Young Cohen Corporate Financial Reporting and Analysis 3rd Edition Solution manual by Ace Test Banks

Corporate Financial Reporting and Analysis, 3rd Edition BY Young, Cohen

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. What are “consolidated financial statements”? 2. What is meant by the term “group financial statements”? 3. The balance sheet (or statement of financial position) is often referred to as a “snapshot.” Why? 4. If the balance sheet is a snapshot, how would you describe the income statement and the statement of cash flows? 5. Why must the statement of financial position (i.e., the balance sheet) balance? 6. What is the purpose of the auditor’s opinion? 7. What is Sarbanes-Oxley, and how has it affected corporate financial reporting? 8. Describe the limitations of the financial reporting process. 9. Financial accounting = Economic truth + error + manipulation. Explain. 10. Can you think of instances in which the creation of bias or error in the financial statements might be justified? 11. Describe how the three principle financial statements are linked. 12. What role is played by the notes in the financial reporting process? 13. What is the primary purpose of the statement of changes in shareholders’ equity? 14. What is meant by the term accounting choice, and why is the concept so important in financial accounting? 15. What is meant by the term “earnings management”?

1. The combined financial statements of a parent company and its subsidiaries. 2. Group financial statements are consolidated financial statements. The former term tends to be preferred in some parts of the world, especially Europe. 3. Because it reflects financial performance at a point in time. 4. You could call them “videos,” in that they describe performance over a period of time. 5. Because shareholders’ equity represents a residual claim against the assets of the firm. Therefore, it will expand or contract to whatever size it needs to be to ensure that the two sides of the balance sheet are equal. 6. It’s an attestation by independent public accountants on the reliability of a company’s financial statements. The auditor tell us whether the financial statements were prepared in accordance with GAAP or IFRS, and therefore whether readers can rely on them in making economic decisions such as whether or not to invest in the firm. 7. A law that was passed in the U.S. in the aftermath of the Enron scandal. Among other things it requires all companies (including non-American) that file with the Securities and Exchange Commission to provide an attestation on the trustworthiness of the company’s financial statements from the CEO, the CFO, and maybe the chief accountant. A statement is also required on the quality of the company’s internal

CORPORATE FINANCIAL REPORTING AND ANALYSIS

controls. Similar requirements have since been imposed in several other countries, although they tend to be less onerous than Sarbanes-Oxley. 8. The first issue is the sheer volume of information readers and analysts must contend with. The obvious risk is one of information overload, and determining which of the many pieces of data are truly important for gaining an accurate understanding of a company’s financial strength and performance. Second, accounting choice can profoundly impact the figures reported on the financial statements. The implication is that financial accounting is a far from being an objective discipline. Three, financial statements can be manipulated. Fourth, the financial statements, and even the accompanying notes, can exclude critical attributes of a company that will profoundly influence future performance. Examples include investment in intellectual capital or brands. Current accounting practice is limited in what it can tell the reader about such assets. 9. Financial accounting exists to help us understand the underlying economic truth of a company. That way, the world’s scarce resources are allocated more efficiently, with the result being greater wealth creation. However, because so much estimation and judgment is required in the accounting process, error is inevitable. Some of that error arises from good faith mistakes on the part of managers who are trying their best to come up with the right numbers. But a lot of that error can be deliberate. This happens when managers deliberately bias accounting numbers upwards or downwards to achieve certain financial reporting goals. 10. Although financial reporting under GAAP and IFRS is separate from tax reporting, companies will often choose financial reporting practices to support a controversial tax position. For example, it may be difficult to defend a position that leads to lower income than the tax authorities believe is reasonable when GAAP or IFRS lead to far higher profits. In such cases, the biasing of accounting numbers to yield lower profits may result in tax savings. We’ll leave the ethics of this behavior to another day. Also, companies may bias accounting numbers to avoid the violation of restrictive covenants in debt contracts. Such violations can be costly, because they may lead to debt getting called in by the bank or a renegotiation of the debt on more onerous terms. 11. They are linked in many ways, but three obvious links are (1) the reconciliation of beginning and ending cash from the balance sheet on the statement of cash flows, (2) the net income figure on the income statement which serves to reconcile beginning and ending retained earnings, and (3) the reconciliation between net income and cash flow from operations. 12. The notes provide amplifying details on financial statement line items. Placing all of that detail on the face of the statements would render them confusing and difficult to read. So the details are reported in the notes that follow the financial statements. An example would be financial details on operating divisions. Another example would be the detailed breakdowns for debt, provisions and income taxes. The notes also describe the accounting policy choices made by management, allowing the reader to better understand the reporting assumptions that underlie the financial statements.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

13. To reconcile beginning and ending balances for every account in the shareholders’ equity section of the balance sheet. In this way, the way can see the movements into and out of those accounts. 14. Although GAAP and IFRS provide guidelines for financial reporting, many choices must be made by management. For example, what depreciation method to use, the estimated useful lives of depreciable assets, etc. Will we revaluate property, plant & equipment, or continue to use acquisition cost? What will be the specific policies we adopt regarding revenue recognition? Managers have some latitude in making these decisions. This is what is meant by “accounting choice.” The concept is not only important for business managers but for financial statement readers too. Different policy choices can lead to very different outcomes on the financial statements. The reader must be aware of these choices and determine whether the choices made by the management of a particular firm were appropriate. 15. Earnings management is the conscious act of biasing accounting numbers to achieve specific financial reporting results. Such acts are often driven by executive bonus plans linked to specific accounting numbers, such as EPS or operating income, or by a desire to manage or finesse the company’s share price. Planned public offerings or management buyouts can also create incentives for earnings management.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. Describe the difference between current assets and noncurrent assets. 2. True or false: The criterion that determines whether or not an asset is current is 12 months. 3. How are current assets listed on the balance sheet? 4. What is meant by “prepaid expenses” and why is this item classified as an asset? 5. What is the dominant valuation basis for property, plant & equipment? 6. Why is share capital described as “direct” investment and retained earnings as “indirect” investment? 7. What does the term “net” mean in the context of net sales or net revenues? 8. Why do deferred income taxes exist? 9. What is the difference between “expensing” an item and “capitalizing” it? 10. What is “comprehensive income” and what is it designed to achieve?

1. Current assets are those which are in the form of cash, are expected to be converted into cash, or consumed within one year or one operating cycle, whichever is longer. Noncurrent assets are simply those assets that don’t meet the criteria for current. 2. Mostly true, but it could be false in companies with long operating cycles such as wine growing, defense contracting, and construction. 3. In order of liquidity; either descending, as in the U.S. or Japan, or ascending, as is usually found in Europe. 4. These are expenditures, usually for rent and insurance, and haven’t been consumed yet. Because they represent future benefits to the firm (the right to use the rented property or the right to insurance coverage), they are considered assets. These assets are examples of current assets that get used up instead of converted into cash. 5. The default option is acquisition or historical cost. It continues to be the dominant valuation basis, even for IFRS companies (which can use fair value is they so choose). 6. Share capital (the sum of par value and capital in excess of par) represents sum invested directly by the firm’s shareholders when the shares were issued. Retained earnings represented all of the profits earned by the company but not paid out as dividends. The implication is that the profits have been reinvested in the firm, indirectly, on behalf of shareholders. 7. Here, “net” means product returns and discounts. 8. To reconcile the taxes recognized under tax law with those recognized under GAAP or IFRS. Without the matching principle, there would be no reason to recognize deferred taxes. Income tax expense in any give year would simply equal what is owed for that year.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

9. Expensing an item is to recognize it as an expense on the current period’s income statement. Capitalizing an item is to recognize it as an asset, perhaps to reach the income statement in the future through depreciation, amortization, or depletion. 10. Comprehensive income is the change in a company's net assets from non-owner sources during the year. It is a statement of all income and expenses recognized during that period, including those that temporarily bypass the income statement. The concept came into existence to make such gains and losses more transparent, and to restore the “clean surplus” relationship to the financial statements.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. Describe the basic criteria that must be met before revenue can be recognized under U.S. GAAP or IFRS. 2. What is the “matching principle” and what role does it play in the financial reporting process. 3. True or false: The criteria describing the key characteristics of financial information (relevance, reliability, and consistency) are contradictory. 4. What is meant by the term “conservatism”? Doesn’t it create bias financial reporting? 5. Describe the “materiality” concept and its influence on the financial statements. 6. What do the concepts of “cohesiveness“ and ”disaggregation” mean and what is their significance for the future of corporate financial reporting? 7. IFRS is often described as a “principles-based” system while U.S. GAAP is described as “rules-based.” What do these differences mean and what impact do they have on accounting and auditing practice? 8. Why did U.S. GAAP evolve into a rules-based system?

1. Revenue must be measurable, earned, and realizable. Measurable means that a reasonable basis exists for determining the amount of revenue earned. Earned means that the seller has produced the produce or delivered the service that the customer is paying for. In other words, the work has been done. Realizable means a reasonable expectation of getting paid (i.e., converting the revenue into cash or other consideration). 2. Revenues in any given year will be “matched” against whatever expenses were incurred to generate those revenues. The accrual method of accounting is the technique devised by accountants to implement the matching principle. It explains all of the accruals we make at the end of each accounting period—for revenues earned but not yet received, employee services already performed but not yet paid, interest expense incurred but not yet paid, depreciation, etc. Also, if it weren’t for the matching principle we wouldn’t see provisions or accrued liabilities on the balance sheet. 3. True. All of the principles discussed in the chapter are desirable, but not equally so. For example, to improve relevance we have to depend more on fair value. But fair value makes financial statements more subjective. It’s a question of trade-offs and prioritizing the desirable attributes of financial statements. 4. Conservatism (or “prudence” in the U.K.) means that one should err on the side of caution when faced with uncertain measurements. On a practical level this means avoiding the overstatement of assets, revenues and gains, and avoiding the understatement of liabilities, expenses and losses. The problem, of course, is that the

CORPORATE FINANCIAL REPORTING AND ANALYSIS

application of the conservatism concept creates bias (i.e., error) in the financial reporting process. Materiality means that if a financial item is deemed to be insignificant, it should be accounted for in whichever way is easiest. In the case of expenditures, this means that the item in question should be expensed, because otherwise (i.e., capitalization) detailed asset records are required. The materiality concept also explains why many balance sheet and income statement accounts are aggregated in the financial statements. They are not considered large enough (or material) to warrant a separate line item. “Cohesivesness” means that firms should present financial information such that the relationship between items across the three principle financial statements complement or articulate with each other as much as possible. “Disaggregation” means that firms should provide enough disaggregation in the financial statements to serve the information needs of investors. These principles have emerged recently, and are likely to have significant effects on the way that financial information is presented in future. For example, we may see the balance sheet and income statement reorganized to coincide more closely with the organization of the statement of cash flows, in particular the operation, investing and financing sections. A principles-based accounting regime provides a conceptual basis for accountants to follow instead of a list of detailed rules. A rule-based approach provides much more detailed guidance. It means that accounting is more prescriptive under U.S. GAAP than under IFRS. A principles-based regime relies more on professional judgment than rules to resolve doubts about how to account for complicated transations. The litigious nature of the U.S. is the most important cause. It created the demand for a “safe harbor” in financial reporting. Detailed rules provide at least some protection against litigation for companies and their auditors when accounting for complex transactions.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. Describe the criteria that must be met before revenue can be recognized. 2. Why do U.S. GAAP and IFRS require, if practicable, the use of the percentage-ofcompletion method for long-term contracts? 3. Under what conditions might percentage-of-completion not be usable? 4. What should a company do if percentage-of-completion cannot be used? 5. Describe the differences between an “input-based” approach and an “output-based” approach to determining the percentage of work completed on a long-term construction project. 6. What is the major drawback of the percentage-of-completion method? 7. What is channel stuffing and how does it impact revenue recognition? 8. Describe the “gross vs. net” controversy. Why might a company prefer to recognize revenues on a gross basis?

1. Revenue must be measurable, earned, and realizable. Measurable means that a reasonable basis exists for determining the amount of revenue earned. Earned means that the seller has produced the produce or delivered the service that the customer is paying for. In other words, the work has been done. Realizable means a reasonable expectation of getting paid (i.e., converting the revenue into cash or other consideration). 2. Because it’s the only method that conforms with the matching principle, and therefore is the only method that is at least capable of providing a “true and fair” view of performance for each period of the contract. 3. When there are significant concerns about getting paid (in which case the revenue might not be “realizable”) and the complexity of the project makes it very hard, if not impossible, to reasonably estimate the percentage of work completed (thereby violating the measurability criterion). 4. Under IFRS, the cost recovery method is required. U.S. GAAP requires the completed contract method. 5. An input-based approach relies primarily on cost data to determine how much of the work has been completed. For example, if budgeted costs are 10, and costs of 3 have been incurred, we would say that the percentage completed is 30%. An output-based approach relies on physical inspections to determine how much work has been accomplished. Most construction companies use an input-based approach, tempered or controlled by output-based inspections. In other words, it’s not a question of one or the other. 6. Regardless of the method used to estimate the percentage of work completed, considerable judgment is required. Project managers under pressure to meet deadlines .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

might try to overstate how much of the project has been completed, resulting in overstatement of revenues. This sort of behavior is common, which explains why analysts tend to be nervous about any set of accounts that relies heavily on the percentage-of-completion method. 7. Channel stuffing is the practice of pushing product downstream without customers asking for it. It’s a way to recognized revenue prematurely, and may be the single biggest revenue recognition game played by companies that seek to boost reported revenue and profit for the period. The risk is present in any industry involving the physical flow of product. 8. The controversy can best be explained with an example. Consider Priceline.com, an Internet auction platform specializing in travel. Assume that a customer bids, and wins, a round-trip ticket from Boston to London for $300. Priceline’s cut is $40, with the remaining $260 passed on to the airline. How much revenue should Priceline recognize from the transaction? There are two possibilities: $40 (net) or $300 (gross). In the latter case, the $260 paid to the airline is classified as cost of sales, leaving gross profit of $40. Net income will be the same in either case. One perceived advantage of gross is that it makes the company look bigger. This was a major consideration during the original dotcom boom in the late 1990s. The larger the revenue, the theory goes, the more substantial the company (in a superficial way, of course). It turns out that Priceline has always use gross, instead of net, even though most people looking at the above transaction would argue that Priceline earned revenue of just $40. But Priceline created a business model where ownership of the items being auctioned passed through Priceline, however briefly. This, combined with other aspects of the company’s business model, allow Priceline to pass itself off as more of a retailer (e.g., WalMart) than an auctioneer (e.g., Sotheby’s).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. What are the primary uses of the statement of cash flows? Why aren’t the statement of financial position (or balance sheet) and the income statement sufficient? 2. Define operating, investing, and financing cash flows. 3. What are the major elements of a “cash flow profile”? 4. What is the indirect method for determining CFFO, and how does it differ from the direct method? Which method is more common? 5. What are the primary causes for differences between net income and CFFO? 6. How can a company report positive net income, but CFFO for the same year is negative? 7. How can a company report a net loss, but CFFO for the same year is positive? 8. Which figure would you expect to be higher for most companies most of the time: net income or CFFO? Why? 9. One argument given for the statement of cash flows is that it is less subject to manipulation than the income statement. Do you agree with this view? 10. Under U.S. GAAP, cash spent on interest is classified as an operating activity but cash spent on dividends are classified as a financing activity. Explain the paradox. 11. What is meant by the term “negative free cash flows”? “positive free cash flows”? What are the managerial implications in either case? 12. True or false: A firm in a strong growth stage of development is more likely to have negative free cash flow than a more mature firm. 13. Why might an investor not put much weight on a firm’s current free cash flow as an indicator of future free cash flow? 14. Why might changes in provisions appear as an item in the operations section of the statement? 15. What does “working capital requirement” mean, and what impact does it have on the statement of cash flows? 16. When total cash inflows exceed total cash outflows, or vice versa, how is the difference reflected on the statement of cash flows?

1. The SCF summarizes all of the company’s cash flows during the period—the cash coming in and the cash going out. In so doing, it reconciles beginning and ending cash. This reconciliation imposes an important constraint on reporting companies. Beginning cash + inflows – outflows must equal ending cash. But what makes the cash flow statement especially distinctive is that is summarizes the cash flows according to the types of activities that caused them—operations, investing, and financing. 2. Operations refer to the cash flows that arise from the normal, day-to-day activities of the business; cash flows from investing activities involve cash flow consequences of buying and selling of PP&E, and the buying and selling of financial securities (including .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

entire companies); financing activities focus on actions that affect the right side of the balance sheet, including the issuance of shares, the buying back of shares, borrowing, paying off loans, and paying dividends. 3. The relationship between net income and CFFO, and the relationship between CFFO, CFFI, and CFFF (i.e., free cash flow). The analysis of the SCF should focus on these two relationships. 4. The indirect method starts with the accrual-based net income figure from the income statement (or possibly some other profit figure such as operating income) and makes a series of adjustments to it. The effect of these adjustments is to strip out the non-cash items that went into earnings, leaving its cash flow equivalent. The direct method begins with the cash inflows from customers and other sources, and then subtracts the cash paid out to employees, suppliers, taxes, for general admin and marketing, etc. The indirect method is much more common. However, we expect that the IASB and the FASB will eventually require all companies to use the direct method, with the reconciliation between net income and CFFO (the indirect method) relegated to the notes. 5. Depreciation and amortization expense (non-cash expenses), changes in provisions and deferred income tax, equity income net of cash dividends received, and changes in the working capital requirement (WCR). 6. The most likely cause would be large increases in the WCR. This could happen if, for example, the company becomes aggressive in its revenue recognition policy, thereby recognizing revenue prematurely. The balancing entry for the recognition of this revenue is a debit to accounts receivable. The increase in receivables (that comes from recognizing revenue too soon, and therefore far ahead of cash payments from customers) will cause the WCR to increase and CFFO to decrease. Meanwhile, the overstated revenues lead to high reported earnings. This is just one possible scenario among many. 7. The company’s accounting policies might be excessively conservative. Alternatively, there may be large depreciation addbacks and/or reductions in the WCR. 8. CFFO should be bigger for most companies most of the time because of the addback for depreciation and amortization. An exception may be found in high growth companies that must grow the WCR quickly in order to ramp up sales. 9. It does have the anchors offered by beginning and ending cash. Because these two figures must be reconciled, and cash balances are harder than other accounts to manipulate, it can be argued that the SCF imposes constraints on managers who seek to misstate results that may not exist to the same extent with the other financial statements. However, as managers has become more familiar with the SCF, and as its importance in the capital markets has become apparent, companies have become remarkably creative in playing games with this statement too. The games tend to focus on redrawing the boundaries that separate operating cash from investing and financing. In other words, a conscious effort is made to make CFFO look better than it really is. 10. When the SCF became a requirement under U.S. GAAP (in the late 1980s), CFFO was intended to be a cash flow equivalent to net income. Because interest expense is included in net income, it had to be included in the operating activities section of the .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

SCF. Dividends, on the other hand, are considered distributions of profit, and do not enter into profit calculations. Therefore, dividends can be placed where they properly belong on the SCF—under financing activities. It should be noted that while IFRS permits this treatment, companies can classify interest payments under financing activities if they choose. 11. Negative free cash flows mean that CFFO is not sufficient to cover the company’s investments. Positive free cash flow means that even after all investments have been taken into account, there is still some operating cash from the period left over—to build up cash reserves, pay off debt, or reward equity holders through buybacks and/or dividends. The sign (and magnitude) of free cash flows largely determines the company’s capital market activities during the year. For example, if free cash flows are negative, the company either ate into cash reserves built up from previous periods or it accessed additional external capital through share offerings or borrowings. Positive cash flows imply that the company was able to finance all of its investment from internally generated cash, and therefore did not need to access additional resources from banks or the capital markets. 12. True. High growth firms not only invest aggressively in PP&E, but also in working capital (inventories and receivables). As a result, operating cash flows tend to be modest (from the sharp increase in the working capital requirement), and therefore insufficient to cover a firm’s financing needs. Hence, negative free cash flow. 13. If a firm invests aggressively for future growth, its free cash flow might be negative, even if all of the investments are positive NPV. Therefore, the current period’s free cash flow will not be a particularly useful reflection of future free cash flows. 14. If provisions increase, it means that there were losses or charges to earnings which were not matched by cash flows in the current period. Therefore, to convert net income to CFFO, the increase needs to be added back to net income. Conversely, if provisions decrease, the implication is that provisions taken in a previous period were paid off (hence the reduction), which means that cash outflows for the year exceeded losses or expenses recognized in that year. In such case, the change in provisions needs to subtracted from net income in converting it to CFFO. The fact that provisions might be reduced because of reversals (and not the use or payment of the provisions) makes the situation more complicated but it doesn’t change the basic story. CFFO in any given year should only reflect the actual cash expenditures for the related items in that year. Any change in the provisions not related directly to cash must be added to or subtracted from net income. 15. The WCR represents the company’s net investment in the operating cycle. It can be thought of as the price the company pays, in terms of cash committed, to get its PP&E to work. A retailer, for example, can build a beautiful store but the store accomplishes nothing without an additional investment in inventories and, if credited is granted to customers, receivables. Any increase in the WCR consumes cash, and therefore causes CFFO to go down. Any decrease in the WCR releases cash, causing CFFO to increase. These changes are usually seen in the bottom part of the operating activities section of the SCF (assuming the company uses the indirect method).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

16. Through the change in the cash position. For example, ending cash will exceed beginning cash when total cash inflows for the year exceed total cash outflows.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. What is the primary purpose of “accounting analysis”? 2. Explain how and why short-term creditors, long-term creditors, and shareholders approach ratio analysis differently. 3. What is the difference between ROIC and ROE? 4. Under what conditions is ROIC equal to ROE? 5. Explain why, all else being equal, an increase in accounts payable and other operating liabilities causes ROIC to increase. 6. True or false: A decrease in SG&A expenses as a percentage of sales will increase ROE and share price. 7. Many companies state ROE targets as important corporate goals. Do you agree with this practice? Why or why not? 8. What is DuPont analysis and what purposes does it serve? 9. True or false: The shorter the operating cycle, the better. 10. Describe the limitations of the current ratio and quick ratio as indicators of liquidity. What alternatives are available for assessing the liquidity of a firm? 11. Average current ratios in Europe and North America are noticeably lower today than they were 30 years? What might account for this change? 12. What is the primary purpose of turnover ratios? 13. Describe the major financial risk ratios and what they are designed to reveal. 14. True or false: The greater the interest coverage, the better.

1. Accounting analysis aims to evaluate the appropriateness of the company’s accounting policies and estimates. Is the company managing its earnings, for example, or is it keeping important debts off of the balance sheet. If so, numbers might be adjusted to reflect what the reader considers to be a more accurate reflection of the business’s underlying economic reality. This step is performed before any financial ratios are calculated. 2. They each have different information requirements. For example, a short-term creditor is most interested in liquidity and the ability of the company to service its obligations over the coming months. Special attention is given to operating cash flows, inventory and receivables periods, and possibly the current and quick ratios. Providers of longterm debt finance tend to focus on capital structure, hence the concern with debtequity ratios and interest coverage. Also, long-term debt holders are interested in the long-run profitability of the business because this profitability will significantly impact the company’s ability to service debt in future years. Therefore, ROIC and other profitability ratios are considered. Equity investors have the broadest perspective on the firm, mainly because they are residual claimants on the firm’s assets and future cash .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

flows. All obligations to creditors must be met in order for shareholders to get anything. Therefore, they care all short-term liquidity, capital structure, operating efficiency and profitability. All of the ratios discussed in the book are of at least some importance to them. 3. ROIC is an “unlevered” perspective on the profitability of the firm. It addresses the issue of how successful it has been in generating returns on capital, independently of whether that capital is debt or equity, or some combination of the two. This why NOPAT is in the numerator. NOPAT reflects the profit available to all capital providers, both debt and equity. ROE explicitly considers financing by relating net income (profit available to common shareholders) to the book value of equity. 4. The two are equal for an all-equity firm (i.e., one with no debt). 5. Increases in current liabilities (apart from ST debt) will cause the working capital requirement to decrease, thereby causing a decrease in invested capital (the denominator for ROIC). 6. False. While the decrease in SG&A will cause ROE to increase, all else being equal, we cannot possibly know what the share price impact is likely to be. If the decrease is seen as value enhancing, share price will increase; otherwise, share price will stay the same or fall. 7. Unless it’s a bank, or similar business, targeting ROE is almost certainly a bad idea. Because it combines operations and investing activities (reflected in ROIC) with financing choice, managers can increase it simply by levering up the firm. The result is that management might take on more debt than is optimal for the firm. Although it has limitations too, ROIC is a better performance metric than ROE. 8. DuPont analysis is an “umbrella” approach to ratio analysis. It starts with a broad measure of profitability, such as ROIC, then disaggregates it into components—NOPAT margins and IC turnover. It then disaggregates these ratios until we are satisfied that we have learned what we need to learn from the company’s operating and investing activities. We then extend the analysis by transitioning from ROIC to ROE, which gives us an opportunity to examine short-term liquidity and capital structure. 9. True, all else being equal. The shorter the cycle, the more quickly the company converts its operating activities into cash. However, we should at least acknowledge that there are practical constraints to how short the cycle can become. For example, if we can achieve a receivables period of 30 days, further reductions may result in lost customers and reduced profitability. 10. The main problem is that both ratios are static, in the sense that both the numerators and denominators come from the balance sheet. Put another way, they are snapshots of short-term liquidity. For a more dynamic perspective, we need to consider operating cash flows, which are an important source of cash available to pay down short-term obligations. Inventory and receivables periods are also useful measures of liquidity because they reveal how quickly these components of working capital are converted into cash. 11. Current ratios of 2.0 were common in the 1970s. But companies gradually came to realize that high current ratios can jeopardize financial health because they can result

CORPORATE FINANCIAL REPORTING AND ANALYSIS

from excessive investments in receivables and inventories, and therefore less operating cash. 12. To help evaluate the operating efficiency of the company. More specifically, we rely on these ratios to tell us how successful the company has been in converting its asset base into sales. 13. These ratios fall into two basic sources. Ratios such as debt-equity are summary measures of the firm’s capital structure. In other words, they show the extent to which the company relies on debt, as opposed to equity, to finance its assets. The asset this ratio, the greater the risk of financial distress. The second class of ratio aims to measure the coverage of some performance measure (usually operating income, but it could be operating cash flows) to financial obligations (i.e., interest charges, etc.). Interest coverage is one example of such a ratio. The higher the ratio value, the safer the company, because it means that there is increasing profit or cash flows to cover interest payments. 14. Probably false. An accurate way to rephrase this is, “The higher the interest coverage, the safer the firm.” Whether more interest coverage is a good thing is an entirely different question. For example, if a company has little debt, the coverage ratio might be very high. But the company is being deprived of potentially valuable tax shields from the use of debt finance. In such cases, taking on more debt, thereby causing a reduction in interest coverage, would be value enhancing for the firm.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. Compare and contrast the discount cash flow (DCF) approach to valuation with the economic profit approach. Which do you prefer, and why? 2. True or false: Using the economic profit approach for valuation yields identical results to the DCF approach. 3. EVA® is a popular version of economic profit. Contrast and compare the two measures. 4. What factors influence the length of the explicit forecast horizon in a DCF valuation model? Why five years, or ten? 5. How are non-operating assets (such as excess cash and real estate no longer used in current operations) handled in DCF models? 6. Numerous approaches are used to estimate terminal values for DCF models. Which approach do you consider to be the best, and why? 7. What accounts for the popularity of relative valuation approaches (p/e ratios, etc.)? 8. What are the drawbacks of relative valuation?

1. The EP, or EVA, approach is mathematically equivalent to DCF valuation, assuming the inputs are exactly the same. The primary difference is that instead of deducting a cash investment from operating cash flow in the period in which the investment is made (to determine free cash flow), the EP approach charges for the investment gradually over its expected life in the form of capital charges and depreciation. 2. True, but only if the inputs to the valuation model are the same. By framing the valuation problem differently, however, it is possible that the two approaches could yield different results. DCF focuses attention more directly on cash flows, while EP is more of an earnings-based approach. 3. EVA and EP are really the same. Some might argue (especially the consultants who trademarked EVA) that EVA is different because it requires a series of adjustments to correct for perceived biases from IFRS or GAAP. However, plenty of companies use EVA while making no adjustments at all. In substance, therefore, EVA and EP are merely different ways of expressing the same idea. What a firm calls it depends to a large extent on the consulting firm they hired for the design and implementation of their performance measurement system. Moreover, a lot of companies who use EVA choose to call it something else because of the trademark issue. One example is the German media company Bertelsmann. Instead of calling their EP measure EVA, they call it “Bertelsmann value added.” “Economic earnings,” “residual income” and “abnormal earnings” are other substitutes for economic profit. 4. The length of the explicit forecast horizon can be somewhat arbitrary, but there are two fundamental factors that will influence it. First, remember that during the explicit

CORPORATE FINANCIAL REPORTING AND ANALYSIS

5. 6.

7. 8.

forecast horizon, financial statement estimates can be quite detailed. An investment banker might forecast nearly every line item you would expect to see in the balance sheet, income statement, and statement of cash flows in a corporate annual report. Therefore, the length of the horizon should be driven by the extent to which such detail improves the accuracy or dependability of the forecasts. Once we get beyond a certain number of years (five? seven? ten?), the added level of detail becomes foolish, merely piling on a level of detail in the forecasts that accomplish nothing in terms of added precision. A second factor will be growth rates. If we are attempting to value a highgrowth company, the length of the forecast horizon must be extended as long as the growth rate exceeds the cost of capital. Otherwise, continuing value formulae won’t work. This is because we divide the expected free cash flow in the first year of the continuing value period by (OCC – g). Note that in the example given in the chapter, we assume zero growth beyond the forecast horizon because growth assumptions have no effect on value. In a three stage model, however, the growth rate assumption in the first continuing value period can have an enormous effect on value. For this period, the determination of value produces nonsensical results if g is greater than or equal to the opportunity cost of capital. They are added to the continuing value (i.e., the present value of future free cash flows) to yield the value of the firm. Our preference is an approach that assumes that, at some point in the future, positive NPV investment is no longer possible. RONIC is set equal to the OCC, ensuring that future investment is neither value creating nor value destroying. A more popular approach, however, is to use a multiple of some accounting variable in the first year of the continuing value period. That variable might be EBIT, EBITDA, economic profit, or something else entirely. The flaw in these approaches is that the user could be making untenable assumptions about future RONIC and other critical factors without knowing it. They are easy. Easy to perform, and easy to explain to others. Also, the necessary data are readily available. Is it even valuation? Multiples are ways to describe the recent prizes paid for “like” assets. The problem is defining “like.” The use of multiples reinforces a common error in valuation, in which price and intrinsic value are conflated. They are, in fact, very different concepts. The purpose of a valuation is to estimate intrinsic value. A multiples approach doesn’t accomplish this task, it’s simply a way to define price.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. What are the major differences between the allowance method and the direct method in accounting for bad debts? 2. What are the advantages of the allowance method (relative to the direct method)? 3. Most tax authorities require use of the direct method. What reasoning would a tax official give for not permitting the allowance method? 4. Why might the Allowance for Doubtful Accounts have a debit balance during the accounting period, but never at the end of the period? 5. Consider the following statement: “The fewer the uncollectible accounts, the better.” Can you think of instances where this statement might be false? 6. What factors cause the balance in the Allowance for Doubtful Accounts to increase or decrease from one year to the next? 7. How are recoveries of cash from previously written-off accounts treated under the allowance method? The direct method? Why is the accounting treatment for such events different under the two methods? 8. Many companies sell their receivables, either through a process known as “factoring” or through “securitization.” Why do companies do this?

1. The allowance method requires the creation of a contra-asset that reflects the amount of receivables that management believes to be uncollectible. Write-offs of individual receivables are made to Accounts Receivable and the allowance account, with no effect on the income statement. The income statement is affected only by increases to the allowance account (or, must less commonly, from reversals to the allowance account). Under the direct method, a bad debt expense is recognized each time a specific account is written off. There is no contra-asset. 2. There are three: (a) it leads to better matching of revenues and expenses; (b) it separates the write-off of individual accounts from the income statement, thereby depriving managing of the ability to manipulate earnings from the timing of the writeoffs; and (c) net receivables represents the actual amount of cash that management expects the company to collect, not how much is owed. 3. The allowance method would give companies the opportunity to determine the amount of their deduction for bad debt expense. For example, if they are having a strong year, and want to reduce their tax liability, they can simply increase the credit to the allowance account (and the debit to bad debt expense). For this reason, a tax deduction will not be given until a specific account is written off. 4. Under the allowance method, every time an account is written off, the allowance account is debited (i.e., reduced). If the monetary amount of the write-offs during the year exceed the beginning balance in the contra-asset, the balance can go negative (i.e., .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

there will be a net debt balance). However, at the end of the year, the contra-asset account will be restored to reflect the amount of outstanding receivables that are deemed to be uncollectible. If we add the statement, “all else being equal,” this statement is true. However, zero bad debt is usually not the best policy. It can result in excessively restrictive credit terms for customers, placing the company at a competitive disadvantage. Customers simply decide to take their business elsewhere. Changing macroeconomic circumstances (e.g., when the economy deteriorates, more customers fail to pay their debts), changing credit terms (e.g., if credit terms are eased, sales will likely increase but so too will bad debts), and over- or under-provisioning of bad debts expense from previous years (which will eventually require a correction in the contra-asset account). Under the allowance method, recoveries are restored to the contra-asset. There is no income statement effect. Under the direct method, recoveries are recognized on the income statement as “other income” (or something similar). The reason why a recovery has an income statement effect under the direct method (and not under the allowance method) is because when the account was written off (mistakenly), an expense was recognized on the income statement. Therefore, the correction also requires an income statement effect. It should be noted, however, that while recoveries don’t directly affect the income statement under the allowance method, there will be an indirect effect. The recovery is recognize by an increase in the contra asset, which means that at year end the amount of the charge to increase the contra asset to its necessary level will be lower. This, in turn, will result in a lower bad debts expense for the year. The primary (legitimate) justification is that putting receivables into special purpose (or variable interest) entities, a company can create a structure that is less risky that the company itself. The only risk in the new entity is the collection risk from receivables. All of the other risks associated with the company rest within the company itself. The new entity is isolated from such risks. The happy result is that the new entity can borrow more cheaply than the company itself, passing on the cash raised, and the lower interest rate, to the parent. The loan is then back by the cash flows from the receivables. A less justifiable reason for securitizing receivables is to get them off of the balance sheet (although not all securitizations are off-balance-sheet).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

QUESTIONS AND DISCUSSION

1. Describe each of the following terms: Depreciation, amortization, and depletion. 2. Why do tax laws permit accelerated depreciation methods? 3. IFRS permits the use of fair value accounting for property and plant assets. Why, then, do most companies prefer to use historical (or acquisition) cost? 4. Why are transport, installation and training costs added to the asset account, and not expensed immediately? 5. What is goodwill? What is the proper accounting treatment for it? 6. Why does the accounting treatment for repairs and maintenance differ from that of improvements? 7. Why are research costs expensed under IFRS, but development costs are capitalized? What’s the difference between “research” and “development”? 8. True or false: the amortization period for an intangible asset is equal to its legal life. 9. How should a company account for an asset, such as a building or piece of equipment, that has been fully depreciated? 10. Why are brand names and trademarks not amortized? 11. True or false: Most large, publicly traded companies use straight-line depreciation for book purposes but accelerated methods for tax. 12. How is a gain or loss determined on an asset sale?

1. Each term describes the process of allocating the cost of an asset to the periods that benefit from its use. The only difference is the type of asset each of the terms relates to. Depreciation applies to tangible assets (e.g., building, equipment, machinery, vehicles), amortization to intangibles with a finite life (e.g., patents, copyrights, licenses, customer lists), and depletion to natural resources (e.g., coal mines, oil wells). 2. Accelerated depreciation, in comparison to the straight-line method, increases the present value of the future tax deductions that arise from asset ownership. This has the effect of reducing the effective net cost of the asset, which encourages companies to invest more. This increased investment is thought (a) indirectly subsidize companies that sell capital goods, (b) improves and expands the dissemination of new technology, and (b) increases productivity and competitiveness. 3. Because fair value estimations are costly. Independent appraisers need to be hired, additional auditing is needed, and the values must be periodically updated. Such updates are not required for assets carried at historical cost, unless the assets become impaired. Also, many companies find that they can communicate the fair value of undervalued assets without having to go through the formal process of revaluing property. For example, if a company has undervalued real estate on its balance sheet, it can offer a list of properties held to potential lenders. The lenders can then use their .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

expertise in local real estate markets to determine what the assets are really worth. In such cases, the company might not gain anything by going through the formal process of revaluation. 4. Because these components are considered part of the cost of putting the asset into service. In other words, they should be viewed as an integral part of historical, or acquisition, cost. 5. Goodwill is the excess of the purchase price paid for another company over the fair value of the net assets acquired, with net assets equal to assets minus liabilities. Goodwill cannot be amortized. Instead it must be subjected to an annual impairment test. If the goodwill is judged to be impaired, the asset is written down and a loss in the amount of the write down (or write off) is recognized in that period as a loss on goodwill impairment (an income-statement account). 6. Repairs and maintenance are considered routine operating expenses and therefore must be expensed as incurred. Improvements, however, expand the useful life of an asset or enhance the asset’s functionality in some way; therefore, improvements are capitalized. For example, changing the light bulbs in a building is a type of maintenance cost and will be expensed immediately. A building overhaul that replaces fixtures such as carpeting, lighting and climate control is considered an improvement. These costs will appear on the balance sheet as assets. The problem, of course, is that the dividing line that separates repairs from improvements is not always obvious. 7. The relationship between current research costs and future benefits are often so uncertain that the only reasonable accounting treatment is to expense everything. Think of a pharmaceutical company that tests thousands of molecule combinations in the hope of discovering a blockbuster drug. On average, only about one in five thousand combination will ultimately lead to a product. For development, however, the research process has advanced to the point where a product has been provisionally developed. In the case of software, for example, a beta model is available. Further expenditures on the beta version (i.e., development costs) are far more likely to lead to a commercially viable product (and therefore future cash flow benefits) than spending on pure research. This is why IFRS requires the capitalization of development costs. The most obvious problem is that it is not always clear where the line should be drawn between research and development. 8. False. It is equal to the legal life or its economic life (the period of time over which the company can reasonably expect to benefit from its use), whichever is shorter. 9. The asset remains on the books at its acquisition cost, as does the accumulated depreciation. Because the asset and contra-asset accounts have identical balances, the net impact on total assets is zero. This treatment will continue until the asset is either sold or otherwise disposed of. 10. Because they have, in theory, indefinite lives. They might be written off in the future, but they cannot be amortized. 11. True. In fact, there aren’t many large, publicly traded companies that don’t follow this practice.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

12. By taking the difference between the net proceeds from the sale of the asset (i.e., selling price, net of selling costs) and the net book value of the asset (acquisition cost, net of accumulated depreciation).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Understanding balance sheet relationships Stora Enso is a large pulp and paper company headquartered in Finland. The Company uses IFRS and reports its results in millions of euros (€). Compute the missing balance sheet amounts for each of the three years.

Current assets Noncurrent assets Total liabilities Total assets Current liabilities Noncurrent liabilities Total shareholders’ equity Share capital Retained earnings Total liabilities and shareholders’ equity a

Net income for 2010 is €766 and dividends are €158. Current assets – Current liabilities = €1,144.

2011: Total assets = 12,999 Noncurrent assets = 8,389 Total liabilities = 7,039 Total shareholders’ equity = 5,960 Share capital = 2,659 2010: Total assets = 13,037 Total liabilities and shareholders ‘ equity = 13,037 Retained earnings = 1,808 Total shareholders’ equity = 4,958 Total liabilities = 8,079 Noncurrent liabilities = 5,510 2009: .

2011

2010

2009

€ 4,610 ? ? ? 2,786 4,253 ? ? 3,301 12,999

€ 4,494 8,543 ? ? 2,569 ? ? 3,150 ?a ?

?b ? ? € 11,593 2,619 ? 5,183 ? 1,200 ?

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Current assets = 3,763 Noncurrent assets = 7,830 Total liabilities and shareholders ‘ equity = 11,593 Share capital = 3,983 Noncurrent liabilities = 3,791 Total liabilities = 6,410

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Preparing a balance sheet and an income statement The following information is based on accounting data for 2011 and 2012 for PetroLim, a petrochemicals company based in Malaysia. It reports its results in thousands of Malaysian Ringgits.

Statement of Financial Position items

December 31 2012 2011__

Cash Accounts receivable Advances to suppliers Inventories Other current assets Property, plant & equipment (net) Oil and gas properties Intangible assets Other noncurrent assets Accounts payable Advances from customers Other current liabilities Long-term debt Other noncurrent liabilities Common shares Retained earnings

177,178 36,838 40,772 176,934 40,734 495,606 652,656 40,044 327,422 208,920 24,866 169,522 70,610 84,124 889,054 541,088

Income statement items

108,140 16,976 25,328 152,076 26,914 463,180 540,992 32,254 264,428 155,872 23,180 181,878 60,802 73,366 708,680 426,510

2012_________

Net operating revenues Interest and other revenues Cost of sales Selling expenses General & administrative expenses Other operating expenses Interest expense Income taxes

1,670,074 6,196 974,224 82,690 98,648 129,320 5,738 98,662

Required a. Prepare an income statement for PetroLim for the year ending 31 December 2012.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

b. Prepare statements of financial position for PetroLim as of 31 December 2011 and 31 December 2012.

a. PetroLim Income Statement For the Year Ended 31 December 2012 In thousands of Ringgits

Revenues: Net Operating Revenues ......................................................... Interest and Other Revenues .................................................. Total Revenues .................................................................... Less Expenses: Cost of Sales ............................................................................ Selling Expenses....................................................................... General and Administrative Expenses .................................... Other Operating Expenses ...................................................... Interest Expense ...................................................................... Income Taxes ........................................................................... Total Expenses .................................................................... Net Income...................................................................................

1,670,074 6,196 1,676,270 974,224 82,690 98,648 129,320 5,738 98,662 1,389,162 287,108

b. Note: This statement is prepared in a format similar to what you would expect to see for most IFRScompliant companies, including those in Malaysia.

PetroLim Statements of Financial Position In thousands of Ringgits

Assets Noncurrent Assets: Intangible Assets ................................................... Oil and Gas Properties ........................................... Property, Plant and Equipment—Net ................... Other Noncurrent Assets....................................... Total Noncurrent Assets ................................... Current Assets:

31 Dec 2012

31 Dec 2011

40,044 652,656 495,606 327,422 1,515,728

32,254 540,992 463,180 264,428 1,300,854

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Inventories ............................................................. Other Current Assets ............................................. Advances to Suppliers ........................................... Accounts Receivable .............................................. Cash ....................................................................... Total Current Assets .......................................... Total Assets .......................................................

176,934 40,734 40,772 36,838 177,178 472,456 1,988,184

Liabilities and Shareholders' Equity Noncurrent Liabilities: Long-Term Debt ..................................................... 70,610 Other Noncurrent Liabilities .................................. 84,124 Total Noncurrent Liabilities .............................. 154,734 Current Liabilities: Advances from Customers .................................... 24,866 Other Current Liabilities ........................................ 169,522 Accounts Payable .................................................. 208,920 Total Current Liabilities ..................................... 403,308 Shareholders' Equity: Common Stock ...................................................... 889,054 Retained Earnings .................................................. 541,088 Total Shareholders' Equity ................................ 1,430,142 Total Liabilities and Shareholders' Equity ............................................................ 1,988,184

152,076 26,914 25,328 16,976 108,140 329,434 1,630,288

60,802 73,366 134,168 23,180 181,878 155,872 360,930 708,680 426,510 1,135,190 1.630,288

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Revenue recognition at and after time of sale Suite Novotel is an all-suites hotel chain owned and operated by the Accor Group. Most of the hotels in this chain are found in France, Spain and Germany. On the company website, customers are offered a nonrefundable special rate at €160 per night, or a refundable rate at €225 per night. In either case, the entire amount is charged to the customer’s account at the time of booking. For the refundable room, if the reservation is cancelled prior to 16.00 on the date of arrival, a full refund of the amount charged is made. If the cancellation occurs after 16.00 the customer forfeits one day at the reserved rate (€225). Required Determine the appropriate journal entries for each of the following transactions: a. On 6 March, a customer makes a nonrefundable reservation for three nights beginning 24 March. The customer arrives as scheduled and checks out on 27 March. b. On 6 March, a customer makes a reservation identical to the one in part a. On 21 March, the customer cancels the reservation. c. On 6 March, a customer makes a refundable reservation for three nights beginning 24 March. The customer arrives as scheduled and checks out on 27 March. d. On 6 March, a customer makes a reservation identical to the one in part c. On 21 March the customer cancels the reservation. e. On 6 March, a customer makes a reservation identical to the one in part c. On 24 March, at 19.30, the customer cancels the reservation.

6 March: Cash ..................................................................................... Advances from Customer ........................................

27 March:

480 480

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Advances from Customer ................................................... Sales Revenue ........................................................

480 480

6 March: Cash ..................................................................................... Advances from Customer ......................................

480 480

21 March: Advances from Customers .................................................. Sales Revenue ........................................................

480 480

6 March: Cash ..................................................................................... Advances from Customer ......................................

675 675

27 March: Advances from Customer ................................................... Sales Revenue ........................................................

675 675

6 March: Cash ..................................................................................... Advances from Customer .......................................

675 675

21 March: Advances from Customer ................................................... Cash ........................................................................ e.

6 March: .

675 675

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Cash ..................................................................................... Advances from Customer .....................................

675 675

24 March: Advances from Customer ................................................... Sales Revenue ....................................................... Cash ......................................................................

675 225 450

CORPORATE FINANCIAL REPORTING AND ANALYSIS

The percentage-of-completion method On 1 April 2011, Rӧller Construction entered into a fixed-price contract to construct an office building for €18 million. Rӧller uses the percentage-of-completion method. Information related to the contract appears below.

Percentage completed Estimated total cost Profit recognized to date

31 December 2011

31 December 2012

20% € 13,500,000 € 900,000

60% € 14,400,000 € 2,160,000

Required a. Calculate the revenues and expenses recognized for both 2011 and 2012. b. What impact did the €900,000 increase in estimated total cost in 2012 have on revenue recognition in that year?

a. 2011 Revenues = €2,700,000 + €900,000 (profit) = €3,600,000 Expenses = (20% × €13.5 million) = €2,700,000

2012 Revenues = (60% x €18 million) = €7.2 million Expenses = €1.98 million* *Cumulative expenses = 60% x €14.4 million = €$8.64 million. Because 2011 expenses were €2.7 million, expense recognition for 2012 must be €5.94 million (8.64 - 2.7).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

b. In theory, there should be no effect. Expenditures that don’t contribute to the completion of the project shouldn’t affect revenue recognized. That said, it must be admitted that cost overruns sometimes lead to increased revenue recognition, especially if the approach used to determine the percentage of completion is input based. This is a chronic problem in the construction industry.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Journal entries for gift cards Subway is a global food retailer with stores located throughout the world. Suppose a customer at one of its Paris stores purchases a sandwich for €5.00, a brownie for €2.00 and a soft drink for €1.50. The customer pays with cash. Required a. What journal entry will Subway record for this transaction? (Ignore expenses.) b. Suppose that in addition to the above items, the customer buys a Subway gift card for €50.00. What journal entry would Subway record for this transaction? c. Now suppose that the customer buys the same items listed above, but uses a previously purchased gift card to pay for the purchases. Also assume that there is a sufficient balance on the care to cover the entire cost. What journal entry would Subway make now to record the transaction?

Cash

8.5 Revenue

8.5

Cash

50 Deferred revenue

(Note: Deferred revenue is a liability account) c.

Deferred revenue Revenue

8.5 8.5

CORPORATE FINANCIAL REPORTING AND ANALYSIS

The percentage-of-completion method On 1 September 2009, Tan Construction Company contracted to build a shopping complex on the east coast of Singapore. The total contract price was $90 million. As required by Singapore’s Financial Reporting Standards (which are based on IFRS), Tan Construction uses the percentageof-completion method in accounting for long-term contracts. The Company uses an input-based (i.e., cost-based) approach to determine the percentage of completion. The schedule of expected and actual cash collections and contract costs is follows:

Year

Cash collections from customer

Estimated and actual cost incurred

$ 18.0 million 22.5 million 22.5 million 27.0 million $ 90.0 million

$ 6.0 million 18.0 million 24.0 million 12.0 million $ 60.0 million

2009 2010 2011 2012

Required a. Calculate the amount of revenue, expense and net income for each of the four years. b. Show the journal entries that Tan Construction will make in 2009, 2010, 2011, and 2012 for this contract. Tan accumulates contract costs in a Construction in Progress account. The costs involve a mix of cash payments, credits to various other asset accounts, and credits to liability accounts. But for the sake of simplicity, assume that all costs are credited to Accounts Payable.

Year

Incremental Percentage Complete

Revenue Recognized

Expenses Recognized

Income

CORPORATE FINANCIAL REPORTING AND ANALYSIS

2009 2010 2011 2012 Total

6/60 18/60 24/60 12/60 60/60

(.10) (.30) (.40) (.20) (1.00)

9,000,000 27,000,000 36,000,000 18,000,000 90,000,000

6,000,000 18,000,000 24,000,000 12,000,000 60,000,000

3,000,000 9,000,000 12,000,000 6,000,000 $30,000,000

b. 2009 Construction in Process (Current asset) ............................. Accounts Payable .....................................................

Cash ..................................................................................... Advances from Customer (Liability) ............................... Sales Revenue .................................................................

Cost of Sales ........................................................................ Construction in Process ..................................................

9 9

2010 Construction in Process ...................................................... Accounts Payable ...........................................................

Cash ..................................................................................... Advances from Customer ................................................... Sales Revenue .................................................................

22.5 4.5

Cost of Sales ........................................................................ Construction in Process ..................................................

2011 Construction in Process ...................................................... Accounts Payable ...........................................................

24 24

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Cash ..................................................................................... Advances from Customer ................................................... Receivable from Customer ................................................. Sales Revenue .................................................................

22.5 4.5 9.0

Cost of Sales ........................................................................ Construction in Process ..................................................

2012 Construction in Process ...................................................... Accounts Payable ...........................................................

Cash ..................................................................................... Receivable from Customer ............................................. Sales Revenue .................................................................

Cost of Sales ........................................................................ Construction in Process ..................................................

9 18

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Year

Cash collections from customer

Estimated and actual cost incurred

$ 18.0 million 22.5 million 22.5 million 27.0 million $ 90.0 million

$ 6.0 million 18.0 million 24.0 million 12.0 million $ 60.0 million

2009 2010 2011 2012

Year

Incremental Percentage Complete

Revenue Recognized

Expenses Recognized

Income

CORPORATE FINANCIAL REPORTING AND ANALYSIS

2009 2010 2011 2012 Total

6/60 18/60 24/60 12/60 60/60

(.10) (.30) (.40) (.20) (1.00)

9,000,000 27,000,000 36,000,000 18,000,000 90,000,000

6,000,000 18,000,000 24,000,000 12,000,000 60,000,000

3,000,000 9,000,000 12,000,000 6,000,000 $30,000,000

b. 2009 Construction in Process (Current asset) ............................. Accounts Payable .....................................................

Cost of Sales ........................................................................ Construction in Process ..................................................

9 9

2010 Construction in Process ...................................................... Accounts Payable ...........................................................

22.5 4.5

Cost of Sales ........................................................................ Construction in Process ..................................................

2011 Construction in Process ...................................................... Accounts Payable ...........................................................

24 24

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Cash ..................................................................................... Advances from Customer ................................................... Receivable from Customer ................................................. Sales Revenue .................................................................

22.5 4.5 9.0

Cost of Sales ........................................................................ Construction in Process ..................................................

2012 Construction in Process ...................................................... Accounts Payable ...........................................................

Cost of Sales ........................................................................ Construction in Process ..................................................

9 18

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Revenue recognition in different types of businesses Determine when each of the following types of businesses is likely to recognize revenue: a. b. c. d. e. f. g.

A bank lending money for home mortgages. A firm that grows and harvests oranges. A hair salon. A professional football team that sells season tickets before the season begins. A dress shop. A cattle rancher. An airline. Customers can accumulate frequent flyer miles, which earn them a free flight if enough miles are accumulated. h. A producer of port wine that is aged from 10 to 15 years. i. A real estate developer selling lots on long-term contracts with down payments equal to 10% of the selling price. j. A real estate developer who constructs houses and then sells them near or at completion. k. A printer who prints custom-order announcements (for weddings, etc.) and brochures. l. A military contractor constructing fighter aircraft.

a. When mortgage payments are made, a portion is assigned to interest based on the loan’s amortization schedule. Also, at the end of each accounting period, any earned but unpaid interest has to be accrued. b. Probably on delivery. Even if the grower has contracts with food processors, and has hedged price risk, the oranges have to grow before revenue is said to have been earned. c. Point of sale. d. Recognizing revenue when the football team sells season tickets is inappropriate because it is required to provide substantial future services in order to earn the revenue. A liability for the present value of these future services appears on the balance sheet when it sells the season tickets. Over the course of the season, the team can recognize proportionate parts of the season ticket revenue. e. Point of sale. f. On delivery. No value added is recognized as the cows are fattened up. Revenue recognition is unaffected by contracts a rancher may have with slaughterhouses and meat packing firms, or the existence of derivatives to lock in prices. The cows need to mature and be delivered to market before revenue can be recognized. g. When the transportation services are provided. A portion of the revenue from each flight represents revenue of the free flight the customer will ultimately take. A proper matching of revenues and expenses requires that the airline either defers a portion of current revenues and recognizes them at the time of the free flight, or estimates the costs it will incur in providing the free flight and recognize it as an expense (and a

CORPORATE FINANCIAL REPORTING AND ANALYSIS

provision) in the periods when customers take fee-paying flights. Airlines have argued that they incur relatively little incremental costs when they provide free flights. The airlines limit the number of seats per flight that customers can use for free flights and would not otherwise use such seats. Given that the costs of a flight is about the same whether the flight is 95 percent full or 100 percent full, the additional non-fee-paying passengers do not add materially to the airline’s costs. Thus, the airlines typically recognize an expense and a liability for the future costs of providing free flights but include only relatively minor incremental costs in measuring the expense and the liability. h. On delivery of the finished product. The issue here is whether the firm should recognize as revenue the increase in the value of the port as it ages or wait until sale to recognize the revenues associated with the increasing value of the whiskey. Uncertainties about the amount of this value increase and the amount of cash ultimately received when the aging is complete argue against early revenue recognition. In addition, the firm will not complete the earnings process until the port is aged and delivered to the customer. Delaying revenue recognition suggests that the firm also should defer all costs of producing and storing the whiskey. These costs are accumulated in inventory accounts on the balance sheet. i. The installment method. The problem here is that the customer can walk away from the debt (90% of the purchase price) if the real estate market collapses. Because the risk of such behavior is significant, revenue should not be recognized unless cash is received. j. Revenue should be recognized when the homes are sold and delivered. If a home is sold before delivery, the percentage-of-complete method can be used. k. On delivery. The work has to be done and the product accepted by the client before revenue can be recognized. l. As each plane is delivered.

CORPORATE FINANCIAL REPORTING AND ANALYSIS Analyzing Cash Flows at Massa Corporation 2011 I.1.

3. 4. 5. 6. II. III.

IV.

2010

2009

Major Sources

Disposal of assets Operations Long-term debt

Sale of discontinued operations Disposal of assets Long-term debt Operations

Long-term debt Short-term debt Disposal of assets Operations

Major uses

Capital expenditures Repaid long-term debt (net use)

Capital expenditures Repaid long-term debt (net source)

Cash flow from operations (CFFO) compared to net income (NI) Reasons:

CFFO > O; CFFO > NI

Repaid long-term debt (net use) Repaid short-term debt Capital expenditures CFFO > O; CFFO > NI

- Depreciation + software amortization - Restructuring + unusual items - A/R down - Inventories down But: - A/P down - Loss on asset sales

- Depreciation + software amortization - Restructuring + unusual items - A/R down But: - A/P down - A/P down - Loss on asset sales

- Depreciation + software amortization - Restructuring + unusual items - A/P up But: - A/R up - Inventories up - Other up

CFFO > capital expenditures (capex)? CFFO > capex + dividend

No Capex < depreciation No (dividend eliminated) N/A Sold assets

No Capex < depreciation No (dividend reduced) N/A Sold assets Sold operations --------------------------------> --------------------------------> -------------------------------->

No Capex > depreciation No

Excess cash invested Sources of cash for dividends + capex Other major items affecting cash flows

Trends 1- Income 2- CFFO (continuing) 3- Capex 4- Dividends 5- Net borrowing 6- Working capital Overall assessment:

(Use) Investing in software (Source) Sold Class B common stock (Use) Purchase treasury stock

CFFO > O; CFO > NI

N/A Borrowed long-term Borrowed short-term --------------------------------> --------------------------------> -------------------------------->

Recovering Up Down ($12.97 million) Eliminated Net repayer Almost all source (except A/P)

Down Loss Up Positive Down $303.6 million Down $26.0 million Net repayer Net borrower Almost all source (except A/P) Almost all use (Company shrinking) Grave concerns: drastic actions; although cash flows from operations are up, capex is down. Other sources of cash are drying up. The dates of the case were moved up by 20 years. The company filed for bankruptcy in August 1992.

1 .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

2 .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Adjustments on the statement of cash flows The 2003 Annual Report of McDonald’s includes the following note: In 2003, the $272.1 million of charges consisted of: $237.0 million related to the loss on the sale of Donatos Pizzeria, the closing of Donatos and Boston Market restaurants outside the U.S. and the exit of a domestic joint venture with Fazoli’s; and $35.1 million related to the revitalization plan actions of McDonald’s Japan, including headcount reductions, the closing of Pret a Manger stores in Japan and the early termination of a long-term management services agreement. In 2002, the $266.9 million of net charges consisted of: $201.4 million related to the anticipated transfer of ownership in five countries in the Middle East and Latin America to developmental licensees and ceasing operations in two countries in Latin America; $80.5 million primarily related to eliminating approximately 600 positions (about half of which were in the U.S. and half of which were in international markets), reallocating resources and consolidating certain home office facilities to control costs; and a $15.0 million favorable adjustment to the 2001 restructuring charge due to lower employee-related costs than originally anticipated.

Required a. McDonald’s reports Cash Flows from Operating Activities using the indirect method. How would the $237.0 million loss in 2003 for the sale of Donatos and other be reported on the company’s Statement of Cash Flows? Why? b. Explain how the $15.0 million favorable adjustment to the 2001 restructuring charge is accounted on each of the three principal financial statements for 2002.

a. The $237 million would be added back to the company’s statement of cash flows operating section as it is a non-cash charge. The actual cash amount that is received from the sale will be recorded in the investing section of the cash flow statement. b. The $15 million favorable adjustment is recorded on the income statement as a negative expense. Thus, it will boost McDonald’s income by this amount. On the balance sheet, the restructuring liability will be reduced by $15 million and the retained earnings will increase by $15 million. Thus, the total liabilities and shareholders’ equity will remain the same. However, the total liabilities will be smaller and the total stockholders equity will be higher. Leverage ratios will be reduced. On the statement of cash flows the boost which made it to the income statement will be reversed because it is not a cash gain. Thus, the higher net income will be reduced by the $15 million to get back to no cash impact.

CORPORATE FINANCIAL REPORTING AND ANALYSIS Part a Allen Company Statement of Cash Flows (2012) Net loss $(110,000) Depreciation expense 200,000 Amortization expense 10,000 Loss on equipment sale 30,000 Undistributed equity earnings (70,000) Increase in accounts receivable (85,000) Decrease in inventory 60,000 Decrease in prepaid expenses 3,000 Increase in accounts payable 154,000 Decrease in accrued liabilities (2,000) Cash flow from operations

$190,000

Purchase of property, plant, and equipment Sale of property, plant, and equipment Investments in affiliates Cash flow from investing

$(350,000) 40,000 (30,000) (340,000)

Issuance of long-term notes Payment of cash dividend Retirement of stock Cash flow from financing Net increase in cash

$280,000 (12,000) (70,000) 198,000 $48,000

Part b. Cash flow from operations is positive even though Allen experienced a net loss. Most of the difference between cash flow and net loss is explained by the large depreciation expense associated with manufacturing. The unexpected production slowdown due to capacity constraints likely led to a sales decrease and explains some of the net loss. However, the slowdown also led to a decrease in (primarily finished goods) inventory, which increased cash flow from operations. Another source of operating cash was the large increase in accounts payable. Coupled with the total decrease of all inventories, this indicates that Allen is stretching out its suppliers. Growth increased accounts receivable (a decrease in CFFO), but probably not as much as it would have given the manufacturing difficulties. Another condition leading to lower CFFO was the retention of dividends at the affiliate. CFFO is not sufficient to continue the plant expansion indicated by cash outflows from investing activities. As a result, Allen accessed capital markets by issuing long-term notes, which is consistent with the acquisition of long-term property, plant, and equipment. The issuance of notes, combined with the net loss and the retirement of stock, points to a shift in capital structure towards debt financing.

CORPORATE FINANCIAL REPORTING AND ANALYSIS Part c Inventory is likely to increase substantially next year due to firm growth and restocking of finished goods. Accounts payable is likely to decrease because Allen will not be able to continued stretching out suppliers at this rate. Accounts receivable will also likely grow faster when sales return to expected levels.

Selected supporting t-accounts for Allen (not required)

Beginning balance Equity income Additional investment (plug) Ending balance

Beginning balance Purchases (plug) Ending balance

Acc. Depr on PPE sold

Retirement of shares

Net loss Dividends Stock dividend

Investment in Affiliates 100,000 80,000 Dividends received 30,000 200,000

10,000

Property Plant Equipment 950,000 350,000 Orig. cost of PPE sold 1,100,000

Accumulated depreciation Beginning balance Depreciation expense (plug) 130,000 Ending balance

Contributed capital Beginning balance Stock dividend 70,000 Ending balance

Retained earnings Beginning balance 110,000 12,000 30,000 Ending balance

200,000

370,000 200,000 440,000

750,000 30,000 710,000

272,000

120,000

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Interpreting the role of accounts payable in cash flow from operations AB InBev is the world’s largest brewer. An abbreviated version of the operating activities section of the Company’s Statement of Cash Flows appears below: Cash flows from operating activities Million US dollar

2011

2010

Profit .............................................................................................................................. Interest, taxes and non-cash items included in profit ............................................................ Cash flow from operating activities before changes in working capital and use of provisions......................................................................................................................

7 959 7 420

5 762 8 503

15 379

14 265

Change in working capital.................................................................................................. Pension contributions and use of provisions ......................................................................... Interest and taxes (paid)/received...................................................................................... Dividends received ........................................................................................................... Cash flow from operating activities ...............................................................................

1 409 (710) (3 998) 406 12 486

226 (519) (4 450) 383 9 905

Elsewhere in the annual report, management reveals that trade payables increased in 2011 because of higher capital expenditures. Also, these payables have, on average, longer payment terms than payables from previous years. Required Explain why the increase in payables and the change in payment terms contributed to the increased in Cash Flow from Operations in 2011. What other factors contributed to the increase?

AB InBev’s cash flow from operating activities was $12,486 million in 2011 compared to $9,905 million in 2010. The increase results mainly from higher profits generated in 2011 and a strong contribution from changes in working capital. The working capital improvements reflect primarily the results of on-going trade payables initiatives. In addition, there is an increase in trade payables related to higher capital expenditures, these payables having, on average, longer payment terms. The lengthening of payment terms reflects the increase in financing of AB InBev’s operating cycle provided by suppliers. The result is a reduction in the Company’s working capital requirement and an increase in CFFO. The increase in profits made a major contribution too. Also, AB InBev reduced interest and tax cash payments by nearly $1/2 billion.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Manipulating the statement of cash flows You are the company’s Chief Financial Officer. It is early December, and your accountants have produced financial statements showing provisional results for the year. (Your company’s fiscal year ends on 31 December.) You show these to the CEO who then expresses concern about several figures. One figure in particular, cash flow from operations (CFFO), appears low. The CEO wonders if anything can be done before the end of the year to increase it. Which of the following actions will increase CFFO this year? Which of these actions do you consider appropriate, which are inappropriate, and why? a. The company sells €2 million of accounts receivable for 97% of face value to a bank. The receivables are sold “with recourse,” which means that the company must reimburse the bank for any amount not collected beyond 3% of total receivables. b. Social charges are due on employees’ wages at the end of the year. The firm can delay these payments by a few days so that they are made at the beginning of the following year. c. The company can work out a deal with some of its customers in which the customers buy goods now, for cash, but they can receive a full refund after the beginning of the next year. d. A training program is moved from the final month of the current year to the first month of the following year. e. Routine maintenance is delayed on machinery and equipment until early next year. f. The company delays the purchase of a new forklift until the beginning of next year.

a. This probably won’t work. The fact that the receivables are sold with recourse means that the auditors are unlikely to treat the transaction as a sale of receivables. The receivables will have to stay on the balance sheet. Therefore, the transactions won’t reduce the working capital requirement (WCR) or CFFO. Is it appropriate? If the company needs additional short-term finance, and this is a relatively low-cost way of obtaining that finance, then yes. But if the transaction is motivated by the desire to artificially boost CFFO, then no. b. This will increase accrued taxes, and reduce the WCR. Therefore, CFFO will increase. The problem is that the company might be assessed interest and penalties on the late payments. If so, the perceived short-term advantage of higher CFFO will carry a heavy price. Also, because the cash flow will occur just after the year end, next year’s CFFO will be correspondingly lower. c. If the auditors are doing their job, this won’t work. Auditors have procedures in which they examine transactions early in the next period to confirm their estimates for the current period. If they observe an unusually high number or product returns, they may guess what is going on. If so, they will require the company to invalidate the recognition

CORPORATE FINANCIAL REPORTING AND ANALYSIS

of revenue and treat the cash received as a financing cash flow. Why financing? Because in such arrangements, the company offers to repay the customer at a premium to the amount the customer paid. In effect, the customer is granting the company a loan. The ethical ramifications of this behavior should be obvious. d. This will boost current period CFFO. But the price will be paid in terms of next year’s CFFO. Is it appropriate? It’s one thing to postpone such expenditures when there is a cash shortfall in the company. But it’s an entirely different matter when the deferral is motivated by the desire to dress up accounting numbers. There may be powerful incentive effects for senior managers to behave this way, but the effort is likely value destroying (which makes it unethical). e. This will work, but see the points made in part d. f. This deferral will boost free cash flow, but won’t affect CFFO. The planned cash flow is an investing activity.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

a. Cash flow from operations in both years Dividends received and decrease in share capital in 2008 (sale of subsidiary in 2007 and long-term debt in 2008) b. Capital expenditures in both years Dividends paid to shareholders in both years c. Neither sources nor uses of cash – these are non-cash charges that reduced accrual net income and that therefore need to be added back when arriving at cash flows from operations. d. In 2008 Capex SKK 4.23 billion exceeded depreciation, depletion, amortization & impairments (“DDAI”) of SKK 2.96 billion, consistent with an increase in the firm’s operating capacity. In 2007, DDAI was slightly lower than the sum of Capex plus acquired subsidiaries (2,891,865+263,856). Given inflation (i.e., that new assets are purchased in today’s dollars while depreciation is being taken on old costs), the relation in 2007 is suggestive of an entity that is either just sustaining or somewhat declining in its productive capacity. e. Net source – cash flow from operations before working capital accounts was SKK 6.029, whereas after working capital accounts it was SKK 6.731. f. This relates to a reversal of impairment. The reversal would have been a positive add-back into accrual net income (i.e., it’s a negative expense). Thus, this amount is subtracted from accrual net income in order to arrive at operating cash flows. g. There was some initial evidence that this entity could be in a growth mode in fiscal 2008, as evidenced by the significant capex exceeding depreciation and related charges previously noted. On the other hand, however, the depreciation and related charges are lower in 2008 than they were in 2007 (despite significant new assets being added to the depreciable base) and accrual net income has dropped by more than 50%. Furthermore, inventories, accounts receivable, and accounts payable are all declining significantly year over year (e.g., both accounts receivable and accounts payable declined by more than the current year’s net income), and the amount of dividends paid to shareholders has declined by more than 25% in 2008, all consistent with a company in contraction rather than growth mode. There is little in the way of net new borrowings, debt repayments, or share capital issuances or repurchases, suggesting that not much has changed in terms of the entity’s capital structure. We see, however, that the company paid out SKK 5.4 billion in dividends while only earning SKK 3.4 billion in net income, so shareholders’ equity has declined by about SKK 2 billion. At the same time, current liabilities have declined by a larger SKK 4.7 billion amount, suggesting that the company may have decreased its overall use of leverage. Since cash has declined by about 25% as well, however, and the company’s available-for-sale investments have

CORPORATE FINANCIAL REPORTING AND ANALYSIS

suffered significant impairments in 2008, there could be some new liquidity challenges facing the entity. We would need to see the balance sheet to confirm or refute this potential problem. Overall, the company seems to have experienced a down year, but it remains profitable and cash flow positive, and it is significantly reinvesting in assets. The entity is able to finance its capex out of operating cash flows, but cash flows from operations are no longer sufficient to cover past levels of dividend payments (i.e., CFOs in 2008 were less than the prior year’s dividend payments). The 2008 pattern of activity is not sustainable, but if 2008 represents just one bad year rather than the start of a trend, then there does not appear to be any threat to the entity’s longerterm survival. The increase in capex, perhaps occurring near the end of the year given the depreciation charges that are lighter than last year, is a positive sign of hope for the future.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Cash flow and credit risk Taipei-based Tang Manufacturing has a $1.45 million bank loan that starts coming due in a year, and the loan officer at the local bank has asked for cash budgets to be reassured that the company can repay the debt on schedule. Management has prepared quarterly cash flow forecasts for each of the next six quarters, excerpts of which are produced in the table below. Also worth noting is that much of Tang’s equipment and machinery is dated, and therefore long overdue for replacement.

Q1 Scheduled loan payments Forecasted cash flows Cash flow from operations $290,000 Capital expenditures 217,500 Dividends

$362,500

$435,000 217,500

$348,000

$725,000

$290,000 253,750 72,500

$319,000

Required a. Why might Tang’s loan officer be concerned about the company’s ability to repay the loan. b. What steps can Tang management take to reduce the bank’s risk on the loan?

a. Scheduled loan payments over the 1½ years total $1,450,000. Expected operating cash flows are $2,044,500 over this same period, but management also expects to pay out $72,500 in dividends and $688,750 on capital expenditures. This means a shortfall in operating cash flows of $166,750. The projected net cash flow shortage is why the loan officer might be nervous about the Tang loan. b. There are at least five steps management can take to reduce the loan’s credit risk: (1) increase the projected cash from operations, perhaps through cost-cutting initiatives or improved working capital management; (2) reducing planned capital expenditures, although this will be hard given the aging physical plant; (3) eliminate the dividend payment; and (4) generate cash by selling non-essential assets or by issuing more equity; (5) seek a modification to the loan terms so the scheduled debt payments can be postponed. The last of these steps is done only when the first four do not generate sufficient cash.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Financial Statement Detective Exercise One of the important lessons to get from this case is that industry factors and business models have huge effects on corporate financial statements. An important challenge for the financial statement reader is to understand what these effects might be. In other words, given what we know about a company and its business model, what should the balance sheet and income statement look like? The proposed sequence is just one of many ways to solve the problem. Step 1 :

Identify the companies with no inventory: #3, #8 and #11. These 3 companies should be SAP, Accor and Interpublic. Note that Southwest does have inventory (mainly spare parts). Likewise, Deutsche Telekom. #11 must be SAP, because it’s the only R&D intensive company among the three. The high profit margin (17.4%) is also consistent with #11 being SAP. The company’s R&D allows it to produce proprietary products with patent/copyright protection. #8 must be Interpublic. Because advertising companies buy access to media on behalf of their clients, they have very large receivables and payables, the largest you will see outside the financial services sector. #3, therefore, must be Accor. The high PP&E is consistent with this. So too are the low profit margins (3.7%).

Step 2:

The other R&D intensive company (14.4%) is #4. This must be Pfizer. The high profit margin (21.6%) and high free operating cash flow is expected from a large pharmaceutical company. Patents give them quasi-monopolies that allow them to extract high margins from their products.

Step 3 :

#7 must be Carrefour. Clues include low profit margins (a feature of discount retailers and grocery store chains) and a negative working capital requirement. The latter is not necessarily a feature of retailing, but it is a logical outcome of Carrefour’s business model (with long accounts payable periods).

Step 4:

The most capital intensive company (#1) must be FPL. PP&E of this magnitude is common for electricity companies because of the massive physical plant required to generate and distribute the product. The high levels of debt are also a common feature of this industry. Utilities can safely bear high levels of debt because their operating cash flows are stable.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Step 5 :

#10 is Dell. There are several clues here. The negative working capital requirement and very low inventory (a result of its business model), the high COGS, modest profit margins (heavy price competition), and low R&D. Dell is not an R&D intensive company. They are more concerned about taking technology created elsewhere (Intel, etc.) and engineering it into their PCs and laptops.

Step 6:

#12 is Deutsche Telekom. PP&E is high, as expected for a telecom, other assets (in this case, goodwill and acquired licenses) are also high, as is long term debt, a common feature of both telecoms and German companies, (owing to a financial system dominated by banks). The high debt is also consistent with the fact that the German government still owns a piece of the company, providing some reassurance to investors that the government is not likely to let the company fail. Therefore, investors can lend with some confidence. The other important factor is high selling and administrative costs, the second highest of the 12 companies. T-mobile, T-online, and the company’s phone business in Germany face intense competitive pressure, making them very marketing intensive.

Step 7:

The other company with very high selling and administrative expenses (36%) is #9. This is Nestle. Because Nestle has thousands of brands, huge marketing spend is required. It’s easily distinguished from Deutsche Telekom by the higher inventory (8.1% vs. 2.4%) and lower PP&E (47.5% vs. 76.3%).

Step 8:

3 companies are left: #2, #5 and #6. These must be Arcelor, Southwest and Toyota, in some order. The most capital intensive, by far, is #2. This must be Southwest Airlines. One reason we know #2 can’t be either of the other two is that the asset (or invested capital) turnover implied by such asset intensity cannot be supported by a manufacturing company. Choosing between the remaining two is not easy but #5 is Arcelor and #6 is Toyota. One clue that differentiates them is inventory. We would expect Arcelor’s inventory to be much higher than Toyota’s. Also, Toyota carries more debt, a result owing more to their Japanese origins than to their industry. The close relationships between Japanese manufacturers and their banks, including cross-ownership, lead to relatively high levels of debt.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

a. b. c. d. e. f. g. h. i. j. k. l. m. n. o.

Total Current Assets

Total Current Liabilities

Working Capital Requirement

Current Ratio

+ + + – – 0 + 0 – 0 0 0 + 0 –

0 0 0 – 0 0 0 0 0 – 0 + + + 0

0 – 0 – 0 0 0 0 0 + – 0 0 – 0

+ + + + – 0 + 0 – + 0 – – – –

1 .

CORPORATE FINANCIAL REPORTING AND ANALYSIS a.

Texas Instruments

2002 $8,383 = 1.61 $5,192

2003 $9,834 = 2.2 $4,463

2004 $12,580 = 3.1 $4,025

Hewlett-Packard

$56,588 = 10.0 $5,661

$73,061 = 10.9 $6,703

$79,905 = 11.6 $6,894

b. The PP&E turnovers of HP exceed those of TI for each year. One likely reason is that HP outsources the manufacturing of components for some of its products. The numerator of the turnover ratio for HP includes the sales of such products but the denominator does not include all of the PP&E used in the manufacture of these products. Some of the assets appear on the balance sheets of the subcontractors. Another reason for the difference is that the manufacturing process for semiconductors is highly capital intensive, which will reduce the PP&E turnover of TI. Note that TI’s higher percentage of PP&E depreciated will increase its fixed assets turnover (because it lowers the denominator) and is not an explanation for TI’s lower turnover ratio. c. The PP&E turnover of TI increased over the period. The increase is the result of an increasing growth rate in sales and an increase in the percentage of PP&E depreciated (i.e., PP&E is aging). TI maintained its level of capital expenditures between 2002 and 2003 and then increased them in 2004. The increase in capital expenditures was not sufficient to offset depreciation, so that average PP&E declined during the three years for TI. The PP&E turnover of HP increased steadily too. HP increased its capital expenditures each year but by less than the growth rate in sales. The percentage of PP&E depreciated increased over time, which tends to lower the denominator of the ratio and therefore increases it.

1 .

CORPORATE FINANCIAL REPORTING AND ANALYSIS Four Firms (1), (2), (3), and (5) incur research and development (R&D) expenditures and three do not. Wilson, American Biotech, Mauborgne Labs (ML), and Morris & Morris engage in research to develop new products. Thus, they represent these four firms in some combination. One would expect that the firms enjoying patent protection (Wilson and American Biotech) would have the highest profit margins (that is, net income divided by sales). This would suggest that Firms (1) and (2) are Wilson and Am. Biotech in some order and that Firms (3) and (5) are Chang and Morris & Morris in some order. The perplexing aspect of this logic, however, is the common-size income statement percentages is the highest of the four companies and its R&D percentage is the lowest, which are inconsistent with this being either Wilson or Am. Biotech. Products with patent protection should have the lowest cost of goods sold percentages (resulting from high markups on cost to arrive at selling prices). Thus, following another line of logic, the need to continually discover new drugs should lead Wilson and Am. Biotech to have the highest R&D percentages, which would be either Firm (2) or Firm (3) as discussed below. This being the case, the other two firms – Firm (1) and Firm (5)—must be ML and Morris & Morris in some order. The brand recognition of Morris & Morris products should give it a high profit margin and competition among generic firms, which compete on the basis of low prices, should give ML a lower profit margin. This reasoning would suggest that Morris & Morris is Firm (1) and ML is Firm (5). The contradictory aspect of this conclusion is the low selling and administrative expenses for Firm (1) versus Firm (5). ML will not need to advertise its products, although it will use a sales force. Morris & Morris, on the other hand, advertises extensively. Thus, Firm (1) is ML and Firm (5) is Morris & Morris. The high profit margin of ML results from offering generic drugs for ethical drugs that have recently come off patent and more aggressive management of drug cost by health care plans (that is, requiring pharmacists to substitute generic drugs for ethical drugs whenever possible). Note that ML has a high proportion of cash, relatively small current liabilities, and minimal long-term debt. With the major ethical drug firms now competing aggressively in the generic market, one might expect the profit margin of ML to decrease in the future. This leaves Firms (2) and (3) as Wilson and Am. Biotech in some order. The biotechnology industry is significantly less mature than the ethical drug industry. Few biotechnology drugs have received FDA approval and research to develop new drugs is intensive. Given the few biotechnology drugs available on the markets, Am. Biotech’s profit margin should be higher and its R&D expense percentage should also be higher than those of Wilson. Thus, Firm (2) is Am. Biotech and Firm (3) is Wilson. Am. Biotech has a higher proportion of cash on the balance sheet than Wilson, reflecting its growth phase and the need to fund R&D. Wilson’s higher selling and administrative expense percentage results from it need to maintain a sales force. The biotechnology products of Am. Biotech are fewer in number and are essentially pulled through the distribution process by customer demand at this point. Thus, it has less need for a sales force. We are now left with Chang, Crimson Health, and Eberhard and Firms (4), (6), and (7). Chang has no inventories, whereas both Crimson Health (a wholesaler) and Eberhard (a retailer) do. Thus, Firm (4) is Chang. Of the remaining two firms, Crimson and Eberhard, the latter will likely have a higher proportion of its assets in PP&E for retail space. Crimson needs only warehousing facilities for its drug wholesaling activities. Thus, Firm (6) is Eberhard and Firm (7) is Crimson Health. Advertising expenditures by Eberhard drive up its selling and administrative expense percentage relative to that of Crimson Health. Eberhard sells for cash or third party credit cards and will therefore have less receivables than Crimson, which sells to businesses on credit. It is interesting to note that the highest profit margins in the pharmaceutical industry occur with the upstream activities (discovery of new drugs) instead of the downstream activities (wholesaling and retailing). It is also interesting to note that the profit margin of Chang lies between the high profit margins of the creators of new drugs and the low profit margins of those firms involved in distribution. Chang must possess some technical expertise in order to offer drug-testing services, thus providing the rationale for a higher profit margin than those achieved by the wholesalers and retailers. The higher profit margin for Eberhard over Crimson Health is probably attributable to brand name

1 .

CORPORATE FINANCIAL REPORTING AND ANALYSIS recognition and the large number of retail stores nationwide. The wholesaling function of Crimson is low value added. The pharmaceutical benefit management services are somewhat differentiable but quickly copied by competitors. It is also interesting to note the extent that these firms use long-term debt financing. The firms involved in upstream activities must invest in research and manufacturing facilities, which can serve as collateral for borrowing. These firms, however, have high profit margins (which should enhance cash flow from operations) and high product risks (introduction of superior products by competitors, legal liability exposure). Thus, these firms tend not to add financial risk to their already high asset-side risk. However, note all the firms operating in the various sectors of the pharmaceutical industry generally carry relatively low amounts of debt. The right order: 1 – Mauborgne Labs 2 – American Biotech 3 – Wilson Pharma 4 – Chang Labs 5 – Morris & Morris 6 – Eberhard 7 – Crimson Health

2 .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Comprehensive financial ratio analysis Financial statements for Wertenbroch Company, a distributor of kitchenware, are presented below (all amounts in thousands of euro).

Statements of Financial Position Assets Land Buildings and equipment (net) Prepaid expenses Inventories Receivables (net) Short-term investments Cash

2012

2011

€ 260 360 58 250 196 104 140 €1,368

€ 260 350 46 270 160 80 130 €1,296

€ 400 272 300 200 96 100 €1,368

€ 400 232 300 200 84 80 €1,296

2012

2011

€1,700 1,240 460 303 157 34 123 37 € 86

€1,580 1,150 430 283 143 23 120 36 € 84

Equities and Liabilities Share capital Retained earnings Long-term debt Short-term debt Accounts payable Accrued liabilities

Income Statements

Revenues Cost of goods sold Gross profit Other operating expenses Operating profit Interest expense Income before taxes Income taxes Net Income

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Additional information:          

All sales were on account. No share transactions took place in either year. Total assets at the beginning of 2011 were €1,260. Accounts payable and accrued liabilities at the beginning of 2011 totaled €146. Receivables (net) at the beginning of 2011 were €176. Inventory at the beginning of 2011 was €236. Shareholders’ equity at the beginning of 2011 was €594. Cash flow from operations was €175 in 2011 and €198 in 2012. Capital expenditures were modest in both years. The tax rate is 30%.

Required Using whatever ratios you need, analyze the liquidity, operating efficiency and profitability of Wertenbroch Company for 2011 and 2012. Has Wertenbroch’s performance improved or deteriorated over the two years? Be as specific as the data allow.

Average receivables (2012): €178 Average receivables (2011): €168 Average inventories (2012): €260 Average inventories (2011): €253 Average invested capital (2012): €1,152 Average invested capital (2011): €1,123 Note: invested capital equals [total assets – (accounts payable + accrued liabilities) Average shareholders’ equity (2012): Average shareholders’ equity (2012): €652 Average shareholders’ equity (2011): €613 NOPAT (2012): €110 NOPAT (2011): €103 Note: NOPAT equals Operating Profit (1 – 0.3) Current assets (2012): €690

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Current assets (2011): €640 Quick assets (2012): €440 Quick assets (2011): €370 Current liabilities (2012): €396 Current liabilities (2011): €364

Current ratio Quick ratio Receivables period Inventory period Invested capital turnover CFFO/Sales ROIC ROE

2012

2011

1.74 1.11 38 days 77 days 1.48X 11.6% 9.5% 13.2%

1.75 1.02 39 days 80 days 1.40X 11.1% 9.2% 13.7%

Performance was consistent across the two years. The current and quick ratios changed little. There were slight improvements in operating efficiency as the length of the operating cycle declined from 119 days to 115 days. ROIC improved slightly but ROE did not. The reason for the discrepancy is that the increase in retained earnings caused shareholders’ equity to increase, while debt was constant. Therefore, the leverage effect was reduced. Overall, there was little change in performance, although the small differences we do observe are generally favorable.

CORPORATE FINANCIAL REPORTING AND ANALYSIS a) ROIC increase driven by NOPAT margin increases. Decrease in CGS/Sales ratio over time likely explained by cost savings. Efficiencies from centralized purchasing. Sales price increases unlikely because of competitive nature of industry and low customer switching costs. Sales volume increases less likely to drive decrease in the ratio because nearly all cost of goods sold is variable for a retailer (inventory purchases only; maybe some fixed distribution costs). SGA/Sales ratio increases then decreases substantially. Initial costs of technology purchases likely increased SGA expenses (either through amortization or expensing). Cost efficiencies likely achieved through reduced labor costs from self services isles and Web kiosks. Another possibility is that slower sales increases may have not been enough to keep pace with increased fixed costs in SGA from store expansions. IC turnover relatively flat due to unchanging large inventory requirements in stores and large stores (large inventory selection is a strategy). Accounts receivable turnover doesn’t matter much when explaining changes because accounts receivables are low to begin with. b) HD has many sales directly to customers and also has credit card arrangement where HD does not hold the receivables. Lower AR levels lead to higher turnovers which are positively related to ROIC. Lower AR levels don’t change current or quick ratios, but do increase speed of cash collection, which indicates lower liquidity risk.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Comparative analysis of receivables and inventories The following information is taken from the annual reports of The Coca-Cola Company and PepsiCo, Inc. The two companies are fierce competitors, but they differ in important respects. Coca-Cola is more “cola-centric,” which means that its core Coke and Diet Coke brands play a more dominant role in the company than Pepsi brand cola does in PepsiCo. Although Coca-Cola is the world leader in soft drinks, by a large margin, PepsiCo is the bigger company because of greater diversification. Both companies sell bottled water and other beverages (e.g., health and energy drinks), but these products feature more prominently in PepsiCo. Also, PepsiCo is the world leader in salty snacks through its Frito Lay business.

(in millions)

Coca-Cola

PepsiCo

Accounts receivable, net

31 Dec. 2010 31 Dec. 2011

$ 4,430 4,920

$ 6,323 6,912

Inventories

31 Dec. 2010 31 Dec. 2011

2,650 3,092

3,372 3,827

Net revenue

2010 2011

35,119 46,542

57,838 66,504

Cost of goods sold

2010 2011

12,693 18,216

26,575 31,593

Required a. For each company, calculate the receivables period, the inventory period, and the length of the operating cycle for 2011. Assume that all sales are on credit. b. Comment on any differences you observe between the two companies. What reasons can you give for why the companies have different operating cycles?

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Coca-Cola

PepsiCo

(1) Receivables Period

(2) Inventory Period

(1) + (2) Length of Operating Cycle

365 ÷ (46,542/4,675)* = 37 days

365 ÷ (18,216/2,871) = 58 days

95 days

365 ÷ (66,504/6,618) = 36 days

365 ÷ (31,593/3,600) = 42 days

78 days

* Note that all receivables and inventory figures are averages for 2011.

b. The receivables periods are practically the same. This comes as no surprise. We would expect that the companies extend similar credit terms to their customers (primarily bottlers and restaurant chains for Coca-Cola; the same for PepsiCo, plus supermarket chains and food wholesalers and distributors). However, the inventory period for PepsiCo is noticeably shorter (by 16 days). One possibility is that PepsiCo is more efficient at turning raw materials into finished products and sales than Coca-Cola. But the latter’s financial performance suggests that this explanation is unlikely. A more likely explanation can be found in the different product portfolios of the two companies. The length of time from the acquisition of raw materials to the sale of concentrate to bottlers and syrup to restaurants is probably very similar (although we don’t know for sure). However, PepsiCo relies more on bottled water and snack foods, and these products have much shorter cycle times than the concentrate and syrup for soft drinks. This difference would explain why PepsiCo’s inventory period and operating cycle are shorter.

CORPORATE FINANCIAL REPORTING AND ANALYSIS Part a 2007 81,5111 1.12 91,292 8% 7,303 32,9941 11% 3,629

2008 91,292 1.12 102,247 8% 8,180 35,872 11% 3,946

Sales in prior year × Forecasted growth factor Forecasted sales × Forecasted NOPAT margin NOPAT Beginning IC (Sales / 2.85) × OCC Capital charge Economic profit (NOPAT – Capital charge) 3,674 4,234 1 Actual (not forecasted) amounts given in Home Depot material.

2009 102,247 1.10 112,472 8% 8,998 39,459 11% 4,340

2010 112,472 1.10 123,719 8% 9,898 43,405 11% 4,775

2011 123,719 1.10 136,091 8% 10,887 47,745 11% 5,252

4,658

5,123

5,635

Part b. Economic profit × PV factor PV ∑ PV + Beginning IC Enterprise Value – PV of debt Equity value Shares Implied equity value 2 (NOPAT in 2011)/0.11

2007 3,674 .90090 3,310 75,606 32,994 108,600 4,000 104,600 2,124 49.25

2008 4,234 .81162 3,436

2009 4,658 .73119 3,406

2010 5,123 .65873 3,375

2011 5,635 .59345 3,344

Terminal 98,9732 .59345 58735

BUY, $49.25 is greater than the current market price of $40 Note: Students may also use discounted cash flow in part b, but should arrive at the same implied equity value.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Explaining differences in p/e ratios The price/earnings ratios (from early 2012 prices and 2011 earnings) of several large companies are shown below: Apple Coca-Cola Bank of China Oracle SABMiller EDF (France) Gazprom

23 13 9 23 30 56 6

Required What factors might explain the differences in p/e ratios observed among these companies?

Because the ratios are based on the previous year’s earnings, we would expect companies with superior growth prospects to have higher p/e ratios than the others. The reason is that current earnings should grow faster. This could explain why the p/e ratios for Oracle and Apple are higher than that of Coca-Cola. It does seem odd, however, that EDF (a French public utility) should have such a high p/e. Growth potential is highly constrained for EDF (given that the French economy is hardly growing these days). The most likely cause for the high p/e is that, for reasons unknown from this problem, earnings in 2011 were depressed. The market is expecting earnings to recover. Similarly, the high p/e for SABMiller is difficult to explain. Perhaps it’s a growth story, but the beer industry is rather stagnant, losing market share to beer, wine, and other beverages. Another important factor explaining differences in p/e ratios is the conservatism of each company’s accounting practices. Investors are willing to pay more for a dollar of earnings if the reporting entity’s practices are judged to be conservative and if there is high confidence in the integrity of the accounting numbers. This latter point is at least a partial explanation for why Gazprom’s p/e is so low. Likewise for the Bank of China.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Explaining differences in p/e ratios The price/earnings ratios (from early 2012 prices and 2011 earnings) of several large pharmaceutical companies are shown below: Pfizer Johnson & Johnson GlaxoSmithKline AstraZeneca Eli Lilly Bayer Abbot Laboratories

20 12 38 8 8 37 17

Required What factors might explain the differences in p/e ratios observed among these companies?

The primary factors explaining differences in p/e ratios are: 



Differences in expected growth. The higher the growth (and the faster the earnings are expected to grow), the higher the p/e. In this industry, companies with a promising pipeline of new drugs will sell for higher p/e ratios than the others. This may go some way in explaining the high p/e for Glaxo and for Bayer. The p/e ratios for AstraZeneca and Eli Lilly may be driven by a thin pipeline and/or key revenue producing drugs about to come off patent protection. If so, future profits will be eroded, leading to a lower p/e. Accounting practices. Investors will pay more for a given level of earnings when those earnings are determined based on relatively conservative accounting policies. We know that German companies tend to follow conservative accounting, which may partially explain the high p/e for Bayer.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

a. Calculate JPMC’s allowance for loan losses as a percentage of gross loans outstanding for each of the three years for which information has been provided.

Allowance Gross Loans

2008

2007

2006

23,164 744,898

9,234 519,374

7,279 483,127

3.11%

1.78%

1.51%

b. What is the dollar value of JPMC’s loan write offs in 2007 and 2008? Allowance for Loan Losses (XA) 7,279 ending balance 2006 (given)

Write-offs

4,909

6,864 provision for credit losses in 2007 (shown in SCF & IS) 9,234 ending balance 2007 (from balance sheet)

7,049

20,979 for credit losses in 2008 (shown in SCF & IS) 23,164 ending balance 2008 (from balance sheet)

c. Their allowance has increased a lot over the periods shown – more than doubling as a percentage of loans outstanding (i.e., from 1.5% to 3%). However, the amount in the allowance account at the end of fiscal 2008 remains more than three times the size of the maximum write-offs that have ever taken. Without having more detail about their loan portfolio, it’s hard to tell whether JPMC’s ending allowance is appropriate but their write-offs have been too low, or whether their write-offs have been appropriate but the allowance has become a bloated “cookie jar” reserve. On the one hand, their gross loans outstanding have grown a lot (i.e., 54% from 2006 to 2008) during a tight credit market, consistent with JPMC possibly not taking enough write-offs of bad loans. On the other hand, the banking sector experienced a terrible year in 2008 (e.g., JPMC’s net income was down by 64% and many other banks experienced losses), so this would be a convenient time for JPMC to take some larger-than-necessary expenses through the income statement. The market was not expecting much in the way of positive performance anyway, so why not go ahead and take the hit now? Time will tell whether they will use this cookie jar to enhance future reported earnings (i.e., by reversing the provision or taking lighter provisions in future years) or whether their realized write-offs in 2009 will absorb the huge allowance that has already been established. Prior to 2008, there is no evidence that they have engaged in significant under- or over-reserving for bad loans. .

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Determining bad debt expense from an aging schedule Hilary Company’s year-end accounts receivable show the following balances by age: Age of accounts

Balance

Not due yet 0-30 days 31-60 days 61-120 days More than 120 days

€ 600,000 200,000 45,000 20,000 10,000

The credit balance in the Allowance for Doubtful Accounts is now €8,600. Hilary Company’s prior collection experience suggests that Hilary should use the following percentages to compute the total uncollectible amount of receivables: 0-30 days, 0.5%; 31-60 days, 1.0%; 61120, 10%; and more than 120 days, 70%. Required Prepare the journal entry to record Hilary’s bad debt expense.

-------------------------------------------------------------------------------------------------------------------------------

Bad Debt Expense ....................................................................................... Allowance for Uncollectible Accounts........................................

1,850

The Allowance account requires a balance of $10,450 [= (.005 X €200,000) + (.01 X €45,000) + (.10 X €20,000) + (.70 X €10,000)]. Therefore, bad debt expense for the current year must be €1,850 (or €10,450 – €8,600).

1,850

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Analyzing receivables and the allowance for doubtful accounts Vermeulen Company of Ghent, a producer of custom-made furniture, was founded in 2010. Revenues in its first year were €3.5 million, all on account. The balance in the receivables account at the end of the year was €1 million. The Company estimated uncollectible receivables at 2% of sales. Based on an aging schedule and other information about customer accounts, €40,000 of receivables were written off on 31 December 2010. One year later, on 31 December 2011, the balances in selected accounts were as follows: Sales Accounts Receivable (gross) Allowance for Doubtful Accounts

€ 4.0 million € 1.5 million € 50,000

On 31 December 2011, Vermeulen Company estimated that its accounts receivable balance contained €55,000 of likely uncollectibles. An adjusting entry was made to the Allowance account to reflect this estimate. As in the previous year, all sales were on account. Required 1. What was the balance in Accounts Receivable (gross) at the end of 2010? 2. What was the balance in the Allowance for Doubtful Accounts account at the end of 2011? 3. What was the bad debt expense for 2011? 4. What was the amount, in euro, of the specific accounts receivable written off during 2011? 5. How much cash was collected in 2011 from customers? 6. What as the balance of Accounts Receivable (net) on the Statement of Financial Position (i.e., Balance Sheet) dated 31 December 2011?

€960,000 Debit balance = €1 million – €40,000.

€30,000 Credit balance = (.02 X €3.5 million) – €40,000.

€105,000 = €50,000 + €55,000.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

€80,000 = €30,000 + €50,000.

€3.38 million = €960,000 + €4 million – €80,000 – €1.5 million.

€1.445 million = €1.5 million – €55,000.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

a. Here are the percentages:

Allowance Gross Loans

2009 1,184 222,636 0.53%

2008 1,428 221,820 0.64%

2007 1,000 222,570 0.45%

221,452 + 1,184 = 222,636 220,392 + 1,428 = 221,820 221,570 + 1,000 = 222,570 b. The amount of Credit Suisse’s loan write offs for 2008 and 2009:

Allowance for Loan Losses (XA) 1000 ending balance 2007 (given) 369

797 provision for credit losses in 2008 (shown in IS) 1428 ending balance 2008 from balance sheet

Write-offs 704

460 provision for credit losses in 2009 (shown in IS) 1184 ending balance 2009 (from balance sheet)

c. The loan amounts have been fairly stable. The allowance increased significantly in 2008 during the financial crisis but it is difficult to know if the amount was appropriate. However, Credit Suisse did suffer a large loss in that year and had incentives either to mitigate it to reassure the markets or, alternatively, to “take a big bath” by overprovisioning.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Comparing the effects of depreciation choice on financial ratios Dieter Loch AG is about to purchase two new assets—a machine for €75,000 and a state-of-the art forklift truck for €40,000. The assets would be acquired at the beginning of 2013. The company’s 2012 income statement and other information are shown below: Sales Cost of goods sold Gross profit SG&A expenses Income before tax Income taxes NOPAT

€ 550,000 310,000 240,000 140,000 100,000 30,000 € 70,000

Additional information:       

Dieter Loch management expects the addition of the two assets to generate a 20% annual growth rate in sales. Depreciation on the new machine will be included as part of cost of goods sold. Depreciation on the new forklift will be classified under other operating expenses. Excluding the new machine’s depreciation, cost of goods sold is expected to increase at an annual rate of 7%. Excluding the new forklift’s depreciation, selling, general and administrative (SG&A) expenses are expected to grow at an annual rate of 5%. Dieter Loch’s invested capital, not counting the new machine and forklift, is expected to increase at a rate of 15% per year. Average invested capital at the end of 2012 was €500,000. Both the machine and the forklift have an estimated useful life of five years, and zero residual value. The tax rate is 30%.

Required a. Why are depreciation charges on the two assets classified differently—COGS for the machine and SG&A for the forklift? b. Prepare forecasted income statements for 2013 and 2014, assuming that Dieter Loch AG elects to use straight-line depreciation for both assets. c. Calculate the firm’s gross profit percentage, NOPAT margin, and return on invested capital. d. Repeat part b. assuming that the company elects to use the double-declining balance method instead for both assets.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

e. Repeat part c. How does the choice of different depreciation methods affect the behavior of the ratios in 2013 and 2014?

a. Because the machine is a manufacturing asset, while the forklift is used for other operating activities. Depreciation on manufacturing assets is part of COGS, while depreciation on other assets is part of SG&A. b. Forecasted income statements assuming straight-line depreciation

Sales COGS, excl. depr. on new machine Depreciation, new machine Gross profit SG&A, excl. depr. on forklift Depreciation, forklift Income before tax Income taxes (30%) NOPAT c. Gross profit percentage NOPAT margin ROIC Invested capital, beginning +15% annual growth +machine & forklift –depreciation on M&F Invested capital, ending Invested capital, average

2013 660,000 331,700 15,000 313,300 147,000 8,000 158,300 47,490 110,810

2014 792,000 354.919 15,000 422,081 154,350 8,000 259,731 77,919 181,812

47.47% 23.98% 19.0%

53.29% 32.79% 26.0%

500,000 75,000 115,000 23,000 667,000 583,500

667,000 86,250 23,000 730,250 698,625

(20%↑ per year) (7%↑ per year) (75k ÷ 5) (5%↑ per year) (40k ÷ 5)

(IC calculations below)

CORPORATE FINANCIAL REPORTING AND ANALYSIS

d. Forecasted income statements assuming double-declining balance

Sales COGS, excl. depr. on new machine Depreciation, new machine Gross profit SG&A, excl. depr. on forklift Depreciation, forklift Income before tax Income taxes (30%) NOPAT e. Gross profit percentage NOPAT margin ROIC Invested capital, beginning +15% annual growth +machine & forklift –depreciation on M&F Invested capital, ending Invested capital, average

2013 660,000 331,700 30,000 298,300 147,000 16,000 135,300 40,590 94,710

2014 792,000 354.919 18,000 419,081 154,350 9,600 255,131 76,539 178,592

45.20% 20.50% 16.6%

52.91% 32.21% 26.5%

500,000 75,000 115,000 46,000 644,000 572,000

644,000 86,250

(20%↑ per year) (7%↑ per year)

(5%↑ per year)

(IC calculations below)

27,600 702,650 673,325

As expected the double-declining balance method results in lower reported gross profit and NOPAT, and therefore lower gross profit and NOPAT margins. Also, ROIC is lower in 2013, although slightly higher in 2014 because the accelerated depreciation method resulted in a significantly lower denominator (i.e., invested capital).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Analyzing depreciation on PP&E

The following note is taken from the 2004 Annual Report of ExxonMobil Corporation: Dec. 31, 2004 ---------------------

Dec. 31, 2003 ---------------------

Historical Accumulated Historical Cost Depreciation Cost

Accumulated Depreciation

$ 148,024

(Millions of dollars) Upstream

62,013

$ 138,701

58,727

Downstream

62,014

29,810

59,939

29,566

Chemical

21,777

10,049

20,623

10,115

Other

10,607

6,767

10,052

6,557

- -------

$ 242,422

$ 108,639

$ 229,315

$ 104,965

Total

In the Upstream segment, depreciation is on a unit-of-production basis, so depreciable life will vary by field. In the Downstream segment, investments in refinery and … manufacturing facilities are generally depreciated on a straight-line basis over a 25-year life and service station buildings and fixed improvements over a 20-year life. In the Chemical segment, investments in process equipment are depreciated on a straight-line basis over a 20-year life. Accumulated depreciation and depletion totaled $133,783 million at the end of 2004 and $124,350 million at the end of 2003.

Required Based on the above note, answer the following: a. By 2004, what percentage of the Upstream segment costs have been depreciated? Assume no salvage value and assume that in 2005, no Upstream acquisitions or divestitures take place. If the Upstream PP&E are used to produce 10% of their capabilities, what would be the depreciation expense and net book value at the end of 2005? b. By Dec. 31, 2003, assuming a 20% salvage (residual) value, on average, what is the age of the Chemical PP&E? c. Assuming no divestiture or retirement of assets, what was the depreciation expense for all PP&E in 2004?

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Part a1: The percentage of the Upstream segment costs that have been depreciated by December 31, 2004 is: $62,013/$148,024 = 41.89% Part a2: depreciation expense for the Upstream segment is calculated using units-ofproduction. Therefore, the cost of $148,024 would be multiplied by the 10% used in 2005. The depreciation expense is calculated to be $14,802.40. This amount will be added to the accumulated depreciation, which would stand at: $62,013 + $14,802 = $76,815. The book value will be calculated as Cost – Accumulated Depreciation, or $148,024 – 76,815 = $71,209. Part b: We know that the cost of assets in 2003 for the Chemical segment is: $20,623. We also know that the company uses a straight-line method for depreciation over a useful life of 20 years. With the knowledge that the salvage value is expected to be 20%, we can determine the depreciation expense using the equation: (Historical Cost – Salvage Value)/Useful Life = Depreciation Expense. Thus, ($20,623 - $4,125)/20 = $825/year. We can now compare the annual depreciation expense to the total accumulated depreciation. By dividing the accumulated depreciation by the depreciation expense, we can get the number of years. $10,115 / $825 = 12.26 years. Part c: with the assumption that no divestitures or asset sales took place, depreciation expense can be calculated by comparing two consecutive years’ accumulated depreciation. Thus, the depreciation expense is the difference between 2004 and 2003 accumulated depreciation accounts. $242,422 - $229,315 = $13,107

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Calculating and analyzing amortization expense The 2003 Annual Report for Microsoft reports the acquisition of Navision: In fiscal 2003, Microsoft acquired all of the outstanding equity interests of Navision a/s, Rare Ltd., and Placeware, Inc. Navision, headquartered in Vedbaek, Denmark, is a provider of integrated business solutions software for small and mid-sized businesses in the European market that is part of the Microsoft Business Solutions segment. Navision, Rare, and Placeware have been consolidated into our financial statements since their respective acquisition dates. The estimated fair values of the assets acquired and liabilities assumed at the date of the acquisitions for fiscal 2003 are as follows: (In millions) Navision a/s at July 12, 2002 Current assets $ 240 Property, plant and 8 equipment Intangible assets 169 Goodwill 1,197 ------------------------------------------ Total assets acquired 1,614 ------------------------------------------ Current liabilities (148) Long-term liabilities (1) ------------------------------------------ Total liabilities assumed (149) ------------------------------------------ Net assets acquired $ 1,465 -- ----- -

Rare Ltd. at September 24, 2002

Placeware, Inc. at April 30, 2003

25 8

75 281 ---- ---- 389 ---- ---- (12) ---- ---- (12) ---- ---- $ 377 ---- ---- -

30 7

30 180 ---- ----247 ---- ----(32) (13) ---- ----(45) ---- ----$ 202 ---- -----

The note provides supplemental information on the intangible assets acquired by Microsoft: The components of intangible assets acquired in the acquisitions above are as follows (no significant residual value is estimated for these assets): Navision a/s

Weighted average life

Rare Ltd.

Weighted average life

Placeware, Inc.

Weighted average life

115

6 years

$ 16

5 years

6 years

Technology-based

4 years

5 years

4 years

Marketing-related

3 years

5 years

1 year

10 years

Contract-based

Customer-related Research and 2 (1) Development ---------------------------- ---

--------

- -- ---

--------

---- -----

--------

Total

5 years

$ 75

5 years

8 years

169

13 (1)

- ------ ---------- -- ------------- -----------(1) Amounts assigned to research and development assets were written off in accordance with FIN 4. Those write-offs were included in Research and Development expenses.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Required

a. How much amortization expense would you expect Microsoft to record in 2004 for the intangible assets purchased in 2003? b. What impact would the amortization expense have on each of the company’s three principal financial statements?

a. Microsoft made three acquisitions in fiscal 2003 that resulted in intangible assets and goodwill coming on their balance sheet. Goodwill is an intangible asset that is not subject to amortization, thus, for this calculation, we will ignore it. However, the other intangible assets will be amortized based on the tables provided. The total amount of intangible assets that was added is: $169 + $75 + $30 = $274. Microsoft provides the detail of the type of intangible asset bought (contract-based, technology-based, marketing-related, customer-related, and R&D) and the specific useful life. For simplicity, we will use the total from each transaction and the weighted-average useful life. Thus, from the Navision deal $169 million with a 5-year life, from the Rare Ltd deal $75 million with a 5-year life and finally from the Placeware deal $30 million with an 8year life. Therefore, the calculation using a useful life and a zero salvage value are: $169/5 + $75/5 + 30/8 = $52.55 million. b. The amount of depreciation expense will be recorded on Microsoft’s income statement as an expense that will reduce net income. On the Balance Sheet the impact of the depreciation expense will be recorded as a decrease in the book value of the assets as well as an eventual, during the closing entries, negative impact on the retained earnings account in the stockholder equity sections. Finally, the indirect statement of cash flows operating section will add back the depreciation expense to the net income as the expense is a non-cash charge.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Calculating depreciation expense On 1 January 2013, Double Happiness Delivery Company acquired a new truck for $90,000. The truck is estimated to have a useful life of five years and no residual value. Required Indicate the amount of the depreciation charge for each year of the asset’s life under the following methods: a. The straight-line method. b. The declining balance method at twice the straight-line rate, with a switch to straightline in 2016. Why would the company switch to straight-line after using the declining balance method for the same asset?

a. $18,000/year, or $90,000/5 b.

2013: 2014: 2015: 2016: 2017:

90,000 × 40% = 36,000 54,000 × 40% = 21,600 34,400 × 40% = 13,760 13,760 ÷ 2 = 6,880 6,880

The switch is made for two reasons. First, the amount of depreciation expense in the fourth year will be higher (50% of net book value vs. 40%); second, it provides a neat solution to the problem of ensuring that the asset is fully depreciated by the end of the fifth year. The alternative is to calculate depreciation in the fourth year using 40% of net book value, then depreciating whatever is left over in the final year.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Effects of changes in estimates on depreciation expense At the end of each year, Patty Chu, the chief accountant at Rex Lin Enterprises, a Singaporebased trading company, reviews long-term assets at the end of each year to determine whether changes are called for in how these assets are depreciated. In December 2011, her attention focused on two assets in particular:

Warehouse Building

Date Acquired 1/1/07 1/1/06

Cost $ 200,000 1,600,000

Accumulated Depreciation End of 2011 $ 50,000 228,000

Useful Life 25 years 40 years

Residual Value $ 10,000 100,000

Patty is proposing the following changes: For the warehouse: a decrease in the useful life to 20 years, and a decrease in residual value to $6,000. For the building: an increase in the useful life to 50 years, and a decrease in the residual value to $55,000. Before agreeing to the changes, Patty’s bosses would like to know what the depreciation charges will be for each asset if the changes are adopted. All assets are depreciated using the straight-line method.

Required Calculate the revised annual depreciation expenses for each asset in 2012, and compare them to what the expenses would be if the changes were not made.

Without changes Warehouse: Depreciable cost = 200,000 – 10,000 = 190,000 Annual depreciation charge = 190,000 ÷ 25 years = 7,600 Building: Depreciable cost = 1,600,000 – 100,000 = 1,500,000

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Annual depreciation charge = 1,500,000 ÷ 40 = 37,500

With changes Accumulated depreciation on warehouse: 5 years × 7,600 = 38,000 Undepreciated cost on warehouse: 200,000 – 38,000 = 162,000 Accumulated depreciation on building: 6 years × 37,500 = 225,000 Undepreciated cost on building: 1,600,000 – 225,000 = 1,375,000 Depreciable basis for the warehouse: 162,000 – 6,000 = 156,000 Remaining years of useful life for the warehouse = 20 – 5 = 15 Annual depreciation charge = 156,000 ÷ 15 = 10,400 vs. 7,600 without the change Depreciable basis for the building: 1,375,000 – 55,000 = 1,320,000 Remaining years of useful life for the warehouse = 50 – 6 = 44 Annual depreciation charge = 1,320,000 ÷ 44 = 30,000 vs. 37,500 without the change

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Solutions Blockbuster, Inc.

1. The only justification for Blockbuster’s approach is that the films acquired for the library can be properly considered “investments.” This logic drives not only the balance sheet accounting (the film library is classified as a long-term asset), but also cash flow accounting. Because Blockbuster classifies the acquisition of films as investments, the resulting cash flows are classified as investing, and not operating, cash flows. Such treatment is justified as long as the films have a useful economic life of several years. The fact that the film can, in theory, last forever, doesn’t really mean much if after a few months not many people are interested in renting it. Also, the lead times between theatrical release and the availability of films for home viewing, including pay-per-view and cable/satellite TV, have been shrinking. This suggests that the economic life of most films is short, at least from a rental perspective. 2. An alternative approach is to consider the library a short-term asset, and therefore any expenditures as operating, and not investing, cash flows. This would have the effect of transferring the film library from long-term assets to current assets, and to the reclassification of purchases for the library as operating cash. The amortization policies are not the problem, and can probably remained unchanged. This approach was forced on Blockbuster early in 2006, forcing the company to restate its financials for 2003, 2004, and the first nine months of 2005. As a result, reported cash flow from operations (CFF0) was restated to $593.7 million for 2003 and $417.0 million for 2004. The difference between the original and restated figures is the amount of cash spent on the film library in each year. For the first nine months of 2005, the original figure of $492.4 million was restated to ($146.1 million). 3. Even with the reclassification of film library purchases, operating cash flow is positive in 2003 and 2004 (though much less strongly so than before). Blockbuster took out a large loan to finance the massive dividend payment that was part of the buyout of Viacom. As a result, there was a large upward spike in the company’s debt in 2004, although the annual report reveals that most of the debt is not due until 2010 and beyond. But the deteriorating cash flow performance in 2005 eventually led to a downgrade by Fitch (to CCC, and a negative

CORPORATE FINANCIAL REPORTING AND ANALYSIS outlook). The debt levels do not, at first glance, appear overwhelming, but the market is losing confidence in Blockbuster’s ability to find new sources of profitability. Within a year, Blockbuster’s share price had lost nearly half of its value from the time Ronald had to make his recommendation (early 2005).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Apple – an introduction to financial statement analysis*: Suggested solutions Balance Sheet 1.

What was the magnitude and direction of the change to Total assets for 2010? An increase of 27,682 (58.3%)

What was the magnitude and direction of the change to Total liabilities for 2010? An increase of 11,531 (72.7%)

What was the magnitude and direction of the change to Total shareholders’ equity for 2010? An increase of 16,151 (51.1%)

Verify that the sum of your answers to 2. and 3. equals your answer to number 1. 27,682 = 11,531 + 16,151

What specific accounts explain the majority of the changes to Total Assets? Cash and cash equivalents increased 5,998 Long-term marketable securities increased 14,863 Those two accounts explain 75% of the change.

Based on your own experience, think about what makes Apple a valuable company. Does this “asset” that you’ve imagined appear on Apple’s balance sheet? Are you satisfied that the balance sheet accurately reflects this value? Why or why not? Apple’s customer loyalty, and it’s ability – at least recently – to introduce products that lead the market as opposed to following others, have made the company successful. While some of the outcomes are on the balance sheet (e.g., the huge pile of cash and investments), these assets themselves are not. From an economic perspective, most analysts would consider customer loyalty and ability to innovate to be “assets”. However, the accountant does not record such items on the balance sheet as assets. The subjectivity and uncertainty involved in determining the value are too great, therefore these do not appear.

This case was prepared by Daniel Bens, Associate Professor of Accounting & Control, INSEAD. This case is designed for class discussion; it is not intended to provide illustrations of either effective or ineffective handling of administrative problems. Copyright © 2012 by Daniel Bens. All rights reserved. This case is not to be sold, reproduced, or generally distributed without permission.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Income Statement (“Consolidated Statement of Operations”) 7.

What was the magnitude and direction of the change to Net sales? An increase of 22,320 (52.0%) in 2010, and 5,414 (14.4%) in 2009.

What was the magnitude and direction of the change to Net income? An increase of 5,778 (70.2%) in 2010, and 2,116 (34.6%) in 2009.

Do the changes above seem consistent with the changes in Total assets you calculated previously? Yes, as the success of the firm continues in terms of sales and income, the result is the increase in the assets previously observed.

10.

Based on your own experience, think about the various product lines that generate these revenues (another word for “sales”) for Apple. Do you see the revenue from the individual product lines on the statement? Are you satisfied that the income statement accurately reflects these revenues? Why or why not? While Apple is a consumer electronics company, that includes a variety of products: phones, various computers, music and material available for download, etc. While the revenues from all of these lines are on the income statement, they are in a highly aggregated form: a single line of “Net sales”. This is not helpful from a forward looking standpoint, especially if the rates of growth in the product lines differ. That is, it would be difficult to forecast a single sales number when it is made up of a basket of products that grow at different rates.

Statement of Cash Flows 11.

What are the names of the three sub-sections that present the different sources of cash flow for the year? Operating, investing, and financing.

12.

Note that Net income is the first figure used in calculating Cash generated by operating activities. How does Net income compare to Cash generated by operating activities? Net income is consistently lower than cash from operations.

13.

What does Apple appear to be doing with the cash that it generates from its day to day operations? Hint: review Investing activities. For the most part, the company is investing the cash in securities (stocks and bonds), rather than significantly expanding productive capacity. While the company sells a lot of securities or lets them mature each year (roughly $46.7 billion in 2010), it plows the cash back into these markets ($57.8 billion in 2010).

CORPORATE FINANCIAL REPORTING AND ANALYSIS

14.

Does Apple appear to have significant Financing activities to report? Not really. Cash from financing activities is 6.8% of that from operations in 2010, and 9.1% of outflows for investing. It is much smaller than these other categories.

Additional Financial Statement Analysis 15.

Review Ernst & Young’s Report (often referred to as the “audit opinion”). a. What exactly is Ernst & Young’s role? They provide assurance that the items reported in the financial statements are accurate. b. How useful is their opinion in helping an investor value Apple? The auditor does not express an opinion on whether Apple is a good or bad investment. So in that sense, it’s not useful to the investor. The main contribution of the auditor is that it allows the investor to have a general level of confidence about the accuracy of the financial statements. By no means is this an absolute sense of security. There is no “guarantee” by the auditor. Rather, the audits conducted provide “reasonable assurance” that the financial statements are “free of material misstatement”.

16.

The excerpt below is a portion of Apple’s note 8 to the financial statements. Read it carefully and then answer the questions that follow: Long-Term Supply Agreements The Company has entered into prepaid long-term supply agreements to secure the supply of certain inventory components, which generally expire between 2011 and 2015. As of September 25, 2010, the Company had a total of $956 million of inventory component prepayments outstanding, of which $157 million is classified as other current assets and $799 million is classified as other assets in the Consolidated Balance Sheets. In August 2010, the Company entered into a long-term supply agreement under which it has committed to prepay $500 million in 2011. The Company had a total of $1.2 billion of inventory component prepayments outstanding as of September 26, 2009. These prepayments will be applied to certain inventory component purchases made over the life of each respective agreement.

a. What are the economics of these transactions? That is, how do they help Apple (if at all) create value for their stakeholders? Apple pays cash to its suppliers in exchange for a promise to deliver components that are part of Apple products (essentially “raw materials” to Apple). As of the end of 2010 Apple has nearly $1billion of these payments outstanding, with another $0.5 billion coming along in 2011. These deals are designed to help Apple insure against production problems, which can be especially acute when rolling out new products. If Apple Copyright © 2012 by Daniel Bens. All rights reserved. This case is not to be sold, reproduced, or generally distributed without permission.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

underestimates demand, they hope that by having pre-paid for inventory they can quickly catch up with their customers’ needs. b. How does this relate to the concept of “unearned revenue” an account frequently observed on corporate balance sheets (sometimes referred to as “deferred revenue” or “advances from customers”)? These are simply the other side of the unearned revenue transaction. That is, the vendors with whom Apple is dealing are recognizing the unearned revenue liabilities as they receive the cash. c. What are the risks and rewards associated with this arrangement for Apple? The rewards were mentioned above in part a.: essentially it’s an insurance policy to help guarantee supply when demand may be high. Risks include non-performance by the supplier. If the supplier faces financial distress and goes into bankruptcy, Apple would have a low likelihood of receiving their money. Apple’s vendors are probably good credit risks – Apple would use their knowledge of financial accounting when making this assessment!

17.

The excerpt below is from Management’s Discussion and Analysis of Financial Condition and Results of Operations. Review it and answer the questions that follow:

CORPORATE FINANCIAL REPORTING AND ANALYSIS Net Sales The following table summarizes net sales and Mac unit sales by operating segment and net sales and unit sales by product during the three years ended September 25, 2010 (in millions, except unit sales in thousands and per unit amounts): 2010

Net Sales by Operating Segment: Americas net sales Europe net sales Japan net sales Asia-Pacific net sales Retail net sales Total net sales Mac Unit Sales by Operating Segment: Americas Mac unit sales Europe Mac unit sales Japan Mac unit sales Asia-Pacific Mac unit sales Retail Mac unit sales Total Mac unit sales Net Sales by Product: Desktops (a) Portables (b) Total Mac net sales iPod Other music related products and services (c) iPhone and related products and services (d) iPad and related products and services (e) Peripherals and other hardware (f) Software, service and other sales (g) Total net sales Unit Sales by Product: Desktops (a) Portables (b) Total Mac unit sales

Change

2009

Change

2008

$24,498 29% $18,981 18,692 58% 11,810 3,981 75% 2,279 8,256 160% 3,179 9,798 47% 6,656 $65,225 52% $42,905

15% $16,552 28% 9,233 32% 1,728 18% 2,686 (9)% 7,292 14% $37,491

4,976 3,859 481 1,500 2,846 13,662

21% 36% 22% 62% 35% 31%

4% 13% 2% 17% 4% 7%

$ 6,201 11,278 17,479

43% $ 4,324 (23)% $ 5,622 18% 9,535 9% 8,732 26% 13,859 (3)% 14,354

8,274 4,948 25,179 4,958 1,814 2,573 $65,225

2% 8,091 (12)% 9,153 23% 4,036 21% 3,340 93% 13,033 93% 6,742 NM 0 NM 0 23% 1,475 (13)% 1,694 7% 2,411 9% 2,208 52% $42,905 14% $37,491

4,627 9,035 13,662

45% 25% 31%

4,120 2,840 395 926 2,115 10,396

3,182 (14)% 7,214 20% 10,396 7%

3,980 2,519 389 793 2,034 9,715

3,712 6,003 9,715

Net sales per Mac unit sold (h) $ 1,279 (4)% $ 1,333 (10)% $ 1,478 iPod unit sales 50,312 (7)% 54,132 (1)% 54,828 Net sales per iPod unit sold (h) $ 164 10% $ 149 (11)% $ 167 iPhone units sold 39,989 93% 20,731 78% 11,627 iPad units sold 7,458 NM 0 NM 0 (a) Includes iMac, Mac mini, Mac Pro and Xserve product lines. (b) Includes MacBook, MacBook Air and MacBook Pro product lines. (c) Includes iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. (d) Includes revenue recognized from iPhone sales, carrier agreements, services, and Apple-branded and third-party iPhone accessories. (e) Includes revenue recognized from iPad sales, services and Apple-branded and third-party iPad accessories. (f) Includes sales of displays, wireless connectivity and networking solutions, and other hardware accessories. (g) Includes sales of Apple-branded operating system and application software, third-party software, Mac and Internet services. (h) Derived by dividing total product-related net sales by total product-related unit sales. NM = Not Meaningful

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Recall question 10., where the income statement was found to be very aggregated with respect to product line information. Does the additional disclosure above satisfy an investor’s need for segment information? Yes, it probably does. Not only are the sales broken out by product, but also by geographic region. With this note, the analyst has a pretty good idea of which markets are key to the company’s success.

Note that the Total net sales from the table ($65,225mm for 2010) agrees with the figure from the income statement. But using the more detailed table allows us to determine which products or segments are really driving revenue growth. Which products are experiencing significant growth, and which appear to be more mature or even in decline? What are the risks and rewards with this pattern? The iPhone is the key driver of Apple’s recent success. In 2008 iPhone sales were $6.7 billion. In two years this has increased nearly four-fold to $25.1 billion. The “Other music” (i.e., iTunes) is also a growth driver, though the magnitudes there are much smaller. “Portable” computers are also very important to the company, with “Desktops” being less so. The results have been fantastic for Apple. However, they are fairly concentrated, and highlight the need for Apple to continue to innovate in the sectors that they dominate, or else lose this significant growth.

18.

Read both articles from the Wall Street Journal (WSJ) regarding the health and ultimate death of Apple co-founder Steve Jobs. a.

How do the stock market reactions differ across the two events covered in the WSJ articles? What does this say about the forward looking nature of the stock market? In January 2009 the stock market was clearly surprised that Jobs’ health problems were complex, and investors bid down the shares of the company by 7% after the announcement. Even though at this time there is no certainty to the situation, the market looks forward as it constantly re-sets price. Jobs will not die for nearly three more years, but the market forecasts this as becoming more likely in 2009 – and something that will ultimately hurt shareholders. In late 2011 when he does pass away, the market does not react much at all. Because the market is forward looking it took the probability of his death into account well in advance.

How are the events (and stock market reactions) described in the articles reflected in Apple’s financial statements? What does this say about the forward looking nature of the financial accounting system?

CORPORATE FINANCIAL REPORTING AND ANALYSIS

There is no effect on Apple’s financial statements, despite the significant market reaction to the original announcement. Because assets related to intangible items such as Mr. Jobs’ vision or his ability to innovate are not recorded on the balance sheet; when such assets are impaired (such as when he passes away) there is no expense or loss. This is consistent with the intuition that financial statements focus on historical information and are not very forward looking.

Integrated Oil Majors Valuation Model

Varden Company Valuation

Professor Kevin Kaiser Fontainebleau, May 2012

The assumptions reflected in the valuation(s) are not intended to represent an accurate reflection of either management nor market expectations for any of the companies presented and therefore cannot be used as the basis for investment decision-making. Please do not quote, reproduce, or distribute without the permission of the author.

Golf, Title

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Integrated Oil Majors Valuation Model

Varden Golf Club Company Valuation

Euros Select Scenario (by choosing 0 for base case, 1 for Cooper Palmer) Scenario: OCC Golf club revenue growth EBIT margin Tax rate Cash as % revenue WCR as % revenue NFA as % revenue Continuing Value growth rate (2017 onwards)

0 <- Base case scenario is chosen 9% 4.00% 20.00% 30.00% 2.00% 15.00% 75.00% 0.00% Year

NOPAT

Golf club revenue EBIT Taxes on EBIT NOPAT

2012 historic 10,000,000 2,000,000 (600,000) 1,400,000

2013 E 10,400,000 2,080,000 (624,000) 1,456,000

2014 E 10,816,000 2,163,200 (648,960) 1,514,240

2015 E 11,248,640 2,249,728 (674,918) 1,574,810

2016 E 11,698,586 2,339,717 (701,915) 1,637,802

2017 E 12,166,529 2,433,306 (729,992) 1,703,314

200,000 1,500,000 7,500,000 9,200,000

208,000 1,560,000 7,800,000 9,568,000

216,320 1,622,400 8,112,000 9,950,720

224,973 1,687,296 8,436,480 10,348,749

233,972 1,754,788 8,773,939 10,762,699

243,331 1,824,979 9,124,897 11,193,207

1,400,000

1,456,000 (60,000) (300,000) 1,096,000

1,514,240 (62,400) (312,000) 1,139,840

1,574,810 (64,896) (324,480) 1,185,434

1,637,802 (67,492) (337,459) 1,232,851

1,703,314 (70,192) (350,958) 1,282,165

0.92 1,005,505

0.84 959,381

0.77 915,372

0.71 873,383

0.65 833,319

Invested Capital Cash WCR NFA Invested Capital

Free Cash Flow NOPAT Increase in WCR CapEx (increase in NFA) Free Cash Flow

Value Discount factor PV (annual FCF) PV(Forecast FCF) Continuing Value Value

4,586,959 12,300,414 16,887,373

Base case scenario Item

Estimate

Golf club revenue growth

4.00%

EBIT margin

20.00%

Tax rate

30.00%

Cash as % revenue

2.00%

WCR as % revenue

15.00%

NFA as % revenue

75.00%

Continuing Value growth rate (2017 onwards)

0.00%

Cooper Palmer performance scenario Item

Estimate

Golf club revenue growth

6.00%

EBIT margin

20.00%

Tax rate

30.00%

Cash as % revenue

2.00%

WCR as % revenue

10.00%

NFA as % revenue

65.00%

Continuing Value growth rate (2017 onwards)

3.00%

Cooper Palmer performance scenario with EBIT improvement too Item

Golf, Golf business

Estimate

Golf club revenue growth

6.00%

EBIT margin

22.00%

Tax rate

30.00%

Cash as % revenue

2.00%

WCR as % revenue

10.00%

NFA as % revenue

65.00%

Continuing Value growth rate (2017 onwards)

3.00%

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Integrated Oil Majors Valuation Model

Golf, Golf business

Page 3 of 4

10:11 AM, 6/12/2024

Integrated Oil Majors Valuation Model

Golf, Golf business

Page 4 of 4

10:11 AM, 6/12/2024

CORPORATE FINANCIAL REPORTING AND ANALYSIS

JanMar Fabrics Cash 221000 (5) 170750

58750 (3) 103000 (4) 194750 (6) 16000 (7)

19250

Equipment 1050000

A/R 170750 136250 (5)

Inventory 340750

(1) 425000

(2) 231500

390500

389750

Sal. Payable (4) 6250 6250 8000 (10)

2000

1750

N/P

8750 (9)

165500 231500 (2)

428750

202250

750000

Ret. Earn. 383250

250 (8)

182500 (12)

A/P 194750 (6)

420000

Prep. Ins.

25000

Interest Payable 250 (11)

8000

Revenues 425000 (1)

Rent Exp. 58750 (9)

Salaries Exp. (4) 96750 (10) 8000

Other Expenses (7) 16000

104750

Insurance Exp. (8) 250

Depr. Exp. (9) 8750

Interest Exp. (11) 250

COGS (12) 182500

CORPORATE FINANCIAL REPORTING AND ANALYSIS

JanMar Fabrics Pre-Closing Trial Balance DR Cash A/R Inventory Prep. Ins. Equipment Accum. Depr. A/P N/P I/P Salaries Pay Common Stock Retained Earnings

Sales COGS Rent Expense Salaries Exp. Misc. Exp. Insurance Exp. Depreciation Exp. Interest Expense

19250 390500 389750 1750 1050000 428750 202250 25000 250 8000 750000 383250

425000 182500 58750 104750 16000 250 8750 250 _______ 2222500

________ 2222500

CORPORATE FINANCIAL REPORTING AND ANALYSIS

JanMar Fabrics Income Statement For July 2012 Sales COGS Gross Profit Rent Expense Salaries Expense Misc. Expense Insurance Expense Depreciation Expense Interest Expense

$425,000 182,500 242,500 $ 58,750 104,750 16,000 200 8,750 250 ________

Net Income

188,750 _______ $ 53,750

Balance Sheet 31 July 2012 Cash A/R Inventory Prep. Ins. Equipment Accum. Depr. Total Assets

19,200 390,500 389,750 1,750 1,050,000 (428,750) ___________ $ 1,422,450

A/P N/P I/P Salaries Pay Common Stock Ret. Earnings Liab + SE

202,250 25,000 200 8,000 750,000 437,000 _____________ $ 1,422,450

CORPORATE FINANCIAL REPORTING AND ANALYSIS

Solutions—Johnson Perry

a. $4.0 million. The amount that is written off in a given year is roughly the same as the provision taken in the previous year. For example, the provision taken in 2008 was $2.7 million, and $2.8 million was written off in 2009. The provision for 2009 was $8.1 million, equal to the amount written off in 2010. Therefore, we would expect that $4.0 million of receivables will be written off in 2011. b. If the same percentage of sales had been used in 2009 as in 2008, the bad debt expense in 2009 would have been $2.5 million, instead of $8.1 million. Therefore, operating income (“earnings from continuing operations before income taxes”) in 2009 would have been $5.6 million higher. But the balance in the allowance account would have been reduced by $5.6 million. At some point in the future, perhaps in 2010, the company and its auditors would conclude that the balance in the allowance account was not sufficient to cover all of the uncollectible accounts. This means that the provision for bad debts (i.e., the expense) will have to be larger in 2010, or later, to make up the difference. In other words, while 2009 income will increase, income in some future year would have to decrease. c. If the direct method had always been used, the allowance for doubtful accounts would never have come into existence. This means that there wouldn’t be a contra account balance of $13.0 million at the end of 2010 to offset against gross receivables. Therefore, receivables on the end-of-2010 balance sheet would be $268.7 million, or $13.0 million higher than the actual figure. As to the income statement, earnings from continuing operations would be $4.1 million lower. The reason is that under the direct method bad debt expense is recognized only when accounts are written off ($8.1 million in 2010). But because Johnson Perry used the allowance method, they recognized $4.0 million of bad debt expense. Hence, bad debt expense in 2010 would be $4.1 million higher under the direct method, and operating income $4.1 lower.

CORPORATE FINANCIAL REPORTING AND ANALYSIS

KIWI BUILDERS Solutions 1 a)

2002 Revenue 7.20 Exp. 6.48 Profit 0.72

2003 7.20 7.02 0.18

2004 9.60 8.40 1.20

24.0 m 21.9 m 2.1 m

OR Revenue 7.20 Exp. 6.48 Profit 0.72

7.20 6.48 0.72

9.60 8.94 0.66

Revenue 0 Exp. 0 Profit 0

0 0 0

24.0 21.9 2.10

Revenue 6.48 Exp. 6.48 Profit 0

7.02 7.02 0

10.50 8.40 2.10

Revenue 6.00 Exp. 6.48 Profit (0.48)

6.00 7.02 (1.02)

12.00 8.40 3.60

($700,000 total loss + $720,000 profit recognized in 2002)

Loss of $ 1.42m

% of completion, because it best reflects the underlying economic reality of Kiwi's performance.

CORPORATE FINANCIAL REPORTING AND ANALYSIS Citigroup – Accounting for Loan Loss Reserves 1. Financial Statements of banks look very different from the financial statements of most firms. Whereas for manufacturing, retail, and even some service companies, one would find assets such as accounts receivables and inventory on the balance sheet, these will not be found on the bank balance sheets. Most assets for financial institutions are monetary assets in the form of marketable securities and loans. The liabilities and shareholders’ equity sections are also very different from most organizations. Banks are very highly levered, with ratios of liabilities to equity often greater than 10. One Income Statement item that will be found on the financial statements of banks is a Provision for Loan Losses. This is an expense that the bank records to acknowledge that some of the loans on the balance sheet will not be collected. 2. Borrowing short and lending long refers to the fact that banks raise a lot of their capital from depositors who open up savings and checking accounts. This money can be withdrawn by the customer at any time. Thus, the bank is borrowing funds from depositors for an unknown, but potentially short period. On the other hand, the bank takes the depositors money and lends it. These customers typically borrow with a long duration, such as a 20- or 30-year mortgage, a car loan, or a school loan. The bank enters into a contract with the borrower to pay interest and principal over a pre-determined duration, often over many years. It cannot force the borrower to pay the money back sooner than agreed to in the contract. Thus, it is argued that the bank lends long. 3. A bank can create a cookie jar (or hidden) reserve by over-provisioning for loan loss reserves in good times, knowing that it is overestimating the expense and reducing earnings. Thereafter, when the bank’s financial performance falls short of expectations, the reserve can be reversed. The reversal results in a negative expense, which increases earnings for the period, perhaps allowing the bank to meet or beat analysts’ consensus estimates. 4. Setting up the reserve:

Use reserve:

Write-off reserve:

Reverse/Release reserve:

Provision for Loan Loss (E) $XX Loan Loss Reserve (XA)

$XX

Loan Loss Reserve (XA) Loan Asset (A)

$XX $XX

Loan Loss Reserve (XA) Loan Asset (A)

$XX

Loan Loss Reserve (XA) $XX Provision for Loan Loss (E)

$XX

5. One of the so-called “modifying conventions” of accounting is the conservatism principle, which requires managers, when in doubt, to err on the side of not overstating assets or .

CORPORATE FINANCIAL REPORTING AND ANALYSIS understating liabilities. However, being overly conservative on the financial statements, to the point of disconnecting from economic reality, is inappropriate. Being overly conservative could be just as bad as being overly aggressive in financial reporting. It is the responsibility of management to use good judgement in determining the proper amount to disclose on the financial statements based on good faith and an thorough understanding of economic reality for their bank.