Chapter 7 Solutions

Overview:
Problem Length Problem #s
{S} 2, 3, 5, 8, and 10
{M} 1, 4, 6, 7, 9, 11, 12, and 13
Appendices
{M} 7A-1 and 7B-1
{L} 7A-2 and 7B-2

1.{M} Exhibit 7S-1 contains the calculations required.

Exhibit 7S-1. Chevron

Adjustments for Capitalization of Interest
Amounts in $ millions part c
Year 1995 1996 1997 1998 1999 1999/95
As reported
Interest expense $ 401 $ 364 $ 312 $ 405 $ 472 1.18
Pretax income 1,789 4,740 5,502 1,834 3,648 2.04
Net income 930 2,607 3,256 1,339 2,070 2.23

Capitalized interest 141 108 82 39 59

Amortization of
capitalized interest 47 24 28 35 9

a. Calculations
EBIT $2,190 $5,104 $5,814 $2,239 $4,120
Times interest earned 5.46 14.02 18.63 5.53 8.73 1.60

b. Adjusted
Net capitalized interest $ 94 $ 84 $ 54 $ 4 $ 50
After 35% income tax 61 55 35 3 33

Interest expense 542 472 394 444 531 0.98

EBIT 2,237 5,128 5,842 2,274 4,129
(i) Times interest
earned 4.13 10.86 14.83 5.12 7.78 1.88
(ii) % reduction from
reported ratio -24.4% -22.5% -20.4% -7.4% -10.9%

Pretax income $1,695 $4,656 $5,448 $1,830 $3,598 2.12

(iii) Net income 869 2,552 3,221 1,336 2,038 2.34
% reduction from
reported -6.6% -2.1% -1.1% -0.2% -1.6%

7-1
 b. (iv) Expensing all interest reduces net income for each
year. However the effect diminishes over time.

c. (i) Because the amount of interest capitalized

declined over time, restatement reduces the rate
of increase in interest expense.
(ii) While the interest coverage ratio is lower after
restatement, its trend improves due to the lower
growth rate of interest expense.
(iii)Both pretax and net income are lower after
restatement but their growth rate improves due to
the lower growth rate of interest expense.

d. The restated data are more useful for financial

analysis because they are based on actual interest
expense. They provide better comparability with firms
that do not capitalize interest.

2.{S}a. (i) Interest cost can be capitalized on borrowings

directly associated with the project or when the
company has debt equal to or exceeding the cost of
construction.
(ii) Start-up costs must be expensed under U.S. GAAP.
(iii) Shipping costs are considered part
of the cost of acquisition.
(iv) Increases in the market value of land and
buildings may not be recognized under U.S. GAAP.

b. (i) While the benchmark treatment under IAS 23 is to

expense all interest, capitalization of borrowing
costs directly attributable to a project is an
allowed alternative.
(ii) Same as U.S. GAAP except that the benchmark The
capitalization of interest is an allowed
alternative under IAS 23 (paragraph 11)
(iii) Same as U.S. GAAP.
(iv) While revaluation is an allowed alternative under
IAS 16, it must be applied to all assets in a
particular class and could be selectively applied
to a particular project.

3.{S}a. Under SFAS 86 (text page 242), computer software

development costs can be capitalized only when economic
feasibility has been established.

7-2
 b. Under IAS 38 (paragraph 45), intangible assets such as
computer software can be recognized when the enterprise
can demonstrate technical and economic feasibility.
4.{M} Exhibit 7S-2 contains the calculations required by
parts a through c.

Exhibit 7S-2
Ericsson
Amounts in SEK millions
1997 1998 1999

a. Under Swedish GAAP:

Net sales 167,740 184,438 215,403

Pretax income 17,218 18,210 16,386
Total assets 147,440 167,456 202,628
Stockholders' equity 52,624 63,112 69,176
Average total assets 157,448 185,042
Average stockholders’ equity 57,868 66,144
Asset turnover 1.17 1.16
Pretax ROE 0.31 0.25

b. Adjustments:
Development costs for software to be sold:
Capitalization 5,232 7,170 7,898
Amortization (3,934) (3,824) (4,460)
Write down (989)
Net effect 1,298 3,346 2,449

Development costs for software for internal use:

Capitalization 1,463
Amortization (152)
Net effect - - 1,311

Total pretax effect 1,298 3,346 3,760

Adjusted pretax income 18,516 21,556 20,146
(i) % change 8% 18% 23%

7-3
 Exhibit 7S-2 (continued)
Year-end balances:
Software to be sold 7,398 10,744 13,193
Internal use software 1,311
Total 7,398 10,744 14,504
Less: deferred tax @ 35% (2,589) (3,760) (5,076)
Increase in equity 4,809 6,984 9,428

Adjusted total assets 154,838 178,200 217,132

(ii) % change 5.0% 6.4% 7.2%
Adjusted equity 57,433 70,096 78,604
(iii) % change 9.1% 11.1% 13.6%

c:
Adjusted average assets 166,519 197,666
Adjusted average equity 63,764 74,350
(i) Adjusted asset turnover 1.11 1.09
(ii) Adjusted pretax ROE 0.34 0.27

d. The adjustments for Ericsson show that capitalization

of software development costs can have a significant
effect on reported income and equity, and on financial
ratios. Therefore comparability requires that all firms
be restated to the same basis.

e. The amounts capitalized highlight expenditures and

enable the analyst to inquire about the new products
under development. The amortization period used may be
useful as a forecast of the useful life of the product.
In both cases (capitalization and amortization)
significant changes from prior periods may provide
useful signals of impending change.

7-4
5.{S}a. The capitalization of the investment in displays delays
their impact on income as compared with expensing. In
addition, cash from operations is permanently increased
as the expenditures are classified as cash flows for
investment. Finally, if these expenditures are
volatile, capitalization and amortization smoothes the
impact on reported income.

b. (i) In 2000, the capitalized amount increased by

$1,648,000. Had promotional displays been
expensed, net income would be $1,071,200 (after
35% tax) lower. Expensing would have reduced net
income by 7.4% ($1,071.2/$14,467).
(ii) Shareholders’ equity would be reduced by 65% of
$10,099,000 equal to $6,564,350 or 7.1%.
(iii) Reported return on (average) assets equals
$14,467/[($166,656 + $140,609)/2] = 9.42%
Adjusted return on (average) assets equals
($14,467 – $1,071)/[($166,656 - $10,099) +
($140,609 - $8,451)/2] = 9.28% as assets must be
reduced by the investment in promotional displays.

6.{M}a. Brand names are clearly an asset. However, it is not

clear that these assets should be shown on corporate
balance sheets.

One advantage of recognizing brand names is

completeness; a balance sheet that ignores major firm
assets is of limited use for analysis. Another
advantage is that the cost of acquiring or developing a
brand name should be recorded as an investment (asset)
in order to properly match revenues and expenses.

The major disadvantage of brand name recognition is the

difficulty of proper measurement. As each brand name is
unique, market transactions are not available to value
the brand. Thus, the value recognized is subjective;
differences across firms may reflect either real
differences in the value of the brands or different
measurement decisions.

One approach involves capitalization of the acquisition

cost (for purchased brands) or the advertising and
other development costs (for internally developed
brands). In the latter case, it is unlikely that the
value of the brand will be equal to the cost of
development. A successful brand will be worth much more

7-5
 than the cost of its development; an unsuccessful brand
may have no value at all. (These characteristics may
also describe acquired brands.)
Further, the value of brands changes over time. Despite
the quotation from Laing, brands can also become
"dilapidated" if they are neglected, if the advertising
is poor, or if the products are defective. The value
of brands will also be affected by changes in market
conditions, e.g., pricing decisions and the inroads
made by generic products.

From the point of view of financial analysis,

therefore, it is not clear that reporting management's
estimate of brand value would be helpful. The "proof of
the pudding is in the eating" and a valuable brand
should be highly profitable. The evaluation of that
profitability might be better left to the marketplace.

b. The advantage of amortization is that the income

statement should reflect all expenses that help produce
income. If profitability is due to the brand name, the
amortization of its acquisition cost should be an
element of expense.

On the other hand, given the subjectivity of brand name

valuation, the amortization amount (also affected by
the choice of method and life) may be a poor measure of
the expired value. In addition, brand names may not
decline in value over time; any decline is likely to be
irregular.

For purposes of analysis, therefore, the amortization

of brand name intangible assets should be excluded from
income. The evaluation of profitability, however,
should consider the role of brand names.

7-6
Exhibit 7S-3
Norsk Hydro
Amounts in NOK millions

Pretax income: Shareholders' equity:

Norwegian GAAP 6,292 Norwegian GAAP 43,532
Capitalized exploration costs (107) Property, plant, equipment 7,999
Depreciation (729) Other differences (net) (3,290)
Capitalized interest 614 US GAAP 48,241
Other differences (net) (239)
US GAAP 5,831 Total debt 30,842

Parts a and b:
(i) Pretax ROE: (ii) Debt-to-equity ratio:
Norwegian GAAP 14.5% Norwegian GAAP 0.71
US GAAP 12.1% US GAAP 0.64

Part c:
Capitalized exploration costs (107) Property, plant, equipment 7,999
Depreciation (729) Deferred tax @ 35% (2,800)
Capitalized interest 614 Net effect on equity 5,199
Net effect (222)

Norwegian GAAP adjusted:

Pretax income 6,070 Shareholders' equity: 48,731
(i) ROE 12.5% (ii) Debt-to-equity ratio: 0.63

7-7
7.{M} Exhibit 7S-3 (previous page) contains the calculations
required by parts a through c.

d. Capitalization policy can significantly affect both

pretax income and shareholders’ equity. Capitalization
rather than expensing always increases equity and,
therefore, reduces the debt-to-equity ratio. The effect
on ROE varies as capitalization increases both return
and equity.

In the case of Norsk Hydro, Norwegian GAAP adjusted to

exclude non-capitalization produces the lowest debt-to-
equity ratio as the expensing of exploration,
environmental, and interest costs increases reported
equity. ROE is highest under Norwegian GAAP
(unadjusted) as income is highest and equity lowest. US
GAAP produces the lowest ROE as income is lowest and
equity highest.

e. The negative adjustment means that exploration costs

were higher under US GAAP than under Norwegian GAAP.
This suggests that exploration costs that Norwegian
GAAP expenses (but US GAAP capitalizes) were below
normal. As a result the amortization of past
expenditures capitalized under US GAAP exceeded the
current year’s capitalized expenditures.

8.{S}a. (i) Given rapidly rising expenditures, Nokia will

report higher net income as current year
capitalization will exceed amortization of prior
year capitalized amounts.
(ii) Regardless of trend, Nokia will report higher cash
from operations as expenditures are reported as
cash for investment and never affects cash from
operations (see Figure 7-4 on page 232).
(iii)Capitalization of development costs results in
higher equity for Nokia, regardless of the trend
of expenditures.

b. (i) Capitalization of development cost increases

operating income (EBIT) and, therefore, the
interest coverage ratio.
(ii) Higher equity under capitalization reduces the
debt-to-equity ratio.

7-8
 c. These steps are described in Box 7-2 of the chapter.
One can adjust Nokia’s reported amounts to those for an
“expensing” firm by:
 Eliminating the capitalized costs from assets
 Eliminating the capitalized costs (net of taxes)
from equity
 Deducting the (tax-adjusted) difference between
expenditures and amortized cost from income
 Transferring expenditures from CFI to CFO

Alternatively, one can adjust Ericsson’s reported

results by assuming that it capitalizes development
costs and:
 Choosing an appropriate amortization period
 Increasing assets by the unamortized portion of
previous years’ expenditures
 Increasing equity by the (tax adjusted) assets
calculated above
 Adding the (tax-adjusted) difference between
expenditures and amortized cost to income
 Transferring expenditures from CFO to CFI

9.{M} Exhibit 7S-4 (page 10) contains the calculations

required by parts a and b.

a. R&D is clearly very important to Pfizer’s business. Its

R&D expenditures are very high relative to sales and
the percentage has been growing even though sales
growth is rapid. These expenditures, at least in the
short run, reduce Pfizer’s reported earnings given the
long time lag between discovery and profitable sales of
prescription drugs.

c. Capitalization and amortization of R & D increases net

income each year, the expected result given rising
expenditures. There is little impact on ROE as higher
equity offsets higher net income. (This latter result
is not surprising given the findings of Sarath et. al,
discussed in footnote 3 on page 233.)

d. (i) Asset turnover will decline under capitalization

due to the higher level of assets; sales are
unchanged.
(ii) Cash from operations will rise under
capitalization as R&D expenditures will be

7-9
classified as investing cash flows and will never
be reported as a component of cash flows from
operations.

7-10
Exhibit 7S-4
Pfizer
Years ended December 31
Amounts in $millions 1995 1996 1997 1998 1999
Net sales $ 8,684 $ 9,864 $ 10,739 $ 12,677 $ 14,133
R & D expense 1,340 1,567 1,805 2,279 2,776
a. % sales 15.4% 15.9% 16.8% 18.0% 19.6%

b. Adjustments
3 year amortization:
1/3 current year $ 602 $ 760 $ 925
1/3 prior year 522 602 760
1/3 2nd prior year 447 522 602
Total amortization $ 1,571 $ 1,884 $ 2,287
Expense less amortization (234) (395) (489)

Adjusted pretax income $ 3,101 $ 2,989 $ 4,937

Adjusted tax expense (857) (780) (1,415)
(i) Adjusted net income $ 2,244 $ 2,209 $ 3,522
Reported net income 2,092 1,952 3,204

R & D asset (net) $ 1,239 $ 1,491 $ 1,726 $ 2,121 $ 2,610

R & D asset after-tax 805 969 1,122 1,379 1,697

Shareholders' equity 5,506 6,954 7,933 8,810 8,887
Adjusted equity $ 6,311 $ 7,923 $ 9,055 $10,189 $10,584
Adjusted average
equity 5,637 7,117 8,489 9,622 10,386

(ii) Adjusted ROE 26.4% 23.0% 33.9%

Reported ROE 28.1% 23.3% 36.2%

7-11
10.{S}a. Because SB expenses the cost of developing new drugs,
their carrying amount on SB’s balance sheet is
extremely low. As a result, the proceeds of sale are
virtually all profit.

b. The drugs were developed over a number of years and the

income from their sale was really earned during that
time period rather than completely in the year of sale.

c. For valuation purposes, it would be more logical to

spread the sale income over the time period during
which the drug was developed. Valuation based on 2000
income that includes the entire gain will overvalue the
company.

11.{M}a. Debt to total assets = $15,431/$65,585 = 23.5%

Debt to equity = $15,431/$32,660 = 47.2%

b. Debt to total assets = $15,431/$61,056 = 25.3%

Debt to equity = $15,431/$28,131 = 54.8%

c. (i) Because the revaluation increment increases

equity, and has no effect on income, ROE is
reduced.
(ii) Because the revaluation increment increases
assets, and has no effect on sales, asset
turnover is reduced.
(iii) There is no effect on EPS as income is
unchanged.
(iv) Revaluation has no effect on cash flow or any of
its components.

d. (i) The initial effect of amortization would be to

reduce income and, therefore, ROE. Longer term
the lower equity base would tend to increase ROE
so that the net effect is difficult to predict.
(ii) Initially and over time, asset turnover would
increase as amortization reduced the carrying
amount of assets.
(iii) Amortization would reduce the level of earnings
per share initially and over time.
(iv) Cash from operations would be unchanged as
amortization is a noncash expense.

7-12
 e. Increased competition would be likely to reduce the
current stock price almost immediately as stock prices
discount future events as soon as information is known.
The financial statement effects would be slower to
occur. Initially there would be reduced profitability.
At some point the intangible asset would be revalued
downward.

f. Revaluation facilitates disclosure of management’s view

of the value of the firm's assets. This disclosure
allows the financial analyst to measure operating
results against the real investment in these assets
rather than an obsolete cost. This permits the analyst
to evaluate the "opportunity cost" of using the assets
in operations rather than selling them.

However, revaluations are subjective by their nature.

Management can manipulate revaluations and provide a
misleading indication of the value of the firm. The
lack of amortization means that changes in economic
value are reflected only when management chooses to
write down the assets, which may be well after the
market price of the company’s shares has recognized the
change.

12.{M} Exhibit 7S-5 (page 13) contains the calculations

required by parts a through e.

a. ROE: SUA = 14.2% May = 15.6% Difference = 1.4%

b. MAY’s reported data is adjusted by increasing R&D

expense by the 2002 increase in R&D assets and reducing
assets by the amount of capitalized R&D.

c. After adjustment, MAY’s ROA is higher at 16.2 %,

widening the gap between the two companies.
ROE: SUA = 14.2% May = 16.2% Difference = 2.0%

d. Capitalizing R&D requires that R&D expense for 2002 be

replaced by one-third of total R&D expenditures over
the 2000 to 2002 period. R&D assets at the end of 2002
equals one-third of the 2001 expenditures plus two-
thirds of the 2002 expenditures.

e. Capitalizing R&D for SUA reduces ROA to 13.8%, widening

the gap between the two companies relative to the
reported numbers.

7-13
 ROE: SUA = 13.8% May = 15.8% Difference = 1.8%

The effect of the differing accounting methods is to

make ROA for the two companies seem closer than it
really is. Adjustment of either company to the method
used by the other makes the disparity clearer.

Exhibit 7S-5

Reported Data:
SUA 2000 2001 2002
R&D expense $ 15,200 $ 16,500 $ 18,100
Net income 27,000 29,000 32,000
R&D assets - - -
Total assets 200,000 210,000 225,000
a. Return on assets1 14.2%

MAY 2000 2001 2002

R&D expense $ 29,500 $ 32,400 $ 35,600
Net income 48,600 52,200 57,600
R&D assets 28,800 31,500 34,600
Total assets 330,000 346,000 370,000
a. Return on assets 15.6%

b. MAY: Adjustment to expense R&D

Change in R&D expense $ 3,100
Adjusted net income 54,500
Change in R&D assets (34,600)
Adjusted total assets 335,400
c. Adjusted ROA 16.2%

d. SUA: Adjustment to capitalize R&D

Change in R&D expense $ (1,500)
Adjusted net income 33,500
Change in R&D assets 17,567
Adjusted total assets 242,567
e. Adjusted ROA 13.8%

1
As can be seen when part b is done, calculation of Sua’s 2001 assets would
require R&D expenditures for 1999 – 2001.

7-14
13.{M}a. (i) 1999 income is reduced as prior year startup
expenses are amortized but there were no startup
costs incurred.
(ii) Cash from operations for 1999 is unaffected as
amortization is a noncash expense.
(iii)Return on equity is reduced because of lower
income and because equity was increased by the
capitalization of startup expenses in prior years.
(iv) Asset turnover is reduced as assets were increased
by capitalization of startup costs in prior years.

b. (i) Initial year income was increased as startup costs

were capitalized rather than expensed.
(ii) Cash from operations was also increased as startup
expenses were reported as investments rather than
operating expenses.
(iii)Return on equity was increased because of higher
income from the initial application of the method.
(iv) Asset turnover was reduced as ending assets were
increased by capitalization of startup costs.

c. When a company capitalizes startup costs, the initial

financial statement effects are mostly favorable.
However if startup expenses are not incurred each year,
then later year effects are negative. The exception is
cash from operations, where the initial favorable
effect is never reversed.

7-15
7A-1{M}
a.
Ratios 1998 1999 2000
United States GAAP
Net income/sales 37.2% -63.8% -47.8%
Return on ending equity 83.3% -41.1% -62.2%
0
Asset turnover .56 0.37 0.28
Book value per share $ 0.50 $ 2.15 $ 1.81

Canadian GAAP
Net income/sales 31.8% 30.9% 26.1%
Return on ending equity 164.6% 13.0% 9.7%

Asset turnover 0.49 0.26 0.21

Book value per share $ 0.19 $ 3.15 $ 6.38

b. Biovail appears to be much more profitable using the

Canadian GAAP data. Further, the declines in 1999 and
2000 are much milder under Canadian GAAP.

Asset turnover is higher under U.S. GAAP, with a

similar declining trend.

Book value per share is higher under Canadian GAAP in

1999 and 2000, with much larger increases from the 1998
level.

c. The rise in the market price of Biovail shares appears

to be more closely related to the Canadian GAAP data
that show a rising book value per share and rising
earnings per share (see Exhibit 7A-1). The rise may
have been due to announcements related to drugs that
received regulatory approvals or marketing
arrangements.

d. The answer to part c suggests that capitalization and

amortization of IPRD comes closer to reflecting the
economic impact (measured by share price) of the
acquisition of drug rights.

e. The answer to part d assumes that the acquired rights

eventually prove to result in profitable drugs. If the
rights proved to be worthless, then immediate write off
would more accurately forecast the eventual decline in
the share price.

7-16
 f. The answers to the preceding parts suggest that
internal drug research expenditures should also be
capitalized, assuming that (in the aggregate) they
result in profitable drugs.

7A-2{L} Exhibit 7AS-1 (page 17) contains the calculations

required by parts a through d.

The adjustments shown remove (from ALZA’s income

statement) the payments from Crescendo, payments to
Crescendo, and IPRD write off. These adjustments are
carried forward to operating and pretax income.

e. (i) The Crescendo transactions reduced the revenue

growth rate as payments from Crescendo declined in
1999 and 2000. The effect on the growth rate of
profitability was negative for the same reason.

(ii) The Crescendo transactions increased the reported

profitability of ALZA for all three years by all
measures (operating profit and margin, pretax
profit and margin). This was because ALZA
effectively converted much of the cost of drug
development from an expense to revenue.

(iii)The volatility of ALZA’s profitability was reduced

by the transactions as their net effect was
relatively stable. ALZA’s pretax profit margin,
for example, would have fallen more than 50% in
1999 and then quadrupled in 2000. The reported
margin was less volatile.

(iv) The return portion of ROE increased as a result of

the Crescendo transactions. However equity also
increased due to higher retained earnings. Unless
ALZA’s equity was very low, it is likely that the
earnings effect dominates and ROE increased.

f. The benefit to AlZA is clearly higher and more stable

profitability, as discussed in part e, subparts ii and
iii. Higher ROE (subpart iv) may be an additional
benefit. While not shown numerically, the Crescendo
transactions may have shifted some of the risk of drug
development to Crescendo shareholdings.

One drawback is a reduced revenue growth rate. More

7-17
important, the cost of capital was very high, as
discussed in the appendix.

7-18
Exhibit 7AS-1
ALZA Corp.
All data in $millions, except per share

Adjustments for Crescendo Years ended December 31 % change

1998 1999 2000 98/99 99/00
Reported revenues $ 646.9 $ 795.9 $ 988.5 23.0% 24.2%
Payments from Crescendo (105.9) (97.4) (71.2)
Adjusted revenues $ 541.0 $ 698.5 $ 917.3 29.1% 31.3%
% reduction -16.4% -12.2% -7.2%

Reported expenses (450.4) (646.7) (732.8) 43.6% 13.3%

In-process R & D 9.4
Payments to Crescendo - 2.4 4.5
Adjusted expenses $(450.4) $(644.3) $(718.9) 43.1% 11.6%
% reduction 0% 0.4% 1.9%

Operating income $ 196.5 $ 149.2 $ 255.7 -24.1% 71.4%

Adjusted operating income 90.6 54.2 198.4 -40.2% 266.1%
% reduction -53.9% -63.7% -22.4%

Interest and other income 26.4 41.6 59.0

Interest expense (56.7) (58.1) (58.0)
Net other expense $ (30.3) $ (16.5) $ 1.0

Pretax income $ 166.2 $ 132.7 $ 256.7 -20.2% 93.4%

Adjusted pretax income 60.3 37.7 199.4 -37.5% 428.9%
% reduction -63.7% -71.6% -22.3%

Reported Ratios
Operating margin 30.4% 18.7% 25.9%
Pretax margin 25.7% 16.7% 26.0%
Times interest earned 3.47 2.57 4.41

Adjusted Ratios
Operating margin 16.7% 7.8% 21.6%
Pretax margin 11.1% 5.4% 21.7%
Times interest earned 1.60 0.93 3.42

7-19
 g. ALZA effectively controlled Crescendo. While it may
have shifted some development risk to Crescendo
shareholders, it is unclear that ALZA could have
“walked away” if no marketable drugs had resulted as
Crescendo had licensed ALZA technology. This technology
may well have alternative uses that would make ALZA
unwilling to see it fall into the hands of competitors.
Therefore the risk transfer may have been limited.
Given these factors, ALZA’s reported financial
data may not portray the company’s underlying
economics. Adjusted data that exclude the Crescendo
transactions may be more useful for evaluating ALZA’s
performance and valuing its shares.

7B-1{M}a.(i) Because all exploration costs are capitalized and

amortized under the full cost method, earnings are
no longer immediately affected by dry hole costs.

(ii) Dry hole costs are unpredictable and volatile;

amortization is predictable and varies only with
the level of production.

(iii)Because capitalized cost includes all exploration

costs, the carrying amount is higher.

(iv) Higher earnings resulting from capitalizing rather

than expensing dry hole costs results in higher
stockholders’ equity.

b. January 1, 1996 retained earnings effect $ 199,196

1996 earnings effect 18,006
1997 earnings effect 130,584
1998 earnings effect (258,351)
Total effect of accounting change $ 89,435

c. (i) Debt-to-equity ratio declines as equity increases.

(ii) Asset turnover declines as assets increase.

(iii)Book value increases as equity increases.

d. In theory, capitalizing dry hole costs would increase

cash from operations. However Sonat, like most firms in
its industry, considers all exploration costs to be
investing cash flows.

7-20
 e. Sonat’s accounting change was clearly intended to
improve the level and stability of reported earnings.

f. When energy prices decline, use of the full cost method

increases the risk that impairment charges will be
required. The SEC requires that the “ceiling test” be
based on discounted present values (rather than
undiscounted present values used by successful efforts
firms). The 1998 ceiling test charges were presumably
greater under the full cost method as restated 1998 net
income was significantly lower than net income reported
under the successful efforts method.

g. The 1991 accounting change suggests that the company

views accounting methods as a free choice and that it
can change methods whenever it believes that the new
method will make its results look better.

7B-2{L} Exhibit 7BS-1 (page 20) contains the calculations

required by part a.

b. U.S. reserve lives increased as production fell and

reserves fell less (oil) or increased (gas). Worldwide
reserves grew for both oil and gas, increasing reserve
lives, especially for gas.

c. Exhibit 7BS-2 (page 21) contains the calculations

required by part c.

d. Capitalized cost per BOE in the United States was

stable at $3.22. However worldwide capitalized cost per
BOE rose slightly each year. Lower capitalized costs
and upward reserve estimates reduce those amounts while
lower reserve balances increase them.

e. Over the four years ending December 31, 2000, the

standardized value rose from less than $18 billion to
more than $26 billion. Price changes accounted for $7.6
billion, or virtually all of the net increase as 1999
and 2000 price increases more than offset 1997 and 1998
declines. Revisions were upward each year, adding $3.3
billion to the standardized measure. Income taxes of
$4.8 billion over the four-year period offset a portion
of the net gain.

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Exhibit 7BS-1
Texaco Reserve Lives in Years

United States
1997 1998 1999 2000
Oil reserves 1,767 1,824 1,782 1,560
Production 157 144 144 130
Ratio 11.25 12.67 12.38 12.00

Gas reserves 4,022 4,105 4,205 4,430

Production 643 633 550 494
Ratio 6.26 6.48 7.65 8.97

Worldwide
1997 1998 1999 2000
Oil reserves 3,267 3,573 3,480 3,518
Production 317 351 336 307
Ratio 10.31 10.18 10.36 11.46

Gas reserves 6,242 6,517 8,108 8,292

Production 839 879 786 730
Ratio 7.44 7.41 10.32 11.36

Data for 2000 from Table I; oil in millions of barrels,

gas in billions of cubic feet

Data for 1997-1999 from Appendix 7-B

f. If we use the standardized measure as a guide, Texaco

increased the economic value of its reserves
significantly over the four-year period. However price
increases account for more of the gain than any other
factor. Sales and transfers greatly exceeded new
discoveries. While Table I in Exhibit 7BP-1 shows that
the company replaced more than 100% of its production
over the past five years, that performance is due more
to upward reserve estimates than to exploration
success.

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Exhibit 7BS-2
Texaco Capitalized Cost per BOE

December 31 U.S. Worldwide

1998
Oil reserves 1,824 3,573
Gas reserves 4,105 6,517
BOE 2,508 4,659
Capitalized costs $8,086 $12,190
Costs per BOE 3.22 2.62

1999
Oil reserves 1,782 3,480
Gas reserves 4,205 8,108
BOE 2,483 4,831
Capitalized costs $7,933 $13,038
Costs per BOE 3.20 2.70

2000
Oil reserves 1,560 3,518
Gas reserves 4,430 8,292
BOE 2,298 4,900
Capitalized costs $7,412 $13,544
Costs per BOE 3.22 2.76

Data for 2000 from Tables I and IV of Exhibit 7BP-1

Data for 1998-1999 from Appendix 7-B
Oil reserves and BOE in millions of barrels, gas reserves
in billion cubic feet, capitalized costs in $millions

g. Exhibit 7BS-3 (page 22) contains the calculations

required by part g.
(iii)The adjustment increased the debt-to-equity ratio
in 1998 but reduced it in 1999 and 2000. Overall
the adjusted ratio shows a sharp declining trend
while the unadjusted ratio declined modestly.
(iv) The adjustment would decrease the asset turnover ratio for 1999
and 2000 as the excess of the standardized measure over the
carrying amount would increase total assets.
Exhibit 7BS-3
Texaco

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Adjustment of Stockholders' Equity

Amounts in $ millions Years Ended December 31

Standardized measure 1998 1999 2000
1
United States $ 4,879 $ 15,604 $ 27,159
Europe1 1,382 4,990 4,656
Other areas2 1,116 3,909 4,984
Total $ 9,375 $ 26,502 $ 38,799
Carrying amount 12,190 13,038 13,544
(i) Excess $ (2,815) $ 13,464 $ 25,255
Reported equity 11,833 12,042 13,444
Adjusted equity $ 9,018 $ 25,506 $ 38,699
% change -24% 112% 188%

Total debt $ 7,291 $ 7,647 $ 7,191

(ii) Debt-to-equity ratio

Reported 0.62 0.64 0.53
Adjusted 0.81 0.30 0.19

1
Pretax basis
2
Posttax basis

h. (i) The change in the standardized measure could be

added to income for each year, and the sum,
divided by adjusted equity, would be a measure of
current cost ROE.

(ii) Current cost ROE would compare a more complete

measure of income with a better measure of the
company’s equity.

(iii)One drawback to this current cost ROE would be its

volatility. As both the numerator and denominator
could change significantly from year to year, it
would be difficult to use this measure to evaluate
management. In addition, when energy prices
change, changes in current cost ROE would be
largely determined by a factor outside of
management’s control, limited the usefulness of
ROE further.

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