounting methods used for reporting the holdings of investments in securities of other entities. In each case, the investee must recognize dividends and interest in the year they are earned. However, carrying values are different under the three accounting treatments when the market values of the securities change.

• The cost method recognizes changes in the market values upon sale of securities.• The market method recognizes changes in the market values in the period in which they occur.• The lower of cost or market method recognizes declines in market value in the period in which they occur.

Gains are only recognized at recovery (if there was a previous decline) or when securities are sold. In other words, the carrying value of the securities can never exceed the purchase price.

Professor’s Note: This topic review deals with the U.S. GAAP treatment of intercorporate investments. See the topic review of IFRS vs. U.S. GAAP in Study Session 6 for more detail on the differences between the two standards as they relate to financial assets and consolidation of financial statements.

CLASSIFICATION OF DEBT AND EQUITY SECURITIES

LOS 1.F.a: Determine whether a debt security or equity security should be classified as held-to-maturity, available-for-sale, or as a trading security.

SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” requires a hybrid of these three methods, depending on the security classification. The accounting treatment for securities that have a public market or a readily estimated fair value is determined based upon management’s designation of the purpose of the security holdings. In the U.S., the cost method must be used for securities that have no public market or readily determined fair value. SFAS 115 requires a company to classify its securities into categories based upon the company’s intent relative to the eventual disposition of the securities. The classification will determine the accounting method used. SFAS 115 establishes three categories of securities classification:

Debt securities held-to-maturity are securities that a company has the positive intent and ability to hold to maturity. These securities are carried at amortized cost and cannot be sold prior to maturity except under unusual circumstances. This classification applies only to debt securities; it does not apply to equity investments.

Debt and equity securities available-for-sale may be sold to address liquidity and other needs of a company. Debt and equity securities classified as available-for-sale are carried at fair market value on the balance sheet. All



interest income, dividends, and realized gains or losses are reported on the income statement. Unrealized gains and losses are excluded from income but reported (net of deferred income tax) as a separate component of shareholders’ equity.

Debt and equity trading securities are securities acquired for the purpose of selling them in the near term. These securities are measured at fair market value and are listed as current assets on the balance sheet. Unrealized and realized gains and losses as well as interest income and dividends are reported in income.

SECURITY CLASSIFICATION: EFFECT ON RATIOS

LOS 1.F.b: Compute and discuss the effect of marketable securities classification on the financial statements and financial ratios under SFAS 115.

A convenient way to keep track of the accounting methods applied to each security classification is as follows:

• Debt securities held to maturity use the cost method.• Available for sale securities use the cost method on the income statement and the market method on the

balance sheet.• Trading securities use the market method.

The classification of the securities will affect the financial statements of the firm. Important financial statement effects are summarized in Figure 1.

Management determines the appropriate classification of its investment securities at the time of purchase, reevaluates such determination at each balance sheet date, and transfers securities from one category to another.

SFAS 115 identifies the following rules related to transfers between portfolios:

• Securities transferred from either held-to-maturity or available-for-sale to trading are transferred at fair market value, and any unrealized gains or losses are included in income.

• Debt securities held-to-maturity transferred to available-for-sale are transferred at fair market value, and any unrealized gains or losses are recorded directly to equity.

• Available-for-sale debt securities transferred to held-to-maturity are transferred at fair market value, and any unrealized gains or losses remain in equity but are subsequently amortized over the remaining life of the security.

Figure 1: Financial Statement Effects of Investment Security Classification

Security Classification

Trading Available-for-Sale Held-to-Maturity

Balance sheet or carrying value:

Fair market value Fair market value with unrealized G/L in comprehensive income

Amortized cost

Recognized as income: • Dividends• Interest• Realized G/L• Unrealized G/L

• Dividends• Interest• Realized G/L

• Interest• Realized G/L

* G/L stands for gains/losses



Securities listed in the available-for-sale and trading securities classifications are measured at FMV, so a portfolio of investment securities can have a value above original cost at the balance sheet date.

Extended Example: Demonstrating Ratio Impact of Security Classification

The following example illustrates the application of the trading, available-for-sale, and held-to-maturity accounting methods and their respective impacts on financial statements and financial ratios. Focus your attention on how the financial statements are affected by the classification of the securities. Don’t worry too much about the calculations.

Figure 2 contains transactions for nonoperating investments executed by Genco, together with associated market data and year-end values.

Figure 3 contains annual income, and realized and unrealized gains and losses on the trades.

Professor’s Note: As you’ll see in the next LOS, unrealized losses are most easily calculated as the change in the market valuation adjustment (MVA), which is the difference between the market value and the cost of the portfolio. For example, the MVA in 2004 is $28,000 – $35,000 = –$7,000. The MVA in 2005 is $72,000 – $60,000 = $12,000. The unrealized gains/losses for 2005 are $12,000 – (–$7,000) = $19,000.

Figure 4 contains the pretax income statement effects of the three reporting methods. Recall that the three methods are virtually identical except that unrealized gains and losses related to securities held for trading are included in current period income. Unrealized gains and losses are not included for the two other categories, which results in the same reported income for those methods.

Professor’s Note: For illustration purposes, we are treating equity investments as held-to-maturity securities, although in practice only debt securities can be classified as held-to-maturity.

Figure 2: Market and Trading Data for Genco

2003 2004 2005

Shares bought (sold) 1,000 (300) 500

Total shares: year-end 1,000 700 1,200

Purchase price $50.00 $50.00

Sale price $30.00

Year-end market price 60.00 40.00 60.00

Year-end holdings at cost 50,000 35,000 60,000

Year-end holdings at market 60,000 28,000 72,000

Figure 3: Genco Portfolio Income Data

2003 2004 2005

Total dividends $1,000 $700 $1,200

Realized gains/losses 0 (6,000) 0

Unrealized gains/losses 10,000 (17,000) 19,000

Figure 4: Reported Income for Genco Portfolio

Reported Income 2003 2004 2005

Trading $11,000 $(22,300) $20,200 (divs + all G/L)

Available-for-sale 1,000 (5,300) 1,200 (divs + realized G/L)

Held-to-maturity 1,000 (5,300) 1,200 (divs + realized G/L)



The resulting reported income for trading securities is more volatile than it is for income associated with available-for-sale and held-to-maturity securities.

Figure 5 contains the reported figures found on the balance sheet under the three categories.

For the trading and the available-for-sale securities, the carrying value on the balance sheet is adjusted to reflect changes in the market value of the securities. Unrealized gains and losses on available-for-sale securities are reported net of deferred income tax as a separate component of other comprehensive income. For held-to-maturity securities there are no adjustments to the carrying value on the balance sheet or to comprehensive income.

The impact on financial ratios is varied. To begin an illustration of some of the effects, let’s consider the rates of return on the carrying value (reported income divided by beginning carrying value) of the portfolio found in Figure 6.

In general, including realized and unrealized gains and losses from trading securities in the income statement and on the balance sheet will result in the most extreme outcomes. For example, any ratio involving net income will be larger (smaller) when unrealized gains (losses) are experienced. Although the pretax income for available-for-sale and held-to-maturity securities is the same, the book rate of return varies because unrealized gains and losses are included in the carrying value of the securities under the available-for-sale method, while the cost of the securities is used under the held-to-maturity method. The best approach to address exam questions on this topic is to follow the impact of the unrealized gains and losses under each accounting method and determine the marginal effect on financial ratios.

Effect of Security Classification on Financial Statements

The most significant effect of security classification on the firm’s reported financial performance that you have to worry about on the exam is the result of management’s ability to manipulate reported earnings and financial performance by reclassifying securities from one category to another.

For example, reclassifying securities that have appreciated in value from available-for-sale to trading results in reporting the unrealized gain in income. Because management classifies investments individually, it is possible for management to move securities with unrealized gains to the trading classification and recognize the gains while leaving securities with unrealized losses in the available-for-sale classification where the income statement is not affected.

There is another more subtle effect on the firm’s investment and financing decisions. Under SFAS 115, firms are restricted from selling held-to-maturity securities prior to maturity, except in unusual circumstances. If the firm

Figure 5: Balance Sheet Carrying Values for Genco Portfolio

2003 2004 2005

Trading $60,000 $28,000 $72,000 (Market value)

Available-for-sale 60,000 28,000 72,000 (Market value)

Held-to-maturity 50,000 35,000 60,000 (Amortized cost)

Figure 6: Book Rate of Return for Genco Portfolio

2004 2005

Trading –37.2% 72.1%

Available-for-sale –8.8% 4.3%

Held-to-maturity –10.6% 3.4%



does sell a held-to-maturity security, it is required by SFAS 115 to carry its remaining held-to-maturity securities at market value instead of cost, which increases the volatility of assets reported on the balance sheet. Therefore, the firm’s investing and financing decisions (e.g., whether to sell marketable securities to pay down debt) will be influenced by the anticipated accounting effects on the financial statements.

Professor’s Note: As we discuss in the topic review of IFRS vs. U.S. GAAP in Study Session 6, transfers in and out of available-for-sale securities should be “rare” according to U.S. GAAP.

MARK-TO-MARKET INVESTMENT RETURN

LOS 1.F.c: Compute the mark-to-market investment return on a marketable securities portfolio under SFAS 115.

Professor’s Note: In this reading, MVA is the acronym for market valuation adjustment. Elsewhere in Level 2 curriculum, MVA refers to market value added.

By now you know that dividends, interest, and realized gains and losses are recognized and recorded in the period they occur. The computation of mark-to-market investment return requires the inclusion of unrealized gains and losses.

mark-to-market return = dividends + interest + realized gains (losses) + unrealized gains (losses)

Unrealized gains and losses are usually tracked through the use of a market valuation adjustment (MVA). The MVA is simply the difference between the fair market value (FMV) of the investment portfolio and its cost on a given balance sheet date. Unrealized gains and losses are reflected in changes in the MVA:

unrealized holding gains (losses) = increase (decrease) in MVA

Example: Calculating mark-to-market investment return

Universal Insurance Co. reported the following book values (cost), market values (MV), and market valuation adjustments (MVA) for their investment portfolio for 2004 and 2005.

In addition, Universal provided the following reported (realized) returns for 2005:

Calculate Universal’s mark-to-market return in total and for each security classification.

Figure 7: Universal Insurance’s Reported Portfolio Balances and MVA

2004 2005

Cost MV MVA Cost MV MVA

Held-to-maturity $356 $391 $35 $377 $426 $49

Available-for-sale 323 301 (22) 298 308 10

Equity securities 155 172 17 214 237 23

Figure 8: Universal’s Reported Investment Income

Held-to-Maturity

Available-for-sale

Equity Securities Total

Dividend and interest income $39 $33 $12 $84

Realized gains or losses 5 (11) 14 8

Reported income $44 $22 $26 $92



Answer:

The reported total return to Universal’s portfolio is $92. The mark-to-market return is $144. The difference is due to the unrealized gains that each investment sub-category experienced during 2005. If these portfolios had experienced losses, the mark-to-market return would have been less than the reported return.

To analyze the relative performance of a company’s marketable securities portfolio, the analyst should compare the mark-to-market returns to a comparable risk portfolio over one complete business cycle.

ACCOUNTING FOR INTERCORPORATE INVESTMENTS

LOS 1.F.d: Determine, given various ownership and/or control levels and relevant accounting standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should be used and compute and compare the effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company’s financial statements and financial ratios.

U.S. GAAP

Percentage of ownership (or voting control) is typically used as a practical guide to determine influence or control for financial reporting purposes. Figure 10 contains the guidelines used to determine which reporting method is required for intercorporate investments. Note that these are only guidelines. Nevertheless, the conceptual distinction for determining reporting methods centers on the degree to which the investee (affiliate) is an integral part of the investor (parent).

Cost or market. Ownership of less than 20 percent is typically viewed as a noncontrolling interest, and the two firms are treated as separate entities. The cost or market methods described in the previous discussion are used for financial reporting purposes in these instances.

Equity method. The equity method is used when the investor has a noncontrolling interest but may significantly influence the decisions of the firm whose stock is owned. The critical test for using the equity method involves the issue of significant influence. FASB defines this to mean at least 20 percent ownership and/or significant influence over the management, operations, investing, and financing decisions of the investee (e.g., it may be possible to have significant influence with only 10 percent ownership).

Figure 9: Universal’s Mark-to-Market Return

Held-to-Maturity

Available-for-sale

Equity Securities Total

Reported income $44 $22 $26 $92

Change in MVA 14 32 6 52

Mark-to-market return $58 $54 $32 $144

Figure 10: FASB Guidelines for Accounting for Investments

Ownership Criterion (degree of influence) Method

Less than 20% No significant influence Cost or market

20–50% Significant influence Equity

Greater than 50% Control Consolidation



The use of the equity method is not allowed, even if the ownership level is more than 20 percent, if any one of the following conditions applies:

• The investor cannot exercise influence over the investee because of pending litigation between the two entities.

• The investor is unable to vote its shares or otherwise influence management of the investee because of restrictions such as a standstill agreement.

• A majority shareholder controls the investee’s operations.• There are other factors that indicate lack of influence on the part of the investor, such as a lack of seats on the

board of directors.

Under the equity method, the proportionate share of the investee’s income is included in the parent’s income. The parent’s reported income is not affected by changes in the market value of the investee unless the value decline is considered permanent or realized losses are incurred upon sale of the investment. The equity method of reporting must be used if significant influence is present but ownership is less than 20 percent.

Consolidated method. Under SFAS 94, direct or indirect ownership of more than 50 percent of the voting shares requires the parent to use consolidated reporting. Consolidated reporting results in two firms being presented as one economic entity, even though the firms may be separate legal entities. All income of the affiliate (less any minority interest) is reported on the parent’s income statement. There are two exceptions under SFAS 94: (1) if control is temporary or (2) if barriers to control exist such as governmental intervention, bankruptcy, civil disorder, or if a nonconvertible currency is involved. These exceptions exist to accommodate situations where the parent cannot use the subsidiaries’ assets or control its actions.

Professor’s Note: The LOS says “given... relevant accounting standards.” Our discussion to this point has focused on U.S. GAAP standards. See the topic review in Study Session 6 for details on how IFRS differs from U.S. GAAP. Country standards vary considerably, but you are not expected to know the specific standards in each non-U.S. country. However, expect a question on the exam in which you are given a set of hypothetical standards for a fictitious country and asked to analyze the effects of using those standards on the reported financial performance.

Non-U.S. Standards

Proportionate consolidation. The proportionate (or pro rata) consolidation reporting method exists because the equity method may not effectively capture the risk-return characteristics of investments in unconsolidated affiliates. While this reporting method is not widely used in the U.S., International Accounting Standards (IAS) 31 recommends proportionate consolidation for all jointly controlled entities and jointly controlled operations. U.S. GAAP does not specify the appropriateness of this method, even though it is commonly used in the construction industry. If this method is used, reported net income and equity will be the same as under the equity method. However, unlike the equity method, the parent reports its ownership share of assets and liabilities in the subsidiary.

EFFECT OF CHOICE OF METHOD ON FINANCIAL STATEMENTS

Professor’s Note: We now turn our discussion to the effects of the different reporting methods on financial statements and financial ratios. The financial statement and financial ratio effects of the cost method were discussed in previous sections.

The Equity Method

The equity method allows the investing firm to include a proportionate share of the investee’s income in its earnings, regardless of whether the earnings are actually received (i.e., whether or not the investee pays out earnings as dividends). The investor also reports a proportionate share of the investee’s net assets.



Under the equity method, market values are ignored, but for purposes of analysis, market values can be compared with the carrying amount under the equity method. Clearly, market values are a better indicator of value.

Example: Implementing the equity method

Assume the following:

• December 31, 2003, Company P (i.e., the parent company) invests $1,000 in Company S (the subsidiary) and receives 30% of the shares of Company S.

• During 2004, Company S earns $400 and pays dividends of $100.• During 2005, Company S earns $600 and pays dividends of $150.

Calculate the investment in Company S reported by Company P on the balance sheet, the reported income, and cash flow.

Answer:

Using the equity method, for 2004, Company P will:

• Recognize $120 = ($400 × 0.3) on its income statement as equity in the net income of Company S.• Increase the investment in the Company S account on the balance sheet by $120 to $1,120, reflecting its

share of the net assets of Company S.• Receive $30 = ($100 × 0.3) in cash dividends from Company S and reduce its investment in Company S

by that amount to reflect the decline in the net assets of Company S due to the dividend payment.

At the end of 2004, the carrying value of Company S on Company P’s balance sheet will be $1,000 original investment + $120 proportional share of Company S earnings – $30 dividend received = $1,090.

For 2005, Company P will recognize income of $180 = ($600 × 0.3) and increase the investment by $180. Also, P will receive dividends of $45 ($150 × 0.3) and lower the investment account by $45. Hence, at the end of 2005, the carrying value of Company S on Company P’s balance sheet will be $1,225 ($1,090 for the carryover balance from 2004 + $180 proportional share of Company S earnings – $45 dividend received).

Equity Method vs. Cost Method: Effect on Ratios

To summarize, under the equity method Company P will report:

For comparison purposes, observe what would happen if the cost method had been used by Company P. The investment is carried at the original book value of $1,000, and dividends received are reported as income.

Figure 11: Equity Method Accounting

Year Investment in Company S Income Reported Cash Flow

2003 $1,000

2004 1,090 $120 $30

2005 1,225 180 45

Figure 12: Cost Method Accounting

Year Investment in Company S Income Reported Cash Flow

2003 $1,000

2004 1,000 $30 $30

2005 1,000 45 45



The point here is that under the equity method, Company P reports higher income, as long as the subsidiary has positive earnings and pays out less than 100 percent of its earnings as dividends, but cash flows will be the same. Hence, interest coverage ratios and return on investment will be higher using the equity method. The parent’s leverage ratios will improve because assets and equity increase, but debt is not affected. If Company S reported losses, Company P would have to write down the investment account (but not below zero) and recognize its share of the loss in net income.

Hence the possibility of earnings management—a firm that acquires stock in an unprofitable firm may try to keep proportional ownership just below 20 percent (so it doesn’t have to recognize the loss). There is some evidence that firms straddle the 20 percent line to get the desired accounting treatment. Using the equity method makes sense when the investee’s undistributed income is increasing.

The use of the equity method results in an assumption that the undistributed earnings of the investee (income less dividends) will eventually accrue to the investing firm. In cases when this assumption is questionable, analysts should adjust equity earnings to a cost basis by including only actual dividends received.

The Consolidation Method

In a consolidated set of financial statements, each account consists of the sum of the corresponding accounts from each of the individual firms, less any intercompany transactions. When firms are consolidated, it is assumed that each subsidiaries’ assets and liabilities are now also held by the parent company.

Let’s do an example using the consolidation method.

Figure 13: Consolidated Method Accounting

Pre-acquisition Balance SheetsDecember 31, 2004 Company P Company S

Current assets $48,000 $16,000Other assets 32,000 8,000

Total $80,000 $24,000

Current liabilities $40,000 $14,000Common stock 28,000 6,000Retained earnings 12,000 4,000

Total $80,000 $24,000



Assume that on December 31, 2004, Company P acquires 80 percent of the common stock of Company S by paying $8,000 in cash to the shareholders of Company S. The following two balance sheets compare the consolidation method and the equity method of accounting for this transaction.

Note that under both methods the current assets will be the original values less the cash used in the investment. Under consolidation the cash balance equals $48,000 + $16,000 – $8,000 = $56,000. Under the equity method the cash balance is $48,000 – $8,000 = $40,000.

The most important thing to recognize is that just about all of the balance sheet accounts are different between the two methods, except common stock and retained earnings (which are in blue in Figure 14). Most balance sheet accounts will be larger under the consolidation method, including total assets and liabilities.

Although under consolidation all of the asset and liability accounts of the subsidiary are added to the parent’s accounts, the parent does not “own” all of these assets and liabilities—the parent “owns” only 80 percent, and the remaining 20 percent are owned by other investors. This difference is accounted for as a liability by use of the minority interest account and is computed as (1 – parent’s ownership) times the subsidiary’s net worth. In our example this is:

minority interest = (1 – 0.80) × ($24,000 – $14,000) = $2,000

Now assume we have the following information about the individual income of P and S for 2005.

Figure 14: Consolidation vs. Equity Method

Post-acquisition Balance Sheet for Company PDecember 31, 2004 Consolidated Equity Method

Current assets $56,000 $40,000Investment in S 8,000Other assets 40,000 32,000

Total $96,000 $80,000

Current liabilities $54,000 $40,000Minority interest 2,000Common stock 28,000 28,000Retained earnings 12,000 12,000

Total $96,000 $80,000

Figure 15: Company P and S Income Data

Income StatementCompany P Company S

Revenue $60,000 $20,000Expenses 40,000 16,000

Net income $20,000 $4,000

Dividends $1,000



The following two income statements compare consolidation with the equity method for the parent:

Once again, notice that every income statement item is different between the two methods, except net income (in blue). In particular, sales is larger under the consolidated method. Note also that the minority interest account in the consolidated income statement reflects the fact that although the parent included all the income of the subsidiary in the consolidated statement, minority interests have a claim to 20 percent of that amount: (1 – 0.8) × $4,000 = $800.

Professor’s Note: This example assumes that the parent company acquired its interest in the subsidiary by paying the proportionate share of the subsidiary’s book value. If the parent pays more than its proportionate share of book value, goodwill is created. See the topic review of business combinations for details on how to analyze goodwill.

Consolidation Method vs. Equity Method: Effect on Ratios

Consolidation and the equity method both result in the same net income and the same equity but differ in two important ways:

• Consolidation results in all of the assets, liabilities, revenues, expenses, and cash flows of the subsidiary being added to those of the investor. Minority interest is subtracted out. The subsidiary’s operating, investing, and financing activities affect virtually every account in the consolidated statements. Parent company cash flows exclude those between parent and investee but include all others.

• The equity method reports only the parent’s share of net income and assets, including it as equity in the earnings of the subsidiary and investment in the subsidiary. Hence, only the investment account and net income are affected by investee results. Moreover, under the equity method, only capital flows between parent and investee (such as dividends) are included in cash flows of the parent.

Figure 17 shows the differences in a few key ratios between the equity and consolidation methods, using the data from the example.

ROE will be the same because net income and equity are the same under both methods. In general, however, if the subsidiary is profitable, the equity method reports better results than the consolidation method.

Figure 16: Income Statements Under the Consolidated and Equity Methods

Income StatementConsolidated Equity Method


Operating income $24,000 $20,000

Equity in income of S 3,200Minority interest (800)

Net income $23,200 $23,200

Figure 17: Ratio Comparison of Consolidation vs. Equity Methods

Ratio Consolidation Method Equity Method

Return on equity 58% 58%

Return on assets 24% 29%

Net profit margin 29% 39%

Debt to equity 1.4 1.0



• ROA will be greater with the equity method because reported assets are lower than with the consolidation method.

• Net profit margin will also be higher because sales are lower with the equity method. • Leverage ratios will be lower with the equity method because, with consolidation, equity is the same but

assets and liabilities are larger.

The Proportionate Consolidation Method (Joint Ventures)

Joint ventures may take place for many reasons and may take various legal, operating, and accounting forms. In many cases, financial statements need adjustment to better reflect the economic substance of the joint venture.

Some joint ventures are only contractual arrangements and do not require the issuance of new equity. Each party reports its own assets, liabilities, revenues, and expenses separately, so there are no new accounting or analytical problems. Other joint ventures result in common ownership of assets but do not start a separate entity. Each party recognizes its share of the common assets, liabilities, revenues, expenses, and income of the joint operations in its own statements. Again, there are no new accounting or analytical problems.

However, in many cases the joint venture is a separate entity created by the contribution of capital from two or more parties. In these cases, the joint venture prepares its own financial statements, and the investors account for their interest in the joint venture using the equity method. If the equity method is used to account for a joint venture, the investor will report only a proportionate share of the net income and net assets in the joint venture. The point is that the equity method results in less than complete information about the total assets, liabilities, revenues, and expenses of a joint venture, which may be as much an integral part of the parent as any wholly owned subsidiary.

Proportionate consolidation accounting for joint ventures provides better information to users of financial statements. When reporting using the proportionate consolidation method, the parent company’s share of each asset and liability of the joint venture is included. Only stockholder’s equity will be the same under the proportionate consolidation and equity methods. The parent will also include its share of the joint venture’s revenues and expenses in its income statement. Net income will not be affected, but many financial ratios will change.

A proportionate consolidation is not a provision of U.S. GAAP, although it has been adopted in IAS 31. Analysts may employ proportionate consolidation on a firm that is currently accounted for using the equity method if the analysts believe that a stronger link exists between the two firms than is implied by the ownership percentage.

A joint venture is a typical example in which you would most likely apply a proportionate consolidation. A proportionate consolidation will lead to the same results as a normal consolidation except there are no minority interest computations. You simply add the parent’s proportionate share of all accounts net of intercorporate transfers. Once again, do not add the equity accounts together.



Example: Proportionate consolidation

Assume Company P owns 30 percent of a joint venture (JV), and the companies each report the financial information shown in Figure 18 (note that the statements for Company P already include the joint venture and have been prepared using the equity method):

In order to adjust the statements for Company P to the proportionate consolidation method, we further assume that the parent purchases 40 percent of the output of the JV, and the JV has an account receivable from Company P for $40 at year end.

Figure 18: Parent and Joint Venture Financial Information

Income Statements Company P (Consolidated) JV

Revenues $5,000 $800

Equity in JV* 12Cost of goods sold 2,000 560Selling and admin. expense 400 104Interest expense 100 68

Earnings before tax $2,512 $68

Tax (40% of $2,500) 1,000 27

Net income $1,512 $41

Balance Sheets Company P JV

Cash $500 $80Inventory 1,000 200Accounts receivable 1,500 200Property, plant, & equipment 1,400 720Investment in JV** 60

Total $4,460 $1,200

Accounts payable $1,000 $320Long-term debt 1,000 680Equity 2,460 200

Total $4,460 $1,200

* Equity in JV = $12 = 0.3 × $41 = (ownership share) × (JV’s net income)* Investment in JV = $60 = 0.3 × $200 = (ownership share) × (JV’s equity)



The effect on ratios between the proportionate consolidation and equity methods is similar to that of consolidation and equity. Net income and total equity are the same, which means ROE is the same. However, if the subsidiary is profitable, the equity method will report more favorable results for net profit margin, ROA, and debt to equity.

Figure 19: Proportionate Consolidation

Income Statement—Company P Calculations

Revenues $5,144 = $5,000 + (0.3 × $800) – (0.3 × 0.4 × $800)1

Cost of goods sold 2,072 = $2,000 + (0.3 × $560) – (0.3 × 0.4 × $800)Selling and admin. expense 431 = $400 + (0.3 × $104)Interest expense 120 = $100 + (0.3 × $68)

Earnings before tax $2,521

Tax 1,008 = $1,000 + (0.3 × $27)

Net income $1,513 (slight rounding error)2

Balance Sheet— Company P Calculations

Cash $524 = $500 + (0.3 × $80)Inventory 1,060 = $1,000 + (0.3 × $200)Accounts receivable 1,548 = $1,500 + [0.3 × ($200 – 40)]Property, plant, & equipment 1,616 = $1,400 + (0.3 × $720)

Total $4,748Accounts payable $1,084 = $1,000 + [0.3 × ($320 – $40)]

Long-term debt 1,204 = $1,000 + (0.3 × $680)

Equity 2,4602

Total $4,748

1 Note the way the intercompany transactions are eliminated. In particular, revenues and cost of goods sold (COGS) are both lowered by the proportionate value of the intercompany transactions (a good way to think of this is that the revenue for one company is the COGS for the other), and the accounts receivable and accounts payable are adjusted by the proportionate value of the intercompany transaction.

2 Note that using the proportionate consolidation method results in the same net income and equity as the equity method.



KEY CONCEPTS

1. Debt securities held-to-maturity are securities the company has a positive intent and ability to hold to maturity. Available-for-sale securities may be sold to address the company’s liquidity needs. Trading securities are acquired for the purpose of selling them in the short term.

2. The unrealized gains and losses of trading securities are reported on the income statement. The unrealized gains and losses of available-for-sale securities are reported as a component of equity on the balance sheet.

3. The MVA is the difference between the fair market value and the book value of the marketable securities portfolio. Unrealized gains (losses) are equal to the change in the MVA.

4. To use the equity method, an investor must exert significant influence over the investee’s operations and management (the investor usually owns between 20 percent and 50 percent of the outstanding shares of the investee).

5. Under the equity method, the investment is listed at cost on the balance sheet. Dividends that are paid by the investee increase cash and decrease the investment account on the assets side of the balance sheet. In addition, the investor’s pro rata share of the investee’s net income increases the asset account and is listed as income on the investor’s income statement.

6. The equity method differs from the cost method in that when the dividend payout is not 100 percent and the income of the investee is positive, the reported net income under the equity method will exceed the net income reported under the cost method (all else the same). Under these same circumstances, the reported amount in the investment account will be greater for the equity method than for the cost method. The reported cash flow will not differ between the two methodologies.

7. To use consolidation, the parent must control a subsidiary (the investor usually owns more than 50 percent of the subsidiary).

8. The mechanics of a consolidation are as follows: add together all asset and liability accounts net of intercorporate transfers; do not adjust the equity accounts of the parent; list the minority interest account on the liabilities and equity side of the parent’s balance sheet. Minority interest is equal to the proportion of the subsidiary that the parent does not own times the net equity of the subsidiary.

9. On the consolidated income statement, add the revenues and expenses of the parent and the subsidiary together. Subtract the minority shareholders’ stake in the subsidiary’s net income from this amount. The minority interest balance on the income statement equals the proportion of the subsidiary that the parent does not own times the net income of the subsidiary.

10. A consolidation will differ from financial statements generated using the equity method in the following ways. First, the consolidated assets and liabilities will exceed those listed under the equity method in most cases. Also, consolidated revenues, expenses, and operating income will exceed those reported under the equity method. Reported equity and net income will be the same under both methods.

11. In general, if the subsidiary is profitable, the equity method reports better results than the consolidation method: ROA and net profit margin will be greater, and leverage ratios will be lower under the equity method.

12. A proportionate consolidation is not a provision of U.S. GAAP, although it has been adopted in IAS 31. Analysts may employ proportionate consolidation on a firm that is currently accounted for using the equity method if the analysts believe that a stronger link exists between the two firms than is implied by the ownership percentage. A joint venture is a typical example in which you would most likely apply a proportionate consolidation.

13. A proportionate consolidation will lead to the same results as a normal consolidation except there are no minority interest computations in a proportionate consolidation. You simply add the parent’s proportionate share of all accounts net of intercorporate transfers. Do not add the equity accounts together.



CONCEPT CHECKERS: ANALYSIS OF INTERCORPORATE INVESTMENTS

1. If a company uses the equity method to account for an investment in another company:A. income is combined to the extent of ownership.B. income to the company is actual dividends, interest, or capital gains.C. all income of the affiliate is included except intercompany transfers.D. earnings of the affiliate are included but reduced by any dividends paid to the company.


Kirk Company acquired shares in the equity of both Company A and Company B. We have the following information from the public market about Company A and Company B’s investment value at the time of purchase and at two subsequent dates:

2. Kirk Company will report the initial value of its Marketable Equity Securities (MES) account as:A. $250.B. $600.C. $1,100.D. $1,200.

3. At t = 1, Kirk will:A. no longer use the cost method.B. carry the MES portfolio at cost.C. write down the MES portfolio to $1,030 and recognize a realized loss of $170.D. write down the MES portfolio to $1,030 and recognize an unrealized loss of $170.

4. At t = 2, Kirk will report the carrying value of its MES account as:A. $1,030.B. $1,150.C. $1,200.D. $1,250.

5. Based on the information provided, which of the following statements is TRUE? A. Classifying the shares as trading securities would result in greater reported earnings volatility for Kirk.B. Classifying the shares as available-for-sale securities would result in a $220 realized gain for Kirk

between t = 1 and t = 2.C It is optimal for Kirk to classify its shares in Company A and Company B as available-for-sale securities

since it results in a net $50 gain recognized on the income statement at t = 2.D. It is optimal for Kirk to classify its shares in Company A and Company B as trading securities because,

of the two methods, the trading securities classification results in the highest reported market value of $1,250 at t = 2.

Security Cost t = 1 t = 2

A $950 $850 $900

B 250 180 350



6. Assume for this question only that at t = 3, Kirk sells all of the Company A shares for $975 and sells all of the Company B shares for $275. Based on this additional information, which of the following statements is TRUE?A. At t = 3, there will be a $75 unrealized gain for Company A shares.B. At t = 3, there will be a $75 unrealized loss for Company B shares.C. At t = 3, there will be a $50 realized gain and a $25 unrealized gain for Company A shares.D. At t = 3, there will be a $100 unrealized loss and a $25 realized gain for Company B shares.

7. Assume for this question only that security A and security B are both debt securities held to maturity. At t = 2, Kirk will report the carrying value of its MES account as:A. $1,030.B. $1,150.C. $1,200.D. $1,250.

Use the following data to answer Questions 8 and 9.

Assume Company P, a U.S. company, buys 1,000 shares of Company A for $80 per share. During the year, Company A has earnings of $6 per share and pays dividends of $4 per share, and at year-end the share price is $75.

8. At year-end, Company P will carry this investment as:If no public market If trading security If available-for-sale security

A. $75,000 $75,000 $75,000B. $75,000 $80,000 $75,000C. $80,000 $75,000 $80,000D. $80,000 $75,000 $75,000

9. Company P will report investment income on its income statement as:If no public market If trading security If available-for-sale security

A. $4,000 $4,000 $4,000B. $6,000 $9,000 $9,000C. $4,000 $4,000 –$1,000D. $4,000 –$1,000 $4,000


Assume Company P acquired 40 percent of the shares of Company A for $1.5 million on January 1, 2005. During the year, Company A earned $500,000 and paid dividends of $125,000. Assume the use of the equity method.

10. At the end of 2005, Company P reported investment in Company A as:A. $1.5 million.B. $1.65 million.C. $1.7 million.D. $1.875 million.

11. Company P reported investment income of:A. $50,000.B. $150,000.C. $200,000.D. $500,000.



12. Company P received cash flow from the investee of:A. $50,000.B. $150,000.C. $200,000.D. $500,000.

Use the following data to answer Questions 13 though 15.

Assume Company P acquires 80 percent of the common stock of Company S on December 31, 2004 by paying $120,000 cash to the shareholders of Company S. The two firms’ pre-acquisition balance sheets as of December 31, 2004 and income statements for the year ending December 31, 2005 follow:

13. Company P will use consolidation and report the following values on the consolidated balance sheet:Current Assets Total Assets Investment in S

A. $960,000 $1,560,000 $120,000B. $840,000 $1,440,000 N/AC. $792,000 $1,440,000 N/AD. $720,000 $1,200,000 $120,000

14. For the year ended December 31, 2005, Company P’s Income Statement will show “minority income interest” and “consolidated net income” of:

Minority Income Interest Consolidated Net IncomeA. $3,000 $300,000B. $3,000 $348,000C. $12,000 $348,000D. $12,000 $360,000

15. The year-end 2005 balance sheet account “minority interest” will show:A. $30,000.B. $39,000.C. $42,000.D. $45,000.

Balance Sheets Company P Company S

Current assets $720,000 $240,000Other assets 480,000 120,000

Total Assets $1,200,000 $360,000

Current liabilities $600,000 $210,000Common stock 420,000 90,000Retained earnings 180,000 60,000

Total Liabilities & Equity $1,200,000 $360,000

Income Statements Company P Company S


Net income $300,000 $60,000

Dividends $15,000




Company M acquired 20 percent of Company N for $6 million on January 1, 2004. Company N reports the following values for fiscal years 2004 and 2005, and M has significant influence over N:

Year Net Income (loss) Dividends2004 ($450,000) $600,0002005 $1,500,000 $750,000

16. If the shares of Company N are not publicly traded, the investment income that Company M reports from its investment in Company N is:A. $90,000 in 2004 and $300,000 in 2005.B. –$90,000 in 2004 and $300,000 in 2005.C. $90,000 in 2004 and $500,000 in 2005.D. –$90,000 in 2004 and $500,000 in 2005.

17. If the shares of Company N are publicly traded, the value of the investment in Company N stock will be reported on Company M’s balance sheet as:A. $5,790,000 in 2004 and $5,940,000 in 2005.B. $5,790,000 in 2004 and $6,300,000 in 2005.C. $6,000,000 in 2004 and $6,000,000 in 2005.D. $6,000,000 in 2004 and $6,300,000 in 2005.

18. If the shares of Company N are publicly traded, the effect on the net income reported on the income statement of Company M from its investment in Company N is:A. $90,000 decrease in 2004 and $300,000 increase in 2005.B. $90,000 decrease in 2004 and $150,000 increase in 2005.C. $600,000 decrease in 2004 and $300,000 increase in 2005.D. $600,000 decrease in 2004 and $175,000 increase in 2005.



Use the following data to answer Questions 19 and 20.

Company C owns a 25 percent interest in a joint venture, JVC, and accounts for it using the equity method. They have each reported the following 2005 financial results.

During 2005, Company C purchased 35 percent of the output of JVC. Additionally, JVC has an account receivable from Company C of $150 at the end of 2005.

19. Using proportionate consolidation, the accounts receivable of Company C reported on the balance sheet were:A. $3,500.00.B. $3,637.50.C. $3,560.00.D. $4,050.00.

20. Using proportionate consolidation, the Company C’s cost of goods on its 2005 income statement was:A. $6,020.B. $6,520.C. $7,000.D. $7,255.

Balance Sheets Company C JVC

Cash $1,750 $300

Accounts receivable 3,500 700

Inventory 3,000 800

Fixed assets 5,000 2,600

Investment in JVC 200

Total Assets $13,450 $4,400

Accounts payable $3,500 $1,200

Long-term debt 4,000 2,400

Equity 5,950 800

Total Liabilities & Equity $13,450 $4,400

Income Statements Company C JVC

Revenues $17,500 $2,800

Equity in JVC earnings 50

Cost of goods sold 7,000 2,000

Other expenses 9,000 467

Income before tax $1,550 $333

Tax 620 133

Net income $930 $200



Use the following data to answer Question 21.

21. The mark-to-market investment return for Ridgeview Corporation for 2005 was:A. $1,620.B. $2,620.C. $3,620.D. $4,970.

Ridgeview Corporation (in $): 2005 2004

Dividends $400 $350

Interest 660 250

Realized gains (losses) (1,040) 750

Investment in securities (at cost) 52,700 24,900

Investment in securities (at FMV) 55,300 23,900



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF INTERCORPORATE INVESTMENTS

1. A With the equity method, the proportional share of the affiliate’s income (% ownership × affiliate earnings) is reported on the investor’s income statement.

2. D Initially, the carrying value of all security investments is cost.

Initial cost = $950 + 250 = $1,200

3. D Both the available-for-sale and trading securities are carried at market value on the balance sheet. Also, both classifications call for recognition of unrealized losses and gains. Market value at t = 1 is $850 + $180 = $1,030. Unrealized loss is ($850 – $950) + ($180 – $250) = –$170. Note that the recognition differs. With available-for-sale securities, the recognition is only on the balance sheet. With trading securities, the recognition impacts the income statement.

4. D The increase in value requires that investment securities be written up to $900 + $350 = $1,250.

5. A Classifying the shares as trading requires both realized and unrealized gains and losses to be recognized on the income statement. As a result, this would have the effect of greater reported earnings volatility. There is actually a $220 unrealized gain between t = 1 and t = 2; the gain is unrealized because the shares were not actually sold. The net gain of $50 between the acquisition date and t = 2 is unrealized; therefore, by classifying as available-for-sale, the gain is not recognized on the income statement (it goes directly to equity). Classification as either trading or available-for-sale securities results in the same fair market value of $1,250 reported on the balance sheet at t = 2.

6. D The sale of Company A’s shares results in a net $25 realized gain ($975 selling price less $950 cost). From t = 2 to t = 3, there would be a $50 unrealized gain to bring the value at t = 2 ($900) back up to its original cost ($950). There would also be a $25 realized gain to bring the value from original cost ($950) to the selling price ($975).

The sale of Company B’s shares also results in a net $25 realized gain ($275 selling price less $250 cost). From t = 2 to t = 3, there would be a $100 unrealized loss to bring the value at t = 2 ($350) back down to its original cost ($250). There would also be a $25 realized gain to bring the value from original cost ($250) to the selling price ($275).

You can also calculate the unrealized loss on both securities as the change in the MVA. Because the company will sell the shares in year 3, the marketable securities balance will be zero at the end of year 3.

7. C Debt securities held to maturity are securities that a company has the positive intent and ability to hold to maturity. They are carried at amortized cost ($1,200), and no unrealized or realized gains or losses are recognized until disposition.

8. D If the shares have no public market, the cost method is used. Trading securities and available-for-sale securities are reported at year-end market value.

9. D Only the dividends are reported on the income statement with either the cost or available-for-sale method. Unrealized losses are posted to the income statement under the trading classification. Hence, unrealized loss of $5,000 plus $4,000 in dividends = $1,000 loss.

Security A Security B

t = 2 t = 3 t = 2 t = 3

Market value $900 $0 $350 $0

Cost $950 $0 $250 $0

MVA ($50) $0 $100 $0

Change in MVA $50 ($100)



10. B $1,500,000 + 0.4($500,000 – $125,000) = $1,650,000

11. C $500,000 × 0.4 = $200,000; dividends are not included in income under the equity method.

12. A $125,000 × 0.4 = $50,000; the dividend is cash flow = $50,000.

13. B Current assets = $720,000 + $240,000 – $120,000 = $840,000

Total assets = $1,200,000 + $360,000 – $120,000 = $1,440,000

Investment in Company S is not relevant with the consolidation method.

14. C Minority interest income = $60,000 (0.2) = $12,000

Consolidated net income (after minority interest income is subtracted) = $300,000 + $60,000 – $12,000 = $348,000

15. B Ending balance sheet minority interest = $30,000 + income statement minority interest of $12,000 – minority interest dividend share of $3,000 = $39,000.

Beginning balance sheet minority interest = (1 – 0.8)(60,000 + 90,000) = $30,000

16. B 2004: 0.2 (–$450,000) = –$90,000

2005: 0.2 ($1,500,000) = $300,000

Under the equity method, the proportionate share of Company N’s income is reported by Company M.

17. A 2004: $6,000,000 + 0.2 (–$450,000) – 0.2 ($600,000) = $5,790,000

2005: $5,790,000 + 0.2($1,500,000) – 0.2 ($750,000) = $5,940,000

18. A 2004: 0.2 (–$450,000) = –$90,000

2005: 0.2 ($1,500,000) = $300,000

19. B $3,500 + 0.25(700 – 150) = $3,637.50

20. D $7,000 + (0.25 × $2,000) – (0.25 × 0.35 × $2,800) = $7,255

The combined cost of goods sold for both entities (100% of Company C and 25% of JVC) must be reduced by the proportionate share of sales from JVC to Company C.

21. C $23,900 – $24,900 = –$1,000 is 2004’s MVA; $55,300 – $52,700 = $2,600 is 2005’s MVA; the increase in MVA from 2004 to 2005 is $2,600 – (–$1,000) = $3,600. The mark-to-market return is the change in MVA plus 2005 dividends, interest, and realized gains/losses = $3,600 + $400 + $660 – $1,040 = $3,620.



BUSINESS COMBINATIONS AND RELATED ISSUES

Study Session 5

EXAM FOCUS

Two procedures can be used to account for thesurviving entity in a merger or acquisition—thepurchase method and the pooling method. Althoughonly the former is now permitted under U.S. GAAP,you need to have a working knowledge of bothmethods, including how the financial statements look,how ratios are affected, the ways in which earnings canbe manipulated and, specifically, accounting forgoodwill.

This is important material and may require some timeto master. For many of the concepts in this topicreview, the best way to communicate the material isthrough an example. Hence we use an extendedexample—don’t skim through it, as you may need toreplicate part of it in the exam. Although the conceptsare not new to the Level 2 curriculum, this is a newtreatment of the material and so very likely to betested in 2006.

LOS 2.A.a: Compare and contrast the purchase and pooling of interest methods of accounting for business combinations and identify which method is required under US GAAP and construct consolidated balance sheets using the purchase method.

Two accounting methods have been used for mergers and acquisitions: (1) the purchase method and (2) the pooling method. With the adoption of SFAS 141, Business Combinations, in 2001 by the FASB, the U.S. rules for reporting of acquisitions were changed to require use of the purchase method and eliminate the use of the pooling method.

Professor’s Note: The pooling of interests method is now also prohibited under International Financial Reporting Standards (IFRS). See the topic review of IFRS and U.S. GAAP in Study Session 6.

The key attributes of the purchase method are:

• The transaction is structured so that the liabilities and assets of one company are assumed by another company.

• If the fair market value of the tangible assets acquired minus the fair market value of the liabilities assumed is less than the purchase price, then the excess purchase price is attributed to separately identifiable intangible assets. In most cases goodwill (an intangible asset) is also created.

• The operating results of the acquired company are included in the income statement of the purchaser from the date of acquisition onward. Operating results occurring before the acquisition are not restated, resulting in pre-and post-acquisition income and cash flow statements that are not comparable.

The pooling of interests method combines the ownership interests of two companies, and views the participants as equals—neither firm acquires the other (intuitively, you can think of the purchase method as an acquisition and the pooling method as a merger). Assets and liabilities of the two firms are combined (and any intercompany accounts are eliminated). Major attributes of the pooling method are:

• The two companies are combined using accounting book values.• Operating results for prior periods are restated as though the two firms were always combined.• Ownership interests continue, and former accounting bases are maintained.


Study Session 5Cross-Reference to CFA Institute Assigned Reading – Giroux, Chapter 9

Note that fair market values play no role in accounting for a business combination using the pooling method—the actual price paid is suppressed from the balance sheets and income statements.

Constructing the Consolidated Balance Sheet Under U.S. GAAP Purchase Method

The best way to communicate the implementation of the purchase method is to start working our way through our extended example.

Assume Firm A (the acquirer) acquires Firm T (the target) by paying T’s shareholders $475 million on June 30, 2005. Assume Firm A finances the acquisition by issuing 15 million shares of common stock. The balance sheets of Firm A and Firm T are presented in Figure 1 as of June 30, 2005. Firm T’s accounting data is shown at historical cost and on a fair value basis (in millions of dollars):

Application of the purchase method requires the following steps:

1. Revalue all tangible assets and liabilities of the acquired firm to their fair market values and compute net tangible assets at fair market value (FMV).• Firm T’s inventories are undervalued by $25 million and are revalued to $75 million.• The book value of the property of Firm T is undervalued due to inflation and is revalued at $275 million.

Assuming the useful life of the revalued assets is ten years, for example, additional depreciation will be $25 million / 10 years, or $2.5 million per year.

• The book value of debt is greater than the market value of debt because the yield on the bonds is greater than the coupon rate. It is revalued at $90 million. Assuming the bond discount will be amortized over five years, for example, interest expense will increase by approximately $2 million per year.

Figure 1: Balance Sheet Data for Firms A and T as of June 30, 2005 (millions of $)

Historical Cost Fair Value

Assets Firm A Firm T Firm T

Cash 50 25 25Inventory 150 50 75Receivables 150 50 50

Current assets 350 125 150

Property 400 250 275In-process R&D 60Software cost 25Licenses 25Goodwill 105

Total assets 750 375 640

Liabilities and shareholders’ equity

Payables 125 50 50Accrued liabilities 75 25 25

Current liabilities 200 75 75

Long-term debt 200 100 90Shareholder equity 200 150 475Retained earnings 150 50

Total liabilities and shareholder’s equity 750 375 640

Note: Common stock of Company T has a fair value of $475 million based on the acquisition price.



2. Recognize all previously unrecognized (intangible) assets or liabilities (e.g., contingencies for lawsuits) of the acquired firm and allocate to net FMV.• In-process R&D (IPRD) is valued at $60 million.• Software development cost is valued at $25 million.• Licenses are valued at $25 million.

3. Allocate any remaining balance of the purchase price to goodwill (net of assumed liabilities). The calculation of goodwill for our example follows shortly.

4. Eliminate the common equity of the acquired firm and replace it with the market value of the shares issued in the transaction. Recall that 15 million new shares of Firm A’s equity were issued in the transaction.

Note that under SFAS 142 (2001), identifiable intangible assets must be valued and reported separately from tangible assets.

tangible assets at FMV = cash + inventory + receivables + property = 25 + 75 + 50 + 275 = $425 million

assumed liabilities at FMV = 50 + 25 + 90 = $165 million

The net assets at FMV equal:

Tangible assets at FMV $425 million

Less: Assumed liabilities at FMV ($165) million

Net tangible assets at FMV $260 million

The purchase price was $475 million. The difference between the purchase price and the net tangible assets at FMV (475 – 260 = $215 million) must be allocated to intangible assets, beginning with separately identifiable intangible assets, which include patents, customer lists, licenses, in-process R&D, and brand names. In this case, a total of $110 million was allocated to intangible assets: $60 million to in-process R&D, $25 million to software development costs, and $25 million to licenses. According to U.S. GAAP, in-process R&D is expensed immediately in the year of the acquisition.

Professor’s Note: Under IFRS, in-process goodwill is not written off.

Any excess purchase price that cannot be allocated to separately identifiable intangible assets must be accounted for as goodwill. In this case, the value of goodwill is $215 – $110 = $105 million. The pre- and post-acquisition balance sheets for Firm A are shown in Figure 2.



Professor’s Note: Negative goodwill is created when the purchase price is less than the value of the net tangible and separately identifiable intangible assets. See Study Session 6 for details on the differing treatment of negative goodwill under IFRS and U.S. GAAP.

PRICE ALLOCATION STRATEGIES

LOS 2.A.b: Compare and contrast the three different price allocation strategies that a company might use in a business combination and analyze the impact of each of these strategies on a company’s income statement and financial ratios.

As you have seen in the previous section, in an acquisition the acquirer reports the assets and liabilities of the target at market value, with goodwill making up the balance of the value paid, whether in cash, stock or bonds. Given the nature of asset valuation, considerable discretion and subjectivity exists in the estimation of market value, which can lead to manipulation of future earnings.

Let’s examine three specific price allocation strategies. We will call these (1) PP&E focus, (2) IPRD focus and (3) goodwill focus. The goal of each of these strategies is to maximize the value of either property, plant and equipment (PP&E), in-process research and development (IPRD), or goodwill.

PP&E Focus

The assigned market values are maximized for all tangible and intangible assets that will be depreciated or amortized under the PP&E focus strategy. The result will be higher assets but lower net income because of the

Figure 2: Consolidated Balance Sheets Under U.S. GAAP Purchase Method (All Equity Financed) (millions of $)

Historical Cost U.S. GAAP Purchase MethodFirm A Firm T Adjustments Consolidated

Cash 50 25 75Inventory 150 50 25 225Receivables 150 50 200

Current assets 350 125 25 500

Property 400 250 25 675In-process R&D 60R&D write-off (60)Software cost 25 25Licenses 25 25Goodwill 105 105

Total assets 750 375 205 1,330

Payables 125 50 175Accrued liabilities 75 25 100Current liabilities 200 75 275

Long-term debt 200 100 (10) 290Common shareholder equity 200 150 325* 675Retained earnings 150 50 (110)** 90Total liab. and shareholders’ equity 750 375 1,330

Current ratio 1.8 1.7 1.8LT debt-to-equity 57.1% 50.0% 37.9%

*325 = Purchase price – write-off of T’s shareholders’ equity = 475 – 150**(110) = –Write-off of T’s retained earnings – write-off of in-process R&D = –50 – 60



higher subsequent charges. Since depreciation and amortization are tax-deductible noncash expenses, this method will reduce taxes and therefore increase the cash flow from operations. A company using a PP&E focus will report more favorable ratios involving CFO. However, net profit margin, return on assets (ROA), total asset turnover, and fixed asset turnover will be lower.

IPRD Focus

There is considerable discretion relating to research and development: how much R&D is “in-process” and how much is complete? Under U.S. GAAP, IPRD must be written off through the income statement immediately after the acquisition. This charge is often overlooked by analysts as non-recurring, so it has less of a market impact. If the acquiring company maximizes the value of IPRD, it can report a big expense this year (that may be ignored by analysts) and reduced costs (and better operating results) in future years. Because the company will report lower assets and higher net income in the future, net profit margin, ROA, total asset turnover, and fixed asset turnover will be higher in future periods.

Goodwill Focus

Under this method, goodwill is maximized, for example by understating PP&E valuations. Since U.S. GAAP prohibits the amortization of goodwill (see LOS 2.A.c), this will maximize future earnings. The disadvantage is that tax-deductible depreciation is minimized, resulting in lower net cash flow despite the higher earnings. Another potential disadvantage of a goodwill focus is the annual review for goodwill impairment: a larger goodwill balance is more likely to result in future write-downs, which are less predictable than regular depreciation and amortization of tangible and intangible assets. Because the company will report higher assets and higher net income in the future (assuming goodwill impairment is lower than amortization would have been in the early years), net profit margin will be higher, but total assets turnover will be lower. The effect on ROE is indeterminate.

LOS 2.A.c: Explain the accounting treatment for goodwill.

Under U.S. GAAP the accounting of goodwill changed radically with SFAS 142, Goodwill and Other Intangible Assets, passed by FASB in 2001. Prior to this accounting standard, goodwill was amortized over a period of up to 20 years, with the amortization charge passing through the income statement.

With SFAS 142 in place, amortization is no longer permitted for financial reporting. U.S. GAAP now requires tests for impairment of goodwill to be carried out at least annually in order to determine whether the value of the intangible assets has increased or decreased. If the assets are deemed impaired, there is an associated non-cash charge to goodwill (i.e., goodwill is written down) to reflect the decrease in value. This also results in a charge to earnings. An impairment is deemed to have occurred if its carrying value is no longer recoverable and exceeds its fair value. It should be noted that the impairment itself could have been caused by a number of different reasons, including loss of key contracts or personnel, increased competition, or even lawsuits.

Professor’s Note: The treatment of goodwill is the same under IFRS as it is under U.S. GAAP: goodwill is not amortized, but instead is subject to an annual impairment test.

LOS 2.A.d: Analyze the impact on a company’s financial statements and ratios under the pooling of interest and purchase (both cash and equity exchange) methods.

In the example from LOS 2.A.a, Firm A acquired Firm T using $475 million of A’s common equity. Note that Firm A had $200 million of common equity pre-acquisition, then $675 million post-acquisition. The difference is exactly the value of equity issued to complete the purchase.

As an alternative method of acquisition, suppose that Firm A had paid in cash for Firm T’s equity. How would the accounts differ? The adjustment to the consolidated balance sheet is straightforward: instead of increasing



equity by $475 million, cash is decreased by $475 million. Of course in this particular case, Firm A only has $50 million of cash on the balance sheet, so a more likely “cash” transaction would be for Firm A to borrow the money, for example via a bond issue. In this case, cash and equity remain the same, but long-term debt rises by the $475 million purchase price.

Before SFAS 141 came into effect the pooling method could have been used. Recall from the earlier discussion that under pooling, historic costs are used with no revaluations, reserves are combined and equity is simply added for the two companies. No goodwill arises when using the pooling method, since goodwill represents an excess payment on acquisition, and pooling is for a merger rather than an acquisition.

Key differences of business combinations are summarized in Figure 3. Note that the descriptions are relative to the pre-acquisition financial statements.

Figure 3: Financial Statement Impact of Purchase and Pooling Methods

Purchase: Cash Purchase: Debt Purchase: Equity PoolingEquity No change No change Increase by FMV of

net assets acquiredIncrease by book value of net assets acquired

Total assets Increase by FMV of total assets acquired (less cash paid out)

Increase by FMV of total assets acquired

Increase by FMV of total assets acquired

Increase by book value of total assets acquired

Total liabilities Increase by FMV of total liabilities acquired

Increase by FMV of total liabilities acquired plus new debt

Increase by FMV of total liabilities acquired

Increase by book value of total liabilities acquired

Current ratio Decrease because of decrease in cash

Depends on acquired asset/liability mix



PP&E, intangibles

Increase, including fair value adjustment



Increase, but no fair value adjustment

Asset turnover Generally decrease Generally decrease Generally decrease IndeterminateLeverage Increase, due to

acquired liabilitiesIncrease significantly because of additional debt

Decrease Depends on acquired liability/equity mix

Revenues Rise, including acquired post-acquisition revenues

Rise, including acquired post-acquisition revenues

Rise, including acquired post-acquisition revenues

Rise, including entire year’s acquired revenues

Operating expenses

Rise by post-acquisition acquired expenses, plus higher depreciation and amortization

Rise by post-acquisition acquired expenses, plus higher depreciation and amortization and interest expense

Rise by post-acquisition acquired expenses, plus higher depreciation and amortization

Rise, by combining firms’ expenses for entire year

Earnings Higher—include post-acquisition earnings less higher depreciation and amortization

Higher—include post-acquisition earnings less higher depreciation and amortization and interest expense

Higher—include post-acquisition earnings less higher depreciation and amortization

Much higher—include both firms’ earnings for entire year

Profit margin Lower, since expenses increase proportionally more than revenues

Lower, since expenses increase proportionally more than revenues

Lower, since expenses increase proportionally more than revenues

Indeterminate

Statement of cash flows

Cost of acquisition is mostly an investing cash outflow

Cost of acquisition is mostly an investing cash outflow offset by a financing inflow

Cost of acquisition is mostly a financing inflow

No cash flow arises as a result of the transaction itself



LOS 2.A.e: Interpret the specific earnings management concerns for business combinations or divestitures and explain possible detection strategies.

The majority of all acquisitions fail to achieve the objective of increasing the acquirer shareholders’ wealth. The bidder may overestimate synergies, the resultant market share in the industry may not be quite as dominant as expected, the integration may not run as smoothly as planned – or the price paid was simply too high, especially if there was a bidding war. Management usually wants to show transactions in the best possible light and so may be tempted to manipulate reported results. The detection of such “earnings management” is critical to the analyst, as few company directors will boast about a failure.

It is not only an acquisition that is subject to earnings management. The corporate marriage may end in a divestiture, in which a company sells to outside purchasers a component of the business. Earnings could be manipulated in such a transaction if, for example, the selling company fails to gain for their own shareholders a sufficient price for the part of the business that is sold.

A number of concerns that an analyst may have regarding a business combination or divestiture, along with some suggestions for detection, are listed in Figure 4.

Figure 4: Earnings Management Concerns for Business Combinations and Divestitures

Concern DetectionBusiness Combinations

The purchase may not fit with the acquirer’s long-term business strategy.

Review the strategies of both the acquirer and target: the MD&A (Management Discussion and Analysis) in the annual report should contain sufficient information. Also consider acquisitions from the previous five years or so.

Acquirers overpay for the target’s shares. This is clearly detrimental to the acquirer’s shareholders.

Review the share price movement in the market after the announcement. If consensus is that too high a price is being paid, then the acquirer’s share price will fall.

Acquisitions could be a significant part of the acquirer’s growth strategy. In such a case the potential for earnings manipulation is high.

Identify the size and frequency of acquisitions to see how much of the bidder’s business is in the form of such transactions. Also review divestitures caused by post-acquisition problems. If an acquired business is subsequently sold off at a loss, it brings into question the motive behind the original purchase.

After the acquisition, how were asset values allocated? In particular, was there a PP&E, IPRD or goodwill focus? Each of these can alter current and future earnings.

The effect of these types of focus was discussed earlier. Calculate the percentages allocated to each asset category (i.e., PP&E, IPRD and goodwill) and compare these to other similar transactions.

DivestituresBy nature, divestitures should be uncommon. If a company has had multiple sales then the analyst should be wary of management motives, in particular relating to the original acquisitions.

Review the MD&A over the past few years to identify how many sales have taken place and whether the divestitures fit the corporate strategy.

The accounting for a divestiture may try to hide problems or losses.

Review the financial statements, including notes, to make a detailed comparison of before versus after the divestiture.

There may be a material impact on the financial statements as a result of a divestiture, in particular earnings and leverage.

Note that results from a discontinued business segment are shown separately on the income statement net of tax. Furthermore, look for the actual gain or loss on sale. The level of debt is likely to decrease after a divestiture, so leverage should be analyzed.



SEGMENT REPORTING

LOS 2.A.f: Calculate financial ratios for segments reported by a company and analyze the resulting information and interpret the specific earnings management related to segment reporting and explain possible detection strategies.

If a company operates in several different industries, then it may be difficult to perform a comparison with other companies. A conglomerate operating in the automotive and computer industries cannot easily be compared with other companies, unless the financial statements of the segments are shown separately. This allows a side by side comparison of, for instance, the automotive division with another company in the auto industry.

SFAS 131 defines a business segment as part of the business that has 10 percent or more of any of (i) total revenues, (ii) operating profits or (iii) identifiable assets of the total operation. The segment may be by industry or geographic—for instance, a global corporation may need to report results separately for European, Asian and American segments.

Actual disclosure requirements are rather limited, including sales, operating profit and identifiable assets, so a detailed analysis of segmental financial statements is not possible.

Some specific earnings management concerns relating to segmental reporting are provided in Figure 5.

Figure 5: Earnings Management for Segment Reporting

Concern DetectionOne key concern is the lack of information, in particular full financial statements for each segment. Management has the potential to hide problems.

Given the limited information, the MD&A and other information in the notes to the accounts should be scrutinized.

The different segments of the business may be underperforming relative to one another.

Each segment should be analyzed to determine the relative performance – the results should be in the context of the business strategy identified in the MD&A.

A segment may comprise a single acquisition, in which case concerns over the acquired business’ results or the strategy leading up to the acquisition can be addressed.

The segmental disclosures in this situation relate to a single acquired business. The analyst can compare the success of the acquisition to the stated objectives of management (for instance, the business strategy identified in the MD&A) prior to the purchase.

Some industries or geographic locations can be susceptible to business and strategic risks. If these risks crystallize, management may be tempted to manipulate earnings.

Detailed ratio analysis should be performed, based on available information and MD&A disclosures.



KEY CONCEPTS

1. The following are the key components of purchase method accounting.• The target firm’s assets and liabilities are valued at FMV and are reported on the consolidated balance

sheet at FMV.• The operating results of the acquired company are included in the consolidated financial statements as of

the acquisition date.• A write-up in the property, plant, and equipment account will generate higher depreciation for the

combined firm.• The FMV of the target’s net assets is compared to the purchase price of the firm. Goodwill equals the

purchase price minus the FMV of the target’s net assets.2. The key components of the pooling method (not allowed under U.S. GAAP) are:

• Accounting book values are used, not revaluations.• Results are combined, effectively backdating the firms’ operations.

3. A company may try to maximize certain balance sheet values in an acquisition using three price allocation strategies.• PP&E: the result is higher assets and lower income, but better cash flow through reduced taxes. Net

profit margin, ROA, total asset turnover, and fixed asset turnover are lower.• IPRD: a one-time charge off in the year of acquisition is followed by relatively high earnings

subsequently. Future net profit margin, ROA, total asset turnover, and fixed asset turnover will be higher.• Goodwill: high goodwill maximizes future earnings (though no cash flow benefit), but risks future

impairment charges. Net profit margin will most likely be higher, but total asset turnover will be lower.4. Goodwill is not amortized under U.S. GAAP—rather it is subject to an annual impairment review. If the

carrying value is not recoverable or exceeds its fair value, then a non-cash impairment write-down is charged to the income statement.

5. Ratios will be affected by an acquisition, depending on the accounting choice and the method of financing. In general, the result of an acquisition will be:• Greater revenues, expenses and earnings, though the purchase method includes only the post-acquisition

part of the year. Revaluations under the purchase method will typically increase depreciation and reduce earnings, and debt financing will add to interest expense.

• Most individual balance sheet asset and liability items will increase, though the acquisition will have a great impact on either cash (decrease), debt or equity (both increase), depending on the method of financing.

• The two entities’ cash flows are combined (pooling method for the whole year, purchase method just post-acquisition). The acquisition itself under the purchase method is an investing cash outflow, though accompanying debt or equity will be financing inflow.

6. “Earnings management” concerns exist for business combinations and divestitures.• For combinations, the acquisition may not fit the long-term strategy, or may cost the acquirer too much

if assumptions were overly optimistic. Too many acquisitions create a higher risk of earnings management.

• Divestitures should be rare, so multiple sales should be investigated thoroughly. Each divestiture should be reviewed to identify problems that may be hidden and determine the impact on the financial statements.

7. A business segment is a component that comprises more than 10% of a company’s revenues, profits or assets, and can be an industry or geographic segment. Although certain disclosures are required, they are fairly limited in scope, making analysis (relative performance, operational risk or segments comprising single acquisitions) difficult.



CONCEPT CHECKERS: BUSINESS COMBINATIONS AND RELATED ISSUES

1. Which of the following statements about the pooling and purchase methods is TRUE?A. In the pooling method, the balance sheets and income statements of the two firms are added together.B. In the pooling method, the balance sheets and income statements are added together after adjusting the

target firm’s statements to reflect the fair market values of the acquired firm.C. In the purchase method, prior period statements are never restated to reflect the results of the acquired

firm’s assets and liabilities.D. In the purchase method, the statement is structured so that all the liabilities and assets of both

companies are combined together.

2. Assume Company P acquires Company T for $100 million. The fair market value of Company T’s net tangible assets is $75 million. The only differences in fair market value of the assets and liabilities is in property, plant, and equipment (PP&E), which has a book value of $20 million and a fair market value of $25 million. The PP&E has a remaining useful life of ten years. Company P has a company policy of amortizing all intangible assets over 20 years. The acquisition takes place on October 1, 2004, and is accounted for using the purchase method according to U.S. GAAP. Company P has a 31st December fiscal year end. The combined amount of incremental amortization of intangible assets and depreciation of PP&E attributable to the write-up of assets under the purchase methods that should be taken by Company P in 2004 is closest to:A. $125,000.B. $375,000.C. $500,000.D. $1,500,000.

3. Adam Corporation acquired Hardy Corporation recently using the purchase method. Adam is preparing to report its year-end results to include Hardy. Which of the following statements is most likely to be TRUE regarding goodwill?A. Adam would amortize its goodwill over no more than 20 years.B. Adam would test its goodwill annually to ensure the carrying value is not greater than the fair value.C. Adam would test its goodwill annually to ensure the fair value is no greater than the carrying value.D. Hardy would test its goodwill for impairment annually.

4. Typically, relative to the pooling method, the purchase method reports:A. both lower asset values and lower reported earnings.B. lower asset values but higher reported earnings.C. higher asset values and lower reported earnings.D. higher asset values and higher reported earnings.

5. Under U.S. GAAP, which of the following statements is TRUE?A. Goodwill can be written off directly to reserves.B. The pooling-of-interest method may only be used in special cases.C. In-process R&D must be written off in the year of the acquisition.D. Goodwill, if amortized, must be written off over at most 20 years.

6. If a company maximizes the value of property, plant and equipment in an acquisition, is this likely to increase or decrease (i) net earnings in subsequent years and (ii) net cash flow in subsequent years?

Net earnings Net cash flowA. Increase IncreaseB. Increase DecreaseC. Decrease IncreaseD. Decrease Decrease



7. If upon the acquisition the acquirer inflates certain balances, there may be a subsequent cash flow impact. Which of the following best describes the subsequent cash flow impact of the acquirer maximizing (i) property, plant, and equipment and (ii) goodwill?

PP&E GoodwillA. decrease decreaseB. decrease no impactC. increase no impactD. increase decrease


Selected information (before considering the acquisition of Midsize by Jumbo) from the financial statements of Jumbo Company and Midsize, Inc.:

Assume for Questions 8 through 11 that Jumbo Company acquired Midsize, Inc. on January 1, 2005, by paying the Midsize shareholders $99 million in cash entirely financed by a new Jumbo long-term bond issue. Jumbo uses the purchase method to account for the acquisition.

Balance SheetDecember 31, 2004 (in $ millions) Midsize, Inc. Jumbo Company

Book Value FMV Book Value FMV

Cash $15 $15 $42 $42Accounts receivable 17 17 40 40Inventory 12 18 62 78Property plant & equip. (net) 28 44 110 142

Total assets $72 $254

Accounts payable $11 $11 $27 $27Long-term debt 40 25 62 48Common stock 10 73Retained earnings 11 92

Total liabilities and equity $72 $254

Income Statement(in $ millions) Midsize, Inc. Jumbo Company

2005 2004 2005 2004

Sales $47 $28 $200 $196

COGS $30 $17 $92 $90

Gross profit 17 11 108 106Other expenses 4 2 52 48Operating profit 13 9 56 58Depreciation and amortization 4 4 18 18Interest 4 5 6 6

Net income $5 $0 $32 $34

Notes:• Midsize holds the rights to a patent on a biochemical process that expires at the end of 2014.

The patent has no value on the books of Midsize but has a fair market value of $10 million.• Midsize has property, plant, and equipment (PP&E) that was acquired January 1, 2002, for $40

million. It is being depreciated over 10 years on a straight-line basis with no salvage value. As of January 1, 2005, the estimated useful life of the PP&E is 4 years.

• Midsize has long-term debt in the form of 30-year bonds that were issued at par.



8. As of January 1, 2005, Jumbo Company should record goodwill on the Midsize acquisition in theamount of:A. $0.B. $27 million.C. $31 million.D. $41 million.

9. Depreciation expense taken in 2005 on the PP&E acquired from Midsize will be:A. $4 million.B. $6.29 million.C. $7 million.D. $11 million.

10. If Jumbo Company maintains Midsize’s long-term debt after the acquisition, interest expense related to the long-term debt will:A. decrease, because the fair market value (FMV) of the long-term debt has been reduced.B. remain the same, because the debt payments do not change.C. increase, because the FMV of the long-term debt has been reduced.D. increase, because the difference between FMV of the long-term debt and its par value must be amortized

as interest expense.

11. Total amortization expense taken in 2005 on the patent and the long-term debt acquired from Midsize, assuming the long-term debt will remain on the books for the next 30 years, will be closest to:A. $500,000.B. $611,111.C. $1,500,000.D. $1,611,111.

Use the following information to answer Questions 12 and 13.

Jumbo Company acquired Midsize Company on January 1, 2005 by paying Midsize shareholders $99 million in cash entirely financed by a new Jumbo common stock issue and accounted for using the U.S. GAAP variant of the purchase method.

12. As of January 1, 2005, the common equity (common stock and retained earnings) account of consolidated Jumbo Company will be:A. $165 million.B. $264 million.C. $274 million.D. $285 million.

13. Jumbo Company’s issuance and sale of $99 million of common stock would, as compared to using$99 million of bonds to finance the acquisition of Midsize, Inc., result in consolidated Jumbo’s debt-to-equity ratio:A. not changing.B. of 0.98 instead of 0.23.C. of 0.38 instead of 0.23.D. of 0.33 instead of 1.13.



14. Assuming a company issues new equity to acquire a target company, which of the two methods, purchase or pooling, will in general produce the highest balance for (i) total assets and (ii) net earnings in the year following the transaction?

Total assets Net earningsA. Purchase PurchaseB. Purchase PoolingC. Pooling PurchaseD. Pooling Pooling

15. Which of the following situations is least likely to cause an analyst to be concerned when trying to identify earnings management issues?A. An acquisition was made in an industry that does not fit with the acquirer’s strategy.B. The majority of a company’s earnings comes from recent acquisitions.C. A company has disposed of many business segments in the last three years.D. Leverage appeared to decline significantly after a divestment.

16. When trying to analyze the different segments of a diversified business, which of the following tasks is likely to prove the most difficult?A. Producing a comparison of the segments’ strategies with the strategies identified in the MD&A.B. Performing a detailed ratio analysis of each segment.C. Determining the relative performance of each segment.D. Calculating profit margins and asset turnover ratios for each segment.



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF BUSINESS COMBINATIONS

1. C Pooling allows the balance sheets and income statements to be added together but only after adjusting for interfirm transactions (if any). Fair market value is not considered in pooling. Pooling restates past financial statements, but purchase doesn’t. Purchase combines results from the effective date forward. In the purchase method, the transaction is structured so that the relevant percentage of ownership (perhaps not all) of liabilities and assets of one company are assumed by another.

2. A Goodwill is not permitted to be amortized under U.S. GAAP. The company policy is irrelevant here. The fair value increment of PP&E of $5 million should be amortized over its remaining useful life of ten years. This results in annual amortization of $500,000. Pro-rated for three months beginning from October 1st, the amount of amortization in 2004 is $500,000 × 0.25 = $125,000.

3. B Adam is required to perform an annual impairment test. The carrying value cannot exceed the fair value – if it does, then an impairment has taken place and the goodwill must be written down.

4. C The purchase method typically reports higher asset values (asset values are normally restated to a higher amount because of inflation) and higher common equity than the pooling of interests method, since the purchase price usually exceeds the stated net worth of the acquired firm. The purchase method also typically results in lower reported earnings due to greater depreciation (because of the restatement of asset value). Hence, profitability ratios will be lower when the purchase method is used.

5. C All goodwill write-offs must be expensed through the income statement. The pooling method may never be used (until 2004 it was permitted under International Accounting Standards). Finally, goodwill may not be amortized – instead an annual impairment review must take place.

6. C If PP&E is maximized, then tax-deductible depreciation in future years will also be maximized. This will have the dual effect of reducing earnings, but also reducing taxes paid, thus increasing net cash flow.

7. D If PP&E is maximized, then tax-deductible depreciation will also be maximized, reducing taxes paid and increasing net cash flow. A maximized goodwill balance implies that PP&E has been understated, reducing depreciation, increasing taxes paid and therefore decreasing net cash flow.

8. C Under the purchase method, the purchase price ($99 million) is reduced by the FMV of tangible assets and liabilities acquired ($15 + $17 + $18 + $44 – $11 – $25 = $58 million); also by the FMV of identifiable intangible assets acquired ($10 million FMV for the patent), so recorded goodwill is $99 – $58 – $10 = $31 million.

9. D Under the purchase method, PP&E of the acquired company is written up to FMV ($44 million) and then depreciated over its remaining useful life (four years). Therefore, the additional 2005 depreciation expense will be $44 / 4 = $11 million.

10. D Under the purchase method, the carrying value of an acquired company’s debt is adjusted to FMV, and the amount of the decrease is amortized over the remaining life of the debt as an increase in interest expense.



11. C Patent:

Long-term bond:Annual amortization of long-term bond over its remaining life of 30 years to bring the FMV in line with the BV (journal entry would be to debit amortization expense and credit long-term bond liability each year; at the end, the long-term bond liability will be $40 million).

12. B The issuance of common stock by the acquiring corporation in a purchase method transaction (note that Midsize shareholders received cash, not stock) results in the proceeds of the stock issuance being added to the parent’s common stock account. None of the common equity accounts of the acquired company are carried forward. The common equity of Jumbo Company is $73 + $92 + $99 = $264 million.

13. D If Jumbo issued $99 million in bonds, the debt-to-equity ratio would be If Jumbo issued

stock, the debt-to-equity ratio would be

14. B Total assets after the acquisition will be higher for both methods, though the purchase method involves revaluing to fair market values (FMV). For the pooling method, book values are used. Therefore, total assets will most likely be higher under the purchase method versus pooling. Earnings are also likely to increase after the acquisition for both methods, since the earnings from both entities are combined. However, the purchase method would usually include higher depreciation charges as a result of the FMV revaluation, and therefore would show somewhat lower earnings than under the pooling method.

15. D The first three answers are all typical examples of red flags that suggest earnings management. If the strategy does not fit, then management motives should be questioned. If recent acquisitions produce most of current earnings, then the analyst should try to investigate the underlying business. Multiple disposals may indicate that acquisitions were made for the wrong reasons. The last answer, that leverage decreased after a divestment, is not a cause for concern, as it is describing a situation that we would expect to see after a disposal of a business segment.

16. B One of the main concerns for analysts when performing segment analysis is the limitation of published information. Although sales, operating profits and identifiable assets are shown (allowing certain margin and turnover ratios to be calculated), full financial statements are not produced, preventing a detailed ratio analysis from being performed.

$10 millionAnnual amortization of patent over its remaining useful life (to end of 2014) = $1,000,000

10 years=

$40 million – $25 million$500,000

30 years

Total amortization $1,000,000 $500,000 $1,500,000

= =

= + =

$62 $99 $251.13.

$73 $92

+ + =+

$62 $250.33.

$73 $92 $99

+ =+ +



CORPORATE GOVERNANCE, COMPENSATION, AND OTHER EMPLOYEE ISSUES

Study Session 5

EXAM FOCUS

Stock option and pension accounting both have an“off-balance-sheet” focus and leave many importantitems related to assessing their true impact in thefootnotes to the financial statements. Since theeconomic reality behind pensions and stock options isburied in the footnotes, the company has ampleopportunity for earnings management. Knowing the“warning signals” to look for is essential for success onthe exam. In the area of stock options, you also needto understand how the SFAS 123 disclosure method of

option accounting can influence a company’s earnings,cash from operations, and leverage and return ratios.In regard to pension accounting, you need to befamiliar with terminology and be able to assess thedifference between a pension plan’s reported and trueeconomic status. None of the LOS in this topic reviewsay “calculate,” but you need to know how to analyzethe various disclosures and make financial statementadjustments as necessary.

WARM-UP: ACCOUNTING FOR STOCK OPTIONS

Professor’s Note: There are a lot of acronyms in this warm-up: IFRS = International Financial Reporting Standards; SFAS = Statement of Financial Accounting Standards; APB = Opinion of the Accounting Principles Board.

In today’s corporate environment, it is common for firms to provide employees with stock options as benefits. Stock option plans allow the employee to purchase stock at a pre-defined price (the exercise price) over a specified time period. Such plans are long-term compensation plans used to build employee loyalty by giving employees the chance to profit in the future if the stock price increases.

Prior to 1995, accounting for stock options was governed by APB 25, which did not require the recognition of compensation expense. In 1995, FASB issued SFAS 123 to govern accounting for stock options. SFAS 123 encouraged, but did not require, companies to recognize the option compensation expense on the income statement. Because most companies opted not to recognize compensation expense, most financial statements accounted for stock options under APB 25, but fulfilled SFAS 123 requirements in the footnote disclosures.

The most recent update to the rules for accounting for stock options occurred in February 2004 with the issuance of IFRS 2, which requires that an option pricing model be applied to determine the fair value of employee stock options, and that recognition for the compensation expense be included in the 2005 financial statements. FASB also issued SFAS 123(R), Share-Based Payment, in December 2004, which requires expensing of employee stock options on the income statement at the beginning of the firm’s next fiscal year that begins after June 15, 2005.

Professor’s Note: The assigned LOS only addresses APB 25 and the original SFAS 123, which do not require the expensing of stock options. Candidates should be aware that the new rules governing option accounting are likely to have a significant impact on a firm’s financial statements. The discussion that follows addresses how an analyst can adjust for the financial statement impact of option expense, making this a timely and important topic.



STOCK OPTION COMPENSATION ACCOUNTING

LOS 2.B.a: Differentiate between APB 25 and SFAS 123 expensing and pro forma disclosure methods of accounting for stock options, analyze disclosures for stock compensation plans, and interpret the impact of these plans on a company’s reported net income, cash from operations, diluted earnings per share, and leverage and return ratios, and interpret the specific earnings management involving stock options and explain possible detection strategies.

Professor’s Note: Whew, that is one big LOS! In the following discussion, we organize the LOS into several topics to make it more manageable.

Rules for Option Accounting

When accounting for stock options, the key accounting issue is how to calculate the compensation expense.

APB 25. Under APB 25, stock option expense is equal to the excess of the stock’s market price over the option’s exercise price on the measurement date. This is referred to as the intrinsic value method. In practice, a company typically will set the exercise price of the options at or above the closing price of the company’s stock on the date of issue. This means that according to APB 25, the intrinsic value of the options is zero and the company is therefore not required to record any compensation expense on the income statement. For example, if the closing price of the company’s stock is $25 and the exercise price of the option is also set at $25, the intrinsic value of the option is zero. Since the intrinsic value of the option is zero on the date of issue, compensation expense according to APB 25 is also zero.

SFAS 123. FASB issued SFAS 123 in 1995 following along battle in the financial community over whether issuing options to employees should result in compensation expense on the income statement. Under SFAS 123, a company has a choice between two methods of accounting for compensation expense: expensing and pro forma disclosure.

• Expensing allows a company to estimate the cost of the option, typically through the use of a complex option pricing model like the Black-Scholes-Merton model, and expense it directly on the income statement. Few companies choose this method since directly expensing the options’ value lowers reported earnings.

• Pro forma disclosure is essentially a compromise with APB 25. Companies can still use APB 25 and do not have to record an expense for options on their income statement, but are required to estimate the option fair value (usually through a pricing model such as Black-Scholes-Merton) and provide a pro forma disclosure of the option expense and earnings per share in the footnotes to the financial statements. We will focus on the pro forma disclosure method for the remainder of our discussion of this LOS.

Pro Forma Disclosures under SFAS 123

SFAS 123 provides for the following required disclosures:

• Effect on net income and earnings per share (EPS).• The number of options outstanding and their related characteristics (expiration dates, exercise prices, and

whether they are currently exercisable).• The fair value of the options issued during the year, valued at the grant date, and whether these options are

in-the-money, out-of-the-money, or at-the-money.• A description of the method and specific assumptions used to value the options, including the risk-free

interest rate, the option’s maturity, the stock’s volatility, and any expected dividends.• Any compensation expense recognized during the period.• Data related to option repricing during the period.• Data related to other compensation using equity instruments, such as restricted stock or phantom stock.



The SFAS 123 footnote disclosure requirements are significant and allow an analyst to reassess the impact of options on the financial statements and restate earnings on a pro forma basis. For a real world example, let’s look

at Procter & Gamble Company’s 2002 SFAS 123 disclosure found in Note 81 of the Company’s notes to the consolidated financial statements. Portions of Note 8 are shown in Figure 1.

Procter and Gamble (P&G) uses the intrinsic value method when valuing stock options. Because the exercise price of the options is equal to the price of the stock on the date of the option grant, the intrinsic value is zero, and P&G does not recognize an expense on the income statement. However, under SFAS 123, P&G must show the pro forma effects on accounting earnings for the options based on their fair value, which was determined using the Black-Scholes-Merton option pricing model in 2002.

Impact of Pro Forma Disclosures on Financial Statement Items

Net income/earnings per share. Under the pro forma disclosure method, no compensation expense is recognized in the financial statements, resulting in a higher reported net income than if the options were expensed. An analyst should use pro forma income to compute normalized income from continuing operations. From P&G’s pro forma statement, it is evident why companies have been reluctant to expense the cost of stock options. For 2002, net earnings decline by $4,352 – $3,910 = $442, a reduction of over 10 percent.

Cash from operations. When employees exercise their stock options, the employee pays cash to the company equal to the exercise price at the date of the option grant. The cash received is recorded as an increase in paid-in-capital. The difference between the market price and the exercise price represents the employee’s profit. While the profit is a tax liability for the employee, it is tax-deductible for the company, and therefore represents a tax

1. Proctor & Gamble, “Form 10-K,” http://www.shareholder.com/Common/Edgar/80424/950152-02-6968/02-00.pdf (September 2004), p. 104–106.

Figure 1: P&G Note 8: Earnings Per Share and Stock Options

Format modified for readability

The Company has stock-based compensation plans under which stock options are granted annually to key managers and directors at the market price on the date of grant …

… As stock options have been issued with exercise prices equal to grant date fair value, no compensation cost has resulted. Had compensation cost for the plans been determined based on the fair value at grant date consistent with SFAS 123, the Company’s net earnings and earnings per common share would have been as follows:

The fair value of grants issued in 2001 and 2000 was estimated using the binomial options-pricing model. For options granted in 2002, the Company has estimated the fair value of each grant using the more widely recognized Black-Scholes-Merton option pricing model. Assumptions are evaluated annually and revised, as necessary, to reflect market conditions and additional experience …

Years Ended June 302002 2001 2000

Net EarningsAs reported $4,352 $2,922 $3,542Pro Forma 3,910 2,612 3,363

Net Earnings Per Common ShareBasicAs reported $3.26 $2.15 $2.61Pro Forma 2.92 1.92 2.47DilutedAs reported 3.09 2.07 2.47Pro Forma 2.77 1.85 2.34



benefit. Since the company does not recognize compensation expense under the pro forma disclosure method, the tax benefit is recorded as a direct increase to stockholder’s equity on the balance sheet. The tax benefit is also included as a component of operating cash flows and may cause a significant increase in reported cash from operations. For some technology companies in the late 1990s, the tax benefit from the exercise of options amounted to over 50 percent of their reported operating cash flow.

Diluted EPS. Stock options that are issued and exercised increase the number of shares of common stock outstanding, resulting in lower diluted earnings per share. A company with a large amount of outstanding options bears the risk of substantially lower future EPS as a result of company earnings being spread over more shares.

Leverage and return ratios. Companies will often repurchase shares of their own stock to offset the dilution impact when options are exercised. The repurchased shares are accumulated as treasury stock, which can be used when employees exercise their options. Acquiring treasury stock reduces both cash and stockholder’s equity. The reduction in equity can cause a significant increase in the debt-to-equity ratio and return on equity (ROE).

Example: Impact of treasury stock on leverage and return ratios

The Lang Stone Company (LSC) and Duffy Granite, Inc. (DGI) are similar companies that ended 2005 with identical assets and net income. In 2005, each company made $10 million in profit; however DGI spent $90 million to repurchase 1,000,000 shares of its common stock. Financial data for each company is in Figure 2 (in millions):

Figure 2: 2004 and 2005 Financial Data for Lang Stone and Duffy Granite (in millions)

Calculate the debt-to-equity ratio, return on assets (ROA), and return on equity (ROE) for each company in 2004 and 2005. Analyze differences in the 2005 leverage and return ratios between the two companies.

Lang Stone Company Duffy Granite, Inc.

2004 2005 2004 2005

Assets $300 $320 $300 $230

LT debt 80 80 80 80

Stockholder’s equity 100 120 100 30

Net income 15 20 15 20



Answer:

Figure 3: Ratio Comparison of Lang Stone and Duffy Granite

Both companies had the same balance sheets and generated of the same net income in 2004, resulting in identical leverage and return ratios.

In 2005, both companies generated an identical $20 million in net income; however DGI used cash to repurchase shares of its own stock. As a result, its leverage and return ratios were dramatically different. DGI appeared to have significantly more leverage than LSC (267% vs. 67%) and a significantly higher ROE (67% vs. 16.7%). We can attribute these differences to lower reported equity as a result of DGI’s share repurchase. The repurchase also caused a difference in ROA (6.3% vs. 8.7%) due to the reduction in assets that occurred when DGI used cash to repurchase the shares.

Earnings Management Concerns and Detection Strategies

Dilution. The issuance of more shares when options are exercised creates significant dilution potential. The potential for dilution can be determined by the following ratio:

If the ratio of options outstanding to shares outstanding is 10 percent or greater, dilution is a significant concern.

Example: Impact of stock options and equity dilution

Bullseye and Stuff Mart are two retailing firms with the following stock options outstanding and total common shares outstanding, as shown in Figure 4.

Figure 4: Shares and Options Outstanding for Bullseye and Stuff Mart

Calculate the percentage of options to shares outstanding and discuss the implications for future equity dilution.

Lang Stone Co. Duffy Granite Inc.

2004 debt-to-equity $80/$100 = 80% $80/$100 = 80%

2005 debt-to-equity $80/$120 = 67% $80/$30 = 267%

2004 ROA $15/$300 = 5.0% $15/$300 = 5.0%

2005 ROA $20/$320 = 6.3% $20/$230 = 8.7%

2004 ROE $15/$100 = 15.0% $15/$100 = 15.0%

2005 ROE $20/$120 = 16.7% $20/$30 = 67.0%

Stock Options Outstanding

Shares Outstanding

Bullseye 42.2 216

Stuff Mart 7.5 198

year-end options outstanding% of options to shares outstanding =

year-end shares outstanding



Answer:

Bullseye = 42.2 / 216 = 19.5%

Stuff Mart = 7.5 / 198 = 3.8%

Bullseye has a ratio of options to shares outstanding that is well in excess of 10 percent, indicating a risk that dilution will significantly reduce future EPS. Stuff Mart’s option to shares outstanding ratio of 3.8 percent indicates that future EPS dilution from option exercise is not a major concern.

Option expense. Option expense could amount to a considerable percentage of net earnings. An analyst should compare net income as reported with the pro forma net income disclosure in the footnotes to determine the impact options would have if they were expensed. A difference between reported and pro forma net income that is more than 10 percent of reported net income should be a warning signal for the analyst.

We saw that the difference between reported net income and pro forma net income for P&G in 2002 was $4,352 – $3,910 = $442. As a percentage, the difference is $442/$4,352 = 10.2 percent, meaning that option expense is a significant concern.

Revaluing/reissuing options. If a company’s stock price falls, investors incur real losses, while company executives holding options only lose the potential for rewards from stock appreciation. After a drop in stock price, some companies may revalue (or replace) options using a lower exercise price that will allow the executives to profit as the stock climbs from its new lows. The practice of revaluing options essentially rewards management for poor past performance. If an option revaluation occurs, it will be included in the footnotes to the financial statements. An analyst should review the footnotes to check the rationale for any revaluation and how frequently revaluation occurs.

Focus on executives vs. employees. Some companies will grant large option contracts to executives, but grant few, if any, options to employees. Such a practice can be an indication of management’s incentive to look out for its own interests rather than those of its stakeholders. An analyst should review a company’s option policy in the footnotes and in the Management Discussion and Analysis (MD&A). A significant focus on option grants for executives compared to other companies in the industry is a potential warning signal.

Use of treasury stock. Acquiring treasury stock reduces a company’s cash and reported equity and is a means of reducing the dilution impact of option exercise. Repurchasing shares when a company’s stock is undervalued can be a sound financial strategy; however, repurchasing shares when the stock price is high is a poor use of cash and is detrimental to shareholders. Large stock repurchases may temporarily inflate the stock price, potentially at a time when management is exercising its options. An analyst should review the amount of treasury stock indicated on a firm’s balance sheet as well as any discussion of treasury stock usage in the footnotes or in the MD&A.

Dividend policy. Paying a dividend may be in shareholders’ best interests. However, since the stock price will drop by the amount of the dividend when it is paid, a dividend payment reduces the likelihood that management will exercise its options at a profit. All else equal, an option holder would prefer for a company to buy back shares rather than have the company pay a dividend. The stock repurchase will not cause the stock price to fall, and may cause it to increase if the market views stock repurchases as good news. An analyst should be aware of the potential of a dividend policy that promotes management compensation at the expense of shareholders. Items to review include stated quarterly dividends and the percentage of income paid as dividends versus options outstanding and the percentage of earnings used to acquire treasury stock.



DEFINED CONTRIBUTION AND DEFINED BENEFIT PENSION PLANS

LOS 2.B.b: Explain the differences in accounting for defined contribution and defined benefit pension plans and how such differences affect a company’s financial statements.

A defined contribution plan is a retirement plan (e.g., cash balance plan, 401(k) plan, profit sharing) in which the employee makes contributions and the employer may be obligated to make periodic contributions (through matching programs) to the retirement accounts of eligible employees. The firm makes no promise to the employee regarding the amount of funds that will accumulate in the plan over time. Investment decisions for the funds are left to the employees, who bear all of the short-fall risk at retirement.

Accounting for defined contribution plans is straightforward. During the reporting period, the employer accrues a liability until the firm makes its contribution to the employee’s account. Once the contribution is made, the contribution amount is recorded as an expense on the firm’s income statement. The pension cost for the period is equal to the required contribution.

In a defined benefit plan, the company promises to pay a certain amount at retirement. Most defined benefit plans base the retirement benefit on the employee’s salary level and length of service. The employer invests funds to meet the future obligation and the employer, not the employee, assumes the risks and rewards associated with the plan assets and liabilities.

Defined benefit plan accounting is more complex than accounting for a defined contribution plan because it requires management to calculate the value of plan obligations based on estimates of the future. Depending on a number of factors, the plan may be overfunded (i.e., plan assets are greater than plan obligations) or underfunded (i.e., plan assets are less than plan obligations). Changes in the relative values of the plan assets and liabilities are reflected on the firm’s financial statements, typically as a net pension expense on the income statement and a net pension liability (or asset) on the balance sheet. Pension-related estimates are subjective, so pension accounting gives management the opportunity to manage the earnings stream by changing the assumptions used to estimate the value of plan obligations. The characteristics of these assumptions are discussed in greater detail in subsequent sections.

PENSION BENEFIT OBLIGATION MEASURES

LOS 2.B.c: Define projected benefit obligation (PBO) and identify and explain the four key items of PBO and calculate and discuss the funded status of a pension plan and compare and contrast the funded status with the net asset (liability) recognized in a company’s financial statements.

The projected benefit obligation (PBO) is the actuarial present value (at the assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases, turnover rates, quit rates, and retirement dates. It assumes that the firm is (and will be) a going concern and that the employee will continue to work for the firm until he retires.

The GAAP calculation of defined benefit plan obligations is largely based on the PBO. There are four major components of the PBO:

• Service cost is the present value of pension benefits earned during the year. It reflects the employee working another year for the company and is a recurring plan expense that increases the plan obligation. Reported service cost is very sensitive to changes in assumptions that management uses to determine the pension obligation, such as the discount rate and rate of compensation increase (which are discussed later).

• Interest cost is the increase in the PBO due to the passage of time. Even if no additional benefits are earned in a given year, the PBO will rise due to the interest owed on the pension obligation. The interest cost is approximately equal to the PBO at the beginning of the period multiplied by the discount rate. Like the service cost, this is a recurring plan expense that results in an increase in plan obligations.



• Actuarial gains and losses. Liability gains and losses result from changes in actuarial assumptions (e.g., changes in the discount rate, the rate of compensation increase, quit rates, mortality rates, and retirement rates) or the composition of plan participants (e.g., an increase in the post-retirement life span increases the PBO). An actuarial gain results in a decrease in the PBO; an actuarial loss results in an increase in the PBO. An example of a liability loss would be an increase in the PBO that would result from a decrease in the assumed discount rate. Asset gains and losses result from differences between the actual and expected return on plan assets.

• Benefits paid are simply the actual cash retirement benefits paid out to employees. Benefits paid are a cash outflow from the plan and reduce PBO.

In addition to the four key components, other factors that may impact the PBO include the following:

• Prior service costs reflect increases in the PBO that results from an amendment to the pension plan. FAS 87 (the relevant standard for pension accounting) requires that the prior service cost be amortized over the expected remaining service life of the employees affected by the amendment. For example, suppose that plan beneficiaries have been promised 50 percent of the average of the last three years of their salary as a pension benefit when they retire. If the plan is amended such that all employees are offered 60 percent instead of 50 percent, the increase in the PBO that would result is referred to as prior service cost.

• Foreign currency exchange rate changes may impact the PBO if some plan benefits are denominated in a foreign currency when that amount is measured in the reporting currency.

• The PBO of an acquired firm is added to the PBO of the acquiring firm in a business combination, and a divestiture may reduce the PBO if the employees affected by the divestiture are no longer covered by the plan.

• Curtailments resulting from plan termination freeze the current level of the PBO.• Termination benefits paid to employees affected by layoffs and settlements that shift the pension obligation

to an unrelated entity, such as an insurance company, will both change the PBO.• Some plans permit contributions by plan participants that increase the PBO.

Under FAS 132, companies are required to disclose a reconciliation of beginning and ending balances of the PBO. The disclosure will include the following:

PBO at the beginning of the yearCost Components

+ Service cost+ Interest cost± Actuarial gains and losses± Prior service cost from plan amendments

Other Factors± Effects of foreign currency exchange rate changes± Effects of business combinations and divestitures± Curtailments, settlements, and special termination benefits

Cash Flows+ Contributions by plan participants that increase plan benefits– Benefits paid= PBO at the end of the year

Fair Value of Plan Assets

The fair value of the pension plan’s assets must also be disclosed in the footnotes. The plan assets are a portfolio of securities (stocks and bonds) managed with the goal of generating sufficient cash to pay the benefits owed to the plan beneficiaries. The fair value of the plan assets is increased by the actual return on the plan assets (dividends and interest), as well as contributions made by the employer. The balance is decreased by benefits paid to the plan beneficiaries.



Pension Plan Funded Status

The funded status of the plan is the difference between the assets (the fair value of the plan assets) and the liability (the PBO):

funded status = fair value of plan assets – PBO

The plan is “overfunded” if the funded status is positive; it is “underfunded” if the funded status is negative.

The funded status of the plan is the true economic position of the plan: the fair market value of the assets minus the liabilities. However, these amounts are “off-balance sheet” items; they are disclosed only in the footnotes. The pension liability (or asset) reported on the balance sheet is not the funded status of the plan, and may bear no resemblance to the true economic position of the plan.

If the company actually recorded the funded status of the plan on its financial statements, the amount recorded would fluctuate dramatically, mainly due to the volatility of plan assets caused by volatility in the financial markets. For the reported pension liability (or asset) GAAP requires various adjustments that smooth out this volatility, which creates opportunities for earnings management.

U.S. GAAP requires the reconciliation of the funded status (which is the true economic pension liability or asset) to the reported (accounting) liability or asset. This involves adjusting the funded status for the unrecognized gains or losses resulting from the transition asset or liability, unrecognized prior service costs, and unrecognized actuarial gains and losses. Unrecognized costs, losses, and liabilities are added back to the funded status to arrive at the reported pension asset or liability. Unrecognized gains and assets are subtracted from the funded status to arrive at the reported pension asset or liability.

Funded status+ Unrecognized actuarial losses

or– Unrecognized actuarial gains+ Unrecognized prior service cost+ Unrecognized prior transition obligation

or– Unrecognized prior transition asset= Net pension asset (liability) recorded on balance sheet

This amount is what is reported as an asset or liability on the balance sheet. Note that different plans may be reported separately, so the company could have both a pension asset and a pension liability on its balance sheet.

The transition liability is the amount that was created when FAS 87 was first applied back in 1987. This is not a very important component of the pension liability or pension expense because it has been almost completely extinguished for most companies.

Professor’s Note: You are probably asking yourself, “Why do we add back losses and subtract out gains?” Here’s a simple example to illustrate the point. Suppose that the FMV of plan assets is $100, PBO is $110, and there are no unrecognized deferrals, so the funded status equals the pension asset (liability), which equals ($10). Now instead suppose that there is a liability loss of $10 because the forecasted life expectancy of the employees is increased. The FMV of assets is $100, the PBO increases to $120 because of the higher liability, and the funded status is now ($20). However, the loss is not recognized, but rather deferred and amortized over time as an increase in pension expense. Therefore the pension liability remains at ($10). Then you have to add back the loss to reconcile the funded status to the liability: ($20) + $10 = ($10).



Example: Calculating the reported pension liability

The pension plan data in Figure 5 was reported by United Parcel Service, Inc. (UPS) in its 2004 10-K1.

Determine the pension asset or liability amount reported on UPS’s balance sheet in 2004.

Answer:

The balance sheet account for UPS’s pension plan is an asset called prepaid pension cost. The value of the asset is $3,160. We can reconstruct the calculation:

funded status = fair value of plan assets – PBO = $9,962 – $9,037 = $925

net pension asset (liability) = $925 + $1,918 + $297 + $18 + $2 = $3,160

Figure 5: Funded Status vs. Reported Pension Asset

Pension Benefits

($ millions) 2004 2003

Fair value of plan assets, current year $9,962 $7,823

Benefit obligation, current year 9,037 8,092

Funded status 925 (269)

Unrecognized net actuarial loss 1,918 2,085

Unrecognized prior service cost 297 331

Unrecognized transition obligation 18 23

Other 2 752

Net amount recognized $3,160 $2,922

Prepaid pension cost $3,227 $2,970

Accrued benefit cost (188) (153)

Intangible asset 4 5

Accumulated other comprehensive income 117 100

Net amount recognized $3,160 $2,922

1. United States Securities and Exchange Commission, nd, <http://www.sec.gov/Archives/edgar/data/1090727/000119312505049642/d10k.htm> (June, 2005)



WARM-UP: CALCULATING THE COMPONENTS OF PENSION EXPENSE

Each year, the company records the net pension expense (income) on the income statement. The net pension expense measures the present value of the cost of providing the promised future benefits. In general, pension expense reflects the increase in PBO resulting from the service and interest costs of the plan, adjusted for other items, which include the accrual of costs that may differ from the actual funding of the plan. The net pension cost on the income statement is smoothed. The smoothing is the result of the use of expected return on plan assets in lieu of actual returns. Also, the amortization of gains/losses and prior service costs smoothes pension costs by spreading these items out over the remaining service life of the employees.

PENSION EXPENSE

LOS 2.B.d: Interpret the total pension expense (income) and its components to be reported on a company’s income statement under U.S. GAAP, compare and contrast the actual return on plan assets with the income (expense) recorded in a company’s income statement under U.S. GAAP, interpret the specific earnings management concerns posed by benefit plans and explain possible detection strategies, and compare and contrast the three actuarial assumption rates disclosed in a company’s pension footnote.

Professor’s note: Another long LOS! We’ll break this one down into manageable pieces as well.

Reported pension expense under U.S. GAAP is calculated as follows:

Actual EventsService cost

+ Interest costSmoothed Events

– Expected return on plan assets± Amortization of prior service costs± Amortization of transition asset or liability± Amortization of actuarial gains and losses= Reported pension expense (income) on income statement

Pension Expense Components

The components of pension cost reported on company’s income statement include:

Service cost. As previously defined, service cost reflects the increase in the PBO resulting from the employee working another year.

Interest cost. Also previously defined, interest cost is the increase in PBO resulting from interest owed on the current benefit obligation.

Expected return on plan assets. As part of the computation of pension expense, the company must estimate an expected long-term rate of return on plan assets. The expected return on plan assets serves to reduce the amount reported as an expense. Rather than use the actual return on plan assets from year to year, the company uses its assumption of the average long-term annual rate of return to smooth out the volatility in pension expense that would be caused by fluctuating market returns. Any difference between the actual return on plan assets and the expected return is deferred and accumulated.



Prior service cost. The prior service cost reflects the change in PBO that results from an amendment to the pension plan. FAS 87 (the relevant standard for pension accounting) requires that the prior service cost be amortized over the expected remaining service life of the employees effected by the amendment. Amortizing the prior service cost smoothes reported pension expense.

SFAS 87 transition gain or loss. SFAS 87: Employer’s Accounting for Pensions was enacted in 1985. Employers that had a pension plan in place prior to 1985 were required to transition to SFAS 87 requirements and the resulting gain was amortized over the expected remaining service life of the effected employees. Since this item is 20 years old, many companies have already amortized most of their transition gain or loss, making it a less important component of pension expense.

Amortization of net actuarial gain (loss) recognized. Amortization of gains (or losses) that occur from changing actuarial assumptions (i.e., changes in the discount rate) directly reduce (or increase) pension expense.

Example: Calculating pension expense

Determine UPS’s net pension expense that should be reported on the income statement for 2004 using the disclosures in Figure 6.

Answer:

UPS’s net pension expense for 2004 is calculated as:

Pension expense = $332 + $521 – $800 + $6 + $37 + $119 = $215

EARNINGS MANAGEMENT CONCERNS POSED BY BENEFIT PLANS

Pension accounting is based on significant assumptions by management including actuarial rate assumptions and GAAP requirements for smoothing procedures that give management ample opportunity to manage earnings. Key earnings management concerns and possible detection strategies are described below.

Economic position. Smoothing means that the reported pension asset or liability on the balance sheet may be completely different from the actual economic position of the plan. A plan’s funded status (fair value of plan assets – PBO) is included in the pension footnotes. An analyst should use the funded status to adjust the financial statements to reflect the true economic position of the plan.

Figure 6: Reported Components of UPS Pension Expense Calculation

Pension Benefits

Net periodic benefit cost ($millions) 2004 2003 2002

Service cost $332 $282 $217

Interest cost 521 465 413

Expected return on plan assets (800) (669) (654)

Amortization of:

Transition obligation 6 8 8

Prior service cost 37 37 30

Actuarial (gain) loss 119 28 4

Net Expense ?? $151 $18



Reported funding level. The reported funding level of the pension plan on the financial statements may not reflect reality when the true economic position of the plan is considered. The analyst should take note of any disclosures in the footnotes that indicate a net pension liability.

Reported pension income. If expected return on plan assets plus smoothing items exceeds service and interest costs, companies may record pension income that serves to increase reported earnings. In some cases, a company’s reported pension income can make up a large percentage of the total reported net income. An analyst should review the reasonableness behind the assumptions used to calculate the pension income, particularly the expected return on plan assets and consider restating earnings without the pension income.

Expected return compared to actual return. The analyst should evaluate the expected return on plan assets to determine if it is reasonable with the returns that the market is providing. The analyst should restate earnings based on the difference between actual and expected returns.

Aggressive actuarial assumptions. The more aggressive a company is with its actuarial assumptions, the better the company’s balance sheet and net income will look. An analyst should compare the actuarial assumption rates to rates used by other firms in the industry and assess how reasonable the rates are in relation to current market conditions. An analyst should also look for any changes in these rates. An increase in the discount rate or expected rate of return, or a decrease in the rate of compensation increase, may suggest that management is trying to manage its earnings.

Cash flows. A pension plan that is significantly underfunded creates the potential for large future contributions by the company in order to meet its obligations to retirees. These contributions could significantly reduce cash from operations. An analyst should take note of disclosures related to contributions to make sure the company is putting enough into the plan and also evaluate the burden of pension expense relative to net income. A pension cost that is a large percentage of net income is a potential warning signal.

Investing in company stock. Pension plans are permitted to hold company stock. However, a large percentage of company stock reflects a lack of diversification and greater risk for employees. The analyst should look for a percentage of pension assets held in company stock that is reasonable for a diversified portfolio (generally 5 percent or less).

ACTUARIAL ASSUMPTION RATES

In pension accounting, the company must make and disclose three actuarial assumptions in the pension footnotes:

• The discount rate is the interest rate used to compute the present value of pension obligations. In theory, this rate should be based on current market interest rates.

• The expected return on plan assets is the long-term assumed rate of return on the investments in the plan. Using an expected long-run return assumption rather than actual returns serves to smooth the net pension expense calculation.

• The rate of compensation increase is the average annual rate that employee compensation is expected to increase over time.

Assumptions of high discount rates, low compensation growth rates, and high expected rates of return on plan assets will decrease pension expense, increase earnings, and improve the apparent status of the plan. The more



aggressive these assumptions are, the lower the earnings quality of the firm. Figure 7 summarizes the off-balance sheet effects of these assumptions on pension fund accounting.

Figure 8 summarizes the income statement effects of these assumptions on pension fund accounting. Pension cost is equal to service cost plus interest cost minus expected return on assets.

Effect of Changes in the Discount Rate Assumption

The use of a higher discount rate will improve reported results because it will:

• result in lower present values and, hence, lower pension liabilities (i.e., lower PBO). Lower discount rates result in higher PBOs.

• usually result in lower pension expense, but there are actually two offsetting effects. First, since the service cost is a present value calculation, it will decrease as the discount rate increases. However, the interest cost will increase if the discount rate is higher. In most cases, the effect on the service cost will be greater than the effect on the interest cost, thus, higher discount rates tend to result in lower pension expense. The interest effect will dominate only for very mature plans with high interest cost relative to service cost.

Off-balance-sheet effects: The funded status of the fund will improve if management increases the discount rate, because the plan assets will not change and the liability (PBO) will decrease.

Income statement effects: All else equal, operating income and net income will increase if management increases the discount rate. Therefore, any ratios with the income measures in the numerator (e.g., net profit margin, operating margin, interest coverage ratios, and return on assets) will be favorably affected.

Balance sheet effects: All else equal, net pension obligations on the balance sheet decrease. Thus, any ratios involving these long-term liabilities in the denominator (numerator) will increase (decrease) if management increases the discount rate. Opposite results will occur for net pension assets. Retained earnings will increase due to the increase in net income. All else equal, leverage ratios will decline.

Figure 7: Summary of Off-Balance-Sheet Impact of Pension Plan Assumptions

Effect on…Higher

Discount RateLower Compensation

Rate IncreaseHigher Expected Return

on Assets

FMV of plan assets No effect No effect No effect

PBO Decrease Decrease No effect

Funded status Favorable Favorable No effect

ABO Decrease No effect No effect

Figure 8: Summary of Income Statement Impact of Pension Plan Assumptions

Effect on…Higher

Discount RateLower Compensation

Rate IncreaseHigher Expected Return

on Assets

Service cost Decrease Decrease No effect

Interest cost Increase Decrease No effect

Expected return No effect No effect Increase

Net pension cost Decrease Decrease Decrease



Effect of Changes in the Rate of Compensation Increase Assumption

The use of a lower rate of compensation increase will improve reported results because it will result in:

• Lower future pension payments and, hence, a lower PBO. • Lower service cost and a lower interest cost; thus, pension expense will decrease.

Off-balance-sheet effects: The funded status of the fund will improve if management lowers the rate of compensation increase, because the plan assets will not change, and the liability (PBO) will decrease.

Income statement effects: All else equal, operating income and net income will increase. Therefore, any ratios with the income measures in the numerator (e.g., net profit margin, operating margin, interest coverage ratios, and return on assets) will be favorably affected.

Balance sheet effects: All else equal, net pension obligations on the balance sheet decrease. Thus, any ratios involving these long-term liabilities in the denominator (numerator) will increase (decrease). Opposite results will occur for net pension assets. Retained earnings will increase due to the increase in net income. All else equal, leverage ratios will decrease.

Effect of Changes in the Expected Return on Plan Assets Assumption

The assumption of a higher return on plan assets will improve reported results because it will:

• Not affect the calculated PBO.• Result in higher expected future pension assets and, hence, improve the apparent status of the plan by

reducing the net pension liability.• Result in lower pension expense.

Off-balance-sheet effects: The funded status of the fund will not change if management increases the expected return on plan assets, because neither the fair market value of the plan assets nor the PBO will change.

Income statement effects: All else equal, operating income and net income will increase. Therefore, any ratios with the income measures in the numerator (e.g., net profit margin, operating margin, interest coverage ratios, and return on assets) will be favorably affected.

Balance sheet effects: All else equal, net pension obligations on the balance sheet decrease. Thus, any ratios involving these long-term liabilities in the denominator (numerator) will increase (decrease). Opposite results will occur for net pension assets. Retained earnings will increase due to the increase in net income. All else equal, leverage ratios will decline.

ADJUSTMENTS TO THE BALANCE SHEET

Pension accounting may affect several items on the balance sheet. The most likely items affected are either a prepaid item (an asset) or an accrued item (a liability). The appropriate balance sheet adjustment is to reflect the actual economic status of the plan (the funded status) rather than the net asset or liability reported on the financial statements for accounting purposes. The offsetting entry is always to equity:

• An increase in a pension liability (or a decrease in a pension asset) will result in an offsetting decline in equity.

• A decrease in a pension liability (or an increase in a pension asset) will result in an offsetting increase in equity.

Professor’s Note: Ignore any tax effects when making these balance sheet adjustments. The entire change in the pension asset or liability should be offset by an equal change in equity. Do not make any adjustments to deferred taxes.



Example 1: Adjusting the balance sheet

Suppose the fair value of the plan assets is $50 million and the PBO is $75 million, but the net pension liability on the balance sheet is $10 million. Determine the adjustments to the balance sheet necessary to reflect the real economic status of the plan and the effect on the firm’s financial leverage.

Answer:

The actual economic status of the plan is a liability equal to $50 less $75, or a liability of $25. The adjustment is equal to $10 – $25 = –$15. Therefore the balance sheet liability should be increased to $25 from $10. The appropriate adjustments are:

• Increase the pension liability by $15.• Decrease equity by $15.

The result is an increase in leverage.


Suppose the fair value of the plan assets is $50 million and the PBO is $75 million. In this case, however, assume the firm reports a pension asset of $40 million. Determine the adjustments to the balance sheet necessary to reflect the real economic status of the plan and the effect on the firm’s financial leverage.

Answer:

The actual economic status of the plan is a liability equal to $50 less $75, or a liability of $25, which means we want the balance sheet to reflect a net pension liability of $25. However, the firm is reporting a pension asset of $40. Therefore the appropriate adjustment is –$25 – $40 = –$65. There are two ways to do this:

• Eliminate the $40 pension asset and record a $25 pension liability. The offsetting entry is a $65 decrease in equity; leverage will increase.

• Create a $65 pension liability with an offsetting $65 decrease in equity. Once again, the net pension liability is $25 ($40 asset less $65 liability), and leverage will increase.


Suppose the fair value of the plan assets is $125 million and the PBO is $80 million. Assume the firm reports a pension asset of $60 million and a pension liability of $40 million. Determine the adjustments to the balance sheet necessary to reflect the real economic status of the plan and the effect on the firm’s financial leverage.

Answer:

The funded status is equal to $45 (the $125 fair value of plan assets less the $80 PBO); the net pension asset is $20 (the $60 pension asset less the $40 pension liability). The adjustment is $45 – $20 = $25. There are two ways to do this:

• Increase the pension asset by $25 to $85. The net pension asset will now be $45 ($85 – $40), which is equal to the funded status. The offsetting entry is a $25 increase in equity. Leverage will decrease.

• Decrease the pension liability by $25 to $15. The net pension asset will now be $45 ($60 – $15), which is equal to the funded status. The offsetting entry is a $25 increase in equity. Leverage will decrease.



ADJUSTMENTS TO THE INCOME STATEMENT

Pension cost on the income statement should be measured as nonsmoothed pension cost, calculated as:

Service cost+ Interest cost= Recurring pension cost+ Actuarial losses+ Plan amendments= Gross pension cost– Actual ROA (loss)= Nonsmoothed pension cost (credit)

Professor’s Note: Actual ROA is subtracted from gross pension cost if ROA is positive (reducing nonsmoothed pension cost). If actual ROA is negative, the loss is added to gross pension cost (increasing nonsmoothed pension cost).

Example: Calculating nonsmoothed pension cost

Calculate nonsmoothed pension cost in 2003 and 2004 for UPS using the data from Figures 5 and 6.

Answer:

2004 2003Service cost $332 $282

+ Interest cost 521 465= Recurring pension cost 853 747+ Actuarial losses 290 3+ Plan amendments 3 876= Gross pension cost 1,146 1,626– Actual ROA (loss) (1,140) (1,143)= Nonsmoothed pension cost (credit) $6 $483

KEY CONCEPTS

1. Stock option accounting is governed by APB 25 and SFAS 123. Under APB 25, stock option expense is equal to the excess of the market price of the stock over its exercise price on the measurement date. If the market price of the stock is less than or equal to the exercise price, the compensation expense recognized is zero. Under SFAS 123, a company has two choices:• Expense the cost of the option based on the option’s fair value.• Use APB 25 and record zero compensation expense on the income statement, but include pro forma

disclosure in the footnotes that provide the fair value of the options granted and the impact on earnings and earnings per share.

2. The net income and earnings per share of firms that choose not to recognize compensation expense are overstated, requiring the analyst to make appropriate adjustments.

3. Companies realize a tax benefit when options are exercised. If no compensation expense is recognized this tax benefit is reported as a direct increase to equity, resulting in increased cash from operations.

4. Stock options that are issued and exercised increase the number of shares outstanding, resulting in dilution of earnings per share.

5. Accumulating treasury stock reduces a company’s cash and equity. The decrease in equity can dramatically increase leverage and return ratios (e.g., debt-to-equity, ROE) that use equity in the denominator.



6. Earnings management concerns involving options and strategies for detecting them are:• Dilution – determine options outstanding relative to shares of stock outstanding.• Option expense – use footnotes to determine the percentage difference between reported net income and

pro forma net income.• Revaluing options – review footnotes for rationale and frequency of revaluation.• Focus on executives vs. employees – compare option grants for executives to those for other firms in the

industry.• Use of treasury stock – review magnitude and usage of treasury stock in the footnotes or Management

Discussion and Analysis.• Dividend policy – compare percentage of income paid as dividends versus options outstanding and the

percentage of earnings used to acquire treasury stock.7. Defined contribution pension plans are those in which the company promises to pay a specified amount of

funds for each employee for each period. Employees bear the short-fall risk. In defined benefit plans, the company promises to pay a certain amount at retirement, and the firm bears the short-fall risk. The accounting for defined benefit plans is much more complicated than for defined contribution pension plans.

8. The projected benefit obligation (PBO) is the actuarial present value of all future pension benefits earned to date, based on expected future salary increases. The PBO has four key components:• Service cost – present value of pension benefits earned during the year.• Interest cost – increase in PBO due to interest owed on the existing pension obligation.• Actuarial gains and losses – result from changes in actuarial assumptions.• Benefits paid – cash retirement benefits paid to employees. Paying benefits reduces the PBO.

9. The economic pension asset or liability of the company is calculated by subtracting the PBO from the fair value of plan assets. If this difference is positive, the plan is overfunded; and if this difference is negative, the plan is underfunded.

10. Reported pension expense under U.S. GAAP is calculated as follows:Actual Events

Service cost+ Interest cost

Smoothed Events– Expected return on plan assets± Amortization of prior service costs± Amortization of transition gain or loss± Amortization of actuarial gains and losses= Reported pension expense (income) on income statement

11. Pension expense components include:• Service cost• Interest cost• Expected return on plan assets – assumed long run rate of return on plan assets used to smooth the

volatility that would be caused by using actual returns.• Prior service cost – amortized costs for changes in PBO that result from amendments to the plan• SFAS transition gain or loss – amortized amount caused by switching to SFAS 87 in 1985.• Net actuarial gain or loss – amortization of gains and losses caused by changes in actuarial assumptions.

12. Assumptions of high discount rates, low compensation growth rates, and high expected rates of return on plan assets will decrease pension expense, increase earnings, and improve the apparent status of the plan. The more aggressive these assumptions, the lower the earnings quality of the firm.



13. Earnings management concerns for pension plans and detection strategies include:• Economic position – difference between reported and economic position of the plan. Analyst should use

funded status to adjust financial statements.• Reported funding level – underfunded pension plans could indicate future cash outflows for the firm.

Analyst should check footnotes that indicate a net pension liability.• Reported pension income – negative pension expense will increase reported income. Analyst should

review reasonableness of expected return assumptions and consider restating income based on the difference between actual and reported returns.

• Aggressive actuarial assumptions – could improve status of company’s balance sheet and income statement. Analyst should compare disclosed rates to other firms in the industry and look for any changes the company makes to these rates.

• Cash flows – underfunded pension creates the potential for large future outflows from operating cash flow. Analyst should review disclosures related to contributions and the ratio of pension cost to net income.

• Investing in company stock – a pension plan invested in more than 5 percent company stock indicates a lack of diversification.

14. The appropriate balance sheet adjustment is to reflect the actual economic status of the plan (the funded status) rather than the net asset or liability reported on the financial statements for accounting purposes. The offsetting entry is always to equity:• An increase in a pension liability (or a decrease in a pension asset) will result in an offsetting decline in

equity.• A decrease in a pension liability (or an increase in a pension asset) will result in an offsetting increase in

equity.



CONCEPT CHECKERS: CORPORATE GOVERNANCE, COMPENSATION, AND OTHER EMPLOYEE ISSUES

1. Which of the following statements about SFAS 123 and APB 25 is TRUE?A. APB 25 recommends the use of the fair value method for valuing options.B. APB 25 requires firms that do not expense options to disclose pro forma earnings per share.C. A firm using the SFAS 123 disclosure method may report a higher cash flow from operations than a

firm that expenses options under SFAS 123.D. SFAS 123 requires firms to recognize compensation expense related to employee stock options on the

income statement.

Use the following information for Questions 2 through 4

David Hartsook is an analyst with Dayton Capital Management and is responsible for research in the financial sector. Hartsook is looking for investment opportunities among insurance companies and believes that analyzing disclosures related to employee stock option compensation will enable him to improve the quality of his earnings models.

Hartsook has put together the following tables of information concerning four companies in the insurance industry that use the SFAS 123 disclosure method of accounting for stock options.

2. Which of the companies has the greatest future equity dilution potential?A. Carley Insurance Group.B. Dawson and Frye, Inc.C. ABI Group.D. Enterprise Financial.

3. Which company should Hartsook be most concerned about when considering the impact of option expense on earnings?A. Carley Insurance Group.B. Dawson and Frye, Inc.C. ABI Group.D. Enterprise Financial.

Company Name Stock Options Outstanding (in millions)

Shares Outstanding (in millions)

Carley Insurance Group 42.8 864

Dawson and Frye, Inc. 64.5 289

ABI Group 9.2 102

Enterprise Financial 5.6 132

Company Name Net Income – Reported (000’s) Net Income – Pro forma (000’s)

Carley Insurance Group $294,000 $269,000

Dawson and Frye, Inc. $236,000 $215,000

ABI Group $581,000 $512,000

Enterprise Financial $195,000 $175,000



4. Hartsook has asked Keith Luscher, a junior analyst, to calculate adjusted financial ratios for Enterprise Financial. Before starting on the project, Luscher wants to confirm his course of action with Hartsook, and makes the following statements:

Statement 1: Pro forma net income should be used when calculating return on assets (ROA).

Statement 2: Accumulating treasury stock may decrease the firm’s debt-to-equity ratio.

In regard to Luscher’s statements, Hartsook should:

A. agree with both statements.B. disagree with both statements.C. agree with statement 1, but disagree with statement 2.D. disagree with statement 1, but agree with statement 2.

5. Ledbetter Industries relies heavily on stock options to compensate its executives. In order to offset some of the dilution potential from the options, Ledbetter’s Chief Financial Officer, Franz Loeber, is considering accumulating treasury stock. In order to make his case to the other members of Ledbetter’s management team, Loeber prepares the following memo citing the benefits of using treasury stock:

Item 1: Repurchasing stock is always in the best interests of shareholders because fewer shares outstanding will increase earnings per share, thus increasing the stock price.

Item 2: Assuming that no new debt is used to repurchase stock, acquiring the treasury stock will reduce Ledbetter’s reported fixed assets and equity.

Item 3: Accumulating treasury stock will have no impact on executives that currently hold options.

Which of the items in Loeber’s memo are CORRECT?

A. Item 1 only.B. Item 3 only.C. Items 1 and 2.D. None of the items are correct.

6. Which of the following items would NOT be adjusted if the perspective is subsequently taken that options should be an expense to the issuer? Assume that adjustments are being made for differing treatment in prior periods.A. Net income.B. Number of shares.C. Retained earnings.D. Compensation payable.

7. All things being equal, which of the following effects would NOT occur if a firm decides to recognize option compensation expense instead of merely disclosing the relevant information?A. Lower return on equity.B. Lower debt-to-equity ratio.C. Lower earnings per share.D. Lower income from continuing operations.



8. Pyramid Consulting Group is considering starting either a defined benefit or defined contribution plan for its employees. Lynne Woods, an accounting intern for Pyramid, is asked to draft a report comparing defined contribution with defined benefit plans. Woods makes the following statements in her report:

Statement 1: In a defined contribution plan, pension expense is recorded directly on the income statement and is calculated as the difference between the required contribution amount and the actual return on plan assets.

Statement 2: The amount recorded on the balance sheet for a defined benefit plan is the plan’s funded status.

With regard to Woods’ memo, Pyramid’s management should:A. agree with both statements.B. disagree with both statements.C. agree with statement 1, but disagree with statement 2.D. disagree with statement 1, but agree with statement 2.

9. Which of the following components of the projected benefit obligation increases every year as a direct result of the employee working another year for the company?A. Service cost.B. Interest cost.C. Benefits paid.D. SFAS 87 transition loss.


The financial statements of Tanner Corp. for the year ended December 31, 2004, include the following (in $ millions):PBO at January 1, 2004 $435Service cost 63Interest cost 29Benefits paid – 44PBO at December 31, 2004 $483Fair value of plan assets at January 1, 2004 $522Actual return on plan assets 77Employer contributions 48Benefits paid – 44Fair value of plan assets at December 31, 2004 $603Average remaining years of service for employees 10Expected return on plan assets: 12 months ended 12/31/04 $32

There were no deferred or amortized amounts as of January 1, 2004.

10. The amount Tanner, Inc., reported as pension expense (in millions) on its income statement for the year ended December 31, 2004, is closest to:A. –$33.B. –$14.C. $31.D. $60.



11. The funded status of the Tanner pension plan (in millions) as of December 31, 2004, is closest to:A. underfunded by $212.B. underfunded by $120.C. overfunded by $120.D. overfunded by $212.

12. The nonsmoothed pension cost (in millions) for the Tanner pension plan for 2004 is closest to:A. $0.B. $15.C. $41.D. $60.

13. Which of the following statements regarding pension accounting is FALSE?A. The service cost is affected by all of the assumptions employed in the determination of the pension

obligation.B. Prior service costs serve to smooth pension expense.C. A plan is described as overfunded if the value of the fair value of the plan assets exceeds the plan

obligation.D. There is a positive relation between the discount rate and the calculated PBO; that is, a higher

discount rate will result in a higher PBO.

14. Jacklyn King has been asked to do some accounting for Alexeeff Corp.’s pension plan. At the beginning of the period, PBO was $12 million, and the fair market value of plan assets totaled $8 million. The discount rate is 9 percent, expected return on assets is $0.96 million, and the anticipated compensation growth rate is 4 percent. At the end of the period, it was determined that the actual return on assets was 14 percent, plan assets equaled $9 million, and the service cost for the year was $0.9 million. Ignore amortization of unrecognized prior service costs and deferred gains and losses. Pension expense for the year is closest to:A. $0.72 million.B. $0.86 million.C. $0.90 million.D. $1.02 million.

15. Suppose management changes its assumption related to mortality rates of its employees, which results in an increase in the projected benefit obligation (PBO) of $40 million. The increase in the PBO is reported as:A. an increase in service cost of $40 million.B. an actuarial loss of $40 million.C. prior service costs of $40 million.D. an actuarial gain of $40 million.

16. The net amount of the cost components of Heritage Bakery’s projected benefit obligation for 2004 is $38 million. The fair market value of plan assets on January 1, 2004 is $159 million. The projected benefit obligation (PBO) on January 1, 2004 is $193 million, and the PBO on December 31, 2004 is $220 million. There are no effects of foreign currency exchange rate changes, business combinations, divestitures, curtailments, settlements, special terminations, or contributions by the employer or plan participants. Actual return on assets in 2004 was $32 million. The expected return on plan assets for 2004 was 10 percent. The market value of plan assets on December 31, 2004 is closest to:A. $148 million.B. $164 million.C. $180 million.D. $191 million.



17. NICEE Company’s pension plan on December 31, 2005 is underfunded by $85 million. Unrecognized actuarial gains total $12 million, and unrecognized prior service cost is equal to $27 million. There is no prior transition asset or liability. The amount of the pension asset or liability on NICEE’s balance sheet on December 31, 2005 is closest to a:A. $70 million pension liability.B. $100 million pension liability.C. $70 million pension asset.D. $100 million pension asset.

18. Best Taste Marketing reports a $33 million accrued pension cost liability on its fiscal year 2004 balance sheet. In the footnotes to the financial statements, the company discloses a projected benefit obligation (PBO) of $106 million, and a fair value of pension plan assets of $81 million. The most appropriate adjustment to the financial statements to properly reflect the economic status of the plan is:A. decrease liabilities by $8 million and increase equity by $8 million.B. decrease liabilities by $30 million and increase equity by $30 million.C. increase assets by $3 million and increase liabilities by $3 million.D. increase assets by $30 million and increase equity by $30 million.

19. All else equal, an increase in the discount rate will most likely have what impact on future pension expense and PBO? Pension Expense PBOA. Increase IncreaseB. Increase DecreaseC. Decrease IncreaseD. Decrease Decrease

20. All else equal, an increase in the expected return on plan assets will most likely have what impact on current pension expense and PBO? Pension Expense PBOA. No effect IncreaseB. No effect No effectC. Decrease IncreaseD. Decrease No effect

21. Walter Denk, an analyst for Honor Investment Advisors, is researching Winchell Enterprises. Denk is currently reviewing Winchell’s financial statements for signs that the company is managing earnings through its defined benefit pension plan. Denk has made the following observations:

Observation 1: Actual investment returns have been significantly higher than expected returns for the last five years.

Observation 2: Assumptions for the discount rate and compensation growth rate are updated on a semi-annual basis.

Observation 3: Pension costs are high relative to net income.

As Denk was drafting his report, Mary Reaume, a fellow analyst, noted that returns on Winchell’s stock have been strong over the last few years and that Winchell stock has grown to 12 percent of the company’s pension fund investment portfolio. Reaume states that the allocation to company stock indicates the plan is not well-diversified.



Denk should:A. agree with Reaume’s statement and flag observations 2 and 3 as earnings management concerns.B. disagree with Reaume’s statement and flag observations 1 and 2 as earnings management concerns.C. agree with Reaume’s statement and flag observations 1 and 2 as earnings management concerns.D. agree with Reaume’s statement and flag all three observations as earnings management concerns.



ANSWERS – CONCEPT CHECKERS: CORPORATE GOVERNANCE, COMPENSATION, AND OTHER EMPLOYEE ISSUES

1. C Under the SFAS disclosure method, firms may not record options as an expense, but may realize a tax benefit when options are exercised. This tax benefit would increase equity and would be considered a component of operating cash flow. The other statements are false. APB 25 recommends the intrinsic value method for valuing options and makes no requirements in regard to disclosures. SFAS 123 allows, but does not require, firms to recognize the value of stock options granted to employees as an expense on the income statement.

2. B Future dilution potential is measured by calculating the percentage of options outstanding to shares outstanding. The firm with the largest percentage has the most potential for future equity dilution. • Carley Insurance Group: (42.8/864) = 5.0%; • Dawson and Frye, Inc.: (64.5/289) =22.3%; • ABI Group: (9.2/102) = 9.0%; • Enterprise Financial: (5.6/132) = 4.2%.

Dawson and Frye, Inc. has the largest percentage of options outstanding relative to shares outstanding, so future dilution potential is greatest for Dawson and Frye.

3. C To calculate the impact of option expense, determine the difference between reported and pro forma net income, and divide that difference by reported net income.• Carley Insurance Group: (294 – 269)/294 = 8.5%• Dawson and Frye, Inc.: (236 – 215)/236 = 8.9%• ABI Group: (581 – 512)/581 = 11.9%• Enterprise Financial: (195 – 175)/195 = 10.3%

The percentage difference between reported and pro forma net income is greatest for ABI Group.

4. C Hartsook should agree with Luscher’s first statement. The percentage difference between Enterprise Financial’s reported and pro forma net income is over 10 percent, which means that option expense is significant. Since Enterprise uses the disclosure method, option expense is not included in net income, which means that pro forma net income may be more meaningful when calculating return ratios. Hartsook should disagree with Luscher’s second statement. Accumulating treasury stock will reduce both cash and equity. The reduction in equity will reduce the denominator in the debt-to-equity ratio, thus increasing the ratio.

5. D None of the items on Loeber’s memo are correct. Item 1 is incorrect: although fewer shares outstanding will increase earnings per share, repurchasing shares can be a poor use of cash if shares are overvalued, and investors would be better off receiving cash as dividends. Item 2 is incorrect: buying back stock will reduce cash (which is a current asset), and equity, but will not change fixed assets. Item 3 is also incorrect; buying back stock may increase the stock price because the market views stock repurchases as good news, which would encourage executives to exercise their options. Therefore, the stock buyback could influence the behavior of executives holding options.

6. D Compensation payable would not be adjusted – the adjusting entry for analysis purposes would likely be to reduce net income and reduce retained earnings directly.

7. B As a result of the expense, earnings would be lower, which would result in lower earnings per share and lower income from continuing operations. Lower earnings leads to lower equity (lower retained earnings) and a higher debt-to-equity ratio. Note that for return on equity (net income divided by equity), the effect on net income is generally greater than for equity since it is presumed that there is a build-up of equity over time and that the equity amount (which is a cumulative amount of net income over several years) is larger than the net income for any given year. Therefore return on equity will also be lower.

8. B Both of Woods’ statements are incorrect. For a defined contribution plan, the total employer contribution is recorded as an expense directly on the income statement. The contribution amount is usually calculated based on a matching percentage of the employee contribution. For defined contribution plans, the employee bears all investment risk, so there are no plan assets, and no actual return on plan assets. For a defined benefit plan, the



amount recorded on the balance sheet is a smoothed figure that may bear little resemblance to a plan’s funded status. The difference between the funded status and the balance sheet asset or liability reflects unrecognized actuarial gains/losses, unrecognized prior service costs, and the unrecognized prior transition asset or obligation.

9. A The service cost is the present value of new benefits earned by the employee working another year. It is an expense that increases the PBO. Note that the interest cost increases every year whether or not the employee works another year.

10. D Where there are no amortizations, pension expense is calculated by subtracting expected return from the sum of interest cost and service cost ($63 + $29 – $32 = $60).

11. C A plan is overfunded when the fair value of plan assets exceeds PBO. This plan is ($603 – $483) = $120 overfunded.

12. B Nonsmoothed pension cost = service cost + interest cost – actual investment return ($63 + $29 – $77 = $15). No figures for actuarial losses and plan amendments were given, so we assume they are zero.

13. D The discount rate is inversely related to the PBO.

14. D Pension expense = service cost + interest cost – expected return on assetsService cost = $0.90 million (given)Interest cost = PBO at the beginning of the period × discount rate = $12 million × 0.09 = $1.08 millionExpected return on plan assets = $0.96 million (given)Total pension expense = $0.90 million + $1.08 million – $0.96 million = $1.02 million

15. B An actuarial loss resulting from changes in actuarial assumptions (such as mortality rates) leads to an increase in the PBO. Prior service costs reflect increases in the PBO that result from amendments to the pension plan. Service cost is the present value of the pension benefits earned during the year.

16. C The first step is to solve for benefits paid. The beginning PBO balance plus the cost components minus benefits paid is equal to the ending PBO balance: $193 + $38 – benefits paid = $220 million, which implies benefits paid are equal to $11 million. The ending fair value of plan assets is equal to beginning value plus actual return on assets less benefits paid: $159 + $32 – $11 = $180 million.

17. A The plan is underfunded, which means the funded status is negative. To reconcile the funded status to the balance sheet amount, subtract unrecognized actuarial gains and add unrecognized prior service cost: ($85) – $12 + $27 = ($70). This amount is negative, so a $70 million liability appears on the balance sheet.

18. A The funded status of the plan is the difference between the PBO ($106 million) and the fair value of plan assets ($81), which is a liability of $25 million. The actual pension liability on the balance sheet is $33 million. Therefore the pension liability should be decreased by $8 million to $25 million, with an offsetting increase in equity. There is no pension asset, so the net pension liability would be $0 – $25 = –$25, which is equal to the funded status.

It would also be appropriate to create a pension asset of $8 million with an offsetting increase in equity of $8 million, because the net pension liability would be $8 – $33 = –$25, which is also equal to the funded status. However, this answer was not one of the four choices.

19. D The use of a higher discount rate will result in lower present values and, hence, lower PBO. The effect of a higher discount rate on pension expense is potentially mixed. On one hand, since the service cost is a present value calculation, it will decrease as the discount rate increases. On the other hand, the interest cost will increase if the discount rate is higher. In most cases, the effect on the service cost will be greater than the effect on the interest cost, and higher discount rates tend to result in lower pension expense.

20. D The expected return on assets does not affect the calculation of the PBO. Pension expense is decreased by the return on assets. If the expected return assumption is increased, then pension expense will fall.



21. A Denk should agree with Reaume’s statement. Although company stock is permitted in a pension plan, a percentage greater than 5 percent is a sign of a lack of diversification. Denk should also flag observations 2 and 3 as earnings concerns. Actual returns being greater than expected returns would not be an earnings management concern because expected returns are used in calculating pension expense. A lower expected rate of return would lead to a more conservative figure for pension expense. Actuarial assumptions should be long-term in nature – rates that change frequently are a potential sign of earnings management. Also, pension expense that is a large percentage of net income could be a sign that the company will have to contribute more cash into its pension plan in the future, thus having a large negative impact on future operating cash flow.



RISK MANAGEMENT, DERIVATIVES, AND SPECIAL PURPOSE ENTITIES

Study Session 5

EXAM FOCUS

In this topic review we’re interested in SPEs thathaven’t been consolidated, and the effect on the

originator of adjusting the financial statements toreflect such a consolidation.

WARM-UP: THE BASICS OF SPECIAL PURPOSE ENTITIES

A special purpose entity (SPE) is difficult to define precisely, but in general it is a separate legal entity created for a specific purpose, such as to securitize loans or purchase receivables. The SPE can be structured as a corporation, trust, limited partnership, joint venture, or limited liability company.

The parties to an SPE include the following:

• The originator is the company that moves the assets and liabilities off of its balance sheet into the SPE.• An outside equity investor contributes at least 10 percent of the fair value of the assets. • A trustee represents the interests of the SPE as an independent third party.• The servicer provides administrative and accounting services for the SPE. Often the originator is the servicer.

SPEs gained notoriety in 2001 because of the general consensus that they were a major contributing factor in the collapse of Enron. Enron used SPEs to hide significant off-balance sheet debt and mask the company’s true financial position.

To address the issue, FASB changed the accounting rules in 2003 by formally defining a specific type of SPE called a variable interest entity (VIE) and making VIEs subject to specific consolidating and disclosure requirements. The details of those rules are not part of the Level 2 curriculum in 2006. However, the intent is to guarantee that the VIE is consolidated by (i.e., reported on the financial statements of ) some company. That company is called the primary beneficiary.

This topic review addresses the analysis issues related to SPEs. Some of the uses discussed in the first LOS are accomplished by creating “qualified” SPEs, which are entities created specifically to transfer financial assets. Qualified SPEs aren’t subject to the new VIE accounting rules and don’t have to be consolidated.

LOS 2.C.a: Discuss the major uses of special-purpose entities (SPES).

The stated purpose in creating the SPE is to manage financial risk. By moving the assets and associated liabilities off the balance sheet, the originator has isolated the financial risk in the SPE. If the assets in the SPE lose their value, the obligation of the originator is limited to the original investment. If the originator goes into bankruptcy, the assets in the SPE are out of reach of the originator’s creditors. The side benefit to the SPE, and the one we’re most interested in as Level 2 candidates, is that the originator strengthens its reported financial position by moving liabilities off of the balance sheet, thereby improving reported leverage.



There are seven major uses you need to be familiar with:

Mortgages and securitized loans. A financial institution sells mortgages or loans to the SPE. The SPE then uses the mortgages as collateral to issue mortgage-backed or asset-backed securities. The advantage to the institution is that it retains servicing rights and receives a fee for providing that service, but the loans themselves are no longer on the balance sheet.

Professor’s Note: See our discussion of asset-backed debt securities in Study Session 15.

Sell receivables with recourse. A company sells receivables to an SPE, which funds the purchase by using the receivables as collateral to obtain outside financing. The receivables are sold with recourse at a discount, so the company retains the credit risk that the receivables will not be paid. Such transactions have the same effect as borrowing money and giving receivables as security for the loan, except the financing is off of the balance sheet.

Collateralize take-or pay-contracts or throughput arrangements. Under a take-or-pay contract, the purchasing firm commits to a supplier to buy a minimum quantity of an input (usually raw material) over a predefined (relatively long) period of time. Such arrangements are made to ensure the availability of inputs for the firm’s operations into the future. The price may be either fixed or tied to market prices. An alternative method of off-balance-sheet financing is a throughput arrangement, in which a firm contracts with an affiliate to provide a certain quantity of raw material (usually gas or oil through a pipeline) required by the firm. Both contracts are very similar to long-term forward contracts.

The party that has agreed to supply the commodity in exchange for cash places the contract in the SPE and uses it as collateral to obtain financing. The funds are used to finance construction of a manufacturing plant to produce the commodity (in the case of a take-or-pay contract) or construction of a pipeline (in the case of a throughput arrangement). Once again the advantage to the supplier is that the debt is off the balance sheet.

Create synthetic leases. The originator sells an asset to the SPE and then leases it back from the SPE. The advantage to the originator is that the lease is treated as an operating lease for financial statement reporting and as a loan for tax purposes. Therefore the company gets the best of both worlds—it receives the tax advantage from interest expense and asset depreciation, but the debt does not appear on the financial statements.

Finance construction projects. The originator enters into a forward contract on a construction project and then sells the forward contract to an SPE, which uses it as collateral to obtain construction financing. When construction is completed, the originator structures a synthetic lease and leases the project back from the SPE.

Finance through in-substance defeasance. The originator places an existing debt agreement and specific assets to support the debt agreement into an SPE to reduce interest expense.

Fund R&D costs. The originator funds R&D through an SPE and thereby takes the associated R&D expense out of the income statement and any associated liabilities off the balance sheet.

LOS 2.C.b: Interpret the specific earnings management concerns posed by SPES and explain possible detection strategies and analyze disclosures relating to SPES that achieve off-balance-sheet financing activities, calculate the impact of such disclosures on a company’s financial statements and ratios, and discuss the significance of these activities on a company’s financial performance and condition.

EARNINGS MANAGEMENT CONCERNS POSED BY SPES AND DETECTION TECHNIQUES

SPEs have legitimate business uses, but the potential for earnings management is high (particularly on the Level 2 exam!). There are a number of specific concerns related to earnings management through SPEs and possible detection strategies that you should be aware of.



• Is the use of SPEs consistent with the company’s business strategy? A careful examination of the MD&A and footnotes, as well as a comparison of the firm’s SPE use to that of its competitors can reveal whether there is a legitimate business reason for using SPEs or whether the firm is using SPEs to hide high levels of debt off of the balance sheet.

• Does the company have too much off-balance sheet debt in SPEs? Analyze trends in the company’s use of off-balance sheet debt and compare the relative magnitude to that of competitors.

• Are the SPE-related disclosures sufficient to properly analyze the firm’s financial position? Analyze the MD&A and footnotes for SPE-related disclosures, and compare their stated use to the firm’s business strategy.

• Does increased SPE use coincide with deteriorating credit ratings? Look for companies that have begun to rely more heavily on SPEs to fund operations at the same time as their debt is being downgraded by the rating agencies.

ANALYZING SPES’ DISCLOSURES AND THEIR EFFECT ON FINANCIAL STATEMENTS AND RATIOS

Companies use SPEs to move debt off the balance sheet, reduce expenses on the income statement, and improve reported financial performance. We’ll discuss the specific financial statement effects of several of the SPE uses in this section, but the most important thing to keep in mind as you deal with SPE questions on the exam is that adjusting for SPEs makes most financial ratios look worse. Just remembering that simple rule will go a long way on exam day.

Take-or-Pay Contracts, Throughput Arrangements, and Project Financing

From a financial reporting standpoint, if long-term financing is involved, the purchaser must disclose the nature of a take-or-pay contract, throughput arrangement, or forward contract, and the minimum required payments in the footnotes to the financial statements. Neither the asset nor the obligation to pay is required to be recognized on the balance sheet itself. In order to properly reflect the nature of these commitments, an analyst should make the following adjustments:

• Increase long-term debt by the present value of the promised payments.• Increase long-term assets by the same amount as long-term debt was increased by creating an asset called

“supply agreement.”• Increase interest expense by the product of the present value of the obligation times the implicit interest rate

on the contract (which will be given in the question).• Increase earnings before interest and taxes (EBIT) by the same amount as interest expense was increased to

reflect the income on the supply agreement.

The effect on selected ratios of adjusting the financial statements to reflect take-or-pay contracts, throughput arrangements, and project financing is shown in Figure 1.

Figure 1: Ratio Effect of Adjusting for Take-or-Pay Contracts, Throughput Arrangements, and Project Financing

Ratio Numerator Denominator Effect on RatioDebt-to-equity Increase debt Not change equity Increase

Total asset turnover Not change sales Increase total assets Decrease

Return on assets Not change net income

Increase assets Decrease

EBIT-to-interest expense

Increase EBIT Increase interest expense Decrease (assuming unadjusted ratio is greater than one)



Synthetic Leases

The proper financial statement adjustment for synthetic leases is to capitalize the operating leases. We addressed this issue in detail in our topic review of leases and off-balance sheet debt in Study Session 5, so we’ll only provide a brief review here.

Make the following adjustments to convert the operating lease into a capital lease:

• At the inception of the lease, recognize the present value of minimum lease payments as an asset and as a liability on the balance sheet, including the current portion of long-term debt.

• During the term of the lease, depreciate the leased asset on the income statement.• Separate the lease payment into interest expense (the discount rate times the lease liability at the beginning of

the period) and principal payment on the lease liability (the lease payment less the interest expense).• Reduce cash flow from operations (CFO) by the interest expense and cash flow from financing (CFF) by the

principal payment on the lease liability.

The following ratios are worse when the synthetic lease is capitalized: current ratio, asset turnover, return on assets and return on equity (in the early years of the lease), and debt-to-equity. The only improvements in financial statement items and ratios from capitalization are an improvement in EBIT (because interest is not subtracted), an increase in CFO (because principal reduction is CFF), and higher net income in the later years of a lease (because interest plus depreciation is less than the lease payment in the later years).

Sales of Receivables With Recourse

The effect of moving receivables off of the balance sheet is to reduce the accounts receivable reported on the balance sheet. Lower levels of receivables suggest more strict credit polices and higher credit quality. However, the use of SPEs to finance receivables by companies that have previously held the receivables on the balance sheet might signal a new strategy: using less stringent credit policies to inflate revenues, while moving those receivables and the resulting higher bad debt expense off the financial statements to hide the deterioration in credit quality.

For analysis purposes, if the risk of noncollection of “sold” receivables has been retained by the seller (if the receivables have been sold with recourse), the following adjustments should be made:

• Accounts receivable and current liabilities should be increased by the amount of the receivables that were sold to reverse the effects of the sale before computing relevant ratios (e.g., the current ratio, receivables turnover, and leverage ratios).

• Cash flow from operations (CFO) should be adjusted by classifying the sale of the receivables as cash flow from financing (CFF) instead of CFO, which decreases CFO and increases CFF.

The effect on selected ratios of adjusting the financial statements to reflect the sale of receivables with recourse is shown in Figure 2.

Figure 2: Ratio Effect of Adjusting for Sale of Receivables With Recourse

Ratio Numerator Denominator Effect on RatioReceivables turnover Not change sales Increase receivables Decrease

Current ratio Increase current assets Increase current liabilities

Decrease (assuming unadjusted ratio was greater than one)

CFO-to-current liabilities

Decrease CFO Increase current liabilities

Decrease



KEY CONCEPTS

1. SPEs are used to securitize mortgages, sell receivables with recourse, collateralize take-or-pay-contracts and throughput arrangements, create synthetic leases, finance construction projects, finance through in-substance defeasance, and fund R&D costs.

2. Specific earnings management concerns related to the use of SPEs include the following:• Is the use of SPEs consistent with the company’s business strategy?• Does the company have too much off-balance sheet debt in SPEs?• Are the SPE-related disclosures sufficient to properly analyze the firm’s financial position? • Does increased SPE use coincide with deteriorating credit ratings?

3. The effect of adjusting the financial statements for take-or-pay contracts, throughput arrangements, and project financing through SPEs is to increase debt-to-equity and decrease total asset turnover, return on assets, and EBIT-to-interest expense.

4. The effect of adjusting the financial statements for synthetic leases is to increase debt-to-equity, and decrease current ratio, asset turnover, return on assets, and return on equity.

5. The effect of adjusting the financial statements for receivables sold with recourse is to decrease the receivables turnover, current ratio, and CFO-to-current liabilities.



CONCEPT CHECKERS: RISK MANAGEMENT, DERIVATIVES, AND SPECIAL PURPOSE ENTITIES

1. Special purpose entities are typically used to move debt off of the balance sheet for all of the following purposes EXCEPT to:A. securitize mortgages.B. securitize tax-loss carryforwards.C. collateralize take-or-pay contracts.D. create synthetic leases.

2. Which of the following is NOT a proper adjustment to make to the parent’s financial statements to reflect a take-or-pay contract placed in a special purpose entity (SPE)?A. Increase long-term debt by the present value of the expected payments to be made under the take-or-pay

contract.B. Increase interest income by the present value of the expected payments to be made under the take-or-pay

contract times the implicit interest rate on the contract.C. Increase EBIT by the present value of the expected payments to be made under the take-or-pay contract

times the implicit interest rate on the contract.D. Increase long-term assets by the present value of the expected payments to be made under the take-or-

pay contract.

3. What is the effect on the debt-to-equity ratio and return on assets of correctly adjusting the financial statements for a throughput arrangement placed in a special purpose entity (SPE)?

Debt-to-equity Return on assetsA. Increase IncreaseB. Decrease DecreaseC. Increase DecreaseD. Decrease Increase

4. What is the effect on cash flow from operations (CFO) and cash flow from financing (CFF) of correctly adjusting the financial statements for a sale of receivables with recourse to a special purpose entity (SPE)?

CFO CFFA. Decrease IncreaseB. Decrease DecreaseC. Increase IncreaseD. Increase Decrease

5. For a company that has sold receivables with recourse through a special purpose entity (SPE), which of the following items does NOT have to be adjusted?A. Accounts receivable.B. Accounts payable.C. Current ratio.D. Debt-to-equity.



6. Based on an analysis of InsideOut Corporation’s 2005 financial statements, Barb Roberts, CFA, compiles the following information:• Total debt = $85 million• Total equity = $100 million• Sales = $400 million• Current assets = $40 million• Current liabilities = $35 million• Interest expense = $7 million• EBIT = $23 million

At the beginning of 2005, InsideOut entered into a throughput agreement that obligated the company to supply $37 million worth of oil to a major refiner over the next five years. InsideOut placed the throughput agreement into a special purpose entity (SPE) to fund the construction of an oil pipeline. Roberts estimates the present value of this contract to be $25 million at the end of 2005, based on a discount rate of 18 percent. After making the appropriate adjustments, the adjusted debt-to-equity and EBIT-to-interest expense ratios are closest to:

Adjusted debt-to-equity EBIT-to-interest expenseA. 1.10 2.00B. 0.88 2.00C. 1.10 2.39D. 0.88 2.39

7. Richards, Inc. decides to raise cash by “selling” its accounts receivable of $2,500,000 to a special purpose entity (SPE) for $2,250,000. At the time of the sale, Richards records a reduction in accounts receivable of $2,500,000, an increase in cash of $2,250,000, and a loss on the sale of receivables of $250,000 that reduces net income. An analyst discovers that the SPE has recourse to Richards for any receivables it fails to collect. After making the appropriate adjustments, liabilities and cash flow from operations will:

Liabilities Cash flow from operationsA. Increase by $2,500,000 Not changeB. Increase by $2,500,000 Decrease by $2,250,000C. Increase by $2,250,000 Not changeD. Increase by $2,250,000 Decrease by $2,250,000

8. Denver Company and a third-party partner each invest $100,000 in Denver’s finance subsidiary, Receivable Finance, Inc. (RFI). Denver obtains 50 percent ownership of RFI. RFI borrows $20,000,000, and Denver then sells $20,000,000 in receivables to RFI. RFI reports $20,200,000 in assets (the initial cash investment of $200,000 plus the receivables it “bought” from Denver) and $20,000,000 in liabilities (the debt RFI owes to its bank) on its balance sheet. Denver Company reports its net investment in RFI of ($20,200,000 – $20,000,000) × 50% = $100,000 on its balance sheet. Denver Company’s balance sheet shows $20,000,000 in cash, no receivables, and no debt. After making the appropriate adjustments, assets and liabilities will both increase by:A. $10.0 million.B. $10.1 million.C. $20.0 million.D. $20.2 million.



ANSWERS – CONCEPT CHECKERS: RISK MANAGEMENT, DERIVATIVES, AND SPECIAL PURPOSE ENTITIES

1. B SPEs are used to securitize mortgages, collateralize take-or-pay contracts and throughput arrangements, and create synthetic leases. They are not typically used to collateralize tax-loss carryforwards.

2. B Interest expense (not interest income) should be increased by the present value of the expected payments to be made under the take-or-pay contract times the implicit interest rate on the contract.

3. C The proper adjustment is to increase long-term debt and long-term assets. Net income will not change. Debt-to-equity will increase, and return on assets will decrease.

4. A Cash flow from operations (CFO) should be adjusted by classifying the sale of the receivables as cash flow from financing (CFF) instead of CFO, which decreases CFO and increases CFF.

5. B A loan payable is created, so accounts payable does not need to be adjusted.

6. C The present value of the take-or-pay contract should be added to total debt, so the adjusted debt-to-equity ratio is:

The implied interest expense ($25)(0.18) = $4.5. The adjusted EBIT-to-interest expense ratio is:

7. D Because the recourse arrangement makes this a financing transaction, not a true sale of the receivables, the analyst needs to adjust the financial statements accordingly. This is done by adding the full amount of $2,500,000 back to accounts receivable, creating a liability called “loan payable net of discount” for the reduced amount of $2,250,000 and eliminating the “loss on sale of receivables” of $250,000.

After making these adjustments, the analyst can perform the appropriate ratio and cash flow analyses. The result will be that Richards’ assets will increase $2,500,000, its liabilities will increase $2,250,000, and net income and equity will be $250,000 higher because of the elimination of the loss. In addition, a $2,250,000 decrease in CFO and increase in CFF will occur.

8. A The analyst should include Denver’s share of RFI’s assets and liabilities in Denver’s balance sheet. To do this, the analyst removes the $100,000 net investment in RFI and adds 50% of RFI’s cash ($200,000 × 50% = $100,000), 50% of RFI’s receivables ($20,000,000 × 50% = $10,000,000), and 50% of RFI’s debt ($20,000,000 × 50% = $10,000,000) to Denver’s balance sheet. As a consequence, Denver’s assets and liabilities will each be increased $10,000,000.

+ =$85 $251.10

$100

+ =+

$23 $4.52.39

$7 $4.5



ANALYSIS OF MULTINATIONAL OPERATIONS

Study Session 6

EXAM FOCUS

This topic review is a detailed illustration related toaccounting for the operating results of foreignsubsidiaries and operations. The issue addressed ishow to reflect the results of foreign operating units inthe consolidated financial statements of themultinational parent. You have several significanttasks to master. First, you need to become familiarwith the terminology of translation. Second, you needto be able to distinguish between and implement the

two methods of accounting for foreign operations(i.e., remeasurement via the temporal method ortranslation via the all-current method). Third, youneed to be able to analyze the impact of these twomethods on reported earnings, cash flows, andfinancial ratios for both the subsidiary and the parent.This reading is important and challenging. Begin byconcentrating on the examples of each method, andthen move on to the analysis section.

FOREIGN CURRENCY FLOW AND HOLDING EFFECTS

LOS 1.a: Determine the impact of changes in local currency sales and changes in exchange rates on the translated sales of the subsidiary and parent company.

Exchange rates can impact the reporting firm’s financial statements in two ways: (1) flow effects and (2) holding gain/loss effects. Flow effects are the impact of changes in the exchange rate on income statement items such as revenue. Holding gain/loss effects are the impact of changes in the exchange rate on assets and liabilities on the balance sheet, such as cash balances. The best way to illustrate these effects is with an example.

Example: The flow effect

A U.S. firm owns a subsidiary located in a foreign country with a local currency LC. In 2004 the subsidiary generated revenue of LC1,000. In 2005, revenue increased by 20 percent to LC1,200. The average exchange rates in 2004 and 2005 were, respectively, LC1 = $1.00 and LC1 = $1.50. Calculate the translated revenue of the subsidiary in U.S. dollars in 2004 and 2005, the total for both years, and the change from 2004 to 2005 in absolute and percentage terms. Determine which portion of the dollar increase in revenue is attributable to the flow effect (the effect of the change in the exchange rate) and which portion is due to the 20 percent revenue growth of the subsidiary.

Answer:

Figure 1: Illustration of the Flow Effect

2004 2005 Total Change in LC or $ (%)

Exchange rate LC1 = $1.00 LC1 = $1.50

Revenues (LC) LC1,000 LC1,200 LC2,200 LC200 (20%)

Revenues ($) $1,000 $1,800 $2,800 $800 (80%)



The $800 increase in revenue is attributable to two components:

• The $200 (LC200 × $1.00/LC) increase in local currency revenue. In other words, revenue from the subsidiary would have increased by $200 if the exchange rate had not changed.

• The flow effect of $600 (LC1,200 × $0.5 change in the exchange rate).

Example: The holding effect

Let’s continue with the previous example and assume that the subsidiary keeps all of the revenue on its balance sheet as cash. Calculate the cash balance in dollars on the consolidated balance sheet at the end of 2004 and 2005. Determine the holding gain/loss effect on the cash balance resulting from the change in the exchange rate.

Answer:

There are two ways to calculate the holding gain/loss effect:

• Total revenue in dollars was $2,800 (from Figure 1), but the cumulative cash balance at the end of 2005 was $3,300, so the holding effect was a gain of $500 ($3,300 – $2,800).

• The LC1,000 in cash on the balance sheet at the end of 2004 increased in value by $500 (LC1,000 × ($1.50/LC – $1.00/LC)) at the end of 2005.

Let’s summarize the analysis. If the exchange rate had remained constant at LC1 = $1.00, the parent would have reported cash on the consolidated balance sheet from the subsidiary at the end of 2005 of $2,200 (LC2,200 × $1.00/LC); the actual amount was $3,300. This $1,100 ($3,300 – $2,200) currency gain is attributable to a:

• Flow effect of $600.• Holding gain effect of $500.

CURRENCY DEFINITIONS

LOS 1.b: Distinguish among local currency, functional currency, and the reporting currency.

• The local currency is the currency of the country in which the foreign subsidiary is located.• The functional currency is defined as the currency of the primary economic environment in which the

foreign subsidiary generates and expends cash. The choice reflects management’s judgment. It can be the currency in which the subsidiary conducts operations or some other currency.

• The reporting currency is the currency in which the multinational firm prepares its final, consolidated financial statements.

The following definitions are also necessary to understand accounting for multinational operations and will be used in subsequent sections.

• The current rate is the exchange rate as of the balance sheet date.

Figure 2: Illustration of the Holding Effect

2004 2005

Exchange rate LC1 = $1.00 LC1 = $1.50

Cash (LC) LC1,000 LC2,200

Cash ($) $1,000 $3,300



• The average rate is the average exchange rate over the reporting period.• The historical rate is the rate that existed when a particular transaction was conducted. For example, if you

bought a widget machine on January 2, 2005, the historical rate for that transaction at every balance sheet date in the future would be the exchange rate on January 2, 2005.

• Remeasurement is the translation of local currency transactions into the functional currency.• Translation is the conversion of the functional currency of a subsidiary into the reporting currency.

Professor’s Note: The term “translation” is used in two different ways in this review. First, translation refers to a specific method of converting account and transaction balances to another currency. Second, translation is used to describe the general process of converting account and transaction balances from one currency to another, without identifying a specific methodology. Thus, both the remeasurement methodology and the translation methodology result in the “translation,” or the conversion of account and transaction balances to another currency. The ensuing discussion should make this distinction clear.

ALL-CURRENT VS. TEMPORAL METHOD

LOS 1.c: Distinguish between the all-current (translation) method and the temporal (remeasurement) method, explain the effects of each on the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios.

SFAS 52, Foreign Currency Translation, prescribes how financial statements of foreign operations are translated. SFAS 52 uses the provisions of both the temporal method and the current rate method, depending on the definition of the functional currency. Note that remeasurement is the process of converting the local currency into the functional currency using the temporal method, with gains and losses flowing to the income statement. The all-current method, or translation, is the process of converting the functional currency into the reporting currency, with gains and losses flowing to the balance sheet as an adjustment to equity.

Temporal Method

The temporal method was the underlying translation method of SFAS 8 under U.S. GAAP. Note that although SFAS 52 has replaced SFAS 8, we still need to know about the temporal method because most of its components are still employed under the new standard. The intent of SFAS 52 is to provide financial information that is reasonably compatible with changes in cash flow and equity due to exchange rate effects and to ensure that information is consolidated on the parent’s financial reports in conformity with U.S. GAAP.

The provisions of the temporal method state that:

• Cash, accounts receivable, accounts payable, short-term debt, and long-term debt (defined as monetary assets and liabilities) are translated using the current rate.

• All other assets and liabilities (nonmonetary assets and liabilities) are translated at the historical rate. Hence, a major drawback of the temporal method is that you need to keep track of many different historical exchange rates—one for the building that you purchased two years ago and another for the inventory you purchased last week. On the exam, the only two nonmonetary items you’re likely to encounter are inventory and fixed assets. The CFA curriculum does not provide any examples of nonmonetary liabilities.

• Revenues and expenses are translated at the average rate.• Purchases of inventory and fixed assets are remeasured at the historical rate as of the date of purchase.

Therefore, remeasurement of cost of goods sold (COGS) and depreciation is based on historical rates prevailing at the time of purchase.

• The translation gain or loss is shown on the income statement. This was seen as another major drawback to the temporal method under SFAS 8 because exchange rate volatility was reflected in the net income of the firm. This forced managers to decide between hedging the economic effects and the accounting effects of foreign exchange volatility.



Translating Inventory and COGS Under the Temporal Method

Before moving on we will go through an illustration of the calculations of COGS and ending inventory balances to help make more transparent the compound effects related to changing foreign exchange rates and inventory accounting methods on COGS and inventory.

Figure 3 contains information related to the purchases and sales of a foreign subsidiary of a U.S. corporation. For simplicity we assume that each unit purchased costs 1 Local Currency (LC) unit. Units purchased equals 150 for both 2004 and 2005. Units sold equals 160 for both 2004 and 2005. At the beginning of 2004, the rate is LC = $1.00. Inventory was acquired at LC1.10 = $1.00 and LC0.95 = $1.00 in 2004 and 2005, respectively.

The calculations for COGS and ending inventory balances in LC are straightforward using the inventory accounting relationship:

Under FIFO, we assume that the units in inventory at the beginning of the year are sold off during the year and that the ending balance consists of units purchased during the year. Under FIFO these units are valued at the exchange rate at which the purchases were made. Under LIFO, the units sold during the year are the ones purchased during the year, and the ending inventory balance is valued at the historical rate.

These calculations and their interpretations are complicated when the values are translated into U.S. dollars because of a depreciating LC in 2004, an appreciating LC in 2005, and the choice between FIFO and LIFO inventory accounting methodologies.

Figure 3: FIFO/LIFO and Exchange Rate Effects

FIFO LIFO

2004 LC Rate $ Rate $

Beginning balance 100 1.00 100 1.00 100

Purchases 150 1.10 136 1.10 136

Units sold 160

Ending balance 90 1.10 82 1.00 90

COGS 160 154 146

FIFO LIFO

2005 LC Rate $ Rate $

Beginning balance 90 1.10 82 1.00 90

Purchases 150 0.95 158 0.95 158

Units sold 160

Ending balance 80 0.95 84 1.00 80

COGS 160 156 168

COGS beginning inventory purchases ending inventory= + −



In 2004 FIFO COGS and ending inventory in U.S. dollars are:

In 2005 FIFO COGS and ending inventory are:

In 2004 LIFO COGS and ending inventory in U.S. dollars are:

In 2005 LIFO COGS and ending inventory are:

Figure 4 provides some general intuition on the compound effects of changing exchange rates and the choice of FIFO versus LIFO accounting methods on the translated COGS and ending inventory measures.

Figure 4: Translated COGS and Ending Inventory under FIFO and LIFO

FIFO LIFO

Depreciating local currency (2004) Higher COGS Lower COGS

Lower ending inventory Higher ending inventory

Appreciating local currency (2005) Lower COGS Higher COGS

Higher ending inventory Lower ending inventory

( )

$

2004

2004

90ending balance $82 rounded

1.10

COGS beginning inventory purchases ending inventory

100 136 82 154

= =

= + −

= + − =

( )2005

2005

80ending balance $84 rounded

0.95


82 158 84 $156

= =

= + −

= + − =

2004

2004

90ending balance $90

1.00


100 136 90 $146

= =

= + −

= + − =

2005

2005

80ending balance $80

1.00


90 158 80 $168

= =

= + −

= + − =



All-Current Method

The all-current method is much easier to apply than the temporal method because:

• All income statement accounts are translated at the average rate.• All balance sheet accounts are translated at the current rate except for common stock, which is translated at the

appropriate historical rate that applied when the equity was issued.• Dividends are translated at the rate that applied when they were paid.• The cumulative translation adjustment is included on the balance sheet as part of equity.

Choice of Appropriate Method

Now we can turn our attention to the issue of which translation method is appropriate to use for a given set of circumstances. The first step in determining which method should be used is to identify the functional currency. The choice of functional currency is based on management judgment and may not be completely objective. This choice determines whether the temporal method or the current rate method will be used.

The following rules govern the determination of the functional currency:

1. The results of operations, financial position, and cash flows of all foreign operations must be measured in the designated functional currency.

2. Treatment of subsidiaries:

• Self-contained, independent subsidiaries whose operating, investing, and financing activities are primarily located in the local market will use the local currency as the functional currency.

• Subsidiaries whose operations are well integrated with the parent (i.e., the parent makes the operating, financing, and investing decisions) will use the parent’s currency as the functional currency.

• Subsidiaries that operate in highly inflationary environments will use the parent’s currency as the functional currency. A high inflation environment is defined as cumulative inflation that exceeds 100 percent over a three-year period.

3. If the functional currency is the local currency, use the all-current method. The use of the all-current method under SFAS 52 is called translation. (See Column 1 of Figure 5.)

4. If the functional currency is the parent’s currency or some other currency, use the temporal method. The use of the temporal method under SFAS 52 is called remeasurement. (See Column 2 of Figure 5.)

5. Finally, a third currency may serve as the functional currency when a subsidiary is operating relatively independently in a market where the local currency, prices, and some costs are controlled or restricted. For example, if a subsidiary of the U.S. parent is operating in China, the Hong Kong dollar might be the functional currency. (See Column 3 of Figure 5.)

Figure 5 illustrates the three ways a local currency may be remeasured and/or translated into the reporting currency for the parent. Note the choice of the functional currency determines the methods used for conversion.



Figure 5: Three Methods for Remeasurement/Translation of Local Currencies

Example: Determining the appropriate method under SFAS 52, part 1

A U.S. multinational firm has a Japanese subsidiary. It has been determined that the Japanese yen (¥) is the functional currency. Determine which foreign currency translation method is appropriate.

Answer:

In this case, remeasurement is not needed, since the financial data is already expressed in the functional currency. Use the all-current method to translate the subsidiary’s data to U.S. dollars.

Example: Determining the appropriate method under SFAS 52, part 2

A U.S. multinational firm has a Swiss subsidiary. It has been determined that the euro (€) is the functional currency. Determine which foreign currency translation method is appropriate.

Answer:

Here we must first remeasure the Swiss firm’s financial data from Swiss francs to euros using the temporal method. Then we translate the functional currency results from euros to U.S. dollars using the all-current method.



TRANSLATION GAINS/LOSSES CALCULATION

LOS 1.d: Calculate the translation effects, and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s currency, using the all-current (translation) method and the temporal (remeasurement) method, determine how the translation of a subsidiary’s financial statements will affect the subsidiary’s financial ratios, and determine how using the temporal (remeasurement) method versus the all-current (translation) method will affect the parent company’s financial ratios.

The middle column of Figure 6 summarizes the exchange rate used to translate the results of foreign subsidiaries under the temporal method. The last column of Figure 6 summarizes the exchange rate used to translate the results of foreign subsidiaries under the all-current method.

Calculating the Translation Gain or Loss

Translation gains or losses result from gains or losses related to balance sheet accounts that are translated at the current rate (i.e., they are exposed to changes in exchange rates). We can use this insight to calculate the translation gain or loss under either the all-current or the temporal method by first calculating the net exposure under each method (the net assets exposed to changes in the exchange rate), and then calculating the flow effect and the holding gain/loss effect associated with that exposure.

Under the all-current method all assets and liabilities are translated at the current rate, so the net exposure is assets minus liabilities, or total shareholders’ equity:

exposure under the all-current method = shareholders’ equity

Under the temporal method only cash, accounts receivable, accounts payable, current debt, and long-term debt are translated at the current rate (remember that inventory and fixed assets are translated at the historical rate):

exposure under the temporal method = (cash + accounts receivable) – (accounts payable + current debt + long-term debt)

Figure 6: Exchange Rate Usage under the Temporal and All-Current Methods

Rate used to translate account using the…

Account Temporal method All-current method

Monetary assets and liabilities current rate current rate

Nonmonetary assets/liabilities historical rate current rate

Common stock and dividends historical rate historical rate

Equity (taken as a whole) mixed* current rate

Revenues and SG&A average rate average rate

Cost of good sold historical rate average rate

Depreciation historical rate average rate

Net income mixed* average rate

* Net income is translated a “mixed rate” (i.e., a mix of the average rate and the historical rate) under the temporal method because (1) the FX translation gain or loss is shown on the income statement, (2) revenues and SG&A are remeasured at the average rate, while (3) COGS and depreciation are remeasured at the historical rate. Equity is “mixed” because the change in retained earnings (which includes net income) is posted to the equity accounts.



The flow effect measured in $ under both methods is equal to the change in exposure (ending exposure less beginning exposure) times the difference between the ending rate and the average rate (in $ per unit of local currency):

flow effect (in $) = change in exposure (in LC) × (ending rate – average rate)

The holding gain/loss effect measured in $ is the beginning exposure times the difference between the exchange rate at the end of the year and the exchange rate at the beginning of the year (measured in $ per unit of local currency):

holding gain/loss effect (in $) = beginning exposure (in LC) × (ending rate – beginning rate)

The total translation gain or loss measured in $ is the sum of the two effects:

translation gain/loss (in $) = flow effect + holding gain/loss effect

Under the all-current method the translation gains/losses are accumulated on the balance sheet in the equity section as part of comprehensive income in an account called the cumulative translation adjustment (CTA). Remember that this is a cumulative account—each year the translation gain for that year (or loss) is added to (or subtracted from) the CTA. For example, if the CTA at the beginning of the year is $100 and the translation loss for the year is $35, the CTA at the end of the year will equal $65.

Under the temporal method the translation gain/loss appears on the income statement.

Example: The all-current method

FlexCo International is a U.S. company with a subsidiary named Vibrant Inc. located in the country of Martonia. Vibrant was acquired by FlexCo on 12/31/2004. FlexCo reports its financial results in U.S. dollars. The currency of Martonia is the loca (LC). Vibrant’s financial statements for 2005 are shown in Figures 7 and 8.



The following exchange rates between the U.S. dollar and the loca were observed:

• December 31, 2004: LC2.00 = $1.00; $0.50 = LC1.00• December 31, 2005: LC2.20 = $1.00; $0.4545 = LC1.00• Average for 2005: LC2.10 = $1.00; $0.4762 = LC1.00• Historical rate for fixed assets, inventory, and equity: LC2.00 = $1.00; $0.50 = LC1.00

Figure 7: Vibrant December 31, 2004 and 2005 Balance Sheet

2004 2005

Cash LC100 LC100

Accounts receivable 500 650

Inventory 1,000 1,200

Current Assets LC1,600 LC1,950

Fixed assets 800 1,600

Accumulated depreciation (100) (700)

Net fixed assets LC700 LC900

Total assets LC2,300 LC2,850

Accounts payable 400 500

Current debt 100 200

Long-term debt 1,300 950

Total liabilities LC1,800 LC1,650

Common stock 400 400

Retained earnings 100 800

Total equity LC500 LC1,200

Total liabilities and shareholders’ equity LC2,300 LC2,850

Figure 8: Vibrant 2005 Income Statement

2005

Revenue LC5,000

Cost of goods sold (3,300)

Gross margin 1,700

Other expenses (400)

Depreciation expense (600)

Net income LC700



The majority of Vibrant’s operational, financial, and investment decisions are made at Vibrant headquarters in Martonia, although Vibrant does rely on FlexCo for information technology expertise.

Use the appropriate method to translate Vibrant’s 2005 balance sheet and income statement into U.S. dollars.

Answer:

Vibrant is relatively self-contained, which means the loca is the functional currency and the appropriate method is the all-current method. The all-current method uses the current rate for all balance sheet accounts (except common stock, which is translated at the historical rate) and the average rate for all income statement accounts. The translation gain or loss appears in the CTA in the equity section as part of comprehensive income.

Let’s first calculate the translation gain/loss for 2005.

ending exposure = LC1,200

beginning exposure = LC500

change in exposure = LC1,200 – LC500 = LC700 (which is equal to net income for 2005 in this example because the company doesn’t pay dividends)

flow effect = LC700 × (0.4545 – 0.4762) = –$15.2

holding loss effect = LC500 × (0.4545 – 0.50) = –$22.7

translation loss for 2005 = –$15.2 – $22.7 = –$37.9

The cumulative translation adjustment for 2005 equals the beginning balance of zero plus the translation loss for the year: $0 + –$37.9 = –$37.9. Because Vibrant was acquired at the end of 2004, the CTA attributable to Vibrant was zero on that date.

Vibrant’s translated 2005 income statement is shown in Figure 9. Notice that we translate the income statement first with the all-current method to derive net income, which we then use to calculate retained earnings on the balance sheet.

Beginning (2004) retained earnings in U.S. dollars was LC100 × $0.50 = $50, so ending (2005) retained earnings are $50 + $333.3 = $383.3.

Figure 9: Vibrant’s 2005 Translated Income Statement Under the All-Current Method

2005 (LC) Rate 2005 ($)

Revenue LC5,000 $0.4762 $2,381.0

Cost of goods sold (3,300) $0.4762 (1,571.5)

Gross margin 1,700 809.5

Other expenses (400) $0.4762 (190.5)

Depreciation expense (600) $0.4762 (285.7)

Net income LC700 $333.3



Vibrant’s 2005 translated balance sheet is shown in Figure 10.

Now let’s move on to the more difficult method: the temporal method. First we’ll take a little detour to explain how inventory, cost of goods sold, fixed assets, and depreciation are actually calculated using the temporal method.

WARM-UP: CALCULATING INVENTORY, COST OF GOODS SOLD, FIXED ASSETS, AND DEPRECIATION UNDER THE TEMPORAL METHOD

Professor’s Note: Although technically these calculations are part of the LOS, I think it’s unlikely you’ll have to do them on the exam. I recommend that you know how to calculate the translation gain/loss under the temporal method, and be able to remeasure all of the other balance sheet and income statement accounts besides inventory, COGS, fixed assets, and depreciation. Remember, however, that these accounts are translated at historical rates.

The exchange rates we use to remeasure inventory under the temporal method depend on whether the FIFO or LIFO inventory cost method is used. We’ll assume Vibrant and FlexCo use the FIFO method, which is much more common than LIFO outside of the U.S. The beginning inventory balance is remeasured at the historical rate of $0.50, while purchases and ending inventory are remeasured at the average rate during 2005 of $0.4762.

Figure 10: Vibrant 2005 Translated Balance Sheet Under the All-Current Method

2005 (LC) Rate 2005 ($)

Cash LC100 $0.4545 $45.5

Accounts receivable 650 $0.4545 295.5

Inventory 1,200 $0.4545 545.4

Current Assets LC1,950 $886.4

Fixed assets 1,600 $0.4545 727.3

Accumulated depreciation (700) $0.4545 (318.2)

Net fixed assets LC900 $409.1

Total Assets LC2,850 $1,295.5

Accounts payable 500 $0.4545 227.3

Current debt 200 $0.4545 91.0

Long-term debt 950 $0.4545 431.8

Total liabilities LC1,650 $750.1

Common stock 400 $0.50 200.0

Retained earnings 800 Calculated 383.3

Cumulative translation adjustment Calculated (37.9)

Total equity LC1,200 $545.4

Total liabilities and shareholders’ equity LC2,850 $1,295.5



Let’s start by calculating cost of goods (COGS) in dollars. We know that beginning inventory is LC1,000, ending inventory is LC1,200, and COGS is LC3,300. Therefore, purchases must be 3,300 + 1,200 – 1,000 = LC3,500.

Remeasured inventory on the balance sheet in 2005 is $571.4, and remeasured COGS on the income statement is equal to $1,595.3.

The second step is to derive net fixed assets and depreciation. Fixed asset investment (i.e., purchases of fixed assets during the year) is remeasured at the average rate, and beginning gross fixed assets are remeasured at the historical rate. The tricky part here is that depreciation on the income statement is remeasured at a “blended rate.” We’ll show you how it is calculated, but you’ll probably be given the blended rate in the unlikely event that you’re asked to remeasure depreciation under the temporal method on the exam.

In the FlexCo example, the blended rate is calculated as follows:

Fixed asset investment for 2005 is equal to the difference between ending and beginning fixed assets: 1,600 – 800 = 800. Fixed assets for 2005 in dollars are calculated in Figure 12.

Figure 11: Deriving Vibrant’s 2005 COGS in U.S. Dollars Using the Temporal Method

LC Rate $

Beginning inventory LC1,000 $0.50 $500.0

+ Purchases 3,500 $0.4762 1,666.7

– Ending inventory (1,200) $0.4762 (571.4)

2005 COGS LC3,300 $1,595.3

Figure 12: Deriving Vibrant’s 2005 Fixed Assets in U.S. Dollars

LC Rate $

Beginning fixed assets LC800 $0.5000 $400.0

+ Fixed asset investment 800 $0.4762 381.0

Ending fixed assets LC1,600 $781.0

beginning fixed assets fixed asset investmentblended rate historical rate average rate

ending fixed assets ending fixed assets

⎛ ⎞ ⎛ ⎞= × + ×⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

( )

( )

800 800blended rate in LC per $ 2.00 2.10 2.05

1,600 1,600

1blended rate in $ per LC 0.4878

2.05

⎛ ⎞ ⎛ ⎞= × + × =⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠

= =



Accumulated depreciation for 2005 in dollars is calculated in Figure 13.

Net fixed assets on the remeasured balance sheet for 2005 is $781 – $342.7 = $438.3. Remeasured depreciation on the 2005 income statement is $292.7.

Now we’re ready to apply the temporal method to the FlexCo example.

Example: The temporal method

Suppose instead that the majority of Vibrant’s operational, financial, and investment decisions are made by corporate headquarters in the United States. All other information is the same.

Use the appropriate method to translate Vibrant’s 2005 balance sheet and income statement into U.S. dollars, given the following information for 2005:

• COGS = $1,595.3• Inventory = $571.4• Fixed assets = $781.0• Accumulated depreciation = $342.7• Depreciation expense = $292.7

Answer:

Now the U.S. dollar is the functional currency (because the subsidiary is well-integrated with the parent), and the temporal method applies.

Let’s first calculate the translation gain/loss for 2005. Remember that with the temporal method the exposure is equal to (cash + receivables) – (payables + current and long-term debt).

ending exposure = (100 + 650) – (500 + 200 + 950) = 750 – 1,650 = –LC900

beginning exposure = (100 + 500) – (400 + 100 + 1,300) = 600 – 1,800 = –LC1,200

change in exposure = –LC900 – (–LC1,200) = LC300

flow effect = LC300 × (0.4545 – 0.4762) = –$6.5

holding gain effect = –LC1,200 × (0.4545 – 0.50) = $54.6

translation gain for 2005 = –$6.5 + $54.6 = $48.1

Figure 13: Deriving Vibrant’s 2005 Depreciation in U.S. Dollars

LC Rate $

Beginning accumulated depreciation LC100 $0.5000 $50.0

+ 2005 depreciation 600 $0.4878 292.7

Ending accumulated depreciation LC700 $342.7



Once again we’ll start with the income statement. Remember that the translation gain appears on the income statement under the temporal method. Vibrant’s remeasured income statement using the temporal method is shown in Figure 14.

Beginning retained earnings in dollars was LC100 × $0.50 = $50, so ending retained earnings is $50 + $350.6 = $400.6.

Figure 14: Vibrant’s 2005 Remeasured Income Statement Under the Temporal Method

2005 (LC) Rate 2005 ($)

Revenue LC5,000 $0.4762 $2,381.0

Cost of goods sold (3,300) Given (1,595.3)


Other expenses (400) $0.4762 (190.5)

Depreciation expense (600) Given (292.7)

Net income before translation gain 700 302.5

Translation gain Given 48.1




Vibrant’s 2005 translated balance sheet is shown in Figure 15.

Why Do the Two Methods Report Significantly Different Results?

You should notice immediately that the two different methods report very different results, particularly related to the size and sign of the translation gain/loss, net income, and total assets. These comparisons for the FlexCo example are shown in Figure 16.

Figure 15: Vibrant 2005 Remeasured Balance Sheet Under the Temporal Method

2005 (LC) Rate 2005 ($)

Cash LC100 $0.4545 $45.5

Accounts receivable 650 $0.4545 295.5

Inventory 1,200 Given 571.4

Current assets LC1,950 $912.4

Fixed assets 1,600 Given 781.0

Accumulated depreciation (700) Given (342.7)


Total assets LC2,850 $1,350.7

Accounts payable 500 $0.4545 227.3

Current debt 200 $0.4545 91.0

Long-term debt 950 $0.4545 431.8


Common stock 400 $0.50 200.0

Retained earnings 800 Calculated 400.6

Total equity LC1,200 600.6


Figure 16: The FlexCo Example: All-Current Versus Temporal Method

All-Current Temporal

Net income before translation gain/loss $333.3 $302.5

Translation gain/loss –$37.9 $48.1

(on the balance sheet) (on the income statement)

Net income $333.3 $350.6

Total assets $1,295.5 $1,350.7



Notice that:

• Net income before translation gain/loss is different between the two methods. This is because COGS and depreciation are different.

• The translation gain/loss is different between the two methods; it’s not even the same sign. The all-current method reports a translation loss, while the temporal method reports a translation gain. This is NOT an unusual occurrence.

• Net income is different between the two methods.• Total assets are different between the two methods because inventory and net fixed assets are different.

The reason the two methods report such different results is because of the differing treatment of specific exchange rate asset and liability gain/losses, as shown in Figures 17 and 18.

There are three key differences:

• Exchange rate gains/losses appear on the balance sheet with the all-current method and the income statement with the temporal method, and the size and sign of the gain or loss are usually different.

• Realized exchange rate gains and losses on inventory and fixed assets are included in COGS and depreciation expense under the temporal method.

• Unrealized exchange rate gains and losses on inventory and fixed assets are ignored under the temporal method—they are not recorded on the income statement or the balance sheet.

Professor’s Note: What does all this mean for the Level 2 CFA candidate? It means that the choice of method matters for reported financial results, and because management makes the decision on the functional currency and ultimately the accounting treatment of consolidated foreign subsidiaries, management can choose the method that reports the best financial results on the consolidated statements. Therefore the analyst needs to understand how the choice of translation method affects financial ratios.

Figure 17: Treatment of Exchange Rate Gains and Losses Under the All-Current Method

Realized Gains/Losses

Unrealized Gains/Losses

Monetary assets and liabilities CTA on the balance sheet

CTA on thebalance sheet

Nonmonetary assets (inventory and fixed assets) CTA on the balance sheet

CTA on the balance sheet

Figure 18: Treatment of Exchange Rate Gains and Losses Under the Temporal Method

Realized Gains/Losses

Unrealized Gains/Losses

Monetary assets and liabilities Translation gain/loss on the income

statement

Translation gain/loss on the income

statement

Nonmonetary assets (inventory and fixed assets) Included in COGS and depreciation expense on the

income statement

Ignored



COMPARING SUBSIDIARY RESULTS TO TRANSLATED RESULTS UNDER THE ALL-CURRENT METHOD

Next you are asked to compare:

• The subsidiary’s financial statements and ratios before translation. • The subsidiary’s translated financial statements and ratios using the all-current method.

For example, Figure 19 is a side-by-side comparison from the FlexCo/Vibrant example of Vibrant’s original 2005 balance sheet and income statement and Vibrant’s translated statements.

Figure 19: Vibrant LC and Translated Balance Sheet and Income Statement

2005 (LC) 2005 ($) All Current Method

Cash LC100 $45.5

Accounts receivable 650 295.5

Inventory 1,200 545.4

Current assets LC1,950 $886.4

Fixed assets 1,600 727.3

Accumulated depreciation (700) (318.2)


Total assets LC2,850 $1,295.5

Accounts payable 500 227.3

Current debt 200 91.0

Long-term debt 950 431.8


Common stock 400 200.0

Retained earnings 800 383.3

Cumulative translation adjustment (37.9)

Total equity LC1,200 $545.4


Revenue LC5,000 $2,381.0

Cost of goods sold (3,300) (1,571.5)


Other expenses (400) (190.5)

Depreciation expense (600) (285.7)




Professor’s Note: This LOS requires a detailed understanding of the all-current method. Fortunately there are a few general rules (i.e., shortcuts) that may buy you some time on the exam, especially if you are only required to identify whether or not a change occurs and the direction of the change if there is one.

Pure Balance Sheet and Pure Income Statement Ratios

All pure income statement and pure balance sheet ratios are unaffected by the application of the all-current method. In other words, the local currency trends and relationships are “preserved.” What we mean by “pure” is that the components of the ratio all come from the balance sheet, or the components all come from the income statement.

For example, the current ratio (current assets over current liabilities) is a pure balance sheet ratio because both numerator and denominator are on the balance sheet and translated at the current rate. If you multiply both numerator and denominator by the same exchange rate, the rate cancels, and you’re left with the same ratio. All profit margin measures are pure income statement ratios because both the numerator (some measure of profit such as gross profit) and the denominator (sales) come from the income statement and are translated at the average rate.

Figure 20 shows a sample of typical pure balance sheet and pure income statement ratios and the actual ratio values for the FlexCo/Vibrant example. Notice that the all-current method preserves the original LC ratio in each case.

Professor’s Note: Interest coverage (EBIT divided by interest expense) is another example of a pure income statement ratio.

Mixed Balance Sheet/Income Statement Ratios

The all-current method results in small changes in mixed ratios that combine income statement and balance sheet items because the numerator and the denominator are almost always translated at different exchange rates. Don’t expect the ratio to remain the same, but don’t expect large changes either. The direction of the change will depend on the relationship between the exchange rate used to translate the denominator and the exchange rate used to translate the numerator.

Figure 21 shows a sample of typical mixed balance sheet/income statement ratios and the actual ratio values for the FlexCo/Vibrant example. Recall that the exchange rate went from $0.50 = LC1.00 in 2004 to $0.4545 =

Figure 20: FlexCo/Vibrant Pure Balance Sheet and Pure Income Statement Ratios

Ratio 2005 (LC) 2005 ($) All Current Method

Pure Balance Sheet Ratios


Quick ratio 1.07 1.07

LTD-to-total capital 0.44 0.44

Pure Income Statement Ratios

Gross profit margin 34.0% 34.0%

Net profit margin 14.0% 14.0%



LC1.00 in 2005, which means the local currency (LC) was depreciating. The average rate in 2005 was $0.4762 = LC1.00.

Notice that in each case the translated ratio is larger than the original ratio. This will always be the case when the LC is depreciating because the average rate is greater than the ending rate. Because the numerator of each of the ratios is on the income statement and is translated at the (higher) average rate, and because the denominator in each is on the balance sheet and is translated at the (lower) ending rate, each translated ratio is larger than the original ratio. When the LC is appreciating, each of these ratios will decrease.

Professor’s Notes: In the Level 2 curriculum we don’t run across many mixed ratios with a balance sheet item in the numerator and an income statement item in the denominator. One example is average receivables collection period. Just remember that if accounts receivable turnover increases, average collection period will decrease. The same is true for average inventory processing period.

On the exam remember these key points regarding the original versus the translated financial statements and ratios.

• Pure balance sheet and pure income statement ratios will be the same.• If the LC is depreciating, translated mixed ratios (with an income statement item in the numerator and a

balance sheet item in the denominator) will be larger than the original ratio. • If the LC is appreciating, translated mixed ratios (with an income statement item in the numerator and a

balance sheet item in the denominator) will be smaller than the original ratio.

COMPARING RESULTS USING THE TEMPORAL AND ALL-CURRENT METHODS

Next you are asked to compare:

• The remeasured financial statements and ratios using the temporal method. • The translated financial statements and ratios using the all-current method.

For example, Figure 22 is a side-by-side comparison from the FlexCo/Vibrant example of Vibrant’s 2005 remeasured financial statements (using the temporal method) and translated financial statements (using the all-current method).

Figure 21: FlexCo/Vibrant Mixed Balance Sheet/Income Statement Ratios (Depreciating LC)

Ratio 2005(LC) 2005 ($) All Current Method

Return on assets 24.6% 25.7%

Return on equity 58.3% 61.0%

Total asset turnover 1.75 1.84


Accounts receivable turnover 7.69 8.06



Figure 22: Vibrant LC and Remeasured Balance Sheet and Income Statement

2005 ($)Temporal Method

2005 ($) All Current Method

Cash $45.5 $45.5

Accounts receivable 295.5 295.5

Inventory 571.4 545.4

Current assets $912.4 $886.4

Fixed assets 781.0 727.3

Accumulated depreciation (342.7) (318.2)

Net fixed assets 438.3 409.1

Total assets $1,350.7 $1,295.5

Accounts payable 227.3 227.3

Current debt 91.0 91.0

Long-term debt 431.8 431.8

Total liabilities $750.1 $750.1

Common stock 200.0 200.0

Retained earnings 400.6 383.3

Cumulative translation adjustment (37.9)

Total Equity 600.6 $545.4

Total liabilities and shareholders’ equity $1,350.7 $1,295.5

Revenue $2,381.0 $2,381.0

Cost of goods sold (1,595.3) (1,571.5)

Gross margin 785.7 809.5

Other expenses (190.5) (190.5)

Depreciation expense (292.7) (285.7)

Net income before translation gain 302.5 333.3

Translation gain 48.1

Net income $350.6 $333.3



Analyzing the effect on the financial ratios of the choice of accounting method is a little more difficult in this case, but the basic procedure is as follows:

• Determine whether the local currency (LC) is appreciating or depreciating.• Determine which rate (historical rate, average rate, or current rate) is used to convert the numerator under

both methods. Determine whether the numerator of the ratio will be the same, larger, or smaller under the temporal method versus the all-current method.

• Determine which rate (historical rate, average rate, or current rate) is used to convert the denominator under both methods. Determine whether the denominator of the ratio will be the same, larger, or smaller under the temporal method versus the all-current method.

• Determine whether the ratio will increase, decrease, stay the same, or if the effect is uncertain, based on the direction of change in the numerator and the denominator.

For example, let’s analyze the total asset turnover ratio, which is equal to sales divided by total assets.

• Let’s assume the local currency is depreciating. • The numerator (sales) is converted at the same rate (the average rate) under both methods. • The denominator (total assets) is converted at the historical rate under the temporal method and the current

rate under the all-current method. If the LC is depreciating, the historical rate will be higher than the current rate, which means assets will be higher under the temporal method.

• Total asset turnover will be lower under the temporal method.

Figure 23 outlines the effect on various balance sheet and income statement accounts of each method with an appreciating and a depreciating currency.



* COGS and depreciation are converted at the historical rate under the temporal method, so they experience the same relative effects as inventory and fixed assets, respectively.

The sign of the translation gain/loss is case-specific using either the temporal or all-current methods, because it depends on whether the exposure and the change in the exposure are positive or negative, and whether the LC is appreciating or depreciating. However, we can make some general observations if the effects are in the same direction, as shown in Figure 24.

Figure 23: Effect of Translation Methods on Balance Sheet and Income Statement Items

Appreciating LC Depreciating LC

Temporal All-current Temporal All-current

Income Statement Items

Revenues same same same same

COGS* lower higher higher lower

Gross profit higher lower lower higher

Depreciation* lower higher higher lower

Other expenses same same same same

NI before translation gain/loss

higher lower lower higher

Translation gain/loss

+/– +/– +/– +/–

NI after translation gain/loss

uncertain uncertain uncertain uncertain

Balance Sheet Items

Cash same same same same

Accounts receivable same same same same

Inventory lower higher higher lower

Fixed assets lower higher higher lower

Total assets lower higher higher lower

Liabilities same same same same

Equity lower higher higher lower



We can use Figure 23 to determine the effect on a selected set of common ratios, as shown in Figure 25. In some cases the effect on the ratio is uncertain because the change in the numerator and denominator are in the same direction or the change in one component is uncertain.

Figure 24: Effect of Appreciating or Depreciating Currency on Translation Gain/Loss for Temporal and All-Current Methods

Appreciating LC Depreciating LC

Beginning exposure > 0Change in exposure > 0

Translation gain Translation loss

Beginning exposure > 0Change in exposure < 0

uncertain uncertain

Beginning exposure < 0Change in exposure > 0

uncertain uncertain

Beginning exposure < 0Change in exposure < 0

Translation loss Translation gain



Professor’s Note: We’ve tried to be as comprehensive as possible in our treatment of all the possible ratios you might see on exam day. However, be prepared to analyze the effect on ratios not listed in Figure 25. You should be able to apply the procedure we’ve discussed to the analysis of any financial ratios.

Professor’s Note: To keep our example as simple as possible, we provided a one-period illustration. Be aware that changing exchange rates may result in what appears to be trends over multiple periods in the translated data. These trends may simply be an artifact of the changing rates and not due to changes in product markets and profitability trends for the subsidiary. Furthermore, ratios calculated from statements translated using the all-current method versus the temporal method will not only differ in terms of absolute value but may also show different trends (e.g., the current ratio may be increasing with one method and decreasing with the other).

Effect on Parent Company Ratios

When parent firms and their foreign subsidiaries experience different trends and ratio characteristics, changing exchange rates will distort trends and ratios calculated from the consolidated financial data. If a local currency is appreciating, the foreign subsidiary’s performance will have a greater impact on the consolidated data. When the local currency is depreciating, it will have a diminished impact. Even if there are no changes in the underlying ratios, changes in exchange rates will result in changes in the consolidated ratios. When the parent has many subsidiaries operating under separate functional currencies, trends and ratios from the consolidated data may become very difficult to interpret without isolating the data by functional currency or by subsidiary.

Figure 25: Effect of Translation Methods on Selected Financial Ratios

Appreciating Local Currency Depreciating Local Currency

Temporal All-Current Temporal All-Current

Liquidity Ratios

Current ratio (assuming subsidiary has inventory)

lower higher higher lower

Quick ratio same same same same

A/R turnover same same same same

Inventory turnover uncertain uncertain uncertain uncertain

Operating Efficiency Ratios

Fixed asset turnover higher lower lower higher

Total asset turnover higher lower lower higher

Profitability Ratios

Gross profit margin higher lower lower higher

Net profit margin uncertain uncertain uncertain uncertain

ROE uncertain uncertain uncertain uncertain

ROA uncertain uncertain uncertain uncertain

Financial Leverage Ratios

Interest coverage higher lower lower higher

LTD-to-total capital higher lower lower higher



Effect on the Statement of Cash Flows

SFAS 95 is intended to isolate the statement of cash flows from the effects of changing exchange rates. It requires that cash flows in the parent (reporting) currency replicate cash flows in the local currency. Thus, in theory the cash flow statement should be unaffected by the translation method used. However, while reported cash flows exclude the effects of changing exchange rates on assets and liabilities (holding effects), flow effects from changing rates are present and do have an impact on reporting currency cash flows.

TRANSLATION METHODS IN HYPERINFLATIONARY ECONOMIES

LOS 1.e: Discuss alternative accounting methods for subsidiaries operating in hyperinflationary economies.

SFAS 52 defines a hyperinflationary economy as one that experiences a cumulative 3-year inflation rate of more than 100 percent. In a hyperinflationary economy, the foreign currency will be rapidly depreciating against the reporting currency because the extremely high inflation rate will quickly deteriorate the purchasing power of the foreign currency. In this case, using the current rate to translate all balance sheet amounts will result in very low values for all assets and liabilities after translation into the reporting currency.

In reality, the real value of nonmonetary assets and liabilities is typically not affected by hyperinflation because the local currency-denominated values increase to offset the impact of inflation (e.g., real estate values rise with inflation). As a result, the temporal method is more appropriate in this situation. Recall that under the temporal method, all nonmonetary accounts are remeasured at the historical rate.

For exam purposes, if you are given an inflation rate for one year, extrapolate that rate for a cumulative 3-year effect. For example, any annual inflation rate above 26 percent will result in a 3-year cumulative inflation rate

greater than 100 percent. This assumes compounded inflation (1.263 – 1 is approximately equal to 1.00 or a 100 percent increase).

KEY CONCEPTS

1. Flow effects are the impact of changes in the exchange rate on income statement items such as revenue. Holding gain/loss effects are the impact of changes in the exchange rate on assets and liabilities on the balance sheet, such as cash balances.

2. Some important definitions:• The functional currency is defined as the primary currency of the economic environment in which the

firm operates. This can be the currency in which the firm operates or some other currency.• The reporting currency is the currency in which the multinational firm prepares its final, consolidated

financial statements. • The local currency is the currency of the country in which the foreign subsidiary is located.• In foreign currency translation, it is possible to have another foreign currency that is different from the

local currency. • The current rate is the exchange rate as of the balance sheet date.• The average rate is the average exchange rate over the reporting period.• The historical rate is the rate that existed when a particular transaction was conducted.

3. Under the temporal method, cash, accounts receivable, accounts payable, and long-term debt are translated using the current rate. All other assets and liabilities are translated at the historical rate. Revenues and expenses are translated at the average rate. COGS and depreciation are translated by applying the historical rate to inventory and fixed asset purchases. The translation gain or loss is shown on the income statement.



4. Under the all-current method, all income statement accounts are translated at the average rate. All balance sheet accounts are translated at the current rate except for common stock, which is translated at the appropriate historical rate that applied when the equity was issued. Dividends are translated at the historical rate that applied when they were issued. The foreign currency adjustment is included on the balance sheet in the equity section. Pure balance sheet financial ratios and pure income statement financial ratios will be unaffected by an all-current method translation.

5. The rules that govern the determination of the functional currency under SFAS 52 are:• The results of operations, financial position, and cash flows of all foreign operations must be measured in

the designated functional currency.• Self-contained, independent subsidiaries whose operations are primarily located in the local market will

use the local currency as the functional currency.• Subsidiaries whose operations are well integrated with the parent will use the parent’s currency as the

functional currency.• If the subsidiary operates in a highly inflationary environment, use the parent’s currency as the functional

currency. A high inflation environment is defined as cumulative inflation that exceeds 100% over a 3-year period.

• If the functional currency is the local currency, use the all-current method. The use of the all-current method under SFAS 52 is called translation.

• If the functional currency is the parent’s currency ($) or some other currency, use the temporal method. The use of the temporal method under SFAS 52 is called remeasurement.

6. Translation gains or losses result from gains or losses related to balance sheet accounts that are exposed to changes in exchange rates. Rates are in $/LC.• Exposure under the all-current method = shareholders’ equity• Exposure under the temporal method = (cash + accounts receivable) – (accounts payable + current debt +

long-term debt)• Flow effect (in $) = change in exposure (in LC) × (ending rate – average rate)• Holding gain/loss effect (in $) = beginning exposure (in LC) × (ending rate – beginning rate)• Translation gain/loss (in $) = flow effect + holding gain/loss effect

7. There are three reasons the temporal and all-current methods report significantly different results.• Translation gains/losses appear on the balance sheet with the all-current method and on the income

statement with the temporal method. • Realized gains and losses on nonmonetary inventory and fixed assets are included in COGS and

depreciation expense under the temporal method.• Unrealized gains and losses on inventory and fixed assets are ignored under the temporal method.

8. On the exam remember these key points regarding the original versus the financial statements translated using the all-current rate.• Pure balance sheet and pure income statement ratios will be the same.• If the LC is depreciating, translated mixed ratios (with an income statement item in the numerator and a

balance sheet item in the denominator) will be larger than the original ratio. • If the LC is appreciating, translated mixed ratios (with an income statement item in the numerator and a

balance sheet item in the denominator) will be smaller than the original ratio.9. To analyze the effect on the financial ratios of the choice of accounting method (temporal versus all-

current):• Determine whether the local currency (LC) is appreciating or depreciating.• Determine which rate (historical rate, average rate, or current rate) is used to convert the numerator

under both methods. Determine whether the numerator of the ratio will be the same, larger, or smaller under the temporal method versus the all-current method.

• Determine which rate (historical rate, average rate, or current rate) is used to convert the denominator under both methods. Determine whether the denominator of the ratio will be the same, larger, or smaller under the temporal method versus the all-current method.

• Determine whether the ratio will increase, decrease, stay the same, or if the effect is uncertain, based on the direction of change in the numerator and the denominator.



CONCEPT CHECKERS: ANALYSIS OF MULTINATIONAL OPERATIONS

1. Which of the following statements is TRUE regarding foreign currency translation? Under the:A. temporal method, the monetary asset accounts of a foreign subsidiary are translated using the current

rate.B. temporal method, the nonmonetary asset accounts of a foreign subsidiary are translated using the

current rate.C. all-current method, all balance sheet accounts of a foreign subsidiary are translated using the average

rate.D. all-current method, dividends of a foreign subsidiary are translated at the current rate.


This information is a continuation of the FlexCo/Vibrant example from the topic review. Suppose it is now the end of 2006, and Vibrant reports the following operating results:

Vibrant December 31, 2005 and 2006 Balance Sheet

2005 2006

Cash LC100 LC150

Accounts receivable 650 800

Inventory 1,200 1,400

Current assets LC1,950 LC2,350

Fixed assets 1,600 2,500

Accumulated depreciation (700) (1,500)

Net fixed assets LC900 LC1,000

Total assets LC2,850 LC3,350

Accounts payable 500 500

Current debt 200 100

Long-term debt 950 1,150

Total liabilities LC1,650 LC1,750

Common stock 400 400

Retained earnings 800 1,200

Total equity LC1,200 LC1,600

Total liabilities and shareholders’ equity LC2,850 LC3,350



The following exchange rates between the U.S. dollar and the loca were observed:• December 31, 2005: LC2.20 = $1.00; $0.4545 = LC1.00• December 31, 2006: LC2.50 = $1.00; $0.40 = LC1.00• Average for 2006: LC2.33 = $1.00; $0.4292 = LC1.00

The CTA for 2005 was equal to –$37.9 under the all-current method.

2. Assume for this question only that management determines Vibrant is well-integrated with FlexCo. For 2006 FlexCo will report a translation:A. loss on the consolidated income statement of $52.0 related to Vibrant.B. gain on the consolidated income statement of $46.2 related to Vibrant.C. loss on the consolidated balance sheet of $46.2 related to Vibrant.D. gain on the consolidated balance sheet of $52.0 related to Vibrant.

3. Assume for this question only that management determines Vibrant operates relatively independently from FlexCo. For 2006 FlexCo will report a cumulative translation loss on the consolidated:A. income statement of $77.1 related to Vibrant.B. income statement of $115.0 related to Vibrant.C. balance sheet of $77.1 related to Vibrant.D. balance sheet of $115.0 related to Vibrant.

4. The gross profit margin and the return on assets from Vibrant’s 2006 U.S. dollar financial statements translated using the all-current method are closest to:

Gross profit margin Return on assetsA. 22.7% 12.8%B. 22.7% 11.9%C. 30.9% 12.8%D. 30.9% 11.9%

5. The gross profit margin from Vibrant’s 2006 U.S. dollar financial statements remeasured using the temporal method is closest to:A. 28.5%.B. 30.9%.C. 32.7%.D. 41.8%.

Vibrant 2006 Income Statement

2006

Revenue LC5,500

Cost of goods sold (3,800)

Gross margin 1,700

Other expenses (500)

Depreciation expense (800)

Net income LC400



6. Accounts receivable turnover from Vibrant’s 2006 U.S. dollar financial statements remeasured using the temporal method is closest to:A. 3.1.B. 5.6.C. 7.4.D. 9.2.

7. Which of the following is NOT a condition that requires the use of the temporal method for a U.S. parent that reports results in U.S. dollars?A. The subsidiary’s functional currency is the euro, while its local currency is the Swiss franc.B. The functional currency is the local currency.C. The foreign subsidiary is operating in a highly inflationary economy.D. The functional currency is some currency other than the local currency or the U.S. dollar.

8. Subsidiary XYZ operates in the UK, and the functional currency is the British pound (£). XYZ’s 2004 income statement shows £400 of net income and a £100 dividend that was paid on October 31 when the exchange rate was $1.60 per £. The current exchange rate is $1.70 per £, and the average rate is $1.55 per £. Translate the dividends at the appropriate historical rate. The change in retained earnings for the period in U.S. dollars under the provisions of SFAS 52 is closest to:A. $460.B. $465.C. $480.D. $510.

9. Which of the following ratios may be larger in the reporting currency versus the local currency when translated with the all-current method?A. Current ratio.B. Return on assets.C. Net profit margin.D. Debt equity ratio.

10. Mazeppa Inc. is a multinational firm with its head office located in Toronto, Canada. Its main foreign subsidiary is located in Paris, but the primary economic environment in which the foreign subsidiary generates and expends cash is in the U.S. (New York). Based on this information, which of the following statements is most likely TRUE?A. The local currency is the U.S. dollar.B. The functional currency is the euro.C. The reporting currency is the U.S. dollar.D. The reporting currency is the Canadian dollar.

11. A Swedish firm owns a foreign subsidiary in Hong Kong. This year, sales of the foreign subsidiary were HK$10 million, and the HK$/SEK average exchange rate was 1.05. Last year, sales were also HK$10 million and the HK$/SEK average exchange rate was 0.94. Based on this information, which of the following statements is TRUE?A. Reported sales in SEK increased by 1.1 million over last year.B. Reported sales in SEK decreased by 11.7% over last year.C. The HK$ has appreciated relative to the SEK over the past year.D. Reported sales in the SEK decreased this year due to the depreciation of the HK$.



12. In translating inventory and COGS under the temporal method, if the local currency is appreciating and LIFO is being used, which of the following combinations of COGS and ending inventory should result compared to FIFO?

COGS Ending InventoryA. Lower HigherB. Lower LowerC. Higher LowerD. Higher Higher

13. Which of the following statements about the temporal method and the all-current method is FALSE?A. The choice of functional currency is completely at management’s discretion.B. Net income is generally more volatile under the temporal method than under the all-current method.C. Subsidiaries that operate in highly inflationary environments will generally use the temporal method.D. Subsidiaries whose operations are well integrated with the parent will generally use the all-current

method.

14. Bob Haskell, CFA, is analyzing the financial statements of a U.S.-based company called Seriev Motor. Seriev has a foreign subsidiary located in Japan. Seriev translates the subsidiary results using the all-current method. Haskell determines that the following four ratios will remain the same after translation from yen into U.S. dollars:

• Gross profit margin.• Interest coverage (EBIT/interest expense).• Return on assets.• Quick ratio.

The dollar has depreciated against the yen during the most recent year. Haskell is correct in his analysis of:A. all four ratios.B. three of the four ratios.C. two of the four ratios.D. one of the four ratios.

15. Under the temporal method, realized exchange rate gains and losses on inventory are:A. a component of the translation gain or loss on the income statement.B. a component of the cumulative translation adjustment on the balance sheet. C. included in cost of goods sold on the income statement.D. not recorded anywhere in the financial statements.

16. How many of the following situations might result in a translation gain if the local currency is appreciating?• Beginning currency exposure and change in currency exposure are positive.• Beginning currency exposure is positive and change in currency exposure is negative.• Beginning currency exposure is negative and change in currency exposure is positive.• Beginning currency exposure is negative and the change in currency exposure is negative.

A. None.B. One.C. Two.D. Three.

17. If beginning currency exposure is negative, the change in currency exposure is positive, and the local currency is depreciating, the flow effect will be: A. negative, and a holding gain will result. B. negative, and a holding loss will result.C. positive, and a holding gain will result.D. positive, and a holding loss will result.



Use the following information to answer Question 18.

18. The translation gain or loss using the all-current method is closest to:A. –$158.89.B. –$141.11.C. $2,800.00.D. $3,200.00.

Beginning of Year Average End of Year

Assets LC6,000 LC7,000 LC8,000

Liabilities LC3,000 LC3,800 LC4,600

Exchange rate (LC/$) 4.0 4.5 5.0



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF MULTINATIONAL OPERATIONS

1. A Monetary asset accounts of a foreign subsidiary are translated using the current rate under the temporal method.

2. B If management determines that Vibrant is integrated with FlexCo’s operations, the functional currency is the U.S. dollar and the temporal method applies.

Remember that with the temporal method the exposure is equal to (cash + receivables) – (payables + current and long-term debt).

Ending exposure = (150 + 800) – (500 + 100 + 1,150) = 950 – 1,750 = –LC800

Beginning exposure = (100 + 650) – (500 + 200 + 950) = 750 – 1,650 = –LC900

Change in exposure = –LC800 – (–LC900) = LC100

Flow effect = LC100 × (0.40 – 0.4292) = –$2.9

Holding gain effect = –LC900 × (0.40 – 0.4545) = $49.1

Translation gain for 2006 = –$2.9 + $49.1 = $46.2

Under the temporal method the translation gain is reported on the income statement.

3. D If management determines that Vibrant operates independently from FlexCo, the functional currency is the loca and the all-current method applies.

Remember that with the all-current method the exposure is equal to shareholders’ equity.

Ending exposure = LC1,600

Beginning exposure = LC1,200

Change in exposure = LC1,600 – LC1,200 = LC400

Flow effect = LC400 × (0.40 – 0.4292) = –$11.7

Holding gain effect = LC1,200 × (0.40 – 0.4545) = –$65.4

Translation loss for 2006 = –$11.7 – $65.4 = –$77.1

This is the translation gain for 2006, but the cumulative translation adjustment (CTA) is reported in the equity section of the balance sheet as part of comprehensive income under the all-current method. The CTA in 2005 was –$37.9, so the CTA in 2006 is –$37.9 – $77.1 = –$115.0.



4. C It might look like you have to construct the translated financial statements to answer this question, but you actually don’t have to if you remember the relationships between the original subsidiary ratios measured in the local currency and the translated ratios measured in U.S. dollars.

Pure income statement ratios like gross profit margin will be the same. The gross profit margin measured in the local currency is LC1,700/LC5,500 = 30.9%; the gross margin measured in U.S. dollars must also be 30.9%.

Mixed ratios like ROA will be different, and in this case, because the local currency is depreciating, the translated ROA will be greater than the original. This occurs because net income (in the numerator) is translated at the higher average rate and assets (in the denominator) will be translated at the lower current rate. ROA measured in the local currency is LC400/LC3,350 = 11.9%. The ROA measured in U.S. dollars must be greater than 11.9%, which means 12.8% is the only possible answer.

If you did go through the process of calculating the translated ratios, you should have arrived at these numbers:

5. A The local currency is depreciating, so the gross profit margin remeasured in U.S. dollars using the temporal method will be lower than the gross profit margin translated into U.S. dollars using the all-current method. This is because cost of goods sold will be measured at the higher historical rate under the temporal method and at the lower average rate under the all-current method. With temporal method COGS greater than all-current COGS, temporal method gross margin will be less than all-current method gross margin. All-current gross margin is the same as in the original currency (30.9% from the previous problem), which means the only possible answer is 28.5%.

6. C Accounts receivable turnover is equal to sales divided by accounts receivable. Under the temporal method sales are remeasured at the average rate ($0.4292 in 2006), and accounts receivable are remeasured at the current rate ($0.40 for 2006):

7. B If the functional currency is the local currency, the temporal method is not required.

8. A Net income is translated using the average rate. Dividends are translated at the historical rate on the date the dividends were paid.

($1.55 × 400) – ($1.6 × 100) = $460

9. B All pure income statement and balance sheet ratios are unaffected by the application of the all-current method. What we mean by “pure” is that the components of the ratio all come from the balance sheet, or the components of the ratio all come from the income statement. Return on assets is a “mixed ratio” because assets come from the balance sheet and are translated at the current rate and net income is translated at the average rate. Unless the exchange rate doesn’t change during the year, the two accounts will be translated at different rates, and the local currency value of the ratio will change when translated into the reporting currency. The other ratios will always be the same using the all-current method.

10. D As a multinational firm, the location of Mazeppa’s head office would most likely determine the currency to be used to prepare its final, consolidated financial statements. That is the reporting currency, and in this case, it is the Canadian dollar. Based on the facts, the local currency is the euro and the functional currency is the U.S. dollar.

1,700 0.4292 $729.6translated gross margin 30.9%

5,500 0.4292 $2,360.6

400 0.4292 $171.7translated ROA 12.8%

3,350 0.40 $1,340

×= = =×

×= = =×

5,500 $0.4292 $2,360.6A/R turnover 7.4

800 $0.40 $320

×= = =×



11. D

Decrease in reported sales = SEK1.1 million = 10.5%

Last year it only cost 0.94 HK$ to purchase 1 SEK. This year it costs 1.05 HK$ to purchase 1 SEK. Therefore, the SEK is relatively more expensive, so the SEK has appreciated relative to the HK$, or the HK$ has depreciated relative to the SEK. Since the HK$ has depreciated relative to the SEK, the translation of HK$ sales into SEK will result in lower reported SEK values.

12. C Under LIFO, the most recent prices are used to determine COGS, so if the local currency is appreciating, the highest prices are being used—this should result in relatively higher COGS amounts. Under LIFO, the oldest prices are used to determine ending inventory, so if the local currency is appreciating, the lowest prices are being used—this should result in relatively lower ending inventory amounts.

13. D Subsidiaries whose operations are well integrated with the parent will generally use the parent’s currency as the functional currency. Remeasurement from the local currency to the functional currency is done with the temporal method.

14. B Gross profit margin and interest coverage are pure income statement ratios that will not change. Quick ratio is a pure balance sheet ratio that will not change. Return on assets is a mixed ratio (income statement item in the numerator and balance sheet item in the denominator), so it will change as long as the average and current exchange rates are different. Given that the dollar is depreciating against the yen, the current and average rates are likely to be different.

Therefore Haskell is correct in his analysis of three of the four ratios: gross profit margin, interest coverage, and the quick ratio.

15. C Realized exchange rate gains and losses on nonmonetary assets (like inventory) are included in operating expenses on the income statement under the temporal method. Realized exchange rate gains and losses on inventory specifically are included in cost of goods sold.

16. D In three of the four situations a translation gain could occur. Only in the case in which both beginning exposure and the change in exposure are negative would a translation gain definitely not occur.

If the local currency is appreciating and both beginning exposure and the change in exposure are positive, a translation gain will definitely occur. If the local currency is appreciating and both beginning exposure and the change in exposure are negative, a translation loss will definitely result. If the beginning exposure and change in exposure are of opposite sign, a translation gain or a translation loss could occur, although which one does occur depends on the specific situation.

17. A Flow effect equals change in exposure times ending minus average rate. If the local currency is depreciating, ending rate will be less than the average rate. The positive change in exposure times the negative exchange rate difference will result in a negative flow effect.

Holding gain/loss effect equals beginning exposure times ending minus beginning rate. The negative beginning exposure times the negative exchange rate difference will result in a holding gain.

HK$10 millionSales (this year) SEK9.524 million

1.05HK$10 million

Sales (last year) SEK10.638 million0.94

= =

= =



18. A Under the all-current method, exposure equals assets minus liabilities, or shareholders’ equity. Notice that the exchange rate is quoted in LC per $, so to compute the flow and holding effects you must convert them into $ per unit of LC by taking the reciprocal.

Beginning exposure = 6,000 – 3,000 = LC3,000

Ending exposure = 8,000 – 4,600 = LC3,400

Change in exposure = 3,400 – 3,000 = LC400

Flow effect = LC400 × [(1/5.0) – (1/4.5)] = –$8.89

Holding gain effect = LC3,000 × [(1/5.0) – (1/4.0)] = –$150.00

Translation gain = –$8.89 – $150.00 = –$158.89



SIMILARITIES AND DIFFERENCES—A COMPARISON OF IFRS AND U.S. GAAP

Study Session 6

EXAM FOCUS

Level 2 candidates need to have a detailedunderstanding of how International AccountingStandards differ from U.S. GAAP, especially given thefact that current efforts make the two sets of standardsmore consistent with each other. The subject of this

topic review is largely factual, and candidates shouldbe highly conversant with its content. It is mostly newmaterial this year and is highly probable for the exam,though most likely in conjunction with other areas offinancial statement analysis.

WARM-UP: CONVERGENCE PROJECT

Since 2002 the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) have been working on a “convergence project” to close some of the differences between International Financial Reporting Standards (IFRS) and U.S. GAAP. Many significant gaps have already been closed or reduced, and projects are under way to continue the progress.

Given the complexities of both sets of standards and the variety of their applications, a considerable number of differences still exist between the two frameworks. This summary focuses on a few specific areas that are most relevant to other readings in the Level 2 financial statement analysis material. You need to be aware of similarities and differences identified in the figures that follow.

Professor’s Note: We’ve tried to be complete in our coverage of all of the differences related to each specific accounting issue. In the Key Concepts at the end of this topic review we narrow the focus to the treatment of those differences that will have a significant impact on the financial statements and ratios and are therefore most likely to be tested on the Level 2 exam.

CONSOLIDATED FINANCIAL STATEMENTS

LOS 2.A: Compare and contrast the IFRS and U.S. GAAP treatment for each of the following, and calculate and interpret the impact of any differences on the financial statements and ratios:

• consolidated financial statements• business combinations• capitalisation of borrowing costs• inventory• financial assets• financial liabilities


Study Session 6Cross-Reference to CFA Institute Assigned Reading – PricewaterhouseCoopers, pp. 21–25

CONSOLIDATED FINANCIAL STATEMENTS

Figure 1: IFRS vs. U.S. GAAP Treatment of Consolidated Financial Statements

IFRS U.S. GAAP

Preparation Requires consolidated accounts to be produced including all subsidiaries, with three exceptions:• Company is wholly owned, and parent’s

accounts comply with IFRS.• Company securities are not publicly traded

(or in process of being issued).• Owners of minority interest do not object.

Requires consolidated accounts to be produced including all subsidiaries, with no exceptions.

Definition of subsidiary

The key is whether the parent has control of the company with respect to operations, financing, and investing policies.Exercisable potential voting rights are also taken into consideration.

Control is the main consideration. A variable interest entity (VIE) that passes losses and returns up to the parent should also be consolidated.

Special purpose entity (SPE)

An SPE must be consolidated if the parent controls it—control being evidenced through conducting activities, making decisions, or having rights to the majority of the SPE’s benefits or risks.

An SPE must be consolidated by the primary beneficiary if it falls under the definition of a VIE. The primary beneficiary is the party that receives the majority of gains, or the majority of losses, or both.

Exclusion of subsidiary

A subsidiary should not be consolidated if it is “held for sale” (instead, show separately the assets and liabilities for disposal).

If the majority owner does not have a controlling interest, then use the equity method.

Uniform accounting policies

All group companies should use the same accounting policies.

No significant differences from IFRS.

Reporting periods

All entities should have the same accounting date, though a difference of up to three months is allowed if adjustments are made for significant transactions.


Definition of associate

Significant influence, as evidenced by a 20% ownership or board representation.

Excludes unincorporated entities, but otherwise no significant differences from IFRS.

Accounting for investment in associates

Equity method must be used, with post-tax earnings shown on the income statement, and the carrying value changing by the share of earnings not paid as dividends.


Definition of joint venture (JV)

Two or more entities jointly control an activity. Three types of JV are defined:1. Jointly controlled entity (a separate

company or partnership).2. Jointly controlled operations (each party

uses its own assets).3. Jointly controlled assets.

A JV is defined as a corporation run by a small number of businesses, for mutual benefit.Only refers to jointly controlled entities.



BUSINESS COMBINATIONS

A business combination is when two or more business entities are combined into a single one. This can be the result of (1) the acquisition of one entity by another, (2) the pooling of interests of two combined entities, or (3) a group reorganization resulting from a transaction within entities under common control.

Accounting for JVs

For (1) jointly controlled entities, proportionate consolidation or equity method may be used.For (2) jointly controlled operations, show the assets, liabilities, income, and expenses appropriate to the company’s contribution to the JV.For (3) jointly controlled assets, show the relevant share of assets and liabilities.

Equity method must be used.For jointly controlled operations or assets, the accounting treatment is not specified, though proportionate consolidation may be appropriate in some instances.

Figure 2: IFRS vs. U.S. GAAP Treatment of Business Combinations

IFRS U.S. GAAP

Accounting for acquisitions and pooling of interests.

Must use the purchase method for acquisitions or pooling of interests.


Date of acquisition

The relevant date is when control passes to the acquirer.

The relevant date is when assets are received by, or securities are issued to, the acquirer.

Cost of acquisition

Value of cash or cash equivalents.If purchase is made with shares, then use fair value (price published on exchange, if listed) at date on which acquirer obtains control.

Value of cash or cash equivalents.Shares should be valued at market price over a reasonable period of time, typically from a few days before to a few days after the transaction announcement.

Contingent consideration

If consideration is contingent on a future event, include an estimate at the date of acquisition (provided payment is likely and measurable). Revisions should be adjusted against goodwill.

Generally exclude contingencies from the purchase price until resolved—then adjust against goodwill.

Restructuring provisions

Can only be recognized in acquired liabilities if the target entity had a restructuring liability at the date of acquisition.

Can recognize in liabilities acquired if there is a plan in place to exit an activity of the acquired business.

Intangible assets Must be separately recognized from goodwill if they can be separately sold, transferred, rented, or exchanged. Acquired in-process research and development (IPRD) may be recognized, provided it can be measured reliably.

Similar to IFRS, except that purchased IPRD must be written off immediately on acquisition, unless it has a specific future use.

Contingent liabilities

Recognize contingent liabilities as part of the fair value of assets and liabilities, provided they can be measured reliably.

If fair value of contingent liabilities can be determined, include them in the allocation of the purchase price. If not, include only if contingency is probable and estimable.

Figure 1: IFRS vs. U.S. GAAP Treatment of Consolidated Financial Statements (Continued)



Deferred tax Deferred tax assets that arise as a result of the acquisition (i.e., did not previously exist) are shown as a credit to income tax expense.

Deferred tax assets that arise as a result of the acquisition should be shown as an adjustment to goodwill.

Minority interests at acquisition

Minority interests are calculated as the minority’s share of the fair value of net assets or liabilities.

Minority interests are valued at historic cost. Only the parent company’s share is valued at fair value.

Goodwill Do not amortize goodwill—instead review at least annually for impairment.


Goodwill impairment

An impairment has occurred if the carrying value of the cash-generating unit (CGU) exceeds the recoverable amount (i.e., the higher of the selling price and the value in use). The impairment loss is the difference between these two.

An impairment has occurred if the carrying value of the reporting unit (RU) exceeds the fair value.The impairment loss is the difference between the carrying value and the implied fair value of net assets. Implied fair value is determined by allocating fair value to assets and liabilities of the RU the same way goodwill is calculated in a business combination.

Negative goodwill

If fair value of acquired assets exceeds the purchase price (after contingencies and transaction costs), recognize the negative goodwill as a credit in the income statement.

Allocate negative goodwill pro rata to all assets other than current assets, deferred taxes, financial assets, prepaid pension assets, and assets to be sold. Remaining negative goodwill should be shown as an extraordinary gain.

Subsequent adjustments to assets and liabilities

Adjustments to fair value of assets and liabilities are permitted against goodwill within 12 months of the acquisition (after 12 months, recognize in income statement).

Similar to IFRS, except that adjustments to restructuring provisions are always made against goodwill if positive; negative adjustments during the allocation period are made against goodwill but expensed after that.

Common control transactions

Purchase or pooling method may be used. Purchase method must be used.

Figure 2: IFRS vs. U.S. GAAP Treatment of Business Combinations (Continued)



CAPITALISATION OF BORROWING COSTS

INVENTORIES

FINANCIAL ASSETS

Financial assets are defined similarly under U.S. GAAP and IFRS and include cash, the right to receive cash or other financial assets, equity instruments, and derivatives.

Professor’s Note: Accounting for derivatives is outside the scope of your exam requirements.

Figure 3: IFRS vs. U.S. GAAP Treatment of Capitalisation of Borrowing Cost

IFRS U.S. GAAP

Recognition of borrowing costs

A company may capitalize borrowing costs attributable to the acquisition, production, or construction of a qualifying asset (i.e., one that takes significant time to prepare for use), but the capitalization decision must be consistently applied.

Borrowing and issue costs must be capitalized.Qualifying asset is defined similarly to IFRS.

Measurement The amount of borrowing costs that may be capitalized are those relating to specific borrowings, or the weighted average of general borrowings.Interest earned by depositing borrowed funds temporarily can be netted against interest to be capitalized.

Similar to IFRS, except that interest earned on temporary deposits may not be offset against interest paid.

Figure 4: IFRS vs. U.S. GAAP Treatment of Inventories

IFRS U.S. GAAP

Measurement of inventories

Lower of cost or net realizable value (NRV). NRV is net of any further costs required to complete the preparation of the inventory.After a write-down, a reversal is permitted up to the value of the original write-down.

Similar to IFRS, except for two issues:1) Holding value must be the lower of

cost and market value, with market value being the lower of replacement cost and NRV (but no less than NRV less profit margin).

2) Reversals of write-downs are prohibited.

Cost basis FIFO or weighted average methods are allowed. LIFO is not permitted.

Any of FIFO, LIFO, or weighted average is allowed.



The initial measurement of a financial asset is the fair value of that asset, net of transaction costs. Subsequently, it may be classified under any of five (for IFRS) or four (U.S. GAAP) categories. Each of these is considered in turn below.

Figure 5: IFRS vs. U.S. GAAP Treatment of Financial Assets: Asset Categories

IFRS U.S. GAAP

Financial assets at fair value through profit or loss

Holding value will vary with the asset’s fair value, with changes in value passing through the income statement. The decision to put an asset in this category is irrevocable.

This classification is not available under U.S. GAAP.

Held-for-trading financial assets

This is a subset of the first category. The asset must be a trading instrument, and there must be an assumption of a fairly short holding period.Balance sheet value is marked to fair value, with all realized and unrealized gains and losses passing through the income statement.


Held-to-maturity (HTM) investments

The company must have the positive intention and ability to hold the instrument to maturity. Payments arising from this asset must be fixed or determinable and hence exclude equity.Holding value is the amortized cost (the effective yield brings the asset’s value to its face value on the date of maturity).If some HTM assets are sold, the remaining HTM assets are “tainted” for two years and must be treated as “available-for-sale.”


Loans and receivables (including those purchased)

These assets must have fixed or determinable payments and are not quoted in an active market.They should be held at amortized cost.

All debt instruments that are not securities should be held at amortized cost.

Available-for-sale financial assets

This includes all debt and equity assets not included in the other categories.Should be held at fair value, with unrealized gains and losses shown in equity net of tax until disposal. Upon sale, all previous unrealized gains and losses are carried through the income statement.

Similar to IFRS, but excludes unlisted equity securities, which should be carried at cost.Unrealized gains and losses are shown in other comprehensive income as part of equity, but not the income statement.



Figure 6: IFRS vs. U.S. GAAP Treatment of Financial Assets: Other Issues

Reclassification between categories

Reclassifications are quite unusual.Transfers into and out from the fair value through profit or loss category are not permitted.If HTM assets are tainted (see previous section), they should be reclassified as available-for-sale, with unrealized gains/losses taken to equity. After the 2-year period the remaining assets are “cleansed” and may be transferred back to HTM, with current value becoming the new amortized cost.

Assets transferred from HTM to held-for-trading are revalued to fair value, with differences passing through the income statement.Transfers from HTM to available-for-sale are also marked to fair value, but differences are taken directly to equity.Tainting provisions apply similarly to IFRS.Assets transferred into HTM will have their fair value treated as the new amortized cost, with previous gains and losses being amortized over the remaining life through an adjusted yield.Despite the above, transfers into or out from available-for-sale are effectively prohibited by the Securities and Exchange Commission (SEC).

Impairment of financial assets

If there is evidence that a financial asset has been impaired, the carrying value is reduced and a loss recognized.The loss is the difference between carrying value and the present value of future cash flows (i.e., the recoverable amount).Reversals of impairments on available-for-sale debt securities should be shown in the income statement, but no reversals are permitted for available-for-sale equity assets.

Similar to IFRS, except reversals of previous impairments are not permitted on any available-for-sale assets, though for debt securities a reversal would result in a change of basis and be recognized through an adjusted amortization.

Derecognition A financial asset is derecognized upon occurrence of one the following events:• The contractual rights to the asset’s cash

flows expire.• The entity transfers the risks and rewards

of the assets.• The entity, although maintaining some

risks and rewards, transfers control of the asset.

Generally similar to IFRS, except an asset is derecognized when control is no longer held by the entity.



FINANCIAL LIABILITIES

Financial liabilities are defined as an obligation to deliver cash or another financial asset to another entity, or an obligation to exchange financial instruments in potentially unfavorable circumstances. For example, the investor of a callable bond faces the risk that he will have to sell the bond back to the issuer at less than the present value of its future expected cash flows. The unfavorable circumstances (for the investor) are when the call price is less than the price of a comparable noncallable bond.

Figure 7: IFRS vs. U.S. GAAP Treatment of Financial Liabilities

IFRS U.S. GAAP

Classification The contractual obligation to deliver cash or a financial instrument meets the definition of a liability. This includes preferred shares that are redeemable at a fixed date or at the option of the holder.By contrast, preferred shares that are redeemable only at the option of the issuer constitute equity.If an instrument’s redemption is dependent on events outside the control of either issuer or holder, the issuer should classify it as a liability unless settlement on redemption is in the form of equity.All putable instruments are liabilities.Convertible bonds should be split between equity (the conversion rights) and debt.

The requirement to transfer economic benefits (whether cash, equity, or other assets) in general constitutes a liability. This applies even if the settlement will be a variable number of equity shares.Contingent settlement is not discussed in U.S. GAAP.Convertible bonds must be treated as a liability, though detachable warrants issued with bonds or preferred shares would be treated as equity.

Measurement The initial liability is the fair value, which is equal to consideration received net of transaction costs.Two methods exist for liability valuation: fair value through profit or loss (this includes liability derivatives and short positions) and amortized cost.

Similar to IFRS, except that certain measurement criteria are imposed, with restrictions on treating liabilities as fair value through profit or loss.

Derecognition A financial liability is derecognized when the liability is extinguished (this includes a material modification, above 10% in present value terms, in the instrument) or when the obligation is transferred to another party.




KEY CONCEPTS

Professor’s Note: As we noted at the beginning of this topic review, we’ve narrowed the focus in the Key Concepts section to the treatment of those differences that will have a significant impact on the financial statements and ratios and are therefore most likely to be tested on the Level 2 exam. The specific effect on the ratios of one standard versus the other are covered in the specific topic reviews of each issue. The study session and reading where you’ll find the accompanying topic review is referenced for each topic.

1. Consolidation of financial statements (Reading 1.F, Study Session 5).• IFRS requires consolidation of SPE if the parent controls it. U.S. GAAP requires consolidation by the

primary beneficiary if the SPE is a VIE and the primary beneficiary receives the majority of the gains or absorbs the majority of the losses, or both.

• Joint ventures are when an entity is controlled by two or more other businesses. U.S. GAAP describes them as a jointly controlled entity. IFRS allows the alternative descriptions of jointly controlled operations or assets. IFRS permits proportionate consolidation or equity method to be used, but U.S. GAAP dictates the equity method.

2. Business combinations (Reading 2.A, Study Session 5).• Both IFRS and U.S. GAAP require the purchase method for an acquisition or pooling of interests.• Intangible assets must be recognized separately from goodwill. IPRD must be expensed immediately

under U.S. GAAP but may be recognized under IFRS.• Goodwill cannot be amortized under either standard. An impairment review should take place at least

annually, with losses passing through the income statement.• Negative goodwill is credited to the income statement under IFRS, but U.S. GAAP requires it to be offset

against asset values, with the remainder reported as an extraordinary gain.3. Inventories (Reading 1.A, Study Session 5).

• Inventories must be held at the lower of cost or net realizable value. IFRS (but not U.S. GAAP) permits reversals of write-downs.

• IFRS allows FIFO or weighted average holding methods to be used for inventories. U.S. GAAP also permits LIFO.

4. Financial assets (Reading 1.F, Study Session 5).• Financial assets may be classified under IFRS as (i) fair value through profit or loss, (ii) held-for-trading,

(iii) held-to-maturity, (iv) loans and receivables, or (v) available-for-sale. U.S. GAAP permits all except the first one. Treatment of the last four categories is broadly similar under both standards. Reclassifications are more common under U.S. GAAP than IFRS.

5. Financial liabilities (Reading 1.D, Study Session 5).• According to IFRS, convertible bonds should be split between equity and debt; U.S. GAAP requires

convertibles to be reported as a liability, though detachable warrants issued with bonds or preferred shares would be treated as equity.



CONCEPT CHECKERS: SIMILARITIES AND DIFFERENCES—A COMPARISON OF IFRS AND U.S. GAAP

1. Under IFRS, which of the following situations would allow a parent company to exclude the consolidation of a subsidiary from its group accounts?A. A minority interest exists.B. The minority interest does not object to the exclusion.C. Securities in the subsidiary are listed on an exchange.D. The subsidiary is wholly owned, and the parents accounts fully comply with U.S. GAAP.

2. Under IFRS and U.S. GAAP, how should an associate company be included in the accounts?IFRS U.S. GAAP

A. Equity method Equity or proportionate consolidationB. Equity or proportionate consolidation Equity or proportionate consolidationC. Equity or proportionate consolidation Equity methodD. Equity method Equity method

3. Which of the following is the best description of accounting for business combinations?A. Under U.S. GAAP the pooling method may only be used under very specific circumstances.B. IFRS prohibits the purchase method from being used in some circumstances.C. U.S. GAAP prohibits the pooling method from being used to account for business combinations.D. Under IFRS the pooling method is preferable to the purchase method for a combination of two similarly

sized companies.

4. Which of the following best describes the position of IFRS and U.S. GAAP with respect to restructuring provisions in a business combination?A. Both IFRS and U.S. GAAP permit restructuring provisions without restriction.B. IFRS allows restructuring provisions to be recognized if the acquirer plans to exit part of the business of

the target.C. IFRS allows the creation of a restructuring provision on acquisition of a subsidiary.D. IFRS allows the recognition of an existing restructuring provision on acquisition of a subsidiary.

5. Which of the following statements concerning accounting for acquired in-process research and development (IPRD) is TRUE?A. IFRS requires that IPRD is recorded as part of goodwill.B. IFRS requires that IPRD is recorded as a separate identifiable asset.C. U.S. GAAP requires that IPRD with alternative uses is recorded as goodwill.D. U.S. GAAP requires that IPRD with no alternative use is expensed in the year it is acquired.

6. How should negative goodwill be reflected in consolidated accounts, under both IFRS and U.S. GAAP?IFRS U.S. GAAP

A. Credit to income statement Reduce certain assets pro rataB. Negative intangible asset Reduce certain assets pro rataC. Credit to income statement Credit to income statementD. Negative intangible asset Credit to income statement



7. Under U.S. GAAP, should borrowing costs that relate to the production or construction of an asset be capitalized, and may interest received on temporary deposits of borrowed funds be offset against interest payments?

Borrowing costs Interest received A. May be capitalized May be offset against interest paymentsB. Must be capitalized May be offset against interest paymentsC. May be capitalized May not be offset against interest paymentsD. Must be capitalized May not be offset against interest payments

8. Which of first in first out (FIFO) and last in first out (LIFO) methods of accounting for inventories are permitted under IFRS and U.S. GAAP?

IFRS U.S. GAAPA. Both permitted Only LIFO permittedB. Only FIFO permitted Only LIFO permittedC. Only LIFO permitted Both permittedD. Only FIFO permitted Both permitted

9. For which of the following types of financial assets are unrealized gains and losses recognized in equity but not the income statement?A. Held-for-tradingB. Held-to-maturityC. Loans and receivablesD. Available-for-sale

10. Under both IFRS and U.S. GAAP, how should a convertible bond be treated in the financial statements of the issuer?

IFRS U.S. GAAPA. Split liability and equity Liability onlyB. Split liability and equity Split liability and equityC. Liability only Liability onlyD. Liability only Split liability and equity



ANSWERS – CONCEPT CHECKERS: SIMILARITIES AND DIFFERENCES—A COMPARISON OF IFRS AND U.S. GAAP

1. B The existence of a minority interest in general requires the consolidation, unless the minority does not object to the exclusion. Subsidiary securities not being listed would also allow an exclusion. The subsidiary being wholly owned, with the parent complying fully with IFRS (not U.S. GAAP) permits an exclusion as well.

2. D The equity method must be used for associate companies under both IFRS and U.S. GAAP.

3. C U.S. GAAP prohibits the pooling method. IFRS allows (but does not prefer) pooling if the business combination is a reorganization resulting from a transaction within entities under common control.

4. D IFRS permits an existing provision to be recognized, but not the creation of a new provision. U.S. GAAP allows a provision to be recognized if there is the intention of exiting from part of the acquired business.

5. D IFRS requires that IPRD is shown as a separate intangible asset if it is identifiable as a distinct asset—alternatively it should be included as part of goodwill. U.S. GAAP requires the writing off of IPRD on acquisition, unless it has a specific alternative future use.

6. A IFRS states that negative goodwill should be credited to the income statement. U.S. GAAP requires certain assets to be reduced pro rata.

7. D Under U.S. GAAP, borrowing costs must be capitalized, but interest received on temporary deposits may not be offset against interest paid.

8. D Under IFRS, LIFO is not permitted. Both IFRS and U.S. GAAP permit FIFO and weighted average methods.

9. D Held-for-trading assets are marked to market with unrealized gains and losses passing through the income statement. Held-to-maturity and loans and receivables are held at amortized cost, in other words with no unrealized gains or losses being recognized in either equity or the income statement. Available-for-sale assets are held at fair value, unrealized gains and losses being included in equity—but only on sale or maturity are these gains and losses taken to the income statement.

10. A Under IFRS, convertible bonds should be split between debt (the bond) and equity (the conversion rights). U.S. GAAP requires the entire bond to be shown as a liability, though detachable warrants issued with bonds would be treated as equity.



“SEEK AND YE SHALL FIND”“SEARCHING FOR SHENANIGANS”

Study Session 7

EXAM FOCUS

This topic review and the three that follow on“Financial Shenanigans” are qualitative treatments ofearnings quality and a nice complement to thefinancial statement analysis “synthesis” material in thisstudy session. Use these four topic reviews of financial

shenanigans as a source of recent examples ofaccounting fraud and management manipulation ofthe financial statements, and use the topic review offinancial statement analysis “synthesis” as the manualfor how to make the appropriate adjustments.

WHY AND WHERE SHENANIGANS OCCUR

LOS 1.A: Discuss the techniques used by management to distort a company’s reported financial performance and financial condition and discuss why such “shenanigans” exist and under what conditions they are most likely to occur.

Analysts must assess the firm’s earnings quality by examining the choices a firm makes in selecting from alternative acceptable accounting methods. Analysts must also understand how the firm applies the selected accounting methods and the timing of business transactions to increase or decrease corporate earnings.

In some cases, management will opt to use financial tricks, or “shenanigans,” to misreport the financial performance of their firm. Financial shenanigans span a continuum from those that are minor to those that represent outright fraud.

Financial shenanigans exist for three reasons:

• It pays to do it.• It is easy to do it. • It is unlikely that a company will get caught.

Let’s look at each reason in greater detail.

It “pays” to do it. In most companies, management incentive plans are structured as salary plus bonus, wherein the bonus component is usually the largest part of a manager’s annual income. When bonuses encourage managers to focus on the “bottom line” and little or no questions are asked about how the bottom line has been achieved, managers have a strong incentive to resort to using accounting gimmicks or very liberal interpretations of generally accepted accounting principles (GAAP). Empirical studies have shown a connection between bonus plans and the accounting choices managers make. Specifically, the studies found that when a manager’s bonus was already at its highest level, the manager opted to use conservative accounting methods to report earnings. However, if a manager’s bonus was “uncapped,” the manager chose more liberal accounting principles to boost corporate profits. A manager whose bonus is uncapped can be personally enriched by relying on financial gimmicks to manipulate corporate profits—so often it pays to do it.

Shenanigans are easy. Financial accounting standards are quite broad. Managers are often faced with selecting accounting methods from a variety of acceptable choices provided by GAAP. Consequently, many devious managers exploit the flexibility provided by GAAP to distort the firm’s financial performance and financial


Study Session 7Cross-Reference to CFA Institute Assigned Reading – Schilit, Chapters 2 & 3

reports. For example, managers can decide whether to capitalize a cost or expense it. Managers can also structure a transaction so that the debt associated with the transaction is kept off the books (e.g., operating leases and joint ventures). In addition to exploiting GAAP’s flexibility, management may have an easy time distorting financial statements if the firm has weak internal controls. Therefore, the flexibility of GAAP, coupled with weak internal controls, enables managers to engage in financial shenanigans because it is easy to do it.

Discovery is unlikely. Finally, even if managers engage in financial shenanigans, what are the penalties for being caught? Companies may use accounting shenanigans because they do not believe they will get caught by auditors or regulators. Even when they are caught, the penalties are often small. Furthermore, although a firm’s annual financial statements are audited, quarterly financial statements are not. Therefore, accounting gimmicks are more likely to go undetected in unaudited financial statements. As a result, it is unlikely that managers will get caught if they rely on creating accounting gimmicks to manipulate reported earnings.

Now that we understand why financial shenanigans exist, it is essential to know what types of companies are most likely to rely on them to distort their financial reports. The public does not know which companies publish misleading information. Therefore, all end-users of financial statements should review a company’s financial statements with caution and a bit of suspicion. The managers most prone to using financial shenanigans are those of high-growth companies, very weak companies, private companies, and newly public companies.

• The price-to-earnings (P/E) multiples of growth stocks are usually high. This makes growth stock prices vulnerable to declines in earnings. Therefore, managers of growth companies are prone to manipulate reported earnings to keep their positive earnings trend in place.

• On the other hand, managers of weak companies may use accounting gimmicks to make financial statement users believe that their companies’ problems are insignificant.

• Private companies that are closely held and whose financial statements are not audited are likely to rely on financial tricks.

• Similarly, newly public companies whose shares have recently been offered to the public through an initial public offering (IPO) often have weak internal controls and are susceptible to management manipulating their reported earnings.

DECEPTION STRATEGIES

As indicated earlier, financial shenanigans are tricks that intentionally distort a company’s reported financial statements and financial condition. There are two basic strategies that underlie all accounting gimmicks:

• Inflating reported current-period earnings by inflating reported current-period revenue and gains or by deflating reported current-period expenses.

• Deflating reported current-period earnings by deflating reported current-period revenue and gains or by inflating reported current-period expenses.

The first strategy is easy to understand. However, shenanigans that inflate revenue should be considered more serious than those that deflate expenses because they tend to make the firm look better than it really is. In contrast, the second strategy seeks to shift earnings to a future period, thereby inflating future profits and improving the growth in reported earnings.

Using these two strategies, seven categories of techniques that management has used to distort a company’s reported financial performance and financial condition can be identified. The seven categories of techniques are:



Recording revenue prematurely or reporting revenue of questionable quality. Included in this category are gimmicks such as:

• Recording revenue when substantial future services still need to be provided.• Recording revenue before shipment or acceptance by the customer.• Recording revenue when the customer is not obligated to pay.• Selling to an affiliate.• Grossing up revenue by not recording or accruing appropriate reserves for product returns.

Recording fictitious revenue. Included in this category are gimmicks such as:

• Recording sales for no apparent reason or that lack economic substance.• Recording investment income as revenue.• Recording cash received in lending transactions (e.g., lending securities) as revenue.• Recording supplier rebates as revenue.

Engaging in special, one-time transactions to generate gains. Included in this category are gimmicks such as:

• Selling undervalued or underutilized assets to enhance profits.• Recording investment income or gains as revenue. • Reporting investment income or gains as a reduction in operating expenses. • Reclassifying balance sheet accounts to create income.

Shifting current-period expenses to an earlier or future period. Included in this category are gimmicks such as:

• Changing accounting practices and shifting current-period expenses to an earlier period.• Capitalizing costs that are usually considered operating expenses.• Amortizing costs over longer periods of time.• Reducing asset reserves.• Failing to write down or write off assets whose value has been impaired.

Failing to record liabilities or improperly reducing liabilities. Included in this category are gimmicks such as:

• Failing to record expenses and related liabilities, especially when future obligations exist.• Changing accounting assumptions to decrease liabilities reported.• Recording cash revenue received, even though future services must still be rendered.• Creating false rebates.

Deferring current revenue to a future period. Included in this category are gimmicks such as:

• Holding back revenue just before a merger or acquisition.• Increasing current reserves (e.g., bad debt, warranty, and returns and allowances reserves) to defer current

earnings into the future.

Transferring future expenses to the current reporting period as a special, one-time charge. Included in this category are gimmicks such as:

• Increasing discretionary expenses, such as advertising, research and development (R&D), and maintenance expenses in the current period.

• Inflating special, one-time expenses.• Improperly writing off in-process R&D costs associated with an acquisition.



DETECTING FINANCIAL SHENANIGANS

LOS 1.B: Evaluate a company’s financial statements and other public information to detect early signs that financial shenanigans are being used to cover underlying problems.

Detecting potential accounting irregularities is easier said than done. There are four sources of information analysts can use to facilitate the detection of problems: press releases, U.S. Securities and Exchange Commission (SEC) filings, company interviews, and commercial databases.

Press releases. Disclosures contained in corporate press releases can provide useful information for end-users of financial statements. However, the analyst must pay close attention to the firm’s use of pro forma earnings. An analyst may interpret pro forma numbers as an indication of what a new business’ earnings should be or what future earnings might be when two firms are merged. Analysts should be wary of companies that issue press releases containing misleading earnings which may exclude expenses related to the company’s normal operating activities. Examples of such expenses include stock-based compensation and amortization expense.

SEC filings. These include a company’s Form 10-K, annual report, proxy statement, Form 10-Q, Form 8-K (special events), Form 144 (when corporate insiders sell stock), and Registration Statement (when additional stocks or bonds are offered to the public). Within these documents an analyst should review the following sections:

• Auditor’s report—investors should be cautious about investing in a company that receives a qualified opinion, has no audit committee, or has an audit committee that is not composed of outside members on the Board of Directors.

• Proxy statement—investors should read the proxy statement to search for significant information such as special compensation plans, corporate “perks” for officers and directors, and any lawsuits or other contingent liabilities the company faces.

• The footnotes to the financial statements enable investors to assess the financial condition of a firm and its earnings quality. The footnotes provide details about a firm’s accounting policies, pending litigation, segment information, long-term purchase commitments, unbilled receivables, and changes in accounting principles and estimates.

• The president’s letter allows an investor to assess the integrity of management in the sense of whether management positively portrays unfavorable circumstances or developments, and whether or not there has been a high level of turnover within management from year to year.

• The Management Discussion and Analysis (MD&A) section includes a discussion by management of specific items on the financial statements as well as the company’s liquidity, current financial position, and planned expenses on fixed assets for the future.

• Form 8-K tells investors about acquisitions and divestitures and any changes in the firm’s auditors. • Form 144—Insider Stock Transactions discloses buying and selling of a firm’s stock by corporate insiders.

Excessive insider sales might indicate looming problems at the firm.

Company interviews. After reviewing a company’s SEC filings, an analyst should seek to interview senior management at the firm, such as the chief financial officer (CFO), the head of investor relations, the corporate comptroller, and the treasurer. During the interviews the analyst can gauge management’s tone by the way it responds to questions and addresses issues raised. The analyst should be aware of SEC Regulation FD (Fair Disclosure Guidelines), which precludes management from providing analysts and other professional investors with information that has not yet been disclosed to the public.

Commercial databases. Analysts should use commercial databases such as Lexis/Nexis™ and Compustat® to screen for companies showing certain warning signs of operating or accounting problems.



KEY CONCEPTS

1. Financial “shenanigans” are tricks that intentionally distort a company’s reported financial performance and financial position.

2. Financial shenanigans exist for three reasons: it pays to do it, it is easy to do it, and it is unlikely that management will get caught.

3. The managers most prone to using financial shenanigans are those of high-growth companies, very weak companies, private companies, and newly public companies.

4. There are two basic strategies underlying all accounting tricks: (1) inflating reported current-period earnings by inflating reported current-period revenue and gains or by deflating reported current-period expenses and (2) deflating reported current-period earnings by deflating reported current-period revenue and gains or by inflating reported current-period expenses. The first method is intuitive, while the second method focuses on improving the growth trend in reported earnings.

5. There are seven techniques that management has used to distort a company’s reported financial performance and financial condition. The seven categories of techniques are (1) recording revenue prematurely or recording revenue of questionable quality, (2) recording fictitious revenue, (3) engaging in special, one-time transactions to generate gains, (4) shifting current-period expenses to an earlier or future period, (5) failing to record liabilities or improperly reducing liabilities, (6) deferring current revenue to a future period, and (7) transferring future expenses to the current reporting period as a special, one-time charge.

6. Four sources of information analysts can use to facilitate their ability to catch accounting shenanigans are (1) press releases, (2) SEC filings, (3) company interviews, and (4) commercial databases.



CONCEPT CHECKERS: “SEEK AND YE SHALL FIND”; “SEARCHING FOR SHENANIGANS”

1. Which of the following is NOT a practice that companies use to manipulate earnings?A. Using reserves to manipulate earnings trends.B. Engaging in special, one-time transactions to generate gains.C. Recording investment income as revenue.D. Expensing advertising costs.

2. Managers opt to use financial shenanigans because:A. it pays to do so.B. it demonstrates the essence of “teamwork.”C. it enhances their retirement plans.D. if they do not, they will be replaced by managers who will.

3. Which of the following types of firms is least likely to engage in financial shenanigans?A. High-growth companies.B. Companies whose sales are not cyclical.C. Newly public companies.D. Private companies.

4. Which of the following documents is least likely to be used by an analyst to search for financial shenanigans?A. Annual report.B. Corporate brochure.C. Form 8-K.D. Prospectus.

5. Which of the following would NOT be an accounting gimmick associated with shifting current-period expenses to an earlier or future period?A. Changing accounting practices and shifting current-period expenses to an earlier period.B. Reclassifying costs that have been expensed as capitalized normal operating expenses.C. Amortizing costs over longer periods of time.D. Selling undervalued or underutilized assets to enhance profits.

6. Which of the following would NOT be an accounting gimmick associated with transferring future expenses to the current reporting period as a special, one-time charge?A. Increasing discretionary expenses, such as advertising, R&D expenses, and maintenance into the

current period.B. Inflating special, one-time expenses.C. Reclassifying costs that have been expensed as capitalized normal operating expenses.D. Improperly writing off in-process R&D costs associated with an acquisition.

7. All of the following are SEC filings EXCEPT:A. the proxy statement.B. the registration statement.C. press releases.D. Form 144.



8. Which of the following is NOT a source of information that an analyst should use to identify “Shenanigans”?A. Company interviews.B. Press releases.C. Research reports of other analysts.D. Commercial databases.

9. Which of the following types of firms is least likely to engage in financial shenanigans? Companies:A. with high P/E multiples.B. with a recent history of losses.C. with strong internal controls.D. whose shares have just been offered to the public.



ANSWERS – CONCEPT CHECKERS: “SEEK AND YE SHALL FIND”; “SEARCHING FOR SHENANIGANS”

1. D Expensing advertising costs is a conservative practice and a sign of high earnings quality. All the other methods cited are practices that companies use to manipulate earnings.

2. A Managers will opt to use financial shenanigans because it pays, it’s easy, and it’s unlikely they will get caught.

3. B Companies that have a stable sales and earnings pattern are least likely to engage in financial shenanigans. The companies most prone to using financial shenanigans are high-growth companies, very weak companies, private companies, and newly public companies.

4. B A corporate brochure would probably not have unbiased, objective information on the firm’s financial performance. An analyst would use all of the other documents cited to search for financial shenanigans.

5. D Selling undervalued or underutilized assets to enhance profits is a special, one-time transaction to generate gains. The other choices provided are accounting gimmicks associated with shifting current-period expenses to an earlier or future period.

6. C Reclassifying costs that have been expensed as capitalized normal operating expenses is an accounting gimmick of shifting current-period expenses to an earlier or future period. The other choices provided are all accounting gimmicks associated with transferring future expenses to the current reporting period as a special, one-time charge.

7. C Corporate press releases do not require filing with the SEC. Registration statements, proxy statements, and Form 144 for insiders buying or selling stock do require filing with the SEC.

8. C An analyst should use press releases, company interviews, SEC filings, and commercial databases to detect financial shenanigans. Research reports undertaken by other analysts tend to include much subjective information and would not be a useful source for identifying accounting gimmicks.

9. C Companies with strong internal controls (i.e., a competent and independent auditor, independent members on the board of directors) are not likely to engage in financial shenanigans. The other types of companies cited are prone to rely on financial shenanigans to provide the public with the financial performance it anticipates.



SHENANIGAN NO. 4: SHIFTING CURRENT EXPENSES TO A LATER OR EARLIER PERIOD

Study Session 7

EXAM FOCUS

This topic review discusses how management at manyfirms inflates profits by recording current expenses ina later accounting period. The focus here is on twotechniques for delaying the reporting of expenses:

(1) capitalizing costs, especially those the firm hadgenerally expensed in the past; (2) amortizing costsover longer periods of time.

WARM-UP: CAPITALIZING VS. EXPENSING COSTS

In general, when a company incurs an expense, the expense is immediately charged to the period in which it was incurred and is reported on the income statement. Selling, general and administrative (SG&A) expenses, interest expense, rent expense, and insurance expense, for example, are accounted for in this manner.

Expenses incurred in making products available for sale (e.g., purchase of raw materials) or expenses that are intended to benefit the firm beyond the current operating cycle are capitalized. These costs are not reported directly on the income statement but are shown instead as an asset on the balance sheet.

A number of Financial Accounting Standards Board (FASB) standards have been adopted over the years relating to the expensing or capitalization of specific items to ensure consistency among firms in how they account for their expenses. Sometimes, however, the standards allow management to decide whether to capitalize the cost of an item and place it on the balance sheet as an asset that will be expensed over time (via depreciation, depletion, or amortization), or to expense the cost of the item immediately and report the expense on the income statement. The choice that management makes will affect the firm’s financial statements and financial ratios.

CAPITALIZING COSTS IMPROPERLY

LOS 1.C: Discuss the costs that are most often improperly capitalized, and estimate the impact on the financial statements and financial ratios of such capitalization and analyze disclosures relating to amortization/depreciation of assets to identify situations that distort financial performance and/or condition.

Examples of Capitalized Costs

Companies have often improperly amortized costs that should have been directly expensed on the income statement. Five such expenses are discussed below: (1) marketing and solicitation costs, (2) landfill and interest costs, (3) software development costs, (4) store preopening costs, and (5) repair and maintenance costs.

Marketing and solicitation costs. Generally Accepted Accounting Principles (GAAP) require that companies immediately expense advertising, marketing, and solicitation costs on the income statement. These costs are considered to be normal, recurring, short-term operating costs. However, certain companies have capitalized these costs as assets on their balance sheet and amortized them over future periods. Three recent examples are AOL, Cendant/CUC, and Excel Communications.

• AOL called the costs associated with sending disks to potential clients “deferred membership and acquisition costs” (DMAC). AOL traditionally amortized DMAC over one year, but later extended the amortization


Study Session 7Cross-Reference to CFA Institute Assigned Reading – Schilit, Chapter 7

period to two years. The effect of capitalizing DMAC and extending the amortization period enabled the firm to report profits rather than losses for two years. AOL’s management justified capitalizing rather than expensing its marketing costs by claiming that the advertising would result in future benefits. The SEC disagreed with AOL’s assertion because AOL was not operating in a stable environment, which is one of the conditions required to legitimately capitalize marketing costs.

• Cendant/CUC was in the business of selling memberships that enabled customers to receive discounts at other companies. Since the firm was required to defer the revenue over the membership contract period, it also deferred the marketing and solicitation costs over the same period. By capitalizing its marketing and solicitation costs, the company increased its reported earnings in the short term.

• Excel Communications, a provider of long distance telephone service, opted to begin capitalizing marketing costs (sales commissions) that it had traditionally expensed. This aggressive accounting decision was made right before its initial public offering (IPO) in order to boost its reported profitability.

Landfill and interest costs. Chambers Development, a company in the trash disposal business, capitalized certain costs, including management wages, public relations costs, travel and legal expenses, and interest expense on funds borrowed during the construction period, by classifying them as landfill assets on its balance sheet. These expenses should have been directly expensed on its income statement. This enabled the firm to overstate its assets and net worth, understate its expenses, and overstate its profits.

After detecting this practice a few years later, the firm’s auditors required Chambers Development management to expense these operating costs and restate its earnings. In some cases, the restatement turned previously reported earnings into reported losses.

Software and research and development costs. GAAP requires that most research and development (R&D) costs be expensed as incurred. In fact, facilities constructed for a specific R&D project and equipment purchased for the project must be expensed immediately if they have no use other than for the R&D project at hand. There have been many objections to this accounting practice, however. Opponents claim that this practice gives no recognition to the possibility that the R&D activities being undertaken may have potential longer-term benefits. As such, they argue that GAAP standards are too conservative in the treatment of these expenses.

There are some instances in which R&D expenses can be capitalized as an asset and then amortized over some future time period. R&D activities undertaken for others under contract are capitalized as a work-in-process (inventory-like) asset. R&D costs incurred by R&D partnerships where there has been a transfer of risk(i.e., a transfer of ownership) are treated the same way.

GAAP requires that any early-stage computer software development costs be expensed as incurred. However, once the project reaches technological feasibility (i.e., there is a program design or working model of the program), then production costs can be capitalized as an asset.

Store preopening costs. Companies that are growing their operations and opening stores in new locations will often capitalize training costs and other operating expenses related to opening the new store during the preopening phase. Restaurant companies and retailers have been known to follow this practice. However, this practice is considered aggressive accounting and should be carefully reviewed by analysts.

Repair and maintenance costs. Maintenance and repair expenses are normal operating costs that should be immediately charged against income. Rent-Way, the nation’s largest rent-to-own chain, began capitalizing vehicle maintenance costs and amortizing them over subsequent years. This aggressive accounting practice increased the firm’s assets and equity and reduced expenses, thereby increasing reported profits. The firm was able to improve its profit margins, its debt-to-equity ratio, and interest coverage.

The Effect of Capitalizing vs. Expensing Items

As we explained earlier, management sometimes has the ability to choose whether to capitalize a cost by placing it on the balance sheet as an asset and expensing it over time via depreciation, or to expense the cost immediately



and report it on the income statement. The choice management makes will impact the firm’s balance sheet, income statement, statement of cash flows, and many financial ratios. It is the analyst’s responsibility to adjust the financial statements to capture the true economic performance of the firm.

Balance sheet effects. When a firm capitalizes costs that should be expensed, total assets and equity on the balance sheet will be higher than for a firm that expenses those costs. This implies that firms with improperly capitalized expenses will have lower asset turnover ratios (e.g., total asset turnover ratio and fixed asset turnover ratio) and lower financial leverage ratios (e.g., debt-to-equity ratio, debt-to-total assets ratio, and the equity multiplier) than firms that expense their costs.

Income statement effects. When a firm capitalizes costs it should have expensed, its reported income and many ratios that include income in their numerator (e.g., net profit margin and operating profit margin) will tend to be higher than a firm that has expensed those costs. Furthermore, the reported income and financial ratios that include income in their numerator will be more stable for the firm that has capitalized its expenses than for the firm that has expensed those same items. Since purchases are not constant, a firm that expenses its costs will tend to have volatile earnings. On the other hand, the firm that capitalizes the same expenses will amortize the asset gradually over future periods of time. This will smooth the firm’s earnings stream and stabilize its income and profitability ratios.

Effect on ROA and ROE. The effect of capitalizing costs on ROA and ROE varies with the situation, because the numerator and the denominator increase for both ratios. In the following example, the net effect in the current year is to increase ROA and ROE.

Example: Effect on financial ratios of capitalizing costs

1. Calculate the asset turnover ratio, asset-to-equity ratio, profit margin, ROA, and ROE given the following inputs:• Sales = $50.• Net income = $5.• Assets = $100.• Equity = $20.• Debt = $80.

2. Now assume that $10 that was expensed originally was instead capitalized at the beginning of the current year and depreciated over this year and the next year. Calculate the same set of ratios assuming the costs were capitalized. Ignore tax effects.

Answer:

1. Assuming the $10 costs were expensed, the ratios are calculated as follows:

100Assets-to-equity 5.0

205

Profit margin 0.10 10%50

50Asset turnover 0.5

100

= =

= = =

= =



2. If we assume the $10 in costs were capitalized and amortized over two years, the expense in the first year would only be $10 / 2 = $5, and the remaining balance of $5 would show up on the balance sheet as an asset. This would increase net income by $5, increase assets by $5, and increase equity by $5. The new ratios are:

Profit margin has increased, and leverage and asset turnover have decreased. While these will tend to have offsetting effects on ROA and ROE, in this example the income effect outweighs the leverage and turnover effects, and both ROA and ROE increase.

Statement of cash flows effects. Regardless of whether a firm opts to capitalize or expense certain costs, the net cash flow of the firm is unaffected because the same amount of cash is paid out. However, the way the firm allocates the cash outflow between operating and investing activities in the statement of cash flows will differ. If the costs are expensed, the expense will be reported as an operating cash outflow. If the costs are capitalized, the costs will be reported as an investing cash outflow. The net effect of improperly capitalizing costs is to increase operating cash flow. This action will also increase investment outflows by the same amount, but the net cash flow is unchanged.

Professor’s Note: See Question 28 from the 2000 exam for an example of how this was tested in the past. In footnote (1) of that question the candidate is asked to analyze the effect of capitalizing versus expensing software expenditures on three ratios: operating cash flow to sales, net income to sales, and sales to net fixed assets. As we discussed, the first two ratios will increase, while the third will decrease.

AMORTIZING ASSETS IMPROPERLY

A company can boost its earnings by improperly allocating costs over future time periods. For example, a company can depreciate new fixed assets over long periods of time, amortize marketing and software costs more slowly (see the previous LOS), or depreciate existing fixed assets over a longer time period. Management has the

5ROA 0.05 5.0%

1005

ROE 0.25 25.0%20

or

ROE profit margin asset turnover assets-to-equity

ROE 10% 0.5 5.0 25%

= = =

= = =

= × ×= × × =

105Assets-to-equity 4.2

2510

Profit margin 0.20 20%50

50Asset turnover 0.476

10510

ROA 0.095 9.5%10510

ROE 0.40 40.0%25

or

ROE profit margin asset turnover assets-to-equity

ROE 20% 0.476 4.2 40%

= =

= = =

= =

= = =

= = =

= × ×= × × =



incentive to extend the amortization period of its assets for two reasons: (1) long amortization periods keep the assets on the firm’s books longer, resulting in a higher net worth in the early years; and (2) longer amortization periods keep expenses lower and profits higher in the early years.

Professor’s Note: The net effect, however, is merely to shift expenses into the later years of the asset’s useful life and shift income to earlier years. The amortized cost over the entire period is the same, and the net effect on profits over the entire period is the same. If the intent is to increase reported profits in the short-term (e.g., next year), however, this is an effective method.

From a statement of cash flows perspective, however, reported cash flow would not be affected because depreciation is not a cash expense.

Financial ratios that include income, net worth or asset values in their numerator or denominator would also be distorted. A longer useful life will tend to increase profit margins (e.g., operating profit margin and net profit margin) and decrease the firm’s debt-to-equity and asset-turnover ratios.

Example of Lengthening Depreciable Lives:

Let’s see how this works by reviewing the following footnote from the Automobile Manufacturers of America (AMA) annual report:

Professor’s Note: AMA is a fictitious company and is used here to emphasize the effect of changing depreciable lives.

Given the capital intensity of the automobile industry, this change had a significant impact on AMA’s reported earnings. Suppose our fictitious company reported operating losses and higher depreciation in the years prior to 2004. By adjusting depreciation and operating losses for the change in depreciation methods, the change in the estimated useful life will result in an improvement in operating results, and AMA may even be able to report operating profits.

Change in Depreciable LivesDepreciation and Amortization

Until December 31, 2003, the Company’s plant and equipment was being depreciated on a straight-line basis to salvage value over a 10-year period from the time they were placed in service. The Company’s management reviewed its manufacturing plans and decided that effective January 1, 2004, it would increase the estimated useful life of its plant and equipment. Plant and equipment that has not been fully depreciated would now be depreciated on a straight-line basis to salvage value over a 20-year period from the time they were placed in service. The result of this change in accounting estimate was a $250 million decrease in depreciation expense and a $47 million increase in reported net income for 2004.



Analysts should be on the look-out for companies such as AMA that distort their financial condition and financial performance by changing the estimated useful life of their fixed assets. In addition, analysts should be wary of companies that:

• Write-off fixed assets too slowly, especially in industries that are experiencing technological advances. • Amortize intangible asset or leasehold improvements over long time periods.• Change the depreciation period on existing fixed assets. This suggests that the company may be in trouble

and needs to change its accounting estimate to hide the deterioration.• Choose long amortization periods for inventory costs. Film companies will often project the number of years

of anticipated revenue flow in order to match their expenses of making the film. If the anticipated revenue flow is assumed to occur over too long of a time period, the company’s inventory and reported profits will be overstated.

• Use longer amortization periods for the marketing or software costs they have capitalized rather than expensed.

Although the SEC does not require firms to disclose details of their property accounts, the analyst must still rely on financial statement footnote disclosures to gain insight into a company’s use of depreciation and amortization to determine how the firm has distorted its financial condition and financial performance.

KEY CONCEPTS

1. Management can decide to capitalize the cost of an item and place it on the balance sheet as an asset that will be expensed over time (via depreciation, depletion, or amortization), or to expense the cost of the item immediately and report the expense on the income statement.

2. Companies have often improperly amortized costs that should have been directly expensed on the income statement, including (1) marketing and solicitation costs, (2) landfill and interest costs, (3) software development costs, (4) store preopening costs, and (5) repair and maintenance costs.

3. When a firm capitalizes costs that should be expensed, total assets and equity on the balance sheet will be higher than for a firm that expenses those costs.

4. When a firm capitalizes costs it should have expensed, its reported income and many ratios that include income in their numerator (e.g., net profit margin and operating profit margin) will tend to be higher than a firm that has expensed its costs on the income statement.

5. Regardless of whether a firm opts to capitalize or expense a cost, the overall cash flow of the firm is unaffected because the same amount of cash is paid out. Capitalizing costs previously expensed will, however, increase operating cash inflow and investment cash outflow by the same amount.

6. Management has the incentive to extend the amortization period of its assets for two reasons: (1) long amortization periods keep the assets on the firm’s books longer, resulting in a higher net worth; and (2) longer amortization periods keep expenses lower and profits higher.



CONCEPT CHECKERS: SHENANIGANS NO. 4: SHIFTING CURRENT EXPENSES TO A LATER OR EARLIER PERIOD

1. Which of the following costs are NOT generally improperly capitalized on a firm’s financial statements? A. Marketing costs.B. Landfill and interest costs.C. Research and development cost.D. Inventory costs.

2. Which of the following statements about the effects of capitalizing expenses is FALSE? In the short-term, the firm’s:A. total assets will increase.B. equity will increase.C. net income will decrease.D. expenses as reported on the income statement will decrease.

3. Which of the following statements about the effects of capitalizing expenses is TRUE? In the short-term, the firm’s:A. net profit margin will be higher.B. operating profit margin will be lower.C. asset turnover will be higher.D. financial leverage will be higher.

4. Which of the following statements about extending the estimated useful life of a fixed asset is TRUE? In the current year:A. depreciation will decrease.B. net income will decrease. C. profit margin will decrease.D. net worth will decrease.

5. Which of the following accounting practices is NOT considered an aggressive practice?A. Writing off fixed assets too slowly.B. Amortizing intangible assets over long periods of time.C. Changing the depreciation method on existing fixed assets.D. Choosing short amortization periods for inventory costs.



ANSWERS – CONCEPT CHECKERS: SHENANIGANS NO. 4: SHIFTING CURRENT EXPENSES TO A LATER OR EARLIER PERIOD

1. D Marketing and solicitation costs, landfill and interest costs, and research and development costs should not be capitalized. These costs should be expensed immediately on the income statement because it is uncertain that these costs will generate revenue past the current operating cycle. Inventory costs should initially be capitalized on the balance sheet as an asset and only transferred to the income statement as cost of goods sold when the inventory has been sold.

2. C Capitalizing expenses, rather than expensing them directly on the income statement, will enable a firm to decrease its expenses and increase its reported income on the income statement, while increasing its net worth and increasing assets (by the amount of the expenses that have been capitalized) on the balance sheet.

3. A Capitalizing costs that should be expensed will increase net income, assets, and equity. This will increase operating and net profit margins. Asset turnover ratios and financial leverage ratios will be lower.

4. A If a firm extends the useful life of its fixed assets, it will result in lower future reported depreciation expense, higher net income, higher net profit margin and higher net worth (via retained earnings) in the current year.

5. D Choosing a short amortization period for inventory costs is a conservative accounting method because it increases expenses and decreases profits. As such, the inventory costs will be reflected as cost of goods sold, which will result in lower reported earnings on the income statement. The other accounting practice choices given will tend to understate reported expenses and overstate reported earnings on the income statement.



SHENANIGAN NO. 5: FAILING TO RECORD OR IMPROPERLY REDUCING LIABILITIES

Study Session 7

EXAM FOCUS

This topic review addresses a common technique forinflating profits: failing to record all liabilities. Manyfirms follow the approach of “less is more” when itcomes to recording their liabilities. In other words, thefewer liabilities they have to report directly on thebalance sheet, the better their financial statements will

look. On the exam, pay particular attention toattempts to misstate liabilities arising fromcommitments and contingencies, unrecorded stockoption liabilities, changes in pension assumptions,release of reserves into income, and unrecordedrevenue.

COMMITMENTS AND CONTINGENCIES

LOS 1.D: The candidate should be able to discuss the situations in which a company is most likely to misstate liabilities with respect to

• commitments and contingencies• unrecorded stock option liabilities• changes in pension assumptions• releases of reserves into income• recording revenue.

Companies often enter into commitments called take-or-pay contracts, in which one entity agrees to make periodic payments to another entity in exchange for regular access to a specific product. The price paid for the product can be fixed by the contract or related to market prices. Firms use take-or-pay contracts to ensure the availability of raw materials and other inputs needed for their operations. These contracts are common in the chemical, natural gas, and metals industries.

Take-or-pay contracts are generally structured as a joint venture. Two companies (i.e, both purchasers of a product) contribute debt and equity capital to create a third company (i.e., the joint venture company) that produces the product. The two companies that own the joint venture commit to periodically pay for the product. In essence, the take-or-pay contract is a commitment that serves as an indirect guarantee of the related borrowing. By creating the joint venture company, both the assets and the liabilities are kept off the balance sheets of the two joint venturers, and their debt-to-equity and current ratios are more favorable than they otherwise would be.

Generally accepted accounting principles (GAAP) requires that when a long-term purchase commitment is used to obtain financing, the purchaser must disclose the nature of the commitment and the periodic payments in the footnotes to its financial statements. The analyst can then use these disclosures to adjust the financial statements of the joint venturer to reflect the effect of its purchase commitment.

For example, by adjusting the balance sheet for the take-or-pay contract commitment, the analyst will increase the firm’s assets and liabilities. There will also be adjustments to the income statement. Instead of reporting the take-or-pay costs as operating costs when they are paid, the take-or-pay costs will be reported partly as interest expense (due to the liability that has been reported) and partly as amortization expense (due to the asset that has



been created). As such, overall cash flows are not affected. However, the firm’s interest coverage ratio (EBIT to interest expense) will decrease because of the higher level of interest expense.

The accounting profession has long debated whether to recognize contingent obligations, or contingencies, as liabilities. Firms are required to recognize a balance sheet liability when (1) it is probable that assets have been impaired or a liability has been incurred, and (2) the amount of the loss can be reasonably estimated. The loss should be accrued by a charge to expense (e.g., operating expense). If these two conditions are not met, the liability may not be accrued (i.e., it may not be shown on the balance sheet as a liability).

At any point in time, a company can find itself potentially liable for events that happened in the past. Unfortunately, GAAP does not recognize these contingencies as liabilities. These are potential future obligations, rather than actual existing liabilities, and are disclosed in the footnotes to the financial statements. Contingencies may arise with respect to litigation, expropriation of assets, environmental remediation liabilities, repurchase agreements, and debt guarantees.

Whether a potential future obligation should be recognized on the balance sheet as a liability depends on the nature of the future event. For example, suppose that a customer of General Motors (GM), an automobile manufacturer, sues GM in court for damages sustained in an accident. The court date has been set for 18 months from now. If GM’s legal counsel and auditors believe that the case is frivolous and that the jury will likely rule in GM’s favor, then GM is not required to recognize a liability on its balance sheet. However, GM must disclose the contingency in its footnotes to the financial statements.

The recognition and measurement of contingencies are problematic because they involve management’s judgment and are, therefore, subjective in nature. Nevertheless, by disclosing these potential liabilities in the footnotes to the financial statements (rather than reporting them in the financial statements), the firm’s debt-to-equity, times interest earned, and current ratios will improve.

EMPLOYEE STOCK OPTIONS

Professor’s Note: This LOS is misstated. Stock option compensation plans do affect reported earnings if the compensation costs are not expensed when the options are granted. However, appropriately adjusting for expense does not affect reported liabilities but rather causes a reallocation between retained earnings and paid-in-capital in the equity section of the balance sheet.

Employees are compensated with salary, bonus, and traditional benefits such as retirement and medical plans. Companies whose shares are publicly traded often give stock options to their managers as part of their total compensation package. Firms adopt stock option plans to motivate managers to undertake actions that will increase the market price of the firm’s common shares.

Firms generally structure their stock option plans so that a period of time elapses between the date when the options are granted and the date on which the employees will exercise the options. This time delay can be achieved by preventing employees from exercising their options for a stated period of time or by setting a high exercise price so the manager has no desire to exercise the option until the market price of the stock increases.

Historically, stock option plans received no accounting recognition when the exercise price of the option equaled the market price at the date the options are granted. At-the-money options were treated as having no intrinsic, or inherent, value on the grant date (i.e., the option is at-the-money). However, if the market price on the exercise date is greater than the exercise price, the company, theoretically, should recognize at least the difference as compensation expense.

For example, suppose IBM awards stock options to its employees to acquire shares of its common stock at an exercise price of $80 per share at any time over the next five years, and the shares are selling for $60 per share on the grant date. These options are currently out-of-the-money, but they still have a positive market value, which the analyst could estimate with an option pricing model like the Black-Scholes-Merton model. IBM should



recognize that market value as compensation expense because employees receive an economic benefit from being given the right, but not the obligation, to purchase common shares at a fixed price.

Unfortunately, GAAP currently does not require recognition of this cost to the firm on the income statement. The true costs are kept off the income statement by not recognizing the compensation expense. These unrecorded stock option plans tend to overstate the firm’s profits and retained earnings. Moreover, the firm’s debt-to-equity is lower than it would be if the compensation expense was reflected on the income statement and in equity. Recording the expense as incurred would reduce equity and increase the debt-to-equity ratio.

Nevertheless, firms that do not recognize this compensation expense are required to disclose the pro forma effect on net income and earnings per share of stock option compensation. In addition, GAAP requires that the terms of the options granted, outstanding, and exercised during the period be disclosed in the footnotes to the financial statements.

Professor’s Note: The topic review of reading 2.B in Study Session 5 provides a more complete treatment of the accounting standards for reporting costs associated with employee stock option plans.

CHANGES IN PENSION ASSUMPTIONS

Professor’s Note: The effects of changes in actuarial pension plan assumptions on the firm’s financial statements are analyzed in detail in our topic review of pension accounting in Study Session 5. Here, we present a brief summary of the effect on the firm’s liabilities.

In pension accounting, the company must make (and disclose) three key assumptions: (1) the discount rate, (2) the rate of compensation increase, and (3) the expected rate of return on plan assets. In general, assumptions of high discount rates, low compensation growth rates, and high expected rates of return on plan assets will improve the apparent status of the plan, reduce the reported liability, and improve reported profitability.

The discount rate is the rate used in the present value computation for the accumulated benefit obligation (ABO) and the projected benefit obligation (PBO). The use of a higher discount rate will result in lower present values and, hence, lower pension liabilities (i.e., lower PBO), and lower pension expense. All else equal, net pension obligations on the balance sheet will decrease, leverage ratios will decrease, and profit margins will improve.

The rate of compensation increase is the rate at which salaries are expected to increase over time. The use of a lower rate of compensation increase will result in lower expected future pension payments and, hence, a lower PBO, and lower current pension expense. Since the ABO is calculated based on current salaries, it is not affected by this assumption. All else equal, net pension obligations on the balance sheet and leverage ratios will decrease, and profit margins will improve.

The expected return on plan assets is the assumed rate of return on the investments in the plan. The assumption of a higher return on plan assets will not affect the PBO or ABO. However, a higher assumed rate of return on plan assets will reduce reported pension expense and improve profit margins.

RELEASES OF RESERVES INTO INCOME

There has been an ongoing debate in the accounting profession regarding firms that create accounting reserves and then release some or all of the reserve into reported earnings in a later period. Firms have discovered that by creating these reserves as liabilities they give themselves greater flexibility to smooth reported earnings and demonstrate an upward trend in income over time.

These liabilities do not arise from an obligation, but rather from management manipulation. For example, suppose a company decides it will close a manufacturing facility. This will result in a reduction in the labor force



and the payment of severance packages to laid-off workers. The company can recognize the restructuring charge as an expense by creating a journal entry as follows:

Restructuring expense $10,000,000Severance obligation $10,000,000

The firm has effectively created a liability called severance obligation. A problem arises when management decides that the initial restructuring charge was too high. If the restructuring charge should have been $6,000,000 instead of $10,000,000, management can reverse part of the initial charge through the following journal entry:

Severance obligation $4,000,000Restructuring expense (reversal) $4,000,000

These journal entries show that management reduced its reported earnings in the initial year through the $10,000,000 restructuring charge. It then increased its reported income in a subsequent period by $4,000,000 by reversing part of the prior restructuring charge.

The accounting profession believes that enabling firms to record charges as expenses in one year only to have them reversed in a subsequent period is a way to manipulate income. Firms may have an incentive to shift reserves into income in order to conceal a decline in their profit margins. Nevertheless, analysts should be aware that failing to maintain a sufficient amount of reserves, or releasing reserves artificially, boosts reported earnings and reduces the quality of a firm’s earnings.

RECORDING REVENUE

The following conditions must be met in order to recognize revenues on the income statement:

• The earnings process must have been substantially complete.• The risk of ownership must have been transferred from the seller to the purchaser.• The firm must have received cash or some other asset whose value can be precisely measured.• The transaction cannot be cancelled or revoked.• The transaction must have been performed at “arm’s length.”

If any of the conditions have not been met, then the firm should not recognize the revenue on their income statement. However, the generality of these conditions provides firms with flexibility in selecting how they recognize revenues.

Most firms recognize revenue at the time they sell goods or render services. However, some firms may opt to recognize revenues prematurely. These aggressive revenue recognition methods will lead a firm to overstate its revenues, cost of goods sold, and net income on the income statement. It will also understate its inventory and liabilities and overstate its retained earnings on the balance sheet. Furthermore, aggressive revenue recognition methods will distort a firm’s financial ratios, such as its debt-to-equity, times interest earned and current ratios, thereby making the firm look better than it really is. As a result, analysts should carefully review the method that a firm has chosen to recognize its revenue to determine if the method is appropriate and meaningful.

An analyst should realize that firms can recognize revenue at the time of production/construction, time of sale, or when the cash is collected. The revenue recognition method that leads to the highest net income depends on the growth stage of the company. Growth firms will generally report the highest net income by recognizing revenue at the time of production (or construction). Firms that are in decline will generally report the highest net income when they recognize revenue at the time of cash collection. The revenue recognition method the firm selects will not affect the total amount of revenue recognized. However, the method selected will affect the timing of the revenue recognition.



KEY CONCEPTS

1. GAAP loopholes have enabled firms to keep liabilities off their balance sheet. As such, firms that exploit these loopholes can understate their liabilities on the balance sheet and, consequently, improve their debt-to-equity and current ratios.

2. GAAP requires that when a long-term purchase commitment is used to obtain financing, the purchaser must disclose the nature of the commitment and the periodic payments in the footnotes to its financial statements. The analyst can then use these disclosures to adjust the financial statements of the joint venturer to reflect the effect of its purchase commitment.

3. GAAP does not recognize contingencies as liabilities. These are potential future obligations rather than current liabilities and are disclosed in the footnotes to the financial statements. By including contingencies in the footnotes to the financial statements, the firm’s debt-to-equity, times interest earned, and current ratios will improve.

4. The recognition of compensation cost for stock option plans is not mandatory. As such, the true costs are kept off the income statement by not recognizing the compensation expense.

5. By changing pension assumptions such as the discount rate used to discount future obligations, the expected return on plan assets, and the wage growth rate, a firm can understate the liabilities shown on its balance sheet and overstate its earnings reported on the income statement. This will distort leverage and profit ratios.

6. Analysts should be aware that failing to maintain a sufficient amount of reserves, or releasing reserves artificially, boosts reported earnings and reduces the quality of a firm’s earnings.

7. For revenues and income to be recognized and reported on the income statement, they must be both earned and realized. The revenue recognition method a firm selects will not affect the total amount of revenue recognized. However, the method selected will affect the timing of the revenue recognition.



CONCEPT CHECKERS: SHENANIGAN NO. 5: FAILING TO RECORD OR IMPROPERLY REDUCING LIABILITIES

1. Which of the following conditions would result in the accrual of a contingency under generally accepted accounting principles (GAAP)?A. The event is unusual in nature and infrequent in occurrence.B. The event is unusual in nature and the likelihood of the event occurring is probable.C. The event is infrequent in occurrence and the amount of the loss is reasonably estimable.D. The occurrence of the event is probable and the amount of the loss is reasonably estimable.

2. Revenue and income should be recognized when they are:A. earned.B. received in cash.C. realized.D. realized and earned.

3. Under which of the following conditions should revenue NOT be recognized by the seller at the time of sale?A. The purchaser has the right to return the product and the amount of returns is not reasonably estimable.B. The payment is made in cash.C. The selling price is less than the normal sales price.D. The payment was made by check.

4. AMA, a manufacturer of automobiles, is preparing its annual financial statements for the period ending December 31, 2005. Due to a recently proven health hazard in the production of AMA’s gas tanks, the federal government has clearly indicated its intention of having AMA recall all automobiles manufactured prior to 2002. AMA’s management estimates that this recall would cost $350 million. What accounting recognition, if any, should AMA’s management undertake in light of this situation?A. Provide a footnote disclosure only.B. Recognize $350 million of operating expenses and create a liability of $350 million.C. No recognition is needed.D. Recognize a liability of $350 million.



ANSWERS – CONCEPT CHECKERS: SHENANIGAN NO. 5: FAILING TO RECORD OR IMPROPERLY REDUCING LIABILITIES

1. D Firms are required to recognize a balance sheet liability when (1) it is probable that assets have been impaired or a liability has been incurred and (2) the amount of the loss can be reasonably estimated. If these two conditions are not met, the liability may not be accrued.

2. D For revenues and income to be recognized and reported on the income statement, they must be both earned and realized.

3. A The following conditions must be met in order to recognize revenues and income on the income statement: (1) the earnings process must have been substantially complete; (2) the risk of ownership must have been transferred from the seller to the purchaser; (3) the firm must have received cash or some other asset which can be precisely measured; (4) the transaction cannot be cancelled or revoked; and (5) the transaction must have been performed at “arm’s length.” If any of the above conditions have not been met, the firm should not recognize either the revenue or the income on their income statement. In this case, condition (4) has not been met.

4. B AMA is required to recognize a balance sheet liability because (1) it is probable that a liability has been incurred, and (2) the amount of the loss can be reasonably estimated. In addition, AMA will accrue the $350 million loss by a charge to operating expense. The liability will be reduced over time as the company pays out cash to satisfy the claims.



ANALYZING FINANCIAL REPORTS

Study Session 7

EXAM FOCUS

This topic review discusses techniques for analyzingand interpreting a company’s financial statements. Foranother treatment of this material, see our topic

review of the financial statement analysis principlesalso discussed in “Analysis of Financial Statements: ASynthesis.”

AGGRESSIVE VS. CONSERVATIVE ACCOUNTING PRACTICES

LOS 1.E: The candidate should be able to analyze the sources of information to

• evaluate whether accounting policies are aggressive or conservative • identify items that should alert an analyst to potential problems• create common-size financial statements• compare cash flow from operations and net income• identify potential warning signs and the deceptive technique used.

When an enterprise’s transactions can be accounted for using alternative acceptable accounting methods, management should make conservative choices. This is not to say that management should use overly conservative accounting methods; rather, it means that management should present realistic earnings and net worth information. When a firm is uncertain about which acceptable accounting principle to apply, it should err on the side of caution and use the more conservative accounting method.

Analysts must assess the firm’s earnings quality by examining the choices a firm makes in selecting from among alternative acceptable accounting principles. Analysts must also understand how the firm applies the accounting principles selected and the timing of business transactions to increase or decrease reported earnings.

Analysts should be able to distinguish between conservative and aggressive accounting policies. When conservative accounting choices are made, a firm’s reported earnings tend to be conservatively stated. The following are examples of conservative accounting policies:

• Using the LIFO method to measure cost of goods sold (COGS).• Not reporting nonrecurring gains as operating income.• Expensing initial start-up costs and software costs.• Providing adequate provisions for contingent liabilities.• Using accelerated depreciation methods with short useful life estimates.• Using completed contract method for long-term projects.• Using high bad debt reserves relative to the size of the accounts receivables.• Not using off-balance-sheet financing.• Providing clear and adequate disclosures explaining accounting practices.



When management uses aggressive accounting methods, the firm’s reported earnings tend to be overstated. The following are examples of aggressive accounting policies that firms have used to manipulate earnings:

• Lengthening the estimated useful life of a fixed asset.• Using straight-line method to depreciate fixed assets.• Using the FIFO method to measure COGS.• Writing off new investments.• Accruing the loss associated with contingencies.• Undertaking major acquisitions without providing adequate disclosures, making it difficult for investors to

compare current period earnings with those of prior periods.• Capitalizing normal operating costs.• Amortizing costs too slowly.• Shifting future expenses to the current reporting period as a special charge.• Recording investment income as revenue.• Recording revenue prematurely.• Manipulating advertising, R&D, maintenance, and other discretionary expenses to smooth the earnings

trend.• Adopting new accounting standards earlier or later than required to create a desired trend in earnings.• Using reserves to create the desired earnings trend.• Frequently changing auditors.• Selling assets or marketable securities to generate gains or losses.• Accelerating or decelerating sales activities to meet earnings expectations or smooth earnings.• Changing accounting policies.• Taking a “big bath” by taking large write-offs, thereby depressing current earnings and setting up the

company’s outlook for a rebound.

By reviewing a firm’s balance sheet, income statement, statement of cash flows, and footnotes to financial statements, an analyst should be able to identify potential warning signs and potential problems.

One method is to use common-size financial statement analysis, which enables an analyst to determine the composition of a company’s balance sheet and income statement in regard to a component such as total sales or total assets. When common-size financial statement analysis is applied to the balance sheet, all accounts are represented as a percentage of assets. When common-size financial statement analysis is applied to the income statement, all line items are represented as a percentage of sales or revenues.

Professor’s Note: See the last topic review in Study Session 7 for the specifics of creating and analyzing common-size financial statements.

One potential warning sign of impending trouble is the relationship between cash flow from operations (CFO) and net income. Healthy companies generate consistent, positive CFO and net income; usually CFO is greater than net income. The analyst should look closely at the causes of the decline in CFO when the trend in CFO is negative despite relative constant reported earnings, and CFO falls below net income.

IDENTIFYING POTENTIAL WARNING SIGNS

High quality earnings are often associated with highly predictable earnings. However, this is not always the case. If a firm’s reported earnings are predictable because revenues and expenses are not highly cyclical and the firm has little operating and financial leverage, then an analyst can conclude that the enterprise’s reported earnings is “high quality.” On the other hand, if reported earnings are predictable due to management’s ability to manipulate them in such a way as to create a smooth, upward-trending pattern, then the analyst should conclude that the enterprise’s earnings are of “low quality.”



In performing financial statement analysis, an analyst should recognize that just because a firm adheres to GAAP does not mean that its earnings are high quality or that its financial condition is strong. The following are some accounting practices that should be identified by the analyst as a potential warning sign or potential problem, even though they are permitted under GAAP.

Balance Sheet and Income Statement Warning Signs

• A decrease in cash and cash equivalents may indicate a liquidity problem and a need to have additional borrowings in the future.

• An increase in accounts receivable greater than the increase in sales (which will increase the accounts receivable period) may indicate that the firm is recognizing revenues prematurely or being too loose in extending credit to customers.

• A decrease in bad debt expense relative to gross accounts receivable may be a sign that the firm is underestimating the amount of accounts receivable that will be uncollectible and inflating operating income.

• An increase in inventory greater than the increase in sales, cost of goods sold (which will reduce inventory turnover), or accounts payable may indicate that the company has not charged the cost of goods sold on some sales, or the inventory requires a write-off because it is outdated.

• An increase in gross plant and equipment relative to the increase in total assets may indicate that the enterprise is capitalizing maintenance and repair costs rather than expensing them.

• A decrease in gross plant and equipment relative to total assets may indicate that the firm is not investing enough in new plant and equipment.

• A decrease in accumulated depreciation as gross plant and equipment increases may indicate that the firm is inflating operating income by recording lower depreciation expense.

• An increase in accounts payable that is greater than the increase in cost of goods sold (which will increase the accounts payable period) may indicate that the firm has not paid off its suppliers and creditors. This will require a future cash outflow.

• An increase in cost of goods sold greater than the increase in sales (which will reduce the gross profit margin) may indicate that the firm is facing stiff price competition that should result in lower gross profit margins.

• A decrease in operating expenses relative to sales (which will increase the operating profit margin) may indicate that the enterprise is capitalizing costs that it should be expensing.

• An increase in operating expenses relative to sales (which will decrease the operating profit margin) may indicate that the firm is less efficient in that it is spending more for each item sold.

• An increase in interest expense relative to long-term debt may indicate that the company will have higher future cash outflows. (Remember: payment of interest expense is an operating cash outflow!)

Statement of Cash Flows Warning Signs

• Cash inflows that are generated primarily from equity and debt offerings and asset sales may be a sign of weakness, especially if cash flow from operations is negative.

• Cash flow from operations that is significantly different from net earnings should indicate that the firm’s quality of earnings is suspicious due to a high level of non-cash expenses or non-cash income recorded on the income statement. Alternatively, the firm’s expenditures for working capital may be too high.

• The enterprise does not provide detailed disclosures regarding its cash flow from operations—this may be a sign that the firm is trying to conceal the source of an operating cash flow problem they have been facing.

Footnotes, Auditor’s Opinion, Proxy and Management Discussion, and Analysis Warning Signs

• A change in accounting estimate (e.g., useful life of a fixed asset or salvage value) or a change in accounting principle may indicate that the firm is trying to conceal an operating problem.

• A change in a firm’s auditor, Chief Financial Officer (CFO) or outside counsel may be an indication that the firm is a risky client or is applying aggressive accounting practices.



• A firm that discloses increasing levels of long-term commitments or contingencies (e.g., take-or-pay and throughput contracts) and current or potential litigation may be a sign that there will be potentially large outflows of cash in the future.

• A firm that has increasing unrecorded liabilities, such as stock options, may indicate that the firm’s future cash outflows will be higher than expected and that operating income may be overstated.

• A firm whose key customer is experiencing financial problems may be in serious trouble, especially if the key customer files for bankruptcy.

• A firm that relies on a few customers for the majority of its sales may be in trouble if any one of the customers leaves.

• A firm that prepays future periods’ operating expenses (e.g., rent, insurance) may overstate operating income in future periods.

KEY CONCEPTS

1. When management makes conservative accounting choices, the firm’s reported earnings tend to be conservatively stated. When aggressive accounting choices are made, a firm’s reported earnings tend to be overstated.

2. By reviewing a firm’s balance sheet, income statement, statement of cash flows, and footnotes to financial statements, an analyst should be able to identify potential warning signs and/or potential problems.

3. When common-size financial statement analysis is applied to the balance sheet, all accounts are represented as a percentage of assets. When common-size financial statement analysis is applied to the income statement, all line items are represented as a percentage of sales or revenues. Common-size financial statement analysis enables an analyst to determine the composition of a company’s balance sheet and income statement in regard to a component such as total sales or total assets.

4. An analyst should peruse the footnotes to a firm’s financial statements. By analyzing the footnotes, an analyst can sometimes identify problems that are not found in the numbers.

5. An analyst should be cognizant that just because a firm adheres to GAAP does not mean that its quality of earnings is high. Some accounting practices, though legal in that they are permitted by GAAP, should be identified as a potential warning sign or potential problem.



CONCEPT CHECKERS: ANALYZING FINANCIAL REPORTS

1. Which one of the following is NOT a practice that companies use to manipulate earnings?A. Using reserves to manipulate earnings trend.B. Engaging in special, one-time transactions to generate gains.C. Recording investment income as revenue.D. Expensing advertising costs.

2. Which of the following accounting practices is considered aggressive?A. Using the FIFO inventory method of accounting during periods of rising prices.B. Expensing advertising costs.C. Using high estimates for bad debts.D. Using an accelerated method of depreciating fixed assets over a shorter period.

3. Which of the following accounting practices would be considered conservative?A. Using the straight-line method of depreciating a fixed asset over a longer period of time.B. Capitalizing advertising expenses.C. Using the completed contract method to account for long-term projects.D. Amortizing costs too slowly.

4. Which of the following accounting practices would be considered least aggressive?A. Shifting future expenses to the current reporting period as a special charge.B. Recording investment income as revenue.C. Recording revenue prematurely.D. Using short useful lives for fixed assets.

5. Which of the following methods is used to normalize the balance sheet and income statement in order to compare companies of different sizes?A. Common-size financial statement analysis.B. Balance sheet reclassifications.C. Off-balance-sheet financing.D. Trend analysis.

6. Which of the following is NOT a characteristic of common-size financial statement analysis?A. It enables analysts to determine the component make up of a company’s balance sheet and income

statement.B. It is used to normalize the balance sheet and income statement to compare companies of different sizes.C. All items on the income statement will be represented as a percentage of sales.D. All accounts on the balance sheet will be reflected as a percentage of current assets.

7. Which of the following would NOT be a warning sign of potential problems at an enterprise?A. A decrease in accumulated depreciation as gross plant and equipment increases.B. An increase in accounts payable that is greater than the increase in cost of goods sold.C. A decrease in cost of goods sold greater than the increase in sales. D. A decrease in interest expense relative to long-term debt.

8. Which of the following would NOT be a warning sign of potential problems at an enterprise?A. A change in accounting estimate.B. A change in a firm’s auditor, chief financial officer, or outside counsel.C. A disclosure of increasing levels of long-term commitments or contingencies.D. Decreasing unrecorded liabilities, such as stock options.



ANSWERS – CONCEPT CHECKERS: ANALYZING FINANCIAL REPORTS

1. D Expensing advertising costs as incurred is a conservative policy. Capitalizing advertising expenses would increase reported earnings.

2. A Expensing advertising costs, using high estimates for bad debts, and using an accelerated method of depreciating fixed assets over a shorter period are all conservative accounting policies because they tend to increase expenses and decrease corporate profits. Using FIFO when prices are rising will tend to understate cost of goods sold and overstate earnings.

3. C Using the completed contract method to account for long-term projects recognizes revenues, expenses, and profits only when the project is completed. This is a conservative revenue recognition method. The other accounting policies cited are aggressive accounting policies because they delay the recognition of expenses.

4. D Using a short useful life to record depreciation expense for fixed assets is a conservative accounting practice because the asset is being depreciated more quickly, thereby increasing depreciation expense and reducing net profits. The other accounting practices are all aggressive.

5. A Common-size financial statement analysis normalizes the balance sheet and income statement so that end users of financial statements can compare firms of different sizes. All accounts on the balance sheet will be reflected as a percentage of total assets, and all income statement line-items will be reflected as a percentage of sales.

6. D When using common-size financial statement analysis all accounts on the balance sheet are reflected as a percentage of total assets, not current assets.

7. C An increase in cost of goods sold greater than the increase in sales may indicate that the firm is facing stiff price competition that should result in lower gross profit margins.

8. D A firm that has increasing unrecorded liabilities, such as stock options, should be an indication that the firm’s future cash outflows may be higher than expected and that operating income may be overstated.



THE INCOME STATEMENT, PART II—EXPENSES, NONOPERATING ITEMS

Study Session 7

EXAM FOCUS

The most important issue in the analysis ofnonrecurring and unusual or infrequent items iswhether they are reported “above the line” (i.e., as partof net income from continuing operations) or “belowthe line” (i.e., after net income from continuingoperations). The most popular earnings manipulationgame is to push good news (gains) above the line andpush bad news (losses) below the line. Look forunusual gains buried in income from continuingoperations and unusual losses classified as

extraordinary.

In our topic review of market multiples in StudySession 13, we calculate “underlying earnings” byadjusting net income for nonrecurring items. Then weuse underlying earnings to compute the firm’s P/Eratio. The analyst should make his own determinationof whether the item is nonrecurring or whether itshould be part of net income from continuingoperations.

LOS 2: Compare and contrast the three categories of nonrecurring items and other unusual or infrequent items and give examples of each category and discuss how to conduct a quantitative analysis of nonrecurring items and other unusual items.

CATEGORIES OF NONRECURRING ITEMS

There are three types of nonrecurring items: extraordinary items, discontinued operations, and accounting changes.

Extraordinary items are events that are both unusual in nature and infrequent in occurrence, and material in amount. Examples of these include:

• Losses from expropriation of assets by a foreign government.• Uninsured loss from fire, flood, tornado, or other natural disaster.• Gains or losses from the passage of a new law.

Extraordinary items are reported net of tax after net income from continuing operations (i.e., below the line).

Analytical implications: Although extraordinary items do not affect net income from continuing operations, the analyst may want to review them to determine whether some portion should be included when forecasting future income. Some companies appear to be suspiciously “accident prone” and report extraordinary losses every year.

Discontinued operations are those operations that management has decided to dispose of but either has not yet done so or did so in the current year after the operations had generated income or losses. To be accounted for as a discontinued operation, the business—in terms of assets, operations, and investing and financing activities—must be physically and operationally distinct from the rest of the firm.

The date when the company develops a formal plan for disposing of an operation is referred to as the measurement date, and the time between the measurement date and the disposal date is referred to as the phaseout period. The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from the discontinued operations. On the measurement date, the


Study Session 7Cross-Reference to CFA Institute Assigned Reading – Giroux, Ch. 6

company will accrue any estimated loss during the phaseout period and any estimated loss on the sale of the operation. Any expected gain on the disposal cannot be reported until after the sale is completed.

Income and losses from discontinued operations are reported net of tax after net income from continuing operations (i.e., below the line).

Analytical implications: The analysis is straightforward. Discontinued operations do not affect net income from continuing operations. The actual event of discontinuing a segment may provide information about the future cash flows of the firm. Determine the impact the discontinued operations will have on the company’s business strategy.

Accounting changes include changes in principle (i.e., changing from one accounting method to another, such as from FIFO to LIFO) or changes in estimate (e.g., changing the useful life estimate of PP&E). Accounting changes can be mandated by new accounting standards or can be discretionary on the part of management.

Any impact on prior period earnings resulting from accounting changes is reported on an after-tax basis. In general, prior years’ financial statements do not need to be restated unless the discretionary change involves one of the following:

• Change from LIFO to another inventory accounting method.• Change to or from the full-cost method for expensing oil and gas exploration costs.• Change to or from the percentage-of-completion revenue recognition method.• Any change just prior to an initial public offering.

The cumulative or prior period earnings impact from an accounting change is reported net of tax after net income from continuing operations (i.e., below the line).

Analytical implications: Any impact on prior-period income resulting from an accounting change does not affect net income from continuing operations. Accounting changes typically do not affect cash flow. An analyst should review any discretionary accounting change to determine why the change occurred (i.e., was it justifiable or was it an attempt to manipulate earnings?) and whether it might have an impact on future operating results.

OTHER UNUSUAL OR INFREQUENT ITEMS

Unusual or infrequent items are either 1) unusual in nature or 2) infrequent in occurrence, but not both unusual and infrequent. Examples of unusual or infrequent items include:

• Gains or losses from the disposal of a portion of a business segment (e.g., employee separation costs or plant shutdown costs).

• Gains or losses from the sale of assets or investments in subsidiaries.• Provisions for environmental remediation.• Impairments, write-offs, write-downs, and restructuring costs.

Unusual or infrequent items are reported pre-tax before net income from continuing operations (i.e., above the line). If material, the item must be reported separately from other income and expense items.

The potential for earnings manipulation is high for these items. Management often classifies gains as immaterial and buries them in other income. Losses, however, are reported as a separate line item to suggest that the loss is nonrecurring and not part of continuing operations.

Analytical implications: Even though unusual or infrequent items do impact net income from continuing operations, an analyst may want to review them to determine whether they should be included when forecasting future income. It is important for the analyst to distinguish among recurring items that have no cash flow effect, those that affect only current-period cash flow, and those that will affect future cash flow.



The analyst should also try to identify those items hidden in other income and segment them out to determine the true measure of recurring income. A careful reading of the management discussion and analysis and the footnotes will facilitate the identification of these items and help the analyst determine their impact on future performance and profitability.

EARNINGS MANIPULATION

Most analysts typically exclude nonrecurring items when estimating a firm’s earning power. However, some companies tend to incur nonrecurring items year after year. For some firms, the nonrecurring items are different each year; others tend to have similar nonrecurring charges (e.g., reorganization) every few years.

The effect of nonrecurring items on the current period’s income is usually clearly stated. However, such items also have effects on past and future earnings, which are not generally stated. If the analyst concentrates on recurring income and ignores nonrecurring charges, an overstatement in the estimate of a firm’s earning trend can result from prior years’ expenses being reported too late (e.g., impairments and write-offs) but classified as nonrecurring items. The same overestimate of the earnings trend will result if the firm expenses future charges early (e.g., restructuring charges). For example, writing down an asset this year will reduce future depreciation of the asset and increase future net income.

One weakness of accrual accounting is that it is subject to management discretion—and a company can use that discretion to manipulate earnings. There are two different types of discretion: the timing of the occurrence and the classification of the item. Earnings manipulation through classification of nonrecurring and unusual and infrequent items can be classified into four categories.

Classification of good news/bad news. Analysts tend to focus on net income from continuing operations because it is usually the best indicator of future earnings. Hence, companies prefer to put good news items in categories that will appear above net income from continuing operations and bad news items below net income from continuing operations (i.e., in income from discontinued operations or extraordinary items). Consider the sale of a subsidiary as an example of selective classification. If a subsidiary is sold for a profit, it is likely to appear above the line. If it is sold at a loss, management may define the subsidiary as a discontinued operation and report the loss below the line.

Income smoothing. Firms try to reduce earnings in good years and increase earnings in bad years to make earnings appear more stable than they actually are.

Big bath behavior. When firms are already having a bad year, they often try to recognize all potential expenses and losses and report all of their bad news at one time. From management’s perspective, this behavior may produce two benefits. First, more of the bad news will typically be reported below the line. If the investing community is focused on above-the-line performance, big bath behavior will minimize the impact of the bad news. Second, following the reporting of the bad news, the firm will appear to be more profitable going forward and may be rewarded for improved accounting performance even though there may be no improvement in economic performance.

Accounting changes. Firms will use accounting changes to smooth earnings (e.g., changing the inventory cost-flow assumption, the capitalization versus expensing decision, or the depreciation methodology). Because these accounting changes can have a material impact on earnings while producing no impact on cash flows, they are seen as a means to manipulate reported earnings and should become a focus of the analysis.

QUANTITATIVE ANALYSIS OF NONRECURRING AND UNUSUAL ITEMS

A quantitative analysis of nonrecurring items involves calculating margin ratios involving income from continuing operations, net income, and nonrecurring and unusual items to determine the effect that the timing and classification of the item had on reported results, and ultimately to detect earnings manipulation.



Example: Quantitative analysis of nonrecurring and unusual items

Sportnuts Inc. reported the following selected income statement items for 2004 and 2005 as shown in Figure 1.

In the footnotes to the financial statements, the company reported that the following unusual gains were included as part of other income and reflected in income from continuing operations for 2005:

• $6 million gain on the sale of excess joint venture land.• $24 million gain on the reversal of excess accruals recorded in 2003 related to discontinuing the

watersports division.

Compute the following ratios for 2004 and 2005, and determine whether the classification and timing of nonrecurring and other unusual items has had an effect on Sportnuts’ reported results:

• ICO/revenues• NI/revenues• Net nonrecurring and other items/revenues

Answer:

The ratios for 2004 and 2005 are shown in Figure 2.

It appears at first glance that the company’s performance in 2005 exceeded 2004 based on income from continuing operations and that the drop in net profit margin reflects the nonrecurring loss from discontinued operations. However, the two unusual gains offset by the extraordinary loss represent 5.9 percent of revenue in 2005. These unusual gains account for a significant portion of the income from continuing operations for 2005. Furthermore, one of the unusual gains results from the reversal of previously accrued losses taken on discontinued operations three years earlier. The fact that the company has reported nonrecurring losses from discontinued operations in two of the last three years (a similar loss was also reported for 2003) and has subsequently reversed the earlier losses two years later suggests the possibility of earnings manipulation.

Figure 1: Selected Income Statement Items for Sportnuts Inc., 2004 and 2005 (in Millions of $)

2005 2004

Revenues $270 $280

Income from continuing operations (ICO) $38 $32

Loss from discontinued operations $14

Net income (NI) $24 $32

Figure 2: Selected Ratios for Sportnuts Inc., 2004 and 2005

2005 2004

ICO/revenues 14.1% 11.4%

NI/revenues 8.9% 11.4%

Net nonrecurring and other items/revenues 5.9% N/A



KEY CONCEPTS

1. Extraordinary items (e.g., losses from expropriation of assets by a foreign government) are reported net of tax after net income from continuing operations (i.e., below the line).

2. Discontinued operations are those operations that management has decided to dispose of but either has not yet done so or did so in the current year after the operations had generated income or losses. Income and losses from discontinued operations are reported net of tax after net income from continuing operations (i.e., below the line).

3. Accounting changes include changes in principle (i.e., changing from one accounting method to another, such as from FIFO to LIFO) or changes in estimate (e.g., changing the useful life estimate of PP&E). Accounting changes can be mandated by new accounting standards or can be discretionary on the part of management. The cumulative or prior period earnings impact from an accounting change is reported net of tax after net income from continuing operations (i.e., below the line).

4. When nonrecurring charges are either prior year expense taken too late (e.g., impairments or write-offs) or future expenses taken too early (e.g., restructuring), the normal practice of focusing only on recurring operating income results in overestimating the firm’s earnings trend.

5. There are four ways in which management can manipulate earnings via nonrecurring items: classification of good and bad news, income smoothing, big bath techniques, and accounting changes. These attempts to increase and smooth earnings must be adjusted for in estimating the firm’s real earning power.

6. A quantitative analysis of nonrecurring items involves calculating margin ratios involving income from continuing operations, net income, and nonrecurring and unusual items to determine the effect that the timing and classification of the items had on reported results and, ultimately, to detect earnings manipulation.



CONCEPT CHECKERS: THE INCOME STATEMENT, PART II—EXPENSES, NONOPERATING ITEMS

For Questions 1 through 3, use the following excerpt from Bianchini Corporation’s income statement for the year ended September 30, 2004:

Unusual income items $450,000Operating expenses $4,112,000Cumulative effect of accounting changes (expense) $175,000Income tax expense $560,000Revenues $5,260,000Extraordinary income item (before tax) $215,000Tax rate 40%

1. Bianchini’s net income from continuing operations for the year is closest to:A. $588,000.B. $1,038,000.C. $1,078,000.D. $1,253,000.

2. The difference between Bianchini’s net income from continuing operations and net income is closest to:A. $24,000.B. $40,000.C. $196,000.D. $390,000.

3. Bianchini’s net income for the year ended September 30, 2004 is closest to:A. $647,000.B. $983,000.C. $1,062,000.D. $1,078,000.

4. Which of the following is NOT an extraordinary item?A. Uninsured losses from earthquakes.B. Expropriations by a foreign government.C. Losses resulting from changes in tax laws.D. Losses from the sale of assets or subsidiaries.

5. Which of the following statements about nonrecurring items is FALSE?A. Cumulative effects resulting from a change in the accounting method for inventory are reported pre-tax

before net income from continuing operations.B. Unusual or infrequent items are reported before taxes above net income from continuing operations.C. A change in accounting principle is reported in the income statement net of taxes after extraordinary

items and before net income.D. Gains or losses from extraordinary items and discontinued operations are reported net of taxes at the

bottom of the income statement before net income.

6. Which of the following statements about discontinued operations is FALSE?A. Expected losses on disposal are accrued prior to the completion of the sale.B. Expected gains on disposal may not be accrued prior to the completion of the sale.C. Income and losses from discontinued operations are reported net of tax after net income from

continuing operations.D. The date when the company develops a formal plan for disposing of an operation is referred to as the

disposal date.



7. Which of the following tactics CANNOT be used to make earnings appear more stable?A. Classification of good news and bad news.B. Income smoothing. C. Big bath behavior.D. Accounting changes.

8. In strong economic periods when firms are profitable, companies are least likely to use which of the following methods of earnings manipulation?A. Big bath behavior.B. Income smoothing.C. Accounting changes.D. Classification of good news and bad news.

9. Which of the following is an example of an unusual or infrequent item?A. Losses from expropriation of assets.B. Provisions for environmental remediation.C. Gains or losses from the passage of new tax laws.D. Accounting changes just prior to an initial public offering.

10. Which of the following would most likely result in higher expenses in future years?A. A plant closing.B. A long-term purchase commitment.C. An early retirement of debt.D. A write-down of equipment.



ANSWERS – CONCEPT CHECKERS: THE INCOME STATEMENT, PART II—EXPENSES, NONOPERATING ITEMS

1. B Revenues + $5,260,000Operating expenses – $4,112,000Unusual item + $ 450,000Income tax expense – $ 560,000Net income from continuing operations $1,038,000

Extraordinary items and the impact of accounting changes are reported net of tax after net income from continuing operations (i.e., below the line).

2. A Extraordinary income must be reported net of tax. Therefore, the net effect is [$215,000 × (1 – 0.40)], or income of $129,000. The cumulative effect of accounting changes must also be reported net of tax. Therefore, the net effect is [$175,000 × (1–0.40)], or expense of $105,000.

The net effect of the two items is to increase net income by $24,000.

3. C Net income from continuing operations $1,038,000Extraordinary income item $ 129,000Cumulative effect of accounting changes $ (105,000)Net income $1,062,000

4. D Losses from the sale of assets or subsidiaries would be considered unusual, but not infrequent, items. Extraordinary items are both unusual and infrequent.

5. A Effects of accounting changes are reported net of tax after net income from continuing operations.

6. D The date when the company develops a formal plan for disposing of an operation is referred to as the measurement date. All the other statements are true.

7. C Big bath behavior makes earnings look even worse during a bad year. Classification of good news and bad news and accounting changes may be used to smooth earnings.

8. A In already bad (unprofitable) years, companies are more likely to try to recognize all potential expenses and losses and report all of their bad news at one time. That’s not the case if the firm is profitable.

9. B Losses from expropriation of assets and gains and losses from the passage of new tax laws are examples of extraordinary items. Any accounting changes just prior to an initial public offering are not considered unusual or infrequent, but will usually require restatement of prior years’ financial statements.

10. B A long-term purchase commitment is not a current expense, but it represents a likely future expense. All the other items would reduce expenses in future years (a plant closing reduces future payroll expense, early retirement of debt reduces future interest expense, and write-down of equipment increases current expenses but reduces future depreciation expense).



FOUNDATIONS OF RATIO AND FINANCIAL ANALYSIS

Study Session 7

EXAM FOCUS

Earnings per share (EPS) is an ingredient in the P/Emarket multiple valuation models you’ll encounter inStudy Session 13, so making the appropriateadjustments to reported EPS and forecasting itaccurately is very important. The distinction betweenbasics EPS and diluted EPS (which reflects thedilutive effects of warrants, options, and convertible

securities) is discussed in this topic review, and thecase is made for using diluted EPS in valuationapplications. There’s one piece of good news: U.S. andIAS GAAP treatment of diluted EPS is identical, sothere’s no “distinguish between U.S. and IAS GAAP”LOS in this topic review.

BASIC AND DILUTED EPS

LOS 3.A: Calculate weighted average shares outstanding and basic and diluted earnings per share (EPS) for a company with a complex capital structure, differentiate between basic and diluted EPS and between weighted average shares outstanding and shares outstanding per the balance sheet, and explain why diluted EPS is more suitable for valuation purposes than basic EPS.

Firms that have issued potentially dilutive securities such as options, warrants, or convertible securities in their capital structure are said to have a complex capital structure. Firms with only straight debt and common and preferred equity are said to have a simple capital structure.

Firms with simple capital structures are required to report basic earnings per share (EPS), which is calculated as:

Weighted-average common shares are the total shares outstanding weighted by the number of months the shares were outstanding.

Firms with complex capital structures are required to report both basic EPS and diluted EPS (DEPS), which is calculated by adjusting both the numerator and denominator of the basic EPS formula:

DEPS recognizes the potential dilutive effects on EPS of the exercise of options and warrants and the conversion of convertible debt and preferred equity. Therefore DEPS is a more conservative measure of EPS and more appropriate for forecasting EPS, which is an important component of valuation models.

earnings available for common sharesbasic EPS

weighted-average common shares outstanding

net income preferred dividends


=

−=

adjusted income available for common sharesDEPS =

weighted-average common and potential common shares outstanding



Numerator adjustments. Adjusted income available for common shares is earnings available for common shareholders adjusted for:

• Dividends on convertible preferred stock.• After-tax interest on convertible debt.

Denominator adjustments. Weighted-average common and potential shares outstanding include the potential effects from dilution. Dilution results from the additional common shares that are issued when the options/warrants are exercised or the convertible preferred and/or convertible debt are converted.

The effect of the conversion for convertible securities is only taken into account if the conversion is dilutive. The conversion is dilutive if the adjustments related to the convertible securities reduce the DEPS.

The Treasury stock method is the required method for dealing with the dilutive effects of warrants and options. Weighted-average common shares outstanding are increased by the “potential” outstanding shares if the average market price (MP) of the shares on the open market during the period is greater than the exercise price (EP). The proceeds from the exercise are then assumed to be used to repurchase common shares on the open market at MP. If exercise is assumed to occur, the denominator of the EPS is adjusted by adding the incremental shares (I) created:

Each security’s effect on EPS is considered independently, and if dilutive, is reflected in the calculation of DEPS. Here are the steps in the process:

Step 1: Calculate basic EPS.

Step 2: If MP > EP, include the effect of the exercise of the options/warrants on shares outstanding by adding the incremental shares (I) to the denominator. If MP EP, do not add the incremental shares.

Step 3: Calculate the after-tax interest expense on the convertible bonds and/or the dividends on the convertible preferred stock.

Step 4: Calculate the weighted-average additional shares issued from a conversion of the convertible bonds and/or convertible preferred.

Step 5: Determine whether the convertibles are dilutive. Calculate EPS with and without the effect of the conversion of the convertible securities. The effect of converting bonds to equity is to reduce interest expense and increase net income available to common shareholders by the after-tax interest expense. Therefore net income is adjusted by adding back after-tax interest expense. The same adjustment applies for convertible preferred stock, except the entire preferred dividend is added back without a tax adjustment since preferred dividends are not tax-deductible. The convertibles are dilutive if EPS with their effect is less than basic EPS.

Step 6: If the convertibles are dilutive and MP > EP, calculate DEPS including the effect of both the convertibles and the warrants. If the convertibles are not dilutive and MP > EP, calculate DEPS including the effects of the warrants only. If the convertibles are not dilutive and MP EP, DEPS equals basic EPS.

MP EPI N

MP

where :N number of shares to be issued upon exercise

−= ×

=

≤

≤



Example: Calculating basic and diluted EPS

Robust Analytics reported $100,000 in net income for 2004 on weighted-average common shares outstanding of 12,500. Robust has $400,000 face value of convertible bonds outstanding with an annual coupon rate of 6 percent. The bonds were issued on April 1, 2004 and can be converted into common shares at a conversion ratio of 20 shares per $1,000 of face value. Robust also had 5,000 outstanding warrants with an exercise price of $40 that were issued on December 31, 2003. The average share price during the year was $45, and the marginal tax rate is 35 percent. Calculate basic and diluted EPS.

Answer:

Step 1:

Step 2: The average market price of $45 is greater than the exercise price of the warrants of $40, so the incremental shares are:

Step 3: The convertible bonds were outstanding for 9 months, so the after-tax interest is:

Step 4: The additional weighted-average shares from the conversion of the bonds is:

Step 5: EPS with the adjustment for the convertible bonds is:

The effect of the convertible bonds is dilutive.

Step 6: DEPS includes the effects of both the warrants and the convertible bonds:

$100,000Basic EPS = $8.00

12,500=

$45 $40I 5,000 556 shares

$45

−= × =

( )9$400,000 0.06 1 0.35 $11,700

12× × × − =

$400,000 920 6,000 shares

$1,000 12× × =

+ =+

$100,000 $11,700$6.04

12,500 6,000

$100,000 $11,700DEPS $5.86

12,500 6,000 556

+= =+ +



KEY CONCEPTS

1. Firms with simple capital structures (no warrants, options, convertible securities outstanding) are required to report basic EPS, which is calculated as:

2. Firms with complex capital structures are required to report both basic EPS and diluted EPS, which is calculated by adjusting both the numerator and denominator of the basic EPS formula:

3. Dilutive EPS recognizes the potential dilutive effects on EPS of the exercise of options and warrants and the conversion of convertible debt and preferred equity. Therefore dilutive EPS is a more conservative measure of EPS and more appropriate for forecasting EPS, which is an important component of valuation models.

4. Under the Treasury stock method, if exercise is assumed to occur, the denominator of the EPS is adjusted by adding the incremental shares created:





=

−=

adjusted income available for common sharesDEPS

weighted-average common and potential common shares outstanding=

MP EPI N

MP

where :N number of shares to be issued upon exercise

−= ×

=



CONCEPT CHECKERS: FOUNDATIONS OF RATIO AND FINANCIAL ANALYSIS

1. Park Services, Inc., reported $100,000 in net income for 2004 on weighted-average common shares outstanding of 12,500. Parker has $400,000 face value of convertible bonds outstanding with an annual coupon rate of 15 percent. The bonds were issued on April 1, 2004 and can be converted into common shares at a conversion ratio of 10 shares per $1,000 of face value. Parker also had 5,000 outstanding warrants with an exercise price of $40 that were issued on December 31, 2003. The average share price during the year was $45, and the marginal tax rate is 35 percent. Basic and diluted EPS are closest to:

Basic EPS Diluted EPSA. $8.34 $7.66B. $8.34 $7.69C. $8.00 $7.66D. $8.00 $7.69

2. Which of the following securities would NOT be found in a simple capital structure?A. 6%, $100 par value nonconvertible preferred stock.B. 8%, $1,000 par value callable mortgage bonds.C. 3%, $100 par value convertible preferred stock.D. 6%, $5,000 par value general obligation bond.



ANSWERS – CONCEPT CHECKERS: FOUNDATIONS OF RATIO AND FINANCIAL ANALYSIS

1. C Step 1:

Step 2: The average market price of $45 is greater than the exercise price of the warrants of $40, so the incremental shares are:

Step 3: The convertible bonds were outstanding for 9 months, so the after-tax interest is:

Step 4: The additional weighted-average shares from the conversion of the bonds is:

Step 5: EPS with the adjustment for the convertible bonds is:

The effect of the convertible bonds is not dilutive.

Step 6: DEPS includes the effects of the warrants only:

2. C The convertible preferred is potentially dilutive and, therefore, would not be found in a simple capital structure.

$100,000Basic EPS = $8.00

12,500=

$45 $40I 5,000 556 shares

$45

−= × =

( )9$400,000 0.15 1 0.35 $29,250

12× × × − =

$400,000 910 3,000 shares

$1,000 12× × =

$100,000 $29,250$8.34

12,500 3,000

+ =+

$100,000DEPS $7.66

12,500 556= =

+



ANALYSIS OF FINANCIAL STATEMENTS:A SYNTHESIS

Study Session 7

EXAM FOCUS

This is the most important topic review in StudySession 7, and perhaps in all of the financial statementanalysis material. Here is where you put everythingtogether by making the appropriate adjustments to thebalance sheet and computing normal operating

earnings and comprehensive income, based on youranalysis of management’s choice of accountingmethods and assumptions. Make sure you candetermine and interpret the effects of these choices onthe reported financial results and ratios.

BALANCE SHEET ADJUSTMENTS

LOS 3.B.a: Modify the balance sheet for assets and liabilities that are not recorded.

Professor’s Note: A detailed example of financial statement adjustments is the best way to address all the LOS presented

in this topic review. For illustration purposes, we will use the FedEx 10-K reports from 20031. The adjustments and the adjusted financial statements are presented with the original financial data in Figures 1, 2, and 3 in the second and third sections of this topic review. Please note that some of the data used in the calculation of adjustments is taken from the actual 10-K but are not otherwise presented separately in Figures 1, 2, and 3.

Two problems are commonly encountered in the analysis of a firm’s balance sheet: (1) some assets and liabilities are not recorded, and (2) the book values of assets and liabilities may differ significantly from their market values. This section describes adjustments to the balance sheet to address the problem of unrecorded assets and liabilities. The next section addresses the second problem related to divergent book and market values and the associated adjustments. Recall that when adjusting financial statements, an analyst is attempting to more accurately represent the underlying economic condition of the firm.

Adjustment #1: Variable Interest Entity

In a footnote, FedEx reports that it is party to a variable interest entity (VIE) through which it leases planes. Currently, the only link in the financial statements to this entity is through rent expense related to an operating lease. Nevertheless, FedEx acknowledges that it is liable for a “residual value guarantee” of $89 million. Thus, under Interpretation 46, FedEx is required to consolidate the assets and liabilities of the entity. However, FedEx chose to delay consolidation because it was not required to do so until 2004 under the new standard, at which time it will recognize $140 million in assets and liabilities. Thus, our first adjustment is to recognize these assets and liabilities immediately (adjustment #1).

Adjustment #2: Leases

Financial leases result in a capitalized asset and a liability, whereas operating leases require only footnote disclosure of rental commitments. The existence of operating leases is essentially off-balance sheet financing. To adjust the balance sheet for operating leases (i.e., capitalize them), increase the assets and liabilities by the present value of the lease payments. Recall that the interest rate in this present value computation is the lower of the

1. United States Securities and Exchange Commission, nd, <http://www.sec.gov/Archives/edgar/data/1048911/000104746903024446/a2114486z10-k.htm> (September 2005).



firm’s financing rate or the interest rate that is implicit in the lease. The present value of FedEx’s $14 billion commitment in operating leases is estimated to be $9.1 billion. Thus, we will increase both the long-term assets and long-term liabilities by this amount (adjustment #2).

Adjustment #3: Guarantees

Next we will consider guarantees reported in the notes accompanying its financial statements. FedEx reports a commitment to purchase a total of 32 new planes, as well as other equipment, to be delivered through 2012. Total outlays for the aircraft and modifications to the aircraft, vehicles and computers, and other equipment through 2012 are estimated to be $2,003 million, $793 million, and $647 million, respectively. The respective present values are $1,110 million, $640 million, and $545 million for a total off-balance sheet liability of $2,295 million. We will adjust the balance sheet by adding this present value to assets and long-term liabilities (adjustment #3).

The company also reports a separate guarantee obligation of $134 million related to the residual value of aircraft, vehicles, and facilities employed under operating leases. This obligation is considered by FedEx to be a low probability event and is not included on the balance sheet. Due to lack of information, we will not make an adjustment related to these guarantees and indemnifications. However, an analyst should be aware of these obligations and be alert to changes in the probability of incurring the related losses while continually monitoring the firm.

Finally, FedEx acknowledges that guarantees and indemnifications exist as a normal course of business but chooses not to report them. Interpretation No. 45 describes the process for identification and measurement of these guarantees but does not require them to be reported unless effective after December 31, 2002. FedEx has no new guarantees to report and chose not to report the potential obligations of the existing guarantees.

Adjustment #4: Contingent Liabilities

FedEx does not report any unconsolidated subsidiaries or other potential off-balance sheet liabilities such as obligations related to environmental problems that would require additional adjustments, with the exception of two lawsuits. First, FedEx has issued coupons as settlement to a lawsuit it lost related to fuel surcharges. The company does not report the amount of the liability in the footnotes but characterizes them as “nonmaterial.”

Second, FedEx has a $70 million judgment against them related to late delivery. It is currently appealing this judgment. Nevertheless, we will add a $70 million liability to the balance sheet (adjustment #4).

If FedEx had used the equity method for reporting its investments in subsidiaries, we would have adjusted the accruals using the proportionate consolidation method.

BALANCE SHEET ADJUSTMENTS FOR RECORDED ITEMS

LOS 3.B.b: Modify the balance sheet for the current value of assets and liabilities.

Next we will discuss the second problem with accounting statements: divergent book and market values for assets and liabilities.

Marketable Securities

FedEx does not provide detailed information on its cash and cash equivalent balances but notes that its cash equivalents in excess of operating requirements are invested in short-term (maturity of 3 months or less) interest-bearing instruments and are stated at cost, which are presumed to be sufficiently close to market values to forego adjustment.



Accounts Receivable

A bad debt allowance of $147 million and $149 million was recognized for 2002 and 2003. FedEx reports that there is minimal fluctuation in the annual proportion of accounts receivable written off. Bad debt allowance represents 5.9 and 5.7 percent of accounts receivable for each year, respectively, which is consistent with the minimal fluctuation assertion. There is no additional information (e.g., decline in the credit risk of a major customer) that would indicate a need to adjust the bad debt allowance further. (Note that adjustment for bad debt is a Level 1 topic). Moreover, FedEx does not participate in the sale of receivables to enhance liquidity. If FedEx did sell its receivables with recourse, we would need to adjust the balance sheet by adding the securitized receivables and a short-term liability equal to the proceeds from the sale to reflect the potential obligation related to the recourse. Cash flow from operations and cash flow from financing would also be adjusted.

Inventories

FedEx uses a weighted-average cost method that is intended to approximate a FIFO accounting method. The method includes an allowance for spare parts obsolescence. Because the FIFO method is the preferred method for reporting inventory balances (it more accurately reflects the current market value of inventory), there is no adjustment needed.

Professor’s Note: For exam purposes, it is likely that candidates will be asked to adjust inventories reported under LIFO accounting. If this is the case, simply add the LIFO reserve to the LIFO inventory balance for the conversion to FIFO. For additional detail, please review the topic review of analysis of inventories in Study Session 5.

Adjustment #5: Plant, Property, and Equipment

Next we need to consider marking-to-market non-financial tangible assets and revaluation of operating assets. The marking-to-market of non-financial assets such as real estate and timberland should be performed if their values can be reasonably estimated, which is often the case. In addition, an attempt to revalue operating assets may give the analyst a more accurate picture of the firm’s economic condition. However, this is a very difficult task. FedEx periodically reviews the value of their fixed assets for impairment. These annual impairment tests resulted in an impairment charge of $93 million in 2001, a favorable adjustment in 2002, and no material adjustments in 2003. However, a change in useful lives and residual values of certain aircraft resulted in a decrease in depreciation of $13 million in 2003. We will address this change in a subsequent section.

FedEx capitalized interest expense related to the acquisition and modification of aircraft, construction of facilities, and development of certain software. In 2003, the total capitalized interest expense was $16 million. Therefore, net long-term assets and equity should be reduced by $16 million (adjustment #5). Additional non-balance sheet adjustments are associated with capitalized interest and will be discussed in a subsequent section. There are no other long-term tangible operating assets that need to be adjusted.

Adjustment #6: Goodwill

Goodwill represents $1,063 million, or approximately 7 percent of FedEx’s total assets. Because goodwill has no value separate from FedEx’s operations, it is eliminated from the market value-based balance sheet. Thus, the goodwill and equity accounts are reduced by $1,063 million (adjustment #6). U.S. GAAP does not permit revaluation of intangible assets, so the carrying value of intangibles may not reflect the assets’ economic value. For analysis purposes, intangible assets may be revalued in order to reflect their fair value. No adjustments are made to the FedEx data for intangible asset values.

Current Liabilities

The book value of current liabilities is typically a reasonable estimate of amounts expected to be paid because these liabilities are short-term in nature. Interest rate adjustments tend to be immaterial. If we had to make the



proportionate consolidation adjustments mentioned earlier, then current liabilities would change to reflect those adjustments. However, this is not the case for FedEx, so no adjustments are made to current liabilities.

Adjustment #7: Long-Term Debt

FedEx reports that the fair market value of its outstanding long-term debt is $1.9 billion. Long-term debt and the current portion of long-term debt are reported on the balance sheet as $1,709 million and $308 million, for a total of $2,017 million. Therefore, we need to adjust long-term debt downward by $2,017 – $1,900 = $117 million (adjustment #7). FedEx does not employ convertible debt or preferred stock, so there are no other adjustments for this part of the balance sheet.

Adjustments #8, #9, and #10: Pension Liabilities

We now address the pension plan presentation. FedEx reports prepaid pension plan costs (an asset) of $1,269 million and pension plan and post-retirement benefit liabilities of $657 million. Based on the reported pension plan assets and liabilities, FedEx has a net pension plan asset of $1,269 – $657 = $612 million. The main balance sheet adjustment should result in the actual economic status of the plan (funded status) being represented, rather than the assets and liabilities reported for accounting purposes. Therefore, we need to consider the funded status of the plans, which are –$1,292 million and –$382 million for the pension and post-pension benefits, respectively. Therefore, we will adjust the balance sheet by:

• Eliminating the pension plan asset of $1,269 million (adjustment #8).• Increasing the pension and post-retirement benefits obligation balance by $1,017 to $1,674 million ($1,292

+ $382) to reflect the net economic condition of the plans (adjustment #9).• Adjusting the equity account downward by the net effect of the above changes to force the balance sheet to

balance. The amount of the adjustment to the equity account is the difference between the reduction in the assets and the increase in liabilities, or –$1,269 – ($1,674 – $657) = –$2,286 million (adjustment #10).

Stock-Option Plans

When considering the balance sheet impact of option-based compensation plans, recall that there are only rare exceptions that merit adjustments. Recognition of these contracts may have small (i.e., insignificant) effects on assets (creation of a deferred tax asset) but typically result primarily in a reclassification of paid-in-capital and retained earnings. This is the case with FedEx.

Adjustments #11 and #12: Deferred Income Taxes

Deferred tax liabilities are shown to be growing for the two years of data presented on the balance sheet. A 5-year trend (not presented) indicates significant annual growth (due to accelerated depreciation and employee benefits), suggesting a low probability of reversal in the near future. Because this is the case, we will assume zero deferred tax liabilities on the adjusted balance sheet and an increase in equity of $882 million (adjustment #11). If this were not the case, an analyst should calculate the present value of the expected tax liability. Note also that FedEx has $140 million in pretax earnings from a foreign subsidiary that is considered permanently reinvested, and therefore no provision for U.S. federal income taxes is recognized. If an analyst feels that a repatriation assumption is more appropriate, long-term liabilities would have to increase to reflect the tax liability associated with the foreign subsidiary’s income.

Deferred tax assets are a function of property and equipment leases, employee benefits, and self-insurance accruals. No valuation allowance was reported. While the deferred tax asset seems to be declining for the reported period, it has actually risen over the last 5 years. Due to lack of information related to the probability of reversal, we will also assume zero deferred tax assets. Therefore, we reduce the deferred tax asset and equity accounts by $416 million (adjustment #12).



Adjustment #13: Comprehensive Loss Account

In addition to all of the adjustments we have already made to the equity account, we need to adjust the accumulated other comprehensive loss account for FedEx. In general, this account may show a loss or a gain. Specifically, this account contains accruals for minimum pension liabilities, unrealized securities gains and losses, and cumulative translation adjustments used to “smooth” changes in shareholder’s equity under U.S. GAAP. For a current cost or market value balance sheet, this account is eliminated (adjustment #13).

Assets Held in Foreign Countries

Complete analysis requires consideration of the currency effects on assets held in foreign countries. It does not appear that the assets or liabilities of FedEx’s foreign subsidiaries are exposed to material changes in exchange rates and therefore no adjustments are made related to the consolidation of these subsidiaries. Management reports that FedEx is exposed to changes in the euro, the yen, and the British pound but that relative fluctuations in those currencies have tended to offset one another in the past.

Adjusted Balance Sheet

FedEx’s reported and adjusted balance sheets are presented in Figure 1.

Figure 1: FedEx Corporation Consolidated Balance Sheets with Adjustments

Adjusted Adjustments May 31(In millions, except share data) 2003 2003 2002

Assets

Current assetsCash and cash equivalents $538 $538 $331

Receivables, less allowances of $147 and $149 2,627 2,627 2,491Spare parts, supplies and fuel, less allowances of $101 and $91 228 228 251Deferred income taxes (adjustment #12) 0 (416) 416 469Prepaid expenses and other 132 132 123

Total current assets $3,525 ($416) $3,941 $3,665

Property and equipment, at costAircraft and related equipment 6,624 6,624 5,843Long term debt of VIE (adjustment #1) 140 140PV of operating leases (adjustment #2) 9,100 9,100PV of guaranteed aircraft & equipment purchase (adjustment #3) 2,295 2,295Package handling and ground support equipment and vehicles 5,013 5,013 4,866Computer and electronic equipment 3,180 3,180 2,816Other 4,200 4,200 4,051

Gross property and equipment $30,552 $11,535 $19,017 $17,576

Less accumulated depreciation and amortization 10,317 10,317 9,274

Net property and equipment 20,235 $11,535 $8,700 $8,302

Adjustment for capitalized interest (adjustment #5) (16) (16)Other Long-Term Assets 0Goodwill (adjustment #6) 0 (1,063) 1,063 1,063Prepaid pension cost (adjustment #8) 0 (1,269) 1,269 411Other assets 412 412 371

Total other long-term assets $396 (2,348) $2,744 $1,845

Total assets $24,156 $8,771 $15,385 $13,812



Adjusted Adjustments May 31Liabilities and stockholders’ investment 2003 2003 2002

Current liabilitiesCurrent portion of long-term debt $308 $308 $6Accrued salaries and employee benefits 724 724 739Accounts payable 1,168 1,168 1,133Accrued expenses 1,135 1,135 975

Total current liabilities $3,335 $3,335 $2,853

Long-term liabilities

Long-term debt of VIE (adjustment #1) 140 140PV of operating lease obligations (adjustment #2) 9,100 9,100PV of guaranteed aircraft & equipment purchase (adjustment #3) 2,295 2,295Late delivery judgment obligation (adjustment #4) 70 70Long-Term Debt, Less Current Portion (adjustment #7) 1,592 (117) 1,709 1,800

Other long-term liabilitiesDeferred income taxes (adjustment #11) 0 (882) 882 599Pension, postretirement healthcare, and other benefit obligations

(adjustment #9) 1,674 1,017 657 599Self-insurance accruals 536 536 476Deferred lease obligations 466 466 417Deferred gains, principally related to aircraft transactions 455 455 484Other 57 57 39

Total long-term liabilities $16,385 $11,623 $4,762 $4,414

Commitments and contingenciesCommon stockholders' investmentCommon Stock, $0.10 par value; 800 million shares authorized; 299 million shares issued for 2003 and 2002 30 30 30Additional paid-in capital 1,088 1,088 1,144Retained earnings 6,250 6,250 5,465Accumulated other comprehensive loss (adjustment #13) 0 30 (30) (53)

$7,368 $30 $7,338 $6,586

Less treasury stock, at cost and deferred compensation (50) (50) (41)Plus: adjustment for deferred tax liability (adjustment #11) 882 882Plus: adjustment for long-term debt mark-to-market

(adjustment #7) 117 117Less: adjustment for deferred tax asset (adjustment #12) (416) (416)Less: adjustment for capitalized interest (adjustment #5) (16) (16)Less: late delivery judgment obligation (adjustment #4) (70) (70)Less: adjustment for goodwill (adjustment #6) (1,063) (1,063)Less: adjustment for pension plan funded status

(adjustment #10) (2,286) (2,286)Less adjustment for comprehensive loss (adjustment #13) (30) (30)

Total common stockholders' investment $4,436 ($2,852) $7,288 $6,545

Total liabilities and stockholders’ equity $24,156 $8,771 $15,385 $13,812

Figure 1: FedEx Corporation Consolidated Balance Sheets with Adjustments (Continued)



Professor’s Note: The appropriate offsetting adjustments to adjustment #13 (accumulated other comprehensive loss) are to the asset and liabilities accounts affected by the specific items that make up the comprehensive loss. For example, the comprehensive loss of $14 associated with minimum pension liability adjustment (as reported in Figure 3) should be offset in the prepaid pension cost asset account. However, to identify each specific offsetting adjustment to the other components of the accumulated comprehensive loss would require more time and effort than is necessary to learn what you need to learn to pass the Level 2 exam. This is especially true in this case because the size of the adjustment ($30) is miniscule compared to the more significant adjustments we’ve already made. Therefore, for this example, we’ve just created an offsetting entry of $30 in the equity section.

Don’t panic! You will NOT see a question on exam day that asks you to do this many adjustments. The point of this example is to illustrate the process that an analyst goes through in adjusting the balance sheet and to identify some of the common types of adjustments that we have discussed so far in Study Sessions 5, 6, and 7. On exam day, be prepared to make two or three adjustments and analyze the effect of those adjustments on the financial statements.

INCOME STATEMENT ADJUSTMENTS

LOS 3.B.c: Compute a company’s normal operating earnings and comprehensive income.

The goal of financial statement analysis is to restate the reported results to reflect the economic character of the firm’s operations. In the case of the income statement, this means that the analyst wants to determine the earning power of the firm. The earning power of the firm is the income that results from ongoing operations. That is, the earning power is the income of the firm without all the noise that is included in most income statements (e.g., differences due to accounting changes, one-time charges, and restructurings). It’s the job of the financial analyst to ferret out the noise inherent in net income and restate income in terms of earning power. This process is called normalization, and the result is called the normal operating earnings.

Professor’s Note: In our topic review of price multiples in Study Session 13, normal operating earnings was referred to as underlying earnings.

Examples of nonrecurring items in reported net income that require adjustment include:

• Discretionary accounting changes (inventory, depreciation, pension plan assumptions, capitalized versus expensed items).

• Regulated accounting changes (impairment, derivatives).• Realized capital gains/losses.• Gains/losses on the repurchase of debt.• Catastrophes such as natural disasters or accidents.• Insurance settlements.• Strikes.• Impairment or restructuring charges.• Litigation or government actions.• Discontinued operations.

Some of these items are included on the income statement as a separate line item. Other items require the analyst to glean the information from the footnotes to the financial statements or from the management discussion and analysis. Additionally, be alert for (1) whether items are reported on a pre-tax or after-tax basis and (2) changes made on other statements that need corresponding changes on the income statement as well. Once earnings are normalized, they can be used to discern trends in operating income and valuation.

Income normalization for non-U.S. firms is somewhat complicated by varied accounting treatments, including different inventory accounting methods (FIFO is more common outside the U.S.), use of capitalization vs. expensing, different lease accounting rules, and different depreciation methods. Nevertheless, income needs to be normalized for comparability purposes.



Figure 2 contains the adjustments and calculations for FedEx’s normalized income.

Both the level and the trend are different for the two income measures. The unadjusted reported income shows a smooth upward trend reflecting a compounded annual growth of 19.2 percent. The normalized income shows a decline from 2001 to 2002 (a result of the events of 9/11) and then a rebound in 2003. The normalized income annualized growth rate is 9.6 percent. The smoothing in the unadjusted numbers is largely attributable to the concession FedEx received from the U.S. government under its airline stabilization program. As indicated in the last row of Figure 2, the adjusted income can be as much as 12 percent greater or 17 percent less than reported income over the three year period. These differences may be even larger because FedEx nets out its gains and losses from asset sales with its depreciation and rent expenses. Because the gains and losses are not reported separately, no adjustment has been made for them.

Comprehensive income (CI) is a relatively new accounting concept. CI is an income figure that allows for all changes in equity (other than owner contributions and distributions). That is, CI is an income measure that aggregates all the valuation changes to assets and liabilities in a component of the equity account called comprehensive income (loss). U.S. GAAP dictates that the following direct-to-equity adjustments be included:

• Minimum pension liabilities determined by SFAS 87 (see our topic review of pensions in Study Session 5).• Unrealized gains and losses on available-for-sale securities according to SFAS 115 (see our topic review of

intercorporate investments in Study Session 5). • Cumulative foreign currency translation adjustments related to SFAS 52 (see our topic review of analysis of

multinational operations in Study Session 6).

FedEx’s reported comprehensive income is presented in Figure 3. Note that some of these adjustments are reported on the balance sheet as “accumulated other comprehensive loss.” The calculation for the change from 2002 to 2003 in this equity component (+23) is also provided in Figure 3. FedEx reports a foreign currency

Figure 2: FedEx’s Normalized Income

2003 2002 2001

Reported net income $830 $710 $584

Items reported pretaxSubsidiary restructuring provisions (3) 22Impairment charges 13 124Airline stabilization program (119)Capitalized interest (16) (27) (27)Goodwill amortization 26Intangible assets amortization 13 14 14

Total pretax adjustments (6) (119) 159

Effective tax rate 38.0% 37.5% 37.0%After-tax adjustments (4) (74) 100

Items reported after taxEarly debt retirement 17Tax adjustments (27)Insurance settlement (8)Stock option grants (34) (37) (31)

Total adjustments (42) (47) (31)

Combined total adjustments (46) (121) 69

Normalized income $784 $589 $653Percent of unadjusted income 94% 83% 112%



translation adjustment (net of taxes) of +37 and a minimum pension liability adjustment (net of taxes) of –14, leading to a net adjustment of 37 – 14 = 23, which results in comprehensive income of $853 million.

While comprehensive income is an interesting concept, the focus of the analyst is on measuring the future earning power of a firm. Comprehensive income is inherently volatile because of its dependent relationship with valuation changes and, as such, it is not a reliable measure of the firm’s earning power. Moreover, the comprehensive income adjustments prescribed by U.S. GAAP do not include many of the adjustments we have discussed so far. These include adjustments:

• Of COGS from LIFO to FIFO on the income statement.• Required to capitalize operating leases.• To deferred tax assets and liabilities.• For marking-to-market long-term assets.• For marking-to-market long-term debt.• For capitalized interest.• For other off-balance sheet transactions (e.g., lawsuits).• For pension plan funded status.

An expanded version of the comprehensive income measure for FedEx, which includes many of these adjustments, is provided in Figure 4. The adjustment for the change in pension plan funded status is taken directly from the FedEx 2003 10-K.

Figure 3: FedEx’s Reported Comprehensive Income for 2003

(In millions, except share data)Common

Stock

Additional Paid-in Capital

Retained Earnings

Accumulated Other

Comprehensive Loss

Treasury Stock

Deferred Compensation Total

Balance at May 31, 2002 $30 $1,144 $5,465 $(53) $(20) $(21) $6,545

Net income – – 830 – – – 830

Foreign currency translation adjustment,net of deferred taxes of $10 – – – 37 – – 37

Minimum pension liability adjustment,net of deferred tax benefit of $7 – – – (14) – – (14)

Total comprehensive income 853Purchase of treasury stock – – – – (186) – (186)Cash dividends declared

($0.15 per share) – – (45) – – – (45)Employee incentive plans and other

(3,268,180 shares issued) – (56) – – 181 (16) 109Amortization of deferred compensation – – – – – 12 12Balance at May 31, 2003 $30 $1,088 $6,250 $(30) $(25) $(25) $7,288



These additional adjustments result in a comprehensive income (expanded definition) measure of $592 million, $238 million less than the reported net income of $830 million. Even though this measure is more volatile than the GAAP definition (which is volatile itself ), it more accurately reflects the economic changes that are excluded from GAAP net income and comprehensive income measures. Note the adjustments are calculated as changes in each measure from the previous year.

FINANCIAL STATEMENT ADJUSTMENTS: EFFECT ON FINANCIAL RESULTS AND RATIOS

LOS 3.B.d: Determine and interpret 1) the effect on reported financial results and ratios of a company’s choices of accounting methods and assumptions (e.g., inventory methods, depreciation methods, lease or purchase of long-term assets), 2) the effect on reported financial results and ratios of changes in accounting methods and assumptions (e.g., depreciation methods or assumptions, employee benefit plan assumptions), and 3) the effects of balance sheet modifications and earnings normalization on a company’s financial statements, financial ratios, and overall financial condition.

Figure 5 contains three sets of financial information for FedEx: the reported income statement and balance sheet, a normalized income statement and adjusted balance sheet, and a comprehensive income statement and adjusted balance sheet.

Up to this point we have already discussed many of the effects related to the adjustments to the income statement and balance sheet. In this section we provide some financial ratios from the three sets of financial data as a means of gaining some additional insight into the effects of the adjustments and of comparing the three measurement methods.

Figure 4: Calculation of the expanded definition of comprehensive income

Reported Comprehensive Income $853

Plus: adjustment for change in deferred tax liability 283

Plus: adjustment for long-term debt mark-to-market 117

Less: adjustment for change in deferred tax asset (53)

Less: adjustment for capitalized interest 16

Less: late delivery judgment obligation 70

Less: adjustment for change in the pension plan funded status 628

Comprehensive income (expanded definition) $592



Effect on Profitability Ratios

The reported financial statements show the highest operating and net profit margins. The margins associated with normalized income are lower, largely due to the recognition of the cost of options-based compensation contracts and the reclassification of capitalized interest to interest expense. While expensing interest rather than capitalizing it does not impact FedEx’s income measure very much, this adjustment can have a very large impact on some firms’ normalized income. The margins related to the comprehensive income measure are the lowest. Much of the difference in these margins is due to the recognition in the change in the funded status of the pension and post-retirement benefit plans. The elimination of the tax assets and liabilities also has a material impact on the margin ratios.

Effect on Liquidity Ratios

Liquidity measures are typically affected by adjustments to current assets (inventories, accounts receivable, and marketable securities) rather than adjustments to current liabilities. If these adjustments are minimal, the changes in liquidity measures will also be minimal. For FedEx the adjustments do not affect the current ratio in a material way.

Effect on Leverage Ratios

To analyze the capital structure, we consider the times interest earned ratio and the total debt to total capital ratios. The most conservative measures of these ratios are obtained with the reported financial information. Higher income results in a higher times interest earned ratio. Note that the balance sheet adjustments, for the operating leases and the pension fund in particular, result in much higher leverage for the adjusted balance sheet. The adjustments cause FedEx’s total debt as a percent of total capital to increase to 81.5 percent from 52.6

Figure 5: Effects on Financial Statements and Ratios

Income Statement Data Reported Normalized Comprehensive

Revenue $19,629 $19,629 $19,629Operating profit 1,071 1,023 1,023Interest expense 144 160 160Effective tax rate 37.0% 37.5% 38.0%

Net income $830 $784 $592

Balance Sheet Data Reported Adjusted Adjusted

Current assets $3,941 $3,525 $3,525

Total assets 15,385 24,156 24,156

Current liabilities 3,335 3,335 3,335

Total debt 8,097 19,720 19,720

Equity 7,288 4,436 4,436

RatiosOperating margin 5.5% 5.2% 5.2%Profit margin 4.2% 4.0% 3.0%

Current ratio 1.2 1.1 1.1

Times interest earned 7.4 6.4 6.4Total debt-to-total capital 52.6% 81.5% 81.5%

ROA 5.4% 3.3% 2.5%ROE 11.4% 17.7% 13.4%



percent. For many firms the adjusted balance sheet will indicate more leverage than the reported balance sheet. For purposes of the test, adjustments for operating leases and pension plan funded status should be expected.

Effect on ROA and ROE

Finally, we consider the ROA and ROE measures. ROA based on the reported financial data is also the highest. ROA for the two other methods is lower due to lower income measures and higher asset bases. Recall that the adjustment for off-balance sheet financing (e.g., operating leases) results in higher asset values as well as higher liabilities. Therefore, ROA is typically lower after adjustments. ROE is lowest for the reported data. Since many of our adjustments result in negative changes in the equity, ROE actually increases because the denominator, or the firm’s equity base, is lower. In the FedEx example, the adjusted equity falls to $4.4 billion from $7.3 billion, a decrease of approximately 39 percent.

Effect of Changes in Accounting Methods and Assumptions

Analysts must also be aware of changes in accounting methods and assumptions. For example, FedEx reported that it changed the useful lives and residual values of some of its assets. These changes resulted in decreased depreciation expense of $13 million. In this case, the change resulted in reported income rising by $13 million × (1 – 0.38) = $8.06 million. This change is not material to FedEx’s reported income or performance measures for 2003, but an analyst should be aware of these kinds of changes because they can be material for other companies and may be used to manipulate earnings.

FedEx also reported that it expects the following changes in the 2004 estimates of the factors used to calculate pension expense:

The net effect of the changes in the assumptions is an increase in estimated 2004 pension plan costs of $115 million. These assumption changes are likely to have a material effect on 2004 reported and normalized earnings. For some perspective, we can compare the cost increases to reported income for 2003. In this case, the $115 million represents approximately 14% of 2003 earnings. Therefore, an analyst should note these changes and factor them into the analysis of the firm, paying particular attention to the effects on earnings trends.

Figure 6: Effects of Changes in FedEx’s Pension Plan Assumptions

Decrease in the discount rate $20 million

Reduction in expected return on plan assets $65 million

Net effect of the amortization of actuarial losses $55 million

Reduction in rate of salary increase and other –$25 million

Total $115 million



LOS 3.B.e: Identify indicators of high and low earnings quality.

Earnings quality refers to the conservativeness of a firm’s financial reporting. High quality earnings are clearly and conservatively stated. There are a number of indicators of quality earnings, including:

• Conservative revenue recognition.• Use of LIFO accounting (assuming prices are rising).• Adequate bad debt reserves.• Use of accelerated depreciation methods.• Minimal capitalization of interest.• Conservative assumptions used for employee benefit plans.• Minimal use of off-balance sheet financing.• Absence of nonrecurring gains.• Clear and adequate disclosures.

Don’t confuse earnings quality with highly predictable earnings streams. Highly predictable earnings streams are often manipulated, which results in low-quality earnings. Therefore, the tests listed above should be used to determine earnings quality.

LOS 3.B.f: Calculate free cash flow using the statement of cash flows.

The purpose of this LOS is to point out the important link between the financial statement analysis concepts in this topic review and the free cash flow valuation models in Study Session 12. The “free cash flow” in this LOS refers to what’s called free cash flow to the firm (FCFF) in Study Session 12, which we discuss extensively as part of the topic review of free cash flow models. In particular, see LOS 1.B.e in Study Session 12 for more on calculating FCFF.

We can calculate FCFF using the statement of cash flows by adjusting cash flow from operations (which is reported in the statement of cash flows) for the after-tax cost of interest and capital expenditures:

Example: Calculating FCFF from the statement of cash flows

New Versions Inc. reports cash flow from operations of $215 million, capital expenditures of $186 million, and interest expense of $18. The firm’s marginal tax rate is 35 percent. Calculate free cash flow to the firm (FCFF).

Answer:

( )

( )

( )

FCFF CFO Int 1 tax rate FCInv

where:CFO cash flow from operations from the statement of cash flowsInt interest expenseFCInv fixed capital investment capital expenditures

= + × − −⎡ ⎤⎣ ⎦

===

( )FCFF $215 $18 1 0.35 $186 $40.7 million= + × − − =⎡ ⎤⎣ ⎦



KEY CONCEPTS

1. There are two problems commonly encountered in the analysis of a firm’s balance sheet: (1) some assets and liabilities are not recorded, and (2) the book values of assets and liabilities may differ significantly from their market values.

2. Examples of assets and liabilities that may not be recorded on the balance sheet include operating leases, assets and liabilities of unconsolidated affiliates, take-or-pay contracts, and effects of lawsuits or environmental obligations.

3. Examples of adjustments to assets include converting LIFO inventories to FIFO, marking-to-market nonfinancial assets such as real estate, revaluation of operating assets or intangible assets, and adjusting for a pension plan value in excess of the projected benefit obligation.

4. Examples of adjustments to liabilities include the restatement of deferred income taxes to reflect the probability of reversal and present value and the revaluation of debt to reflect changes in interest rates or risk.

5. Extraordinary or nonrecurring items may require adjustments to the income statement. Adjusting net income for nonrecurring items results in an estimate of normal operating income. Examples of income statement items requiring adjustment include accounting changes, one-time charges, and restructurings.

6. Earnings quality refers to the conservativeness of a firm’s financial reporting. High quality earnings are clearly and conservatively stated. For example, the method of revenue recognition has a direct impact on the quality of a firm’s earnings reports.

7. Free cash flow to the firm is calculated using CFO from the cash flow statement:

( )FCFF CFO Int 1 – tax rate – FCInv= + ×⎡ ⎤⎣ ⎦



CONCEPT CHECKERS: ANALYSIS OF FINANCIAL STATEMENTS: A SYNTHESIS

Use the following data to answer Questions 1 through 6. Consider each question independently of information contained in the other questions.

Dot.Com has 10 million shares of common stock outstanding.

The footnotes to Dot.Com’s financial statements provide the following information:• Inventories are valued at cost as determined by the last-in, first-out (LIFO) method. The LIFO reserve is $5

million.• Additional operating facilities and equipment are financed with operating leases that have a present value of

$10 million.• Intangible assets include $2 million of goodwill from previous acquisitions.• Due to a decrease in interest rates, Dot.Com’s long-term debt has a current market value of $75 million.

1. In addition to the information already presented in the question, assume there are $15 million of take-or-pay contracts disclosed in the financial statement footnotes. For analysis purposes, which of the following will NOT occur as a result of making the appropriate adjustments for the commitments?A. Increase in total assets.B. Increase in total liabilities.C. Decrease in debt-to-equity ratio.D. Decrease in return on assets.

Dot.Com Company Balance Sheet(in millions of $)

Assets

Cash $10Marketable securities 5Accounts receivable 20Inventories 40

Total current assets $75

Net property, plant, & equipment $115Intangible assets 10

Total assets $200

Liabilities & Owners’ Equity

Accounts payable $15Notes payable 5

Total current liabilities $20

Long-term debt $60Common stock (10 million shares) 20Retained earnings 100

Total stockholders’ equity $120

Total liabilities & equity $200



2. The long-term debt-to-equity ratio based on the historical balance sheet bears what relationship to the ratio based on the adjusted balance sheet? The long-term debt-to-equity ratio:A. based on the historical balance sheet is the same as that based on the adjusted balance sheet.B. based on the historical balance sheet is greater than that based on the adjusted balance sheet.C. based on the historical balance sheet is less than that based on the adjusted balance sheet.D. cannot be determined for the adjusted balance sheet.

3. In addition to the information already presented in the question, assume that the tax basis of net property, plant, and equipment is $100 million and that the capital expenditures are expected to grow indefinitely in the future. The applicable tax rate is 30 percent. The required adjustment to Dot.Com’s equity balance to account for deferred taxes is closest to:A. $0.B. –$4.5 million.C. +$4.5 million.D. +$15.0 million.

4. In addition to the information already present in the question, assume that the current allowance for doubtful accounts is $5 million and that sales for the year were $100 million. The analyst subsequently discovers that a more reasonable estimate for allowance for doubtful accounts should be 6 percent of sales. Dot.com’s adjusted current assets balance based on all the available information is closest to:A. $74 million.B. $76 million.C. $79 million.D. $81 million.

5. The amount of the adjustments to equity necessary to arrive at an adjusted balance sheet for Dot.Com is closest to:A. –$12 million.B. $12 million.C. $18 million.D. $30 million.

6. Dot.com’s total liabilities and equity balance after any necessary adjustments is closest to:A. $203 million.B. $213 million.C. $215 million.D. $225 million.




The following information is obtained from footnotes to XYZ’s financial statements and other sources:• One of XYZ’s major customers that accounts for $5,000 of receivables has just filed for bankruptcy

protection.• Inventories are valued at cost as determined by the LIFO method. The LIFO reserve is $3,000.• The deferred tax asset and liability are unlikely to reverse in future periods.• Additional operating facilities and equipment are financed with operating leases that have a present value of

$15,000.• The value of XYZ’s pension plan assets in excess of the projected benefit obligation is $8,000.• Intangible assets represent $12,000 of goodwill from previous acquisitions.• Due to a decrease in interest rates, XYZ’s long-term debt has a current market value of $26,000.• The current market price of XYZ’s preferred stock is $40 per share.• XYZ is expected to incur expenses with a present value of $5,000 to settle a legal claim related to a workmen’s

compensation case.

7. XYZ’s adjusted inventory based on the FIFO method is closest to:A. $7,000.B. $10,000.C. $13,000.D. $16,000.

XYZ Company Balance Sheet(in thousands of dollars)Assets

Cash $5,000Marketable securities 3,000Accounts receivable 20,000Inventories 10,000Deferred taxes 5,000


Net PP&E 80,000Prepaid pension cost 6,000Intangible assets 12,000

Total assets $141,000

Liabilities & Owners’ EquityAccounts payable $18,000Notes payable 7,000


Long-term debt 24,000Deferred taxes 8,000

Preferred stock (200 thousand shares) 10,000Common stock (2 million shares) 40,000Retained earnings 34,000

Total stockholders’ equity $84,000

Total liabilities & equity $141,000



8. XYZ’s current ratio after any necessary adjustments is closest to:A. 1.44.B. 1.64.C. 1.72.D. 1.84.

9. XYZ’s long-term assets balance after any necessary adjustments is closest to:A. $101,000.B. $103,000.C. $113,000.D. $115,000.

10. XYZ’s long-term liabilities balance after any necessary adjustments is closest to:A. $34,000.B. $46,000.C. $49,000.D. $54,000.

11. XYZ’s ratio of long-term debt to common and preferred equity based on the historical cost balance sheet is:A. 0.17.B. 0.29.C. 0.58.D. 0.68.

12. XYZ’s ratio of long-term debt to common and preferred equity based on the adjusted balance sheet is closest to:A. 0.29.B. 0.58.C. 0.60.D. 0.68.

13. Which of the following is the best indicator of high earnings quality?A. Straight-line depreciation method is used.B. Interest is capitalized on an on-going basis.C. LIFO inventory costing is used in a rising-price environment.D. High expected return on assets assumption is used for employee benefit plans.

14. The formula for calculating free cash flow to the firm using the statement of cash flows is:A. cash flow from operations + [interest expense × (1 – tax rate)] – capital expenditures.B. cash flow from operations – cash flow from investing + net working capital expenditures.C. cash flow from operations + (interest expense × tax rate) – capital expenditures.D. cash flow from operations + [interest expense × (1 – tax rate)] – capital expenditures + net working

capital expenditures.

15. Penguins Inc. uses the temporal method to translate foreign currency amounts. During the year, it reported net income of $5,000,000, an unrealized gain on available-for-sale securities of $150,000, an extraordinary loss of $200,000, a gain from discontinued operations of $175,000, and a foreign currency translation loss of $250,000. Penguins’ comprehensive income and normal operating income, respectively, are closest to:

Comprehensive Income Normal Operating IncomeA. $4,875,000 $5,025,000B. $4,875,000 $5,125,000C. $5,150,000 $5,125,000D. $5,150,000 $5,025,000



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF FINANCIAL STATEMENTS: A SYNTHESIS

1. C Take-or-pay contracts will increase both assets and liabilities by an identical amount. The increase in assets, all else equal, will decrease the return on assets. The net effect on equity is zero, but the increase in debt will result in an increase in the debt-to-equity ratio.

2. C The long-term debt to equity ratio is calculated as:

3. A If capital expenditures are expected to grow indefinitely in the future, then any temporary differences would not be expected to reverse. Therefore, no deferred taxes should be recorded. Since there are no deferred taxes recorded on the balance sheet, no adjustment is required.

4. C The current allowance for doubtful accounts balance (a contra-asset account) of $5 million is already incorporated in the accounts receivable balance. Since a more reasonable balance for allowance for doubtful accounts is $6 million ($100 million × 6%), we should reduce the accounts receivable balance by $1 million. We also have to increase the inventory balance by the LIFO reserve of $5 million to reflect the use of the FIFO method. The net change as a result of these two adjustments is a $4 million increase in current assets and an adjusted balance of $79 million.

5. A Equity adjustments:$ 5 million (from inventory adj.)

– 2 million (from goodwill adj.)– 15 million (from long-term debt adj.)

–$12 million (total)

Note that you have to ignore the allowance for doubtful accounts information from question #4 because the instructions say “consider each question independently of information contained in other questions.”

$60based on historical balance sheet 50%

$120= =

$85based on the adjusted balance sheet 78.7%

$108= =



6. B See detail in the adjusted balance sheet for Dot.com Company in the following table.

The footnotes to Dot.Com’s financial statements provide the following information:

7. C LIFO inventory of 10,000 + LIFO reserve of 3,000 = FIFO inventory of $13,000

Dot.Com Company Adjusted Balance Sheet(in millions of $)

Assets

Cash $10Marketable securities 5Accounts receivable 20Inventories 45

Total current assets $80

Net property, plant, & equipment $125Intangible assets 8

Total assets $213

Liabilities & Owners’ Equity

Accounts payable $15Notes payable 5

Total current liabilities $20

Long-term debt $85

Common stock $20Retained earnings 100Equity adjustment –12

Total stockholders’ equity $108

Total liabilities & equity $213

Item Adjustment

Inventories are valued at cost as determined by the LIFO method. The LIFO reserve is $5 million.

Adj. inventory = $40 + 5 = $45 million.Also, add $5 million to equity.

Additional operating facilities and equipment are financed with operating leases that have a present value of $10 million.

Add $10 million to net property plant and equipment and to long-term debt.

Intangible assets represent $2 million of goodwill from previous acquisitions.

Reduce intangibles by the $2 million goodwill.Also reduce equity by $2 million.

Due to a decrease in interest rates, Dot.Com’s long-term debt has increased in value by $15 million.

Add $15 million to long-term debt. Reduce equity by $15 million.



8. A

Current assets:Cash $5,000Marketable securities $3,000Accounts receivable $15,000 (20,000 – 5,000)Inventories $13,000 (10,000 + 3,000)Deferred taxes $0 (5,000 – 5,000); see detail in the summaryTotal current assets $36,000

Current liabilities:Accounts payable $18,000Notes payable $7,000Total current liabilities $25,000

9. B Long term assets = net PP&E + prepaid pension cost + intangible assets(80,000 + 15,000) + (6,000 + 2,000) + (12,000 – 12,000) = $103,000See detail in summary.

10. B Long term liabilities = long-term debt + capitalization of operating leases + deferred taxes + environmental obligation(24,000 + 2,000) + (0 +15,000) + (8,000 – 8,000) + (0 + 5,000) = $46,000See detail in the summary.

11. B

12. D

See detail in the summary.

Summary of adjustments—adjusted balance sheet for XYZ:

Assets

Cash $5,000Marketable securities 3,000

Accounts receivable1 15,000

Inventories2 13,000

Deferred taxes3 0


Net PP&E4 $95,000

Prepaid pension cost5 8,000

Intangible assets6 0

Total assets $139,000

Current assetsCurrent ratio =

Current liabilities

=$36,000Current ratio = 1.44

$25,000

24,000Long-term debt-to-equity (unadjusted) 0.29

84,000= =

+ + += =24,000 15,000 2,000 5,000Long-term debt-to-equity (adjusted) 0.68.

68,000



Notes:

1. A/R declined to $15,000 due to the bankruptcy of a customer. Equity will be reduced by this amount as well.

2. Recognition of the LIFO reserve will increase inventory by $3,000 and equity by $3,000.

3. The deferred tax asset and deferred tax liability have been eliminated because the tax timing differences are unlikely to reverse in future periods. $5,000 tax asset is eliminated, reducing equity by $5,000. $8,000 tax liability is eliminated, increasing equity by $8,000. The net equity adjustment is a $3,000 addition.

4. Operating leases are capitalized by adding $15,000 to PP&E and $15,000 to long-term debt.

5. The current balance sheet valuation of the pension plan is $6,000. Since the plan surplus is actually $8,000, a $2,000 addition to prepaid pension cost is posted. Equity rises by this same amount.

6. Intangible assets are eliminated. Equity is reduced by $12,000.

7. LTD is adjusted to market value. An increase of $2,000 is posted to LTD, and a decrease of $2,000 goes to equity.

8. The preferred stock valuation is reduced to $8,000 = $40 (200). The offset is a $2,000 increase to equity.

9. The legal claim contingency is a liability. The offsetting adjustment is to equity of $5,000.

10. The net adjustments to equity are (5,000) + 3,000 + 3,000 + 2,000 + (12,000) + (2,000) + 2,000 + (5,000) = ($14,000) respectively for items 1-9.

13. C High earnings quality generally refers to reporting a more conservative (i.e., lower) level of earnings. LIFO inventory costing (when prices are rising) generally results in a more conservative level of reported earnings. The other three items result in less conservative (higher levels of ) reported earnings.

14. A

Liabilities & Owners’ EquityAccounts payable $18,000Notes payable 7,000


Long-term debt7 $26,000

Capitalization of oper. leases4 15,000

Deferred taxes3 0

Environmental obligation9 5,000

Total long-term obligations $46,000

Preferred stock8 $8,000Common stock (1 million shares) 40,000Retained earnings 34,000

Net adjustments to equity10 (14,000)

Total stockholders’ equity $68,000

Total liabilities & equity $139,000

( )FCFF CFO Int 1 tax rate FCInv⎡ ⎤= + × − −⎣ ⎦



15. D Comprehensive incomeNet income $5,000,000Unrealized gain on available-for-sale securities $150,000Total $5,150,000

Normal operating incomeNet income $5,000,000Add back: Extraordinary loss $200,000Deduct: Gain from discontinued operations ($175,000)Total $5,025,000

Penguins uses the temporal method, so the foreign currency translation loss, which is recorded on the income statement, is already incorporated in net income. The unrealized gain on available for sale securities is recorded directly to equity.



ANALYSIS OF FINANCIAL STATEMENTS

Study Session 7

EXAM FOCUS

This topic review is your source for the calculation ofmost of the ratios you will be analyzing. This review isa repeat from Level 1, so you’re probably already wellon your way to memorizing the important ratios:current ratio, debt-to-equity, asset turnover, interestcoverage, return on equity, and profit margin, just toname a few. Memorize the three- and five-part

DuPont breakdown of return on equity as well as thesustainable growth rate formula, and be prepared touse them on the exam. The DuPont formula is as closeto a sure thing as you’ll find on the Level 2 exam; itshowed up on the exam every year between 2000 and2004.

WARM-UP: CALCULATION AND INTERPRETATION OF FINANCIAL RATIOS

The purpose of this topic review is to introduce you to the basics of financial statement analysis. Financial statement analysis is a key element in security analysis and valuation. Analysts review a company’s financial statements to gain insight into the firm’s financial decision-making and operating performance. Financial data is converted into ratios to make them easier to analyze. Although there are literally dozens of ratios that can be computed, there is a relatively small subset that provides an analyst with most of the relevant information about a firm.

When performing analysis with financial ratios it is important to remember that:

1. A single value of a financial ratio is not meaningful by itself, but must be examined in the context of a firm’s history (past performance), industry, major competitors, and the economy.

2. Ratios by themselves don’t answer the analyst’s questions. Rather, ratios are designed to provide the analyst with pertinent questions to assist in conducting the analysis of the firm. Ratios enable the analyst to ask: Why? What? How?

Professor’s Note: LOS 4.a and 4.b are not directly addressed in the cross-referenced reading associated with this review, but instead come from the other financial statement analysis material in Study Sessions 5, 6, and 7. I strongly suggest you go back through the other financial statement analysis material in those study sessions as you study these two LOS.

ACCOUNTING CHOICES: EFFECT ON FINANCIAL RATIOS

LOS 4.a: Describe some of the important accounting choices (typically explained in the footnotes of financial statements) that companies must make when constructing financial statements using generally accepted accounting principles (GAAP).

One of the major themes from the financial statement analysis material in Level 2 is that the accounting methods management chooses have a material effect on the presentation of the balance sheet, the income statement, the statement of cash flows, and the financial ratios calculated from those statements. Here is a list of a few of the most important issues you’ve encountered so far in your reading:


Study Session 7Cross-Reference to CFA Institute Assigned Reading – Reilly and Brown, Chapter 10

• LIFO versus FIFO inventory valuation methods. • Depreciation methodologies and useful lives. • Operating versus capital leases. • Cost, equity, or consolidation methods for intercorporate investments. • U.S. vs. IAS GAAP purchase methods for business combinations. • Temporal versus all-current methods of consolidating foreign subsidiary operations. • Assumptions regarding the discount rate, rate of compensation increase, rate of return on plan assets, and

healthcare inflation rate for retirement benefit accounting.• Other management accounting choices such as restructuring charges, deferral of costs, front-loading income,

and use of reserves.

LOS 4.b: Describe how a company’s accounting choices make comparability among companies difficult.

It is important to realize that these choices are not uniform across companies or even for the same company through time. Firms with similar operations can have very different reported results due to differences in accounting choices. Comparability, either on a time-series or cross-sectional basis, is often difficult. The analyst’s job is to make the appropriate adjustments to the financial statements so that he can compare financial results among companies.

CASH FLOW MEASURES

LOS 4.c: Distinguish among “cash flows from operating activities” (from the statement of cash flows), “traditional cash flow,” and “free cash flow.”

Analysts use cash flows to measure the financial health of the corporation. However, there are several measures of cash flow. The following are the three most common measures.

Traditional cash flow serves as the base case for our other cash flow measures. It is calculated as:

traditional cash flow = net income + depreciation + change in deferred taxes

Cash flow from operating activities (CFO) adjusts the traditional measure for noncash working capital. For this reason it is a more exact measure of operating cash flows than the traditional measure. Remember that increases in current assets and decreases in current liabilities are uses of cash; decreases in current assets and increases in current liabilities are sources of cash.

CFO = traditional cash flow – increase in noncash working capital

Free cash flow (FCF) recognizes that some investing and financing activities are vital to the ongoing nature of the business, including capital expenditures and dividend payments. FCF adjusts CFO accordingly:

FCF = CFO – capital expenditures – dividends

Professor’s Note: This definition of free cash flow is different from the more commonly used definition of free cash flow to the firm (FCFF) from the previous topic review and Study Session 12:

FCFF = CFO + [Int × (1 – tax rate)] – FCInv

I suggest that on the exam you use this more popular definition (FCFF) and not the less common “free cash flow” as defined in this LOS.



FINANCIAL RATIOS: CALCULATION AND INTERPRETATION

LOS 4.d: Calculate and interpret financial ratios in the following categories: common size, internal liquidity, operating efficiency, operating profitability, business risk, financial risk, external liquidity, and growth potential and prepare, using financial ratios, a comparative analysis of a company over time and relative to its industry or to the market.

Ratios can be used to evaluate five different facets of a company’s performance and condition: (1) internal liquidity, (2) operating performance, (3) risk profile, (4) growth potential, and (5) external liquidity. Common size statements are also useful in analyzing firm performance.

Common size statements. Common size statements normalize balance sheet and income statements and allow the analyst to make easier comparisons of different sized firms.

• A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets.• A common-size income statement expresses all income statement items as a percentage of sales.

In addition to the comparison of financial data across firms and time, common-size analysis is appropriate for quickly viewing certain financial ratios. For example, the gross profit margin, operating profit margin, and net profit margin are all clearly indicated within a common-size income statement.

Example: Common size statements

The common-size statements in Figure 1 are computed using data from Kraft Inc.’s 2002 10-K report.1 The common-size balance sheet states items as a percentage of assets, and the common-size income statement shows all items as a percentage of sales.

• You can convert all asset and liability amounts to their actual values by multiplying the percentages listed below by their total assets of $57,100, $55,798, and $52,071 respectively for 2002, 2001, and 2000 (data is millions of $). Columns might not add due to rounding.

• All income statement items can be converted to their actual values by multiplying the given percentages by total sales, which were $29,723, $29,234, and $22,922 respectively for 2002, 2001, and 2000.

1. United States Securities and Exchange Commission, nd, <http://www.sec.gov/Archives/edgar/data/1103982/000104746903010159/0001047469-03-010159-index.htm> (September 2005)

Figure 1: Kraft Inc. Common-Size Statement

Balance Sheet Fiscal year end 2002 2001 2000

AssetsCash & cash equivalents 0.38% 0.29% 0.37%Accounts receivable 5.46% 5.61% 6.20%Inventories 5.92% 5.42% 5.84%Deferred income taxes 0.89% 0.84% 0.97%Other current assets 0.41% 0.40% 0.36%

Total current assets 13.06% 12.56% 13.74%Gross fixed assets 25.31% 23.79% 25.05%Accumulated depreciation 8.57% 7.46% 6.98%

Net gross fixed assets 16.74% 16.32% 18.06%

Other long-term assets 70.20% 71.12% 68.20%

Total assets 100.00% 100.00% 100.00%



Ratios can be used to evaluate five different facets of a company’s performance and condition: (1) internal liquidity, (2) operating performance, (3) risk profile, (4) growth potential, and (5) external liquidity.

Internal liquidity ratios are employed by analysts to determine the firm’s ability to pay its short-term liabilities.

The current ratio is the best-known measure of liquidity:

The higher the current ratio, the more likely it is that the company will be able to pay its short-term bills. A current ratio of less than one means that the company has negative working capital and may be facing a liquidity crisis. Working capital equals current assets minus the current liabilities.

The quick ratio is a more stringent measure of liquidity because it does not include inventories and other assets that might not be very liquid:

The higher the quick ratio, the more likely it is that the company will be able to pay its short-term bills.

LiabilitiesAccounts payable 3.40% 3.40% 3.79%Short-term debt 1.00% 2.19% 1.65%Other current liabilities 8.16% 10.32% 9.14%

Total current liabilities 12.56% 15.91% 14.58%Long-term debt 18.24% 14.58% 5.18%Other long-term liabilities 23.96% 27.44% 53.27%

Total liabilities 54.76% 57.92% 73.02%Preferred equity 0.00% 0.00% 0.00%Common equity 45.24% 42.08% 26.98%

Total liabilities & equity 100.00% 100.00% 100.00%

Income Statement Fiscal year end 2002 2001 2000

Revenues 100.00% 100.00% 100.00%

CGS 59.62% 60.09% 60.90%

Gross profit 40.38% 39.91% 39.10%

Selling, general, & administrative 16.82% 17.34% 17.84%Depreciation 2.39% 2.33% 2.18%Amortization 0.02% 3.29% 2.33%Other operating expenses 0.58% 0.25% -0.75%Operating income 20.57% 16.71% 17.50%Interest and other debt expense 2.85% 4.92% 2.60%Income before taxes 17.72% 11.79% 14.90%Provision for income taxes 6.30% 5.35% 6.17%

Net income 11.42% 6.44% 8.73%

Figure 1: Kraft Inc. Common-Size Statement (Continued)

current assetscurrent ratio

current liabilities=

cash marketable securities receivablesquick ratio

current liabilities

+ +=



The most conservative liquidity measure is the cash ratio:

The higher the cash ratio, the more likely it is that the company will be able to pay its short-term bills.

The current, quick, and cash ratios differ only in the assumed liquidity of the current assets that the analyst projects will be used to pay off current liabilities.

A measure of accounts receivable liquidity is the receivables turnover:

Professor’s Note: In most cases when a ratio compares a balance sheet account (such as receivables) with an income or cash flow item (such as sales), the balance sheet item will be the average of the account instead of simply the end-of-year balance. Averages are calculated by adding the beginning-of-year account value and the end-of-year account value, then dividing the sum by two. On the exam, you will usually be instructed as to whether to use average, ending, or beginning balance sheet values.

It is considered desirable to have a receivables turnover figure close to the industry norm.

The inverse of the receivables turnover times 365 is the average receivables collection period, which is the average number of days it takes for the company’s customers to pay their bills:

It is considered desirable to have a collection period (and receivables turnover) close to the industry norm. The firm’s credit terms are another important benchmark used to interpret this ratio. A collection period that is too high might mean that customers are too slow in paying their bills, which means too much capital is tied up in assets. A collection period that is too low might indicate that the firm’s credit policy is too rigorous, which might be hampering sales.

A measure of a firm’s efficiency with respect to its processing and inventory management is the inventory turnover:

Professor’s Note: Pay careful attention to the numerator in the turnover ratios. For inventory turnover, be sure to use cost of goods sold, not sales, unless otherwise instructed on the exam.

The inverse of the inventory turnover times 365 is the average inventory processing period:

As is the case with accounts receivable, it is considered desirable to have an inventory processing period (and inventory turnover) close to the industry norm. A processing period that is too high might mean that too much

cash marketable securitiescash ratio

current liabilities

+=

net annual salesreceivables turnover

average receivables=

365average receivables collection period

receivables turnover=

cost of goods soldinventory turnover

average inventory=

365average inventory processing period

inventory turnover=



capital is tied up in inventory and could mean that the inventory is obsolete. A processing period that is too low might indicate that the firm has inadequate stock on hand, which could adversely impact sales.

A measure of the use of trade credit by the firm is the payables turnover ratio:

The inverse of the payables turnover ratio multiplied by 365 is the payables payment period, which is the average amount of time it takes the company to pay its bills:

The cash conversion cycle is the length of time it takes to turn the firm’s investment into cash, which is used to create inventory, which is turned back into cash in the form of collections from the sales of that inventory.

High cash conversion cycles are considered undesirable. A conversion cycle that is too high implies that the company has an excessive amount of capital investment in the sales process.

Operating efficiency ratios are comprised of the total asset turnover, net fixed asset turnover, and equity turnover ratios. Note that all of these ratios take some asset or equity account and divide it into sales to determine how efficiently the company uses assets and capital.

The effectiveness of the firm’s use of its total assets to create revenue is measured by the total asset turnover:

Different types of industries might have considerably different turnover ratios. Manufacturing businesses that are capital-intensive might have asset turnover ratios near one, while retail businesses might have turnover ratios near 10. As was the case with the current asset turnover ratios discussed previously in this topic review, it is desirable for an asset turnover to be close to the industry norm. Low asset turnover ratios might mean that the company has too much capital tied up in its asset base. A turnover ratio that is too high might imply that the firm has too few assets for potential sales or that the asset base is outdated.

The utilization of fixed assets is measured by the net fixed asset turnover:

As was the case with the total asset turnover ratio, it is desirable to have a fixed asset turnover close to the industry norm. Low fixed asset turnover might mean that the company has too much capital tied up in its asset base. A turnover ratio that is too high might imply that the firm has obsolete equipment, or at a minimum, the firm will probably have to incur capital expenditures in the near future to increase capacity to support growing revenues.

cost of goods soldpayables turnover ratio

average trade payables=

365payables payment period

payables turnover ratio=

cash payablesaverage receivables average inventory

conversion – paymentcollection period processing period

cycle period

⎛ ⎞⎛ ⎞ ⎛ ⎞ ⎜ ⎟= +⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠ ⎜ ⎟

⎝ ⎠

net salestotal asset turnover

average total net assets=

net salesfixed asset turnover

average net fixed assets=



The equity turnover is a measure of the employment of owners’ capital:

For this ratio, equity capital includes all preferred and common stock, paid-in capital, and retained earnings, although some analysts use only common equity, which excludes preferred stock. Analysts need to consider the capital structure of the company in evaluating this ratio because a company can increase this ratio without increasing profitability simply by using more debt financing.

Operating profitability ratios look at how good management is at turning its efforts into profits. Operating ratios compare the top of the income statement (sales) to profits. The different ratios are designed to isolate specific costs.

Know these terms:

Gross profit = Net sales − COGSOperating profit = Earnings before interest and taxes = EBITNet income = Earnings after taxes = EATCapital = Long-term debt + short-term debt + preferred and common equity

How they relate in the income statement:

The gross profit margin is the ratio of gross profit (sales less cost of goods sold) to sales:

An analyst should be concerned if this ratio is too low.

The operating profit margin is the ratio of operating profit (gross profit less sales, general, and administrative expenses) to sales. Operating profit is also referred to as earnings before interest and taxes (EBIT):

Analysts should be concerned if this ratio is too low. Some analysts prefer to calculate the operating profit margin by adding back depreciation expense to arrive at earnings before interest, taxes, depreciation, and amortization (EBITDA).

Net sales– Cost of goods sold

Gross profit– Operating expenses

Operating profit (EBIT)– Interest

Earnings before taxes (EBT)– Taxes

Earnings after taxes (EAT)

net salesequity turnover

average equity=

gross profitgross profit margin

net sales=

operating profit EBIToperating profit margin

net sales net sales= =



The net profit margin is the ratio of net income to sales:

Analysts should be concerned if this ratio is too low. The net profit margin should be based on net income from continuing operations because analysts should be primarily concerned about future expectations and because “below the line” items, such as discontinued operations, will not impact the company in the future.

The return on total capital (ROTC) is the ratio of net income before interest expense to total capital:

Analysts should be concerned if this ratio is too low. Total capital is short- and long-term debt plus preferred stock plus common stock. The interest expense that should be added back is gross interest expense, not net interest expense (which is gross interest expense less interest income).

An alternative method for computing ROTC is to adjust the balance sheet by adding the present value of operating leases as a fixed asset and as a long-term liability. This adjustment is especially important for firms that are dependent on operating leases as a major form of financing.

The return on total equity is the ratio of net income to total equity (including preferred stock):

Analysts should be concerned if this ratio is too low.

A similar ratio to the return on total equity is the return on common equity:

This ratio differs from the return on total equity in that it only measures the accounting profits available to and the capital invested by common stockholders, instead of common and preferred stockholders. That is why preferred dividends are deducted from net income in the numerator. Analysts should be concerned if this ratio is too low.

Professor’s Note: Often the company you’re analyzing has no preferred stock, and the term “return on equity” is used in place of “return on common equity.”

The return on common equity is often more thoroughly analyzed using the DuPont decomposition, which will be described later in this topic review.

BUSINESS AND FINANCIAL RISK

LOS 4.f: Discuss business risk and financial risk.

Risk analysis calculations measure the uncertainty of the firm's income flows. They can be divided into two groups: those that measure business risk and those that measure financial risk.

net incomenet profit margin

net sales=

net income interest expensereturn on total capital

average total capital

+=

net income return on total equity

average total equity=

net income – preferred dividends return on common equity

average common equity=



Professor’s Note: See the topic review of capital structure and leverage in Study Session 8 for more information on measuring business and financial risk.

Business risk is the uncertainty regarding the operating income of a company and is a result of the variability of sales and production costs. A general way of measuring risk of any data series is the coefficient of variation, which is the standard deviation of a data series divided by its mean. The calculation of business risk is the coefficient of variation of a company’s quarterly operating income over several years:

Between five and ten years of quarterly data should be used to calculate the coefficient of variation because using less data does not yield much statistical reliability and data more than ten years old is not likely relevant to the company’s present situation. Analysts should be concerned if this calculation is too high.

One of the contributing sources of earnings variability is sales variability. Sales variability is the coefficient of variation of sales over several years:

As was the case for business risk, between five and ten years of quarterly data should be used in this calculation. Analysts should be concerned if this calculation is too high.

Another source of the variability of operating earnings is the firm’s operating leverage, which measures how much of the company’s production costs are fixed (as opposed to variable). The greater the use of fixed costs, the greater the impact of a change in sales on the operating income of a company, and, consequently, the greater the risk. The actual measurement of operating leverage is complex. For a given set of years, the percent change in operating earnings (%∆OE) and the percent change in sales (%∆S) from the previous year are calculated. The average value of the absolute value of the ratio is:

Financial risk is the additional volatility of equity returns caused by the firm’s use of debt. Financial risk can be measured using balance sheet ratios—which include the debt-to-equity ratio, the long-term debt-to-total capital ratio, and the total debt ratio—or earnings and cash flow ratios, which include the interest coverage ratio, the fixed financial charge ratio, the total fixed charge coverage ratio, the cash flow-to-interest expense ratio, the cash flow coverage ratio, the cash flow-to-long-term debt ratio, and the cash flow-to-total debt ratio.

A measure of the firm’s use of fixed-cost financing sources is the debt-to-equity ratio:

Some analysts exclude preferred stock and only use owner’s equity. Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.

Note that for all ratios in which debt is part of the equation, the analyst has a choice of whether to include deferred taxes as part of debt. If deferred taxes are mainly a result of accelerated and straight-line depreciation differences, then the amount will likely not reverse and should be included as part of equity and not long-term

of operating incomecoefficient of variation of operating income

mean operating income

σ⎡ ⎤= ⎢ ⎥⎣ ⎦

of salescoefficient of variation of sales

mean sales

σ⎡ ⎤= ⎢ ⎥⎣ ⎦

% OEoperating leverage mean absolute value

% S

∆⎡ ⎤⎛ ⎞= ⎜ ⎟⎢ ⎥∆⎝ ⎠⎣ ⎦

total long-term debtdebt-to-equity ratio

total equity=



debt. However, in other cases, deferred taxes may be a result of income recognition on long-term contracts and do reflect taxes that will have to be paid at some point (the deferred tax amount will reverse). In this case, deferred taxes should be considered part of long-term debt. You should be prepared to calculate the ratios both ways—with and without deferred taxes.

Another way of looking at the usage of debt is the long-term debt-to-total capital ratio:

Total long-term capital equals all long-term debt plus common and preferred equity. Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.

A slightly different way of analyzing debt utilization is the total debt ratio, which includes current liabilities in both the numerator and the denominator:

Total debt plus total equity is also known as total capital. As discussed in the section on the debt-to-equity ratio, total capital may or may not include deferred taxes. Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.

Oftentimes, only interest bearing debt and equity are considered to be long-term capital. A further refinement excludes accounts payable and accrued expenses, which may be considered part of the firm’s working capital, to get the following relationship:

The remainder of the risk ratios help determine the firm’s ability to repay its debt obligations. The first of these is the interest coverage ratio:

The lower this ratio, the more likely it is that the firm will have difficulty meeting its debt payments.

A slight variation on the interest coverage ratio is to recognize that firms that use leased facilities are in essence borrowing the capital to utilize those facilities. These lease payments are accounted for in the fixed financial cost ratio:

where:ELIE = estimated lease interest expense

This ratio is interpreted in the same manner as the earlier version. Higher coverage ratios suggest the firm is better able to manage its current debt levels or that the firm has unused borrowing capacity.

total long-term debtlong-term debt-to-total capital

total long-term capital=

current liabilities total long-term debttotal debt ratio

total debt total equity

+=+

total interest-bearing debttotal interest-bearing debt to total funded capital total capital – noninterest-bearing liabilities

⎛ ⎞ =⎜ ⎟⎝ ⎠

EBITinterest coverage

interest expense=

EBIT ELIEfixed financial cost ratio

gross interest expense ELIE

+=+



A different type of variation in the coverage ratio is to use cash flow instead of income in the numerator. The basis of the cash flow measure is cash flow from operations (CFO) found in the financial statements. In this form, the cash flow measure includes depreciation expense, deferred taxes, and the impact of changes in net working capital. This version of the coverage ratio is defined as:

A different way of determining the ability of a company to meet its debt obligations is to compare cash flow to the amount of long-term debt. This yields the cash flow-to-long-term debt ratio:

where:BV of long-term debt = the book value of long-term debt PV of operating leases = the present value of operating leases

Remember that the denominator can be computed either with or without deferred taxes. The lower this ratio, the more likely it is that the firm will have difficulty meeting its long-term debt payments.

A slight variation on the cash flow-to-long-term debt ratio is the cash flow-to-total interest-bearing debt ratio:

The lower this ratio, the more likely it is that the firm will have difficulty meeting its debt payments.

Growth potential. Owners and creditors are interested in the firm’s growth potential. Owners pay attention to growth because stock valuation is dependent on the future growth rate of the firm. The analysis of growth potential is important to the creditors because the firm’s future prospects are crucial to its ability to pay existing debt obligations. If the company doesn’t grow, it stands a much greater chance of defaulting on its loans. In theory, the growth rate of a firm is a function of the rate of return earned on its resources and the amount of profits retained and reinvested.

To calculate the sustainable growth rate for a firm, the rate of return on resources is measured as the return on equity capital, or the ROE. The proportion of earnings reinvested is known as the retention rate (RR).

The formula for the sustainable growth rate, which is how fast the firm can grow without additional external equity issues while holding leverage constant, is:

g = RR × ROE

Professor’s Note: We discuss sustainable growth rate again in our topic review of dividend discount models in Study Session 12.

CFO interest expense ELIEcash flow coverage of fixed financial costs

interest expense ELIE

+ +=+

CFOcash flow to long-term debt

BV of long-term debt PV of operating leases=

+

CFOcash flow to total interest-bearing debt total long-term debt current interest-bearing liabilities⎛ ⎞ =⎜ ⎟ +⎝ ⎠

( )where:RR 1 – dividend payout ratio

dividends declareddividend payout ratio

earnings

=

=



Example: Calculating sustainable growth rate

Figure 2 provides data for three companies.

Calculate the sustainable growth rate for each company.

Answer:

External liquidity is an important aspect of any traded security. Illiquid stocks are difficult to sell, at least without significantly impacting the sale price. External liquidity is positively related to the relative speed at which you can trade your shares for a given impact on the price. Alternatively, smaller price impacts are associated with greater liquidity.

The most important determinant of external market liquidity is the number of shares traded during a given time period. The number of shares traded is positively related to liquidity. Other measures of liquidity include the following:

• The bid-ask spread is negatively related to liquidity.• The total market value of the outstanding securities is positively related to liquidity.• The number of shareholders is positively related to liquidity.• The trading turnover (or number of shares traded during the period divided by the number of shares

outstanding) is positively related to liquidity.

Figure 2: Growth Analysis Data

Company A B C

Earnings per share $3.00 $4.00 $5.00

Dividends per share 1.50 1.00 2.00

Return on equity 14% 12% 10%

RR 1 – dividend payout ratio

1.50Company A: RR 1 – 0.500

3.00

1.00Company B: RR 1 – 0.750

4.00

2.00Company C: RR 1 – 0.600

5.00

=

= =

= =

= =

g RR ROE

Company A : g 0.500 14% 7.0%

Company B : g 0.750 12% 9.0%

Company C: g 0.600 10% 6.0%

= ×= × == × == × =



DUPONT ANALYSIS

LOS 4.e: Compute and interpret the components of return on equity (ROE) using the original DuPont system and the extended DuPont system.

DuPont analysis is a technique that can be used to analyze return on equity (ROE). It uses basic algebra to break down ROE into a function of different ratios so an analyst can see the impact of leverage, profit margins, and turnover on shareholder returns. There are two variants of DuPont Analysis: the traditional approach (referred to here as the DuPont system) and the extended DuPont system.

For the original DuPont system, start with ROE defined as:

Note that there are two subtle aspects of this ROE measure. First, the numerator does not subtract preferred dividends as is commonly done. Second, the common equity figure that is used is not average equity, but simply end-of-year equity.

Professor’s Note: Here is one of those annoying little inconsistencies in the CFA curriculum. Here in the financial statement analysis material, the DuPont formula is calculated with ending balance sheet values. In Study Session 12, the use of beginning values is suggested. Our suggestion on the exam is to use beginning balance sheet values unless you’re instructed differently. In the 2003 Level 2 exam, the candidate was specifically instructed to use beginning values in Question 5, parts b and c.

Multiplying ROE by sales/sales and rearranging terms produces:

The first term is the profit margin and the second term is the equity turnover:

We can expand this further by multiplying these terms by assets/assets, and rearranging terms:

Professor’s Note: For the exam, remember that (net income / sales)×(sales / assets) = return on assets (ROA), so ROE = ROA × assets-to-equity.

The first term is still the profit margin, the second term is now asset turnover, and the third term is now an equity multiplier that will increase as the use of debt financing increases:

net income return on equity

equity

⎛ ⎞= ⎜ ⎟⎝ ⎠

net income salesreturn on equity

sales equity

⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠

net profit equityreturn on equity

margin turnover⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠

net income sales assets return on equity

sales assets equity

⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠

equitynet profit assetreturn on equity

margin turnover multiplier⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠



This is the traditional DuPont equation. It is arguably the most important equation in ratio analysis, since it breaks down a very important ratio (ROE) into three key components. If ROE is low, it must be that at least one of the following is true: the company has a poor profit margin, the company has poor asset turnover, or the firm is not highly leveraged.

Example: Original DuPont system

Explain how an Internet-based car dealer and a traditional car dealership might differ in terms of asset turnover and gross profit margin.

Answer:

One would expect that the traditional car dealership would have much lower asset turnover than the Internet-based dealership. The regular dealer has to have a large amount of capital tied up in its physical facility. Also, most dealers have repair facilities that require a lot of equipment. An Internet dealership will not have the same investment needs.

Conversely, the traditional dealership would likely have a higher gross profit margin than the Internet dealer. Selling a commodity over the Internet is very competitive, and price pressures would likely drive the sales price to slightly above cost. Traditional dealers attempt to keep margins higher by differentiation—offering various services and through salesmanship.

Example: Original DuPont system

A company has a profit margin of 4 percent, an asset turnover of 2.0, and a debt-to-assets ratio of 60 percent. Calculate the ROE.

Answer:

Debt-to-assets = 60%, which means equity-to-assets = 40%; this implies assets-to-equity is

The extended DuPont system takes the net profit margin and breaks it down further. The numerator of the net profit margin is net income. Since net income is equal to earnings before taxes multiplied by 1 minus the tax rate (1 – t), the DuPont equation can be written as:

Earnings before tax is simply EBIT minus interest expense. If this substitution is made, the equation becomes:

The first term is the operating profit margin. The second term is total asset turnover. The third term is new and is called the interest expense rate. The fourth term is the same leverage multiplier defined in the traditional

12.5.

0.4=

( )( )( )

assetsnet profit total assetROE

margin turnover equity

0.04 2.00 2.50 0.20, or 20%

⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠

= =

( )earnings before tax sales assetsROE 1 – t

sales assets equity

⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠ ⎝ ⎠

( )interest expenseEBIT sales assetsROE – 1 – t

sales assets assets equity

⎛ ⎞⎡ ⎤⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟ ⎜ ⎟⎢ ⎥⎝ ⎠⎝ ⎠ ⎝ ⎠⎣ ⎦ ⎝ ⎠



DuPont equation, and the fifth term is called the tax retention rate. It is also equal to net income divided by pretax income. The equation can now be stated as:

Note that in general, high profit margins, leverage, and asset turnover will lead to high levels of ROE. However, this version of the formula shows that more leverage does not always lead to higher ROE. As leverage rises, so does the interest expense rate. Hence the positive effects of leverage can be mitigated by the higher interest payments that accompany more debt. Note that marginal tax rates will always lead to lower levels of ROE.

Example: Extended DuPont system

An analyst has gathered data from two companies in the same industry. Calculate the ROE for both companies using the extended DuPont equation, and explain the critical factors that can lead to a higher ROE.

Answer:

Figure 3: Selected Income and Balance Sheet Data

Company A Company B

Revenues $500 $900Operating income 35 100Interest expense 5 0Income before taxes 30 100Taxes 10 40

Net income $20 $60

Total assets 250 300

Total debt 100 50

Owners’ equity 150 250

operating total interest financial taxROE profit asset expense leverage retention

margin turnover rate multiplier rate

⎡ ⎤⎛ ⎞⎛ ⎞ ⎛ ⎞ ⎛ ⎞⎛ ⎞⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟= −⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠ ⎝ ⎠ ⎝ ⎠⎝ ⎠⎣ ⎦

EBIToperating profit margin

sales35

Company A: operating margin 7.0%500

100Company B: operating margin 11.1%

900

=

= =

= =

salesasset turnover

assets500

Company A: asset turnover 2.0250

900Company B: asset turnover 3.0

300

=

= =

= =



Asset turnover for Company B is much higher, which is the main reason that its ROE is higher. Profit margin is also a contributing factor. Company B’s ROE is higher despite the fact that it is using less leverage.

Professor’s Note: See our topic review of dividend discount models in Study Session 12 for more on the DuPont system.

COMPARATIVE RATIO ANALYSIS

The value of a single financial ratio is not meaningful by itself but must be interpreted relative to one of three factors: industry norms, overall market norms, and the company’s own historical performance. Comparison to industry norms is the most common type of comparison. Industry comparisons are particularly valid when the products generated by the industry are similar.

Primarily, comparisons are made to industry averages. However, if there are wide variations within the industry, it may be more appropriate to use medians instead of means for the purposes of comparison (recall from the quantitative methods material that significant outliers can distort the mean).

Moreover, it may be better not to use all of the firms in the industry but to use cross-sectional analysis, in which the analyst uses only a subset of firms with similar characteristics, including size. For firms that operate in multiple industries, the analyst can use cross-sectional analysis to find a group of firms that are involved in a

interest expenseinterest expense rate

assets5

Company A: interest expense rate 2.0%2500

Company B: interest expense rate 0%300

=

= =

= =

assetsfinancial leverage

equity

250Company A: financial leverage 1.67

150

300Company B: financial leverage 1.2

250

=

= =

= =

taxest income tax rate

pretax income

10Company A: income tax rate 33.3%

30

40Company B: income tax rate 40.0%

100

= =

= =

= =



⎡ ⎤⎛ ⎞⎛ ⎞ ⎛ ⎞ ⎛ ⎞⎛ ⎞⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟= −⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠ ⎝ ⎠ ⎝ ⎠⎝ ⎠⎣ ⎦

Company A: ROE (7.0% 2.0 – 2.0%) 1.67 (1 – 33.3%) 13.4%

Company B: ROE (11.1% 3.0 – 0%) 1.2 (1 – 40%) 24.0%

= × × × =

= × × × =



similar mix of industries. Alternatively, the analyst can calculate composite industry averages by using a weighted-average based on the proportion of the company’s sales in each industry segment.

Comparing a company to the overall market is particularly important when overall business conditions are changing. For example, a stable profit margin might be considered good if the economy is in recession and the economy-wide average profit margin is declining. On the other hand, it might be considered problematic if a stable profit margin occurs during an economic expansion, and overall average profit margins are increasing.

Comparing a firm with its history is very common. Analysts often conduct time-series analysis, which considers the trend in a ratio. Indeed, it is problematic to simply consider long-term averages of ratios without taking their trend into account.

In most ratio comparisons it is considered desirable to be near the industry (or economy) average. For example, in all turnover ratios, a value could be considered too high or too low if it differs widely from the industry average. However, for some ratios, simply being high is considered good, even if it deviates from the industry average. This is true for most ratios involving income or cash flow. For example, most analysts would agree that having a high return on assets or high profit margin is good. An analyst would not suggest that a company with a return on assets of 15 percent when the industry average was 10 percent had an ROA that was too high.

Sometimes the goodness of a ratio depends on the context. A high ROE that results from high profit margins or asset turnover is typically looked upon favorably. However, high ROEs that result from high levels of leverage are typically met with a great deal of skepticism.

Example: Comparative analysis

Figure 4 shows a balance sheet for a company for 2004 and 2005. Figure 5 shows its income statement for 2005. Using the company information in Figures 4, 5, and 6, calculate the current year ratios. Discuss how these ratios compare with the company’s performance last year and with the industry’s performance.

Figure 4: Sample Balance Sheet

Year 2005 2004

Assets

Cash $105 $95Receivables 205 195Inventories 310 290

Total current assets $620 $580

Gross property, plant, and equipment $1,800 $1,700Accumulated depreciation 360 340Net property, plant, and equipment 1,440 1,360

Total assets $2,060 $1,940

Liabilities

Payables $110 $90Short-term debt 160 140Current portion of long-term debt 55 45Total current liabilities $325 $275



Long-term debt $610 $690Deferred taxes 105 95Common stock 300 300Additional paid in capital 400 400Retained earnings 320 180Common shareholders equity 1,020 880

Total liabilities and equity $2,060 $1,940

Figure 5: Sample Income Statement

Year 2005

Sales $4,000


Gross profit $1,000Operating expenses 650

Operating profit 350Interest expense 50

Earnings before taxes 300Taxes 100

Net income 200

Common dividends $60

Figure 6: Financial Ratio Template

Current Year Last Year Industry


Quick ratio 1.0 0.9

Receivables collection period 18.9 18.0


Total asset turnover 2.3 2.4

Equity turnover 4.8 4.0

Gross profit margin 27.4% 29.3%

Net profit margin 5.8% 6.5%

Return on capital 13.3% 15.6%

Return on equity 24.1% 19.8%

Debt-to-equity 78.4% 35.7%

Interest coverage 5.9 9.2

Cash flow-to-long-term debt 35.1% 45.3%

Retention rate 50.0% 43.6%

Sustainable growth rate 12.0% 8.6%

Figure 4: Sample Balance Sheet (Continued)



Answer:

The current ratio indicates lower liquidity levels when compared to last year and more liquidity than the industry average.

The quick ratio is lower than last year and is in line with the industry average.

The average collection period is a bit lower relative to the company’s past performance but slightly higher than the industry average.

The inventory turnover is much lower than last year and the industry average. This suggests that the company is not managing inventory efficiently and may have obsolete stock.

The total asset turnover is slightly lower than last year and the industry average.

The equity turnover is lower than last year but still above the industry average.

The gross profit margin is lower than last year and much lower than the industry average.

620current ratio 1.9

325= =

( )105 205quick ratio 0.95

325

+= =

365average collection period 18.2

4,000205 195

2

= =⎡ ⎤⎢ ⎥+⎛ ⎞⎢ ⎥⎜ ⎟⎝ ⎠⎣ ⎦

3,000inventory turnover 10.0

310 2902

= =+⎛ ⎞

⎜ ⎟⎝ ⎠

4,000total asset turnover 2.0

2,060 1,9402

= =+⎛ ⎞

⎜ ⎟⎝ ⎠

4,000equity turnover 4.2

1,020 8802

= =+⎛ ⎞

⎜ ⎟⎝ ⎠

1,000gross profit margin 25.0%

4,000= =

200net profit margin 5.0%

4,000 = =



The net profit margin is lower than last year and much lower than the industry average.

The return on capital is below last year and below the industry average. This suggests a problem stemming from the low asset turnover and low profit margin.

The return on equity is lower than last year but better than the industry average. The reason it is higher than the industry average is probably because of greater use of leverage.

Note that this calculation assumed that deferred taxes is not a part of long-term debt.

The debt-to-equity ratio is lower than last year but still much higher than the industry average. This suggests the company is trying to get its debt level more in line with the industry.

The interest coverage is better than last year but still worse than the industry average. This, along with the slip in profit margin and return on assets, might cause some concern.

change in noncash current assets and liabilities = [(205 + 310) – 110] – [(195 + 290) – 90] = 10

CFO = 200 + 20 + 10 – (10) = 220

Professor’s Note: Depreciation was estimated by using the change in the accumulated depreciation reported on the balance sheet. The change in deferred taxes is the change in the balance sheet account: 105 – 95 = 10. Current liabilities exclude short-term debt and the current portion of long-term debt.

The cash flow to long-term debt ratio is better than last year but much worse than the industry average. This should concern an analyst.

200 50return on capital 12.5%

2,060 1,9402

+= =+⎛ ⎞

⎜ ⎟⎝ ⎠

200return on common equity 21.1%

1,020 8802

= =+⎛ ⎞

⎜ ⎟⎝ ⎠

610debt-to-equity ratio 59.8%

1,020= =

350interest coverage 7.0

50= =

220cash flow-to-long-term debt 36.1%

610= =

60retention rate 1 – 70%

200= =



The retention rate is much higher than last year and much higher than the industry. This might suggest that the company is aware of its cash flow and earnings issues and is reinvesting cash into the company to improve the ratios.

With the high retention rate and good ROE, the company is positioned to grow at a faster rate than last year and faster than the rest of the industry.

Summary: The company has average liquidity. However, performance figures suggest that earnings have declined and turnover has worsened. Coverage ratios have slipped a bit, which might cause some concern, particularly for lenders.

INTERNATIONAL RATIO ANALYSIS

LOS 4.g: Discuss the challenges of international ratio analysis.

There are many differences in accounting principles among the developed countries. It is certainly not necessary for you to burn up half your brain cells trying to memorize every last detail of international accounting differences. However, you should note that the areas of major differences across borders are:

• Goodwill. The key issue here is whether or not goodwill is amortized (flowing through the income statement). Goodwill arises in acquisitions where the acquiring firm must recognize as an intangible asset the excess of the purchase price over the fair market value of the acquired firm's net assets. In some countries, goodwill is amortized according to IAS standards. According to U.S. GAAP, goodwill is not amortized but is instead subject to an annual impairment test.

• Deferred taxes. The issue here is whether or not deferred taxes are recorded when taxable income differs from accounting income.

• Leases. Capitalization of long-term leases is required only in the U.S. and Canada. Leases in all other countries are treated as operating leases.

• Discretionary reserve accounting. This is typically not allowed in the U.S., Canada, and the U.K. However, reserve accounting is prevalent in France, Germany, and Japan.

• Foreign currency translation. See Study Session 6 for an in-depth analysis of foreign currency translation methods. Accounting for foreign currency translation differs widely across countries.

Cross-border differences in accounting practices can lead to broad and persistent variations in the values of certain ratios. The key is that cross-border ratio analysis is difficult at best due to these financial and cultural differences. For example, it would be inappropriate for an analyst to compare the P/E ratios of companies in the U.S. to similar companies in Japan and to attempt to assign relative valuations to these companies. Adjustments for accounting and cultural differences are necessary before any attempt at cross-border ratio evaluation is made.

USING FINANCIAL RATIOS

LOS 4.h: Contrast the ratios that are most likely to be useful for valuing common stock, establishing bond ratings, and forecasting bankruptcy.

There are four major areas where financial ratios are used: (i) stock valuation, (ii) systematic risk measurement, (iii) bond ratings, and (iv) forecasting bankruptcy.

200ROE 0.211, or 21.1%

1,020 8802

sustainable growth rate 0.7 0.211 0.148, or 14.8%

= =+⎛ ⎞

⎜ ⎟⎝ ⎠

= × =



Stock valuation. Most equity valuation models attempt to derive earnings multipliers based on earnings growth models projected using financial ratios. The following are ratios that can be helpful for stock valuation:

• Debt-to-equity.• Interest coverage.• Dividend payout.• ROE.• Retention.• P/BV, P/CF, and P/S.

Systematic risk measurement. The capital asset pricing model (CAPM) asserts that the relevant risk variable is systematic risk. Significant relationships exist between accounting variables and market-determined risk variables such as beta. The following are ratios that can be helpful here:

• Dividend payout.• Debt to assets.• Cash flow to debt.• Interest coverage.• Working capital to assets.• Current ratio.

Financial ratios and bond ratings. The four bond rating agencies rely heavily on financial ratio analysis in their debt ratings. The following ratios are used when rating bonds:

• Long-term debt to assets.• Total debt to total capital.• Cash flow to total debt.• Fixed-charge coverage.• ROE.• ROA.• Cash flow to interest.

Forecasting bankruptcy. Several academic studies have shown that it is possible to forecast bankruptcy through ratio analysis. Ratios such as those bulleted below are useful in this application:

• Cash flow to total debt.• Sales to assets.• ROA.• EBIT to assets.• Total debt to assets.• Current ratio.• Cash to current liabilities.



KEY CONCEPTS

1. Financial analysis uses numerous financial ratios. The ratios can be divided into five groups—internal liquidity, operating performance, risk analysis, growth potential, and external liquidity.• Internal liquidity ratios indicate the company’s ability to pay its short-term obligations. The ratios use

various components of current assets, current liabilities, sales, and cost of goods sold. Remember to use an average amount for balance sheet accounts in the denominator.

• Operating performance ratios indicate how well management operates the business. There are two categories: operating efficiency ratios (turnover ratios) and operating profitability (margin ratios).

• Risk analysis ratios measure the uncertainty of the firm’s income flows. There are two groups: business risk (resulting from variability in sales and operating costs) and financial risk (volatility resulting from the use of debt).

• Growth potential ratios indicate the company’s ability to pay future obligations. The calculation of the sustainable growth rate, g, is critical to stock valuation analysis. g = RR × ROE, where RR = retention rate = 1 – (dividends declared / earnings) and ROE is return on equity.

• External liquidity ratios indicate how quickly an investor could sell a security and whether the investor would sustain large losses by selling the stock. Larger market capitalization, larger number of shareholders, and higher trading turnover all indicate higher liquidity.

2. To calculate ROE, know the original (three component) and extended (five component) DuPont methods. Remember that the DuPont formulas use ending balances, not averages, for balance sheet accounts.• Both approaches begin with:

• The original DuPont equation is:

You may also see it presented as:

• The extended DuPont equation is:

You may also see it presented as:

3. Common-size statements normalize balance sheet and income statements and allow the analyst to make easier comparisons of different-sized firms. A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets. A common-size income statement expresses all income statement items as a percentage of sales.

4. Remember that ratios are valid only in a relative context—when compared to other firms, industry averages, economic averages, or the firm’s ratios from prior years.

5. Major differences between U.S. GAAP and non-U.S. accounting practices include balance sheet presentation, income statement detail, and different accounting principles.

6. Major accounting principle differences include the treatment of goodwill, deferred taxes, lease accounting, discretionary reserve accounting, and foreign currency translation.

net income return on equity

equity

⎛ ⎞= ⎜ ⎟⎝ ⎠

net income sales assets return on equity

sales assets equity

⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠

equitynet profit assetreturn on equity

margin turnover multiplier⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠



⎛ ⎞⎡ ⎤⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟ ⎜ ⎟⎢ ⎥⎝ ⎠⎝ ⎠ ⎝ ⎠⎣ ⎦⎝ ⎠



⎡ ⎤⎛ ⎞⎛ ⎞ ⎛ ⎞ ⎛ ⎞⎛ ⎞⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟= −⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠ ⎝ ⎠ ⎝ ⎠⎝ ⎠⎣ ⎦



CONCEPT CHECKERS: ANALYSIS OF FINANCIAL STATEMENTS

1. To study trends in a firm’s cost of goods sold (COGS), the analyst should standardize the cost of goods sold numbers to a common-sized basis by dividing COGS by:A. assets.B. sales.C. net income.D. the prior year’s COGS.

2. A company’s current ratio is 1.9 times. If some of the accounts payable are paid off from the cash account, the: A. numerator and the current ratio would remain unchanged.B. numerator would decrease by the same amount as the denominator, resulting in a lower current ratio.C. denominator would decrease by the same amount as the numerator, resulting in a higher current ratio.D. numerator and denominator would decrease proportionally, leaving the current ratio unchanged.

3. A company’s quick ratio is 1.2 times. If inventory were purchased for cash, the:A. numerator and the quick ratio would remain unchanged.B. numerator would decrease more than the denominator, resulting in a lower quick ratio.C. denominator would decrease more than the numerator, resulting in a higher quick current ratio.D. numerator and denominator would decrease proportionally, leaving the current ratio unchanged.

4. All other things held constant, which of the following transactions will increase a firm’s current ratio if the ratio is greater than one?A. Accounts receivable are collected and the funds received are deposited in the firm’s cash account.B. Fixed assets are purchased from the cash account.C. Accounts payable are paid with funds from the cash account.D. Inventory is purchased on account.

5. RGB Inc.’s income statement indicates cost of goods sold of $100,000. The balance sheet shows an average accounts payable balance of $12,000. RGB’s payables payment period is closest to:A. 28 days.B. 37 days.C. 44 days.D. 52 days.

6. RGB Inc. has a gross profit margin of $45,000 on sales of $150,000. The balance sheet shows average total assets of $75,000 with an average inventory balance of $15,000. RGB’s total asset turnover and inventory turnover are closest to:

Total Asset Turnover Inventory TurnoverA. 2.00 times 0.33 timesB. 2.00 times 7.00 timesC. 0.50 times 7.00 timesD. 0.50 times 0.33 times

7. RGB Inc. has annual sales of $100,000, average accounts payable of $30,000, and average accounts receivable of $25,000. RGB’s receivables turnover and average collection period are closest to:

Receivables Turnover Average Collection PeriodA. 1.8 times 111 daysB. 1.8 times 91 daysC. 4.0 times 111 daysD. 4.0 times 91 days



8. RGB Inc.’s receivable turnover is 10 times, the inventory turnover is 5 times, and the payables turnover is 9 times. RGB’s cash conversion cycle is closest to:A. 69 days.B. 104 days.C. 150 days.D. 170 days.

9. RGB Inc.’s income statement shows sales of $1,000, cost of goods sold of $400, pre-interest operating expense of $300, and interest expense of $100. RGB’s interest coverage ratio is closest to:A. 1 time.B. 2 times.C. 3 times.D. 4 times.

10. Return on equity using the traditional DuPont formula equals:A. net profit margin × interest component × solvency ratio.B. net profit margin × total asset turnover × tax retention rate.C. net profit margin × total asset turnover × financial leverage multiplier.D. tax rate × interest expense rate × financial leverage multiplier.

11. RGB Inc. has a net profit margin of 12 percent, a total asset turnover of 1.2 times, a financial leverage multiplier of 1.2 times, and a return on assets of 14.4 percent. RGB’s return on equity is closest to:A. 12.0%.B. 14.2%.C. 17.3%.D. 18.9%.

12. What is RGB Inc.’s return on equity given the following information?EBIT/sales = 10% Tax retention rate = 60%Sales/assets = 1.8 times Current ratio = 2 timesInterest/assets = 2% ROA = 0.096Assets/equity = 1.9 timesA. 10.50%.B. 11.32%.C. 12.16%.D. 18.24%.

13. All of the following equations represent return on equity EXCEPT:A. net profit margin × equity turnover.B. net profit margin × total asset turnover × assets-to-equity.C. ROA × interest burden × tax retention rate.D. [(operating profit margin × total asset turnover) – interest expense rate]

(financial leverage multiplier × tax retention rate).

14. The percentage change in operating earnings divided by the percentage change in sales is referred to as the:A. coefficient of variation of operating income.B. coefficient of variation of sales.C. operating leverage.D. gross profit margin.



15. A firm has a dividend payout ratio of 40 percent, a net profit margin of 10 percent, an asset turnover of 0.9 times, and a financial leverage multiplier of 1.2 times. The firm’s sustainable growth rate is closest to:A. 5.5%.B. 6.5%.C. 7.5%.D. 8.0%.

Use the following data for Questions 16 through 22. (Answers may be rounded off.)

16. Alpha’s inventory turnover is closest to:A. 3.1 times.B. 4.2 times.C. 6.3 times.D. 8.4 times.

17. Alpha’s average inventory processing period is closest to:A. 37 days.B. 44 days.C. 65 days.D. 88 days.

18. Alpha’s receivables turnover is closest to:A. 11.11 times.B. 12.12 times.C. 13.50 times.D. 15.00 times.

19. Alpha’s average collection period is closest to:A. 25 days.B. 30 days.C. 33 days.D. 45 days.

20. Alpha’s payables turnover is closest to:A. 4.0 times.B. 4.8 times.C. 5.0 times.D. 10.0 times.

Alpha Company

Sales $5,000


AverageInventories $600Accounts receivable 450Working capital 750Cash 200Accounts payable 500Fixed assets 4,750

Total assets $6,000

Annual purchases $2,400



21. Alpha’s average days payable is closest to:A. 37 days.B. 62 days.C. 73 days.D. 76 days.

22. Alpha’s cash conversion cycle is closest to:A. 33 days.B. 127 days.C. 48 days.D. 19 days.


Beta Co. has a loan covenant requiring it to maintain a current ratio of 1.5 or better. As Beta approaches year-end, current assets are $20 million ($1 in cash, $9 in accounts receivable and $10 in inventory), and current liabilities are $13.5 million.

23. Beta’s current ratio is closest to:A. 0.675 times.B. 1.480 times.C. 1.500 times.D. 0.740 times.

24. Beta’s quick ratio is closest to:A. 0.675 times.B. 0.740 times.C. 0.810 times.D. 1.480 times.

25. What can Beta Co. do to meet its loan covenant?A. Sell $1 million in inventory and deposit the proceeds in the company’s checking account.B. Borrow $1 million short term and deposit the funds in its checking account.C. Sell $1 million in inventory and pay off some of its short-term creditors.D. Do nothing at all.

26. Paragon Co. has an operating profit margin (EBIT/S) of 11 percent, an asset turnover (S/A) of 1.2, a financial leverage multiplier (A/E) of 1.5 times, an average tax rate of 35 percent, and an interest expense rate (I/Assets) of 4 percent. Paragon’s return on equity is closest to:A. 0.09.B. 0.10.C. 0.11.D. 0.12.



27. Paragon Co. has the following information:• Interest expense ratio (I/Assets) of 10%.• Current ratio of 1.8.• Tax retention rate (1 – t) of 70%.• Effective tax rate of 30 percent; a leverage ratio (A/E) of 2 times.• Debt-to-equity ratio of 1.• Total asset turnover of 1.2 times.• Operating profit margin of 12%.

Paragon’s return on equity is closest to?A. 5.7%.B. 6.2%.C. 6.7%.D. 3.0%.

28. In 1994, RGB Inc.’s operating profit margin (EBIT/S) was 15 percent; total asset turnover (S/A) was 1 time; financial leverage multiplier (A/E) was 2; tax retention rate was 70 percent; and interest expense rate (I/A) was 7 percent. In 2004, RGB’s operating profit margin was 10 percent; total asset turnover 1.5 times; financial leverage multiplier was 2 times; tax retention rate 70 percent; interest expense rate 7 percent. Which statement is TRUE?A. Return on equity increased because the firm’s asset turnover increased.B. Return on equity fell because the firm’s profit margin fell.C. Return on equity remained constant because the fall in profits offset the increase in sales.D. Return on equity remained constant because the increase in profits offset the decrease in sales.

29. Use the following 10 ratios,1. Debt/equity 6. I/assets2. 1 – t 7. EBT/EBIT3. EAT/EBT 8. EBT/EAT4. CA/CL 9. EBIT/sales5. Assets/equity 10. Sales/assets

Using their corresponding numbers, which five combined together will give the firm’s ROE?A. [(9)(4) + (7)](5)(6).B. [(1 + 3 + 5)(7)] – (9).C. [(9)(10) – (6)](5)(2).D. (3)(5)(6)(9)(10).



ANSWERS – CONCEPT CHECKERS: ANALYSIS OF FINANCIAL STATEMENTS

1. B With a common-size income statement, all income statement accounts are divided by sales.

2. C If cash and AP decrease by the same amount and the CR is > 1, then the denominator falls

faster than the numerator and the current ratio increases.

3. B Quick ratio = (cash + AR) / AP. If cash decreases, the quick ratio will also decrease. The

denominator is unchanged.

4. C If CR is > 1, then if CA and CL both fall, the overall ratio will increase.

5. C

6. B

7. D

8. A

9. C

10. C This is the correct formula for the three-ratio DuPont model for ROE.

11. C = (0.12)(1.2)(1.2) = 0.1728 = 17.28%

12. D

13. C (ROA)(interest burden)(tax retention rate) is not one of the DuPont models for calculating ROE.

14. C The percentage change in operating earnings divided by the percentage change in sales is referred to as the operating leverage.

15. B g = (retention rate)(ROE)

g = (1 – 0.4)(0.108) = 6.5%

cash + AR + invCR .

AP=

cash + ARQuick ratio .

AP=

current assetsCurrent ratio .

current liabilities=

COGS 100Payables turnover 8.33.

avg. AP 12= = =

365Payables payment period 43.8 days

8.33= =

sales 150 COGS 150 – 45TAT 2 times; inventory turnover 7 times

total assets 75 avg. inventory 15= = = = = =

S 100 365RT 4; CP 91.25 days

avg. AR 25 4= = = = =

365 365 365– 69 days

10 5 9+ =

EBIT 1000 – 400 – 300ICR 3 times

I 100= = =

net income sales assetsreturn on equity

sales assets equity

⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠

( ) ( )( )EBIT S I AROE – (1– t) 0.1 1.8 – 0.02 1.9 0.6 0.1824 18.24%

S A A EQ

⎛ ⎞⎡ ⎤⎛ ⎞= × = × = =⎡ ⎤⎜ ⎟⎜ ⎟ ⎣ ⎦⎢ ⎥⎝ ⎠⎣ ⎦ ⎝ ⎠

( ) ( )( )net profit asset equityreturn on equity (0.1)(0.9)(1.2) 0.108multipliermargin turnover= = =



16. B

17. D

18. A

19. C

20. C

21. C

22. C = 33 + 88 – 73 = 48 days

23. B

24. B

25. C This transaction would increase the current ratio: Selling $1 million in inventory and

depositing the proceeds in the company’s checking account would leave the ratio unchanged:

Borrowing $1 million short term and depositing the funds in their checking account would

decrease the current ratio:

26. A

27. B

28. C

29. C The correct formula for the extended DuPont model for calculating ROE is:

COGS 2,500 Inventory turnover 4.166 times

avg. inventory 600= = =

365 365Average inventory processing period 87.6 days

inventory turnover 4.166= = =

sales 5,000Receivables turnover 11.11 times

avg. account receivable 450= = =

365 365Average collection period 32.85 days

receivables turnover 11.11= = =

COGS 2,500 Payables turnover 5 times

avg. payables 500= = =

365 365Average days payable 73 days

payables turnover 5= = =

( ) ( )cash payablesaverage receivables average inventoryconversion – paymentcollection period processing period periodcycle

⎛ ⎞⎜ ⎟= +⎜ ⎟⎝ ⎠

current assets 1 9 10 20current ratio 1.48 times

current liabilities 13.5 13.5

+ += = = =

cash marketable securities receivables 1 9 10quick ratio 0.74 times

current liabilities 13.5 13.5

+ + += = = =

20 –1 191.52.

13.5 –1 12.5= =

20 1–11.48.

13.5

+ =

20 + 1 211.45.

13.5 + 1 14.5= =

( )EBIT S I AROE – (1– t) 0.11 1.2 0.04 (1.5)(0.65) 0.0897

S A A E⎡ ⎤⎛ ⎞ ⎛ ⎞= × = × − =⎡ ⎤⎜ ⎟ ⎜ ⎟ ⎣ ⎦⎢ ⎥⎝ ⎠ ⎝ ⎠⎣ ⎦

( ) ( )( )ROE 0.12 1.2 0.1 2 0.7 0.0616 6.16%= × − = =⎡ ⎤⎣ ⎦

( ) ( )1994 ROE 0.15 1 0.07 (2)(0.7) 0.112 and 2004 ROE 0.10 1.5 0.07 (2)(0.7) 0.112= × − = = × − =⎡ ⎤ ⎡ ⎤⎣ ⎦ ⎣ ⎦

EBIT sales I assets– (1– t)


⎛ ⎞⎡ ⎤⎛ ⎞⎛ ⎞ ⎛ ⎞⎜ ⎟⎜ ⎟⎜ ⎟ ⎜ ⎟⎢ ⎥⎝ ⎠⎝ ⎠ ⎝ ⎠⎣ ⎦ ⎝ ⎠


FINANCIAL STATEMENT ANALYSIS

OLD QUESTION REVIEW1

Professor’s Note: Unfortunately for Level 2 candidates, CFA Institute no longer releases the actual questions from past exams. The last publicly-available financial statement analysis (FSA) question from past Level 2 CFA exams is an essay question from the 2004 exam. In 2006, you will be facing six-question, multiple-choice item sets.

Despite this rather discouraging fact, we’ve reprinted several recent questions that are still relevant to the 2006 curriculum. We think you will derive some benefit from a review of these old questions, because you will get an idea of the topics that CFA Institute has emphasized on past exams, and see the general format in which the accompanying information is presented.

In recent years, in fact, many of these so-called “essay” questions were actually “quasi-multiple choice” questions in which the candidate was expected to answer by circling a response in a template. See Question 15 from the 2004 exam for an example of this approach. We encourage you to pay particular attention to those types of questions, because you might see similar questions in a multiple choice format in 2006.

However, there is some good news! The sample exams in Book 6 of the Schweser Study Notes are six-question item sets that we’ve created to help you be prepared for the 2006 exam. We recommend allocating some of the study time you had planned to devote to a study of old FSA questions to a realistic attempt to work the practice FSA exam questions in exam-like conditions.

2004 QUESTION 15 HAS ONE PART FOR A TOTAL OF 12 MINUTES.

Professor’s Note: This question was actually categorized as asset valuation on the 2004 exam, but we think it is more appropriate to call it a financial statement analysis question.

David Yam, CFA, is evaluating which of two companies in the same industry sector is a more attractive investment. Lin Semiconductor Inc., based in a Pacific Rim country where the local currency is the tig, is the largest company in the “merchant silicon” industry. Warren Integrated Circuits Inc., based in the U.S., is the second largest company in the industry. Both companies sell products globally.

Yam has gathered summary financial information, shown in Exhibit 15-1, for the two companies, as well as supplemental information, shown in Exhibit 15-2, for Lin.

1. Copyright, 2006, CFA Institute. Reproduced and republished from Level II questions from CFA Program Materials with permission from CFA Institute. All Rights Reserved.


Financial Statement AnalysisOld Question Review

Exhibit 15-1Summary Financial Information

(all financial statement data in local currency unless otherwise noted)

Lin Semiconductor

Inc. (Tig millions)

Warren Integrated

Circuits Inc. (U.S. $ millions)

Income Statement Data for the Year Ended 31 December 2003

Total Revenues 121,208 3,483

Earnings Before Interest and Taxes (EBIT) 29,833 984

Earnings Before Taxes 20,417 939

Net Income (presented according to local accounting principles) 16,208 746

Balance Sheet Data as of 31 December 2003

Total Assets 292,907 4,235

Total Shareholders’ Equity 221,890 2,378

Lin Semiconductor

Inc.

Warren Integrated

Circuits Inc.

Share Data as of 31 December 2003

Fully Diluted Number of Shares Outstanding (millions) 14,942 263

Market Price per Share (local currency) 95 24



Exhibit 15-2Lin Semiconductor Inc.

Supplemental Information

Warren is a U.S. GAAP-reporting firm, while Lin reports its financial statements in accordance with GAAP of the country in which it is based. Yam wants to compare price/earnings (P/E) ratios for Lin and Warren. He is deciding whether to adjust Lin’s income statements for the following three items related to the comparability of Lin’s P/E ratio to Warren’s P/E ratio:

• Assets available-for-sale

• Investments held-to-maturity

• Unusual gain

Determine, for each of the three items related to the comparability of Lin’s P/E ratio to Warren’s P/E ratio:

i. Whether the item requires a positive adjustment, a negative adjustment, or no adjustment to Lin’s 2003 pre-tax income

ii. The amount of any required adjustment to Lin’s 2003 pre-tax incomeiii. Why an adjustment is or is not required

During 2003, Lin acquired a small competitor for strategic reasons. Lin paid 1.4 billion tigs for 100 percent of the outstanding shares of the company. Goodwill was charged directly to shareholders’ equity. Lin continues to operate the company as a separate entity.

Details of the Acquisition

At the Date of Acquisition (net of Goodwill)

Book Value (Tig millions)

Fair Value(Tig millions)

Total Assets Acquired 650 750

Total Liabilities Acquired 350 350

Accounting for Investments

As of 31 December 2003 Cost(Tig millions)

Market(Tig millions)

Assets Available-for-Sale Portfolio Equity Investments

20,000 25,000

Investments Held-to-MaturityGovernment-Backed Bonds

31,500 30,000

All investments were acquired early in 2003. The company records all investments at the lower of cost or market, with all resulting gains and losses being reported on the income statement.

Unusual Gains

Included in Lin’s income for the year was an unusual gain in the amount of 5.0 billion tigs. The gain was related to the sale of a piece of land that had been purchased for a future factory; Lin has now abandoned its plans to build the factory. Lin has not had similar gains in the past.



Professor’s Note: On the original exam, the candidate was instructed to answer the question in a template that was provided. We’ve removed the blank template to save space although the completed template is shown in the answer.

(12 minutes)

2004 LEVEL II, QUESTION 15 ANSWERReading References: The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003), in 2004 CFA Level II Candidate ReadingsA. “Analysis of Intercorporate Investments,” Ch. 13B. “Analysis of Business Combinations,” Ch. 14Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2002)A. “Market-Based Valuation: Price Multiples,” Ch. 4

2003 QUESTION 4 HAS FOUR PARTS (A,B,C,D) FOR A TOTAL OF 18 MINUTES.

Vacations Unlimited Inc. (VU) owns Catalina Resorts, located in the Caribbean country of Costa Guda. This 75-room hotel is a popular vacation destination for North American tourists. The majority of operating and financing decisions are made by Catalina management in Costa Guda, although Catalina relies on VU’s managerial and technological expertise. The local currency is the guda (G); recent annual inflation rates for Costa Guda are given in Exhibit 4-1.

Three items

Determine, for each of the three items related to the comparability of Lin’s P/E ratio to Warren’s P/E ratio:

Whether the item requires a positive adjustment, a negative adjustment, or no adjustment to Lin’s 2003 pre-tax income

(circle one for each item)

The amount of any required

adjustment to Lin’s 2003 pre-tax

income

The justification for why an adjustment is or is not required

Assets available-for-sale

Positive Adjustment

Negative Adjustment

No Adjustment

0 Tigs

or blank

Under U.S. GAAP, assets available-for-sale are marked to market, and mark to market gains on assets available for sale are reported directly to equity. Lin’s LOCOM also does not recognize the unrealized gains in the income statement so no adjustment is necessary.

Investments held-to-maturity

Positive Adjustment

Negative Adjustment

No Adjustment

1.5 billion Tigs

Investments held-to-maturity are not marked to market under U.S. GAAP. Therefore the loss on the long-term investments included in pre-tax income must be removed.

Unusual gain

Positive Adjustment

Negative Adjustment

No Adjustment

5.0 billion Tigs

Nonrecurring items need to be removed from the calculation of pre-tax income before evaluating against comparables.



Exhibit 4-1Inflation Rates for Costa Guda

A. Identify the appropriate functional currency that Vacations Unlimited should have used in 2002 to account for its investment in Catalina Resorts. Justify your response with one reason.

(3 minutes)

B. Identify the appropriate functional currency that Vacations Unlimited should use in 2003 to account for its investment in Catalina Resorts, if Costa Guda’s annual inflation rate in 2003 is 50 percent. Justify your response with one reason.

(3 minutes)

Catalina Resorts’ balance sheet and relevant exchange rates for the guda and the U.S. dollar are shown in Exhibits 4-2 and 4-3, respectively.

Exhibit 4-2Catalina Resorts Balance Sheet

31 December 2001(guda millions)

Exhibit 4-3Exchange Rates

Guda (G) and U.S. Dollar (USD)

C. Determine the translation effect (gain, loss, or no change) for 2002 on Vacation Unlimited’s investment in Catalina Resorts using each of the following two translation methods:

i. All current method.

Year Annual Inflation Rate

2000 20%

2001 25%

2002 30%

Cash 25Accounts Receivable 50Current Assets 75Gross Fixed Assets 425Accumulated Depreciation (100)Net Fixed Assets 325Total Assets 400

Short-term Debt 100Current Liabilities 100Common Stock 25Retained Earnings 275Total Shareholders’ Equity 300Total Liabilities and Shareholders’ Equity 400

2001 2002

Year-end G 1.06 = U.S. $1.00 G 1.20 = U.S. $1.00

Average G 0.98 = U.S. $1.00 G 1.13 = U.S. $1.00

Historical

Fixed Assets G 0.75 = U.S. $1.00



ii. Temporal method.

Justify your response with one reason for each method.

Professor’s Note: On the original exam, the candidate was instructed to answer the question in a template that was provided. We’ve removed the blank template to save space, although the completed template is shown in the answer.

(6 minutes)

D. Identify the translation method (all current, temporal, or neither) that will result in each of the following two ratio effects for Catalina Resorts:

i. A higher asset turnover ratio (in U.S. dollar terms).ii. A higher current ratio (in U.S. dollar terms).


Note: No calculations are required.

Professor’s Note: On the original exam, the candidate was instructed to answer the question in a template that was provided. We’ve removed the blank template to save space, although the completed template is shown in the answer.

(6 minutes)

2003 LEVEL II, QUESTION 4 ANSWER

Reading References: “Measuring Accounting Exposure,” Ch. 8, Foundations of Multinational Financial Management, 3rd edition, Alan C. Shapiro (Prentice Hall, 1998). “Analysis of Multinational Operations,” Ch. 15, pp. 819-854, The Analysis and Use of Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 1998).

A. The local currency (guda) is the appropriate functional currency.

When the subsidiary in its entirety (its operations and assets) is deemed “independent” of the parent’s operations and viewed as an “investment” of the parent, the functional currency of such an autonomous affiliate is generally the local currency. These circumstances describe Vacations Unlimited and Catalina Resorts, so the local currency is the functional currency.

B. The parent currency (U.S. dollar) is the appropriate functional currency.

SFAS 52 mandates the use of the parent (reporting) currency as the functional currency for foreign operations in a hyperinflationary country (defined as greater than 100% cumulative inflation for three years). Costa Guda’s cumulative inflation will have exceeded 100 percent over the last three years (i.e., 2001-2003).



C.

D.

2000 QUESTION 27 HAS THREE PARTS FOR A TOTAL OF 23 MINUTES.

27. Telluride has a wholly owned foreign subsidiary, Fuente, Ltd., whose functional currency is the local currency (LC). The relevant exchange rates for Fuente are shown below.

Translation method

Determine the translation effect for 2002 on Vacation Unlimited’s

investment in Catalina Resorts using each of the two translation methods

(circle one for each method).


i. All current method

gain

loss

no change

Under the all current method, exposure is equal to net investment. Net investment is G300 (the difference between total assets of G400 and total liabilities of G100, or total shareholders’ equity of G300). With the guda (local currency) depreciating, Vacation Unlimited’s net investment in Catalina will decrease in value, resulting in a loss for 2002.

ii. Temporal methodgain

loss

no change

Under the temporal method, exposure is equal to net monetary liability (g) = cash + accounts receivable –debt = 25 + 50 – 100 = -25. With the guda (local currency) depreciating, the net monetary liability will decrease, resulting in a gain for 2002.

Two ratio effects

Determine the translation method that will result in each of the two ratio effects for Catalina Resorts (circle one

for each method).

Justify your response with one reason for each effect.

i. A higher assets turnover ratio (in U.S. $ terms)

all current method

temporal method

neither

The numerator (sales) is the same for both methods, so only the denominator (assets) can cause a difference. With the guda (local currency) depreciating, assets will be lower under the all current method, resulting in a higher asset turnover rate.The historical rate is used in the temporal method for fixed assets.

ii. A higher current ratio (in U.S. $ terms)

all current method

temporal method

neither

Cash, accounts receivables, and short-term debt are treated in the same manner under both methods, and Catalina Resorts has no inventory. Therefore, neither method results in a higher current ratio than the other.



Exhibit 27-1Exchange Rates

A. Calculate the reporting currency (US$) amounts, using the appropriate translation method, for the balance sheet and income statement accounts indicated by the blank boxes in the template.

(5 minutes)

Template for Question 27-A - (Do not provide answers for the blacked-out boxes.)

Date LC/US$At purchase of Fixed Assets (historic rate) 1.10January 1, 1999 1.03Average for 1999 0.95December 31, 1999 0.87

BALANCE SHEET as of December 31, 1999LC US$

Cash 15.2Accounts Receivable 3.8Inventories 7.7Fixed Assets (Net) 35.6Other 12.1

Total Assets 74.4

Current Liabilities 13.3Long Term Debt 19.6

Total Liabilities 32.9

Stockholders’ Equity 41.5Total Liabilities and Equity 74.4

INCOME STATEMENTFor the Year Ended December 31, 1999

LC US$Revenue 47.1Cost of Goods Sold 16.9Depreciation 3.2Other Operating Costs 14.8Operating Profit 12.2

Interest Expense 3.4

Income Before Taxes 8.8Taxes 3.2

Net Income 5.6



B. Indicate, based on the all-current method, whether the four ratios in the template are the same or different in the reporting currency compared to the local currency. No calculations are necessary.

Template for Question 27-B

(8 minutes)

C. Indicate whether the five ratios in the template are the same or different under the temporal method compared to the all-current method. No calculations are necessary.

(10 minutes)

Template for Question 27-C


Reading References: “Analysis of Multinational Operations,” Ch. 15, pp. 819-854, The Analysis and Use of Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (John Wiley & Sons, 1997); “Analyzing the Firm’s Operations,” Ch. 6, Corporate Finance: A Valuation Approach, Simon Z. Benninga and Oded H. Sarig (McGraw-Hill, 1997)

RatioRatio Same or Different in Reporting Currency vs.

Local Currency (Circle One)

Return on AssetsSame

Different

Debt/AssetsSame

Different

Net Profit MarginSame

Different

Accounts Receivable TurnoverSame

Different

RatioRatio Same or Different under Temporal

Method vs. All-Current Method (Circle One)

Return on AssetsSame

Different

Debt/AssetsSame

Different

Net Profit MarginSame

Different

Accounts Receivable TurnoverSame

Different

QuickSame

Different



A. The appropriate method is the all-current method.

Under the all current method, the balance sheet translation requires division by the year end exchange rate and the income statement translation requires division by the average exchange rate.

B.

Under the all-current method, the income statement accounts are translated at the average exchange rate, and balance sheet accounts are translated at the year end rate. Therefore the ratios that use only the income statement accounts or only the balance sheet accounts are the SAME. Ratios that use accounts from both the income statement and the balance sheet are DIFFERENT in the functional currency compared to the local currency.

* Earnings are translated at the average exchange rate and assets are translated at the year end exchange rate, so the ratio is different.

** Both debt and assets are translated at the year end exchange rate, so the ratio is the same. *** Both earnings and revenue are translated at the average exchange rate, so the ratio is the same.

BALANCE SHEET as of December 31, 1999 CalculationsLC U.S.$

Cash 15.2Accounts Receivable 3.8 4.4 ÷ .87 =Inventories 7.7Fixed Assets (Net) 35.6 40.9 ÷ .87 =Other 12.1

Total Assets 74.4

Current Liabilities 13.3Long Term Debt 19.6 22.5 ÷ .87 =

Total Liabilities 32.9

Stockholders’ Equity 41.5Total Liabilities and Equity 74.4

INCOME STATEMENT for the Year Ended December 31, 1999 CalculationsLC US$

Revenue 47.1 49.6 ÷ .95 =Cost of Goods Sold 16.9Depreciation 3.2Other Operating Costs 14.8Operating Profit 12.2

Interest Expense 3.4 3.6 ÷ .95 =

Income Before Taxes 8.8Taxes 3.2

Net Income 5.6

RatioRatio Same or Different in Reporting Currency

vs. Local Currency

Return on Assets Different*

Debt/Assets Same**

Net Profit Margin Same***

Accounts Receivable Turnover Different****



**** Accounts receivable are translated at the year end exchange rate, and revenue is translated at the average exchange rate, so the ratio is different.

C.

Under the temporal method the current rate applies only to monetary assets and liabilities. Non-monetary assets and liabilities are translated at the historical rates (date of transaction). Therefore the following principles apply to ratio analysis comparison between the temporal and all-current methods.

Income Statement:• Sales are the same • Other expenses are the same• Cost of goods sold is different • Depreciation is different • Net income is different

Balance Sheet:• Accounts receivables and cash are the same • Inventory is different • Fixed Assets are different • Debt is the same

* Both net income and assets are different, so the ratio is different.** Debt is the same, but assets are different, so the ratio is different.

*** Sales are the same, but net income is different, so the ratio is different. **** Accounts receivable and sales are the same, so the ratio is the same.

***** Cash, accounts receivable, and current liabilities are the same, so the ratio is the same.

2000 QUESTION 28 HAS ONE PART FOR A TOTAL OF 18 MINUTES.

28. Patricia Bouvier, CFA is an analyst following Telluride. In reviewing Telluride’s 1999 annual report, Bouvier discovers the following footnotes:

Footnote (1) During the fourth quarter of 1999, Telluride changed its accounting policy from expensing to capitalizing software expenditures. The amount capitalized in 1999 was $15 million, including $12 million that had been expensed during the first three quarters of the year.

Footnote (2) On December 31, 1999, Telluride established a restructuring charge of $20 million, of which $8 million was for severance pay for workers who will be terminated in the year 2000 and $12 million was for the write down of assets on December 31, 1999.

Footnote (3) Telluride leases assets under an operating lease that expired on December 31, 1999. The lease renewal terms required Telluride to capitalize the lease, which has a present value of $50 million. The amount of the monthly lease payment does not change.

RatioRatio Same or Different under Temporal Method

vs. All-Current Method (Circle One)

Return on Assets Different*

Debt/Assets Different**

Net Profit Margin Different***

Accounts Receivable Turnover Same****

Quick Same*****



Indicate, for each of the three footnotes, the effect of the adjustments on the financial ratios shown in the template for:

i. the year 1999.ii. the year 2000 compared to adjusted 1999.

Note: Assume all financial information remains unchanged from 1999 through 2000, except that referenced in the footnotes above.

(18 minutes)

Template for Question 28

RatioEffect on 1999 Ratio

(Circle One)

Effect on 2000 RatioCompared to Adjusted

1999 Ratio (Circle One)Footnote (1)

Operating Cash Flow/Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Net Income/Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect

Sales/Net Fixed Assets

Increase

Decrease

No Effect

Increase

Decrease

No EffectFootnote (2)


Increase

Decrease

No Effect

Increase

Decrease

No Effect

Net Income/Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect


Increase

Decrease

No Effect

Increase

Decrease

No EffectFootnote (3)


Increase

Decrease

No Effect

Increase

Decrease

No Effect

Net Income/Sales

Increase

Decrease

No Effect

Increase

Decrease

No Effect


Increase

Decrease

No Effect

Increase

Decrease

No Effect




Reading References: “Analyzing the Finn’s Operations,” Ch. 6, Corporate Finance: A Valuation Approach, Simon Benninga and Oded Sarig (McGraw-Hill, 1997); “Accounting Bulletin #69,” David F. Hawkins (Merrill Lynch, 1998); “Analysis of Financial Statements: A Synthesis” Ch. 17, The Analysis and Use of Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 1997); “Analyzing Financing Activities,” Ch. 3, Financial Statement Analysis, 6th edition, Leopold A. Bernstein and John J. Wild (Irwin/McGraw Hill, 1998) (1999 Level I)

Footnote (1)Operating Cash Flow / Sales: In 1999, capitalizing the software expenditures results in the capitalized software expenditures beingreclassified from operating to investing cash flows, increasing operating cash flow. In 2000, there is no effect because amortization ofthe capitalized software is a non-cash item.

Net Income / Sales: In 1999, net income increases because capitalized software expenditures are not recognized as expenses, increasing the ratio for that year. In 2000, the capitalized expense is amortized, reducing income and decreasing the ratio.

Sales / Fixed Assets: In 1999, the capitalized software expenditures are reclassified as a fixed asset, decreasing the ratio. In 2000, the fixed asset account decreases as the asset is amortized, thus increasing the ratio since the denominator declines.

Footnote (2)Operating Cash Flow / Sales: In 1999, the restructuring charge is a non-cash item, therefore there is no effect on operating cash flow or the ratio. In 2000, the $8 million in severance is paid, reducing operating cash flow and therefore reducing the ratio. The fixed asset write-down has no effect on operating cash flow in year 2000.

Net Income / Sales: In 1999, net income, and hence the ratio, is decreased because of the charge. In year 2000, depreciation declines because of the write-down of assets in 1999. This increases net income and the ratio for 2000.

Sales / Fixed Assets: In 1999, writing down $12 million of fixed assets increases the ratio by reducing the denominator. In 2000, there is no additional effect from this write-down. The ratio is not affected by the charge for severance pay.

Footnote (3)Operating Cash Flow/ Sales: In 1999, the change is effective at year end and therefore does not affect operating cash flow. In 2000, as a capital lease, part of the lease payment is classified as a financing cash outflow, increasing operating cash flow and therefore the ratio.

RatioEffect on 1999 Ratio

(Circle One)

Effect on 2000 RatioCompared to Adjusted

1999 Ratio (Circle One)

Footnote (1)

Operating Cash Flow / Sales Increase No Effect

Net Income / Sales Increase Decrease

Sales / Net Fixed Assets Decrease Increase

Footnote (2)

Operating Cash Flow / Sales No Effect Decrease

Net Income / Sales Decrease Increase

Sales / Net Fixed Assets Increase No Effect

Footnote (3)

Operating Cash Flow / Sales No Effect Increase

Net Income / Sales No Effect Decrease

Sales / Net Fixed Assets Decrease Increase



Net Income / Sales: In 1999, the lease was capitalized at the end of 1999, so neither net income nor the ratio are affected that year. In 2000, lease expense is replaced by interest and depreciation on the capital lease, which in the early years exceed the lease payment. As a result, net income is reduced, reducing the ratio.

Sales / Fixed Assets: In 1999, capitalizing the lease increases fixed assets, increasing the denominator and decreasing the ratio. In 2000, the leased asset is depreciated, reducing the denominator and increasing the ratio.


effective tax rate measures:

pretax income attributable to specific temporary differences:

funded status of the plan: funded status = fair value of plan assets – PBO

translation gain/loss:

exposure under the all-current method = shareholders’ equity

exposure under the temporal method = (cash + accounts receivable) – (accounts payable + current debt + long-term debt)

flow effect (in $) = change in exposure (in LC) × (ending rate – average rate)

: beginning inventory purchases ending inventory cost of goods sold+ = +basic inventory formula

original cost – salvage value =

depreciable lifeSL depreciation expense

( ) ( )original cost – salvage value n – x 1 =

SYD

× +SYD depreciation in year x

2 = book value at beginning of year x

depreciable life×DDB depreciation in year x

( )( )

income tax expense from the f/s

pretax income from the f/s=reported effective tax rate

( )( )

( )( )

=

=

taxes payable from the tax returneffective tax rate measure #1


income tax paid from the tax returneffective tax rate measure #2


( )− = deferred tax expensepretax income taxable income

statutory tax rate

FORMULAS


Financial Statement AnalysisFormulas

holding gain/loss effect (in $) = beginning exposure (in LC) × (ending rate – beginning rate)

translation gain/loss (in $) = flow effect + holding gain/loss effect

basic earnings per share (EPS):

diluted EPS (DEPS):

incremental shares (I):

traditional cash flow = net income + depreciation + change in deferred taxes

cash flow from operating activities (CFO): traditional cash flow – increase in noncash working capital

free cash flow (FCF): CFO – capital expenditures – dividends





=

−=

adjusted income available for common sharesDEPS =

weighted-average common and potential common shares outstanding

MP EPI N

MP

−= ×

current assets

current liabilities=current ratio

cash marketable securities receivables

current liabilities

+ +=quick ratio

net annual sales

average receivables=receivables turnover

cost of goods sold

average inventory=inventory turnover

net sales

average total net assets=total asset turnover

net sales

average net fixed assets=fixed asset turnover


Financial Statement AnalysisFormulas

debt-to-equity ratio

long-term debt-to-capital

sustainable growth rate: g = RR × ROE

original DuPont system:

extended DuPont system:

gross profit

net sales=gross profit margin

operating profit EBIT

net sales net sales= =operating profit margin

net income

net sales=net profit margin

net income

average total equity=return on total equity

net income – preferred dividends

average common equity=return on common equity

total long-term debt

total equity=

total long-term debt

total long-term capital=

EBIT

interest expense=interest coverage

net income sales assetsROE

sales assets equity

equitynet profit assetmargin turnover multiplier

⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠

⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠⎝ ⎠



operating total interest financialprofit asset expense leverag

margin turnover rate

⎛ ⎞⎡ ⎤⎛ ⎞⎛ ⎞⎛ ⎞= ⎜ ⎟⎜ ⎟⎜ ⎟ ⎜ ⎟⎢ ⎥⎝ ⎠⎝ ⎠ ⎝ ⎠⎣ ⎦⎝ ⎠⎡ ⎤⎛ ⎞⎛ ⎞ ⎛ ⎞⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟= −⎢ ⎥⎜ ⎟⎜ ⎟ ⎜ ⎟⎝ ⎠⎝ ⎠ ⎝ ⎠⎣ ⎦

taxe retention

multiplier rate

⎛ ⎞⎛ ⎞⎜ ⎟⎜ ⎟⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠


A

ABO. See accumulated benefit obligationaccelerated depreciation methods 31, 236accounting changes 243, 262accounts payable period 238accounts receivable period 238actuarial gains and losses 136aggressive accounting policies 237amortization 32amortization of net actuarial gain (loss) recognized 140amortizing assets improperly 224analysis of lessees 72analysis of lessors 76analyzing effective tax rates 44analyzing income tax disclosures 41auditor’s report 216available-for-sale financial assets 206average inventory processing period 283average rate 167average receivables collection period 283

B

basic earnings per share 250benefits paid 136bid-ask spread 290bond covenants 63bonds 58book values 57business combinations 203business risk 287

C

calculating the translation gain or loss 172capital lease 72capitalisation of borrowing costs 205capitalizing costs improperly 221cash conversion cycle 284cash flow from operating activities 280cash flow from operations 237cash flow-to-long-term debt ratio 289cash flow-to-total interest-bearing debt ratio 289CFO. See cash flows from operations

CI. See comprehensive incomecommercial databases 216commitments 229commodity bonds 62common size statements 281common-size financial statement analysis 237complex capital structure 250comprehensive income 263comprehensive loss account 260conservative accounting policies 236consolidated financial statements 202consolidation 280consolidation method 99contingencies 230, 237, 239contingent liabilities 236, 257contributions by plan participants 136cost 280cost method 91current liabilities 57current rate 166current ratio 282curtailments 136

D

DDB. See double-declining balancedebt and equity securities available-for-sale 91debt and equity trading securities 92debt securities held-to-maturity 91debt-to-equity ratio 287deferred income tax expense 38deferred tax asset 38deferred tax liability 38deferred taxes 259, 299deferring current revenue 215defined benefit plan 135defined contribution plan 135depletion 32depreciation methodologies 280DEPS. See diluted EPSdiluted EPS 250direct financing lease 77discontinued operations 242, 262discount bond 58discount rate 141, 231

INDEX


Financial Statement AnalysisIndex

discretionary reserve accounting 299double-declining balance 31DuPont analysis 291

E

earning power 262earnings quality 268employee stock options 230engaging in special, one-time transactions 215EPS. See earnings per shareequity 280equity method 97, 202equity turnover 285expected return on plan assets 139, 141, 231extended DuPont system 292external liquidity 290extraordinary items 242

F

failing to record liabilities 215fair value of plan assets 136FCF. See free cash flowFCFF. See free cash flow to the firmFIFO 10, 280FIFO method 237financial assets 205financial labilities 208financial ratios, limitations of 301financial risk 287financing liability disclosures 58first in, first out. See FIFOfixed financial cost ratio 288flow effects 165foreign currency exchange rate changes 136foreign currency translation 299Form 10-K 216Form 10-Q 216Form 144insider stock transactions 216Form 8-K 216free cash flow 280free cash flow to the firm 268functional currency 166

G

goodwill 116, 118, 258, 299gross profit margin 238, 285growth potential 289guarantee obligation 257

H

held-for-trading financial assets 206held-to-maturity (HTM) investments 206historical rate 167holding gain/loss effects 165hyperinflationary economies 190

I

impairment or restructuring charges 262income tax expense 38income tax paid 38indefinite reversals 44in-process research and development (IPRD) 116, 203in-substance defeasance 158interest cost 135, 139interest coverage ratio 288internal liquidity ratios 282intrinsic value method 130inventories 205inventory turnover 238, 283

J

joint ventures 102

L

landfill and interest costs 222last in, first out. See LIFOLCM. See lower of cost or marketleases 256, 299leverage ratios 266LIFO 10, 280LIFO liquidation 19LIFO method 236LIFO reserve 13liquidity ratios 266loans and receivables 206local currency 166long-term debt-to-total capital ratio 288lower of cost or market 9, 91



M

management discussion and analysis 216market method 91market valuation adjustment 95market values 57marketable securities 257marketing and solicitation cost 221MD&A. See management discussion and analysismonetary assets and liabilities 167mortgages and securitized loans 158MVA. See market valuation adjustment

N

net fixed asset turnover 284net profit margin 286nonmonetary assets and liabilities 167nonrecurring gains 236nonrecurring items 262normal operating earnings 262

O

off-balance sheet financing 256operating efficiency ratios 284operating lease 72operating leverage 287operating profit margin 238, 285operating profitability ratios 285

P

par bond 58payables payment period 284payables turnover ratio 284PBO. See projected benefit obligationpension assumptions 231pension expense 139pension liabilities 259pension plan funded status 137permanent difference 39perpetual debt 62pooling of interests method 114premium bond 58president’s letter 216pretax income 38price allocation strategies 117prior service cost 136, 140pro forma disclosure 130profitability ratios 266

projected benefit obligation 135, 231proportionate consolidation 102proxy statements 216purchase method 114, 203

Q

quick ratio 282

R

rate of compensation increase 141, 231receivables turnover 283recording fictitious revenue 215recording revenue prematurely 215registration statement 216remeasurement 167repair and maintenance costs 222reporting currency 166research and development cost 222retirement benefit accounting 280return on common equity 286return on total capital 286ROTC. See return on total capital

S

sales-type lease 77SEC filings 216segment reporting 121sell receivables with recourse 158senior 57service cost 135, 139service hours method 32SFAS 52, Foreign Currency Translation 167SFAS 87, Transition Gain or Loss 140shifting current-period expenses 215simple capital structure 250software costs 222, 236special purpose entity (SPE) 157, 202stock option compensation accounting 130stock-option plans 259store preopening costs 222straight-line depreciation 31subordinated 57sum-of-years’ digits 31sustainable growth rate 289SYD. See sum-of-years’ digitssynthetic leases 158



T

take-or-pay contracts 158, 229, 239tax loss carryforward 38taxes payable 38temporal method 167temporal versus all-current methods 280temporary difference 39termination benefits 136throughput arrangements 158timing difference 38total asset turnover 284total debt ratio 288traditional cash flow 280transferring future expenses 215translation 167treasury stock method 251

U

U.S. vs. IAS GAAP purchase methods 280unconsolidated subsidiaries 257units-of-production method 32unusual or infrequent items 243

V

valuation allowance 38variable interest entity 157, 256VIE. See variable interest entity

W

warrants 61weighted average costing 10

Z

zero-coupon debt 60

OOK INANCIAL TATEMENT NALYSIS

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