Professional Documents
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KJ Palepu ch04
KJ Palepu ch04
Question 1. Use the templates in Tables 4-1, 4-2, and 4-3 to recast the financial
statements for Amazon.com.
Questions arise about several classifications: (a) fulfillment costs – these are viewed as
cost of sales for most retailers; (b) stock option costs – these are probably for senior
management and hence should probably be classified as SG&A; and (c) in the cash flow
statement gains and losses on currency translations (shown at the end of the statement are
shown as operating factors that imply that cash from operations in the standardized
format does not equate to that reported by the firm.
Amazon
Year Beginning January 1, ($000's) 2002 2003
Beginning Balance Sheet
Assets
Cash and Marketable Securities 996,585.0 1,300,969.0
Accounts Receivable 67,613.0 112,282.0
Inventory 143,722.0 202,425.0
Other Current Assets 0.0 0.0
Total Current Assets 1,207,920.0 1,615,676.0
Shareholders' Equity
Preferred Stock 0.0 0.0
Common Shareholders' Equity -1,440,000.0 -1,352,814.0
Total Shareholders' Equity -1,440,000.0 -1,352,814.0
Income Statement
Sales 2,761,983.0 3,122,433.0 3,932,936.0
Cost of Sales 2,520,715.0 2,698,125.0 3,332,785.0
Gross Profit 241,268.0 424,308.0 600,151.0
SG&A 583,065.0 473,947.0 488,976.0
Lucent’s inventory on December 31, 2000 was $6.9 billion, equivalent to 107 days. If the
optimal days inventory was 58 days, the value of the optimal inventory would be
58/107*$6.9 billion, or $3.7 billion. If 50% of the gap (50%*(6.9-3.7)=$1.6 billion was
impaired, the changes to Lucent’s financial statements would be as follows:
Adjustment
Liabilities &
($millions) Assets
Equity
Balance Sheet
Inventory -1,600
Deferred Tax Liability -560
Common Shareholders’ Equity -1,040
Income Statement
Cost of Sales +1,600
Tax Expense -560
Net Income -1,040
What was the initial estimate for loss reserves originating in 1990? How
has the firm updated its estimate of this obligation over time? What
liability remains for 1990 claims As a financial analyst, what question
would you have for the CFO on its 1990 liability?
The estimate for the 1990 liability made in 1990 was $100.3 million. As can be seen from
the reestimated liability amounts, this forecast has been steadily increased over the last
eight years to $113.4 million. The unpaid liability in 1998 is the total estimated liability
of $113.4 million less the liability paid at the end of 1998, $111.8, a balance of $1.6
million.
The key questions that an analyst would have about the 1990 liability relates to the fact
that the company ex post underestimated the its amount. This could arise for a number of
reasons – management are not very good at making these types of forecasts (not a good
sign since that is the key risk for the business), the firm was ex post unlucky, or
management have been managing the liability for regulatory or other purposes. Questions
that could shed some light on this include:
a. What were the reasons for the under-estimate of the 1990 liability? Did the same
factors affect other firms in the industry? Did the same pattern occur for estimates of
liability for other years?
b. Is the firm in good standing with the industry regulators? If not, what are the
regulators’ concerns? Do these give management an incentive to manage liabilities?
c. How is the firm performing in the stock market? Is there strong pressure on
management to deliver earnings performance either from potential acquirers, or the
board of directors? Is the firm likely to be accessing the capital market in the near
future?
Question 4. AMR, American Airlines provides the following footnote information on
its capital and operating leases:
To estimate the interest rate that equates the value of capital lease payments to the
reported value of $1,740, students have to first make an assumption about how to split the
2007 and subsequent payments over time. If the payments occur evenly over the next six
years ($205.5 per year), the appropriate interest rate is 7.7%:
Reported Assumed
PV factor PV
Year Payment Payment
2002 $326 $326.0 0.9285 $303
2003 243 243.0 0.8621 209
2004 295 295.0 0.8005 236
2005 229 229.0 0.7433 170
2006 231 231.0 0.6901 159
2007 and subsequent 1,233 205.5 0.6408 132
205.5 0.5950 122
205.5 0.5524 114
205.5 0.5129 105
205.5 0.4763 98
205.5 0.4422 91
1,740
For operating leases, the average contract life appears to be longer. This is based on the
large balloon value for lease payments beyond 2007. If we assume that the average life of
the operating leases is 16 years, the present value of operating leases using a 7.7%
discount rate is as follows:
Reported Assumed
Year PV factor PV
Payment Payment
2002 $1,336 $1,336 0.9311 $1,244
2003 1,276 1,276 0.8669 1,106
2004 1,199 1,199 0.8072 968
2005 1,138 1,138 0.7516 855
2006 1,073 1,073 0.6998 751
2007 and subsequent 11,639 1,058 0.6516 689
$17,661 1,058 0.6067 642
1,058 0.5649 598
1,058 0.5260 557
1,058 0.4897 518
1,058 0.4560 482
1,058 0.4246 449
1,058 0.3953 418
1,058 0.3681 389
1,058 0.3427 363
1,058 0.3191 338
$10,368
The adjusted balance sheet for December 31, 2001 is as follows:
Adjustment December
31, 2001
Liabilities
($ millions) Assets
& Equity
Balance Sheet
Long-term Tangible Assets +10,368
Long-Term Debt +10,368
For the year ended December 31, 2002, the impact on net income would be as follows:
Income Statement
Cost of Sales: Lease expense -1,336
Depreciation expense (1/16*$10,368) +648
Interest Expense (.077*$10.368) +798
Tax Expense (35% of sum) -39
Net Income -71
Question 5. What approaches would you use to estimate the value of brands? What
assumptions underlie these approaches? As a financial analyst, what would you use to
assess whether the brand value of 1.575 billion pounds reported by Cadbury
Schweppes in 1997 was a reasonable reflection of the future benefits from these
brands? What questions would you raise with the firm’s CFO about the firm’s brand
assets?
As was mentioned in the chapter, in the United Kingdom firms like Cadbury Schweppes
are allowed to report brand value on their balance sheets. Generally, these firms must
hire independent valuation experts to value the brand assets. The valuation experts may
use any of the following approaches to estimate brand value. First, the experts might
estimate brand value based on the premium price that branded products command over
their non-branded counterparts. Given the firm’s sales volume of branded products, the
expected life of the brand, and a discount rate, it is possible to estimate the present value
of any price premium over the foreseeable future. Second, a brand could be valued based
on the present value of advertising costs required to convert a non-branded product into a
branded product. Third, brand valuation experts could estimate value based on industry
practice, amounts that were paid for similar branded products in recent mergers and
acquisition transactions.
Several assumptions underlie the above brand valuation approaches. First, under the price
premium approach, brands will only have value if: (a) the consumers will continue to
value branded products more highly than non-branded in the foreseeable future, (b)
companies continue to maintain the value of their brands, despite potential competition,
and (c) premium prices are accompanied by higher advertising outlays, so that brands
create economic value for shareholders.
The second and third valuation approaches requires that the valuer assume that the
product being valued requires the same level of advertising or has the same relative value
as comparable brands used to benchmark the valuation.
A financial analyst should question the 1.575 billion pounds reported on Cadbury
Schweppes’ financials. Is this outlay reasonable or excessive compared to similar
companies that report brands on their balance sheet? How was the figure calculated? Was
an independent valuation expert hired? Did the independent auditors question the
amount? Has the amount grown or declined in the past couple years? Why? What
activities and expenditures did Cadbury incur to maintain the brand name?
Question 6. As the CFO of a company, what indicators would you look at to assess
whether your firm’s long-term assets were impaired? What approaches could be used,
either by management or an independent valuation firm, to assess the dollar value of
any asset impairment? As a financial analyst, what indicators would you look at to
assess whether a firm’s long-term assets were impaired? What questions would you
raise with the firm’s CFO about any charges taken for asset impairment?
Impairment is the loss of a significant portion of the utility of an asset through casualty,
obsolescence, or lack of demand for the asset’s service. A loss should be recognized
when an asset suffers permanent impairment. A CFO should look for evidence of such
potential impairment of the firm’s assets.
On the other hand, if the firm cannot assess the current market value of the asset, the
impairment loss amount is calculated as the difference between the old net book value
and the expected net present value of the future cash flows.
A financial analyst should look for the same types of indicators that the CFO looks for, of
course understanding that the CFO, as an insider of the company, has a great deal more
information about such issues as casualty, obsolescence, or lack of demand of certain
assets. Indicators of impairment include sustained declines in a firm’s and/or industry’s
return on assets relative to its cost of capital, recognition of asset impairments by
competitors, and the introduction of new technologies that make existing assets obsolete.
The financial analyst should question the CFO concerning the cause of the asset
impairment. Was the loss due to casualty, obsolescence, or lack of demand? If not, what
did cause the loss? The analyst should inquire about the method the impairment of asset
loss was calculated? If it was calculated using a fair market value, how was the fair value
determined?
Question 7. The cigarette industry is subject to litigation for health hazards posed by
its products. The industry has been negotiating a settlement of these
claims with state and federal governments. As the CFO for Philip Morris,
one of the larger firms in the industry, what information would you report
to investors in the annual report on the firm’s litigation risks? How would
you assess whether the firm should record a liability for this risk, and if
so, how would you assess the value of this liability? As a financial analyst
following Philip Morris, what questions would you raise with the CEO
over the firm’s litigation liability?
The litigation risks that Philip Morris faces are reported as contingent liabilities defined
in SFAS 5. Contingent liabilities arise from events or circumstances occurring before the
balance sheet date, here the filling of lawsuits against Philip Morris, the resolution of
which is contingent upon a future event, the court ruling or a potential settlement.
The accounting treatment for Philip Morris’ pending litigation depends on the likelihood
that it will lose or settle the lawsuit and whether the amount of damages the firm will be
liable for is reasonably estimable. Accounting rules on required disclosure for these types
of liabilities depend on whether the loss is probable, reasonable possible, or remote.
Probable – If it is probable that Philip Morris will lose the lawsuit and the loss can be
reasonably estimated, the estimated loss should be reported as a charge to income and as
a liability. If the loss is probable but no specific reasonable estimate can be agreed upon,
rather only a range of possible losses can be estimated without any amount being more
reasonable than the other, the amount that should be accrued by Philip Morris is the
minimum amount in the range. Note that this contradicts the conservatism principle of
accounting.
Reasonably possible - Where the likelihood that Philip Morris will lose the lawsuit is
reasonably possible, no amount needs to be accrued as a liability but the nature of the suit
needs to be disclosed in the footnotes of the annual report.
Remote - Where the likelihood that Philip Morris will lose the lawsuit is remote, no
amount needs to be recorded as a liability nor is any disclosure required in the footnotes
of the annual report.
The CFO of Philip Morris faces a dilemma. It is widely recognized that the company
faces huge potential litigation costs. It is therefore important that the CFO confront these
issues in the annual report, explaining the nature of the suits, the amount of the claims
against the company, and the company’s plans for responding to the suits. To fail to
provide adequate disclosure about these issues, potentially leads investors to fear the
worst, reducing the value of the firm’s stock. However, the CFO also has to be careful not
to make statements that could undermine the company’s legal position or its negotiating
position with the claimants.
As a financial analyst following Philip Morris I would push the CEO for as much
information as possible about the likelihood that the company will lose the lawsuits or
come to a settlement with the claimants. This requires that the analysts understand the
law and case history for the industry. It also requires information on the company’s plans
to either take the cases to trial or to settle, as well as the costs of a legal battle, the
company’s assessment of its chances of victory, and the costs of a potential settlement.
In addition, given that the company’s stock is depressed due to fears of losing these suits,
analysts can probe management on what actions the company is considering to increase
the stock price and maximize shareholder value. For example, is Philip Morris
considering spinning off the Kraft food division? What is the firm doing to maintain
employee moral and retain Kraft executives that might be inclined to accept jobs with
similar food companies not tied to tobacco products? Is Philip Morris considering raising
the annual dividend payment to compensate shareholders for lower stock prices?
As reported in the text, the funding status for 2000 and 2001 are as follows:
($millions) Adjustment
Balance Sheet
Long-term Debt $6,444
Deferred Tax Liability (35%) (2,255)
Common Shareholders’ Equity $(4,189)
The primary differences in unfunded obligation arises from increased obligations
from adjusting actuarial assumptions used to estimate the liability (e.g. worker lives,
retirement ages, health care inflation, etc). These adjustments are reported gradually
over time, rather than shown as an immediate hit to the financial statements when the
assumptions are revised.
Question 9. Intel reports the following information on its stock options incentive
programs in its December 31, 2001 financial statement footnotes.
The company's stock option plans are accounted for under the intrinsic
value recognition and measurement principles of APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and related
Interpretations. As the exercise price of all options granted under these
plans was equal to the market price of the underlying common stock on
the grant date, no stock-based employee compensation cost, other than
acquisition-related compensation, is recognized in net income. The
following table illustrates the effect on net income and earnings per
share if the company had applied the fair value recognition provisions
of SFAS No. 123, "Accounting for Stock-Based Compensation," to
employee stock benefits, including shares issued under the stock option
plans and under the company's Stock Participation Plan, collectively
called "options."
(In Millions) 2002 2001 2000
Net income, as reported $ 3,117 $ 1,291 $ 10,535
Less: Total stock-based 1,170 1,037 836
employee compensation
expense determined under
the fair value method for
all awards, net of tax
Pro-forma net income $ 1,947 $ 254 $ 9,699
Intel's total stock-based employee compensation expense under the fair value method
for all awards is expressed net of tax. In order to record the adjustments to the
financial statements, including the impact on Tax Expense and Deferred Tax Liability,
first restate the 2001 and 2002 stock option expenses as pre-tax figures. The pre-tax
expenses for 2001 and 2002 are $1,594.4 (1.037/.65) and $1,800 (1,170/.65),
respectively. Since we are not provided with information about how Intel allocates
this expense throughout the income statement, we will assume that 100% of the stock
option expense is allocated to SG&A. The increase in SG&A expense in each year
will lower Intel's Tax Expense in 2001 and 2002 by $558.4 (.35*1,595.4) and $630
(.35*1,800), respectively. The difference between the increase in SG&A expense and
reduction in tax expense is charged to Net Income. On the balance sheet, the
reduction in Tax Expense is reflected by an offset to Intel's Deferred Tax Liability,
and the reduction in Net Income is mirrored by a reduction in Common Shareholders'
Equity.
The adjustments to the financial statements would therefore be as follows:
Balance Sheet
Common Shareholders'
Equity 558.4 630
Adjustments Adjustments
for Dec.31, for Dec.31,
2001 2002
Income Statement
SG&A 1,595.40 1,800
If Lufthansa used a 25-year average aircraft life (rather than 12 years) and a 5%
salvage value (rather than 15%), the depreciable cost of its fleet would have been Euro
12,900.62m (13,579.6*(1-.05)). The annual depreciation rate would have been 4%,
implying that given the average age of its fleet (6.9 years), Accumulated Depreciation
would have been Euro 3,560.57m (6.9*.04*12,900.62), versus the reported Euro
6,679.6. Consequently, the company's Long-term Tangible Assets would have
increased by Euro 3,119.03m. Given the 35% marginal tax rate, this adjustment to
Long-term Tangible Assets would have required offsetting adjustments of Euro
1,091.66m (.35*3,119.03) to the Deferred Tax Liability and Euro 2,027.37m
(.65*3,119.03) to Common Shareholders' Equity.
Assuming that Euro 1,021.5m net new aircraft purchased in 2001 were acquired
throughout the year, the Depreciation & Amortization expense for 2001 would have
been Euro 535.43m (.04*(12,900.62+(1021.5*.95)/2)), versus the Euro 865m reported
by the company. Thus, Depreciation & Amortization Expense would decline by Euro
329.57m. Given the 35% tax rate for 2001, the Tax Expense for the year would
increase by Euro 115.35m. On the balance sheet, these changes would increase Long-
term Tangible Assets by Euro 329.57m, increase Deferred Tax Liability by Euro
115.35m, and increase Common Shareholders' Equity by Euro 214.22m.
Balance Sheet
Common Shareholders'
Equity +2027.37 +2027.37
+214.22
Question 11. In early 2003, Bristol-Myers Squibb announced that it would have to
restate its financial statements as a result of stuffing as much as
$3.35 billion worth of products into wholesalers' warehouses from
1999 through 2001. The company’s sales and cost of sales during this
period was as follows:
Balance Sheet
Sales -3.35
Cost of Sales -1.00
Tax Expense -.82