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CASE 1-1 Analysis of Contingent Obligation: Bristol-Myers Squibb

INTRODUCTION
In 1992, Bristol-Myers Squibb [BMY], a major U.S. based drug company, reported substantial litigation against the company by recipients of breast implants manufactured and sold by a subsidiary of the company. In 1993, BMY made a provision for losses expected from such litigation.1 In succeeding years, as the litigation proceeded, the company added to that provision for loss. Eight years later, as of December 31, 2000, while many of these claims had been settled, the amount of BMYs ultimate cash outows remained uncertain. This case illustrates the difculty in assessing the impact of such litigation on reported income and nancial position.

EXHIBIT 1C1-1. BRISTOL-MYERS SQUIBB Breast Implant Litigation Footnotes Note 17: Contingencies The company is a defendant in a substantial number of actions led in various U.S. federal and state courts and in certain Canadian provincial courts by recipients of two types of breast implants, formerly manufactured and sold by a subsidiary of the company, alleging damages for personal injuries of various types. Certain of these cases are class actions, some of which seek to allege claims on behalf of all breast implant recipients. All federal court actions have been consolidated for pre-trial proceedings in federal District Court in Birmingham, Alabama. In the case of Pamela Jean Johnson v. Medical Engineering Corporation, tried in state Court in Harris County, Texas, a jury on December 23, 1992 awarded plaintiff compensatory and punitive damages totaling $25 million. Absent settlement, the companys subsidiary will appeal this verdict.
Source: Bristol-Myers Squibb Annual Report, December 31, 1992

Note 17 Litigation Breast Implant The Company, together with its subsidiary, Medical Engineering Corporation (MEC), and certain other companies, has been named as a defendant in a number of claims and lawsuits alleging damages for personal injuries of various types resulting from polyurethane-covered breast implants and smooth-walled breast implants formerly manufactured by MEC or a related company. Of the more than 90,000 claims or potential claims against the Company in direct lawsuits or through registration in the nationwide class action settlement approved by the Federal District Court in Birmingham, Alabama (the Revised Settlement), most have been dealt with through the Revised Settlement, other settlements, or trial. In the fourth quarter of 1993, the Company recorded a charge of $500 million before taxes ($310 million after taxes) in respect of breast implant cases. The charge consisted of $1.5 billion for potential liabilities and expenses, offset by $1.0 billion of expected insurance proceeds. In the fourth quarters of 1994 and 1995, the Company recorded additional special charges of $750 million before taxes ($488 million after taxes) and $950 million before taxes ($590 million after taxes), respectively, related to breast implant product liability claims. In the fourth quarter of 1998, the Company recorded an additional special charge to earnings in the amount of $800 million before taxes and increased its insurance receivable in the amount of $100 million, resulting in a net charge to earnings of $433 million after taxes in respect to breast implant product liability claims. . . . At December 31, 2000, $186 million was included in current liabilities for breast implant product liability claims.
Source: Bristol-Myers Squibb Annual Report, December 31, 2000

As an offset to the loss provisions for the company also provided estimates for amounts recoverable from insurance.

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CASE OBJECTIVES

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CASE OBJECTIVES:
1. Discuss the value to nancial analysts of the initial disclosures in BMYs 1992 nancial statement footnotes. 2. Examine the impact on BMYs nancial statements and ratios of the 1993 loss provision and additional loss provisions in following years. 3. Consider the impact on BMYs nancial statements and ratios of alternative nancial reporting (timing and measurement) of the loss. Exhibit 1C1-1 contains excerpts from the Annual Reports of Bristol-Myers Squibb for the years 1992 and 2000. These extracts provide a review of the rms disclosures on breast implant litigation. Exhibit 1C1-2 contains data, extracted from annual reports for the years 1993 through 2000, regarding the income statement and balance sheet consequences of the accounting for this litigation. Required: 1. The rm did not record a liability for the breast implant litigation for the year ended December 31, 1992. Discuss the usefulness of the footnote disclosure in 1992. 2. The rm recorded a special charge and related liability in the fourth quarters of 1993, 1994, 1995, and 1998. The 1993 charge was offset by $1.0 billion of expected insurance proceeds; the 1998 charge was offset by $100 million of expected insurance recovery. The rm engaged in litigation with some of its insurers regarding the extent of insurance coverage for these losses. Describe the impact of this offset on the income statement and the balance sheet. 3. Estimate the actual cash inows and outows related to this litigation for the years 1993 through 2000, using the income statement and balance sheet information provided. 4. Restate reported earnings for the years 1993 through 2000 assuming that Bristol-Myers had recorded an expense for each year equal to the (net of insurance recovery) cash outow for that year. [Use a marginal tax rate of 35% for each year.]

EXHIBIT 1C1-2. BRISTOL-MYERS SQUIBB Selected Financial Statement Data Years Ended December 31 ($ in millions)

Income Statement Breast Implant Litigation Special charge: gross (Expected insurance recovery) Net charge (pretax) Net charge (after-tax) Net earnings*

1992

1993

1994

1995

1996

1997

1998

1999

2000

$1,500 (1,000) $ 500 310 $1,378 $1,696

$ 750 $1,5 $ 750 488 $1,542

$ 950 $1,5 $ 950 590 $1,517 $2,484 $2,744

$ 800 $1(100) $ 700 433 $2,750 $3,789 $4,096

*Continuing operations, using restated data from 2000 annual report

Balance Sheet Non-Current Assets: Insurance recoverable Product Liability: Current portion Non-current portion Total
Source: Bristol-Myers Squibb Annual Reports, 19922000

$1,000

$ 968

$ 959

$ 853

$ 619

$ 523

$ 468

$ 262

100 $1,370 $1,470

635 $1,201 $1,836

700 $1,645 $2,345

800 $1,031 $1,831

865 $1,171 $1,036

877 $1,244 $1,121

287 $3,167 $ 354

186 $1,1 $ 186

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CASE 1-1

ANALYSIS OF CONTINGENT OBLIGATION: BRISTOL-MYERS SQUIBB

5. Discuss the effect of the restatement in part 4 on the level and trend of BMY earnings over the 1992 to 2000 time period. 6. Discuss the effect of the restatement in part 4 on Bristol-Myers reported return on equity (ROE) for the years 1993 through 2000. [Hint: consider the effect of the restatement on stockholders equity as well as income.] 7. Based on information available at December 31, 2000, describe how to compute the charge that Bristol-Myers should have recorded in December 31, 1992. Describe the impact of that charge on BMY earnings and ROE in 1992 and subsequent years. 8. Based on your answers to parts 1 through 7, discuss the advantages and disadvantages to the company of recording expense equal to (i) The actual cash ows estimated in part 3 (ii) The charge described in part 7 rather than the special charges actually recorded.

CASE 2-1 Revenue and Expense RecognitionOrthodontic Centers of America


CASE OBJECTIVES
The objective of this case is to evaluate the revenue and expense recognition methods used by the company.

INTRODUCTION
The following information was extracted from the 1999 and 2000 annual reports of Orthodontic Centers of America [OCA]. The company provides practice management services to orthodontic practices in the United States. OCA acquires and develops orthodontic centers and manages the business operations and marketing aspects of afliated orthodontic practices. At December 31, 2000, there were 592 orthodontic centers, of which the company developed 306 and acquired 361 (75 were consolidated into another center). The afliated orthodontists control the orthodontic practices, determine which personnel, including orthodontic assistants, to hire or terminate, and set their own standards of practice in order to promote quality orthodontic care. A typical patient receives an initial consultation and preliminary procedures (teeth impressions, x-rays, and the placing of spacers between the teeth for braces) in advance of the next appointment. The patient signs a contract for treatment in the event the orthodontist recommends orthodontic treatment. Generally, braces are applied two weeks later and subsequent adjustments to the braces are made every four to eight weeks. The contract species the terms and the length of the treatment as well as the total fees. The average contract length is 26 months. No initial down payment is required; the patient makes equal monthly payments followed by a nal payment on completion of the treatment. OCA provides the following services to its afliates: 1. Stafng 2. Supplies and inventory 3. Computer and management information services 4. Scheduling, billing, and accounting services An unrelated nancial institution nances operating losses and capital improvements for newly developed orthodontic centers; OCA guarantees the related debt.

1999 REVENUE RECOGNITION


The Company earns its revenue from long-term service or consulting agreements with afliated orthodontists. Through December 31, 1999 OCA recognized monthly fees equal to approximately: 24% of the aggregate amount of all new patient contracts entered into during that particular month, plus The balance of contract amounts allocated equally over the remaining term of the contract. Gross amounts are reduced by the portion of contract amounts expected to be retained by the orthodontist. OCA recognizes operating expenses as incurred. Required: 1. OCA believes that at least 24% of its services relate to the rst month of the patient contracts. Given the services provide by OCA and the terms of the service and consulting agreements: Evaluate the revenue recognition method used by OCA. Propose and justify a more appropriate revenue recognition method.

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REVENUE AND EXPENSE RECOGNITIONORTHODONTIC CENTERS OF AMERICA

2. Estimate OCAs average contract balance for new patients in 1999, using the operating data in Exhibit 2C-1. 3. Estimate the rst year revenue that OCA recognizes from a new patient contract, assuming that OCAs share of the contract amount is $3,000, the contract length is 26 months, and the contract is signed on (i) January 1 of the rst year (ii) July 1 of the rst year (iii) December 1 of the rst year 4. Estimate the second year revenue that OCA recognizes from a new patient contract, under the same assumptions as Question 3, for each of the three signing dates. 5. Explain why, using your answers to Questions 3 and 4, OCA must expand its operations rapidly to maintain revenue growth. 2000 Revenue Recognition Effective January 1, 2000, OCA changed its revenue recognition method citing SEC Staff Accounting Bulletin No. 101 (see page 45 of text). OCA now recognizes net revenue using a straight-line allocation of patient contract revenue over the duration of the patient contract (typically 26 months). The company reported that
The cumulative effect of this accounting change, calculated as of January 1, 2000, was $50.6 million, net of income tax benet of $30.6 million. The effect of this accounting change in 2000 was to reduce revenue by $26.3 million. In 2000, the Company recognized revenue of $57.3 million that was included in the cumulative effect adjustment.1

The company also reported the pro forma effect of the accounting change on net income, assuming it had been in effect in prior years. Results for those years were not, however, restated. Exhibit 2C-1 contains operating and income statement data for OCA for the years 1997 through 2000. The exhibit also shows reported balance sheet data for 1998 through 2000, and restated data for 1999 (see Question 15). Use the exhibit to answer the questions that follow. Required: 6. Redo Questions 3 and 4, using the revenue recognition method that OCA adopted in 2000. 7. Compare the rst and second year revenue recognized under the 2000 and 1999 methods. Note: use an average of the three signing assumptions. 8. The accounting change had two effects on year 2000 revenue: Revenue recognized from new patients was reduced. Revenue from patients signed in prior years, included in the cumulative effect adjustment, was recognized in 2000. (i) From the companys disclosure of the effect of the accounting change, compute each of these effects. (ii) Use your answer to Question 7 to estimate the second of these effects. 9. Compute OCAs 2000 revenue and net income assuming that it had not changed its revenue recognition policy. 10. Explain why OCAs revenue recognition policy has a disproportionate effect on net income. 11. Discuss the effect of the accounting change on your answer to Question 5. 12. Compute the annual percent changes in each of the following statistics for 1997 to 2000, and discuss their trend and their implications for future revenue growth: Number of orthodontic centers Total case starts Number of patients under treatment 13. Describe the effect of the accounting change on OCAs receivables.

Source: footnote 2 to 2000 nancial statements.

1999 REVENUE RECOGNITION

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EXHIBIT 2C-1. ORTHODONTIC CENTERS OF AMERICA Reported Operating and Financial Data Years Ended December 31 Operating Data Number of orthodontic centers Total case starts Number of patients under treatment New patient contract balances ($ millions) Income Statement (Amounts in $ Thousands, Except Per Share Data) Net revenue Operating expense Operating prot Net interest income (expense) Pretax income Income tax expense Net income*
*Before cumulative effect of accounting changes

1997 360 70,611 130,000

1998 469 95,377 195,000

1999 537 126,307 267,965 $ 369.1

2000 592 160,639 343,373 $ 494.1

Years Ended December 31 1997 $117,326 $(81,368) $ 35,958 $331,143 $ 37,101 $ (14,469) $ 22,632 1998 $171,298 (117,012) $ 54,286 $444,280 $ 54,566 $ (20,753) $ 33,813 1999 $226,290 (149,366) $ 76,924 $1 (2,204) $ 74,720 $ (28,206) $ 46,514 2000 $268,836 (188,834) $80,002 $8 (3,731) $ 76,271 $ (28,549) $ 47,722

Diluted earnings per share Provision for bad debt expense Pro Forma for 2000 Accounting Change Net income Diluted earnings per share Balance Sheet Data (Amounts in $ Thousands) Patient receivables1 Unbilled patient receivables2 Service fees receivable3 Total assets Patient prepayments Deferred revenue Total debt Total liabilities Stockholders equity
1 2

$ $

0.50 1,851

$ $

0.70 2,295

$ $

0.96 2,079

$ $

0.96 373

$ 12,013 $ 0.26

$ 22,276 $ 0.46

$ 32,326 $ 0.66

n/a n/a

December 31 1998 Reported $ 20,163 46,314 296,798 4,326 20,055 65,639 231,159 $ 25,976 65,793 367,022 4,206 50,632 88,495 278,527 $ 87,563 362,816 50,632 84,289 278,527 $ 35,350 367,947 2,516 58,575 80,751 287,196 1999 Restated 2000

Net of allowance for uncollectibles of $5,356 in 1998 and $6,403 in 1999 Net of allowance for uncollectibles of $2,209 in 1998 and $3,241 in 1999 3 Net of allowance for uncollectibles of $9,644 in 1999 and $2,598 in 2000

14. Compute each of the following statistics for 1997 to 2000. Discuss their trend, their impact on reported income, and their implications for future revenue and income growth. Discuss the effect of the accounting change on the 2000 statistics. (i) Revenue, expense, and operating prot per patient under contract (ii) Revenue, expense, and operating prot per center 15. In 2000, OCA restated its 1999 balance sheet to aggregate billed and unbilled patient receivables (as service fee receivables). It also reduced that amount by patient prepayments,

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REVENUE AND EXPENSE RECOGNITIONORTHODONTIC CENTERS OF AMERICA

previously shown as a current liability. Compute the ratio of the allowance for uncollectible amounts to gross receivables for: Billed and unbilled patient receivables for 1998 and 1999 Service fees receivable for 1999 (restated) and 2000. (i) Discuss whether the differences between the ratios for billed and unbilled receivables accord with the nature of the receivables. (ii) Discuss the trend in the allowance ratios over the 1998 to 2000 period. (iii) Explain why the aggregation is a loss of information useful for nancial analysis. 16. Compare the trend of earnings per share for 1997 to 2000 using the pro forma data with the trend as originally reported. Explain which time series better represents the operating results over that time period. 17. Discuss two reasons why the time series that is your answer to question 16 may not be a reliable basis for forecasting future results.

CASE 3-1 Cash Flow AnalysisOrthodontic Centers of America [OCA]


This case is a continuation of Case 2C-1, which provides information about the business conducted by OCA and describes the revenue recognition method used by OCA (both before and after the January 2000 accounting change). Use the data provided in Case 2C-1 and Exhibit 3C-1 to answer the following questions. Required: 1. Calculate the actual cash collections for the years 19982000. 2. Compare the cash collection amounts computed in question 1 with revenues (i) Reported for each year (ii) Calculated using the pre-January 1, 2000 revenue recognition method (see Case 2-1, question 9). (iii) Calculated using the post-January 1, 2000 revenue recognition method. (Hint: To adjust reported 1998 and 1999 revenue, use the pro forma earnings provided and assume a 35% tax rate.) 3. Discuss how the answers to question 2 provide insight as to the appropriate revenue recognition method. 4. Analyze the trends in the companys cash from operations, cash for investing, free cash ows, and cash from nancing. Exhibit 3C-1 also provides information as to how the company acquires new afliated orthodontists. 5. (a) Explain how these acquisition costs affect the companys cash from operations, cash for investing, and free cash ows. State where the remaining acquisition costs are reported in the cash ow statement. (b) Explain how the reporting of the cash ows associated with the acquisition of afliated practices differs from the reporting of cash ows associated with newly developed practices. 6. Describe the effect of the companys treatment of the afliated practice acquisition costs on the analysis of the companys cash ows. Suggest an alternative approach to cash ow analysis and redo question 4 after making the required adjustments to the cash ow statement for the acquisition costs.

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CASE 3-1

CASH FLOW ANALYSISORTHODONTIC CENTERS OF AMERICA [OCA]

EXHIBIT 3C-1. ORTHODONTIC CENTERS OF AMERICA Financial Statement Disclosures Consolidated Statements of Cash Flows ($ in thousands) OPERATING ACTIVITIES Net income (loss) Adjustments Provision for bad debt expense Depreciation and amortization Deferred income taxes Cumulative effect of changes in accounting principles Changes in operating assets and liabilities: Service fee receivables Supplies inventory Prepaid expenses and other Advances to/amounts payable to orthodontic entities Accounts payable and other current liabilities Cash from operations INVESTING ACTIVITIES Purchases of property and equipment Proceeds from (sales of ) available-for-sale investments Intangible assets acquired Advances to orthodontic entities Payments from orthodontic entities Cash used in investing activities FINANCING ACTIVITIES Repayment of notes payable to afliated orthodontists and long-term debt Proceeds from long-term debt Repayment of loans from key employee program Issuance of common stock Cash provided by nancing activities Foreign currency translation adjustment Change in cash and cash equivalents Cash and cash equivalents: beginning of year end of year (6,530) 7,483 2,632 $(14,299 $ 7,884 $11,(127) $ (1,132) $(15,822 $ 4,690 (6,742) 30,577 $(23,114 $ 23,949 $(48,5 $ 4,221 $(11,601 $ 5,822 (7,864) 20,055 $(43,595 $ 12,786 $(48,5 $ (8,264) $(19,865 $ 1,601 (20,271) (16) (28,246) $(48,5 $(48,533) (22,520) 204 (17,178) (3,951) $$(48,370 $(43,075) (17,638) 19,674 (42,216) (4,906) $(41,927 $(43,159) 2000 $ (2,854) 373 15,175 (7,792) 50,576 (13,549) 889 (2,309) (8,233) $(17,368 $ 39,644 Years Ended December 31 1999 $ 45,836 2,079 12,238 1,273 678 (27,491) (2,305) (1,342) (2,420) $1(5,199) $ 23,347 1998 $ 33,813 2,295 9,124 (2,767) (22,733) (2,663) 228 (1,756) $(26,568 $ 22,109

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES Notes payable and common stock issued to obtain Service Agreements Transactions with Orthodontic Entities The following table summarizes the Companys nalized agreements with orthodontic entities to obtain Service Agreements and to acquire other assets for the years ended December 31, 2000, 1999 and 1998: Total Acquisition Costs 2000 1999 1998 $34,220,000 21,700,000 56,900,000 Remainder (Primarily Cash) $28,246,000 17,190,000 43,994,000 Share Value (at average cost) $4,719,000 910,000 4,206,000 Common Stock Shares Issued 227,000 80,000 253,000 $ 5,974 $ 4,512 $ 13,609

Notes Payable Issued $1,255,000 3,600,000 8,700,000

CASH FLOW ANALYSISORTHODONTIC CENTERS OF AMERICA [OCA]

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EXHIBIT 3C-1 (continued) At December 31, 2000 and 1999, advances to orthodontic entities totaled $16,701,000 and $20,530,000, respectively. Of these amounts, approximately $1,208,000 and $5,045,000 related to orthodontic entities that generated operating losses during the three months ended December 31, 2000 and 1999, respectively. At December 31, 2000 and 1999, advances to orthodontic entities in international locations totaled $6,196,000 and $1,413,000, respectively. Intangible Assets The Company afliates with a practicing orthodontist by acquiring substantially all of the non-professional assets of the orthodontists practice, either directly or indirectly through a stock purchase, and entering into a Service Agreement with the orthodontist. The terms of the Service Agreements range from 20 to 40 years, with most ranging from 20 to 25 years. The acquired assets generally consist of equipment, furniture, xtures and leasehold interests. The Company records these acquired tangible assets at their fair value as of the date of acquisition, and depreciates or amortizes the acquired assets using the straight-line method over their useful lives. The remainder of the purchase price is allocated to an intangible asset, which represents the costs of obtaining the Service Agreement, pursuant to which the Company obtains the exclusive right to provide business operations, nancial, marketing and administrative services to the orthodontist during the term of the Service Agreement. In the event the Service Agreement is terminated, the related orthodontic entity is generally required to purchase all of the related assets, including the unamortized portion of intangible assets, at the current book value.
Source: 2000 Annual Report

CASE 4-1 Integrated Analysis of Pzer, Takeda Chemical, and Roche


INTRODUCTION
Ratio analysis should not be simply a mechanical exercise but a means to an end. It can be used in two different ways. The rst method is to compute a number of ratios and then look for changes over time or differences among companies. Such analysis leads to an understanding of the level and trend of protability as measured by return on equity (ROE). The second method is to start with ROE and then, by analyzing the components that comprise this measure, explain changes over time or differences among companies.

CASE OBJECTIVES
1. Compute the nancial statement ratios for two companies in the same industry, using the following categories: activity, liquidity, solvency, and protability. 2. Discuss the factors that limit the usefulness of such comparisons. 3. Show how ratios can be aggregated to explain differences in ROE among companies. 4. Show how top-down ratio analysis can be used to explain changes in ROE for a company over time as well as differences between companies. Takeda operates in the same industry as Pzer and its 1999 nancial statements are contained in the CD (and web site) accompanying the text. Note that the Takeda statements are prepared in Japanese yen and in accordance with Japanese GAAP. Required 1. For Takeda, compute ratios for 1999 in the following categories, using the Pzer exhibits cited as a guide: Activity (Exhibit 4-4) Liquidity (Exhibit 4-6) Solvency (Exhibit 4-8) Protability (Exhibit 4-10) 2. Using your answers to Question 1 and the corresponding Pzer data, compare the ratios of the two companies in each of these categories. Discuss factors that limit the usefulness of this comparison and additional data that would be needed to improve it. 3. Prepare an integrated ratio analysis of Takeda, using Exhibits 4-12 and 4-14 as a guide. 4. Compare the 1999 ROE of Pzer and Takeda, and determine the key ratios that explain the difference in ROE. Discuss other factors that might explain the differences in ROE and any additional data needed to adjust for these factors. Roche also operates in the same industry as Pzer and Takeda. Its year 2000 annual report is available on the CD (and web site) accompanying the text. Its nancial statements are denominated in Swiss francs (CHF) and prepared according to IAS GAAP. 5. Using the top-down approach suggested by the discussion relating to Exhibit 4-13, determine the key ratios that explain the (i) changes in Roches ROE from 1999 to 2000 (ii) difference between the 1999 ROE for Pzer and Roche

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CASE 6-1 Inventory Analysis of Nucor


INTRODUCTION
Nucor [NUE] is one of the largest steel companies in the United States. Exhibit 6C-1 contains nancial data for the ve years ended December 31, 1999. Nucor has used the LIFO method for all inventories during the entire time period.

CASE OBJECTIVES
The objectives of this case are to 1. Show the impact of Nucors use of the LIFO inventory method on its: Balance sheet Income statement Cash from operations Financial ratios 2. Discuss the advantages and disadvantages of use of the LIFO method. 3. Discuss the relationship between price trends and use of the LIFO method. The following questions should be answered using the data provided in Exhibit 6C-1. Assume a marginal tax rate of 35% for all years. 1. Calculate gross margin (both level and as a percent of sales) under both the LIFO and FIFO methods for the years 19951999. EXHIBIT 6C-1. Nucor Selected Financial Data Years Ended December 31 Data in $millions 1994 Income Statement Sales Cost of products sold Pretax Net income Earnings per share Tax rate Balance Sheet LIFO inventory LIFO reserve Current assets Current liabilities Stockholders equity Per share Statement of Cash Flows Cash from operations
Source: Nucor Annual Reports, 19941999

1995

1996

1997

1998

1999

$3,462,046 2,900,168 432,335 274,535 $ 3.14 35%

$3,647,030 3,139,158 387,769 248,169 $ 2.83 35%

$4,184,498 3,578,941 460,182 294,482 $ 3.35 35%

$4,151,232 3,591,783 415,309 263,709 $ 3.00 35%

$4,009,346 3,480,479 379,189 244,589 $ 2.80 35%

$ 243,027 81,662

$ 306,773 93,932 830,741 447,136

$ 385,799 73,901 828,381 465,653 1,609,290 18.33

$ 397,048 100,576 1,125,508 524,454 1,876,426 21.32

$ 435,885 5,121 1,129,467 486,897 2,072,522 23.73

$ 464,984 28,590 1,538,509 531,031 2,262,248 25.96

1,122,610 12.85

1,382,112 15.78

$ 447,160

$ 450,611

$ 577,326

$ 641,899

$ 604,834

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INVENTORY ANALYSIS OF NUCOR

2. Discuss the differences in the level, trend, and variability of gross margins under the two methods. 3. Calculate net income assuming Nucor had used the FIFO method of reporting for 19951999 and discuss differences in the level, growth rate, and variability of net income under the two methods. 4. Calculate stockholders equity per share assuming Nucor had used the FIFO method of reporting for 19951999. Compare your results to reported equity and discuss the difference in level and growth rate. 5. Calculate Nucors cash from operations assuming Nucor had used the FIFO method of reporting for 19951999. Compare your results to reported cash from operations and discuss the difference in level and growth rate. 6. Calculate the following ratios for Nucor, using both reported data and assuming it had used the FIFO method of reporting, for 19951999: Current ratio Return on (average) equity Discuss the effect of using LIFO on the level and variability of both ratios. 7. Calculate Nucors inventory turnover ratios for 19951999, using: (i) LIFO data (ii) FIFO data (iii) Current cost data Discuss the differences among these three turnover ratios and select the method that provides the best measure of economic turnover. Discuss the trend in Nucors inventory turnover over the 19951999 period. Discuss factors that might account for the variability of reported turnover. 8. Using the results of Questions 17 and the data in Exhibit 6C1-1, discuss the advantages and disadvantages to Nucor of use of the LIFO method over the 19951999 time period. 9. Nucors LIFO reserve at December 31, 1999 was less than 6% of gross inventory (FIFO basis) compared with a peak of more than 27% at December 31, 1990. There have been no LIFO liquidations during this time period. (a) What information does this decline provide about the price trend in steel scrap (Nucors major raw material input)? (b) Discuss how this decline affects the advantages and disadvantages to Nucor of using the LIFO method. 10. If Nucor were considering switching from LIFO to FIFO, what date would it have chosen to make the change? Why? 11. If Nucor did switch from LIFO to FIFO, what information would that convey about the companys price expectations? Explain. 12. Steel Dynamics [STLD], a Nucor competitor, uses the FIFO inventory method. Selected data for 1997 through 1999 follow ($ in thousands): 1997 Sales Cost-of-goods-sold Net Income Ending Inventory Ending Equity 1998 $514,786 428,978 31,684 126,706 351,065 1999 $618,821 487,629 39,430 106,742 391,370

$ 60,163 337,595

(a) Using reported data, compute each of the following ratios for 1998 and 1999 for Steel Dynamics: Gross prot margin Return on equity Inventory turnover ratio (b) Assume that Steel Dynamics used the LIFO inventory method. Redo (a) using adjusted ratios for Steel Dynamics. For each ratio, use the method(s) you deem most appropriate and justify your choice.

CASE OBJECTIVES

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(c) Explain why the adjustments improve the apparent performance of Steel Dynamics for 1998 but reduce it for 1999. (d) Explain why the adjusted ratios provide a more useful comparison for the two years. (e) Explain why the adjusted ratios provide a more useful comparison between Steel Dynamics and Nucor for the two years.

CASE 7-1 Analysis of Software Capitalization: International Business Machines


INTRODUCTION
The capitalization of computer software costs affects reported net income and stockholders equity in each accounting period. Because capitalized amounts must be amortized, the capitalization decision affects future accounting periods as well. In addition, while capitalization does not affect cash ow, it does change the allocation between cash from operations and cash for investment. In this case we explore these issues using International Business Machines [IBM], the worlds largest computer manufacturer.

CASE OBJECTIVES:
1. Compute the effect of IBMs capitalization of software expenditures on its reported balance sheet, income, cash ows, and nancial ratios. 2. Show how changes in IBMs capitalization affected the level and trend of measures of income and cash ow. 3. Show how capitalization obscures trends in total spending on software and on research and development. 4. Show how capitalization affects segment protability measures. 5. Discuss the possible effect of changes in corporate protability on accounting policies. Exhibit 7C1-1 contains corporate nancial data, software segment data, and data regarding the capitalization of computer software costs by IBM over the period 1992 2001. IBM capitalized a portion of computer software costs as permitted by accounting standards discussed in the chapter. Use the information provided to answer the following questions. 1. Compute the effect on IBMs net income of software capitalization for the years 1992 2001. Assume a 35% tax rate. 2. Compute the effect of software capitalization on IBMs (i) Cash from operations (ii) Cash for investment for the years 19922001. Discuss the effect of capitalization on the trend of both cash ow measures. 3. Compute IBMs total spending on computer software (whether expensed or capitalized) over the period 1992 2001. Compute the percentage of spending that was capitalized each year. 4. Compute the year-to-year percentage change in IBMs software segment external revenues for 19922001. Discuss the trend over that time period. Note that IBM redened that segment in 1996 so that 1996 2001 revenues are not comparable to 19921995 amounts. 5. Compute the gross prot and gross prot percentage for IBMs external software revenues for 1992 2001. Discuss the trend in segment protability over that 19922001 period. 6. IBM started disclosing total software revenues in 1996. Compute the pretax prot margin for IBMs total software revenues for 19962001. Discuss the trend in segment profitability over that time period. 7. Compute the return on assets for IBMs software segment over the 1996 2001 period. Discuss the trend in segment ROA over that period. Explain how the level and trend of segment ROA are affected by IBMs accounting policies on R&D. Hint: consider the effect on ROA of capitalizing either all software-related R & D or none. 8. Discuss how the capitalization of software affects ROA in (i) Years with large capitalized amounts (ii) Years with small capitalized amounts

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CASE OBJECTIVES

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EXHIBIT 7C1-1 International Business Machines Amounts in $millions Corporate Financial Data Revenue Net income*
*Before accounting changes

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

$64,523 $62,716 (6,865) (7,987) 6,274 (5,878) 27,624 6,522 8,327 (4,202) 19,738 5,558

$64,052 $71,940 3,021 4,178 11,793 (3,426) 23,413 4,363 10,708 (5,052) 22,423 4,170

$75,947 5,429 10,275 (5,723) 21,628 4,654 435 1,726 $11,426 $12,593 $12,019 2,946 2,466 2,813

$78,508 6,093 8,865 (6,155) 19,816 4,877 2,016 $11,164 $12,671 $11,835 2,785 2,034 2,642

$81,667 6,328 9,273 (6,131) 19,433 5,046 111 2,086 $11,863 $12,749 $12,612 2,260 2,742 2,57

$87,548 7,712 10,111 (1,669) 20,511 5,273 111 2,036 $12,662 $12,767 $13,429 2,240 3,099 2,527

$88,396 8,093 9,274 (4,248) 20,624 5,151 9 1,948 $12,598 $12,828 $13,426 2,283 2,793 2,488

$85,866 7,723 14,265 (6,106) 23,614 5,290 1,926 $12,939 $12,981 $13,920 2,265 3,168 3,356

Cash from operations Cash for investing Stockholders equity Total R & D Expense*
*IPRD included in expense

Software-related R & D Software Segment External revenue Internal revenue Total revenue Cost of external revenue Pretax segment income Segment assets

1,840 1,161 1,097 793 1,157 Not comparable to 19962001 $11,103 $10,953 $11,346 $12,657

3,924

4,310

4,680

4,428

Statement of Cash Flows CFO: Addback to Net Income Amortization of software CFI Investment in software 1,752 1,507 1,361 823 295 314 250 464 565 655 1,466 1,951 2,098 1,647 1,336 983 517 426 482 625

Source: Data from International Business Machines Annual and 10-K Reports, 19942001

9. Compute IBMs total R&D expenditures (including amounts capitalized) over the period 19922001 and compute total expenditures as a percentage of total corporate revenues. Discuss the trend in that percentage, the possible reasons for that trend, and the questions you would want to ask IBM management about that trend. Note: IBM reclassied some R&D expenditures in 2001; our data for prior years is not restated. 10. Compute IBMs after-tax prot margin and return on average stockholders equity over the period 1992 to 2001. [1991 equity was $36,679 million.] 11. The capitalization of software expenditures reects accounting standards in effect each year, the nature of software expenditures, and changes in corporate policy. Discuss the possible effects of each of these three factors on the amount of software capitalization by IBM over the 19922001 time period. Your answer should incorporate your answers to parts 1 through 10 of this case.

CASE 10-1 Analysis of Debt Capitalization: Read-Rite


INTRODUCTION
Read-Rite [RDRT] is one of the largest manufacturers of magnetic recording heads for computer disk drives, a highly competitive business characterized by rapid technological change. In August 1997, Read-Rite issued $345 million of convertible subordinated notes. Over the next three years, the companys operating results and nancial condition deteriorated, bringing the company close to insolvency. Early in 2000, the company offered to exchange new notes for the old ones. That exchange, accompanied by improved operations, resulted in the retirement of virtually all of the old notes in exchange for common stock, with benecial effects on the companys nancial statements.

CASE OBJECTIVES
The objectives of this case are to: 1. Analyze the nancial condition of Read-Rite over time. 2. Show the effects of the exchange offer on Read-Rites nancial condition. 3. Discuss the economic signicance and the nancial statement relevance of the recognized gain from the exchange offer. 4. Discuss the signicance of the difference between carrying value and market value of debt. 5. Analyze, from the note holder perspective, the decision to accept the note exchange. In August 1997, Read-Rite issued $345 million of 6.5% subordinated notes, due in September 2004. The notes were convertible into Read-Rite common shares at $40.24 per share. As shown in Exhibit 10C-1, the company reported substantial losses in 1998 and 1999. As a result, ReadRites auditor opinion at September 30, 1999 had a going concern qualication (Exhibit 1-3). Because of its large losses, Read-Rite violated the nancial covenants of its bank debt facility, which it had drawn down in 1998 and 1999 to fund its cash needs and provide adequate liquidity. Threatened with default and the possibility of having to le for bankruptcy, Read-Rite made an exchange offer for the 6.5% notes. For each $1,000 of old notes, holders were offered $500 of new notes, convertible into Read-Rite common shares at $4.51 per share (15% above the current stock price). Interest at 10% could be paid in cash or Read-Rite shares, at the companys election. The new notes were due September, 2004. In March 2000, Read-Rite completed the exchange of $325.2 million of old notes for $162.6 million of new notes, and sold an additional $61.2 million of new notes for cash. ReadRite wrote off $5 million of unamortized issuance costs of the old notes. The new notes provided for automatic conversion into common shares if the Read-Rite share price exceeded $9.02 for a specied time period. When that condition was achieved, Read-Rite invoked the automatic conversion provision and the notes were converted to common shares in October 2000. The pro forma balance sheet at September 30, 2000 reects that conversion as well as the sale of new common shares for $18.9 million cash and $28.8 million of bank debt repayments. The auditors opinion at September 30, 2000 has no qualication. Exhibit 10C-1 contains Read-Rite nancial data for the four scal years ended September 30, 2000. Use the information provided to answer the following questions. 1. Compute each of the following ratios at December 31, 19972000: (i) Total debt to equity (both as reported) (ii) Net debt to equity (both as reported) (iii) Total debt to equity (both at market) (iv) Net debt to equity (both at market) where net debt is total debt less cash and marketable securities and equity is dened as shareholders equity plus minority interest.

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EXHIBIT 10C-1 Read-Rite Selected Financial Data Amounts in $millions Years Ended September 30 Balance Sheet Data Cash and equivalents Short-term investments Other current assets Total current assets Property, plant, equipment Intangible and other assets Total assets 1997 $ 118.6 179.5 $1,285.2 $ 583.3 672.8 $1,145.4 $1,301.5 $ 1998 62.4 46.0 $1,172.9 $ 281.3 573.6 $1,124.9 $ 879.8 $ 1999 80.5 145.9 $1,183.2 $ 309.6 457.2 $1,117.7 $ 784.5 $ 2000* 54.6 $1,127.6 $ 182.2 285.1 $1,119.9 $ 477.2

*Pro forma for debt conversion and related transactions.

Short-term debt Other current liabilities Total current liabilities Convertible debt1 Other long-term debt Other long-term liabilities Total liabilities Minority interest Stockholders equity2 Total equities
1 2

$ 12.6 $1,227.5 $ 240.1 345.0 58.9 $1,138.7 $ 682.7 73.1 $1,545.7 $1,301.5
345.0 191.1

$ 22.5 $1,161.1 $ 183.6 345.0 43.3 $1,132.0 $ 603.9 42.0 $1,233.9 $ 879.8
182.8 (129.2)

$ 158.1 $1,132.8 $ 290.9 345.0 16.7 $1,115.8 $ 658.4 41.9 $1,184.2 $ 784.5
146.3 (284.3)

$ 11.1 $1,125.3 $ 136.4 19.8 25.4 $1,115.1 $ 186.7 19.3 $1,271.2 $ 477.2
12.7 (409.1)

Fair value Includes retained earnings

Income Statement Data Net sales Cost of sales Operating expenses3 Interest expense Debt conversion expenses Interest income Income tax expense Minority interest Net income before extrod.item Gain on debt conversion Net income
3

$1,162.0 (923.2) (119.1) (15.7) 8.6 (29.3) (((((((7.1) $ 76.2

$ 808.6 (941.4) (220.1) (29.6) 7.1 24.6 $(3131.1 $ (319.7)

$ 716.5 (739.7) (159.0) (31.9) 4.1 25.9 $(1128.4 $ (155.7)

$ 555.9 (616.9) (213.0) (33.0) (29.4) 11.1 $(1141.9 $ (283.4) $1,158.6 $ (124.8)
(106.5)

Includes PPE write-downs

(70.0)

(29.7)

Cash Flow Data Operating activities Investing activities4 Financing activities Foreign currency effects Net cash ow
4

$ 190.1 (392.8) 235.7 $111,3.3 $ 36.3


(272.8)

(8.8) (54.4) 7.0 $$$,.1 $ (56.2)


(186.2)

76.2 (200.8) 142.7 $$$,.1 $ 18.1


(101.0)

(67.7) 52.2 (0.6) $$$,.1 $ (16.1)


(93.6)

Includes capital expenditure

Stock pricehigh low year end Year-end shares (millions)


Source: Read-Rite data from 19982000 annual reports.

33.13 15.38 26.81 48.133

26.81 5.50 7.81 48.764

19.69 4.03 4.41 49.675

11.56 1.88 11.25 117.014

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CASE 10-1

ANALYSIS OF DEBT CAPITALIZATION: READ-RITE

2. Discuss the trend in these four ratios over the period 19971999. 3. State and justify which of the ratios computed in (1) best represented the companys nancial condition. 4. Justify the auditors decision to give a going concern qualication at September 30, 1999. Your response should include the computation and discussion of Read-Rites: (i) Gross margin (ii) Interest coverage ratio (iii) Cash ow over the 19971999 period. 5. Discuss three benets that Read-Rite obtained from the exchange offer. State the cost to the company of the exchange offer. 6. When the note exchange became effective in 2000, Read-Rite recognized a gain of $158.6 million. Show how that gain was computed. 7. Discuss whether the $158.6 million gain should have been recognized in scal 2000 rather than scal 1998 and 1999. Discuss whether, in economic terms, there was any gain at all. 8. From the note holder perspective, explain one advantage and two disadvantages of the new notes. Discuss why most note holders accepted the exchange offer. Evaluate that decision based on subsequent events.

CASE 11-1 Off-Balance-Sheet Financing Techniques for Texaco and Caltex


The objective of this case is to extend the analysis of the off-balance-sheet nancing activities of Texaco begun in Exhibit 11-7 of the text. Specically the case focuses on Texacos afliates and their OBS activities and the adjustments to reported nancial statements required to reect these activities. Caltex is a joint venture between Texaco and Chevron [CHV] (another oil multinational); each partner owns 50%. Exhibit 11C-1 contains the 1999 condensed balance sheet, income statement, and selected footnotes of Caltex as well as general information, all extracted from Texacos 1999 10-K report. Relevant nancial information relating to Texaco can be obtained from Texacos 1999 Annual Report (on the website/CD) and from the information provided in Exhibits 11-6 and 11-7 in the text. Required: 1. Exhibit 11-7 shows Texacos reported and adjusted debt-to-equity ratios. To extend the analysis, compute the following ratios on a reported and adjusted basis for 1999: Return on assets (Use 1999 year end total assets) Times interest earned 2. (a) Using the Caltex reported balance sheet and income statement (without any adjustments), prepare a capitalization table for Caltex for the year ended December 31, 1999. (b) Compute the following Caltex ratios for 1999: Debt-to-equity Return on assets Times interest earned 3. (a) Using the footnote data from Exhibit 11C-1, compute the appropriate adjustments to Caltex debt for its off-balance-sheet obligations. (b) Using the result of part (a), recompute the ratios in question 2(b). (c) Discuss the signicance of your results. 4. Use the results of Questions 2 and 3 to further adjust Texacos debt and equity, and ratios calculated in Question 1. 5. Describe the information not contained in the Texaco and Caltex nancial data that would help you evaluate the impact of their off-balance-sheet obligations on future cash ows. (Your discussion should include both nancial and operational factors.) In addition to Caltex, Texacos major afliates are Equilon Enterprises LLC (44% owned) and Motiva Enterprises LLC (32.5% owned).1 A description of these afliates follows. Equilon was formed and began operations in January 1998 as a joint venture between Texaco and Shell. Equilon, which is headquartered in Houston, Texas, combines major elements of Texacos and Shells western and midwestern U.S. rening and marketing businesses and their nationwide transportation and lubricants businesses. Texaco owns 44% and Shell owns 56% of the company. Equilon renes and markets gasoline and other petroleum products under both the Texaco and Shell brand names in all or parts of 32 states. Equilon is the seventh largest rening company in the U.S. (Continued on page W87.)

Equilon and Motiva are limited liability companies (LLC) and do not pay income taxes directly. Taxes are the responsibility of the limited partners. As such, their nancial statements do not record a provision for taxes.

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EXHIBIT 11C-1. CALTEX GROUP OF COMPANIES Excerpts from 1999 Financial Statements ($millions) Condensed Consolidated Income Statement Year Ended December 31, 1999 Sales and other operating revenue Cost of sales Selling, general and administrative Depreciation, depletion, and amortization Maintenance and repairs Total expenses Operating income Income in equity afliates Dividends, interest, and other income Foreign exchange, net Interest expense Minority interest Total other income (deductions) Income before income taxes Income taxes Net income Condensed Consolidated Balance Sheet December 31, 1999 Assets Current assets Investments and advances Net property Other Total assets Liabilities and Equity Short-term debt Accounts payable Other Current liabilities Long-term debt Deferred income taxes Other Minority interest Long-term liabilities Stockholders equity Total liabilities and equity General Information The Caltex Group of Companies (Group) is jointly owned 50% each by Chevron Corporation and Texaco Inc. (collectively, the Stockholders) and was created in 1936 by its two owners to produce, transport, rene, and market crude oil and petroleum products. Note 4Equity in Afliates Investments in afliates at equity include the following: Equity % Caltex Australia Limited Koa Oil Company, Limited (sold August, 1999) LG-Caltex Oil Corporation Star Petroleum Rening All other 50% 50% 50% 64% Various 1999 $ 260 1,441 269 $2,157 $2,127 1998 $ 324 298 1,170 304 $2,158 $2,254 $ 1,588 1,545 $10,262 $ 3,395 1,054 206 1,356 $10,223 $ 2,639 $14,275 $10,309 $ 2,705 2,223 5,170 $10,211 $10,309 $14,583 12,775 582 459 $13,154 $13,970 613 252 80 (11) (152) $1211(2) $ 167 780 $13,390 $ 390

OFF-BALANCE-SHEET FINANCING TECHNIQUES FOR TEXACO AND CALTEX

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EXHIBIT 11C-1 (continued) Shown below is summarized combined nancial information for equity afliates: 100% 1999 Current assets Other assets Current liabilities Other liabilities Net worth $3,005 6,333 (3,351) .(1,883) $4,104 1998 $3,689 7,689 (3,547) .(3,505) $4,326 100% 1999 Operating revenues Operating income Net income $12,796 726 539 1998 $11,811 1,101 193 1997 $14,669 1,078 853 1999 $6,511 358 252 Equity Share 1999 $1,535 3,287 (1,816) ..$(937) $2,069 1998 $1,855 4,004 (1,795) .(1,866) $2,198 Equity Share 1998 $5,968 539 58 1997 $7,452 532 390

Cash dividends received from these afliates were $71 million, $50 million, and $43 million in 1999, 1998, and 1997, respectively. Retained earnings as of December 31, 1999 and 1998 includes $1.4 billion which represents the Groups share of undistributed earnings of afliates at equity. Note 7Operating Leases The Group has operating leases involving various marketing assets for which net rental expense was $112 million, $103 million, and $105 million in 1999, 1998, and 1997, respectively. Future net minimum rental commitments under operating leases having non-cancelable terms in excess of one year are as follows (in Millions of U.S. Dollars): 2000$66; 2001$42; 2002$30; 2003$13; 2004$10; and 2005 and thereafter$37. Note 9Commitments and Contingencies . . . .A Caltex subsidiary has a contractual commitment until 2007 to purchase petroleum products in conjunction with the nancing of a renery owned by an afliate. Total future estimated commitments under this contract, based on current pricing and projected growth rates, are approximately $700 million per year. Purchases (in billions of U.S. dollars) under this and other similar contracts were $0.7, $0.8, and $1.0 in 1999, 1998, and 1997, respectively. . . .Caltex is contingently liable for sponsor support funding for a maximum of $278 million in connection with an afliates project nance obligations. The project has been operational since 1996 and has successfully completed all mechanical, technical, and reliability tests associated with the plant physical completion covenant. However, the afliate has been unable to satisfy a covenant relating to a working capital requirement. As a result, a technical event of default exists which has not been waived by the lenders. The lenders have not enforced their rights and remedies under the nance agreements and they have not indicated an intention to do so. The afliate is current on these nancial obligations and anticipates resolving the issue with its secured creditors during further restructuring discussions. During 1999, Caltex and the other sponsor provided temporary short-term extended trade credit related to crude oil supply with an outstanding balance owing to Caltex at December 31, 1999 of $149 million. Environmental Matters The Groups environmental policies encompass the existing laws in each country in which the Group operates, and the Groups own internal standards. Expenditures that create future benets or contribute to future revenue generation are capitalized. Future remediation costs are accrued based on estimates of known environmental exposure even if uncertainties exist about the ultimate cost of the remediation. Such accruals are based on the best available undiscounted estimates using data primarily developed by third party experts. Costs of environmental compliance for past and ongoing operations, including maintenance and monitoring, are expensed as incurred. Recoveries from third parties are recorded as assets when realizable.

EXHIBIT 11C-2. TEXACO AFFILIATES: EQUILON AND MOTIVA Excerpts from 1999 Financial Statements ($millions) Condensed Consolidated Income Statement Year Ended December 31, 1999 Equilon Sales and other operating revenue Cost of sales Selling, general, and administrative Depreciation, depletion, and amortization Total expenses Operating income Equity in income of afliates Dividends, interest and other income Interest expense Minority interest Total other income (deductions) Net income $29,174 26,747 1,308 $28,878 $28,933 241 154 70 (115) $2891(3) $ 106 $ 347 Motiva $12,196 10,917 876 $12,378 $12,171 25 , , (94) $12 , $ (94) $ (69)

Condensed Consolidated Balance Sheet December 31, 1999 Equilon Assets Current assets Investments & advances Net property Other assets Total assets Liabilities and Equity Short-term debt Accounts payable Other Current liabilities Long-term debt Other liabilities Long-term liabilities Stockholders equity Total liabilities and equity Equity in Afliates Equilon: Summarized nancial information for Equilons afliate investments and Equilons equity share thereof for the year ended December 31, 1999 is as follows: Equity Companies at 100% and at Equilons Percentage Ownership ($ millions) 100% Current assets Noncurrent assets Current liabilities Noncurrent liabilities and deferred credits Net assets Revenues Income before income taxes Net income Dividends received $1,684 3,601 (1,585) (2,543) $1,157 2,002 664 494 Equilons Share $ 750 1,097 (629) $1(692) $ 526 615 176 154 144 2,157 2,481 1 1,998 $ 5,636 5 11 ,730 $ ,735 2 5,046 $11,417 363 377 1 ,538 $1,278 1,451 2 ,644 $2,095 $3,205 $6,578 $ 4,209 529 6,312 1 1,367 $11,417 $1,271 180 4,974 6 ,153 $6,578 Motiva

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OFF-BALANCE-SHEET FINANCING TECHNIQUES FOR TEXACO AND CALTEX

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EXHIBIT 11C-2 (continued) Operating Leases and Throughput Agreements As of December 31, 1999 Equilon and Motiva had estimated minimum commitments for payment of rentals under leases that, at inception, had a non-cancelable term of more than one year, as follows: ($ millions) Equilon 2000 2001 2002 2003 2004 After 2004 Total Less sublease rental income Total lease commitments 76 63 62 61 59 $1,775 $1,096 $1,075 $1,021 $ Motiva $ 51 49 47 39 38 $410 $634 $1 $634

Equilon has assumed crude and rened product throughput commitments previously made by Shell and Texaco to ship through afliated pipeline companies and an offshore oil port, some of which relate to nancing arrangements. As of December 31, 1999 and 1998, the maximum exposure was estimated to be $297 million and $333 million, respectively. No advances have resulted from these obligations. Motiva was formed and began operations in July 1998 as a joint venture among Shell, Texaco, and Saudi Refining, Inc., a corporate affiliate of Saudi Aramco. Motiva combines Texacos and Saudi Aramcos interests and major elements of Shells eastern and Gulf Coast U.S. refining and marketing businesses. Texaco and Saudi Refining, Inc., each owns 32.5% and Shell owns 35% of Motiva. Motiva refines and markets gasoline and other petroleum products under the Shell and Texaco brand names in all or part of 26 states and the District of Columbia, providing product to almost 14,000 Shell- and Texaco-branded retail outlets. Exhibit 11C-2 contains the condensed balance sheet, income statement, and selected footnotes of Equilon and Motiva, all extracted from Texacos 1999 10-K report. 6. Using the data from Exhibit 11C-2, compute the appropriate adjustments to Texacos nancial statements and recompute the ratios calculated in Question 1.

CASE 13-1 Coca-Cola: Consolidation Versus Equity Method


Coca-Cola (Coke) [KO] is the largest soft drink rm in the world. However, Coke does not bottle and distribute its beverages; that activity is carried out by afliates in which Coke has a large equity interest. Coca-Cola Enterprises (Enterprises) [CCE] is the worlds largest marketer and distributor of Coke products. The relationship between the two rms is complex: 1. Enterprises produces virtually all its products under license from Coke and buys soft drink syrup, concentrates, and sweeteners directly from or through Coke. 2. Coke provides national advertising as well as local marketing support for Enterprises products. 3. Through programs such as Jumpstart that are designed to accelerate the placement of cold drink equipment, Coke provides funding to Enterprises to help set up the infrastructure required to distribute its products. 4. Approximately 90% of Enterprises sales volume is generated through the sale of products of The Coca-Cola Company; raw materials purchased from Coke account for over 50% of Enterprises cost of goods sold. To a great extent, Coke controls Enterprises products and input costs. 5. Three members of Enterprises board of directors are current ofcers of Coke. It would not be an understatement to suggest that Enterprises (and Cokes other afliated bottling companies) are an integral part of Cokes success, providing an outlet for its products. However, by keeping its ownership below 50%, Coke has been able to use the equity method to report its interest in Enterprises and the other bottlers. Exhibit 13C1-1 contains condensed 2001 nancial statements of Coke and Coca-Cola Enterprises. The following information with respect to its ownership interest in its bottlers is excerpted from Cokes nancial statements: Coca-Cola Enterprises is the largest soft drink bottler in the world. Coke owns approximately 38 percent of the outstanding common stock of Coca-Cola Enterprises and, accordingly, accounts for its investment by the equity method of accounting. At December 31, 2001, the Company owned approximately 35 percent of Coca-Cola Amatil, an Australia-based bottler of Company products that operates in 12 countries. As a result of a merger in 2000 between Coca-Cola Beverages and Hellenic Bottling Company S.A. to form the combined entity Coca-Cola HBC S.A., Cokes previous 50.5% ownership in Coca-Cola Beverages was reduced to a 24% share of the combined entity Coca-Cola HBC S.A. Coke states in its MD&A that
In line with our long-term bottling strategy, we consider alternatives for reducing our ownership interest in a bottler. One alternative is to combine our bottling interests with the bottling interests of others to form strategic business alliances. Another alternative is to sell our interest in a bottling operation to one of our equity investee bottlers. In both of these situations, we continue to participate in the bottlers results of operations through our share of the equity investees earnings or losses.

Additional information that is also relevant to analysis of the bottling afliates is presented below: 2001 Financial Information ($ in millions) Intercompany sales Net marketing payments From Coke to Enterprises From Enterprises to Coke From Coke to Enterprises $3,900 395 606

(Continued on page W90.)

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COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD

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EXHIBIT 13C1-1. THE COCA-COLA COMPANY AND COCA-COLA ENTERPRISES Condensed 2001 Financial Statements (in millions) Balance Sheets at December 31, 2001 Current Assets Cash and marketable securities Trade accounts receivable Inventories Prepaid expenses and other assets $ 1,934 1,882 1,055 $12,300 $ 7,171 $ 284 1,540 690 $23,362 $ 2,876 Coke Enterprises

Investments Equity method investments Coca-Cola Enterprises Coca-Cola Amatil Limited Coca-Cola HBC S.A Other, principally bottling companies Cost method investments, principally bottling companies Other assets

788 432 791 3,117 294 $22,792 $ 8,214 4,453 $12,579 $22,417

$23,1 6,206 $14,637 $23,719

Property, Plant, and Equipment (Net) Intangible assets* Total assets Current Liabilities Accounts payable and accrued liabilities Accounts payable to The Coca-Cola Company Deferred cash payments from The Coca-Cola Company Notes payable and current debt

$ 4,530

$ 2,610 38 70 $11,804 $ 4,522

$23,899 $ 8,429

Noncurrent Liabilities Long-term debt Other long-term liabilities Deferred taxes Deferred cash payments from The Coca-Cola Company 1,219 961 442 $23,1 $ 2,622 10,365 1,166 4,336 $16,510 $16,377

Shareholders Equity Preferred stock Common stock Capital surplus Retained earnings Other comprehensive income Treasury stock Total liabilities and equity 873 3,520 23,443 (2,788) (13,682) $11,366 $22,417 37 453 2,527 220 (292) $12(125) $ 2,820 $23,719

*Intangible assets of Coke consist primarily of goodwill and trademarks. Intangible assets for Enterprises consist primarily of franchise rights to bottle Coca-Cola products.

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CASE 13-1

COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD

EXHIBIT 13C1-1 (continued) Income Statement, Year Ended December 31, 2001 Net operating revenues Cost of goods sold Gross prot Selling, administrative, and general expenses Operating income Interest income Interest expense Equity income Other income Income before taxes Income taxes Income before cumulative effect of accounting change Cumulative effect of accounting change Net income Preferred dividends Net income (loss) applicable to common shareholders Cash Flow Statements, Year Ended December 31, 2001 Cash Flow from Operations Net income Equity income, net of dividends Other adjustments Cash Flows from Investing Activities Cash Flows from Financing Activities Debt nancing Issue and repurchase of stock Dividends Effect of exchange rate changes Change in cash (926) (113) $ (1,791) $ (2,830) $212(45) $ 47 946 12 $111(72) $ 886 $11,3 $ (10) $ 3,969 (54) $11,195 $ 4,110 (1,188) $ (324) Coke $20,092 $,(6,044) $14,048 $,(8,696) $ 5,352 325 (289) 152 $11,130 $ 5,670 $,(1,691) $ 3,979 $111(10) $ 3,969 $11,3 $ 3,969 Enterprises $15,700 $,(9,740) $ 5,960 $,(5,359) $ 601 (753) $11,512 $ (150) $11,131 $ (19) $11(302) $ (321) $1111(3) $ (324)

Coke

Enterprises

$11,438 $ 1,114 (2,010)

Source: Adapted from 2001 annual reports of The Coca-Cola Company and Coca-Cola Enterprises.

Prior to 2001, Enterprises had recorded payments received from Coke for programs such as Jumpstart as offsets to expenses incurred in constructing the infrastructure. Starting in 2001, Enterprises changed its accounting and recorded the money received as obligations to Coke to be amortized over the life of the programs. Coke, itself, records these expenditures as part of Other Assets and amortizes them over time. Required: 1. Given the relationship between Coke and Enterprises, discuss the appropriateness of Cokes use of the equity method to account for its investment in Enterprises. 2. Prepare a 2001 balance sheet, income statement, and cash ow statement for Coke, with Enterprises fully consolidated. 3. Compute the following ratios for Coke (as reported), Enterprises, and Coke after full consolidation of Enterprises: (a) Current ratio (h) Return on assets (b) Debt-to-equity (i) Return on tangible assets (c) Debt-to-tangible equity (j) Return on equity (d) Debt-to-assets (k) Return on tangible equity (e) Current ratio (l) Times interest earned (f) Debt-to-equity (m) Inventory turnover (g) Debt-to-tangible equity (n) Receivable turnover

COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD

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EXHIBIT 13C1-2. THE COCA-COLA COMPANY AND SUBSIDIARIES Supplementary Data Notes to Consolidated Financial Statements Other Equity Investments Operating results include our proportionate share of income (loss) from our equity investments. A summary of nancial information for our equity investments in the aggregate, other than Coca-Cola Enterprises, is as follows (in millions): December 31, Current assets Noncurrent assets Total assets Current liabilities Noncurrent liabilities Total liabilities Shareowners equity Company equity investment Year Ended December 31, Net operating revenues (1) Cost of goods sold Gross prot (1) Operating income (loss) Cash operating prot (2) Net income (loss) 2001 $ 6,013 $17,879 $23,892 $ 5,085 $ 7,806 $12,891 $11,001 $ 4,340 2001 $19,955 $11,413 $ 8,542 $ 1,770 $ 3,171 $ 735 2000 $ 5,985 $19,030 $25,015 $ 5,419 $ 8,357 $13,776 $11,239 $ 4,539 2000 $21,423 $13,014 $ 8,409 $ (24) $ 2,796 $ (894) 1999 $19,605 $12,085 $ 7,520 $ 809 $ 2,474 $ (134)

Notes: Equity investments include non-bottling investees. (1) 2000 and 1999 Net operating revenues and Gross prot have been reclassied for EITF Issue No. 00-14 and EITF Issue No. 00-22. (2) Cash operating prot is dened as operating income plus depreciation expense, amortization expense and other non-cash operating expenses.

Net sales to equity investees other than Coca-Cola Enterprises were $3.7 billion in 2001, $3.5 billion in 2000, and $3.2 billion in 1999. Total support payments, primarily marketing, made to equity investees other than Coca-Cola Enterprises, the majority of which are located outside the United States, were approximately $636 million, $663 million, and $685 million for 2001, 2000, and 1999, respectively. In February 2001, the Company reached an agreement with Carlsberg A/S (Carlsberg) for the dissolution of Coca-Cola Nordic Beverages (CCNB), a joint venture bottler in which our Company had a 49 percent ownership. In July 2001, our Company and San Miguel Corporation (San Miguel) acquired Coca-Cola Bottlers Philippines (CCBPI) from Coca-Cola Amatil Limited (Coca-Cola Amatil). In November 2001, our Company sold nearly all of its ownership interests in various Russian bottling operations to Coca-Cola HBC S.A. (CCHBC) for approximately $170 million in cash and notes receivable, of which $146 million in notes receivable remained outstanding as of December 31, 2001. These interests consisted of the Companys 40 percent ownership interest in a joint venture with CCHBC that operates bottling territories in Siberia and parts of Western Russia, together with our Companys nearly 100 percent interests in bottling operations with territories covering the remainder of Russia. In July 2000, a merger of Coca-Cola Beverages plc (Coca-Cola Beverages) and Hellenic Bottling Company S.A. was completed to create CCHBC. This merger resulted in a decrease in our Companys equity ownership interest from approximately 50.5 percent of Coca-Cola Beverages to approximately 24 percent of the combined entity, CCHBC. In July 1999, we acquired from Fraser and Neave Limited its ownership interest in F&N CocaCola Pte Limited. If valued at the December 31, 2001, quoted closing prices of shares actively traded on stock markets, the value of our equity investments in publicly traded bottlers other than Coca-Cola Enterprises exceeded our carrying value by approximately $800 million.
Source: Coca-Cola 2001 Annual Report

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CASE 13-1

COCA-COLA: CONSOLIDATION VERSUS EQUITY METHOD

4. Discuss the differences in the ratios in part 3 between Coke as reported and after the consolidation of Enterprises. 5. Repeat parts 2 through 4, but using proportionate consolidation for Enterprises. 6. Exhibit 13C1-2 contains summarized data regarding Cokes other bottling afliates (excluding Enterprises) accounted for using the equity method. Discuss the expected effect of: (i) Full consolidation on Cokes nancial statements. (ii) Proportionate consolidation 7. Discuss the expected effect of the FASB exposure draft on consolidation (Box 13-3) on Cokes accounting treatment of its bottling afliates. 8. Coke states In line with our long-term bottling strategy, we consider alternatives for reducing our ownership interest in a bottler. Discuss Cokes motivation to reduce such ownership interests. 9. As a nancial analyst, discuss the advantages and disadvantages of viewing Coke, with its bottling afliates: (i) On the equity method (ii) Proportionately consolidated (iii) Fully consolidated

CASE 14-1 Conversion of Pooling to Purchase Method Pzer Acquisition of Warner-Lambert


INTRODUCTION
On June 19, 2000 Pzer [PFE] merged with Warner-Lambert [WLA], issuing approximately 2,440 million PFE shares in exchange for all of the equity of WLA. The merger was accounted for as a pooling of interests as permitted by U.S. GAAP at that time.

CASE OBJECTIVES
1. Determine the effect of the acquisition of Warner-Lambert on Pzers nancial statements. 2. Compare the nancial statement effects of the merger with the effects if Pzer had accounted for the acquisition as a purchase under (i) U.S. GAAP (SFAS 141 and SFAS 142) (ii) IAS GAAP Exhibit 14C1-1 shows the condensed balance sheet of Warner-Lambert on December 31, 1999. Exhibit 14C1-2 contains extracts from WLAs nancial statement footnotes on the same date. Exhibit 14C1-3 shows the condensed income and cash ow statements for Warner-Lambert for the year ended December 31, 1999. Use these exhibits and the Pzer 1999 nancial statements on the CD/website to answer the following questions. 1. Describe the effects of the merger with Warner-Lambert on Pzers 1999 (i) Balance sheet (ii) Income statement (iii) Cash ow statement (iv) Financial statement footnotes as reported in Pzers 2000 Annual Report 2. Compute the effect of the merger with Warner-Lambert on each of the following Pzer ratios for 1999: (i) Current ratio (ii) Total debt to equity (iii) Book value per share (iv) Gross prot margin (v) Operating prot margin (vi) Return on equity (vii) Cash from operations (CFO) to debt

EXHIBIT 14C1-1. WARNER-LAMBERT Condensed Balance Sheet at December 31, 1999 Amounts in $ millions Cash and equivalents Inventories Other current assets Property (net) Investments and other assets Intangible assets Totals $ 1,943 979 2,768 3,342 793 $11,616 $11,441 Short-term debt Other current liabilities Long-term debt Deferred income tax Other long-term liabilities Stockholders equity 297 3,391 1,250 463 942 $15,098 $11,441 $

Source: Warner-Lambert 1999 10-K

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CASE 14-1

CONVERSION OF POOLING TO PURCHASE METHOD

PFIZER ACQUISITION OF WARNER-LAMBERT

EXHIBIT 14C1-2. WARNER-LAMBERT Extracts from Footnotes at December 31, 1999 Amounts in $ Millions Fair Values of Financial Instruments Carrying Amount Investment securities Long-term debt Foreign exchange contracts Pensions and Other Postretirement Benets Benet obligation at year-end Plan assets at year-end Amounts recognized on balance sheet: Prepaid benet cost Accrued benet liability Intangible asset Comprehensive income $ 149 (1,249) Fair Value $ 149 (1,222) (16)

Pensions $2,634 2,644 219 (161) 4 14 Assets 1,020

OPEB $ 277

(169)

Liabilities 463

Deferred Income Taxes


Source: Warner-Lambert 1999 10-K

3. Assume that Pzer had been required to account for the acquisition of Warner-Lambert under SFAS 141 and SFAS 142. Prepare a pro forma balance sheet for December 31, 1999 using the Pzer balance sheet on the CD/website, the data in Exhibits 14C1-1 and 14C1-2, and the following assumptions: (i) The price of PFE shares on that date was $32.44 (ii) The following fair values of WLA assets ($millions): Inventories $1,250 Fixed assets 4,000 In process research and development 1,000 4. Prepare a pro forma 1999 income statement for Pzer as if the merger had occurred January 1, 1999, using the data and assumptions from Question 3. State any additional assumptions required to prepare the income statement. 5. Redo Question 2 using the data and assumptions from Questions 3 and 4. 6. Describe the effect of the acquisition of Warner-Lambert, using the assumptions from Question 3, on Pzers (i) Income statement for 2000 (ii) Income statement for following years EXHIBIT 14C1-3. WARNER-LAMBERT Condensed Income and Cash Flow Statements, Year Ended December 31, 1999 Amounts in $ Millions Condensed Income Statement Sales Cost of goods sold Selling, general, administrative Research and development Other expense, net Pretax income Income tax expense Net income
Source: Warner-Lambert 1999 10-K

Condensed Cash Flow Statement $12,929 (3,042) (5,959) (1,259) $1, (228) $ 2,441 $1, (798) $ 1,643 Operating activities Investing activities Financing activities Exchange rate effects Increase in cash $2,437 (1,234) (500) $1, (15) $ 688

CONVERSION OF POOLING TO PURCHASE METHOD

PFIZER ACQUISITION OF WARNER-LAMBERT

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7. 8. 9.

10. 11.

(iii) Cash ow statement for 2000 (iv) Cash ow statement for following years Using your answers to the prior questions, explain why PFE preferred using the pooling of interest method to account for the acquisition. From the perspective of a nancial analyst, state two advantages of each accounting method (pooling and purchase). Now assume that Pzer accounted for the acquisition of Warner-Lambert using IAS GAAP. Redo Questions 3 through 6, in each case showing how the effect of IAS GAAP differs from SFAS 141 and 142. State and justify whether Pzer, given a choice, is likely to prefer using IAS standards to account for the acquisition of WLA, rather than SFAS 141 and 142. In 2000 Pzer recorded an income statement charge for merger-related costs, broken down as follows (in $millions): Payment to American Home Products* Transaction costs Restructuring charges Integration costs Total $1,838 226 947 $3,246 $3,257

Discuss which (if any) of these components should be included in Pzers net income for valuation purposes.

*For termination of merger agreement with Warner-Lambert0

CASE 14-2 Conversion of Purchase to Pooling Method Westvaco Acquisition of Mead


INTRODUCTION
On January 29, 2002 Westvaco [W] merged with Mead [MEA], issuing approximately 99.2 million shares and $119 million cash in exchange for all of the equity of MEA. The merger was accounted for as a purchase as required by SFAS 141. While the companies were quite similar in size, and the merger was presented as a merger of equals, Westvaco was deemed to be the acquirer. The new (combined) company is called MeadWestvaco [MWV]. The purchase price was estimated as: Value of MWV shares issued (at $30.06 per share) Cash paid to MEA shareholders Value of MEA stock options Transaction costs Total which was allocated as follows: Mead net assets at historical cost Fair value adjustments Elimination of MEA goodwill Acquisition goodwill recognized Total $2,981 million 119 85 $3,235 $3,220 2,317 846 (257) $3,314 $3,220

CASE OBJECTIVES
1. Determine the effect of the acquisition of Mead on Westvacos nancial statements. 2. Compare the nancial statement effects of the merger with the effects if Westvaco had accounted for the acquisition as a purchase under IAS GAAP: (i) Using the purchase method (ii) Using the pooling of interests method 3. Compare the nancial statement effects of the merger with the effects if it had been accounted for as a purchase under US GAAP but with Mead as the acquirer. Exhibit 14C2-1 shows the pro forma condensed balance sheet of the combined company (MWV) as of October 31, 2001. Exhibit 14C2-2 shows the pro forma condensed income statement of MWV for the year ended October 31, 2001. Use these exhibits and the additional information provided to answer the following questions. 1. Describe the effects of the merger with Mead on Westvacos 2001 and 2002 (i) Balance sheet (ii) Income statement (iii) Cash ow statement (iv) Financial statement footnotes 2. Compute the effect of the merger with Mead on each of the following Westvaco ratios for 2001: (i) Current ratio (ii) Total debt to equity (iii) Book value per share (iv) Gross prot margin (v) Operating prot margin (vi) Interest coverage ratio (vii) Return on ending equity

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CASE OBJECTIVES

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EXHIBIT 14C2-1. MEADWESTVACO Pro Forma Condensed Balance Sheet Amounts in $ millions October 31, 2001 Adjustments Assets Cash and equivalents Accounts receivable Inventories Other current assets Total current assets Property (net) Prepaid pension asset Goodwill Other assets Total assets Liabilities and Equity Current debt Other current liabilities Total current liabilities Long-term debt Deferred income tax Other liabilities Total liabilities Stockholders equity Liabilities and equity Millions of shares outstanding Adjustment # 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Fair value adjustment Deferred income tax Fair value adjustment Pension plan adjustment to plan status Acquisition goodwill less elimination of Mead goodwill Fair value adjustment Debt incurred for payments to Mead shareholders and other costs Transaction and restructuring costs and fair value adjustments Fair value adjustment Deferred income tax Pension and OPEB adjustments to plan status Replace Mead equity with value of MWV shares issued 173 $6,528 $ 701 2,660 1,008 $4.477 $4,446 $2,341 $6,787 102.4 227 $6,698 $ 925 1,315 591 $3,311 $3,142 $2,317 $5,459 99.1 148 $6,110 $ 258 (7) 297 $1,310 $ 558 $1,755 $1,313 7 8 9 10 11 12 548 $11,336 $ 1,884 3,968 1,896 $13,398 $ 8,146 $15,413 $13,559 198.5 Westvaco $ 81 415 426 $1,094 $1,016 4,227 780 565 $6,199 $6,787 Mead $ 51 471 540 $1,107 $1,169 3,129 317 257 $6,587 $5,459 Amount # Combined 132 886 1,175 $13,136 $ 2,329 8,604 868 879 $13,879 $13,559 $

$ 209 $11(65) $ 144 1,248 (229) 57 $6,193 $1,313

1 2 3 4 5 6

Source: Adapted from March 8, 2002 corporate release

3. Discuss the effect of use of the purchase method on MWVs (i) Trend of reported revenue for scal years 20012003 (ii) Trend of reported income for scal years 20012003 (iii) Trend of reported CFO for scal years 20012003 (iv) Trend of balance sheet ratios for scal years 20012003 4. From the perspective of a nancial analyst, explain the usefulness of the pro forma nancial statements. 5. Discuss whether the restructuring charges should be included in pro forma net income for analysis purposes.

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CASE 14-2

CONVERSION OF PURCHASE TO POOLING METHOD

WESTVACO ACQUISITION OF MEAD

EXHIBIT 14C2-2. MEADWESTVACO Pro Forma Condensed Income Statement Amounts in $ Millions Year Ended October 31, 2001 Adjustments Westvaco Sales Cost of goods sold Gross margin Selling and administrative Restructuring charges Other revenues EBIT Interest expense Pretax income Income tax expense Net income Earnings per share Average shares (millions) Adjustment # 1. Additional depreciation resulting from fair value adjustment less Mead goodwill amortization and effect of pension plan adjustments 2. Amortization of higher fair value of Mead intangible assets 3. Same as #2 4. Interest on new debt and amortization of fair value debt adjustment 5. Income tax effects of other adjustments
Source: Adapted from March 8, 2002 corporate release

Mead $ 4,176 $ (3,597) $ 579 (494) (45) $13,119 $ 59 $41(110) $ (51) $13,134 $ (17) 0.18 99.1

Amount

Combined $ 8,111 $(6,881) $ 1,230 (863) (97) $(6,166 $ 336 $1,(322) $ 14 $81124 $ 38 0.19 197.6

$ 3,935 $ (3,241) $ 694 (364) (52) $3,2 (48 $ 326 $12(208) $ 118 $3,2 (30) $ 88 0.87 101.5

$(43) $(43) (5) $1(1) $(49) $1(4) $(53) $(20 $(33)

1 2 3 4 5

6. Assume that Westvaco had been required to account for the acquisition of Mead using the purchase method under IAS GAAP. Discuss any differences in the effect of the merger on the combined companys (i) Pro forma balance sheet at October 31, 2001 (ii) Pro forma income statement for the year ended October 31, 2001 7. Assume that the merger had been accounted for as the acquisition of Westvaco by Mead using the purchase method under US GAAP. Using the following fair value adjustment information for Westvaco, prepare a pro forma balance sheet for the combined company at October 31, 2001: Assets Inventories Capitalized operating leases Timberland 135 145 461 Liabilities Long-term debt Capitalized leases Deferred income tax 100 145 (1,007)

Note: information from Exhibit 14C2-1 and the introduction is also required to answer this question.

8. Discuss any differences (from the actual method used) in the effect of the merger on the combined companys (i) Trend of reported revenue for scal years 20012003 (ii) Trend of reported income for scal years 20012003 (iii) Trend of reported CFO for scal years 20012003 (iv) Trend of balance sheet ratios for scal years 20012003

CASE OBJECTIVES

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9. Now assume that Westvaco accounted for the acquisition of Mead using the pooling method under IAS GAAP. Prepare a pro forma condensed: (i) balance sheet for the combined company as of October 31, 2001, using the format of Exhibit 14C2-1. (ii) income statement for the combined company for the year ended October 31, 2001, using the format of Exhibit 14C2-2. 10. Redo Questions 1 through 3, in each case showing how the effect of IAS GAAP differs from US GAAP. 11. State and justify which method, given a choice, the companies would have preferred to use to account for the merger.

CASE 15-1 AFLAC Analysis of Exchange Rate Effects: Single Currency


INTRODUCTION
AFLAC (American Family Life) is a major specialty insurance company. Although the company is American, its Japanese subsidiary, AFLAC Japan, accounted for 85% of 1995 revenues and 90% of assets. Because AFLAC presents its nancial statements in U.S. dollars, changes in the yen-dollar exchange rate have important effects on reported income, net worth, cash ow, and nancial ratios. With only a single foreign currency, the complexity that often characterizes the analysis of exchange effects is eliminated. The yen is one of the worlds major currencies, and exchange rate data are widely available. As a result, the impact of exchange rate changes is easier to calculate and understand.

CASE OBJECTIVES
The objectives of this case are to use AFLAC to: 1. Show the effects of exchange rate changes on levels and trends of revenue, income, cash ow, and nancial position. 2. Calculate translation gains and losses. 3. Show how currency exposure can be managed.

EXCHANGE RATE EFFECTS ON INCOME STATEMENT


As AFLAC Japan dominates corporate results, we start with an examination of that subsidiary. Exhibit 15C1-1 shows the revenues and pretax income of AFLAC Japan over the 1986 to 1995 period, in both Japanese yen and U.S. dollars. The average annual yen-dollar exchange rates are also provided. The Japanese yen rose from 168 to the dollar (1986 average) to 94 to the dollar (1995 average) over this time span, rising in seven of the nine years. The strengthening yen magnied the growth rate of AFLAC Japan, as yen results were translated into U.S. dollars at ever higher rates. Revenues rose from 154 billion yen (1986) to 575 billion yen in 1995, an increase of 274%; the nine-year increase in U.S. dollars was 570%. Due to an average 6% increase in the value of the yen, average revenue growth of less than 16% (in yen) was reported as more than 24% in dollars. The effect of the yens rise on reported pretax earnings was equally dramatic. Over the 1986 to 1995 period, AFLAC Japans pretax earnings increased 175% in yen but 392% after translation to U.S. dollars. It should be noted that the effect of the exchange rate on revenue and pretax income is not affected by the choice of functional currency in this case; all the subsidiaries revenues and expenses are monetary.1 However, the exchange rate effect was not beneficial every year. As shown in Exhibit 15C1-1, the U.S. dollar revenue growth rate was only 2.8% in 1989, as 10.7% revenue growth (in yen) was mostly offset by a 7.7% decline in the yen relative to the dollar. A further yen decline in 1990 again resulted in a lower growth rate in dollars than in yen. Pretax income gains in 1989 to 1990 were also depressed (when reported in dollars) by the falling yen. AFLAC Japans growth rate has declined (in yen) in recent years. Strong gains by the yen, however, made the revenue growth rate accelerate (in dollars) in the 1990s.

As an insurance company, AFLAC has immaterial depreciation and no cost of goods sold.

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EXCHANGE RATE EFFECTS ON BALANCE SHEET

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EXHIBIT 15C1-1. AFLAC JAPAN Exchange Rate Effects on Revenues and Pretax Operating Income (Japanese Yen and U.S. $ in Billions) Revenues Yen 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 153.9 194.1 218.7 242.1 286.7 339.8 399.6 456.3 524.3 575.5 Rate 168.56 144.67 128.19 138.00 144.83 134.52 126.67 111.21 102.26 94.10 Percent Change (%) Yen 1987 1988 1989 1990 1991 1992 1993 1994 1995 Average 26.1 12.7 10.7 18.4 18.5 17.6 14.2 14.9 9.8 15.9 Rate 14.2 11.4 7.7 4.9 7.1 5.8 12.2 8.0 8.0 6.0 Dollars 46.9 27.2 2.8 12.8 27.6 24.9 30.1 25.0 19.3 24.1 Yen 9.4 11.9 18.3 14.4 11.9 13.2 10.2 8.6 9.5 11.9 Dollars 0.913 1.342 1.706 1.754 1.980 2.526 3.155 4.103 5.127 6.116 Yen 19.2 21.0 23.5 27.8 31.8 35.6 40.3 44.4 48.2 52.8 Pretax Operating Income Rate 168.56 144.67 128.19 138.00 144.83 134.52 126.67 111.21 102.26 94.10 Dollars 0.114 0.145 0.183 0.201 0.220 0.265 0.318 0.399 0.471 0.561

Percent Change (%) Rate 14.2 11.4 7.7 4.9 7.1 5.8 12.2 8.0 8.0 6.0 Dollars 27.4 26.3 9.9 9.0 20.5 20.2 25.5 18.1 19.0 19.5

Source: AFLAC, 1995 Annual Report.

EXCHANGE RATE EFFECTS ON CASH FLOW


As AFLAC Japans cash ows are translated into dollars at the average exchange rate, the strengthening yen also increased reported cash ow, as can be seen from the following data: Cash Flow from Operations ($ in billions) 1993 Consolidated AFLAC Japan % Increase Exchange rate effect $1.8 1.7 N/A N/A 1994 $2.4 2.1 24% 9% 1995 $2.9 2.7 28% 9%

Exchange rates accounted for approximately one-third of the increase in AFLAC Japans cash from operations over the 1993 to 1995 period; AFLAC Japan accounted for more than 90% of consolidated cash from operations.

EXCHANGE RATE EFFECTS ON BALANCE SHEET


Because AFLAC Japan has no inventories and almost no xed assets, its assets and liabilities are virtually all translated at current exchange rates.2 Thus, changes in the yen-dollar exchange rate directly affect the consolidated balance sheet as AFLAC Japan accounts for 90% of corporate assets.
2

This is true regardless of whether the functional currency is the yen or dollar.

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CASE 15-1 AFLAC

ANALYSIS OF EXCHANGE RATE EFFECTS: SINGLE CURRENCY

The effect on total assets can be seen in Exhibit 15C1-2. Appreciation of the yen against the dollar increased the growth rate of total assets. Although assets grew 476% in yen over the 1986 to 1995 period, the growth rate in dollars was 799%. The yen appreciated in six of the nine years. Note that the exchange rate effects each year differ from the income statement effects shown in Exhibit 15C1-1. The reason is that balance sheet accounts are translated at the closing rate for the year, whereas income statement (and cash ow) accounts are translated at the average rate. For example, although the yens average rate appreciated 8% during 1995, its closing rate at December 31, 1995 declined 3.1% from the rate one year earlier. Although liabilities also increased as the yen rose, signicant net assets in yen had a positive effect on stockholders equity in dollars. As the Japanese yen is the functional currency for AFLAC Japan, translation gains and losses are accumulated in the cumulative translation adjustment (CTA) mandated by SFAS 52. At December 31, 1995, the CTA was $213 million, or 10% of AFLAC consolidated equity. With the yen as the functional currency, the CTA is a function of changes in the yen-dollar exchange rate and the net assets (in yen) of AFLAC Japan. Given the substantial size (and net worth) of AFLAC Japan, we would expect the CTA to increase when the yen rises and decline when it falls. Changes in the CTA over the 1993 to 1995 period were 12/31/93 12/31/94 12/31/95

Opening CTA Increase during year


Closing CTA

$ 68,978 $154,316
$123,294

$123,294 $150,797
$174,091

$174,091 $139,228
$213,319

Given the depreciation in the yen during 1995, it is surprising that the CTA increased in that year. That increase can be explained, however, using information provided in AFLACs annual report and an understanding of how exchange rate changes impact the CTA.

EXHIBIT 15C1-2. AFLAC JAPAN Exchange Rate Effects on Total Assets (Japanese Yen and U.S. $ in billions) Total Assets Yen 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 408.1 511.5 631.0 760.5 909.3 1,093.4 1,285.8 1,523.0 1,822.9 2,351.0 Rate 160.60 123.05 126.00 143.55 134.60 125.25 124.70 112.00 99.85 102.95 Percent Change (%) Yen 1987 1988 1989 1990 1991 1992 1993 1994 1995 Average 25.3 23.4 20.5 19.6 20.2 17.6 18.4 19.7 29.0 21.5 Rate 23.4 2.4 13.9 6.2 6.9 0.4 10.2 10.8 3.1 4.3 Dollars 63.6 20.5 5.8 27.5 29.2 18.1 31.9 34.3 25.1 28.4 Dollars 2.541 4.157 5.008 5.298 6.756 8.730 10.311 13.598 18.256 22.836

QUESTIONS FOR FURTHER DISCUSSION

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AFLACs yen exposure decreased sharply, from 60 billion yen at December 31, 1994, to 29 billion yen one year later. The reduced exposure resulted from two management decisions: AFLAC incurred yen debt, designated as a hedge of its investment in AFLAC Japan. AFLAC Japan increased its U.S. dollar investments by more than $300 million. But AFLACs yen exposure remained positive, suggesting that the CTA should still have declined in 1995. The timing of these decisions, however, is crucial to an analysis of their impact. These transactions apparently took place in the summer of 1995 (the borrowing took place in August), when the yen rose to approximately 85 per dollar, before declining to the year-end level of 103 per dollar. The change in CTA during the year, therefore, has two components: 1. An increase due to the yens rise from 100 to 85 (per dollar) from January through August 2. A decline (but with sharply reduced exposure) over the balance of the year The following calculations approximate the 1995 CTA change: Dollar exposure at December 31, 1994 Exchange rate Yen exposure at December 31, 19943 $601.9 million 99.85 yen/dollar Y 60.1 billion

If we assume the yen borrowing and increase in dollar investments took place August 15, 1995, at an exchange rate of 85 yen per dollar, the CTA change from January 1 to August 15, 1995 would be Y 60.1 1 99.85 1 85 $105 million Increase

If the yen exposure was reduced to Y 29 billion on August 15, 1995, the CTA change over the balance of 1995 (August 15 to December 31) would be Y 29.3 1 85 1 102.95 $60 million Decrease

The net increase in the CTA for 1995 would be $105 $60 $45 million. This increase exceeds the actual increase in the CTA during 1995; some of the investment changes were probably made at exchange rates closer to 90 yen per dollar, reducing their positive impact on the CTA. Anticipating the reversal of the yen-dollar exchange rate, AFLAC was able to reduce its exposure to the yen sharply and mitigate the effect of the yens decline on the CTA and consolidated stockholders equity. AFLAC describes the critical transactions in its annual reports. However, the surprising change in the CTA would have alerted a perceptive analyst that a significant alteration in AFLACs yen exposure must have taken place. This is another example of how nancial analysis can focus attention on management actions, even when those actions have not been reported.

QUESTIONS FOR FURTHER DISCUSSION


1. The yen continued to decline, reaching nearly 110 per dollar by June, 1996. Predict the effect of this decline on AFLACs: (a) Revenue growth for the second quarter (ending June 30) of 1996 as compared with the second quarter of 1995 (b) Growth in pretax income for the second quarter (ending June 30) of 1996 as compared with the second quarter of 1995 (c) CTA change for the six months ended June 30, 1996 (d) Asset growth for the six months ended June 30, 1996 2. AFLAC carries all investments as available-for-sale under SFAS 115 (see Chapter 13). AFLAC Japans fixed income investments (including those purchased in 1995) are,

$601.9 times 99.85.

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CASE 15-1 AFLAC

ANALYSIS OF EXCHANGE RATE EFFECTS: SINGLE CURRENCY

therefore, reported at their market value in U.S. dollars. The current yield (interest) on these $U.S. investments is far higher than that on yen investments of comparable quality. Discuss the effect of the 1995 shift from yen investments to dollar investments on 1996 growth in investment income (and pretax income) of both: AFLAC Japan (in yen) The consolidated enterprise (in U.S. dollars) 3. AFLAC accounts for the U.S. dollar investments of its Japanese subsidiary by reporting them at market value and ignoring any exchange effects. Yet one might argue that, under SFAS 52, the U.S. dollar investments of AFLAC Japan should be remeasured into yen, the functional currency for AFLAC Japan, and then translated into dollars. Discuss how this accounting approach would alter the reported effects of yen-dollar changes on reported income.

CASE 15-2 Exchange Rate Effects on Operations and Financial Statements Aracruz
INTRODUCTION
Aracruz Celulose, S.A. is a leading producer of wood pulp in Brazil. It exports more than 90% of its production, mainly to the United States and Europe. Its shares are traded in Brazil and on the New York Stock Exchange [ARA]. Because it is primarily an exporter and international pulp prices are referenced in U.S. dollars, Aracruz nances its operations mainly using $U.S. debt. While almost all operations are located in Brazil, Aracruz prepares nancial statements using U.S. GAAP with the U.S. dollar as the functional currency (see footnote 1(a)).1 The Aracruz 2000 Annual Report (which includes $U.S. nancial statements), is located in the CD and website.

CASE OBJECTIVES
1. Examine the effect of changing exchange rates on the local currency nancial statements of a company that exports most of its output. 2. Forecast future results using alternative exchange rate assumptions. 3. Discuss the expected result of exchange rate changes on a companys common stock price. 4. Discuss whether the accounting effects of exchange rate changes on foreign operations are consistent with their economic effects. The following exchange rates (reai/dollar) should be used for the case: Average 1998 1999 2000 1.16 1.81 1.83 Year-end 1.21 1.79 1.96

Required: 1. Exhibit 15C2-1 contains the balance sheet for Aracruz at December 31, 1998. Certain assets and liabilities are subdivided by currency. Using the 2000 nancial statements and footnotes, complete Exhibit 15C2-1 for 1999 and 2000. Note: as currency data is provided only for total debt, we have aggregated current and non-current debt into a single amount. Assume that the debt securities are denominated in $U.S., as stated in footnote 17(a). For simplicity, we have combined all balance sheet amounts denominated in euros with the U.S. dollar amounts. 2. Compute ARAs net debt, segregated between $U.S. and R, at each balance sheet date. Note: net debt is dened as total debt, less cash and cash equivalents and debt securities available for sale. 3. Using the exchange rates provided in the table above, compute the net debt in reais (R), segregated between $U.S. and R, at each balance sheet date. 4. Compute the amount of net debt reduction (measured in dollars) in 1999 and 2000 that was due solely to exchange rate changes. 5. Explain why the currency in which monetary assets and liabilities are denominated is relevant to the analysis of ARAs balance sheet.

Aracruz also reports in Brazilian reais, using local GAAP.

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CASE 15-2

EXCHANGE RATE EFFECTS ON OPERATIONS AND FINANCIAL STATEMENTS

EXHIBIT 15C2-1 Aracruz Balance Sheet by Currency, December 31, 1998 ($ in thousands) Assets Cash and equivalents Investment in debt securities Accounts receivable: Inventories Other current assets Current assets Property, plant, equipment Other long-term assets Total assets Liabilities and Equity Non-debt current liabilities Total debt Other long-term liabilities Total liabilities Minority interest Stockholders equity Total liabilities and equity R $US R R R 65,515 1,262,876 259,879 $1,644,619 $1,632,889 $1,632,436 $1,567,164 $3,200,489 $US R $US $US R $US $US $US R $ 123,464 29,607 696,404 52,519 21,518 82,942 $1,023,864 $1,030,318 $1,892,451 $1,277,720 $3,200,489

Source: Data from Aracruz 1998 Annual Report.

6. Exhibit 15C2-2 contains the Aracruz income statement for the year ended December 31, 1998, slightly reformatted. Using the 2000 nancial statements, complete Exhibit 15C2-2 for 1999 and 2000. 7. ARA reported a translation loss for 1998 and 1999 and a translation gain for 2000. Discuss whether these amounts are consistent with the balance sheet data in Exhibit 15C2-1. EXHIBIT 15C2-2 Aracruz Income Statement by Currency, Year Ended December 31, 1998 ($ in thousands) Revenues: Domestic Export Total revenue Sales taxes Cost of sales Other expenses Total operating cost Operating income Financial income Financial expense Translation gain (loss) Other expense (income) Pretax income Income tax expense Minority interest in loss Net income Sales volume (000 tonnes): Brazil Export Total
Source: Data from Aracruz 1998 Annual Report.

R $US R R R

$ 38,449 $(462,163 $ 500,612 (39,490) (349,621) $(109,657) $(498,768) $ 1,844 104,840 (120,955) (7,780) $498,1(65) $ (22,116) 25,306 $(498,257 $ 3,447 68.8 $(.1,085.0 1,153.8

CASE OBJECTIVES

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8. Assume that Aracruz used the Brazilian reai as its functional currency. Discuss the impact on the computation of $U.S. (i) Total assets (ii) Stockholders equity (iii) Reported net income Your response should explain the principal differences from use of the $U.S. as functional currency and, where possible, the direction of change. 9. Compute the average sales price per tonne in U.S. dollars. 10. Compute the average sales price per tonne in reais (R) for each year using the same measure as in Question 9 and the appropriate exchange rate. 11. In its press release reporting 2000 results, Aracruz stated that the largest single factor in its earnings improvement was higher prices of $186 million. Show how that amount was computed. 12. Compute ARAs operating cost (cost of sales plus other expenses) per tonne in both U.S. dollars and Brazilian reais. Discuss which measure is more useful as a base for forecasting future cost levels. 13. Compute ARAs operating margin (net revenue less operating cost) per tonne in both U.S. dollars and Brazilian reais. Discuss the impact of exchange rate changes on both measures of operating margin. 14. Forecast 2001 operating income in U.S. dollars for Aracruz using the following assumptions: No change in sales volume No change in $U.S. prices under each of the following sets of assumptions: Case I: No change in exchange rates Operating costs (R/tonne) increase 10% from 2000 Case II: The reai declines by 20% (average for year) against the $U.S. Operating costs (R/tonne) increase 15% from 2000 For each case, compute operating margin per tonne in both R and $U.S. 15. Discuss the sensitivity of the 2001 forecast to changes in exchange rates and R costs. Discuss whether these changes are independent. 16. Using your answers to Questions 1 through 15, discuss the expected effect of changes in the R/$ exchange rate and the price of Aracruz shares: (i) in R (ii) in $U.S. 17. Explain why the U.S. dollar is a more appropriate functional currency for ARA than the Brazilian reai (R). 18. Now assume that Aracruz is a subsidiary of a U.S. company that uses the U.S. dollar as the functional currency to account for its investment. (i) Describe the effect of the decline in the Reai on the parents investment in Aracruz (in $U.S.). (ii) State where the resulting gain or loss would be reected in the parents balance sheet. (iii) Discuss whether the resulting gain or loss is consistent with your answer to Question 16. 19. Answer Question 18 assuming that the functional currency is the reai.

CASE 15-3

IBM

Analysis of Exchange Rate Effects: Multiple Currencies


INTRODUCTION
IBM is one of the worlds largest multinational corporations, and changes in currency rates have pervasive effects on the rms nancial statements. As IBM provided supplementary data regarding its foreign operations for many years, we can use the company to illustrate the analysis of multinational corporations.

CASE OBJECTIVES
The objectives of this case are to use IBM to: 1. Show the effects of exchange rate changes in levels and trends of revenue, income, cash ow, and nancial position. 2. Show the effect of exchange rate changes on nancial ratios. 3. Calculate the effect of exchange rate changes on assets and liabilities. 4. Calculate translation gains and losses resulting from exchange rate changes.

IBM DISCLOSURES RELATED TO FOREIGN OPERATIONS


Exhibit 15C3-1 contains IBMs balance sheet at December 31, 1989, and 1990. Within the stockholders equity section, we see translation adjustments of $1,698 and $3,266 billion (4.4 and 7.6% of net assets), respectively. These entries tell us that the company has signicant nonU.S. operations and its uses foreign functional currencies. If the company used the U.S. dollar as the functional currency for all foreign operations, all gains and losses would have been included in income. Exhibit 15C3-2 contains IBMs consolidated statement of cash ows for the three years ended December 31, 1990. The only reference to translation in the cash ow statement is the effect of exchange rate changes on cash and cash equivalents near the bottom. Exhibit 15C3-3, which provides the primary raw material for our analysis, is supplementary data on IBMs non-U.S. operations. Although much of this disclosure is not required (and, unfortunately, rarely provided), it enables us to obtain an understanding of the effect of changing exchange rates on the companys nancial condition and operating performance. The rst part of Exhibit 15C3-3 contains summarized balance sheets and income statements for IBMs non-U.S. operations. These data suggest steady growth in foreign revenue, net earnings, and net assets over the period 1988 to 1990. Comparison of these data with IBMs consolidated balance sheet and income statement indicates that foreign operations accounted for 60% of revenue for 1990. We return to the analysis of these data shortly.

ESTIMATION OF COMPOSITE EXCHANGE RATES


Before starting our analysis, we need data on the exchange rates that affect IBMs financial statements. For a company operating in a single currency (such as Foreign Subsidiary, in the chapter, or AFLAC in Case 15C1-1), we can obtain year-end and average exchange rates covering the period being analyzed. For a multinational such as IBM, we need data on many currencies and a breakdown of IBMs operations by functional currency. The latter is unavailable (to an external user), and the analysis of many currencies is very time-consuming.1 We need a shortcut.

In some cases, annual reports for foreign subsidiaries of multinational companies are available, either because of local ling requirements or subsidiary nancing. These reports can shed light on signicant foreign operations. However, these reports are generally prepared in local currencies according to local accounting standards, not in U.S. dollars under U.S. GAAP. In some cases, reports are available only in the local language, further hampering use. Nonetheless, when a company has one or a few highly signicant foreign subsidiaries, the subsidiary annual report may provide insights not available from the parents consolidated nancial statements.

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ESTIMATION OF COMPOSITE EXCHANGE RATES

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EXHIBIT 15C3-1. IBM Balance Sheet At December 31: (Dollars in millions) Assets Current Assets Cash Cash equivalents Marketable securities, at cost, which approximates market Notes and accounts receivabletrade, net of allowances Other accounts receivable Inventories Prepaid expenses and other current assets 1990 1989

$ 1,189 2,664 698 20,988 1,656 10,108 1,617 38,920

741 2,959 1,261 18,866 1,298 9,463 1,287 35,875 48,410 23,467 24,943

Plant, Rental Machines, and Other Property Less: Accumulated depreciation

53,659 26,418 27,241

Investments and Other Assets: Software, less accumulated amortization (1990, $5,873; 1989, $4,824) Investments and sundry assets

4,099 17,308 21,407 $87,568

3,293 13,623 16,916 $77,734

Liabilities and Stockholders Equity Current Liabilities: Taxes Short-term debt Accounts payable Compensation and benets Deferred income Other accrued expenses and liabilities

$ 3,159 7,602 3,367 3,014 2,506 5,628 25,276

$ 2,699 5,892 3,167 2,797 1,365 5,780 21,700 10,825 3,420 3,280

Long-Term Debt Other Liabilities Deferred Income Taxes Stockholders Equity: Capital stock, par value $1.25 per share Shares authorized: 750,000,000 Issues: 1990571,618,795; 1989574,775,560 Retained earnings Translation adjustments

11,943 3,656 3,861

6,357

6,341

33,234 3,266 42,857 25 42,832 $87,568

30,477 1,698 38,516 7 38,509 $77,734

Less: Treasury stock, at cost (Shares: 1990227,604; 198975,723)

Source: IBM Corporation, 1990 Annual Report.

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EXHIBIT 15C3-2. IBM Statement of Cash Flows For the Year Ended December 31:

CASE 15-3 IBM

ANALYSIS OF EXCHANGE RATE EFFECTS: MULTIPLE CURRENCIES

1990

1989

1988

(Dollars in millions) Cash Flow from Operating Activities: Net earnings Adjustments to reconcile net earnings to cash provided from operating activities: Depreciation Amortization of software Loss (gain) on disposition of investment assets (Increase) in accounts receivable Decrease (increase) in inventory (Increase) in other assets Increase in accounts payable Increase in other liabilities Net cash provided from operating activities Cash Flow from Investing Activities: Payments for plant, rental machines, and other property Proceeds from disposition of plant, rental machines, and other property Investment in software Purchases of marketable securities and other investments Proceeds from marketable securities and other investments Net cash used in investing activities Cash Flow from Financing Activities: Proceeds from new debt Payments to settle debt Short-term borrowings less than 90 daysnet Payments to employee stock plansnet Payments to purchase and retire capital stock Cash dividends paid Net cash used in nancing activities Effects of Exchange Rate Changes on Cash and Cash Equivalents Net Change in Cash and Cash Equivalents Cash and Cash Equivalents at January 1 Cash and Cash Equivalents at December 31 Supplemental Data: Cash paid during the year for: Income taxes Interest
Source: IBM Corporation, 1990 Annual Report.

$ 6,020 4,217 1,086 32 (2,077) 17 (3,136) 293 1,020 7,472

$ 3,758 4,240 1,185 (74) (2,647) (29) (1,674) 870 1,743 7,372

$ 5,806 3,871 893 (133) (2,322) (1,232) (1,587) 265 519 6,080

(6,509) 804 (1,892) (1,234) 1,687 (7,144)

(6,414) 544 (1,679) (1,391) 1,860 (7,080)

(5,390) 409 (1,318) (2,555) 4,734 (4,120)

4,676 (3,683) 1,966 (76) (415) (2,774) (306) 131 153 3,700 $ 3,853

6,471 (2,768) 228 (29) (1,759) (2,752) (609) (158) (475) 4,175 $ 3,700

4,540 (3,007) 1,028 (11) (992) (2,609) (1,051) (201) 708 3,467 $ 4,175

$ 3,315 $ 2,165

$ 3,071 $ 1,605

$ 3,405 $ 1,440

Fortunately, there are indices of the value of the U.S. dollar against a basket of foreign currencies, normally computed on a trade-weighted basis. Using such a series for IBM requires us to make the assumption that IBMs business has the same currency mix (distribution over various currencies) as U.S. trade ows. Although that assumption might be untenable for a smaller company with more limited foreign operations, it appears reasonable for a giant multinational such as IBM. Exhibit 15C3-4 shows average and year-end exchange rates for the period covered by our analysis.

BALANCE SHEET EFFECTS

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EXHIBIT 15C3-3. IBM Data on Non-U.S. Operations Non-U.S. Operations (Dollars in millions) At end of year: Net assets employed: Current assets Current liabilities Working capital Plant, rental machines, and other property, net Investments and other assets 1990 1989 1988

$24,337 15,917 8,420 11,628 9,077 29,125

$20,361 12,124 8,237 9,879 6,822 24,938 3,358 2,607 1,814 7,779 $17,159 167,291

$20,005 11,481 8,524 9,354 5,251 23,129 2,340 2,505 1,580 6,425 $16,704 163,904

Long-term debt Other liabilities Deferred income taxes

5,060 2,699 2,381 10,140

Net assets employed Number of employees For the year: Revenue Earnings before income taxes Provision for income taxes Net earnings Investment in plant, rental machines, and other property

$18,985 168,283

$41,886 $ 7,844 3,270 $ 4,574

$36,965 $ 7,496 3,388 $ 4,108

$34,361 $ 7,088 3,009 $ 4,079

$ 3,020

$ 2,514

$ 2,389

1988 net earnings before cumulative effect of accounting change for income taxes.

Non-U.S. subsidiaries which operate in a local currency environment account for approximately 90% of the companys non-U.S. revenue. The remaining 10% of the companys non-U.S. revenue is from subsidiaries and branches which operate in U.S. dollars or whose economic environment is highly inationary. As the value of the dollar weakens, net assets recorded in local currencies translate into more U.S. dollars than they would have at the previous years rates. Conversely, as the dollar becomes stronger, net assets recorded in local currencies translate into fewer U.S. dollars than they would have at the previous years rates. The translation adjustments, resulting from the translation of net assets, amounted to $3,266 million at December 31, 1990, $1,698 million at December 31, 1989, and $1,917 million at December 31, 1988. The changes in translation adjustments since the end of 1988 are a reection of the strengthening of the dollar in 1989 and the weakening of the dollar in 1990.
Source: IBM Corporation, 1990 Annual Report.

BALANCE SHEET EFFECTS


Exhibit 15C3-3 states that IBM had non-U.S. net assets of approximately $19 billion. What functional currencies did the company use to account for its foreign operations? The exhibit reports that
non-U.S. subsidiaries which operate in a local currency environment account for approximately 90% of the companys non-U.S. revenue. The remaining 10% . . . is from subsidiaries and branches which operate in U.S. dollars or whose economic environment is highly inationary.

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CASE 15-3 IBM

ANALYSIS OF EXCHANGE RATE EFFECTS: MULTIPLE CURRENCIES

EXHIBIT 15C3-4 Dollars Trade-Weighted Exchange Index, 1988 to 1990 (1973 100) December 31 1988 1989 1990 Index 92.8 93.7 83.7 Average Rates for Year, 1980 to 1990 Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Index 87.4 103.4 116.6 125.3 138.2 143.0 112.2 96.9 92.7 98.6 89.1

Sources: Economic Report of the President, February 1991 (annual data) and Federal Reserve Bank of St. Louis (December 31 data).

In other words, the local currency is the functional currency for 90% of IBMs foreign operations. The U.S. dollar is the functional currency for the remainder, including subsidiaries operating in hyperinationary economies. Assuming that the 90% gure applies equally to the balance sheet, we conclude that IBM had net assets in nondollar functional currencies of $17.086 billion (90% of total nondollar net assets of $18.985 billion) at December 31, 1990. The corresponding gures for year-end 1989 and 1988 were $15.443 billion (0.90 $17.159 billion) and $15.034 billion (0.90 $16.704 billion), respectively. These amounts represent IBMs exposure to changes in exchange rates under SFAS 52. Translation gains and losses resulting from exchange rate uctuation have been accumulated as a component of stockholders equity, in accordance with SFAS 52. The text of Exhibit 15C3-3 gives us the cumulative translation adjustments at each year-end: December 31 1988 1989 1990 Cumulative Translation Adjustments $1.917 billion 1.698 3.266

These calculations enable us to compute the actual increase in IBMs foreign net assets in functional currencies. By taking the reported change and subtracting the effects of translation (change in accumulated adjustment), we get the real change ($ in millions): Year 1989 1990 Reported $ 455 1,826 Translation $ (219) 1,568 Real $674 258

From the reported change, it appears that IBMs foreign net assets increased more rapidly in 1990 than 1989. The reality is that the large 1990 increase was mostly due to the appreciation of foreign currencies against the dollar; before translation (in real terms), the 1989 increase was larger.

BALANCE SHEET EFFECTS

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The year-to-year change in the cumulative translation adjustment account is the effect of translation for each year. Compare those changes with IBMs exposure: 1989: $1.698 billion $1.917 billion $15.034 billion $3.266 billion $1.698 billion 1990: $15.443 billion 1.46% 10.15%

These calculations reveal that the IBM-weighted functional currency composite declined by 1.46% against the dollar in 1989 and rose by 10.15% against the dollar in 1990.2 Turning to our trade-weighted index in Exhibit 15C3-4, we see that the percentage changes are 1989: 1990: 1.0% 11.9%

These changes approximate the IBM-weighted changes, reassuring us that our index is a good proxy. But when possible, we use the IBM-weighted index that we have now derived. First, consider the companys inventories. Exhibit 15C3-3 does not break out non-U.S. inventory, so we must assume that inventories are a constant percentage of current assets.3 At December 31, 1989, consolidated inventories were 26.4% of consolidated current assets (Exhibit 15C3-1). We assume that non-U.S. inventories also were 26.4% of non-U.S. current assets of $20.361 billion or $5.375 billion, of which $4.838 billion (90%) were in nondollar functional currencies. Applying the IBM-weighted exchange rate change of 10.15% results in an estimated increase in non-U.S. inventories of $491 million due to changing exchange rates. This accounts for most of the $645 million ($10.108 billion$9.463 billion) increase in IBMs consolidated inventories during 1990 (data from Exhibit 15C3-1). These calculations suggest that most of the 1990 inventory increase was due to the impact of changing exchange rates rather than to operating changes. We can conrm this result from the companys cash ow statement. In Exhibit 15C3-2, we nd that IBMs inventory change, excluding the effect of translation, was a decrease of $17 million, suggesting that the true effect of exchange rate changes was $662 million [$645 million actual change less ( $17 million) real change].4 Although our estimated effect of $491 million is not equal to the true effect of $662 million for 1990, they are not unreasonably far apart. Clearly, our assumptions did not precisely hold. But even if we did not have the true gure, our estimate would still have told us that IBMs inventory increase in 1990 was mostly due to currency effects rather than operating causes. It is this conclusion that makes the analysis worthwhile. This technique, although superuous when the cash ow statement excludes the impact of exchange rate changes, is useful when cash ow statements (such as those for non-U.S. rms) are not adjusted to exclude that impact. We can perform this same analysis for IBMs xed assets. Exhibit 15C3-3 shows that nonU.S. xed assets were $9.879 billion; we estimate that $8.891 billion (90% of $9.879 billion) was in nondollar functional currencies. The estimated effect of currency changes is $902 million (10.15% of $8.891 billion). The actual impact of currency changes on xed assets was disclosed in IBMs 10-K report in Schedules V and VI. These reconciliations of xed assets (gross) and accumulated depreciation reveal that translation increased xed assets by $963 million ($2,143 million for gross xed assets less $1,180 million for accumulated depreciation). Again, our estimate is approximately correct, despite the assumptions required. Consolidated net xed assets rose by $2.298 billion in 1990 (Exhibit 15C3-1), or 9.2%. Nearly half the gain resulted from exchange rate changes rather than new investment. Even if the 10-K data had not been available (Schedules V and VI are no longer required), we would have the same knowledge.

Perceptive readers will note that we have omitted the effect of changing exchange rates on the increase in IBMs net assets in functional currencies. Given the small change in those assets (in functional currency terms) over the period 1988 to 1990, we have opted for simplication. 3 IBM uses the FIFO inventory method worldwide. For companies with signicant LIFO inventories, this calculation should be made on a FIFO basis by adding back the LIFO reserve (see Chapter 6). 4 This computation, and similar computations in this case, are possible only because IBM made no purchase method acquisition during 1990. Chapter 14 discusses the impact of purchase method acquisitions on the statement of cash ows.

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INCOME STATEMENT EFFECTS

CASE 15-3 IBM

ANALYSIS OF EXCHANGE RATE EFFECTS: MULTIPLE CURRENCIES

Turning to the income data (Exhibit 15C3-3), we note that IBM had revenues of $41.886 billion in currencies other than the dollar, an increase of 13.3% from the 1989 level of $36.965 billion. On the surface, it appears that the 1990 gain in foreign sales was much larger than the 1989 increase (up 7.6% from the 1988 level of $34.361 billion). However, analysis reveals that exchange rate effects distort the data. In 1990, non-U.S. sales of $37.697 billion (90% of $41.886) were in operations with nondollar functional currencies (FC) (with the remainder in operations with nondollar local currencies but the dollar as functional currency). These revenues (and all expenses) were translated into dollars at the average rate for 1990. Using the data in Exhibits 15C3-3 and 15C3-4, we can compute the effect of rate changes for each year: ($ in millions) 1988 Non-U.S. revenues ($, Exhibit 15C3-3) Non-$ FC revenues ($, 90%) % Increase Dollar index (Exhibit 15C3-4) FC revenues % Increase $34,361 30,925 92.7 FC 28,667 1989 $36,965 33,268 +7.6% 98.6 FC 32,802 +14.4% 1990 $41,886 37,697 +13.3% 89.1 FC 33,588 +2.4%

The last entry, FC revenues, is an articial index, derived by multiplying estimated non-$ FC revenues by the dollar index.5 The result is a measure of revenue from which the impact of changes in the value of the dollar has been removed. As a result, we can estimate the real change in foreign revenues. We nd that the decline in the value of the dollar accounted for most of the gain in foreign revenues in 1990; the increase is only 2.4% when that factor is removed. Conversely (since the dollar rose in value in 1989), the real (FC) gain is 14.4% as compared with a gain of 7.6% in dollars. The rise in the dollar in 1989 resulted in a smaller percentage sales gain in dollars than local currencies. (These calculations assume that local currency prices were unaffected by exchange rate changes.) This exercise, therefore, approximates the impact of changing exchange rates on IBMs nondollar revenues. A similar calculation approximates the effect on net income. IBMs annual report to shareholders provides virtually no disclosure of this impact. Exhibit 15C3-5 contains the result of this analysis for the 11-year period 1980 to 1990.6 Comparison of the reported data with the adjusted data reveals differences that are quite significant. The year-to-year percentage changes in both revenues and pretax income are, in most years, quite different after adjustment for changes in the value of the dollar. We have already

5 We must use the index because we do not have average IBM weights, only year-end to year-end data. As we have shown that the index tracked the IBM weights well, we can use it to examine the trend of revenues and pretax income. 6 The analysis in Exhibit 15C3-5 uses total non-U.S. sales rather than the proportion for which IBM uses nondollar functional currencies. This proportion has declined over the 1980 to 1990 period, but the disclosure on this point is vague. For simplicity and because we believe the analysis would not be signicantly affected, we omit that step in our analysis. In principle, it is preferable to use only sales in nondollar functional currencies, as in the 1988 to 1990 computations above. Although other foreign sales are also affected by exchange rate changes, there is an important difference. Foreign sales for which the dollar is the functional currency are likely to be in hyperinationary countries or where local selling prices are the local currency equivalent of dollar prices. In these cases, changes in exchange rates may affect volume but do not affect dollar prices; they do not create income statement distortion as discussed in this section. In addition, the index derived from changes in the cumulative translation adjustment is not applicable to these situations. In practice, however, the proportion of sales for which the dollar is the functional currency is rarely available and, therefore, the analyst must use total foreign sales for analytic purposes.

INCOME STATEMENT EFFECTS

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EXHIBIT 15C3-5 Analysis of IBMs Foreign Operations, 1980 to 1990 Year Revenues % Change Pretax Income % Change

Reported Data ($U.S. in millions) 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 $U.S. 13,787 13,982 15,336 17,053 18,566 21,545 25,888 29,280 34,361 36,965 41,886 1.4% 9.7 11.2 8.9 16.0 20.2 13.1 17.4 7.6 13.3 $U.S. 2,772 2,664 3,226 3,841 4,640 5,546 5,871 5,683 7,088 7,496 7,844 3.9% 21.1 19.1 20.8 19.5 5.9 3.2 24.7 5.8 4.6

Adjusted Data (FC Units in Millions) 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 FC 12,050 14,457 17,882 21,367 25,658 30,809 29,046 28,372 31,853 36,447 37,320 20.0% 23.7 19.5 20.1 20.1 5.7 2.3 12.3 14.4 2.4 FC 2,423 2,755 3,762 4,813 6,412 7,931 6,587 5,507 6,571 7,391 6,989 13.7% 36.6 27.9 33.2 23.7 16.9 16.4 19.3 12.5 5.4

discussed the impact on the period 1988 to 1990. For a broader perspective, we have summarized the data for the entire period: Percentage Changes in IBM Foreign Results, 1980 to 1990 Revenues Period 198085 198590 198090 Reported 56.3% 94.4 203.8 Adjusted 155.7% 21.1 209.7 Pretax Income Reported 100.1% 41.4 183.0 Adjusted 227.3% 11.9 188.4

Source: Data in Exhibit 15C3-5.

Over the entire ten years, the reported and adjusted trends are quite similar. As the dollar showed a very small increase in value over the period, we conclude that local currency revenue growth was only slightly greater than revenue growth reported in dollars. But for the two subperiods, the adjusted data tell a completely different story from the reported data. During the period 1980 to 1985, the value of the dollar rose sharply; the data in Exhibit 15C3-4 show that the average value of the dollar in 1985 was 63.6% higher in 1985 than 1980 (143.0/87.4 1.636). Thus, revenues and earnings in foreign currencies were continuously devalued when translated into dollars. The growth in revenues during this period was 155.7% in local currencies, but only 56.3% after translation into dollars. Pretax income was similarly devalued; the local currency growth was 227.3%, whereas the dollar growth was only 100.1%. The individual year-to-year changes also reect the impact of the strengthening dollar. In 1981, for example, reported pretax income declined by 3.9%; after adjustment, there was a gain

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CASE 15-3 IBM

ANALYSIS OF EXCHANGE RATE EFFECTS: MULTIPLE CURRENCIES

of 13.7%. In every year during the period 1980 to 1985, the performance of IBMs foreign operations was better in local currencies than U.S. dollars. During the second half of the decade, 1985 to 1990, the impact of exchange rates reversed. The value of the dollar declined in most years, and by 1990 it had returned to a level very close to 1980. The declining value of the dollar inated foreign currency revenues and income when translated into dollars. Over the 1985 to 1990 period, IBMs foreign revenues (in dollars) increased by 94.4%, higher growth than in the 1980 to 1985 period. The adjusted data suggest that the reverse was true; IBMs local currency revenues grew by only 21.1% over the second half of the decade, a marked slowing from the 155.7% growth during the rst half. Although the decline of the dollar was not consistent, some of the individual year data echo this conclusion. In both 1986 and 1987, foreign revenues (in dollars) rose sharply, suggesting favorable performance trends. The adjusted data show that, for both years, foreign currency revenues declined. The pretax income data also appear signicantly different after adjustment for changes in the value of the dollar. Over the period 1985 to 1990, foreign pretax earnings rose by 41.4% in dollars, but declined by 11.9% in local currencies. The years 1986 and 1990 are the clearest examples of this effect in individual years: In both cases, pretax income rose in dollars but declined in local currencies. It is important to caution, however, that this analysis makes a crucial assumptionthat IBMs foreign operations were unaffected by exchange rate changes. For some rms, selling prices (and, therefore, revenues and earnings) are affected by variations in exchange rates, which impact the cost of imported components, and the prices of competitive products. We cannot assume that local currency results are always independent of exchange rates. Nonetheless, it is apparent that the rising value of the dollar during the 1980 to 1985 period disguised the excellent performance of IBMs foreign operations. It is equally clear that the dollar decline during the second half of the decade masked the deterioration of the operating performance of the companys foreign subsidiaries. These conclusions show that analysis of a multinational enterprise is seriously decient unless the impact of changing exchange rates is taken into account. Despite the approximations and assumptions required, the analyst gains important insights into operating trends and can use these to question management more perceptively about its real operating performance.

RATIO EFFECTS
The impact of foreign currency changes on IBMs nancial ratios is hard to determine because of inadequate data. Since IBM uses functional currencies other than the U.S. dollar for 90% of its non-U.S. operations, we can conclude that income statement ratios in dollars largely replicate the local currency data. This would also be true of ratios using only balance sheet data, such as the current or debt-to-equity ratios. The increased importance of foreign operations in 1990, resulting from the weakness of the dollar, gave foreign operations more weight in the consolidated total in 1990 than 1989. Without details of the income statement and balance sheet for foreign operations, we cannot easily tell which ratios are improved (or worsened) by this effect.7

CONCLUDING COMMENTS
As stated at the outset, the analysis of IBM was made possible by the voluntary disclosures (the rst part of Exhibit 15C3-3) regarding its non-U.S. operations. Few companies provide similar data; IBM stopped providing extensive disclosures after its 1991 Annual Report. Why, then, have we devoted a case to this analysis? Our major objective is to illustrate how changing currency rates distort nancial statements in the context of a real company. The analysis issues exist for all companies with signicant foreign operations. Our goal is to enable analysts and other readers of this text to apply portions of this analysis of IBM to other companies.
7

By using cash ow data and the technique previously employed to estimate the effect of exchange rate changes on various balance sheet and income accounts, we can approximate ratios for IBMs foreign operations.

CONCLUDING COMMENTS

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Required: Note: Make the simplifying assumption that IBM uses local currencies as the functional currency for all foreign subsidiaries. 1. Using Exhibit 15C3-3, the balance sheet and income statement for IBMs non-U.S. operations after translation to U.S. dollars: (a) Convert the 1989 and 1990 balance sheets to FC units. (b) Convert the 1990 income statement to FC units. (c) Using only FC net income, try to reconcile the change in FC equity (net assets) during 1990. Provide one possible reason for the discrepancy. 2. Exhibit 15C3-3 states that IBM invested $3,020 million in plant, rental machine, and other properties during 1990. Calculate the amount in FC units. Using this result, estimate depreciation expense (in FC units) for IBMs non-U.S. operations. 3. [Cash ow analysis of IBM foreign operations] (a) Assume that cash is 5% of the current assets shown in Exhibit 15C3-3. Prepare a 1990 cash ow statement in FC units for IBMs non-U.S. operations. (b) Convert the FC unit cash ow statement prepared in part (a) to a U.S. dollar cash ow statement. (c) (i) Compute the percentage of IBMs 1990 consolidated cash from operations that came from its non-U.S. operations. (ii) Compute the percentage of IBMs 1990 consolidated borrowings made by its non-U.S. operations. (iii) Compute the percentage of IBMs 1990 investment in xed assets that took place in its non-U.S. operations. (iv) Discuss how your answers to parts (i) through (iii) contribute to your understanding of the importance of IBMs non-U.S. operations to the company. (v) Discuss the limitations of your answers to parts (i) through (iii). (d) Using the cash ow data calculated in part (c) estimate the effect of exchange rate changes on cash and cash equivalents. Compare your results to the amount shown in IBMs statement of cash ows (Exhibit 15C3-2).