1
Objectives for today….
#1 Full-time only:1. Finish Cash Flow Statement
Cumulative returns 4 Greats Look at red flags.
2
Objectives for today….2.Look at a simple Enron
maneuver
3.Discuss four articles and some other Creative Accounting
4. Presentations
5. Begin discussion of costs
3
1. Accounts Receivable when Allowance
2. Sales and A/R
Or Sales and A/R
Red Flags
4
3. Sales when Inventory
4. Debt and Assets
5. Other
Red Flags continued
5
6. Goodwill
7. Given my skepticism about Goodwill….
Red Flags continued
6
Creative Accounting 101
7
The Birth of JEDI, an SPE
or….
Enron’s End run
8
Must Enron include SPEs on its balance sheet?
Not if……. a)not in control of SPE andb)outsiders invest & have at risk at least 3% of total capital………
Why does Enron not want to consolidate?
9
CALPERS
ENRON
JEDI
$250 Mil
EnronStock
1993
10
1997
•CALPERS wants to cash out of JEDI.
• Enron must figure out a way to redeem the CALPERS investment. They create Chewco to buy out CALPERS.
11
CALPERSENRON
JEDI
$383 Mil
CHEWCO
This is the plan….
12
CHEWCONeeds $383 million to give CALPERS ……It gets…..$240 mil loan from Barclay’s bank Guaranteed by Enron$132 mil credit from JEDI (only asset is Enron stock)
Must get 3% from outside sources to avoid consolidation.
13
CHEWCO Capital Structure The Outside 3%
$115,000 from M.Kopper (worked at time for Enron)
$11.4 mil loans from Big and Little River (two new LLCs formed for this purpose who get a loan from Barclay’s Bank)
14
CHEWCO
Big RiverLittle River
$11.4 mil.Kopper
$.115 m
CHEWCO Capital Structure Outside 3%
15
In the following slide…a solid line is actual cash transfer. A dashed line is aloan. All dollars are inmillions.
16
CALPERS
JEDIEnron now
sole partner
383
Little RiverBig River
Chewco
Barclay’s Bank
ENRON
11.4
Kopper
240 Enron guar.
.115
11.4
132
17
What causes trouble for Enron?• Barclay’s Bank begins to doubt the
strength of the new LLCs – Big River and Little River- and requires a CASH reserve to be deposited (as security) for the $11.4 million dollar loans. This Cash Reserve is paid by JEDI, which by this time consists solely of Enron stock, putting Enron in the at risk position for this amount.
• (See red arrow on the next slide.)
18
CALPERS
JEDIEnron now
sole partner
383
Little RiverBig River
Chewco
Barclay’s Bank
ENRON
11.4
Kopper
240 Enron guar.
.115
11.4
132
6.6
19
Revenue Recognition?I.e. Profit to Enron?
$10 mil in guarantee fee + fee based on loan balance to JEDI. A total of $25.7 mil revenues from this source.
20
Other Profit to Enron?
The increase in the price of Enron stock held by JEDI. Enron recognized $126 million in the first quarter of 2000 from this.
21
ING 1. Dutch and US Goodwill?
2. Difference in income greater under existing or prior US rules?
3. Which treatment provides a better , “more faithful” representation?
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STAPLES 1. Changes??? 2. VENDOR ALLOWANCE definition?
Prior accounting method? 3. Current accounting for Vendor
Allowance? 4. How was change treated? 5. Why did market react as it did?
23
Contingent ConvertiblesMezzanineAccounting’s
Newest Addition ---
Contingent Convertibles
24
Contingent ConvertiblesLatest Accounting Magic – CoCosHow to borrow money for free
and let shareholders feel the pain later.
25
Contingent ConvertiblesTwo key Points:1. Exercise of option is NOT an expense
2. CoCo’s do not affect diluted EPS
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Contingent ConvertiblesCompany issues debt at lower than market or NO interest rate. Why would lenders buy the bonds?
Because they contain a conversion option.
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Contingent ConvertiblesRegular conversion option:You can buy the stock for $50/share when the price hits $50 per share.
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Contingent ConvertiblesLoCos work slightly BUTSIGNIFICANTLY different:You can buy the stock for $56.50/share when the price hits $67.80 per share.
29
Contingent ConvertiblesProblem?
Another twist…Cephalon bought a hedge from Credit Suisse to protect against conversion.
30
Contingent Convertibles They paid $258 million, which is DEDUCTIBLE and saves them about $80 mil in taxes.
But that’s a big chunk of a $750 million issue, so……
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Contingent ConvertiblesCredit Suisse gave back $178 when Cephalon agreed
to assume some risk of price variation. This is NOT taxable revenue.
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1.Capitalizing vs. expensing
A. AOLB. World Com
2.Recognizing Revenues Prematurely….
More Creativity…..
33
C. Halliburton D. Microstrategy
long term software
contracts3.Pyramids.
1.ZZZZ Best
More Creativity…..
34
4.Rainy day reservesA. XeroxB. W. R. Grace
5.Book more than you earn..
Priceline
More Creativity…..
35
6.Channel stuffing Sunbeam….gladly sell
you a grill that you pay for next summer
Vendor financingSell to a warehouse
More Creativity…..
36
Costs, CVP and Leverage
37
Fixed Cost - Total
$
Activity Level
38
$
Activity Level
Variable Cost - Total
39
$
Activity Level
Mixed Cost - Total
40
$
Activity Level
Mixed Cost - Total
41
VOLUMEVolume = level of activity…But this concept is flexible.
Volume should be measurable and
Should relate to changes in costs...
42
Fixed versus Variable?
Not always easy…depends on point of view. Think of the passenger on the already scheduled flight….variable costs are minimal. But what about when the flight was originally scheduled?
43
Questions to answer with CVP1. Change in profit is NBC gets a new affiliate to run its evening news?2. How many patient days for IA Methodist Hospital to break even?3. What if hospital leases a new
computerized patient information system?4. What if nurses’ salaries change?
44
Uses of CVP…..When there are changes in… Selling Price Costs -- variable or fixed Income tax rates Product mix
Applies to non-profit orgs as well…How many services can be provided?
45
Assumptions
1. Linear, constant costs2. Costs only fixed or variable3. Sales and Production are equal4. No capacity additions during period5. Sales mix remains constant6. Inflation is ignored7. Technological assumptions remain unchanged..productivity same.
46
CVP as a Flow DiagramSlide 16-18
UR
UR
Fixed Costs Profits
UVC
UVC
UVC
Variable Costs ContributionC
C
47
Equation ApproachSales revenue – Variable expenses – Fixed expenses = Profit
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Equation ApproachAssume Sales Price of $500Variable cost/unit of $300 and Fixed Costs of
$80,000
How many units must Curl Co.sell to break even?
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Equation Approach($500 × X))
($300 × X)––
–– $80,000 = 0
X = Break Even in units
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Contribution Margin Approach
CONTRIBUTION MARGIN =$500 - $300 or $200 per unit
At Break Even the TOTAL CMis equal to Total FIXED Costs…or.. $200 (X) = $80,000
X = Break Even in units
51
Contribution-Margin Approach
==
Break-even point(in units)
Fixed expenses Unit contribution margin
52
Contribution-Margin RatioWe can calculate the break-even point in sales
dollars rather than units by using the contribution-margin ratio.
Fixed expense CM Ratio
Break-even point(in sales dollars)==
53
Contribution-Margin Ratio Approach
CM Ratio = Sales Price - Var CoSales Price
I.E. What % of the selling priceis left after paying variable unitcost?
54
Contribution-Margin Ratio ApproachCM Ratio = Sales Price - Var Cost
Sales Price
In our example, $500 - $300 = $200 CM. $200 is 40% of SP.Fixed Costs of $80,000, dividedby 40% = ?
55
Cost-Volume-Profit Graphed
Units Sold
Sal
es in
Dol
lars
56
Cost-Volume-Profit GraphBreak-even
point
Units
$$$$
57
Increase selling price per unit (SP) Decrease variable cost per unit (UVC) Decrease fixed costs (TFC) Increase volume (X)
Improving Profit PerformanceSlide 16-19
58
Three more Important Cost Terms
1. Opportunity
2. Sunk
3. Differential or Incremental
59
Opportunity CostThe potential benefit that is given up
when one alternative is selected over another.Example: If you were not
attending college, you couldbe earning $15,000 per year. Your opportunity costof attending college for one year is $15,000.
60
Sunk Costs All costs incurred in the past that
cannot be changed by any decision made now or in the future.
Sunk costs should not be considered in decisions.
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Sunk CostsExample: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.
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Sunk CostsExamples…..Beloved of politicians…Knee Deep…..
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Sunk Costs Basketball players
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Incremental CostsCosts that differ between
alternatives. Example: You can earn $1,500 per month in yourhometown or $2,000 per month in a nearby city.Your commuting costs are $50 per month in your
hometown and $300 per month to the city.
What is your incremental cost?
65
Incremental CostsCosts that differ between
alternatives. Example: You can earn $1,500 per month in yourhometown or $2,000 per month in a nearby city.Your commuting costs are $50 per month in your
hometown and $300 per month to the city.
What is your incremental cost? $300 - $50 = $250
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Incremental or Diffferential or Marginal CostsOften these are related to
Variable and Fixed patterns, i.e.they are driven by volume changes….Another Boeing 757? Another Palm Pilot? Another Windows XT?
67
Marginal Costs and Average Costs
The extra costincurred to produceone additional unit.
The total cost toproduce a quantity
divided by thequantity produced.
Marginal and average costs arelargely a function of cost behavior
-- variable and fixed costs.
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For next week…..
1. Homework
2. Read Cost material Part I It is on the Web site.
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