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Chapter 4

Implementing Accounting Analysis

Question 1. Use the templates in Tables 4-1, 4-2, and 4-3 to recast the financial
statements for Amazon.com.

Questions arise about several classifications: (a) fulfillment costs – these are viewed as
cost of sales for most retailers; (b) stock option costs – these are probably for senior
management and hence should probably be classified as SG&A; and (c) in the cash flow
statement gains and losses on currency translations (shown at the end of the statement are
shown as operating factors that imply that cash from operations in the standardized
format does not equate to that reported by the firm.

Income Statement Standardization


Classifications 2002 2001 2000
Sales Net sales $3,932,936 $3,122,433 $2,761,983
Cost of Sales Cost of sales 2,940,318 2,323,875 2,106,206
Gross profit 992,618 798,558 655,777
Operating expenses:
Cost of Sales Fulfillment 392,467 374,250 414,509
SG&A Marketing 125,383 138,283 179,980
SG&A Technology and content 215,617 241,165 269,326
SG&A General and administrative 79,049 89,862 108,962
SG&A Stock-based compensation 68,927 4,637 24,797
Amortization of goodwill and
Other Operating Expense other intangibles 5,478 181,033 321,772
Other Operating Expense Restructuring-related and other 41,573 181,585 200,311
Total operating expenses $928,494 $1,210,815 $1,519,657
Income (loss) from operations 64,124 -412,257 -863,880
Interest Income Interest income 23,687 29,103 40,821
Interest Expense Interest expense -142,925 -139,232 -130,921
Other Income Other income (expense), net 5,623 -1,900 -10,058
Other Income Other gains (losses), net -96,273 -2,141 -142,639
Total non-operating expenses, net ($209,888) ($114,170) ($242,797)
Loss before equity in losses of equity-
method investees -145,764 -526,427 -1,106,677
Equity in losses of equity-method
Other Income investees, net -4,169 -30,327 -304,596
Loss before change in accounting
principle ($149,933) ($556,754) ($1,411,273)
Cumulative effect of change in
Unusual Loss (after tax) accounting principle 801 -10,523  
Net Income Net loss ($149,132) ($567,277) ($1,411,273)

Balance Sheet Standardization


Classifications Year Beginning January 1, ($000's) 2003 2002
Current assets:
Cash and Marketable Securities Cash and cash equivalents $738,254 $540,282
Cash and Marketable Securities Marketable securities 562,715 456,303
Inventory Inventories 202,425 143,722
Accounts receivable, net & other
Accounts Receivable current assets 112,282 67,613
Total current assets $1,615,676 $1,207,920
Long-Term Tangible Assets Fixed assets, net 239,398 271,751
Long-Term Intangible Assets Goodwill, net 70,811 45,367
Long-Term Intangible Assets Other intangibles, net 3,460 34,382
Other Long-Term Assets Other equity investments 15,442 28,359
Other Long-Term Assets Other assets 45,662 49,768
Total Assets Total assets $1,990,449 $1,637,547
LIABILITIES AND STOCKHOLDERS'
DEFICIT
Current liabilities:
Accounts Payable Accounts payable 618,128 444,748
Accrued expenses and other current
Other Current Liabilities liabilities 314,935 305,064
Other Current Liabilities Unearned revenue 47,916 87,978
Other Current Liabilities Interest payable 71,661 68,632
Current portion of long-term debt
Short-Term Debt and other 13,318 14,992
Total current liabilities $1,065,958 $921,414
Long-Term Debt Long-term debt and other 2,277,305 2,156,133
Shareholders’ deficit    
Common stock, $0.01 par value:
Authorized shares 5,000,000
Issued and outstanding shares --
387,906 and 373,218 shares,
respectively 3,879 3,732
Additional paid-in capital $1,649,946 $1,462,769
Deferred stock-based
compensation -6,591 -9,853
Accumulated other
comprehensive income (loss) 9,662 -36,070
Accumulated deficit -3,009,710 -2,860,578
Common Shareholders' Equity Total stockholders' deficit ($1,352,814) ($1,440,000)
Total liabilities and stockholders' deficit 1,990,449 1,637,547
Cash Flow Statement Standardization

Classifications Year Ended December 31, ($000's) 2002 2001 2000


OPERATING ACTIVITIES:
Net Income Net loss ($149,132) ($567,277) ($1,411,273)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Long-term operating accruals-depreciation and Depreciation of fixed assets and other
amortization amortization 82,274 84,709 84,460
Long-term operating accruals-other Stock-based compensation 68,927 4,637 24,797
Long-term operating accruals-other Equity in losses of equity-method investees 4,169 30,327 304,596
Long-term operating accruals-depreciation and Amortization of goodwill and other
amortization intangibles 5,478 181,033 321,772
Long-term operating accruals-other Non-cash restructuring-related and other 3,470 73,293 200,311
Non-operating losses (gains) Gain on sale of marketable securities, net -5,700 -1,335 -280
Non-operating losses (gains) Other losses (gains), net 96,273 2,141 142,639
Long-term operating accruals-other Non-cash interest expense and other 29,586 26,629 24,766
Cumulative effect of change in accounting
Non-operating losses (gains) principle -801 10,523
Changes in operating assets and liabilities:
Net investment/liquidation of op. wc Inventories -51,303 30,628 46,083
Net investment/liquidation of op. wc Accounts receivable, net and other cur. assets -32,948 20,732 -8,585
Net investment/liquidation of op. wc Accounts payable 156,542 -44,438 22,357
Net investment/liquidation of op. wc Accrued expenses and other current liabilities 4,491 50,031 93,967
Net investment/liquidation of op. wc Unearned revenue 95,404 114,738 97,818
Net investment/liquidation of op. wc Amortization of previously unearned revenue -135,466 -135,808 -108,211
Net investment/liquidation of op. wc Interest payable 3,027 -345 34,341
Net cash provided by (used in) operating activities $174,291 ($119,782) ($130,442)
Classifications Year Ended December 31, ($000's) 2002 2001 2000
INVESTING ACTIVITIES:
Sales/maturities of marketable securities and
investments 553,289 370,377 545,724
Purchases of marketable securities -635,810 -567,152 -184,455
Purchases of fixed assets, including internal-use
software -39,163 -50,321 -134,758
Investments (including in equity-method investees)   -6,198 -62,533
Net (investment in) or liquidation of operating
long-term assets Net cash provided by (used in) investing activities ($121,684) ($253,294) $163,978
FINANCING ACTIVITIES:
Net stock (repurchase) or issuance Proceeds from exercise of stock options and other 121,689 16,625 44,697
Proceeds from issuance of common stock, net of
Net stock (repurchase) or issuance issue costs 99,831
Net debt (repayment) or issuance Proceeds from long-term debt and other 10,000 681,499
Net debt (repayment) or issuance Repayment of capital lease obligations and other -14,795 -19,575 -16,927
Net debt (repayment) or issuance Financing costs     -16,122
Net cash provided by financing activities $106,894 $106,881 $693,147
Effect of exchange-rate changes on cash and cash
Non-operating losses (gains) equivalents 38,471 -15,958 -37,557
Net increase (decrease) in cash and cash equivalents $197,972 ($282,153) $689,126
The resulting standardized financial statements are as follows:

Amazon
Year Beginning January 1, ($000's) 2002 2003
Beginning Balance Sheet

Assets
Cash and Marketable Securities 996,585.0 1,300,969.0
Accounts Receivable 67,613.0 112,282.0
Inventory 143,722.0 202,425.0
Other Current Assets 0.0 0.0
Total Current Assets 1,207,920.0 1,615,676.0

Long-Term Tangible Assets 271,751.0 239,398.0


Long-Term Intangible Assets 79,749.0 74,271.0
Other Long-Term Assets 78,127.0 61,104.0
Total Long-Term Assets 429,627.0 374,773.0
Total Assets 1,637,547.0 1,990,449.0

Accounts Payable 444,748.0 618,128.0


Short-Term Debt 14,992.0 13,318.0
Other Current Liabilities 461,674.0 434,512.0
Total Current Liabilities 921,414.0 1,065,958.0

Long-Term Debt 2,156,133.0 2,277,305.0


Deferred Taxes 0.0 0.0

Other Long-Term Liabilities (non-interest bearing) 0.0 0.0


Total Long-Term Liabilities 2,156,133.0 2,277,305.0
Total Liabilities 3,077,547.0 3,343,263.0

Minority Interest 0.0 0.0

Shareholders' Equity
Preferred Stock 0.0 0.0
Common Shareholders' Equity -1,440,000.0 -1,352,814.0
Total Shareholders' Equity -1,440,000.0 -1,352,814.0

Total Liabilities and Shareholders' Equity 1,637,547.0 1,990,449.0


Amazon

Year Ended December 31, ($000's) 2000 2001 2002

Income Statement
Sales 2,761,983.0 3,122,433.0 3,932,936.0
Cost of Sales 2,520,715.0 2,698,125.0 3,332,785.0
Gross Profit 241,268.0 424,308.0 600,151.0
SG&A 583,065.0 473,947.0 488,976.0

Other Operating Expense 522,083.0 362,618.0 47,051.0


Operating Income -863,880.0 -412,257.0 64,124.0
Investment Income 0.0 0.0 0.0
Other Income, net of Other Expense (457,293.0) (34,368.0) (94,819.0)
Other Income -457,293.0 -34,368.0 -94,819.0
Other Expense 0.0 0.0 0.0
Net Interest Expense (Income) 90,100.0 110,129.0 119,238.0
Interest Income 40,821.0 29,103.0 23,687.0
Interest Expense 130,921.0 139,232.0 142,925.0
Minority Interest 0.0 0.0 0.0
Pre-Tax Income -1,411,273.0 -556,754.0 -149,933.0
Tax Expense 0.0 0.0 0.0
Unusual Gains, Net of Unusual Losses (after tax) 0.0 -10,523.0 801.0
Net Income -1,411,273.0 -567,277.0 -149,132.0
Preferred Dividends 0.0 0.0 0.0
Net Income to Common -1,411,273.0 -567,277.0 -149,132.0
Amazon

Year Ended December 31, ($000's) 2000 2001 2002

Statement of Cash Flows


Net Income (1,411,273.0) (567,277.0) (149,132.0)

After-tax net interest expense (income) 90,100.0 110,129.0 119,238.0


Non-operating losses (gains) 104,802.0 (4,629.0) 128,243.0
Long-term operating accruals 960,702.0 400,628.0 193,904.0
Depreciation and amortization 406,232.0 265,742.0 87,752.0
Other 554,470.0 134,886.0 106,152.0

(255,669.0) (61,149.0) 292,253.0


Operating cash flow before working capital investments

177,770.0 35,538.0 39,747.0


Net (investments in) or liquidation of operating working capital

(77,899.0) (25,611.0) 332,000.0


Operating cash flow before investment in long-term assets

163,978.0 (253,294.0) (121,684.0)


Net (investment in) or liquidation of operating long-term assets

86,079.0 (278,905.0) 210,316.0


Free cash flow available to debt and equity

After-tax net interest expense (income) 90,100.0 110,129.0 119,238.0


Net debt (repayment) or issuance 648,450.0 (9,575.0) (14,795.0)
Free cash flow available to equity 644,429.0 (398,609.0) 76,283.0

Dividend (payments) 0.0 0.0 0.0


Net stock (repurchase) or issuance 44,697.0 116,456.0 121,689.0

Net increase (decrease) in cash balance 689,126.0 (282,153.0) 197,972.0


Question 2. Refer to the Lucent example on delaying write-downs of current assets.
How much excess inventory do you estimate Lucent is holding in
December 2000 if the firm’s optimal Days Inventory is 58 days? Calculate
the inventory impairment charge for Lucent if 50% of this excess
inventory
is deemed to be worthless. Record the changes to Lucent’s financial
statements from adjusting for this impairment.

Lucent’s inventory on December 31, 2000 was $6.9 billion, equivalent to 107 days. If the
optimal days inventory was 58 days, the value of the optimal inventory would be
58/107*$6.9 billion, or $3.7 billion. If 50% of the gap (50%*(6.9-3.7)=$1.6 billion was
impaired, the changes to Lucent’s financial statements would be as follows:

Adjustment
Liabilities &
($millions) Assets
Equity
Balance Sheet
Inventory -1,600
Deferred Tax Liability -560
Common Shareholders’ Equity -1,040
Income Statement
Cost of Sales +1,600
Tax Expense -560
Net Income -1,040

Question 3. Acceptance Insurance Companies Inc. underwrites and sells specialty


property and casualty insurance. The company is the third largest writer
of crop insurance products in the United States. In its 1998 10-K report to
the SEC, it discloses the following information on the loss reserves
created
for claims originating in 1990:

Cumulative net liability paid through: 12/31/90


One year later 40.6
Two years later 70.8
Three years later 88.5
Four years later 101.2
Five years later 107.5
Six years later 109.7
Seven years later 111.4
Eight years later 111.8
Net reserves reestimated as of:
One year later 100.3
Two years later 102.3
Three years later 107.4
Four years later 110.7
Five years later 112.7
Six years later 112.0
Seven years later 112.5
Eight years later 113.4
Net cumulative redundancy (deficiency) - 13.4

What was the initial estimate for loss reserves originating in 1990? How
has the firm updated its estimate of this obligation over time? What
liability remains for 1990 claims As a financial analyst, what question
would you have for the CFO on its 1990 liability?

The estimate for the 1990 liability made in 1990 was $100.3 million. As can be seen from
the reestimated liability amounts, this forecast has been steadily increased over the last
eight years to $113.4 million. The unpaid liability in 1998 is the total estimated liability
of $113.4 million less the liability paid at the end of 1998, $111.8, a balance of $1.6
million.

The key questions that an analyst would have about the 1990 liability relates to the fact
that the company ex post underestimated the its amount. This could arise for a number of
reasons – management are not very good at making these types of forecasts (not a good
sign since that is the key risk for the business), the firm was ex post unlucky, or
management have been managing the liability for regulatory or other purposes. Questions
that could shed some light on this include:

a. What were the reasons for the under-estimate of the 1990 liability? Did the same
factors affect other firms in the industry? Did the same pattern occur for estimates of
liability for other years?
b. Is the firm in good standing with the industry regulators? If not, what are the
regulators’ concerns? Do these give management an incentive to manage liabilities?
c. How is the firm performing in the stock market? Is there strong pressure on
management to deliver earnings performance either from potential acquirers, or the
board of directors? Is the firm likely to be accessing the capital market in the near
future?
Question 4.  AMR, American Airlines provides the following footnote information on 
        its capital and operating leases:

AMR's subsidiaries lease various types of equipment and property,


primarily aircraft and airport facilities. Lease terms vary but are
generally 10 to 25 years for aircraft. The future minimum lease
payments required under capital leases, together with the present value
of such payments, and future minimum lease payments required under
operating leases that have initial or remaining non-cancelable lease
terms in excess of one year as of December 31, 2001, were (in millions):

Year Ending December 31, Capital Leases Operating


2002 $326 $1,336
2003 243 1,276
2004 295 1,199
2005 229 1,138
2006 231 1,073
2007 and subsequent 1,233 11,639
2,557 $17,661
Less amount representing interest 817
Present value of net minimum lease $1,740
What interest rate does AMR use to capitalize its capital leases? Use this rate to
capitalize AMR’s operating leases at December 31, 2001. Record the adjustment
to AMR’s balance sheet to reflect the capitalization of operating leases. How
would this reporting change affect AMR’s Income Statement in 2002?

To estimate the interest rate that equates the value of capital lease payments to the
reported value of $1,740, students have to first make an assumption about how to split the
2007 and subsequent payments over time. If the payments occur evenly over the next six
years ($205.5 per year), the appropriate interest rate is 7.7%:
Reported Assumed
PV factor PV
Year Payment Payment
2002 $326 $326.0 0.9285 $303
2003 243 243.0 0.8621 209
2004 295 295.0 0.8005 236
2005 229 229.0 0.7433 170
2006 231 231.0 0.6901 159
2007 and subsequent 1,233 205.5 0.6408 132
205.5 0.5950 122
205.5 0.5524 114
205.5 0.5129 105
205.5 0.4763 98
205.5 0.4422 91
1,740

For operating leases, the average contract life appears to be longer. This is based on the
large balloon value for lease payments beyond 2007. If we assume that the average life of
the operating leases is 16 years, the present value of operating leases using a 7.7%
discount rate is as follows:

Reported Assumed
Year PV factor PV
Payment Payment
2002 $1,336 $1,336 0.9311 $1,244
2003 1,276 1,276 0.8669 1,106
2004 1,199 1,199 0.8072 968
2005 1,138 1,138 0.7516 855
2006 1,073 1,073 0.6998 751
2007 and subsequent 11,639 1,058 0.6516 689
$17,661 1,058 0.6067 642
1,058 0.5649 598
1,058 0.5260 557
1,058 0.4897 518
1,058 0.4560 482
1,058 0.4246 449
1,058 0.3953 418
1,058 0.3681 389
1,058 0.3427 363
1,058 0.3191 338
$10,368
The adjusted balance sheet for December 31, 2001 is as follows:

Adjustment December
31, 2001
Liabilities
($ millions) Assets
& Equity
Balance Sheet
Long-term Tangible Assets +10,368
Long-Term Debt +10,368

For the year ended December 31, 2002, the impact on net income would be as follows:

Income Statement
Cost of Sales: Lease expense -1,336
Depreciation expense (1/16*$10,368) +648
Interest Expense (.077*$10.368) +798
Tax Expense (35% of sum) -39
Net Income -71

Question 5. What approaches would you use to estimate the value of brands? What
assumptions underlie these approaches? As a financial analyst, what would you use to
assess whether the brand value of 1.575 billion pounds reported by Cadbury
Schweppes in 1997 was a reasonable reflection of the future benefits from these
brands? What questions would you raise with the firm’s CFO about the firm’s brand
assets?

As was mentioned in the chapter, in the United Kingdom firms like Cadbury Schweppes
are allowed to report brand value on their balance sheets. Generally, these firms must
hire independent valuation experts to value the brand assets. The valuation experts may
use any of the following approaches to estimate brand value. First, the experts might
estimate brand value based on the premium price that branded products command over
their non-branded counterparts. Given the firm’s sales volume of branded products, the
expected life of the brand, and a discount rate, it is possible to estimate the present value
of any price premium over the foreseeable future. Second, a brand could be valued based
on the present value of advertising costs required to convert a non-branded product into a
branded product. Third, brand valuation experts could estimate value based on industry
practice, amounts that were paid for similar branded products in recent mergers and
acquisition transactions.
Several assumptions underlie the above brand valuation approaches. First, under the price
premium approach, brands will only have value if: (a) the consumers will continue to
value branded products more highly than non-branded in the foreseeable future, (b)
companies continue to maintain the value of their brands, despite potential competition,
and (c) premium prices are accompanied by higher advertising outlays, so that brands
create economic value for shareholders.

The second and third valuation approaches requires that the valuer assume that the
product being valued requires the same level of advertising or has the same relative value
as comparable brands used to benchmark the valuation.

A financial analyst should question the 1.575 billion pounds reported on Cadbury
Schweppes’ financials. Is this outlay reasonable or excessive compared to similar
companies that report brands on their balance sheet? How was the figure calculated? Was
an independent valuation expert hired? Did the independent auditors question the
amount? Has the amount grown or declined in the past couple years? Why? What
activities and expenditures did Cadbury incur to maintain the brand name?

Question 6. As the CFO of a company, what indicators would you look at to assess
whether your firm’s long-term assets were impaired? What approaches could be used,
either by management or an independent valuation firm, to assess the dollar value of
any asset impairment? As a financial analyst, what indicators would you look at to
assess whether a firm’s long-term assets were impaired? What questions would you
raise with the firm’s CFO about any charges taken for asset impairment?

Impairment is the loss of a significant portion of the utility of an asset through casualty,
obsolescence, or lack of demand for the asset’s service. A loss should be recognized
when an asset suffers permanent impairment. A CFO should look for evidence of such
potential impairment of the firm’s assets.

Assessing the dollar value of an asset impairment:


If the current book value exceeds the sum of the expected undiscounted future cash
flows, an asset impairment has occurred. The conservatism principle requires that a firm
write down its asset to its then current fair value, which is the market value of the asset.
The accounting transaction would show the asset and any contra-asset being written off,
the new market value of the asset being recorded, and the residual amount recorded as a
loss due to impairment of the asset. Hence, the loss amount that appears in the income
statement is the difference between the old net book value and the current market value.

On the other hand, if the firm cannot assess the current market value of the asset, the
impairment loss amount is calculated as the difference between the old net book value
and the expected net present value of the future cash flows.

Example: Darden Restaurants Inc.


“Darden recorded asset impairment charges of $158,987 in 1997, representing the
difference between fair value and carrying value of impaired assets. The asset impairment
charges relate to low-performing restaurant properties and other long-lived assets. Fair
value is generally determined based on appraisals or sales prices of comparable
properties.”

A financial analyst should look for the same types of indicators that the CFO looks for, of
course understanding that the CFO, as an insider of the company, has a great deal more
information about such issues as casualty, obsolescence, or lack of demand of certain
assets. Indicators of impairment include sustained declines in a firm’s and/or industry’s
return on assets relative to its cost of capital, recognition of asset impairments by
competitors, and the introduction of new technologies that make existing assets obsolete.

The financial analyst should question the CFO concerning the cause of the asset
impairment. Was the loss due to casualty, obsolescence, or lack of demand? If not, what
did cause the loss? The analyst should inquire about the method the impairment of asset
loss was calculated? If it was calculated using a fair market value, how was the fair value
determined?

Question 7. The cigarette industry is subject to litigation for health hazards posed by
its products. The industry has been negotiating a settlement of these
claims with state and federal governments. As the CFO for Philip Morris,
one of the larger firms in the industry, what information would you report
to investors in the annual report on the firm’s litigation risks? How would
you assess whether the firm should record a liability for this risk, and if
so, how would you assess the value of this liability? As a financial analyst
following Philip Morris, what questions would you raise with the CEO
over the firm’s litigation liability?

The litigation risks that Philip Morris faces are reported as contingent liabilities defined
in SFAS 5. Contingent liabilities arise from events or circumstances occurring before the
balance sheet date, here the filling of lawsuits against Philip Morris, the resolution of
which is contingent upon a future event, the court ruling or a potential settlement.

The accounting treatment for Philip Morris’ pending litigation depends on the likelihood
that it will lose or settle the lawsuit and whether the amount of damages the firm will be
liable for is reasonably estimable. Accounting rules on required disclosure for these types
of liabilities depend on whether the loss is probable, reasonable possible, or remote.

Probable – If it is probable that Philip Morris will lose the lawsuit and the loss can be
reasonably estimated, the estimated loss should be reported as a charge to income and as
a liability. If the loss is probable but no specific reasonable estimate can be agreed upon,
rather only a range of possible losses can be estimated without any amount being more
reasonable than the other, the amount that should be accrued by Philip Morris is the
minimum amount in the range. Note that this contradicts the conservatism principle of
accounting.
Reasonably possible - Where the likelihood that Philip Morris will lose the lawsuit is
reasonably possible, no amount needs to be accrued as a liability but the nature of the suit
needs to be disclosed in the footnotes of the annual report.

Remote - Where the likelihood that Philip Morris will lose the lawsuit is remote, no
amount needs to be recorded as a liability nor is any disclosure required in the footnotes
of the annual report.

The CFO of Philip Morris faces a dilemma. It is widely recognized that the company
faces huge potential litigation costs. It is therefore important that the CFO confront these
issues in the annual report, explaining the nature of the suits, the amount of the claims
against the company, and the company’s plans for responding to the suits. To fail to
provide adequate disclosure about these issues, potentially leads investors to fear the
worst, reducing the value of the firm’s stock. However, the CFO also has to be careful not
to make statements that could undermine the company’s legal position or its negotiating
position with the claimants.

As a financial analyst following Philip Morris I would push the CEO for as much
information as possible about the likelihood that the company will lose the lawsuits or
come to a settlement with the claimants. This requires that the analysts understand the
law and case history for the industry. It also requires information on the company’s plans
to either take the cases to trial or to settle, as well as the costs of a legal battle, the
company’s assessment of its chances of victory, and the costs of a potential settlement.
In addition, given that the company’s stock is depressed due to fears of losing these suits,
analysts can probe management on what actions the company is considering to increase
the stock price and maximize shareholder value. For example, is Philip Morris
considering spinning off the Kraft food division? What is the firm doing to maintain
employee moral and retain Kraft executives that might be inclined to accept jobs with
similar food companies not tied to tobacco products? Is Philip Morris considering raising
the annual dividend payment to compensate shareholders for lower stock prices?

Question 8. Refer to the General Motors example on post-retirement benefits.


Show the adjustments that would be required to record the full amount
of the unfunded post-retirement benefit on December 31, 2000. What
factors account for the difference between the adjustments to Common
Shareholders’ Equity on December 31, 2000 and 2001?

As reported in the text, the funding status for 2000 and 2001 are as follows:

($millions) 2001 2000


Funded status $(47,544) $(43,165)
Unrecognized actuarial loss 8,902 6,444
Unrecognized prior service cost 249 207
Net amount recognized $(38,393) $(36,514)
The unfunded portion of the post-retirement benefit on December 31, 2000 is therefore
$6651 (6,444+207). These arise from prior adjustments to actuarial assumptions that are
smoothed over time, and to prior increase in the firm’s benefit, which are also smoothed
over time. The adjustment to the balance sheet required to record this additional liability
is therefore as follows:

($millions) Adjustment
Balance Sheet
Long-term Debt $6,444
Deferred Tax Liability (35%) (2,255)
Common Shareholders’ Equity $(4,189)
The primary differences in unfunded obligation arises from increased obligations
from adjusting actuarial assumptions used to estimate the liability (e.g. worker lives,
retirement ages, health care inflation, etc). These adjustments are reported gradually
over time, rather than shown as an immediate hit to the financial statements when the
assumptions are revised.

Question 9. Intel reports the following information on its stock options incentive
programs in its December 31, 2001 financial statement footnotes.

The company's stock option plans are accounted for under the intrinsic
value recognition and measurement principles of APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and related
Interpretations. As the exercise price of all options granted under these
plans was equal to the market price of the underlying common stock on
the grant date, no stock-based employee compensation cost, other than
acquisition-related compensation, is recognized in net income. The
following table illustrates the effect on net income and earnings per
share if the company had applied the fair value recognition provisions
of SFAS No. 123, "Accounting for Stock-Based Compensation," to
employee stock benefits, including shares issued under the stock option
plans and under the company's Stock Participation Plan, collectively
called "options."
(In Millions) 2002 2001 2000
Net income, as reported $ 3,117 $ 1,291 $ 10,535
Less: Total stock-based 1,170 1,037 836
employee compensation
expense determined under
the fair value method for
all awards, net of tax
Pro-forma net income $ 1,947 $ 254 $ 9,699

Record the adjustments to the financial statements required to show an


expense for stock options under the fair value method for 2001 and 2002.
Intel reports that its marginal tax rate is 35%.

Intel's total stock-based employee compensation expense under the fair value method
for all awards is expressed net of tax. In order to record the adjustments to the
financial statements, including the impact on Tax Expense and Deferred Tax Liability,
first restate the 2001 and 2002 stock option expenses as pre-tax figures. The pre-tax
expenses for 2001 and 2002 are $1,594.4 (1.037/.65) and $1,800 (1,170/.65),
respectively. Since we are not provided with information about how Intel allocates
this expense throughout the income statement, we will assume that 100% of the stock
option expense is allocated to SG&A. The increase in SG&A expense in each year
will lower Intel's Tax Expense in 2001 and 2002 by $558.4 (.35*1,595.4) and $630
(.35*1,800), respectively. The difference between the increase in SG&A expense and
reduction in tax expense is charged to Net Income. On the balance sheet, the
reduction in Tax Expense is reflected by an offset to Intel's Deferred Tax Liability,
and the reduction in Net Income is mirrored by a reduction in Common Shareholders'
Equity.
The adjustments to the financial statements would therefore be as follows:

Adj. for Dec.31, 2001 Adj. for Dec.31, 2001


Liabilities & Liabilities &
($millions) Assets Equity Assets Equity

Balance Sheet

Deferred Taxes -558.4 -630

Common Shareholders'
Equity 558.4 630

Adjustments Adjustments
for Dec.31, for Dec.31,
2001 2002
Income Statement
SG&A 1,595.40 1,800

Tax Expense -558.4 -630

Net Income -1,037 -1,170

Question 10. Refer to the Lufthansa example on asset depreciation estimates.


What adjustments would be required if Lufthansa’s aircraft
depreciation were computed using an average life of 25 years and
salvage value of 5% (instead of the reported values of 12 years and
15%)? Show the adjustments to the 2000 and 2001 balance sheets, and
to the 2001 income statement.

If Lufthansa used a 25-year average aircraft life (rather than 12 years) and a 5%
salvage value (rather than 15%), the depreciable cost of its fleet would have been Euro
12,900.62m (13,579.6*(1-.05)). The annual depreciation rate would have been 4%,
implying that given the average age of its fleet (6.9 years), Accumulated Depreciation
would have been Euro 3,560.57m (6.9*.04*12,900.62), versus the reported Euro
6,679.6. Consequently, the company's Long-term Tangible Assets would have
increased by Euro 3,119.03m. Given the 35% marginal tax rate, this adjustment to
Long-term Tangible Assets would have required offsetting adjustments of Euro
1,091.66m (.35*3,119.03) to the Deferred Tax Liability and Euro 2,027.37m
(.65*3,119.03) to Common Shareholders' Equity.
Assuming that Euro 1,021.5m net new aircraft purchased in 2001 were acquired
throughout the year, the Depreciation & Amortization expense for 2001 would have
been Euro 535.43m (.04*(12,900.62+(1021.5*.95)/2)), versus the Euro 865m reported
by the company. Thus, Depreciation & Amortization Expense would decline by Euro
329.57m. Given the 35% tax rate for 2001, the Tax Expense for the year would
increase by Euro 115.35m. On the balance sheet, these changes would increase Long-
term Tangible Assets by Euro 329.57m, increase Deferred Tax Liability by Euro
115.35m, and increase Common Shareholders' Equity by Euro 214.22m.

The adjustments to the financial statements would therefore be as follows:


                                               Adj. for Dec.31, 2001                 Adj. for Dec.31, 2001
Liabilities & Liabilities &
(EUR millions) Assets Equity Assets Equity

Balance Sheet

Long-term Tangible Assets +3119.03 +3119.03


+329.57

Deferred Tax Liability +1091.66 +1091.66


+115.35

Common Shareholders'
Equity +2027.37 +2027.37
+214.22

Adj for Dec.31,


2001
Income Statement
Depreciation & Amoritzation Expense -329.57

Tax Expense +115.35

Net Income +214.22

Question 11. In early 2003, Bristol-Myers Squibb announced that it would have to
restate its financial statements as a result of stuffing as much as
$3.35 billion worth of products into wholesalers' warehouses from
1999 through 2001. The company’s sales and cost of sales during this
period was as follows:

2001 2000 1999


Net sales $ 18,139 $ 17,695 $ 16,502
Cost of products 5,454 4,729 4,458
sold
The company’s marginal tax rate during the three years was 35%.
What adjustments are required to correct Bristol-Myers Squibb’s
balance sheet for December 31, 2001? What assumptions underlie your
adjustments? How would you expect the adjustments to affect Bristol-
Myers Squibb’s performance in the coming few years?
In the Bristol-Myers Squibb example, the firm's Accounts Receivable, Sales, and Income
are overstated. To correct for this problem in the 2001 balance sheet, Accounts
Receivable needs to decline by $3.35 billion, and Inventory needs to increase by an
amount that reflects the effect of gross profit margins. The Inventory adjustment can be
achieved by multiplying the Accounts Receivable adjustment by the ratio of Cost of Sales
to Sales. The increase in Inventory is approximately $1 billion (3.35 * (5,454/18,139)).
The $3.35 billion decline in Accounts Receivable is mirrored by a decline in 2001 Sales
of the same amount. Similarly, the $1 billion increase in Inventory reflecting unsold
product corresponds to a decline in the Cost of Sales by the same amount. Multiplying
the -$2.35 difference between the reduction in Sales and the reduction in Cost of Sales by
the firm's 35% marginal tax rate results in a $.82 billion reduction in Tax Expense, with
the remaining $1.53 billion ($2.35-.82) difference being charged to Net Income. The
decline in both Tax Expense and in Net Income are reflected in the Balance Sheet by a
decline in Deferred Taxes and in Common Shareholders' Equity, respectively.

Adjustments for Dec.31, 2001


($billions) Assets Liabilities & Equity

Balance Sheet

Accounts Receivable -3.35


Inventory +1.00
Deferred Taxes -.82
Common Shareholders' Equity -1.53

Income Statement Adjustments for Dec.31, 2001

Sales -3.35
Cost of Sales -1.00
Tax Expense -.82

Net Income -1.53