Web Case 1

Hewlett-Packard: A Pack Ard (of) Mess

Hewlett-Packard Corporation (HP) designs, manufactures, and distributes

computer systems and imaging and printing products and offers information technology
services. Before performing a financial statement analysis, it is appropriate that we adjust
the financial statements for items considered unusual or nonrecurring and therefore
unlikely to affect ongoing assessments of the firm. This case asks you to identify data
issues in the financial statements and notes of HP and to make appropriate adjustments.
The statutory income tax rate is 35 percent. You may find it useful to use FSAP4, a
financial statement analysis program available in the website for this book. You should
download the file “HPReported” available on the website and load it into FSAP following
the commands on the menu. You can then make changes to the financial statements that
you consider appropriate. Note that changes made do not automatically work through
each of the financial statements. For pedagogical reasons, you must identify the impact
of any adjustment on all three financial statements and decide if and how you would
adjust for it.

Exhibit 1
Hewlett-Packard — Income Statements
(amounts in millions)

Fiscal Year Ended October 31

1999 2000 2001 2002
Revenues……………………………………………. $43,047 $49,734 $45,376 $56,657
Net Investment Gains (losses)………………………. 31 41 (455) (106)
Cost of Goods Sold………………………………….. (29,720) (34,864) (33,240) (41,390)
Selling and Administrative………………………….. (6,479) (7,195) (7,085) (9,019)
Research and Development…………………………. (2,440) (2,646) (2,670) (3,312)
Restructuring Charges*………………………………. -- (102) (384) (1,780)
Litigation Settlement*……………………………….. -- -- (400) --
Interest……………………………………………….. (202) (257) (266) (206)
In-Process Research and Development Charge*……… -- -- -- (793)
Acquisition-Related Charge*…………………………. -- -- -- (701)
Intangibles Amortization*…………………………….. (43) (86) (174) (402)
Income Taxes………………………………………… (1,090) (1,064) (78) 129
Income from Continuing Operations………………… $ 3,104 $ 3,561 $ 624 $ (923)
Income from Discontinued Operations (net)…………. 387 136 -- --
Extraordinary Gain on Bond Retirement (net)……….. -- -- 56 20
Cumulative Effect of Change in Accounting
Principles…………………………………………….. -- -- (272) --
Net Income……………………………………………. $ 3,491 $ 3,697 $ 408 $ (903)
*
Included on the line, Other Expense and Losses II, in the FSAP data file.
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Exhibit 2
Hewlett-Packard — Balance Sheets
(amounts in millions)

October 31
Assets 1998 1999 2000 2001 2002
Cash…………………………………… $ 4,046 $ 5,411 $ 3,415 $ 4,197 $11,192
Marketable Securities…………………. 21 179 592 139 237
Accounts Receivable…………………. 6,598 7,847 8,568 6,671 11,909
Inventories……………………………. 4,699 4,863 5,699 5,204 5,797
Prepayments………………………….. 3,143 3,342 4,970 5,094 6,940
Total Current Assets……………… $18,507 $21,642 $23,244 $21,305 $36,075
Property, Plant, and Equipment (cost). $ 9,038 $ 8,920 $ 9,505 $ 9,808 $12,536
Accumulated Depreciation…………… (4,161) (4,587) (5,005) (5,411) (5,612)
Property, Plant, and Equipment (net)… $ 4,877 $ 4,333 $ 4,500 $ 4,397 $ 6,924
Net Assets of Discontinued Business… $ 3,084 $ 3,533 $ 0 $ 0 $ 0
Investments and Other Assets………… $ 5,240 $ 5,789 $ 6,265 $ 6,882 $27,711
Total Assets……………………….. $31,708 $35,297 $34,009 $32,584 $70,710
Liabilities and Shareholders' Equity
Accounts Payable…………………….. $ 2,768 $ 3,517 $ 5,049 $ 3,791 $ 7,012
Notes Payable………………………… 1,245 3,105 1,555 1,722 1,793
Other Current Liabilities…………….. 7,861 7,699 8,593 8,451 15,505
Total Current Liabilities………….. $11,874 $14,321 $15,197 $13,964 $24,310
Long-term Debt……………………… 2,063 1,764 3,402 3,729 6,035
Other Noncurrent Liabilities………… 852 917 1,201 938 4,103
Total Liabilities………………….. $14,789 $17,002 $19,800 $18,631 $34,448
Common Stock……………………… $ 10 $ 10 $ 19 $ 19 $ 30
Additional Paid-in Capital………….. 0 0 0 0 24,660
Accumulated Other Comprehensive
Income…………………………. 0 0 93 41 (401)
Retained Earnings…………………. 16,909 18,285 14,097 13,893 11,973
Total Shareholders' Equity…….. $16,919 $18,295 $14,209 $13,953 $36,262
Total Liabilities and
Shareholders' Equity…………. $31,708 $35,297 $34,009 $32,584 $70,710

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Exhibit 3
Hewlett-Packard — Statements of Cash Flows
(amounts in millions)

Fiscal Year Ended October 31

Operations 1999 2000 2001 2002
Income from Continuing Operations………………… $ 3,104 $ 3,561 $ 624 $ (923)
Depreciation and Amortization………………………. 1,316 1,368 1,369 2,119
Net Investment (Gains) and Losses………………….. (31) (41) 455 106
Tax Benefit of Employee Stock Plans……………….. 289 495 16 21
Deferred Taxes on Earnings…………………………. (171) (689) (970) (351)
Other Addbacks……………………………………… -- -- 491 3,932
Other Subtractions…………………………………… (76) (514) -- --
(Increase) Decrease in Accounts Receivable………… (1,637) (1,312) 566 899
(Increase) Decrease in Inventories…………………… (171) (845) 1,096 765
Increase (Decrease) in Accounts Payable…………… 751 1,544 (1,249) 395
Increase (Decrease) in Other Current
Assets and Current Liabilities…………………….. (278) (107) 163 (1,519)
Cash Flow from Continuing Operations………. $ 3,096 $ 3,460 $2,561 $ 5,444
Cash Flow from Discontinued Operations…….. $ (62) $ 965 $ -- $ --
Investing
Sale of Marketable Securities……………………….. $1,048 $ 1,004 $ 742 $ 381
Acquisition of Marketable Securities……………….. (1,015) (1,131) (434) (351)
Sale of Property, Plant, and Equipment…………….. 542 420 447 362
Acquisition of Property, Plant and Equipment……… (1,134) (1,737) (1,527) (1,710)
Other Investing Transactions……………………….. (69) 318 223 4,436
Cash Flow from Investing……………………… $ (628) $(1,126) $ (549) $ 3,118

Financing
Increase (Decrease) in Short-term Borrowing……… $ 2,399 $(1,297) $ 303 $ (2,402)
Increase in Long-term Borrowing………………….. 240 1,936 904 2,529
Issue of Common Stock…………………………….. 660 748 354 377
Decrease in Long-term Borrowing…………………. (1,047) (474) (930) (599)
Acquisition of Common Stock……………………… (2,643) (5,570) (1,240) (671)
Dividends…………………………………………… (650) (638) (621) (801)
Cash Flow from Financing……………………… $(1,041) $(5,295) $(1,230) $ (1,567)

Change in Cash……………………………………… $ 1,365 $(1,996) $ 782 $ 6,995

Cash - Beginning of Year…………………………… 4,046 5,411 3,415 4,197
Cash - End of Year………………………………….. $ 5,411 $ 3,415 $ 4,197 $11,192

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Selected Notes to the Financial Statements

Note 1: Revenue Recognition: HP recognizes revenue at the time of delivery of products to

customers, at the same time providing for estimated returns. HP recognizes revenues from
services when it performs the services. HP adopted Securities and Exchange Commission Staff
Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” in fiscal 2001.
Prior to adoption, HP had recognized revenues at the time of shipment to customers. The
cumulative effect of changing the method of revenue recognition was $272 million, net of $108
million of income taxes, and is recognized in earnings for 2001.

Note 2: Corporate Acquisition: HP acquired Compaq Computer Company (Compaq) on May 3,

2002 for $24,170 million. HP gave shares of its common stock in exchange for the outstanding
common stock of Compaq and accounted for the acquisition using the purchase method. In
addition to allocating the purchase price to the tangible assets acquired and the liabilities
assumed, HP allocated $793 million to in-process technologies, $3,517 million to intangibles
with a limited life (for example, customer lists, distribution agreements, developed
technologies, and patents), $1,422 million to intangibles with an indefinite life (the Compaq
brand name), and $14,450 to goodwill. GAAP requires firms to expense amounts allocated to
in-process technologies in the year acquired. Charges related to in-process technologies
acquired do not give rise to tax benefits in any year. During fiscal 2002 and prior years, GAAP
also required firms to amortize all intangibles acquired in corporate acquisitions prior to July 1,
2001 over their expected useful lives. Such amortization does not give rise to a tax benefit.
GAAP will no longer require firms to amortize goodwill and other intangibles with indefinite
lives beginning with its fiscal 2003 year. GAAP does require firms, however, to test such assets
annually for possible impairment and to recognize impairments losses if they arise. Firms must
continue to amortize intangibles with limited lives. To consummate the acquisition of Compaq,
HP incurred acquisition-related charges totaling $701 million ($529 million after taxes) for
professional services, advertising, and proxy solicitation costs.

Note 3: Restructuring Charge: In fiscal 2000, HP’s management approved “an enhanced early
retirement program designed to balance the workforce with HP’s long-term business strategy.”
HP recorded a restructuring charge of $102 million, making payments during the year to
employees accepting the offer of $76 million. HP’s management approved restructuring actions
in fiscal 2001 “to respond to the global economic downturn and to improve HP’s cost structure
by streamlining operations and prioritizing resources in strategic areas of HP’s business.” HP
recorded a restructuring charge of $384 million to reflect these actions. This charge consisted of
severance and other employee benefits related to the planned termination of approximately
7,500 employees, as well as costs related to the consolidation of excess facilities. As of the end
of fiscal 2001, HP has made payments of $264 million related to the restructuring and expected
to pay the remainder of the accrual in fiscal 2002. In fiscal 2002, HP recognized a $1,780
million restructuring charge prior to its acquisition of Compaq. The charge included employee
severance and early retirement benefits, costs of vacating duplicate facilities, and asset
impairment losses related to HP’s activities. Be the end of fiscal 2002, HP had made payments
of $502 million and incurred non-cash charges from asset writedowns of $650 million related to
this restructuring. In addition, Compaq made a provision for restructuring prior to its acquisition
by HP for the same types of items as HP. The provision totaled $960 million, which Compaq

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included in current and noncurrent liabilities on its balance sheet on the date of its acquisition
by HP. HP allocated a portion of the purchase price to this restructuring liability. During the
last six months of fiscal 2002, restructuring costs of $631 million related to the restructuring
were charged against these liabilities.

Note 4. Net Investment Gains and Losses: HP’s investments include debt and equity securities
in public and privately-held emerging technology companies. HP realized gains on sales of
these investments during fiscal 1999 of $31 million. It realized gains from sales of $104 million
in fiscal 2000, offset by impairment losses of $63 million. HP realized gains of $16 million in
fiscal 2001, offset by impairment losses of $471 million. It recognized impairment losses of
$106 million in fiscal 2002.

Note 5: Litigation Settlement: On June 4, 2001, HP and Pitney Bowes announced that they had
entered into agreements that resolved all pending patent litigation between the parties without
admission of infringement and in connection therewith HP paid Pitney Bowes $400 million in
cash on June 7, 2001.

Note 6: Discontinued Operations: On March 2, 1999, HP announced its intention to launch a

new company, Agilent Technologies, through a distribution of Agilent Technologies common
stock to HP shareholders in the form of a tax-free spinoff. Agilent Technologies comprises HP’s
former test and measurement business. HP distributed its interest in Agilent Technologies
through a dividend to HP shareholders on June 2, 2000, resulting in a $4.2 billion reduction of
retained earnings. HP reports Agilent Technologies as a discontinued operation prior to the
distribution.

Note 7: Early Extinguishment of Debt: HP occasionally repurchases its debt prior to maturity
based on its assessment of current market conditions and financing alternatives. During fiscal
2001, HP repurchased notes with a face value of $1.2 billion and a book value of $729 million,
resulting in an extraordinary gain of $56 million (net of related taxes of $33 million).
Repurchases during fiscal 2002 resulted in a gain of $20 million net or related taxes. Beginning
in 2003, firms will include gains and losses form early extinguishment of debt in income from
continuing operations instead of reporting it as an extraordinary item.

Note 8: Leases: HP has signed leases for various items of property and equipment. It accounts
for these leases as operating leases. Generally accepted accounting principles treat operating
leases as mutually unexecuted contracts and therefore do not report them in the balance sheet.
The income statement includes rent expense of $340 million in fiscal 1999, $325 million in
fiscal 2000, $354 million in fiscal 2001, and $566 million in fiscal 2002. The present value of
operating lease commitment when discounted at 8 percent are as follows: October 31, 1998:
$715 million; October 31, 1999: $640 million; October 31, 2000: $715 million; October 31,
2001: $720 million; October 31, 2002: $1,575 million.